Highmark Capital Management will swap 10% of its portfolio, or $200 million, from agencies into corporates and ABS, while shortening the duration, on the view that the yield curve will be steeper by year-end. Dick Grahman, portfolio manager with the San Francisco-based firm, says the economy will start to look brighter toward the end of the year, and an inflation premium will begin to be built into bond yields. The curve will steepen because, as the Federal Reserve holds down the short end, the long end will start to move up. He plans to deploy this strategy up to the end of the year, when he thinks rates may begin to move back up again. It may take a year and a half to two years before rates are high enough to buy back agency bonds, so he considers the trade a long-term shift in strategy.
Grahman says the shortening of the portfolio via the sale of three- to 10-year agencies bullet debentures into the one- to three-year corporate/ABS sectors follows a rationale of sacrificing some yield in order to preserve principal. On the other hand, the manager hopes to make up for the loss of yield via the rotation from agencies into spread products. The purchases will be equally divided between corporates and ABS. As an example, Grahman recently sold five-year Fannie Mae debentures with a 5.50% coupon. With the proceeds, he bought AAA-rated 4.68% of '05 ABS issued by Wells Fargo & Co. The ABS Wells Fargo bonds have an average maturity of '03, which means that the investor is expected to get half the principal by that year. Grahman explains that the bond is going to trade as if it was a 1.9-year corporate bond due to this average life feature, which is why he gains as much yield buying ABS as corporates. In addition, he bought Deutsche Bank (A1/AA-) 6.70%s of '06.
In general, Grahman buys single-A corporates across the board with no sector preference, but admits he likes financial companies for their actual yield. An example of a name he is interested in is Citigroup (Aa2/AA-) because the bond is attractively priced and offers good liquidity. For instance, he bought the Citigroup 6.45% notes of '02 at $102.08, and one of Citigroup's subsidiaries, Commercial Credit Co (Aa3/AA-) 6.875%s '02 at $102.42. As of last Tuesday, the bonds were offered at $102.47 and $101.97, respectively. He says the purchases offer the portfolio shorter maturities and even though those bonds are priced at a premium, the premium is a small price to pay for such high coupons since rates are presumably going to come down. Grahman manages a $2 billion portfolio whose asset allocation is 45% agencies debentures, 40% corporates and 15% ABS. With a 4.70-year duration, the fund is slightly shorter its benchmark, the Lehman Brothers aggregate index, whose duration is 4.78%.
