Thu, 19 May 2016
Morningstar's Sarah Bush discusses the risks that bond investors face, including rising interest rates, credit-quality concerns, liquidity risk, and inflation.
Christine Benz: I am Christine Benz for Morningstar.com. It's Risk Management Boot Camp week on Morningstar.com. Joining me to discuss some of the key risks that can confront bond investors is Sarah Bush, she is director of fixed income strategies in Morningstar's Manager Research Group.
Sarah, thank you so much for being here.
Sarah Bush: Thanks for having me Christine.
Benz: So Sarah, we are discussing fixed income as part of our Risk Management Boot Camp this week and I'd like to look at the major risks that confront bond investors and kind of take them one by one, starting with the big one that has been really vexing investors for several years now and that's interest rate risk. I think investors were sort of bracing for this interest rate Armageddon that really hasn't materialized. So I'm wondering if you can kind of talk about that risk today. You talk to a lot of fixed income managers. So I'd be curious to hear what they're thinking and what you're thinking about the trend in interest rates and how worried investors, bond investors should be about this particular risk.
Bush: So certainly you're right, this is one that I think is always kind of top of mind for bond investors and ever since the credit crisis, every year we did have a little bit of a rise in interest rates in 2013, but it's really been on people's mind. I think most people are expecting the Fed to continue to move slowly, somewhere between one or two rate hikes this year. And then the question becomes what happens out the yield curve, what happens to longer-term bonds, like you might see in a core bond fund. Here I think you're still pretty much seeing a consensus around lower for longer. We've had a pretty big rally coming into this year, if you look at the 10-year Treasury, for example. So I think people definitely think that those yields could go up a little bit, but there aren't a lot of people calling for much, much higher yields than we've seen in recent years. One potential outlier on that is Michael Hasenstab at Franklin Templeton, he has actually said that fair value on that 10-year Treasury could be 4% or 5%, which will clearly be a big increase. But most of what we're hearing kind of from the consensus view is, if you look globally you're looking at slow growth, very active central banks, potential of slowing of growth in China's or slowing of growth in China and that's all having a downward pressure on what we're likely to see from rates going forward.
Benz: So in terms of how you would counsel investors to sort of look at their portfolios and think about interest rates risk, they should look at duration and see what that looks like if they have bond funds in their portfolios?
Bush: Right. So duration is a good way of thinking about that. Where you're going to see more interest-rate risk in general is in longer-term higher-quality funds. So kind of at the extreme example of long-term government funds are very, very sensitive to interest rates. For what a lot of people are seeing in their core bond funds, if you look at your experience in 2013 or maybe you lost a couple of percentage points, that's probably 100 basis point move in rate, so that's probably something to kind of think about as a sign post. I think the other thing though to keep in mind is that, you really need to think about bonds in terms of your broader portfolio and what they're doing for you. And ultimately your increase in yields is a good thing and if that happens gradually, those yields will start to offset the losses that you're getting from, due to the rising interest rates. If the rest of your portfolio is doing well, if rates are rising because of the economy is strong for example, you'd expect the equities to be doing well in your portfolio. So it may not be such a terrible doomsday scenario.
Benz: Right, right, that's good perspective. Let's take a look at credit risk, which sometimes we think of as the other big risk that can confront bond and investors. When you think about the fixed-income market today, the economy seems fairly healthy, has that translated into a fairly healthy corporate credit market?
Bush: So corporate credit was one of the big stories last year kind of coming out of 2014 and through 2015, we just saw a ton of pain in the energy part of the market. So energy prices have come down, also metals and mining. So high yield funds with a lot of exposure to lower quality, energy and metals and mining names did really, really poorly. That's kind of reversed this year, one of the best performing sectors is high yields energy. Just a huge rebound, but I think oil prices are still low relative to what they were before we saw this big drop and I think people are still expecting the defaults to continue. But credit has been a strong part of the market year-to-date. I think there is couple of other pockets of weakness. There is concern that supply might start to put some pressure on corporate bond valuation. And some financials in Europe, we've heard a little bit about the issues of negative interest rates and that's putting some pressure on some corporate names. But broadly outside of the metals and mining in energy space, I don't think there is a ton of concern especially when you're looking at higher quality corporates.
Benz: How about munis in a related vein sort of the health of the muni credit market?
Bush: Yeah, munis have been doing pretty well, there has been some big headline news out of Puerto Rico and that's a completely different story and really some clear problems there that I think will take some time to resolve. And actually interestingly there is not a lot of Puerto Rico exposure in most muni funds, there are a few exceptions, but it's pretty unusual today. The rest of the muni market though, state and local, governments for the most part--outside of Chicago, I follow that one, though, maybe it's another exception to mention, Chicago and Illinois,--but other than that, they're mostly doing pretty well. So not something that we're particularly concerned about.
Benz: So when investors are thinking about the credit sensitivity of their bond portfolios, you mentioned high yield, that's obviously a place you'd want to take a look and see what sort of credit qualities maybe you have in that portfolio. But assume that they're not very high quality credits. Are there any other types of bond funds where you think investors should be especially attuned to this credit risk issue?
Bush: Sure. So high yield munis and taxable, obviously bank loan funds which have a lot of overlap with the high-yield taxable market. Then again this some core plus or especially some of the more aggressive multisector funds are nontraditional bond, you might see some more credit exposure. But in general, in your kind of typical core fund, it's going to be more limited in terms of your exposure there.
Benz: They'll usually be capped by charter on how much they can invest in true junk bonds.
Benz: Let's talk about liquidity risk and this is one that was out there in the bond community, really a lot of hand-wringing over this issue of liquidity and whether that would be the next big problem in the bond market. Before we get into how big a risk is this is, let's talk about what this means, why you hear some bond market participants concerned about liquidity.
Bush: So liquidity risk I think if you compare to interest-rate risk, I think it's pretty straightforward, credit risk, are you going to be get paid back, I think going to be a little bit harder to get your arms around. I think the best explanation, I've heard of what is liquidity is the ability to buy or sell a bond kind of in a reasonable amount, over a reasonable amount of time, at a reasonable price.
Bush: You know, this price kind of makes sense in terms of what we think the ultimate valuation is. Do remember the bond market isn't over-the-counter market, and if you're in a situation where you're trying to sell a riskier bond on a day when the markets aren't doing so well and you've got a lot of it to sell that can put pressure down, people aren't going to be willing to pay perhaps the price that you think that that could warrant. So I think that that's kind of the clearest explanation I've heard. And clearly if you look at the growth of the corporate bond market for example, and then also shrinking broker, dealer balance sheets, there is less liquidity out there in the market, I think everybody agrees on that. So that's one of the reasons in addition to some of what we saw last year with Third Avenue Focused Credit--one of the reason it's attracted so much attention.
Benz: OK. So I guess the question is, when you're talking to bond managers today or your personal view, do you think that liquidity risk is a big issue that bond investors should have on their minds today?
Bush: I think it's definitely one to be aware of. As we've talked about before and written before, we're not concerned that we're going to see a lot of funds or really very many fund that all follow in Third Avenue Focused Credit's footsteps. First of all they were high-yield fund, and second of all, they are a very aggressive high-yield fund with a lot of exposure to really low rate and distressed credit, so they were kind of an outlier. So we're not--I don't think you should be concerned about that by and large even in kind of a standard high yield bond fund. But it is important to be aware that that risk is out there and when you start looking at funds, one of the things we always worry about is, we're looking at category fund and especially on the lower credit quality side and you start looking for the highest yielding funds. Investors get paid for liquidity risk and that can be a sign that the bonds and the portfolio might not be so liquid. So we're less concerned that you're not going to be able to get your money back, but if you get into a difficult period and the fund sees a lot of outflows or a group of funds sees a lot of outflows, it really could kind of exacerbate the types of losses, that you might see. So I think it's something to be aware of, I don't think it's a panic type of situation. But definitely I think it's something we need to be thinking about when you're looking at in the funds.
Benz: And that's such a good point about yield being, maybe a risk flag in its own right, that if you see a portfolio that has a really juicy yield in an environment that we know does not have many such opportunities certainly in the high-quality space that that should be your cue to take a look at what else is going on there.
Bush: Yeah, and I think a lot of that applies--that screen or that potential red flag applies both to lower-quality funds, but we've talked about this before, you're get nervous and you look at ultrashort or short term funds or there really isn't a lot of yield to be had and higher quality names. If you start seeing a fund that's an outlier in terms of yield in that space where you really don't want to be taking a lot of risk, it's something to be careful about.
Benz: Yeah, good point. The last risk I'd like to cover with you Sarah is inflation risk, I would think of inflation as the natural enemy of a bond. And let's talk about why that is and when you survey the market environment today, how big a risk factor you think inflation is for bond investors?
Bush: Inflation definitely can eat away even if you're not seeing losses on kind of on a nominal level on your bonds, if your purchasing power is going down, you want to get power back, it can definitely eat away what we call your real returns or inflation adjusted return. Inflation has been really subdued in recent years, in fact, we've almost heard more concern about deflation where we actually see the opposite thing happening. And earlier this year, there is one way to think about what market expectations are about inflation is to look at what's called the break-even rate. So that's basically the level at which you'd be kind of indifferent between owning a nominal Treasury and a Treasury inflation protected security. That can be kind of a signal about market expectations about where inflation is likely to go. So that got as low, got a little bit over 1%--only a little bit over 1% for 10-year earlier this year. And a lot of managers have seen that as a buying opportunity. It's since risen, but still significantly lower.
Benz: So that means that the market thinks well, inflation isn't likely to go much higher than that, but the managers you talk to think, over the long-term probably it will?
Bush: Right. I think people think it will get higher, and again for the most part, the consensus you kind of like with interest rates is, it will get higher, but it won't get too much higher. So you often hear people throw out any other trend the Fed is targeting 2% inflation. And they think, well, they'll probably get there, maybe it will go a little over, a little under, but that's a good number. Again to go back to contrarian views, Hasenstab at Templeton, has also, Franklin Templeton has maybe this is little bit of more of a concern, maybe we will start to see some wage growth in the U.S. but at this point that's still kind of a contrarian view.
Benz: OK. So any bond with a nominal yield is going to be affected by inflation. TIPS, Treasury Inflation Protected Securities would have that sort of built in hedge against inflation. Are there any other categories that you think tend to offer good inflation protection under the bond umbrella?
Bush: Yeah, you know one that we've talked about a little bit before, floating rate bank loans. They obviously if you see a rise in nominal yields, which can happen if you're having problems with inflation because inflation is a part of that--they're going to adjust upward, there is a little bit of a lag where they'll adjust upward. Also you know anything with exposure to corporate credit could do well if the underlying companies are doing well, it kind of depends why you're getting inflation. But in general TIPS are kind of the most obvious place to look for that inflation protection.
Benz: OK, Sarah, risks are naturally front and center for a lot of bond investors, so thanks for being here to do this roundup with us.
Bush: Thanks for having me, Christine.
Benz: Thanks for watching. I am Christine Benz for Morningstar.com.