Fundamentals aren’t in place for a strong economic recovery, some experts note

The recent sharp rise in interest rates is catching some bond managers by surprise.

The fixed-income managers at JPMorgan Fleming Asset Management in New York, for one, weren’t expecting what happened in June and July.

“We were long, rather than neutral,” in the fixed-income portfolio, says Seth Bernstein, head of global fixed income at the firm. “We were disappointed when the Fed didn’t cut interest rates by a [half-point].”

“The severity of the backup [in interest rates] within the current time frame has been extraordinary,” he says. He thinks the fundamentals aren’t in place for a strong economic recovery and that the bond market has oversold.

“I don’t see how an increase in interest rates from here could be justified,” Mr. Bernstein adds.

some damage

JPMorgan Fleming has $264 billion in global fixed-income assets. While the interest rate jump hurt the portfolio, Mr. Bernstein declines to disclose specifics or how the portfolio might have been repositioned because of the changes.

“I was caught by surprise and didn’t think rates would rise as much as they have,” says Sean McCaffrey, head of fixed-income enhanced strategies and mutual funds at Deutsche Asset Management in New York.

“Given the lack of evidence in the economy so far – the economic fundamentals are caught in a strong technical situation. You could flip a coin” to see which way the economy will go, says Mr. McCaffrey, who is portfolio manager of the Scudder U.S. Government Securities and the Scudder Short Term Bond funds.

“It’s difficult to know, when this stops, where 10-year Treasuries might settle in,” he says. The yield on the 10-year Treasury bonds had risen to 4.4% as of July 31.

“We do not make yield curve or duration bets – we remain duration neutral,” Mr. McCaffrey adds. He says the firm’s fixed-income investments are “hedged out versus the curve risk. Movements of the curve of any significance haven’t harmed us. The short-term blip-up in rates may or may not be meaningful.”

Deutsche has $150 billion in fixed-income portfolios.

Bill Lissenden, who manages core and core-plus portfolios at Deutsche Asset Management’s Scudder Investments unit, says his portfolios have market-weighted Treasury holdings, generally don’t hold agency securities, have close to a market-weighted position in mortgages and are overweighted in the corporate-bond sector.

He says the firm’s core composite portfolio performed about 0.6 percentage points ahead of the Lehman Aggregate Bond Total Return Index for the first six months of the year. Declining to give specific numbers, Mr. Lissenden says that for July, he believes the portfolio was ahead of the index, which was down 3.36%.

“Most [fixed-income] managers are down in absolute terms for the month of July,” says James Duberly, a consultant at Frank Russell Co. in Tacoma, Wash. “But the magnitude of the decline is not that great, compared to the volatility of the equity market.”

“We caught up with the rise in interest rates about midway to their peak,” says Ken Bowling, director of U.S. fixed income with INVESCO Funds Group Inc. of Denver. “At the low in rates, there were still indications that rates could go either way. We put on a modest short about halfway through the rise in rates.”

INVESCO’s core fixed-income fund was half a point ahead of the Lehman Aggregate year-to-date through July 29, when the index was down 2.5%. The firm manages more than $64 billion in domestic fixed income.

However, Mr. Bowling still isn’t convinced that the rise in interest rates will continue to warrant a full short duration. “Funds will remain modestly short duration in the near term because there isn’t enough conviction in the upward trend of interest rates to warrant a full short in duration,” he says.

INVESCO’s fixed income has a modest short in overall portfolio duration and has extension protection in the mortgage portfolio guarding against prepayment slowdown and duration extension, Mr. Bowling says.

The fixed-income portfolio is also underweighted in agencies, where political risk is high, and is overweighted in the corporate-bond sector, where spreads are still tightening.

“The amount of the rise surprised us, but we had felt that interest rates were unsustainably low,” says Sam Paddison, Philadelphia-based head of fixed-income investments with Evergreen Investments of Boston. Declining to elaborate, he says: “We were short duration when rates started to rise,” which helped performance.

down on treasuries

Mr. Paddison thinks “we are now in a bear market” for Treasury securities, and their performance will suffer. Evergreen’s managers, with $120 billion in fixed income, are continuing with their short-duration approach.

“We think the yield curve between two years and 30 years, which has steepened all month, will continue to steepen during the next quarter,” he says.

“I didn’t expect an increase [in interest rates] of that magnitude, but we had a modest short position because we felt the market had gotten overextended on the upside in terms of price,” says Tom Croft, head of fixed income at DuPont Capital Management Corp. in Wilmington, Del., which has about $5 billion in fixed income.