While a number of our clients make use of our dedicated bond management service for their fixed-income needs, some of you may be unfamiliar with this program and its experienced leader, Chris Keith. With the changing of the guard at the Federal Reserve, the reintroduction of the 30-year Treasury Bond, and renewed debate about when the Fed will end its current cycle of rate hikes, this seemed like a good opportunity to check in with Chris. In the following interview, Chris talks about the role of bonds in an overall portfolio, how he works with clients who want to build a custom bond portfolio, and what area of the bond market he likes today.

“You’ve been with KIM for 5 years, tell me a little bit about your prior experience .”

I’m proud of claiming that I have always been “a bond guy.” I’ve never traded stocks, or commodities or even studied other asset classes — only fixed income. And wherever I have worked (past employers include Robertson Stephens, Donaldson, Lufkin & Jenrette and Dean Witter), I have provided high-net worth clients with a low volatility, lower risk portfolio by customizing the bond component. One thing I have found is that while many investors have a solid grasp on stocks (they know that buying IBM at $70 and having it appreciate to $80 is a good thing), when it comes to bonds, just how you make money seems a little more difficult for them to see.

“What does the typical managed bond client look like?”

For the most part there is no “typical” bond client. I know that sounds like a sales-pitch but it is true. I will say that my (our) clients do have one thing in common and that is that they have amassed a substantial amount of wealth. After that each client’s objective differs for the most part. Many learned the hard way (the bear market of 2000-2002) that they were not properly diversified, and had too little exposure to bonds. It’s easy to see how many investors fell into the “strategy” of having little bond exposure just by looking at the S&P 500’s performance during the late 1990s. For the five year period from 1995 to 1999 the index returned more than 20% per year! Against that backdrop, I had a tough time convincing clients they needed a bond portfolio with 10-year Treasuries averaging “just” 6.04%. However, after the dot.com bubble burst, people suddenly got religion. Others come to us because they are concerned about protecting their income from taxation. I fully understand the necessity of taxes — I have school-age children and I drive to work on our highways and as a result pay my taxes. But if an investor can keep a little extra savings through tax-exempt or tax advantaged investments, then why not? In sum there are many reasons investors come to KIM and each is treated as unique when I develop their portfolios.

“What were some of the reasons they decided to work with you?”

I think that once they see the tools we have and the resources we commit to a managed bond portfolio, along with the passion we have for the asset class, they recognize that this is going to be a good fit. One of the best things we do is prepare a sample portfolio. This sample paints a clear picture of what a complete bond portfolio will look like. I firmly believe that the more our clients understand about bonds, the bond market and the way we structure portfolios, the happier they will be with the end result.

“How do you invest your clients money?”

Cautiously. People on the other side of the trades I make - those that I am buying the bonds from, can sometimes get a little frustrated with my pace. I really do try and make sure that I have reviewed all my options before committing to a specific trade. If there is a better offering out there then I want it. I have to. This is a relatively low interest rate world right now and every basis point counts.

“How did you go about constructing a portfolio for a client?”

The first step involves discussing with the client the types of bonds that are right for their particular situation (tax-exempt, tax-advantaged or fully taxable). Once that is determined, then I wait for the right time to start creating the portfolio. By that I mean that I ideally look for a day when the bond market is trading down on weakness — I tend to be more active in buying bonds on down days than on up days.

In structuring the portfolio, my goal is to generate a relatively even interest payment in every month of the year. That’s important because many of our clients depend upon their bond portfolio to augment their income. It’s always a little easier at first because everything is wide open, and I can shop for whatever bonds happen to offer the best prices at that time. As the purchasing continues, it gets a little harder as I have fewer options in filling out the portfolio. For example if I have income being generated in every month except say May and November, then I need to focus on finding a bond with those payment dates.

The other element that I build into the structure is frequent “liquidity events.” That is, I want to own bonds that mature at different times providing a flow of cash (liquidity) to the portfolio. That cash flow allows for two things. First, a client may need to withdraw cash (other than the income from the portfolio) and rather than have to sell a bond (with the risk of a loss) it is nice to have a steady stream of maturing bonds. One of the great features of individual bonds (as opposed to bond funds) is that if you hold them to maturity you will get face value (unless they default — which is rare in the investment grade universe that we invest in).

Second, and more important, is that a variety of maturity dates helps us to manage reinvestment risks and opportunities, something most people don’t usually think about. Let me provide an illustration. Suppose all of an investor’s portfolio matured in June of 2003. The proceeds would then have to be reinvested at the interest rates prevailing at that time — which were as low as 2.03% for the 5-year Treasury. If, on the other hand, half of the portfolio didn’t mature until today (February 06), you would be able to reinvest that cash in a 5-year Treasury now yielding 4.60%. So a portfolio that has a variety of maturity dates (sometimes called a “laddered” portfolio) will smooth out the impact of changes in interest rates on the income the portfolio will generate over time.

“Why should I hire a bond manager when I can ladder a portfolio myself?”

I like to think I bring a sense of discipline and experience to the table. I really don’t like to use the phrase “ladder” when describing what I do. Laddering is simply buying a bond that matures each year for X amount of years. For example, a 10-year laddered portfolio would consist of bonds maturing from 2007 to 2016.

What I do is “structure” portfolios to capitalize on the current interest rate environment. Why “slavishly” go out ten years (2016) to capture the exact same yield I can get by only going out five years (2011)? For that matter - given the shape of today’s yield curve, if I only go out three years to 2009, I can actually receive a higher yield than I can if I go out five.

When I’m looking for individual bonds for our clients, I review the offerings and inventories of more than two dozen dealer desks. Now some of those desks have a stronger presence in the taxable market versus the tax-exempt and vice versa, but the point I’m trying to underscore, especially in the fractured muni market, is that you have to look carefully and thoroughly. And when I do, I can usually pick up a little extra yield for my efforts.

I will also selectively use callable bonds in a portfolio. The risk in a callable bond is that interest rates decline and the issuer “calls” the bond (meaning you have to surrender it back at face value) and then issues new bonds at the lower rates (and you are forced to reinvest your proceeds at the new lower yields). However, you are rewarded for assuming the call-risk with a higher yield than on a comparable non-callable bond.

It would be quite easy to invest with a lack of discipline and buy all higher-yielding callable bonds. But keep in mind that nothing says yields can’t go back down to the June 2003 levels I referenced earlier. In that case, you would again be stuck in the position of having all your bonds “maturing” at once, as they would get called away. Structure, quality and discipline matter.

“Your responsibilities also include fixed income mutual fund research, tell us about that.”

While I have talked at length about individual bonds with passion, I share that same feeling for bond funds. Believe me when I tell you that I fully recognize the merits of bond funds. They serve a distinct purpose and factor significantly in our portfolios for many clients. In addition, my skills as a bond manager have benefited immensely from my research duties related to bond funds. Through the process of mutual fund research, I have had the opportunity to meet many of the heavyweights in the bond business in an often free flowing exchange of ideas and outlooks. I can then turn around and take that knowledge and apply it to our managed bond portfolios.

“Where are you seeing opportunities in the bond market right now?”

I have had a bit of a struggle over the past few months competing with certificate of deposit yields. Some of those introductory teaser rates have been quite attractive. E*TRADE’s 1-year CDs are at 4.8%. I knew eventually that bond yields would come around and recently they did. It all has to do with the shape of the yield curve. Today I invested in a 9-month Federal Agency bond to yield 5% - and that is tax-exempt at the state level, too, whereas CDs are fully taxable. So that is one area. Other areas I like are some of the higher coupon agencies that are callable in 18 to 24 months and selling at a modest discount to face value.

“What is the biggest challenge you face in your role?”

Finding the right balance between research and trading. We have a very demanding research process and like to stay in close contact with the managers we select. We do this by participating in conference calls, making direct calls to managers, visiting managers in their offices or having them come and visit us. In addition, we not only pay close attention to what our managers are doing, but also what their competitors are doing. That makes for a lot of funds to look at within my respective peer groups. Fortunately, I have other analysts here to help me in that role. In managing and trading our managed bond portfolios, no two accounts are identical, so what may work for account A may not work for account B and that adds up to a lot of detail. But with our trading systems, and a lot of hard work, it is all very manageable. The best part is, I simply love doing this job.

“What is the most important aspect of wealth management and the client-advisor relationship?”

That’s an easy answer: know your client, know his or her expectations, and make them understand not only what could go right, but also what could go wrong. If you properly set expectations and provide a clear illustration of how to get there, everyone usually winds up satisfied.

“Thanks Chris!”

Sincerely,

Rusty Vanneman, CFA
Director of Research
Co-Portfolio Manager