McGregor: People Are Overpaying for Income

Zimmerman: Oh, right now, yes.

McGregor: So, it's very difficult today. My fixed-income team meets with me every Wednesday and as needed otherwise, and they are quite dubious about our ability to extend duration in a way that doesn't add meaningfully to the riskiness of the portfolio. So, we've done some things in smaller-cap, high-yield issues where we feel we have an analytical edge. We certainly do have a large TIPS position. We have 4% of the entire portfolio in sovereign debt issues, but it's very difficult to do anything creative today on the fixed-income side, in our opinion, that does not increase risk materially.

Zimmerman: So, in the [summer] commentary for the Equity and Income fund, you talk about the way that investors are subsidizing the government by buying bonds at such unattractive rates. Yet, there are short-dated Treasuries in the portfolio, too, and there are negative real yields on those right now.

McGregor: On the TIPS.

Zimmerman: On the TIPS, and then on the shorter-dated Treasuries I believe.

McGregor: Well, maybe.

Zimmerman: So, how do you get comfortable with that? In the past my understanding has been that that part of the portfolio--I mean you have parameters that you can't go beyond in terms of fixed-income allocation and equity allocation--is almost a holding pin for cash. When you want to put it to work in equities, you will, which why it's the most liquid fixed-income instruments possible. But in terms of right now, there are not very attractive yields at all in that space. How do you get comfortable with that?

McGregor: Well, it's hard to be comfortable with it. It's basically a holding tank now for future opportunities primarily on the fixed-income side. We are at our highest equity allocation…

Zimmerman: Close to 70%.

McGregor: Yes, just over 70%. So we have potentially the room to go to 75% equity; that's the prospectus max for the fund. But the reserve position at this point in the very short-term Treasury and Canadian debt positions in the portfolio really are for future fixed-income portfolio additions at this point in time. The longest duration fixed-income assets in the fund are all TIPS. They all have negative nominal yields today. I think the entire TIP universe is negative out to over 20 years. So there the marketplace is making a very explicit bet that there will be inflation further out in the future, but that you can hold these things today as a flight-to-safety asset.

One of the things we've also written about, we think, people are overpaying for income, and that the fight to safety is meaningfully overdone. We don't think that the conditions in the world are as grim as these kinds of actions would suggest.

Finally we don't see how people are going to be able to retire on yields like this. As again I mentioned, I'm close to 60, as my generation retires, how are they going to convert equity holdings into bonds in a way that it will be able to support their lifestyle. So we think that these things will change over time, but we did not expect this suppression of yield to continue as long as it has.

Zimmerman: Sure. Let me circle back around to the question of what you might do with the fixed-income part of the portfolio going forward after you have a comanager or a team of comanagers with you? Understanding it right now, the environment for fixed income is not very attractive broadly. Thinking long term though, is Ed's departure and then the vetting of people who might come on and be your comanager provide an opportunity to think about, "We could have a more diversified fixed-income portfolio if we had the resources." Is that a part of the conversation as you interview folks for the job?

McGregor: Yes, it is. I think we will have a more diversified fixed-income portfolio in the future than has typically been the case. When the fund started in 1995, and I was sole manager at that point in time, we felt that the spreads between investment-grade corporates and Treasuries were insufficient to compensate us for the risk of specific events. There are not so many leveraged-buyouts happening today, but if you are the owner of a bond for a company that gets LBO'd, basically, value from you has been transferred to the equity owners. We wanted to avoid that risk as much as possible. We just didn't think that to buy an excellent bond that you're getting enough of a pickup versus owning a Treasury to give up the liquidity, and so we just didn't think it was all worthwhile.

Today, with all the spreads being compressed so greatly, it's hard to do anything but take on risk in fixed income. So, in the future we think we will have a more diversified fixed-income portfolio. But tell me when that will be? I can't tell you when they will stop holding rates down.

Zimmerman: Right. It's quite counterintuitive to think about fixed income being riskier than equity because historically that's not been the case. But given the current environment, it's easy to see why that is the case.

McGregor: Yes.