Christine Benz: Hi, I'm Christine Benz, director of personal finance for Morningstar.com. We have a very special presentation for you today. We have three of Morningstar's investment experts who are going to sit down with us and discuss some of their best ideas for retirement portfolios.
With me today is Josh Peters. He is equity strategist and editor of Morningstar DividendInvestor. Josh is our resident dividend guy.
Next to Josh is Miriam Sjoblom. Miriam is associate director of fixed-income research for Morningstar, and a wealth of knowledge on bonds and bond funds. Miriam, thanks for being here.
Finally, we have Scott Burns. Scott is head of Morningstar's exchange-traded fund and closed-end fund analysis operations, and Scott is also editor of Morningstar's ETFInvestor newsletter. Scott, thanks for being here.
So let's kick this off. Top of mind for so many retirees right now is fixed income. Retirees are looking at the possibility of higher interest rates and wondering how that should affect how they position their portfolios.
Miriam, I'd like to throw it to you and talk about what you're thinking about fixed income these days and also what you're hearing from the many fund managers you are talking to. How concerned should retirees be about rising rates and should they be taking steps at all to try to protect their portfolios against rising rates.
Miriam Sjoblom: Sure, Christine. For starters, a lot of intermediate-term bond managers, which make up a most of the core holding of most U.S. investors' portfolios for bonds, there are definitely many managers who are thinking about these issues and concerned about it.
Normally, after a big rally for credit sectors like corporate bonds, you would expect to see...when corporate bonds get really cheap, managers sell Treasuries and buy corporates, and now you've had this huge rally for more credit-sensitive sectors. What they'd normally do in that time is sell corporates and buy Treasuries.
So now this kind of placeholder, the U.S. Treasury, that you would normally move the portfolio to to get neutral, to get back closer to your benchmark, is suffering from some real risk of rising interest rates down the line. Treasury yields are still near pretty low levels relative to where they've been historically.
Then you've got the concerns of the U.S. growing debt burden and the problem of entitlements down the line. So, there are some issues that are impacting that decision that used to be so natural.
So, some things managers are doing are looking for ways that [they] can very carefully build a little bit of a yield advantage into the portfolio. One extreme example is a favorite fund of ours, Loomis Sayles Bond, but [managers] Dan Fuss and Kathleen Gaffney and the rest of the team there, they've been focusing more on: "how do we minimize market risk, which is interest rate risk, and focus on specific risk--use our 30-some-person credit research team to try to identify really mispriced bonds that also offer a good yield advantage over Treasuries."
In addition, they are thinking that the equity market looks somewhat attractive these days, so you're seeing them add more convertibles--that could be for a lower-quality issuer, but it could also be for a high-quality issuer. They've been talking about Intel a lot. They have added Intel convertibles. It just gives you some upside potential from the appreciation of the stock price.
So, you're hearing more and more bond managers say, "oh, we kind of think the equity market is attractive and doing some things like that. That's an extreme example."
Benz: That's a pretty aggressive fund, a very good fund, but very aggressive. Is that another idea, though, to potentially look at some of these go-anywhere funds, and there have been more of them cropping up recently where the manager really can do a lot more than just focus on high-quality bonds. Is that another idea for investors' fixed-income portfolios?Read Full Transcript
Sjoblom: Well, I'd say, in general, protecting against interest rates, rising interest rates, is a big focus these days. So you might see a lot of product launches, a lot of trendy, absolute return, go-anywhere, or take on negative short interest rate risks, that type of thing.
So, I think it's important to really be selective and go with a team that has a good track record, a long track record, a deep team. I think of PIMCO Unconstrained Bond as an example. Just sort of be a little bit of wary and selective, because these types of strategies haven't really been proven yet over the type of environment that we are anticipating.
Benz: So, PIMCO is one you like. Are there any other firms that you think are equipped to do a go-anywhere strategy, or is PIMCO pretty much it?
Sjoblom: Well, I think there are other firms that we do like, but I think the PIMCO one stands out, because we named Bill Gross, Manager of the Decade last decade. He has just built a real first-rate team around him, a real deep team, incredible expertise in all types of asset classes.
But you know, you don't have to necessarily be a cowboy, trying to work miracles with bonds, because let's not kid ourselves. Most bond funds have interest rate risk, and there is very little you can do to get away from that.
But what [the bond manager] can do is try to, on the margins, invest in areas that you think will be less sensitive to that. One thing we are seeing is some diversified bond managers are moving more into bank loans. I am thinking of specifically Fidelity has a suite of high-yield bond funds, and their bank loans have taken up a bigger portion of those funds over time. And typically managers have said, high-yield corporate bonds tend to be less sensitive to Treasury yields, but there will come a point where they will become more sensitive. We've seen the additional yield offered by high-yield bonds over Treasuries has come down. It's near the long-term averages, but as Treasuries rise, there is only so much more room before high-yield won't also be impacted. So, you're seeing some high-yield managers invest in bank loans to have a little bit of protection against interest rates. Some diversified intermediate term bond managers are doing the same.
Benz: So, let's quickly just explain how a bank loan works when rates go up. You do get that reset along with LIBOR of what the bank loan is paying out?
Sjoblom: So, bank loans are known to be floating rate instruments, but lately managers have been saying, with short rates just staying where they are, there is nothing floating about them; they have been more fixed lately.
...People will think, bank loans aren't necessarily attractive because they price off of LIBOR, which is very low right now, but a lot of these new loans that are getting issued are coming with LIBOR floors of 1.5% to 2%, which is above where LIBOR is now, plus in addition to that you're getting another 3.5% to 4.5% in coupon income. So, loans are yielding anywhere from 5% to 6%--not too bad given how low short-term rates are these days. So, you're getting a pretty attractive yield to start, but then once short rates eventually do start to rise, your income will adjust upward.
Benz: So, if someone is looking at a bank loan-only fund, are there any particular ones that you like right there?
Sjoblom: Well, we really are a big fan of Fidelity Floating Rate High Income, and it's on the conservative side. The challenge of investing through these open-end like mutual fund structures is, the bank loan market is not the most liquid market. It's a privately negotiated market. There are big operational hurdles to investing in bank loans.
So this fund tends to own more cash than its peers to be able to deal with inflows and outflows. So, it tends to stick with the higher-quality, large-cap type issuers, but we think for taking less credit risk, giving up a little bit of yield, this is a really good option.
Benz: Okay. Scott, I want to throw it to you, I know you and your team manage some ETF portfolios. Talk about how you've been thinking about fixed income given the headwinds that fixed-income investors might be facing?
Burns: Well, I think one of the big themes obviously with where demographics are going is, we used to say fixed income, but now I have just changed it to income, because in a lot of places in the fixed-income world there isn't a lot of income, and I'm sure we'll get to that.
One other thought on what's happening with the interest rate sensitivity--I don't necessarily know the answer, but I want to throw it out there as something to think about: Everybody is saying we have a bubble in Treasuries, we have a bubble in Treasuries. But when you look at the curve really the bubble is at the very short end of the curve.
We have record steepness to the interest rate curve. That is the difference between Treasury bonds due in the next 30 days and five years, right. So, can we really have a bubble in 90-day paper, as it is, and if we do, what is the disaster around that?
So, when you look at interest rates and the steepness of the curve, we're seeing a lot of things like inflation starting to get priced into the 10-year. So, you do want to worry about that kind of shorting and that shifting.
One thing we did in our tactical portfolio was actually by a interesting new [ETN] product out there, the iPath Flattener is what it's called, the ticker is FLAT. And this is a fund that very simply shorts the two-year Treasury and goes long into 10-year. So, all you are really betting on is that this curve will not steepen or will contract back to a more normalized flatness. So, we are at a record spread right now, as it were, between the two-year and the 10-year--I think it's something like 3.5%, maybe 3.6% right now right now. Higher than it's ever been in the history of interest rates. I mean, this includes periods like World War II and the '80s. Places where we had some very significant distortions in the yield curve.
So, with investors with all the money that's pooled into fixed income, we really like this tool. We think it's really kind of a fantastic tactical play, because you are betting against this record split between the two-year and the 10-year, but also as some insurance in your portfolio, that if you don't want to sell your fixed income, but you are concerned that there's going to be some inflation, this is a nice tool to get in there to layer in, because the other problem, and I think a lot of fund managers are split on this, some think that deflation is still a bigger problem.
So really when you have a tool like this, well if there's inflation, and the two-year comes up to the 10-year, it makes money, and if there's deflation and the 10-year comes down to the two-year, it makes money.
So the only place it doesn't make money is if the curve stays steep or everything goes up formally, but if that happens then everything else in your portfolio should be making money. So that's what makes it such an interesting play.
Benz: So, if you're looking at a product like that, how much of a fixed-income portfolio should it take up?
Burns: Well, again, I think you need to look at the composition of the portfolio. I think for our particular fixed-income tilt, where we buy ETFs and they are basically tracking the indexes like the Barcap indexes. Lot of the indexes, just because of where flows have been coming have really shortened up on duration already. So, what's you are looking for again is that longer-term kind of duration interest rate risk right now. We're not as concerned about the things that are going to turn over in 30 days.
I really don't think interest rates will go from 0% to 2% short-term rates sooner than 90 days. I think it will take a little longer for that to happen. I could be wrong, that's why we do this, but I think that we have time ... you'll roll and reset as you go, and it may not be the best thing for you, but it's not cataclysmic type risk.
So, you are really more concerned about where you're looking five years out, 10 years out, and your duration and your portfolio. So, use tools like Morningstar X-Ray to understand what the duration tilt of your fixed-income holdings are and then size it appropriately to that, understanding that there is that trade-off.
I think the other thing to understand, too, is that if you are using it in the allocation more for an insurance policy or hedging policy. Understand that if it doesn't make money, that's a good thing, because hopefully everything else did just fine. And if does, it's offsetting other risk. I think that's one of the big challenges investors are trying to get their hands around post-2008, 2009 is when I entered these hedging types agreements and structures, you have to understand that you are limiting your upside as well as your downside, and that any insurance that you don't have to pay a premium for is not insurance worth having. So that's just one thing to keep in mind.
Sjoblom: I'll add a comment, if you are using active bond managers in your portfolio, then it's important because yield curve management is a huge part of just about every active bond manager strategy. So, you want to make sure you are not maybe doubling down on a view by using this tool.
Benz: That's a great point.
Burns: ...If they have tightened up themselves using swaps and futures and things like that.
Benz: ... You could be duplicating that effort.
Scott, I want to follow-up with you: Miriam mentioned a couple of very active funds that she likes and you and I have talked. You have in the past at least thought of fixed income as an area, where maybe you do want to delegate to an active manager versus going with an index portfolio. Is that still kind of how you are thinking about the world?
Burns: I think it depends. For me personally, I own actually active fixed-income managers, but I also own some passive vehicles. I don't think owning an aggregate bond, passive vehicle right now is a good idea. I think just given where flows are with Treasuries and mortgage-backed that having an active manager that can deviate from that index is in your favor. I think that the index is just not a very good investment right now.
Benz: So a total bond market –
Burns: So, a total bond market. I think if you are going to some more strategic things such as high yield, the broad-based diversification of a high-yield ETF or even a municipal bond ETF will help you out with some of those things.
I think, actually, one of the more interesting developments is the target-date fixed income. So we have target-date corporate bonds and target-date municipal bonds out there. If you're doing targeted liability investment, your trade-off is between individual bonds or an open end--whether it's a mutual fund or an ETF. These are products that will buy you a basket of corporate bonds at A rated investment grade quality that will all mature 2013, 2014, 2015--there is a series of them.
So I think if your choices are to do a fixed-income ladder using individual portfolios or using open-end managers, when really you have a targeted structure, I think these are really unique interesting products that help solve that. You get the liquidity and you get the diversification, but you also get the certainty of principal repayment that you don't get in a more open-end structure--again whether ETF or mutual fund.
So I'm a very "it depends" guy. My first professor in finance told me that that was always the answer in finance: "it depends." So not to hedge, I think when we're doing some more tactical things, very specific areas, I like to use a passive tool that's going to get me the exposure that I'm looking for, but in more broad spaces, I do like a more active go-anywhere manager, because I just think the index is not very good right now.
Benz: Which active funds do you like?
Burns: So I own PIMCO Total Return. That's I think I own another one, but I can't think of it off the top of my head.
Benz: So Josh, wanted to talk to you about bonds.
Peters: Why? (laughing)
Benz: Under the best of circumstances you're not a big bond fan. How are you feeling about fixed-income these days?
Peters: It's a question that I'm very happy to dodge at every opportunity. I mean, what I try to do with DividendInvestor and the investment philosophy and the individual stock selections that go into the model portfolios and newsletter is really try to take the approach that whoever is coming to me looking for these recommendations that are going to deal with the equity piece of their portfolio, that they've already hopefully got a broader asset allocation plan in place.
Benz: So it's not one or the other.
Peters: So it's not one or another. That isn't to say that I don't think about the bond market, I'm not thinking about what can happen to interest rates, especially stocks being long, very long duration instruments, what is going to happen in the long run to the long end of the curve.
But I think that one good way to approach it is to just simply look back and say, "what has been working?" Well, bonds have been working for a very long time. But there is kind of a ceiling, there is mathematical limit to how low interest rates can go. Each drop in interest rates is juicing your past return profile, and that is going to give you essentially a misleading track record if you're trying to project forward, which is obviously where you want to go.
Equities have had a rotten decade, and I think for a lot of very good reasons, and I'm not really all that optimistic. In the scale of what's out there, in terms of equity strategy, looking down the road, I'm not thinking that this is going to automatically be a great decade because the last one was so bad. I think there are a lot of structural reasons in the U.S. economy to suspect that. I think there are a lot of structural reasons in corporate governance and dividend policy, which is right in my wheelhouse, to doubt that we're going to just go back to the days of 9%, 10%, 11% like clockwork, which I think is what most people would like.
But there is only so much that bonds can really give you from this point, and so I think that anybody who comes at the market thinking well, if I'm retiring, this might be [my default approach]. [This might be] my dad's default approach. He is not retired yet, but we talk about this: If I've got to take all this money that's in the stock mutual funds and put it in the bank and get CDs? No, that's not really going to work.
I tend to think of bonds really as a tool to manage the near-term and intermediate-term liabilities that you have as an investor. If you are retired, this means your living expenses. Your initial profile is invested very conservatively, very short-term. Then look at the bond piece in the middle to supplement the longer recurring income of your portfolio, but recognize that a lot of traditional asset allocation approaches are not going to give you that price sensitivity. They are not bringing in the valuation piece that I think is absolutely essential, and so even though I'm not all that bullish on the stock market in general, I think there is reason to believe that higher-yielding stocks can do well, can do well even in the context of some drift upwards over the long run in long-term interest rates. And that bond piece, I think you use mainly to manage the volatility of your portfolio and to help match some of those near-term calls for cash while really looking to equities to carry the load in a long run.
Benz: I want to follow up with you with some of your best high-yield stock picks. But before we move to that, Miriam, I just want to quickly discuss what's been going on in the muni market. There have been a lot of scare tactics out there, if you will--Meredith Whitney's 60 Minutes report where she was talking about potentially cataclysmic levels of defaults in the muni market.
From what you're hearing, and you are certainly a specialist in the muni market, what do you think about what happened to munis in the fourth quarter? Are there more risks to come? How should investors be thinking about that sector?
Sjoblom: Well, it's interesting that this sell-off for munis didn't coincide with a spike in defaults for munis. But it did coincide with rising Treasury yields on the one hand and increased attention in the media. Individual investors make up a huge portion of demand in the municipal bond market. It's about two-thirds when you count mutual funds and individually owned bonds, et cetera. Retail investors' appetite for municipal bonds can have a very big impact on the market.
So, we've just seen--it's continued into 2011 so far--record outflows for municipal bond funds and that can really have an impact. Muni fund managers know their job is to get tax-free income to their shareholders. They try to stay fully invested. When a muni fund manager has to sell, even a high-quality bond, it can be difficult if there's no one out there who wants to buy it.
So, I think that to the extent that these headline concerns continue to impact investor demand, I think you can see definitely some rockiness going forward, but so far even what we're hearing in 2011 is as yields rise on municipal bonds, they are starting to become attractive to taxable bond managers who don't need the tax exemption; the yields are that attractive. So, taxable bond managers can step in and buy.
I think from a credit risk standpoint, the confidence that some taxable bond managers, who can invest anywhere they want, have in Build America Bonds, the taxable segment of the municipal bond market, kind of speaks volumes about whether these credit concerns are overblown or not, or whether there are good opportunities out there, even though things are looking bad for some issuers.
Benz: So they are not required to invest in municipalities, and yet they've bought some of these Build America Bonds?
Sjoblom: Right. Would you like to know who: PIMCO, Met West, Dodge & Cox, BlackRock.
Benz: (joking) So, all the dumb money, right?
Sjoblom: Yeah (laughing). So, that's some pretty good confidence, I think.
Benz: So, Scott, I want to talk to you about the muni ETFs that have launched. I know initially at least there were some concerns about the bid/ask spreads that were cropping up in some of these products. Let's talk about whether you think they are ready for primetime--people look at the municipal bond market a reasonable area to use an ETF with? What's your take on that?
Burns: In our portfolio, just to echo Miriam, we're looking in our tactical portfolio at muni bonds, and we run that as a taxable portfolio. So, we don't try to make assumptions about--we won't give ourselves credit back for not paying taxes on the yield. And even the yields are still attractive enough that we're looking at it from a tactical perspective, even though we won't be able to make that adjustment.
We think municipal bond ETFs--there has been a lot of noise about them. The lack of liquidity underlying municipal bonds makes it hard for a very liquid instrument like an ETF to trade and show the same kind of efficiency that we see with the S&P 500 and even emerging markets, anything in equity we see very strong efficiency. Fixed income is a little bit of different story.
During the darkest days in 2008, we were seeing 16% premiums and discounts appearing in the ETF, and then people started come to conclusions: These things are broken and they are not working.
My team has been digging into that quite a bit, our initial runs on the research actually have turned up a different story than that the ETFs aren't working. It's actually turned out that the NAVs don't work. So, what we're finding is that, when we have these big differences or delocations between price and the NAV--which is really the premium and discount not necessarily the bid/ask spread, although that will widen as well in times of uncertainty--is that we're getting T+1 price discovery on the ETF compared to the NAV, and we're actually seeing that translated over to the mutual funds as well.
So, what means is that on a day like after Meredith Whitney's primetime exposé on the coming municipal crash, municipal bond ETFs traded at a 3% discount. What we found was the next trading day, it wasn't the price that moved so the discount collapsed the next day, but it was actually that the NAV came down, and that the price stayed the same. And, we've been running the numbers, and we see that this is happening pretty consistently throughout history.
So, the price discovery is actually happening in the municipal market on the ETF. These are ETFs that are trading $30 million to $130 million a day. This is very liquid market on the ETF. Nowhere near as liquid on an individual basis on the municipal funds, so we're seeing that the NAVs are changing, and that's translating over to the mutual fund as well.
So, there are a couple of key takeaways. If you want to think like a hedge fund manager, and you want to do something a little more sophisticated, then the answer is, to own a municipal mutual fund, municipal bond mutual fund, up until the day of that dislocation, and on the day of the dislocation, sell the mutual fund and buy the ETF, and you'll add 3% to your return.
The other ramification if you're a mutual fund holder on that is that, that even if you hold through those times, because remember these losses are only recognized if you sell or don't, but because the mutual fund structure is kind of a demand-deposit structure, and as you said, Miriam, people leaving force managers to have to do things, they wouldn't want to otherwise. You're essentially subsidizing the people who are leaving on days where there's things like discounts in the ETF. So, the people that are leaving the fund are leaving at an NAV that's higher than what the market price says it should be.
So, we're still working on bringing all those numbers together, but you asked, so those are some of our preliminary showings.
So I do think the ETF is ready for primetime. I think these discounts and premiums again are only reality if you decide to make a trade. ... But really I do think there are some things that it tells us about the investing world and fixed-income pricing models in general from that dislocation that we're seeing in there.