Though portfolio managers at National City Investment Management Company always keep a vigilant eye on benchmarks, durations and rates, when it comes to making crucial investment decisions, they aren't in the game of interest rate betting.

"We're not interest rate specialists," explained Michael Santelli, director of taxable fixed income at Cleveland-based National City. "We don't play that game, because the risk reward is not that high, and it is too tough a game to play. Instead, our philosophy is one of sector rotation, where we add real value by looking for the most attractive spread product across the spectrum."

Right now, about one-third of its $22 billion portfolio is allocated to fixed income, with a focus on spread products like mortgage-backed securities.

"We are now overweight in spread product in the fixed-income division," Santelli noted, "mostly in MBS, ABS, and some corporates."

Instead of placing tremendous emphasis on constantly tracking interest rates, Santelli's team instead achieves its goals by attempting to outperform the Lehman indices, specifically the Lehman Aggregate Index.

Although not obsessed with rates the way some firms are, Santelli still points out the importance of keeping aware of durations what he calls, "keeping an eye on the duration ball."

"You must always watch the [duration] ball because you never know when it is going to shift," Santelli said.

"Our attitude towards rates and duration is kind of like the attitude towards nuclear weapons," he added. "You don't want to use them, but you always want to know where they are."

According to Santelli, the remaining two-thirds of the $22 billion portfolio is equally divided between equity and money market securities. Incidentally, National City has one of the largest inventories of municipal, corporate and U.S. government agency bonds in the Midwest.

Preference For Pass-Throughs

Due to last year's bond market debacle, Santelli noted that it's going to be awhile before liquidity is back to where it was one year ago. Though the mortgage bond market seemed rich this past May, everything is on the cheap side now, he adds.

That helps to explain why National City has focused on a sector where there is still decent liquidity: pass-throughs.

"Pass-throughs are not as liquid as they were pre-August 1998, but they still have tremendous liquidity," Santelli said. "Things will be backing up in the market for a while, it seems, but in terms of liquidity and credit, you can get in the [range of] 140 [basis points] off the curve [with pass-throughs], which is not bad."

Santelli also notes that CMBS product has been cheap recently as well, and some index managers may even use CMBS to outperform long agencies. In a similar manner, he has seen whole loan securities with more overweighted spread product outperform agencies.

Though he has instructed his team to "tread lightly" because of the lack of liquidity, he still sees pass-throughs as the most logical choice during this time.

"If you have an overweight spread, pass-throughs are the place to do it," Santelli noted, "mainly because it is easy to get out if anything goes wrong."

Rate Hike Priced In

To be sure, Santelli is keenly aware of this week's Federal Open Market Committee meeting. Like many market players, he fully expects Federal Reserve Chairman Alan Greenspan to raise the interest rate by a quarter of a point next week.

However, if the rate change occurs, it shouldn't have much impact on National City's immediate strategy, as Santelli has already factored in where interest rates are likely headed.

"For us, we've already priced the change into the market," he said. "That is, as long as it is a quarter-point change and not a half-point change. We'll all be surprised if they do a half point in June, but I doubt that will happen."

According to Santelli, the mid-May announcement of a tightening bias was somewhat of a wake-up call to investors, who were seeing spreads gradually tighten between October of last year and May 1999.

"I'd say it really woke investors up out of their complacency," admits Santelli. "Ever since the announcement, spreads have been widening, and though they are not near October levels, there has been underperformance in all spread sectors." - AT

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