The Comfort of Bonds

Mason Street Select Bond Fund's Varun Mehta thinks we could still return to recession. Here are some of his top picks for tough times

Bond funds have enjoyed a nice upward run this year, providing some comfort for investors weary of the equity markets. But if you believe the economy will continue its current weakness, bond funds should remain a good investment, says portfolio manager Varun Mehta. With the latest U.S. economic data -- namely durable goods, consumer confidence and third-quarter gross domestic product ( GDP) -- coming in lower than expected, the market has been speculating that the Federal Reserve will cut interest rates at its Nov. 6 meeting.

Mehta, who runs the Mason Street Funds Select Bond Fund (MBDAX ), believes rates could decline in 2003 because of the economy's continuing weakness. He believes high-quality fixed-income securities could still be attractive, particularly U.S. Treasuries and corporate issues in the energy, defense, and consumer-products sectors.

Mehta attributes his fund's strong record to its focus on strong credit fundamentals and its avoidance of many of the decliners in areas such as the telecommunications and utilities sectors. For the 12-month period ended Sept. 30, Mason Street Select Bond Fund gained 11.6%, vs. 6.7% for the average intermediate-term high-quality bond fund. For the three-year period ended Sept. 30, the fund delivered an average annualized return of 10.4%, higher than the 8.1% gain for its peers. Mehta has managed the $75 million portfolio, which carries a 4-STARS overall ranking from Standard & Poor's, since its inception in March 1997.

Palash Ghosh of Standard & Poor's Fund Advisor recently spoke with Mehta about his fund's investment strategy, top holdings and portfolio reallocations. Edited excerpts from their conversation follow:

Q: What is your current asset allocation?


As of Sept. 30, we had 90.9% in bonds and 9.1% in cash. This is a core investment-grade bond portfolio of about 100 holdings, so we have a mix of government securities, corporate bonds, mortgage securities, and asset-backed securities. We typically don't invest in any junk bonds.

Q: How do you construct the portfolio?


We use a combination top-down/bottom-up methodology. The top-down side involves our views on the economy, monetary and fiscal policy, and inflation. We then determine parameters, such as total duration exposure, yield-curve exposure, etc., and our asset-allocation profile based on our macroeconomic outlook.

On the bottom-up side, our research staff does a detailed credit analysis on the corporate-bond portion of the fund. Within the government-bond segment, we basically invest in U.S. Treasuries. Among mortgage securities, we focus primarily on Government National Mortgage Assn. securities.

Overall, we currently have about a 40% risk-weight in corporate bonds, which represents an underweight (to the benchmark index); 15% in mortgage-backed securities, a neutral weight; and the remainder in government securities, an overweight.

Within the corporate sector, we focus on leverage, return-on-equity, and return-on-capital measures to determine companies we want to own. We look at liquidity as well. We want to make certain a company has sufficient liquidity so it isn't exposed to refinancing risks when it comes back to the market to raise money to pay off existing debt.

Within the mortgage sector, the focus is primarily on refinancing risk. Our government exposure is predicated on the shape of the U.S. yield curve.

Q: What are some of your top individual holdings?


As of Sept. 30: U.S. Treasurys, 41.4%; Federal National Mortgage Assn., 3.4%; Coca-Cola Enterprises CCE , 2.7%; GNMA, 2.7%, and Occidental Petroleum OXY , 6.75%.

Q: What is your fund's duration, average credit quality, and average maturity?


The average duration is about six years, which is longer than our benchmark, the Lehman Bros. Aggregate Bond Index. It is also longer than our universe of comparable bond funds, the Lipper Corporate A-Rated Debt Index, which has an average duration of 5.1 years.

Including the government Treasuries, the average credit quality would be AAA. Excluding the government securities, I would say it is an A+ ... The average maturity is roughly 11 years.

Q: Assets have been pouring into bond funds as stocks and interest rates have declined. Has your fund received a large cash flow this year?


We have been receiving quite a lot in new inflows this year. This is one of the reasons we currently have had a slightly higher cash stake.

Q: Why has the fund outperformed?


Broadly, our process involves avoiding downside credit risk. As a result, we haven't suffered from credit blow-ups. The list of U.S. companies that have had credit disasters spans the spectrum of American industry -- WorldCom WCOEQ , PG&E PCG , Qwest Communications Q , Dynegy DYN , Edison International EIX , Xcel Energy XEL , El Paso EP , and Sprint FON , to name a few. Thus, a large number of very large, well-capitalized companies, which were widely owned in the corporate-bond market, imploded this year.

We take companies' financials apart and really get into income statements, balance sheets, etc., to avoid these situations. We think too many bond managers emphasize sector exposure and benchmarking instead of focusing on underlying credit fundamentals.

In addition, we have been keeping a longer duration this year. We have taken advantage of declining interest rates, relative to our competitors and benchmarks, by taking on more interest-rate risk through buying long-term U.S. Treasuries. This has been the best-performing fixed-income asset class this year.

Q: Are there certain corporate sectors that you are overweighting?


We have a number of holdings in oil and gas concerns. Two that we like a lot are Occidental Petroleum OXY and Chevron CVX .

We are also overweight in the defense sector. We think this is a nice long-term play, with the U.S. government devoting more resources to the military. We especially like Raytheon RTN , a good turnaround story that is also cheaply priced. Another interesting company in defense is TRW TRW , which is actually divided 60%-40% between the auto-parts business and defense. But within the defense segment, it does a lot of work on missile-defense shields, which is a big priority for the Bush Administration.... TRW has been trading cheaply because of the weakness of its auto-parts division.

We have also been overweight in consumer products, which have provided a nice safe haven. In this sector, we particularly like Coca-Cola Enterprises, which markets and distributes Coca-Cola products. We think this is a cheaper way to play Coca Cola KO itself.

We also favor Anheuser-Busch BUD . Although I wouldn't call it a completely recession-proof company, it still possesses great fundamentals.

Although we've recently reduced our exposure in pharmaceuticals, it still remains an overweight position. Among our favorite core holdings is Merck MRK .

We also like certain electronic and electric-parts manufacturers like Emerson Electric EMR , Hubbell HUB.B , and Pall PLL , a filtration maker. Relative to how they are rated, these companies have excellent credit fundamentals.

In addition, Occidental Petroleum is rated Baa2, but we think it should have a credit rating of AA. The debt-to-market value of equity is 37%. Cash return-on-equity is an outstanding 13%. Return-on-capital is about 7%.

Q: What corporate sectors have you been avoiding or keeping underweight?


We are heavily underweight in telecoms. We like Alltel AT , however, which has a strong competitive position in the rural-telecom sector. It also has a solid financial profile from a bondholder's perspective.

We are also underweight in utilities. Credit issues have hammered this sector. In addition, we have largely avoided cable and media companies, but as advertising appears to be coming back, we may lift our stake to a neutral position. One media company we like is News Corp. NWS

Q: Tell me about your exposure to Treasury-Inflation Protected Securities (TIPS).


The 'real yield' on TIPS is too high now. The real yield correlates pretty well with gross domestic product growth. When GDP growth is weak, the real yield comes down. That translates into capital appreciation for TIPS. Earlier in the year, TIPS were yielding just north of 3.25%. We thought this was very attractive, since our outlook was that the economy would slow and real yields would come down. Subsequently, real yields have indeed declined quite a bit, but currently they're still at about 2.99%. Given that GDP growth projection for next year is between 1% and 2%, that real yield is too high. We still believe that TIPS are one of the best values in the fixed-income marketplace. TIPS helped the performance of our fund this year, but they have been a minor part of the portfolio.

Q: What about mortgage securities?


We have been reducing our exposure to mortgage-backed securities over the past two months or so because prepayments have spiked considerably and volatility has been rising since the end of June. Both of these are negative factors for mortgages. We had an overweight position in mortgage securities in the first half of the year, which helped the fund's returns. But because interest rates have remained so low, we pared back our stake in this area. This has worked out quite well since mortgage securities have seriously been underperforming Treasurys.

Q: How do you answer people who are cautious on bond funds and believe interest rates will surely rise next year?


Treasury interest rates look very low. However, regardless of where interest rates are relative to historical levels, one has to examine the fundamental components of interest rates.

The two main components are projected inflation and projected real economic growth. If you look at the producer-price index, we are in deflationary territory. If you look at the consumer price index, inflation is very low, and appears to be declining even further. Moreover, we are forecasting a slower economy going into 2003. In fact, we believe the chance of a recession in early 2003 is quite high. We have seen four consecutive quarters of declines in the leading economic indicators. All of this points to low interest rates going even lower.

Although the equity markets seem to have staged a bit of a rally over the last month, the macroeconomic data -- weak manufacturing, capital spending, corporate profitability, and slowdown in consumer spending -- all indicate an economic downturn going forward.

Edited by Karyn McCormack

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