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Stokes: Investing in a 'Tricky' Bond Market

With low yields and stretched valuations, today's bond market is a lot more about bond picking and building specific risk into the portfolio, says Loomis Sayles' Elaine Stokes.

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Sarah Bush: Hello, my name is Sarah Bush. I'm an analyst with Morningstar, and today I'm joined by Elaine Stokes from Loomis Sayles.

Elaine, thanks very much for being with us today.

Elaine Stokes: Thanks for having me.

Bush: I thought we could talk a little bit about the bond markets. There was a lot going on last year, and again we have seen some rallies in the Treasuries. Lots of news out there. Could you talk about you and your firm's outlook for the bond markets?

Stokes: Yes. I would say that the current outlook is constructive, but I will call it a little bit tricky. We definitely are at a time when yields are still pretty low, and valuations feel a little bit stretched, as we have been in a rally for quite some time now. So it really is a market where it's a lot more about bond picking, about building specific risk into the portfolio. Buying credits that we believe can have real upside potential that we can see--rating movement.

It's one where we feel very good about the U.S. We feel like the U.S. economy has a pretty solid base right now and has the potential to do well without the fiscal drag of last year. We are really, I would say, being a little bit more U.S.-centric in the portfolios because of that, and we see more of the minefields being outside of the U.S. And we also like where we are in the corporate credit cycle. We are still in the expansionary phase. Not quite getting into that late expansion. So we are still in the expansionary phase, and that should be good for credit ratings and a decent environment for corporate credit.

Bush: With all that said, could you talk a little bit about some specific areas where you found particular opportunities or where valuations are still attractive?


Stokes: I think the areas that we are finding opportunities in are sectors and industries with long-term secular trends. So, what is the right way to play the demographic change going on around the world, and the growth in the middle class? We can look to health care, and we can find attractive health-care offerings in both the high-yield market and the convertibles sector.

Another example is technology. We are all seeing such change in the way we all do things. Our kids will never understand how we viewed the world, will never understand having to go to a library and pick up a dictionary. There is just such a change in how everything is being done, and there are many different ways that we can play that--whether it's in investment-grade bonds, high-yield bonds, global credit, convertibles, and even all the way down to equities.

Bush: We have a lot of interest and a lot of questions about valuations in the high-yield market and the bank loan market; both of those markets have seen a huge rebound since 2008. Are you still seeing valuations … and again maybe it's on a specific name-by-name basis … but how do valuations in those two markets look today?

Stokes: Well I think I will start with the high-yield market. I believe the high-yield market still has a very attractive yield. You can build a pretty decent high-yield portfolio with a 6% type of yield. That's a very attractive yield versus what else is available. So it's a relative game with high yield. What you need to be aware of is that we are in a rising-rate environment. So what you want to do is build that portfolio with credits that have potential upgrades and upside.

So, it's about finding a portfolio that we can see some spread compression and really trying to build in a way to capture that yield and not give it back to what's going on in the overall bond market. And we feel like we can do that, as long as you are patient and you have the solid research background to do that.

When I look at bank loans, that is definitely an attractive market right now, especially, when you look at it versus BB high yield. It takes away some of the interest-rate risk that you get with BB high yield, and it gives you a nice spread cushion, and it's really just about capturing that yield, and as rates rise, re-upping in the market and capturing that yield. So is it attractive versus all of high yield? Maybe not so much. But definitely versus the more interest rate sensitive part of the market.

Bush: You also mentioned another area of the market where you are finding opportunities is in convertibles and equities. I know some of your funds have relatively large stakes compared to other bond funds in those sectors. Could you talk a little bit about the role that those equities and convertibles play in the portfolio?

Stokes: Yes. As I mentioned, it's a bit of a tricky time in the markets, and it's one where valuations are stretched. So what we are doing is trying to identify the company--get the story right first--then look across that capital structure and figure out where across that capital structure is the best place to be.


And for some high, high-quality companies, that best place to be is in the high-dividend-paying equity. For some other companies that have had an upgrade trajectory, but maybe still are high yield, maybe it's time now to move down to the convertible bond. So it's really about taking on specific risk and identifying where in the capital structure to be.

Bush: Thank you very much, Elaine. Thanks for joining us today. It's been nice to talk to you.

Stokes: Thank you.

Sarah Bush does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.