John Flahive, Larry Dunn: Mellon Financial

Flahive and Dunn are part of Mellon's Private Wealth Management Group in Boston. Flahive oversees $17 billion in fixed income and has been at Mellon since 1994. Dunn manages $1.5 billion in government, agency and mortgage-backed securities and has worked at Mellon for 14 years. What should a bond salesman know about your strategy?

Flahive: We manage $17 billion in investment-grade bonds for private wealth clients, anything in investment-grade dollar-denominated fixed income, including corporates and mortgage-backed securities. We seek to produce consistency to our benchmark. As a result we own a bit of everything in the benchmark; it's rare that we would own nothing of something that's a big portion of the index. In taxable fixed income, we run Lehman Brothers Aggregate Bond Index and Lehman Intermediate Government/Credit money, as well as some money funds.

How are you trying to capture spreads within government bonds?

Dunn: One of the funds I manage is the Mellon Short-Term U.S. Government Securities Fund, which has $155-165 million. That fund has had a mild overweight to agency debt and a mild out-of-index position to MBS that had been as large as 25% of the fund's holdings. Now we're at more like 10% for MBS. Overall that fund is short duration, equivalent to a two-year note. It's hard to be long right now given that the Federal Reserve is pretty relentless.

At some point you have to ask how much spread tightening is left [within agencies]. If they get much tighter, you have to start justifying to your clients how you're providing yield by owning agencies. Also, agencies are falling as part of the Lehman 1-3 Government Index. Five years ago, Treasuries were around 55% and agencies were 45% of the index. Now Treasuries are 62% and agencies are 38% of the index.

Are you avoiding certain names within agencies due to headline risk?

Dunn: Given that agencies are 38% of the Lehman 1-3 Government Index and there are only four major issuers, it's hard to not own something of all the issuers. Even with Fannie Mae in the newspapers, the scope for playing one issuer against another is very small. It seems like nowadays when you get a headline, spreads don't seem to move very much because [market participants] yawn and say, 'Ok, when is this going to be over?'

 

Flahive: Our strategy is not to switch from one agency name to another. [Dunn] would not go from owning all Freddie Macs to all Fannie Maes. We want to have a good representation and flavorings for our clients given the benchmark.

Do you plan to invest in TIPS as inflation continues to rise?

Dunn: We tend to view TIPS as another spread sector. If you want to own TIPS versus nominal Treasuries, you should have a pretty serious conviction that they're the better value. Breakevens on Jan. '07s have moved from 240bps in late December/early January to 310bps as of [March 10 or 11]. So if you didn't buy TIPS then, you'd have to have a pretty big conviction to make the change now.

Flahive: If you're going to buy TIPS frankly you'd need good realized CPI in the next few years. Given our macro viewpoint, we don't see a big increase in headline inflation this year. Relative to nominal Treasuries, our weighting in TIPS is zero, but that could change. To go into TIPS we would want the [Consumer Price Index] to get to 3-3.5%.

What is your strategy in mortgages?

Dunn: We had bought five- and seven-year balloons [mortgages with a 30-year amortization schedule where bondholders are paid the principal at the end of five or seven years.] More recently we're looking to add high-coupon balloons. We want stuff where duration is not going to extend as much, although all mortgage products will extend duration.

As long as the Fed continues to tighten, we're more concerned about extension than prepayment risk. We're a little more concerned with extension risk than prepayment risk just because we've seen the mortgage component of the Lehman Ag extend from 2.25 years in mid-February to now just shy of 3.5 years. Specifically, the 30-year 5.5% have gone in duration from 2.2 years to four years. But if the 10-year went below 4%, we could see another refinancing wave.

Which broker-dealers do you prefer to work with?

Flahive: We deal with the top dealers around the country, but we also use Internet sites and technology to provide the best prices for our clients. [Thomson]TradeWeb on the taxable side has been continuing to grow in importance. What we see is more and more sectors getting a greater and greater use of platforms. There are more corporate bonds trading through there. Now it's trickling down to less homogeneous markets. There are half a dozen technologies now, but over time there will be fewer platforms.