Varun Mehta of Mason Street Select Bond Fund

MEHTA: Broadly, our process involves avoiding downside credit risk. As a result, we have not suffered from credit blowups. The list of U.S. companies that have had credit disasters spans the spectrum of American industry — WorldCom, PG&E, Qwest Communications, Dynegy, Edison International, Xcel Energy, El Paso, and Sprint, 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. Treasurys. This has been the best-performing fixed-income asset class this year.

S&P: Are there certain corporate sectors that you are overweighting?

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

We are also overweight in the defense sector. We think this is a nice long-term secular play, with the U.S. government devoting more resources to the military. We especially like Raytheon, a good turnaround story that is also cheaply priced. Another interesting company in defense is TRW, which is actually divided 60%/40% between the auto parts business and defense. But within the defense segment, they do a lot of work on missile defense shields, which is a big priority for the Bush Administration [Northrup Grumman has recently agree to acquire TRW]. 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 Co. itself.

We also favor Anheuser-Busch. 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.

We also like certain electronic and electric parts manufacturers like Emerson Electric Co., Hubbell Inc. and Pall Corp., 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%.

S&P: What corporate sectors have you been avoiding or keeping underweight?

MEHTA: We are heavily underweight in telecom. We like Alltel, 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 & 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.

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

MEHTA: The `real yield’ on TIPS is too high now. The real yield correlates pretty well with GDP 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 minor part of the portfolio.

S&P: What about mortgage securities?

MEHTA: We have been reducing our exposure to mortgage-backed securities over the last 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.

S&P: How do you answer people who are cautious on bond funds, believing interest rates will surely rise next year?

MEHTA: 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 CPI, 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 — i.e., weak manufacturing, capital spending, corporate profitability, and slowdown in consumer spending, etc. — all indicate a economic downturn going forward.