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On the Go for Fixed Income

Dan Fuss and Michael Hasenstab have independent streaks that lead them to unconventional and profitable opportunities.

Miriam Sjoblom, 06/12/2012

This article originally appeared in the June/July 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

Let’s face it. Last year was a triumph for traditional U.S. bond investing. Helped by a jolt of fear and a Federal Reserve shimmying to Chubby Checker, the passively managed Vanguard Total Bond Market Index VBTLX gained 7.7% in 2011, leaving many active bond managers in the dust. That rally did little to calm concerns about rising yields and the dearth of value in U.S. Treasuries, though. Many core bond managers have resorted to looking eyond their own backyard—to non-U.S. sovereign debt and currencies, junk bonds, and further down in companies’ capital structures—for relief from the lean opportunities offered by their increasingly U.S.-government-heavy investment-grade home base.

That contingent looks like a herd of Johnnycome- latelies next to Dan Fuss, though. For more than 20 years, his Loomis Sayles Bond LSBRX has charted its own profitable path in and out of distressed corporate debt, busted and balanced convertibles, real estate investment trusts and other types of preferred and common stock, emerging-markets debt, and nondollar bonds. A dauntless contrarian, Fuss has yet to weather a crisis that he couldn’t use to his advantage, even if it means picking up a few battle scars along the way.

Also known for investing with a staunchly independent mind, Templeton Global Bond’s TPINX Michael Hasenstab doesn’t need to throw out his playbook either. Hasenstab has a remarkable talent for spotting long-term trends in advance and then getting in on the ground floor. That was the case when he moved into Asian government bonds and currencies eight years ago, for example, and it could be the case again. In recent years, he has substantially reduced the fund’s interest-rate risk by shifting into short-maturity bonds across markets and taking currency positions, such as shorting the yen, designed to do well when Treasury yields march higher.

Both Fuss and Hasenstab will be speaking at the 2012 Morningstar Investment Conference, June 20–22, in Chicago. To get a sense of their thinking heading into the conference, we invited them to discuss the challenges facing bond investors in today’s low-yield environment, where to find opportunities (hint: go global), and how to successfully navigate a prolonged period of rising yields. Our conversation took place on April 26 and has been edited for clarity and length.

Miriam Sjoblom: You both have expressed concern about the risk of rising bond yields, and it shows up in your portfolios. Yet yields have stayed stubbornly low for some time and last year surprised many investors when they sunk even lower. How imminent is the threat of rising rates, and how do you see this scenario unfolding?

Dan Fuss: My guess, which I’ve been guessing for a long time, is that eventually our own central bank starts to back away from buying Treasuries. The offshore central banks really can’t. Their setting is a little different, but our own central bank has been buying notes, especially seven years on out, and bonds—the long end. So you take away that support, and you’ve taken away a support that has counted for maybe two thirds of the purchases—their friends offshore account for the rest. So then, that supply doesn’t hit our market or go out into the general markets.

The question then becomes, when does our central bank back away? Now, from what I read, the center of gravity on the boat for the Fed seems to be two years from now. The next question then is, is there a point in between where the currency relative to all others starts to slide? Not so much relative to the Canadian dollar and New Zealand dollar, but relative to the yen, where it’s slid a bit, relative to the euro—that’s the other option, and then, say, sterling and Swiss franc. I’m really more on the global side on that one. But that’s going to take some time.

But we’ve chosen not to sit around and wait to read that it has happened. We’ve already positioned the portfolios, we think, for the first leg up in interest rates. Now, we’re just waiting, and it could take another year or two. I don’t know.

Michael Hasenstab: I agree with Dan. Timing is always difficult, but better to be early than late. Intervention can distort prices. In this case, it can keep yields artificially low for some time, but intervention is not a permanent solution. In fact, the longer it goes on, the risk is that the adjustment is even larger when it happens. So I don’t think intervention by itself is a sound justification to be chasing yields at this point. Additionally, the complete lack of fiscal progress in the U.S. and the political divide of our government that prevents any compromised solution make us concerned that ultimately our fiscal ineptitude will require that we pay a higher cost to finance our debt.

The last factor that I’ll mention that has been supportive was that in 2011, at its peak, the crisis in Europe created a bid for Treasuries. In fact, it’s a curse that the U.S. has become this safe haven because it has taken away the motivation for policymakers to do the right things on the fiscal side. With the problems in Europe, people bought our Treasuries, and that has given politicians a false sense of comfort. But if you take away the crisis in Europe, as they move away from the apex, you take away that safe-haven bid, as well.

Looking Globally
Sjoblom: So what are you doing in your portfolios to prepare for this eventuality?

Hasenstab: First of all, not owning any U.S. Treasuries. That’s the easy part. The second is significantly positioning outside of the U.S. We’re looking for opportunities to invest in short-dated government bonds in countries that have better fiscal dynamics; countries that are not overly indebted; countries that are growing because they do not face this deleveraging overhang that we’re facing in the U.S.; countries with interest rates that are higher, so we’re able to earn an attractive yield; countries that aren’t printing money. One of the consequences of the U.S. policy to print money—and Europe’s printing of money, while Japan has been and probably will have to print even more money—is currency debasement.

So, we’re looking for short-dated government bonds where we’re not concerned about credit risk; we’re not taking a lot of interest rate risk, but we are exposed to currencies. We are taking that exposure where we feel comfortable with the currencies because they’re in countries with good debt conditions, good growth dynamics, and they’re not printing money. So in the long term, we think they will outperform the U.S. dollar, the euro, and the yen.

Sjoblom: Can you give us some examples?

Hasenstab: Pretty broadly throughout non- Japan Asia, which would include everywhere from Korea to Singapore, Malaysia, and Indonesia. In Europe, we favor Scandinavia over core Europe.

Sjoblom: Dan?

Fuss: Wow. This is getting spooky.

On the global side, in our non-U.S.-dollarcentric funds, essentially the same thing as Michael just described. On the U.S.-dollar-based ones—take Loomis Sayles Bond, for example—on the currency side, we have a constraint that 60% has to be in U.S. dollar. Up to another 20% can be in the Canadian dollar, and if it’s not, then it has to be filled by the U.S. dollar. So the non-U.S., non-Canada max is 20%. That means that the U.S.-dollar-based funds look quite a bit different than the others for us, but again, the same format that Michael just described; we just don’t have quite as much elbowroom.

First place, Canada is where we have all but 2% of the reserves right now. We’re sitting in short Canadian Treasuries. A year-and-a-half is our stuff. The next big concentration is Australia and New Zealand together. And the rest is scattered throughout Southeast Asia and Norway, and a little tiny bit of Swiss franc in there. So that’s it on the currency side. The maturity of all of that is intermediate and shorter.

Within the U.S. dollar, no Treasuries, so it’s corporates, and a couple of what were badly busted munis. The focus there is sort of a mix, but basically most of it is from high triple-B down into some single-B and some triple-C. We do have constraints on quality. We have to average investment-grade, and max is below 35% of assets, and that’s at 25% right now. We do have some concerns on the high-yield market. We also have an allowance to put 5% in common stock, which we’ve done. We built most of that up late last August, early September with just a handful of growing-dividend-type stocks.

So, that’s how we’ve dealt with it so far. In terms of average maturity, I think at its peak, which was a while back, the bond fund had an average maturity of around 19 years. It’s now 10, and if you took the common stocks out, it’d be nine and a fraction. That’s a lot different than before. To bring that down any more would mean letting go of the monthly dividend, which would be hazardous to my health once the trustees saw it.

Sjoblom: Hearing what the both of you are saying—Michael, you’re focusing more on currencies and not taking a lot of interestrate risk, and Dan, you’re adding equity-type risks with common stock and convertibles— is the key to successful bond investing in a rising interest-rate environment to just become less bond-like?

Fuss: Yeah. Well, actually, it’s a wonderful environment. That’s a serious statement, but it sounds facetious. I grew up managing bonds. For my first 23 years of doing it, it was wonderful. Interest rates always went up. Every time you reinvested, you were reinvesting at higher rates. The value of the issuer’s call option, you could laugh at it. In other words, you didn’t have to worry about it. Then, for 31 awful years, interest rates went down. Now, we’re coming out of that.

Now, clients don’t see it that way. The clients say, “Oh my goodness, interest rates go up, bond prices go down.” That’s true, so you have to prepare for that, too, and that’s where it becomes an art form. I’ve been giving some CFA speeches in recent weeks, and what works well with the CFAs is to say, “How to substitute specific risk for market risk.” That is actually what we’re doing to the degree you can do it with bonds. You cannot—at least, I haven’t found a way—get the bond prices to go up when interest rates go up. When we find it, I won’t advertise it.

Hasenstab: I think it’s important for clients to focus on taking out a lot of the interest-rate risk in their bonds, and it’s going to mean substituting other risk. I like the way Dan said it: substituting specific risk for market risk. Whether it’s credit risk or whether it’s currency risk, there’s no way to get returns without taking some degree of risk, but when we balance those different components—interestrate risk, currency risk, credit risk—it seems to us that we’re getting better paid for currency and credit than we are for interest rates.

The real challenge for investors is to make sure that their bond portfolio has the least amount of interest-rate sensitivity as possible to position for what we think the next part of this multiyear cycle will be, which would be higher interest rates.

That’s not to say, though, that you can’t protect yourself. If you own short-dated bonds in Korea, paying three-and-a-half to 4%, and you can roll those over as they raise rates, you’re not necessarily going to lose money on a rising interest-rate environment. So there are ways to protect yourself, but it requires being very active, getting away from the index and looking at bonds a little bit differently.

Sjoblom: Dan, you mentioned you have some concerns about the high-yield market. Can you talk about what those are?

Fuss: Valuation, and the type of credits coming through, and the indentures. Now, when I discuss high yield, I throw bank loans in there, and we are using some bank loans. Not a lot, because you’re darned if you do, darned if you don’t. If the credit’s getting better, they’ll refinance on you. You have poor call protection. But if you’ve got that covered for a few years and you’ve got a reasonable spread to Libor and a max at the end of it, you’re all right. You get your money back in 2016 or ‘17. That’s fine.

What concerns us is if interest rates are higher at that point—let’s be moderate in our view here and say what would still be a low number for the 10-year Treasury: 4%, four-and-a-quarter— historically a number you would see not at the peak of the cycle but early on in the rise. So at some point, the central bank loses control or backs away, and rates start to move up. And if you have a credit that is stretched financially, and all of a sudden they have to refinance in a rising interest-rate environment, the credit will look different at that time than it does now.

And if this continues, which we actually think it will, because we think we’re in a secular rise in interest rates, that changes the credit dynamics remarkably within industries. It does not play well with the number-three, number four market shares.

So they get stopped out of growing with the market, and you have a credit problem if they have to refinance. If they don’t have to, if they’re more mature than that, that’s not a problem. They just run it down. But a lot of these credits and a number of the big credits in the high-yield market in the U.S. and Europe really don’t fit that description. They may be viewed as stable or improving credits now, but higher interest rates will turn that around on them.

It’s really strange. You look at it, and you say, “Well, you ought to put the whole thing in high yield.” No, but there are some wonderful credits that are rated below investment-grade that will do all right, but it is not a broadscale list, so you do have to get very specific.

If you’re running a pure high-yield fund, God help you. Now, we run a number of those, but there, we’re following the same practice that we are on the investment-grade or medium-grade side. The credits in some parts of the world yield more than they do here and they’re better credits. So let’s go there. It’s an investment-grade credit, but it’s providing enough yield to be acceptable in the high yield. You substitute the specifics to the degree you can because—pure interest-rate risk right now— you don’t want to stand in front of that. You want to get out of the way of it to the degree you can.

Hasenstab: The positive news in the high-yield space is that one of the bright spots in the U.S. is the corporate sector. There’s been a lot of improvement in balance sheets as companies have used these low interest rates to refinance. The corporate profitability is quite strong, given fairly aggressive shedding of costs, including in the labor area, hence our high unemployment rate. So the health of the corporate balance sheet and profitability, given the cleansing in the system, bodes well for the high-yield space.

Another side of high yield that is attractive is its lower sensitivity to movements in U.S. Treasury yields, given the fairly large spread cushion. So at this point, we’re still constructive on the high-yield space.

Buying Into Irish Austerity
Sjoblom: Let’s talk about the eurozone crisis. After some optimism earlier in the year, it’s started to rattle markets again. Is this just investor overreaction?

Hasenstab: It’s important to separate out an Armageddon scenario, which would involve the break apart of the eurozone or a credit event in a major country like Italy. I think the policymakers greatly reduced the possibility of that Armageddon scenario by the ECB [European Central Bank] showing its willingness to commit its balance sheet to prevent contagion from a Greek event or a Portuguese event from spilling over into the other major markets. It’s very important to remember that anchor.

The good news is that the ongoing uncertainty and crisis have moved governments toward some change. Think about Italy, for example. The change in government there was motivated by stressed market conditions. Italy is moving forward with labor market reforms to help boost the growth rate. Stressed market conditions in Spain continue to impose market discipline on both the federal as well as the state levels to move forward with fiscal improvements.

So I think we should expect a period of political noise—the natural part of an election cycle—and we should expect economic growth to be pretty anemic. From time to time, the markets will focus on those events, but that is very different than the scenario where you see the eurozone split apart, which I think remains a fairly low probability at this point.

Fuss: Any period of near-term underperformance by the markets due to eurozone issues will be short-lived. The ECB’s banklending program has, for now, provided the markets with some assurance that the ECB is willing to expand its balance sheet to prevent a total meltdown. Volatility creates opportunities for investors, and this episode is no different.

Sjoblom: You both bought Ireland’s government bonds. Why them over others in the periphery?

Hasenstab: We had been analyzing Ireland for well over a year. We had been doing a lot of research on the fundamentals of all of the problem borrowers. We looked very closely at Greece but couldn’t get comfortable with the debt dynamics, so we did not invest there. As we were going through the various countries, Ireland struck us as very different. It’s a very competitive economy, has a skilled labor force, commitment to low tax regimes, attracting foreign investment, and a social cohesion between the population and policymakers to take tough measures sooner rather than procrastinate.

We liked all of those things. Then came the period when they were downgraded, and there was a real market panic in July 2011. We were comfortable with the long-term fundamentals and finally the market reached a distress level that gave us an entry point. From the summer onwards, we were taking a position.

It’s very characteristic of things that we look for. We look for something that everyone hates, and we look for something that in the long term has good macro-fundamentals, even if in the short term it may be a little bit volatile. But if we can feel comfortable long term that Ireland is money good, that they have the right policy prescription in place, and that they can actually execute that prescription because there’s the social cohesion to do so, we’re comfortable taking contrarian positions.

The other thing I would say about Ireland, although it’s a small country and there are unique situations there, is that their approach to the crisis can be very instructive for other countries in Europe and, frankly, for us here in the U.S. When we look at the debt crisis, it’s about debt ratios relative to GDP. It’s about the stock of debt as well as the growth rate. Ireland is dealing with both of those issues—both the numerator and the denominator.

They are dealing with the debt issues by aggressively tackling fiscal reform and getting a handle on budget deficits, rather than procrastinating. They are doing a very good job on their deficit management, something clearly we’re not even touching here in the U.S. But they didn’t put in place policy measures that would jeopardize their growth prospect even though there was a lot of pressure from the Europeans to increase their taxes. They didn’t.

So, they kept their economy really competitive. They also took a lot of pain in terms of making adjustments to get competitive again. Unit labor costs in Ireland in the manufacturing sector were cut by over 20%. But by taking that upfront pain, they were able to get competitive again, export again, and then in the medium to long term, people’s livelihoods will be improved. That model of taking short-term pain, dealing with the deficit head-on, being focused on making your economy competitive on the growth side— I think those lessons can be applied to many countries. Even though Ireland’s small, I don’t see why those lessons are not applicable to the U.S. or other European countries.

Fuss: Yes, they dealt with their debt issues quickly. They significantly lowered unit labor costs and were committed to low corporate tax rates, which gives companies incentive to invest. Those and an educated workforce were some of the main characteristics of the situation that looked attractive to us. All of these qualities are unique to Ireland, when measured against euro-area countries.

Sjoblom: How do you look at policy risk around the globe? Where do you see the most potential for policymakers to get it wrong?

Hasenstab: Well, we’re already getting it wrong in the U.S. The lack of progress on the fiscal side is pretty clear. Policy implementation is going to be critical. For example, in Europe, there is a need to follow through with plans for a more constrained fiscal union so that they’re not allowed to have a repeat of the overspending that has happened in the past.

The challenge in emerging markets will be staying ahead of the curve. They’ve done a very good job so far. They certainly did a good job in 2009, 2010, as their economies recovered, obviously a lot faster than the developed world. They had to lead the interest-rate cycle. The Fed, in continuing to ease, was doing nothing, but many of these countries started tightening, which is a very different dynamic than we’ve experienced before, when most emerging markets followed the Fed. This time, they led the Fed.

But it’s important that they continue to demonstrate that, because the growth dynamics in many emerging markets are very different than what we’re experiencing in the U.S. or what’s being experienced in Europe. We’re already starting to see early signs of inflation in some emerging markets that you clearly are not witnessing here in the U.S. So staying ahead of the curve—tightening policy to prevent inflation from becoming a problem—will be important for emergingmarkets policymakers.

There are three main policy components: exchange-rate policy, interest-rate policy, as well as fiscal policy. A good example is Malaysia. They were pre-emptive on interest rates, being one of the first countries to tighten. They’ve been fairly flexible on the exchange rate, allowing it to appreciate to help cool some of the imported inflationary pressures. Progress on the fiscal side has been less impressive, as they’re running still larger deficits than probably would be ideal. But when you take it all in combination, the mix is appropriate for their economic condition. We look at the combination of all those factors, not just interest rates, not just exchange rates, or not just fiscal. All of those in combination are important.

Fuss: Monetary policy in most of the developed world is currently either on hold or in easing mode. Debt monetization, bank-lending programs, QE2, and possibly QE3, and other initiatives have all helped to provide a wave of inexpensive banking reserves throughout the globe. The developed world is awash in liquidity. The key in the U.S. will be the timing and how to manage the withdrawal of these reserves, without a massive dose of inflation as a by-product of the policy. The pace of change to policy in the U.S. depends on a number of factors, including resolution to the pending “fiscal cliff,” the presidential election in November, and the degree to which Dodd/Frank is implemented. With so much uncertainty near term, conservative management on the corporate front looks to be the path of least resistance. A significant pro-growth change to policy that the markets gain confidence from may be the trigger that starts the transition in monetary policy.

Again, our view is that we are at a turning point with regards to the secular direction of U.S. interest rates. Over the past 30-plus years, bond investors have enjoyed not only the coupon component of fixed-income securities, but also the potential for capital appreciation, as rates descended. Given the extremely accommodative Fed policy since the crisis, we expect to experience meaningfully higher rates at some point the future, for a prolonged period of time, perhaps the next 10 to 20 years, with cyclical dips lower along the way.

In Europe, the markets are now more convinced that policymakers will act as a lender of last resort. The speed and to what degree they act however, continues to confound investors. Given the ECB’s sole mandate to maintain price stability and the history of inflation in Germany after World War II, the desire to act to increase liquidity, while necessary, continues to be done with some degree of apprehension. It bears mentioning that the recent statements from various political officials in Europe that address the need for growth initiatives in addition to austerity measures could be an important step in the right direction. Monetary policy alone cannot fix what ails the markets the most, which is a lack of growth.

Emerging markets continue to manage growth and battle inflation, some of which has been exported from the U.S. as a result of the Fed’s accommodative policy. As with any monetary-policy stance, the key is to act before the issues becoming evident in the marketplace. Long term, economies that continue to grow wealth, build infrastructure, and develop a growing and educated middle class will continue to prosper. The main issue the U.S. and Europe are currently grappling with is the increasingly costly nature of the social safety nets for its populations. Emerging markets haven’t had to bear that burden—yet.

Sjoblom: Any final thoughts for financial advisors as they’re advising their clients about how to invest in the bond market in coming years?

Fuss: Being flexible will be very important. Taking a global approach to investing will also be critical, given the direction of interest rates here in the U.S. Look beyond the U.S. to areas of global growth for investment ideas. Issuance and opportunity in global markets is mushrooming. In addition, advisors often strive to put as much yield into a client’s fixed-income portfolio as is appropriate. With this so-called “yield advantage,”’ however, comes risk. Most often, this risk is associated with lower-rated bonds in the corporate market. The best way to mitigate credit risk, besides avoiding it at all, is superior security selection, based on fundamental research. We call this investing in specific risk, which means buying securities that will move in price based on the merits of their own specific credit stories, as opposed to the movements of the general marketplace, or interest rates. A diversified approach that encompasses a number of different sectors of fixed income, along with broad flexibility within the mandate will serve advisors well as we enter a new secular era.

Hasenstab: A couple of take-aways would be: First, as Dan alluded to, the home-country bias that a lot of investors have on the fixed-income space probably will not serve them well over the next part of the cycle. The same advantages that one has on the equity side of going global—those same diversification benefits, new opportunities, opportunities for returns—are also shared on the bond side. This more global approach can help people better advise their clients and manage their wealth.

Second, be active and look for ways to manage against a long-term rise in interest rates. This goes hand in hand with my first point because going global is one of the ways to manage this risk. It’s important for investors after they have made their decision between equities and bonds to actively manage within the bonds space and look for things other than just U.S. Treasuries, which may not be the safe-haven asset that they’ve been for the past 10 years.

Sjoblom: So you’re saying you don’t like U.S. Treasuries.

Hasenstab: That would be another way of saying it.

Miriam Sjoblom is an associate director of fund analysis at Morningstar.
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