Tue, 25 Dec 2012
FPA's Tom Atteberry says interest rates are at unsustainable levels and offers his strategies and opportunities for managing a portfolio in an uncertain bond market.
Sarah Bush: Hello, I'm Sarah Bush, fund analyst with Morningstar, and today I'm here with Tom Atteberry, portfolio manager from FPA New Income.
Thank you very much joining us today, Tom.
Tom Atteberry: Appreciate you having me today, thank you.
Bush: So, we have a variety of stuff to talk about, but I thought to start with maybe you talk a little bit about your approach at FPA New Income, and I know you've changed your benchmark recently and talked a lot about absolute returns. It's a little different from some of the benchmark-oriented managers in our space. So could you talk a little bit about that?
Atteberry: It's an outgrowth of what the fund has always strived for. The first thing it always strived for is to have that absolute positive return in a 12-month period. So, we looked at that and wanted to expand upon it and said "What do investors really need to focus on and try to accomplish over a long term?" And we went from taking just the absolute return on a 12-month period, which we've accomplished it since we started doing it in July of '84, to one of, "What's the real objective?"
Well, we need to at least get to CPI, so we could protect the capital? And then could we get CPI, say, plus 100? This is a bond fund. It's a more conservative investment. So, could the return over, say, a five-year period be CPI plus 100 basis points or 1%. So if you had CPI of 3%, then you were looking to have the portfolio producing annualized return on a five-year period of 4%.
And so we said, "OK, this is a conservative approach to protecting capital and modestly growing capital on a real basis."
Bush: That makes a lot of sense. Now, obviously, this is a challenging environment for bond-fund investors today and you have a strong macro view and outlook in your portfolio. Could you talk a little bit about how you're viewing the world today and what opportunities are out there for bond investors?
Atteberry: For bond investors, the opportunities are limited, because you've got some significant distortions in the marketplace against conventional wisdom and sort of conventional thoughts about interest rates. You have a Federal Reserve policy of which it is purchasing Treasuries, with a thought process of lowering interest rates, and it's lowered Treasury rates to where they are less than inflation. So real rates are all negative, unless you go out to a 30-year bond.
And what they're wanting you to do is they're wanting you to take more risk: Go buy high-yield bonds, go buy equities, go buy 30-year this, go buy corporates. All sorts of risk assets. And that has occurred to a degree. But now those risk assets have become mispriced.
People need to keep in mind that interest rates, the interest rate charged on a bond is really a barometer of the credit risk that bond has. The more the risk, the higher the rate. And if you can't even get inflation, then you're not getting a valuable return to put that money to work. As an example, take a five-year Treasury at 65 basis points. Assume inflation is 2%. Well, you're certainly not earning that.
So, we look at that and go, this valuation is very out of line. It doesn't make sense. We also look at and realize a long-term policy of the Federal Reserve Bank printing money in order to buy Treasuries or to buy mortgages is not a long-term policy for funding a Federal Government deficit. It doesn't work.
If I look at a deficit and go, "We don't have a solution to get out of it," whatever it may be--we sit around today on a fiscal cliff, which is a contrived, Congressional activity, we don't have solution to it. We have bunch of [politicians] arguing about it, but we don't have a solution. Until you have that solution of, "How am I going to get through funding the government? Do I need to raise taxes? Do I need to cut spending? How am I going to solve my entitlement programs? How am I going to provide the benefits to the people I've promised--and maybe some people aren't going to get them or maybe I need to charge some more for them--what's the long-term [result] of that? And how if I look out 10 years is the path of my deficit going up or down?" We don't have an answer to any of those.
In an environment where it gets hard to buy fixed-income securities that even can earn you [the rate of] inflation--so you realize I don't know my playing field and my outcomes, I don't know my rules, and I'm not getting paid very much for the uncertainty. And so to us, it says, all right, the investor needs to take a very prudent and a very conservative approach until those all get spelled out. A; I get paid, which means I need to paid at least inflation; and B, I know how you are going to fund the government and fund the entitlement programs.
And I know the regulations of them so I've to exist under as a business. If you have those answers, we'd be really happy to hear them. The problem is, no one has them. So, until you get them, I think it's a very difficult environment today.
Bush: But you have been finding some opportunities in certain parts of the market, so talk to us a little bit about your asset-backed securities?
Atteberry: Yes. You sit back and go, "Where are the opportunities?" A little over 5% of our portfolio is invested in asset-backed securities backed by shipping containers. The 20x40-foot metal boxes that we all seeing running around. It's a very critical to shipping. If you want to bring something from China to Chicago, it will come by ship to Los Angeles, by probably train to Chicago and by truck to the store that you purchase it in.
That container has to be the exact same size. It can't vary. They all have to be the exact same size because it has to fit on the ship, the train, and the truck. So, they're all exactly the same, but they're critical to the shipping business. Now, specifically we find that refrigerated [products] are much more attractive to us, food, medical, some electronics, things that just don't like to be real warm. They need to have some temperature control.
We sort of used to this. If you are in the North and it's March and you go into the grocery store and you see mangos, we weren't growing mangos in the U.S. We were growing them in Indonesia, and they were put on a refrigerated container and brought to the U.S. We have fresh fruits in the winter time. We have fresh vegetables in the winter time.
So, trade of food is one of the things that we looked at. We said, "How could we participate?" And the container space was one because we realized that was the critical element to make the grocery store in the cold climate have fresh fruits and vegetables.
Now, when we're in the summer time, the Southern Hemisphere is in winter time, and they're getting the same thing. And as emerging markets grow more, their middle classes grow more. One of the key elements when that happens is that people want a better diet. A better diet then gets fresh fruits and vegetables less on a season-to-season basis. Some of it's in more meat. So, maybe we sell beef, pork, chicken.
Bush: That's interesting and then another place that the fund has found some opportunities is in the mortgage space. And that's fairly common to see in a core portfolio, but I think you're investing in some different types of securities than some of your competitors. Can you talk a little bit about that?
Atteberry: Yes. We sat down [to examine] how we want to invest in a general sense. And said, we want to invest to where we're lending on assets that are critical to a business or an entity. Housing fits into that. We then said, "We are in an uncertain environment, economy is not growing very well, and consumers are overleveraged. We need to focus on high credit quality."
And that led us originally to look at 10- and 15-year amortization mortgages because that borrower tends to have a better credit quality; it's a lower loan to value. It's interesting, it's really someone that's saving-oriented. If you think about a 10 year amortization mortgage, most of that monthly payment is principal. They're actually acting in a savings mode. They're trying to reduce their debt more rapidly. And we focused on that.
We've done some other niche areas. We find we're looking into right now the jumbo borrower, the very large people that have a mortgage say of $650,000 or $700,000. They used to be able get those through Fannie Mae and Freddie Mac guarantees. Those went away in October of last year.
The securitization market for that kind of jumbo mortgage just doesn't really exist now in the market place. So, they have fewer refinancing options. Yet they are a high-quality borrower. So we find that's an attractive place. While it won't be 10 or 15 years, it might be 30 years. We can get a slightly higher yield through a higher coupon realizing they have few refinance options.
So, we continued just to look at this as a way to ask, "Where can I find a high-quality borrower, who for some reason may be constrained in their ability to refinance or maybe less refinance-centric." They become agnostic to interest rates because the amortization is so short on their mortgages. As an example [take a] 10-year, you can lower rates, but it just doesn't save them any money.
Bush: Those are interesting opportunities. Now, broadly the portfolio has been positioned for a rising-interest-rate environment to protect capital, capital preservation. What happens to the portfolio--and it may take some time for rates to rise--how does this portfolio perform if you do see rates remain low for five years?
Atteberry: Our view is, yes, rates are at unsustainable levels. We have talked about you've got negative real rates. That's just an unsustainable path. We don't have a crystal ball that tells us next Tuesday or the third Friday in 2014 of May, it's going to happen. We don't know.
So we looked at the portfolio and said let's construct it in a manner where we become agnostic to that. So, it has a five-year maturity and less. Things like the mortgages or the container space, and other things, those are bonds that amortize principal and interest every month. So we have that coming back. When you look at the five-year period, 75% of the fund's assets will have come back to us, either as an interest payment or a maturity, or a principal amortization.
And we'll sit and ask, "Where is our best opportunity to reinvest? Have interest rates corrected to more normalized levels, which means maybe we could a longer duration? If they haven't, we'll continue [shorter duration]." What it did is it took us out of the business of having to think "Do I need to sell this to buy that?" No. We'll let the cash flow just come to us, and then look for the best opportunity.
So, what it ends up with is a portfolio that's going to earn probably inflation; that's about what it's going to do. It's going to be very stable as we go through this process. It's not going to have a lot of swings and volatility. And it can protect capital because remember the amortization comes back to us at par, we don't have credit risk to a large degree. So, we don't have default as a big risk and not getting all of our principal back. So, it is [a strategy] very much designed to ride the storm out, preserve capital, earn sort of inflation while it's to doing it, and wait for the opportunities to come and then have that cash going back to you to reinvest in a very systematic fashion.
Bush: Well, this has been very helpful. Thank you very much for joining us today.
Atteberry: Thank you for having me.