Mon, 14 Nov 2011
Metropolitan West CIO Tad Rivelle says his team is seeing opportunity in high yield, investment-grade financials bonds, and the non-agency mortgage market.
Jason Stipp: I'm Jason Stipp for Morningstar.
Stock investors haven't had the best time in the market, but the bond market also hasn't been a walk in the park for investors, either.
Here with me to talk about how they're investing in the current environment is Tad Rivelle; he is Metropolitan West's CIO, and also a Manager on Metropolitan West Total Return.
Thanks for calling in today, Tad.
Tad Rivelle: Thank you. Good to be here.
Stipp: So we have had some interesting effects in the bond market recently. We've seen that market shocks, headlines out of Europe, have caused, especially in the third quarter, a flight to quality, so that we're seeing Treasuries continue to perform well.
At the same time we have a lot of managers tell us that they are positioning ultimately for what could be a higher interest rate environment.
When you're looking at the current factors at work in the bond market today, how are you managing the portfolio, given that we are seeing these somewhat countervailing forces that work?
Rivelle: And those countervailing forces work almost on a day-by-day or almost sometimes hour-by-hour type basis. And to a certain degree, you can actually see a very obviously manifestation of those forces in terms of their expression, with respect to, on the one hand, a very elevated price for gold, which is usually thought of as an inflation hedge, and on the other hand, a very high price in the Treasury market, therefore a very low yield, which is usually thought of as protection against some type of deflationary type of outcome.
So what we have in effect is a market that is putting a very elevated concern with respect to tail risk without necessarily being conclusory, as it relates to which direction that tail risk is going to take.
Our particular view is that, what it really speaks to is concern as it relates to risk of policy error, and that policy error to a very large degree connects back to the current trajectory of Federal Reserve policy.
What we have is an economy obviously with a very high level of unemployment, a very large output gap, which has natural deflationary forces in it, that are being resisted very powerfully by the Federal Reserves through quantitative easing, through its zero rate policy, and so forth.
We could expand on this view, but it is our view that ultimately the Fed will be successful in terms of bringing about an increase in nominal GDP, that will be associated with a higher level of inflation than we have traditionally seen, and so, we're more in the risk-on camp.
Stipp: When we're talking about the Fed and what the Fed's policy has been, they recently said that they're going to continue to be accommodative for quite a while. But at the same time, as you are saying, we could expect that we would see higher interest rates in the future. Do you have any thoughts on what the timeline for that might be? Do you expect to see rising rates in 2012 or it's going to be after that?
Rivelle: Well, the near-term environment in the Treasury market I think can be fairly characterized by the term "financial repression." And what we mean by that, is in effect what the Fed has on one the hand done is by pegging rates at zero, the short rate, and telling the marketplace that it will keep it at zero until 2013, as it did several months ago, they have created, in effect, an arbitrage such that investors are induced to continue to support the Treasury market at very, very low yield levels--in fact, yield levels well below that of the prevailing rate of inflation, a 30-basis-point-yielding two-year Treasury versus a 4% 12-month trailing rate of inflation is a negative real rate.
But, by virtue of the fact that the Fed has stated its willingness to provide 0% financing to any and all financial institutions, for instance, that wish to put a negative real asset on their book, like a short-term Treasury, they can do that with their borrowing from the Fed.
So that keeps short rates, two-year rates, five-year rates, low, and that of course begs the question that if that policy is so inflationary, then why isn't the 30-year soaring to the moon in terms of yield. And the answer is, that's Operation Twist. The other element of financial repression is for the Fed to, on the one hand peg the short rates with the zero-rate policy, and then, in effect, to buy up the longer-dated securities through its twist.
So what this all means is that we shouldn't expect rates to be rising in the near term, but if you put on a portfolio manager hat, as opposed to the trader hat, the portfolio manager hat tells you that rates are being held through this repression, at well below their long-term equilibrium, and ultimately there will be a very severe rate rise, we believe, in the Treasury market.
Stipp: So I want to discuss a little bit about your portfolio. So one of the ways that you are positioned, and I think this obviously has somewhat to do with your expectations for that rising rate environment, you do hold some financial corporates. You have some non-agency mortgages. You also have some high yield.
I wanted to talk to you a little bit about the fundamentals of those securities, because we're seeing as the market is keying in on Europe, swings day-by-day, concerns--sometimes we're up, sometimes we're down. And the volatility has been pretty extreme.
But when you guys are looking at the fundamentals of those holdings, what are you seeing? Are you seeing that this is noise that's happening in the shorter term, or do you have concerns that have arisen about fundamentals, given some of the news we've seen out of Europe, for example?
Rivelle: Well, you mentioned financials, and of course, we are bond investors. But perhaps one indicator that's barometric as it relates to investor concerns about the financial health of the banking sector, is to recognize that we have a condition in which we have very large, obviously, money center type banking institutions whose equities are trading at steep discounts to book. In the case of Bank of America, I believe, it's actually something between maybe one-third to one-half of its tangible book value. I think what that tells you is that there is deep investor concern about the potentiality of some type of cataclysm coming out of Europe and demolishing large tracts of the U.S. financial system.
Now, while there is, of course, always a risk of something like a major policy error in Europe actually occurring, we think that the fears as it relates to the continuity of the euro currency regime, are well overdone. And what that suggests to us is that, perhaps not just the stocks, we can't really perhaps opine so knowledgably on that, but other parts of the capital structure, such as the senior debt and even some of the subordinated debt in the financial sector, we think is trading at very-very wide yield premiums. In the case of Bank of America that I mentioned, the senior debt is trading at yield spreads north of 400 basis points over Treasuries.
In the case of the high-yield market, there, too, we would counsel an overweight. Perhaps not an overweight to the lowest levels of the high-yield market, that would be the CCC area, but the BB area is trading in the mid-500s in terms of spreads, that's about 200 basis points wider than its 20-year median, and in the case of Bs, at 750 or so basis points--also looks quite attractive given a trailing default rate of something in the neighborhood of perhaps 1.5% overall in the high-yield market. It all looks good to us.
Stipp: You mentioned a few compelling opportunities that you've been seeing there. We also know that volatility, although it can cause us to have a stomachache, it can also sometimes create some opportunities.
So given that we have seen the market moving around quite a bit recently, have you been able to put any new money to work or found any newer opportunities over the last few months?
Rivelle: Yes, quite a few actually. We would suggest that in addition to the opportunity in high yield and in the financial sector of the investment-grade corporate bond market, that the non-agency mortgage market is also quite interesting.
The non-agency mortgage market, of course, largely exists today in a non-investment-grade that is below BBB rated type form, even though these securities, when originally issued, were AAA rated bonds, and they are typically the legacy securitizations of subprime and Alt-A mortgages from the good times, from the '05-'06 type period. And the pricing of these securities has migrated or evolved into one in which we believe that, on a loss-adjusted basis, that there is a likelihood of somewhere between 8% and 11% IRRs that are at least reasonable and probable in this sector--even considering the potentiality for further declines in the overall housing market.
Stipp: Tad Rivelle of Metropolitan West, thanks so much for calling in today, and for your insights on the fixed-income market.
Rivelle: Well, thank you so much.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.