John Cerra: managing director, Richard Cheng, director, Stephen Liberatore, director, TIAA-CREF

Cerra, Cheng and Liberatore manage $10 billion in total return bond portfolios at TIAA-CREF. Cerra is in charge of broad strategic allocation from New York, while Cheng and Liberatore focus on the investment-grade corporate sector. They are based in New York and Charlotte, N.C., respectively.

What are some of your concerns in a rising-rate environment? Cerra: We've been continually worried about rising-rate issues. First of all, we've been seeing an increase in budget deficits. Eventually, it will cost more for the government to borrow money; it needs to straighten out economic issues. The government has not dealt with Medicare and Social Security issues yet. In a year with the upcoming election and concerns about terrorism, we've tried to build a convex portfolio by underweighting the mortgage sector. We're concerned about a lot of volatility. Numerically, volatility is very low, but by how my stomach feels, it's very high. It is a very tense time but we will continue to sit on that.

Liberatore: One of the things we've talked about we feel is specific to the corporate sector is it appears as though market volatility is low but depending on the situation, there's a lot of individual name volatility. You don't want to be too far from the index because of volatility in individual names.

Is event risk in corporates a big concern for you now?

Liberatore: Yes. When you're managing companies, as a bondholder, you're not their primary concern. During 2001-2002 there was a shift where companies were making sure their balance sheets improved. Now we're seeing an increase in share buybacks, dividends and acquisitions. There has been a shift from using cash for bondholders to shareholders.

Cheng: I agree. I'd add that TIAA-CREF is a leader in terms of keeping an eye on corporate governance. We have a team of respected analysts on our insurance accounts that we leverage. We've been able to avoid the blow-up credits over the past three to five years. We've played credit from the overweight position, but believe now credit has fully priced in the good news. We've expected spreads to widen but have been reluctant to play from under because technicals are so strong.

What's your strategy in this fully priced market? Are you considering using credit derivatives as a tool to short the market?

Cerra: At the moment we don't have the ability to use credit derivatives though we will probably use them in the future. We're also on the verge of using some of the exchange traded derivatives, but it won't change how we manage our portfolio. But I'd come back to the group and focus on how diversified [Cheng] keeps the corporate portfolio. With the assumption that the index will have some volatility, we've come to appreciate this as a strength of our portfolio.

Liberatore: I started in June and think [Cheng] has done an outstanding job of managing our corporates through some shaky times credit-wise. Back in 2001, people were very uninterested in smaller deals and names. They weren't interested in deals of the $500 million size, but he's done a great job of looking at diversification. We've benefited from not having 4-5% in one name. Cerra: With an increase in volatility, our being well diversified will help. Who knows if recent events are isolated or not? We're playing at the sector level, not individual names as much.

Which sectors are attractive now?

Cerra: Given the low level of Treasuries and increased volatility, we see a lot of relative value in callable agencies.

Cheng: The corporate sectors that have helped us perform are paper and packaging, utilities, natural gas and oil refining within the energy sector. Going forward, the higher beta names still have some juice. But the honeymoon in credit might be over. Some bad news may be priced into the nirvana. Late in November, we may see corporate credit come in. We've also been underweight sectors such as airlines. If you look through our portfolio, we only have one position in an airline. Liberatore: Our general view of the overall economy is negative. We've seen some data indicating the economy isn't that strong, especially at the consumer level. We haven't seen strong jobs growth, which would flow through at the bottom lines. Companies don't have pricing power right now. But a lot depends on a lot of factors, including the budget deficit, and if we can improve the pricing power of the dollar and reduce the cost of foreign imports. Also if consumers experience increases in disposable income, then they will accept increases in prices. But at times like these, the average consumer is not sure if wages are increasing. Consumer spending is a big driver of the overall general economy.

What kind of strategy are you executing in this tight market?

Cerra: [Cheng] mentioned the priced-to-perfection scenario. And as someone looking at various sectors, this notion creates a problem. I ask myself if I can own anything with this idea right now. There are strong reminders of the potential damages on the corporate side--a little hiccup has big repercussions. Now is a time when you should pull back to the core because something's not right. Given spreads are as tight as they are, there's a lot of hanging around home base and doing small trades to add a little value.

Cheng: You might be asking why are we playing corporate credit overweight then? We take pride in our analysis and we play credit from market weight to overweight. We think you can find growth in the corporate area. We also neglected to mention the wireless space. We're very comfortable in that space and think you can find value there. Some of the names we own still have some juice left, especially some of the higher beta names.

Liberatore: We've also looked a lot at yield curves. Less so than last year, but you can still take advantage of a name in curves. You can go from a 2014 in issue A to a 2013-12 and pick up z-spread by shorting up. That's one other way of picking up excess return.

Cheng: Overall, corporate credit is facing a situation where fundamentals and spreads don't match up. Spreads are too tight, but technicals are still strong. Managements have gotten balance sheets so strong; a lot of corporate issuers have a boatload of cash sitting on their balance sheets, which presents a risk they will do something.

Liberatore: Some people have assumed that meant debt has been paid down. There's been a run of saving up cash so that companies will have flexibility going forward. That's good from a credit position if the money's going to be used in a bondholder-friendly manner. But as companies shift to being more shareholder-focused it impacts their credit. There hasn't been a whole lot of debt pay down and the fundamentals don't match up to where everything is trading.