How one pro nav­i­gates a bond mar­ket that looks like a minefield.

The Washington Post Sunday - - BUSINESS - BY JON­NELLE MARTE jon­nelle.marte@wash­post.com More at wash­ing­ton­post.com/ getthere

Safe. Steady. Sleepy. Those are the words in­vestors used to ut­ter when dis­cussing bonds.

But now that two global economies are on the brink of de­fault and much of the mar­ket is poised to lose value, the world of fixed in­come is look­ing more like a minefield.

If the Fed­eral Re­serve raises short-term in­ter­est rates this year as ex­pected, the move could set off a pe­riod of ris­ing in­ter­est rates that would lead to price drops for many— if not most— of to­day’s bonds.

Of course, fig­ur­ing out ex­actly when the bond mar­ket will turn is as risky as try­ing to time the stock mar­ket— and typ­i­cally a los­ing propo­si­tion. That’s why Elaine Stokes, a vice pres­i­dent at Bos­ton­based Loomis, Sayles& Co., a firm known for its global bond funds, isn’t stress­ing the tim­ing.

Af­ter cut­ting loose many of the long-term bonds that would suf­fer the most se­vere losses if rates rise— with some ex­cep­tions for cor­po­rate bonds— Stokes, co­man­ager of the flag­ship $23 bil­lion Loomis Sayles Bond Fund, is “sit­ting back at base camp” with ex­tra cash on hand, wait­ing for the mar­ket to read­just.

She re­cently spoke with The Washington Post about how in­vestors should nav­i­gate the bond mar­ket.

What are you watch­ing in the mar­ket right now?

There are three things I think you have to deal with. The first would be the Fed. The sec­ond would be the credit cy­cle and where we are in the credit cy­cle, specif­i­cally in the U.S. credit cy­cle. Although we are global in­vestors, we’re U.S. fo­cused right now. And the third would be liq­uid­ity of mar­kets.

Howare you deal­ing with the un­cer­tainty of when ex­actly the Fed will raise rates?

We be­lieve that in­ter­est rates are go­ing up even­tu­ally and the bot­tom line is the Fed des­per­ately wants rates to be higher, they just don’t want to raise them. So how do we get there? By that day when the mar­ket is dis­ap­pointed that you’re not go­ing to raise rates, that’s when you raise rates.

So there’s a lot of talk that the mar­ket is kind of say­ing, “Hey, you can move things up, we’re get­ting pretty ready.” Not yet, though, be­cause Greece is still out there; we just got through a bout of eco­nomic weak­ness. Things have bounced back as we ex­pected them to, but it’s still fresh on our minds. There are things that are still hang­ing over us that don’t al­low the mar­ket to feel real com­fort­able. It could be the time by Septem­ber, but it could not be the time un­til the first quar­ter.

Howdo you char­ac­ter­ize the mar­ket right now?

I liken what’s go­ing on in the mar­kets to climb­ing Mount Ever­est. If you go up the moun­tain, when you start get­ting to­ward the top and things be­come more dan­ger­ous, your body doesn’t ad­just to the new at­mos­phere. So you have to go up, come back down to base camp and ad­just. And then you can go back up. That’s where we are right now.

We just had com­modi­ties ad­just. We had a very dif­fi­cult first quar­ter. We had the dol­lar move, the type of move thatwe sawin ’08 and ’09. So not the type of move you would have ex­pected in this type of en­vi­ron­ment. We’ve had huge spreads in high yield. There’s def­i­nitely kind of a sea change go­ing on in the Mid­dle East. It’s be­com­ing more ac­cept­able to be­lieve that China’s growth is go­ing to be slower for a long pe­riod of time. A lot of things have changed.

But if you just fo­cus on the re­set in com­mod­ity prices and the re­set in the dol­lar, that’s not just some­thing we’re just go­ing to be able to fol­low through. They’re part of ad­just­ments that are be­ing made in the econ­omy. So we’re sit­ting back at base camp, we’re wait­ing for the ad­just­ments to hap­pen, and then we’ll be able to get on with it again. Now how long will that take? I don’t know. Six months? Five? Four? Maybe we’re ready by the end of the year, maybe not. All that means for us in the port­fo­lio is we need to be aware of that head­wind and take in­ter­est-rate risk out of the port­fo­lio and fo­cus on credit risk.

Howare you go­ing about re­duc­ing that risk? Are you avoid­ing bonds with cer­tain ma­tu­ri­ties?

We have been re­duc­ing the in­ter­est rate risk and over­all rate sen­si­tiv­ity in our port­fo­lios by tak­ing down ex­po­sure to higher qual­ity (i.e, in­vest­ment grade) po­si­tions. We are not avoid­ing cer­tain ma­tu­ri­ties; rather, we have a bar­belled yield curve po­si­tion with our cash/re­serve-type hold­ings in the short end and our “best ideas,” [in­clud­ing in­vest­ment-grade and high-yield cor­po­rate bonds] in the longer­dated ma­tu­ri­ties.

Are you hold­ing more cash while you wait for the mar­ket to ad­just?

The re­serves have ranged from 10 per­cent to 15 per­cent over the past year, but are closer to 10 per­cent most re­cently.

What are some ar­eas you’re adding to right now?

High yield. We are ab­so­lutely adding to high yield as of Novem­ber through Jan­uary. For us, high yield is yield, in­come. Some credit up­side but a lit­tle bit more in­come. The spread com­pres­sion we hope to off­set the ris­ing rates. The thing we are do­ing with our credit port­fo­lio is fo­cus­ing more on in­dus­tries that have a sec­u­lar trend, ver­sus cycli­cally driven. Health care, tech­nol­ogy, any­thing to do with wire­less. Fi­nan­cials, I think, fall into that cat­e­gory.

What are some of the cycli­cal sec­tors youmay be shy­ing away from?

I think within tech­nol­ogy, there are parts of tech­nol­ogy. Maybe PCs aren’t a place to be.

A true cycli­cal like chem­i­cals. I think energy is a dif­fer­ent story be­cause of how cheap val­ues are.

Let’s talk about that. When oil prices fell, it was some­thing that was good for con­sumers in away but also threw the mar­ket for a loop, right?

It was such a dra­matic move. When con­sumers started to feel money in their wal­lets, they didn’t feel like it was go­ing to last. So they didn’t spend it. The heat­ing bill went down, but you think it’s just go­ing to come back up.

What is your per­spec­tive on oil, then?

It was def­i­nitely sup­ply-driven. Weak global growth com­bined with all the sup­ply com­ing on, it was set­ting up for a good [ad­just­ment.] Our view prob­a­bly didn’t change very much. We just went through it. We were at $100 [per bar­rel] and thought we were go­ing down to $75, but it went down to $40. So I don’t know that our view changed that much but the value changed. And we started to add on.

Lastly, how much should we worry about Greece? How does that af­fect your ev­ery­day strat­egy at this point?

It doesn’t. If they do exit, we’ll see a re­ac­tion. We’ll prob­a­bly see an out­size re­ac­tion in spe­cific as­set classes— the euro and pe­riph­eral bonds. but the fact that the Eu­ro­zone is al­ready do­ing quan­ti­ta­tive eas­ing, I think, is a good thing.

So how do you po­si­tion to be ready for what­ever hap­pens there?

We look at it as a rel­a­tively short­term phe­nom­e­non. If there’s a re­ac­tion, that would be the kind of thing thatwe could take ad­van­tage of. Maybe that would be a good time to buy some Euro­pean credit. It’s more of a wait-and-see ap­proach to see what op­por­tu­ni­ties present them­selves.

“We need to be aware of that head­wind and take in­ter­est-rate risk out of the port­fo­lio and fo­cus on credit risk. ”

Elaine Stokes of Loomis, Sayles & Co.

COUR­TESY OF LOOMIS, SAYLES AND CO.

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