Tue, 2 Apr 2013
The outlook for bonds is just as cloudy as ever, but Morningstar's Miriam Sjoblom and Marta Norton offer helpful tips for setting the right expectations and creating a game plan in today's challenging bond market.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com, and welcome to [our] second session, Practical Strategies for Today's Bond Market. In this session, we are going to be discussing many of the headwinds confronting fixed-income investors today, and we'll also talk about some practical strategies for confronting them. We will, as always, throughout today be accepting questions from our audience, and in fact, we welcome them. So, if you would like to submit a question, please click the 'Ask a Question' button next to your viewer.
I'm happy to say that I'm joined here today by two of my favorite bond experts. Marta Norton is here from Morningstar Investment Services. She is an investment manager there. Prior to assuming her current position, she was a senior fund analyst with Morningstar, and before that she was an economist at the Bureau of Labor Statistics. She is a CFA charterholder.
Miriam Sjoblom is also here. Miriam is associate director of fund analysis with Morningstar, and she is also head of our active fixed-income coverage. Prior to joining Morningstar in 2007, Miriam was an investment analyst within Citigroup's investment banking division. She, too, is a CFA charterholder.
Miriam and Marta, thank you so much for joining us here today.
Miriam Sjoblom: Good to be with you.
Marta Norton: My pleasure.
Benz: So, obviously, it's a tough time for fixed-income investors. When I go out and about the main think I hear about is bonds and how people should manage their bond portfolios. So, I thought a good structure for today's discussion would be to talk about some of the strategies that we hear people are employing, and I thought we could just start with the first one, which is, why do I need bonds in my portfolio at all?
Yields are really low; prospective interest-rate hikes could crunch bond prices. Should I just forgo this asset class in my portfolio altogether? Marta, I am hoping you can tackle this question because I know you're involved in managing portfolios for Morningstar Investment Services. Let's talk about how you would approach this question?
Norton: Right. And I think that is a good question. Obviously, one of the big advantages to a bond is the fixed income it's producing. So, obviously, if it's not producing as much income, investors have reason to call it into question. But I think there are still advantages to fixed income even if the income isn't that high, and it mainly comes down to portfolio construction.
[Bonds] act as risk mitigators in a number of different ways. One, if you're just looking at it from the perspective of diversification, bonds have low correlation historically with the equity market. I mean, Treasuries, in particular, are the segment of the bond market that are actually negatively correlated with the equity market. So when the equity market is maybe tanking, bonds are going to be holding up and offering some stability to portfolios.
And then just if you look at typical risk measures like volatility, like drawdowns, bonds have exhibited less volatility than the stock market. They typically have less severe drawdowns than the stock market. So for investors who are maybe approaching the point at which they are going to tap their assets, an asset class that's offering stability is not one to avoid altogether or to sell out of altogether. They are stability producers for portfolios.
Benz: So one topic I would like to discuss and maybe you can address it Miriam, is this issue of what happens when yields rise. I think people are really worried about that scenario and realistically it's a possibility in the decades ahead. So, let's talk about as yields rise that depresses the prices of existing bonds. But you get some of that back as yields rise, right? It's just sort of a time-lag effect.
Sjoblom: Right, right. The neat quality of bonds is as yields go up, you suffer some pain in the short term but then you're earning a higher yield on your money. So there's kind of this mechanism built into bonds that whereby over time you can get some of that loss back.
Benz: One thing I often hear from investors is that they are saying, I think I'm just going to build a laddered portfolio of individual bonds. That way I'm not buffeted around. I'm not in for those potential principal losses if yields go up. What do you say to that strategy? And where does buying individual bonds makes sense? Where does it not makes sense?
Sjoblom: Well I think the most important thing is diversification and unless you have a very large sum of money to invest, it can be very difficult for you to get good diversification because there is just a chance that one credit in your portfolio, something unexpected could happen and you lose some of your principal. So, that's a big concern. You get much better diversification, in general, from a bond fund.
The other thing would be trading costs. It can be very difficult for investors to have the size and the market knowledge to be able to get a good price on their bonds and to get good transaction costs. Institutional investors by far in a way have an advantage when it comes to trading bonds. So, liquidity is another thing. If it's difficult to trade and you need to liquidate your holdings, you're going to pay for it. So, those are considerations I think that make it really challenging to be successful investing in individual issues, if you're an individual investor.
Benz: So, would you say Treasuries and high-quality corporates, assuming you have a large enough portfolio, might be a place to consider [buying individual bonds] and then maybe some of these other areas you would go with a fund?
Sjoblom: I would stop at Treasuries. That is where you can go. You can go directly and buy them from the government. So, if you wanted to put together a Treasury portfolio or a Treasury Inflation-Protected Securities portfolio, you can do that very easily.
Benz: Marta, another strategy I've been hearing a lot about and I think it makes a lot of sense to me is if you have bonds within your portfolio, you certainly want to avoid long-duration bonds, I would think [note: duration is a measure of interest-rate sensitivity]. And some people have been saying, "I'm just shortening up. I'm sticking with short-maturity, high-quality bonds with that portion of my portfolio." But at that point, I think people are wondering, you're not picking up that much in yield, but you're still exposed to some loss potential, why not just stick with cash?
Norton: That idea of staying in cash and then investing when valuations are better is something that we see managers do across the board. We own mutual fund managers who tend to be flexible and very valuation-conscious in that regard. So they will sit out an asset class. They will be on a buyer's strike if they don't see the proper valuations, and I think that's a valid choice.
I think there are a few cautions though, to have there. I think, one, it takes discipline to move back into an asset class when that asset class is selling off, and that's what's going to happen in fixed income. You're going to have to see the asset class sell off for the yields to pop back up, and to be moving against the grain is something that investors have not shown they have the psychological fortitude to do. So that's just something to keep in mind when you are thinking about that strategy.
And I think something else to keep in mind is that, it would be easy to have gone on a buyer's strike two or three years ago, right. I mean some of these same conditions might be not as pronounced, but they were still in place.
So, to be sitting out the market over this period, you missed incremental return, you missed incremental income. So it's a little bit of a tactical call that can be costly.
Sjoblom: And just think, there were managers calling for buyer's strike 10 years ago.
Sjoblom: So, this has been really hard to time, and so there is a cost to doing it now, too.
Benz: I want to talk about how investors, if they are looking at their portfolios and concerned about maybe their successive interest-rate sensitivity there, how should they go about kind of troubleshooting those risks within their portfolios? What would you advise them to do?
Sjoblom: Well, a really simple rule of thumb would be to look at the duration of your fund and then look at the yield that the fund--the closest to current yield you can get is the SEC yield. A real simple rule of thumb is if rates were to rise by 100 basis points, or 1 percentage point, you take the yield on the fund…
Norton: Take the yield on the fund and subtract it from the duration.
Sjoblom: Yeah, exactly. So, that would give you – I'll just get though that the Barclays Capital Aggregate Bond Index right now has a duration of 5, and a yield of less than 2. It's hard to believe, but it's true. So, over a year, if yields were to rise by 1 percentage point you might see a 3% loss.
Benz: So that duration statistic, that was going to be a less useful measure if you have other asset types. So, it seems like it's a really good measure if you've got something that's fairly closely tracking Treasury rates; but if you've got, say, other asset classes within your bond portfolio, it might not be as useful?
Norton: Right, Yeah, I think duration, I mean, it's certainly one tool to measure interest-rate sensitivity, but it can just not be as accurate. I think in credit-sensitive instruments that default risk that's built in that kind of bumps up the yield. Duration can overstate the interest-rate sensitivity of those instruments, and I think with short- and long-term parts of the yield curve, duration can overstate the interest-rate sensitivity at the short end too. So, I think it's something that's kind of a rule of thumb, but it's not necessarily going to paint a perfect picture of what your interest-rate exposure is.
Sjoblom: Very back-of-the-envelope, too. When you're doing it over a year's time is actually a little misleading because duration, that 1-percentage-point rise assumes an instantaneous rate rise across all maturities at the same level, which is the scenario that never actually happens in reality. So, it really is just the back-of-the-envelope kind of gut check on what you can expect.
But also another thing is, portfolio durations, especially where you're talking about global portfolio, they're average durations. You don't really take into account where the manager is getting that duration from. So, you have different dynamics impacting different markets. A manager might be very long duration in one market, short duration in another market. And what matters more is the performance in the particular market, not the average duration of the fund.
Benz: And we are getting some questions from our viewers which is great. One question here is, with regard to interest rates going up, do you see them increasing at a slow rate or a rapid rate, and I'll ask you both to get out of your crystal balls. Any insight on that question, what investors should brace themselves for?
Norton: I think you could play out both scenarios. I think there is certainly a case for some sort of events or some sort of catalysts to cause a spike which would be relatively painful, but I also think that you could see like a slower, an improving economy, a slowly changing picture that would cause interest rate movement to draw out a little bit over time. And I don't think that at Morningstar Investment Services, we're really calling for one scenario or the other.
Sjoblom: Most managers I talk to these days too are not necessarily predicting this year a large rise in interest rates or even any rise in interest rates. Some managers who are positioning their portfolios more defensively from a duration standpoint are talking about it just the risk reward trade-off [saying], "Right now, we want to protect against this eventuality and this possibility, but we're not making a call that rates are going to be higher by a lot soon."
Benz: That segues neatly into my next strategy, which is something I've been hearing from investors and we've certainly been seeing it when we look at dollar flows into funds. Investors seem to, be preferring a lot of the core type funds that do have pretty wide mandates; they can range across different parts of the fixed-income sector. And so it seems like investors are preferring some funds like that. I'd like to hear from you both about that strategy; Miriam, you in particular, because you do work on active funds. I'd like to hear about some of your favorite funds that you think would be well-positioned to potentially navigate a challenging fixed-income environment.
Sjoblom: Well, PIMCO Total Return is an obvious choice. It's an enormous fund, but one of our favorites, and in recent years especially, [manager] Bill Gross and the team have done a lot to diversify away from the U.S. market. I think the most recent portfolio statistics put them close to 20% in a mix of emerging markets and developed markets like Canada, Mexico, and Brazil. So, they really are a bit more flexible; you're not going to find those types of securities in your typical aggregate bond-focused portfolio. So, they have a lot of tools at their disposal, and they'll use all they can. I would say no matter what bond fund you're talking about, whether it is Bill Gross or other top managers, they are bond funds, and they are not going to be totally insulated from a bear market for bonds.
Benz: So Bill Gross and PIMCO Total Return, and they also run Harbor Bond. Any others that you like in that realm of quite flexible fund managers?
Sjoblom: Well, I'll throw Dodge & Cox Income out there, not because they are so flexible; they tend to move very slowly. But it's a more straightforward portfolio than you find at PIMCO Total Return, and some investors like to be able to look at a list of holdings and understand what they are getting. The use of derivatives is minimal. So, their focus has been on corporate bonds over the years because they think their research gives them an edge and we do too in the analyst group. So they have focused on corporates lately, they have kept the fund's duration a bit shorter than benchmark for many years now, and again, it's just they think their risk is too high to be taking on interest-rate risk now. If they can get yield by keeping a shorter duration and investing in good corporate opportunities, that's what they're doing.
Benz: One thing I'd like to follow up on is, and I know our colleague Eric Jacobson has been tracking this issue, when you look across the universe of core intermediate-term bond funds, you've seen this tendency for them not to track the major index, the Barclays Aggregate Bond Index. Let's talk about sort of when you look at the typical active core fund today, what does it look like, and why has there been that break in terms of funds not positioning their portfolios to sync up with the index?
Norton: Yeah. Well, I think it's the Treasury issue. I believe the Aggregate Bond Index, and correct me if I'm wrong, it's roughly 36% of it is straight Treasury, and then there are agency [bonds] as well, and those issues, just like individual investors are noting, aren't offering much yield. And they certainly just don't seem to have the strong fundamentals that they've had maybe in the past. And we've heard manager after manager saying that they don't want as much of that in the portfolio. They might not be completely out of that market, but they are very, very underweight. And I think that's very true across the board.
Sjoblom: Well, I would say, if we were talking a year ago, it would be very true across the board, but more recently after you had such a huge rally for corporates, for high yield, banks, agency mortgages have now, with the Fed buying them, become really expensive-looking to a lot of managers. So, I have seen a lot more managers move back into Treasuries as a placeholder just because the really good values that we saw a year ago have dissipated. And there are still some funds out there who do have duration-neutral mandates. So, yeah, I would say, on average you tend to see less Treasury exposure, and I think over time even before the past recent years you would tend to see less Treasury exposure in active fund.
But just to bring your point about it being 36% of the Aggregate Bond Index. The index itself has changed dramatically. At the end of 2007, Treasuries were 22% of the index. So, if the index is changing, managers are faced with, "Should I adjust my portfolio just because issuance is moving in this direction?" So, I think, that's another important thing to keep in mind.
Benz: So, what does that mean for holders of the index, and there are certainly a lot of investor dollars that are invested in some product tracking the Barclays Aggregate Bond Index, should they be worried, should they be augmenting that portfolio with corporates, sort of doing what active portfolio managers do? What's your counsel to them?
Sjoblom: I don't actually think that Ag is over as an investment because I think recent years have shown that there is still a place for government bonds in the bond universe as a diversifier for U.S. government bonds, too. I think you have seen flows into emerging-markets funds, high-yield funds. It's possible investors who do own the Aggregate Bond Index are addressing that issue by investing in these other areas in addition to [the index]. In the past, I think investors are comfortable sticking close to home, U.S. investors. But I can't find anyone even though some managers will use Treasuries as a placeholder today, no one says they are a good buy today. So given how Treasury-heavy the portfolio is, it makes sense to not just have it be your only bond allocation.
Benz: So, just to clarify, in what type of environment would Treasuries tend to perform well?
Norton: Well, they certainly do great when there is a flight to safety. Everyone is looking for the safest security when equity markets are tanking, commodities are tanking, non-U.S. securities, stocks or bonds are tanking. So they tend to hold up fairly well in that environment. And certainly when yields have been higher, they do quite well. I think that they make sense as a security. The valuations are not attractive, but to Miriam's point, valuations across the board aren't what they were a few years ago.
Sjoblom: Morningstar analysts get criticized for sometimes having a 20-year, 50-year horizon. Treasuries will be a good value again. There is no question about that.
Benz: In a related vein, there has been a lot of handwringing about Treasury Inflation-Protected Securities. On the surface, it would seem to be the perfect hedge against higher inflation rates down the line, but you're seeing negative real yields currently on TIPS. So what should investors make of that asset class? Should they avoid it for now and plan to get in when yields are more attractive? How should they be thinking about TIPS?
Norton: So, in terms of a strategic portfolio, a strategic allocation, I think TIPS have a place just like Treasuries do, just like other parts of the fixed-income market have a place in a portfolio. So in our portfolios, TIPS are still an allocation that we have. We are underweight TIPS. So, when we look at those negative real yields, that's not bringing home a lot of bacon for our portfolio. So we're looking for other areas of the market to get some of that exposure. I think when you think solely about inflation, I think there are other tools at your disposal to add to a portfolio or to include in your portfolio that will offer you some measure of inflation protection alongside of TIPS. So floating-rate bonds are one area. High-yield bonds maybe not as much [of an attractive area] as in the past as their coupons have shrunk somewhat, but they still offer some inflation protection. And then there are asset classes outside of fixed income that also can be a good hedge. So I don't think you have to rely solely on TIPS for your inflation protection, and at negative real yields they are not quite as appealing, but I still think as diversifiers, they really do a great job in that department.
Sjoblom: I think it's a basic point, but sometimes I think people confuse inflation protection with interest-rate risk protection. And TIPS do have a duration component and that when real yields are rising, they can suffer losses. So I think we've gotten, at times when there have been rough periods for TIPS, we get a lot of readers of our analyses writing us and calling us, saying, "What is going on?" So I think it's just important to remember if you're concerned about interest-rate risk in general, overall, TIPS are not going to provide protection against that. It's really the inflation component.
And if you look at the 10-year nominal Treasury today, it's at about 1.9% yield, a negative 6% yield. The difference between that is on the TIPS for 10-year Treasuries is called the break-even. So basically you're going to win out if inflation averages over the next 10 years above 2.5%. If not, then you didn't do well in TIPS. But as a hedge, for the possibility that inflation is going to spike above that, it could be useful.
Norton: And if you look at the Consumer Price Index which is a rough proxy of inflation, not seasonally adjusted, over time, its level has been 2.5. So, what you are asking is, is inflation going to be over the next 10 years higher than historical levels of inflation? And I think a lot of people would say, yes, it will be, given the forces that we have at play. So, maybe TIPS aren't so bad after all in light of that perspective.
Benz: Marta, you mentioned floating-rate funds, and this kind of had been sort of a niche asset category until recently where we've seen really robust flows. Let's talk about the characteristics of bank-loan or floating-rate investments and why they might tend to be a pretty good addition to your toolkit, if you are thinking about inflation protection?
Norton: So, floating-rate bonds are relatively, I don't know if you can say relatively unique, but they are special in the fixed-income universe because they are not fixed income. They are coupons that receive adjustments for rate hikes over LIBOR. So, that in itself is a great component because when inflation starts to rise, often interest rates start to rise. And so you're getting kind of a coupon that's getting fatter as inflation and interest rates are moving higher
So that can offer appeal because inflation, or interest rate hikes, are going to be taking less of a bite out of the coupon payments there. And that is not the case for your Treasury or for your corporate bond. So, that's an appealing characteristic. And I think if you just look at where floating-rate bonds sit in the capital structure, they are senior to other types of bonds, though they are often issued by non-investment-grade companies.
So, they have characteristics that just give them enduring appeal, and I think as people worry about inflation and they worry about rising rates, they are starting to shovel money into the floating-rate category, and that maybe means valuations aren't what they were. I mean if you look at the percentage of floating-rate bonds that are trading above par value at this point, I believe at the end of 2012, it was somewhere in the 80% realm; a year before, it was around the 60% realm. So, all of that flow has really pushed valuations to less attractive levels. But if you look at the fundamentals of the asset class, I wouldn't say that we're seeing a breakdown there. I mean, there are more covenant light issuance coming out.
Benz: What does that mean?
Norton: That means that the bonds offer less protection really for the lender. They're less stringent in terms of their requirements. So that's a sign that maybe fundamentals aren't where they were, but still if you look at coverage ratios, they're at their highest in three years. A lot of companies have refinanced their debt, so they don't have maturing debt coming due right away. And the economy is showing signs for improvement. So there are fundamental characteristics about the floating-rate bond universe that still make it somewhat attractive. So on a relative-value basis, even though they are not as attractive as they used to be, they still offer some appealing characteristics.
Benz: Miriam, I know your team covers some floating-rate or bank-loan funds. Can you mention any funds that they tend to like more than others?
Sjoblom: I will defend with my last breath Fidelity Floating Rate High Income, which has not looked extremely great in recent years. It's really probably the most conservative bank-loan fund. But I think for investors who want just simply that protection from rising rates and not the volatility of a really credit-heavy portfolio, this is a great option. And it hasn't had the chance to shine in recent years, but I think it will do really well. If to the extent, credit fundamentals do deteriorate, the fund will be really well-positioned in addition to just benefiting from floating rates.
Benz: Okay. So the junkier portfolios have had better returns recently and higher yields probably, so investors might be attracted to them, but you think the conservatively positioned fund is a little better, a lot better.
Norton: And just to point on that, so in spaces like floating-rate bonds or high-yield, where you are dealing with non-investment-grade securities. Our perspective is typically that we want to find a conservative manager. We can still get some of the income or some of the appeal of those securities but we don't have to get dangerous to do it. And these managers tend to hold out very well in downturns. If you look at Fidelity's returns in 2008, they were stronger relative to peers who really got their shirts handed back to them.
Benz: We got a question from one of our viewers, and that's about allocations to bank loans or floating-rate funds. So, assuming I have a fixed-income portfolio, what would be a reasonable ballpark for the floating-rate piece?
Norton: Well, something to remember is that a lot of high-yield managers also invest in bank loans. They see it as kind of an alternative or a substitute good. So, you can get some exposure there. So, you'd want to double-check what kind of exposure you already have. But I think it depends on your mandate for your portfolio. We have some portfolios that are aimed at inflation, so the floating-rate component there is actually high, and high in my perspective is, 15% of an overall portfolio is unusual for floating-rate bonds. But I think that if that isn't your main goal, I think you could keep some more marginal players under 10%. I think it just depends on your mandate for your portfolio.
Benz: I know some people have been actually using bank-loan funds or bank-loan investments in lieu of cash. I'm thinking you're saying not such a good idea.
Norton: I mean from my perspective, no. I don't think I would go that route.
Benz: So, we have hinted at this a couple of times, we've seen these very robust flows to noncore fixed-income asset classes; bank loans have been big beneficiaries, high-yield bonds have been getting great inflows, as well. And I'd like you to both talk about whether that worries you. Emerging-markets bonds is another big category in terms of new inflows. Are you concerned, Miriam, about some of the flows we're seeing there?
Sjoblom: Well, I'm always concerned to the extent investors are chasing yield and chasing performance without a full appreciation of the risks. And I think with yields so low on investment-grade bonds in the U.S., there's just this push out further to take on more risk, and it feels a little indiscriminate to me. So, I would say for high yield, we're still hearing from managers. A high-yield manager will always love to talk about how great…
Norton: … his asset class is. It's never, never a bad value.
Benz: So even though the spreads are really compressed, they still think…
Sjoblom: Well, spreads, because Treasury yields are so low, are actually just inside of historical averages.
Sjoblom: So, from a relative-value perspective, that's why you're seeing diversified managers [consider high yield]. And actually, interestingly enough, it is the high-yield manager today who will point out absolute yields are incredibly, incredibly low for high yield. At the beginning of 2012, the yield on the Barclays High-Yield benchmark was above 8%, it's now below 6%, which is incredibly low. And Dan Fuss of Loomis Sayles Bond is known for investing in credit-sensitive stuff, and he has been very vocal about saying, high-yield, as across the board, is just priced at ridiculous levels. He's been very vocal about saying that.
Norton: And correct me if I'm wrong, but I believe in January the Barclays High-Yield Index hit an all-time high price of $106, and I believe historically it's been around $92. So, I mean just in percentage terms, that's a big jump, that's a big move.
Benz: So, from a practical standpoint, if those yields go down, and they had been higher, if the yields are down in absolute terms, that means they have less of a cushion, right? If anything happens, if people get worried about the economy, it's just that they have less of that buffer?
Norton: To that point, I've read some folks pointing out that high-yield tends to be relative to other areas of the fixed-income universe, a place where you can get some interest-rate protection or at least not suffer quite as much. And the point is that with coupons shrinking, they're not offering quite as much protection in that scenario, and that's a scenario that's on a lot of people's minds. So that's just something to keep in mind. If you think you have fail-safe portfolio because you're heavily invested in high-yield, it might not do as well as it's done in the past.
Sjoblom: That's especially true for the higher-quality BB segment of the market where yields are lower than that 5%-plus that I mentioned for the market overall. And so, I think the last option-adjusted spread over Treasuries that I saw for the BB segment is around 300 basis points, 3 percentage points, and that's a pretty thin cushion. If Treasury yields are going to start rising that cushion is going to start compressing. And one thing I hear from managers is, as the diversified core bond funds move down in quality, they're buying the BBs, too, so there has been a lot of demand for that segment of the market. So people who might think they are being conservative from a credit risk standpoint might find they have more interest-rate risk than they imagined.
Benz: Another category that investors have obviously been embracing has been the emerging-markets bond category. We've seen a couple of years of just tremendous flows there. And investors, I think, are enticed by what they see as improving fundamentals in emerging markets. Let's talk about that category and talk about the role of international bonds more generally within investors' fixed-income portfolios. Should they be part of their toolkits? What sorts of risk factors should they have in mind at this particular juncture?
Sjoblom: Well, I think, yes. And we can talk in more detail about that. But I think the biggest question right now facing an investor is, "What do I own in the emerging-markets category?" because just in the last several years the market has changed dramatically and the category has changed dramatically. We have 75 funds in our active emerging-markets bond category right now. And funds with three-year records right now are 28. So, the category has grown tremendously in just the past three years…
Benz: To meet that investor demand for products probably.
Sjoblom: But you are seeing also a very heavy launch in local-currency bonds, emerging market corporates, but you know, dedicated strategies.
Benz: Let's discuss first, Miriam, when you think about emerging-markets bonds, what is sort of the core vanilla take on that asset class?
Sjoblom: Well, I think it's changing because the old stalwarts in the category are focused on the external sovereign debt market, which is dollar-denominated sovereign debt, and historically that was the market because these were countries with dicey finances, dicey credit fundamentals. And the only way they could entice investors is to issue in dollars. So, that has changed dramatically.
I saw a statistic that said local currency bonds are actually 80% of the emerging-markets universe. So, you've seen a shift from healthier countries that have gotten their fiscal houses in order and have continued to exhibit prudent fiscal and monetary policy have developed these local currency markets at home, and those have grown substantially. So, you get better liquidity as the market has grown in those markets, but at the same time you get the added element of currency risk, which currency investing just is more volatile. So you've got some better fundamentals in the local currency market.
Still in the hard currency market you are finding the dicier countries are just starting to issue bonds, or still issuing into that market, so there are some credit concerns there. So, it's kind of a balance. It's a trade-off; one, you'll get credit risk and no currency risk; and one where you get currency risk, less credit risk.
Benz: So, what guidance would you give if investors are looking at this category? How should they go about conducting due diligence on what the fund is doing? Marta, maybe you can take that.
Norton: Yeah, I think they should read Morningstar Analyst Reports for one on some of those funds.
Sjoblom: I agree.
Norton: But I think it's very complicated, and I think that's something worth pointing out that you're dealing with a different animal. I think it's an animal that's worth having in your portfolio. I mean, we have exposure on a strategic basis, meaning on an evergreen basis we have non-U.S. and emerging allocations in our portfolio.
But we tend to go with managers who are proven their worth, who show that they can manage these different markets, who have a lot of resources at their disposal, who can clearly explain what they're doing. I believe it's Warren Buffet who says, you really should own what you know and stay away from what you don't know. So, if a manager is doing things that you just don't understand, even if it's compelling, even if it compels your neighbor, I don't think you should necessarily go into that space.
So, go with a manager who is doing something that makes common sense, who has experience, who has resources, and then this is a point I'm sure everyone gets tired of hearing Morningstar people say, but also look for low expenses and good stewardship and funds that are reasonably managed from that perspective. And I think that there are good funds out there, where they are flexible, and the manager is making that currency call for you. And he knows a little bit more about it, and I don't think that's such a bad way to go about it. It's a way we think about it. We let the managers make the currency call for us because to be honest, we just don't have the resources or the wherewithal to make that call ourselves.
Sjoblom: That is the really the missing component, I think from that category is you have hard currency…
Norton: On the emerging side.
Sjoblom: On the emerging side, yeah, hard currency, local currency, corporates, and very few total-return or fully flexible strategies. More are coming out. PIMCO recently launched what they are calling a full spectrum of emerging markets. TCW Emerging Markets Income has every single one of those components in their strategy. That fund has really taken off and performed really well and at a time when risk-taking paid off. So I think that says something about the risks that it takes. But I would really like to see more of these sort of full-spectrum options because it will change over time [depending on] what's more attractive. Is it more attractive to be incorporates or local currency or hard currency. And it'd be nice to have a manager with some expertise making that decision.
Benz: So, just to dial it back even further, Miriam, you cover the Templeton Global Bond products for Morningstar. Let's talk about those funds, and I know a lot of do-it-yourself, no-load, investors are kind of on the outside looking in, but let's talk about how those funds are managed and how one might think about holding such a fund? What sort of expectations they should have?
Sjoblom: Well, the central premise of the fund is that global bond benchmarks are fundamentally flawed. They skew toward the most indebted issuers, the biggest issuers out there, and countries with sort of not the best fundamentals.
So, the approach is really I would say the old-school version of unconstrained because cash is the starting point. That's neutral for [manager] Michael Hasenstab and his team, and so then he evaluates all potential investment opportunities relative to cash.
So, I think there are other strategies that take a similar approach in the world-bond space, and then there are some that are very more benchmark-constrained. And what you get in a benchmark constrained approach is very heavy exposure to Japan, to the eurozone, to the U.S. if it's a fully global fund, to the United Kingdom and not very much exposure to emerging markets that are looking a lot like they are on much more solid footing from a fundamental standpoint.
Benz: So, can you give an example of a no-load non-benchmark-constrained fund for people who are looking that that Templeton fund and wanting it, but not wanting to pay a sales charge?
Sjoblom: I can't.
Benz: There is no good substitute?
Sjoblom: Do you have one?
Norton: Tough situation. I don't. Unfortunately, I don't know one off the top of my head.
Sjoblom: I think it's possible you might get exposure through your retirement plan to Templeton or others. Another one I really like that is not anywhere near as big, but has a similarly long or longer track record running this kind of approach is run by a team out of a company, a subsidiary of Legg Mason called Brandywine Global. It's Legg Mason Brandywine Global Opportunities Bond.
And they've just had the same approach where they don't want to invest in the poor credits out there. So, they've had much more of an emerging-markets focus, very active on the currency and rate calls across these markets, and also they are very concentrated usually picking about 15 countries that are their favorites.
And they have a tremendous record of doing this. The managers really pioneered this approach about almost two decades ago.
Benz: Another user question is if they are thinking about their fixed-income portfolio, what percent should be in foreign bonds?
Norton: These questions are tough because it's going to depend on the portfolio mandate. So, if you get to a more conservative portfolio, meaning more allocation to fixed income that's a bigger part of the portfolio. From our perspective about 10% of the overall portfolio could be in non-U.S. bonds.
Benz: So, it depends not just on you as an investor, but also given how different these portfolios are, what the structure and what the setup of the fund is?
Sjoblom: Yes. To bring you back to Templeton for a second. It's the biggest world-bond fund, but it's also one of the biggest outliers in terms of how it's positioned today and how it's performing. Its duration is very low. It's been under 2 years for the past two years, Michael Hasenstab is very concerned about inflation across the globe, and so he doesn't want to take that interest-rate risk on. But he's at the same time liking emerging markets, liking Asia, and some Eastern Europe. Ireland was a call. So he's taking some credit risk in areas. Mexico is another one he likes.
The result has been a pretty volatile portfolio in recent years for good and for bad, and of much higher correlation to equities, too. So when you're deciding how much you want to allocate to a global-bond fund, you got to understand its strategy and how it is positioned today and how it's been performing and what role it's likely to play.
Norton: I just want to touch on that point a little bit more because I think that's a really important point. I think when people think of bonds, they think of Treasury risk/reward and the past history of Treasury risk/reward. And they don't necessarily realize the correlation that some of these niche products or noncore products have with the equity market. I mean, high yield, it's correlation over time with the equity market has been very high.
Benz: Much higher than with the bond market, correct.
Norton: Right. And so I've actually heard some high-yield managers argue that your high-yield stake shouldn't necessarily come from your fixed-income bucket. It should maybe come from your equity bucket, so, just something to think. When you're thinking of your overall portfolio, your overall diversification, don't just think that because this has bond in its name, it's going to perform with the volatility of a Treasury bond over the past 20 years.
Sjoblom: And one more point to that, too. When you talk about an actively managed, a very flexible mandate, the past performance is not necessarily that relevant if the manager has dramatically changed the portfolio. In the case of Templeton, that's what we saw. The fund was one of the best performers in 2008 because he positioned it very defensively at that time. Now, it's a completely different animal.
Benz: So, another viewer question here. And this is a person saying given the fixed-income environment, what do you think about a barbell strategy of half very safe short-term bond funds, half riskier high-yield and floating-rate funds? It sounds like based on what you just said that that would be too much in the high-yield/bank-loan/floating-rate category.
Norton: It seems like a lot. I mean if this person has a higher risk tolerance and if the concern is truly rates and inflation and he can withstand volatility, I mean perhaps it's the right approach for him. I think that's more aggressive than many investors can handle.
Benz: Miriam, we also have some questions here about municipal bonds, and I know that that is an area of great interest for you. You've focused on that area for us for a long time. So the question is, can you discuss the overall muni landscape? We've talked about taxable bonds exclusively up until this moment. So, I'm wondering if you can kind of share what you're thinking about this sector and also maybe harness some of the intelligence that you're hearing from the fund managers who you like?
Sjoblom: Sure. So post-Meredith Whitney's [comments on 60 Minutes in 2010] the predictions of a very large number of municipal defaults turned out not to be accurate. On the fundamental trend standpoint, we are seeing revenues increasing for states and some local governments. There are still some challenging situations out there.
Local governments, a lot of them do rely on their states for support, and you are seeing states having to cut back. The federal government is cutting back support, states are cutting back, and local governments, many managers have said, are going to be the ones holding the bag at the end of the day.
But that doesn't mean there's going to be a broad wave of defaults among local governments. What we have seen since the recession has been very tough political decisions being made. Revenue is being raised, costs are being cut, and for the most part, budgets have been balanced.
So credit, I think, has turned out to be a bit of a red herring as a concern for investors. However, I think what's more important is, if you're investing in a bond fund, what is the strategy of the municipal-bond fund you're investing in, because if you're investing in a lot of credit, you're going to get the volatility of those lower-quality bonds. Some managers use leverage, and open-end fund investors may not realize…
Benz: So you do find leverage in open-end funds?
Sjoblom: You do, yeah. It's through a structure called tender option bonds or they're also called inverse floaters, so you can have leverage. It's a way of increasing income but it also increases interest-rate risk and volatility in the portfolio.
Benz: So how would I know that? If I have a fund or I'm looking at a fund, how do I go about finding if it's got these inverse floaters or some other form of leverage?
Sjoblom: Well, you could read the Morningstar Analyst Report.
Norton: Those crack analysts.
Sjoblom: But it does require a little more work. You've got to go in. Maybe a fund company is going to disclose it in their summary information, but I wouldn't count on it. I would go into the actual disclosure of the scheduled investments. They'd have to disclose them four times a year and look and see. You can do a search for an inverse floater or a tender option bond and see if it shows up. And another thing, you could look and see if the net assets, if it looks like there's some liabilities that are large at the bottom of the schedule of investments, it's possible those are from leverage from an inverse floater.
Norton: And I also think, I mean, even though credit hasn't been the concern that people had before, I don't think you'd necessarily recommend that individual investors buy muni bonds directly thinking that credit's not an issue, I mean the credit research matters.
Sjoblom: I think one of the interesting things about the Meredith Whitney episode was there were concerns about a wave of defaults in an area where you had never seen defaults before, and by and large that turned out to be incorrect. But there have been defaults still in areas where you would expect them to be.
One of the biggest areas of muni-bond defaults has been the Florida Real Estate Land-Secured Bond sector. Many of those land developments were never built out, dealers walked away, and they have defaulted. They burnt through their debt-service reserves.
Another area would be corporates. [American Airlines parent] AMR's bankruptcy. AMR is a very large muni issuer in the high-yield muni market. So some funds, when AMR declared bankruptcy, did suffer because they had large exposure. So, I think especially in the lower-quality area of the muni market is still somewhere you have to be with a manager who has got a great research team. I'd say that for high quality too. You want to invest with a manager that has a solid research foundation.
Benz: I'm wondering, if you can give us a couple of picks and maybe in the high-quality space, more sort of core as well as something that is maybe going to venture into the lower-quality muni area?
Sjoblom: Sure. Fidelity Intermediate Municipal Income is one for the high quality, and that is a pick. And that one has been also not a great performer in recent years because the market has favored the riskier funds. And you've seen in the intermediate category, especially managers are less concerned about duration, and they're just looking to get the incremental yield.
So they'll move further out, to take on more interest-rate risk, but Fidelity has kept their duration close to benchmark, kept being very circumspect about security selection. But they're just a top grade team, fantastic, deep team of analysts, managers who are very experienced and have great background in trading quantitative resources. They're just the package.
Benz: So, how about a more aggressive idea for muni investors to keep to a small percentage of a portfolio?
Sjoblom: Yes. I would say T. Rowe Price Tax-Free High Yield is one of our favorite high-yield muni funds and that is another one that has been more in the middle of the pack in recent years because it's not one of the riskier funds, but very minimal use of leverage in that fund. It has great solid research, support, and foundation.
They have been investing a little more in corporate-backed munis in recent years, and you have a really great corporate analyst team at T. Rowe Price, as well, so it makes good use of the full firm's capabilities.
Benz: Another question from one of our users is about muni ETFs, exchange traded funds. What's your take on buying an index tracker within the muni space?
Sjoblom: Well, I think Vanguard's active funds are in many ways seen as index trackers, even though they're not technically such.
Benz: There are so big.
Sjoblom: They are so big. They do try to keep very broad exposure to the market and don't take big bets against the market in any one area. So, low-cost is sort of the appeal of the Vanguard lineup, and I think the ETFs would be the same story. I think that the muni market is very inefficient. So, I do think there are plenty of opportunities for active managers to be able to take advantage of mispricing. So, if you are willing to pay a little bit more for active management, a good solid firm, then that's my preference.
Norton: From our perspective, we offer a lineup of ETF portfolios with taxable bonds, but we don't have the same lineup with muni bonds, simply because we're a little concerned that ETFs in the muni space have the ability to track as closely as we'd like the benchmarks.
Benz: One other last question and we'll have to tackle it quickly, even though it's kind of a large category, convertible bonds' role within a portfolio. Do either of you focus on that area? Do you like it, or how should investors think about investing in converts?
Norton: On an asset-allocation basis, we don't have a separate allocation to convertible bonds, but I do think that they are a great vehicle. I think they can offer a great source of return. Again, I think taking an approach, there are not a lot convertible mutual funds out there, first of all. But I think Calamos is typically the place people go for those types of securities.
I think it's important to keep risk in mind with converts, too. A lot of times to get convert exposure you can use a strategy, convertible arbitrage, which is selling underlying equity and I think that's a meaningful approach, and I think there are some options, not very many, but some options out there and that's a way to slot it into your portfolio.
Benz: Well, I think we're going to have that be the last question. I want to thank both you, Miriam Sjoblom and Marta Norton, for being here today. You both offered a lot of great ideas and indeed a lot of individual picks, and I wanted to note that we will eventually later be providing a transcript that will include all the tickers. So for people who were furiously scribbling notes, we'll actually have the fund names that we've discussed here, as well as the tickers. So, thank you both for being here. We really much, very much appreciate it.
Sjoblom: Thank you.