Thu, 22 Sep 2011
Unaddressed governance issues could create significant economic growth problems in the eurozone, ultimately affecting U.S. assets, says the head of Vanguard's Taxable Bond Group.
Tim Strauts: I'm Tim Strauts at the Morningstar ETF Invest Conference. With me today is Ken Volpert, head of Vanguard's Taxable Bond Group.
Thanks for being here, Ken.
Ken Volpert: Thanks, Tim. Glad to be here.
Strauts: Well, just yesterday Ben Bernanke announced his Operation Twist program. What does this really mean for investors, and really, can you explain, what is Operation Twist?
Volpert: So, Operation Twist is where the Fed sells--the Fed owns a lot of Treasury securities--so it's going to sell the short Treasury securities inside of three years, about $400 billion, and it's going to put that money out longer. So, it's going to buy a lot of six-year out to 10-year paper and then also a very large percent, about 30%, is going to be out in the 20- to 30-year part. So, that’s a much larger percent than the market expected. So, what we've seen is that long-term Treasury yields have come down significantly. The 10-year has also come down a fair amount as well because they are putting a lot of money in that part of the curve as well.
So, I think that's what Operation Twist is about, but yesterday's announcement was interesting also because the Fed announced that they are going to be redeploying or reinvesting the mortgage principal and interest back into the mortgage market. ... Remember they bought well over $1 trillion of mortgages a couple of years ago, 2008 and 2009, so what they're going to be doing with that principal and interest is reinvesting that back into the mortgage market instead of in Treasuries. So, the mortgage market actually has gotten a very strong bid and has performed really well even compared to Treasuries. So, that's another part.
And the last thing is they made a statement about the downside risk in the economy as being significantly large or significantly great, and the last time they mentioned that it was just, that there was downside risk. Now they talked about significant downside risk. And so the market--a lot of the decline that we're seeing in rates is actually because it seems like the Fed is pushing out further and further and further the recovery and is concerned about some more global kind of risks like the eurozone problems, etc., that are going to potentially cause our economy to grow much more slowly in the future.
Strauts: Well moving on to the euro, it sure seems that the European debt crisis only gets worse by the day. Most people are saying that Greece is definitely going to default.
Do you think that's true and how does Greece and Europe affect investors’ fixed income holdings?
Volpert: So Greece itself isn’t as big of a problem as when you start bringing Italy and Spain in. They are just so much larger than Greece. So, I think the concern that Greece creates is the domino effect: When Greece falls then what's next? And that's where the crisis really is.
So, I think the European governments and the whole eurozone is trying to push further and further out the resolution of the Greece issue. So, they are feeding them the money they need, trying to get them to do the actions that they need in terms of austerity. But, ultimately, Greece probably is going to default, or restructure as they call it, and the main problem with Greece, ultimately, is that they don’t have a good governance model. They don’t have a central group that makes the decisions. They have this group that makes a decision and then it goes to each country's Congress or Parliament or whatever to get approved, and it’s just is a very cumbersome, very difficult process. And if you get one country that's says no, the thing falls apart, and so it's just the model that, you know, ... in the good days, it works fine, but in the bad days when you really need to make tough decisions, it's difficult.
So, I think what they need to do is modify their treaty to really address the governance issues. So, they literally are having a group that have authority to make decisions around fiscal spending.
Strauts: Does that mean euro bonds?
Volpert: I don’t think it necessarily means euro bonds. I think even the ECB or the ESFS, the ability of them to buy bonds at a discount, but the authority to actually do it in size, I think gives fiscal discipline.
I think that's one of the things. People talk about euro bonds, the problem with a euro bond is unless it’s accompanied by some way of really disciplining the governments that aren't managing their fiscal policy well, unless they're able to do that, euro bonds are just pushing all the debt to Germany and into France.
So, what they really need is a centralized decision-making authority that can be more responsive but also some real teeth in terms of punishing countries that aren't doing it well, and right now buying Greece bonds at 30%, 40%, 50%, or buying the Italian bonds at 400 or 500 basis points off of Germany, that hurts Italy. It keeps their rates very high. So there is some discipline there in buying at those higher levels because it doesn't cause them to go bankrupt, but there is a pain there that they're paying by having to finance at much higher rates in terms of their new issues and ultimately where their bonds clear. So, I think a Euro bond potentially might take that away and actually result in less discipline than exists right now.
Strauts: It seems to be that what we're concerned about here is the contagion effects. So, we know it's bad in Europe. We are not the country that's going to be bailing these people out, but overall, we're concerned about Lehman Brothers-type contagion. Do you think that's a real concern?
Volpert: It is a concern, definitely. I mean, if they can't get the governance issue addressed and countries pull out of the euro, it's a very significant problem in terms of economic growth in the eurozone and that is going to filter into the banking system and create deleveraging going on in the European banks that are going to affect assets that are in the U.S., because a lot of European banks own U.S. assets. So, there is definitely a contagion that would hurt us, but we also do a lot of export business to Europe. So, there are other kinds of impacts on our GDP that are going to come about from that.
So, I think a lot of the decline in yields that we've seen in Treasuries has been a flight to quality because of the uncertainty around the euro, which is really the second-most-liquid deep bond market out there. So, if all of a sudden, there is uncertainty around that market and around that whole structure, they're going to go to the U.S. for safety.
Strauts: Changing topics a little bit, most investors track with their fixed-income holdings, either they index to or they benchmark themselves against the Barclays Aggregate Bond Index, the most widely followed intermediate-term bond index. But today with over 30% of the holdings in U.S. Treasuries and over 40% in Fannie Mae and Freddie Mac debt and mortgage-backed securities, which are essentially, you know, backed by the U.S. government, is this the appropriate index people should follow? Is it overweighted too much in government-related securities?
Volpert: Well, I don't think so. I think first of all the benefit of the Barclays Capital Aggregate is that it is what the market is. The U.S. investment-grade bond market is 70% the governments and 30% the corporates, and that's just the fact.
So, the beauty of indexing and the whole argument for indexing is, if you take all of the active funds out there and you add them up, you're going to get the bond market, except with higher costs, transaction costs, higher expense ratios, but if you can get that same market, that same exposure, with 12 basis points in expenses and almost no transaction costs, you're going to be way ahead. You're going to do better than the average active manager, and that's the argument with indexing.
So, when you move away from that market-cap weighted structure of the Agg, you start losing that truth of the structure. So fundamental indexing, all these other things, are moving away from the beautiful reason why indexing works, which is because the sum of all the active managers is the market, and if you can in the market at lower cost, you are in better shape.
Now, one thing I want to say, you know, we've moved to the what's called the Float-Adjusted Index, the Fed has been buying a lot of mortgages and taking them out of circulation, and so while it looks like that mortgages may be 40%, they are really maybe 30% of the market. They're considerably smaller because the Fed has taken a lot of them out of circulation. So, we've gone to, a couple of years ago, to what’s called the Float-Adjusted Index, which we think is more appropriate. We do it on the equity side. It's a common practice in the equity side. And historically, the Barclays Capital Agg has taken Treasuries out that the Fed buys, but when they started buying mortgages, they didn't take the mortgages out. So, we had them create one that's called the Float-Adjusted. I think we're the only provider that actually manages against the Float-Adjusted Index, but we think it's a better index because it really represents the market, the bonds that are available for investors right now.
Strauts: Does it help improve liquidity, too?
Volpert: It helps improve liquidity as well, right, because they're including a lot of issues that aren’t unavailable because the Fed has bought them all, or bought most of them. So, they are very illiquid and they've got to buy a much larger weight of the Fannie Mae 4 percents than is available in the market. So, there is definitely a liquidity issue that benefits to having a Float-Adjusted as well.
Strauts: Well, thank you for being here, Ken.
Volpert: You're welcome. Thanks, Tim.