Fri, 12 Apr 2013
Relative to history and expectations, bonds are overpriced in general, says Loomis Sayles Bond manager Dan Fuss, who is taking a selective approach with caution toward credit risk.
Jason Stipp: I'm Jason Stipp for Morningstar. We're talking about the future of fixed income this week on Morningstar.com, and we're checking in with bond veteran Dan Fuss of Loomis Sayles Bond, that's a Gold-rated Morningstar Analyst-Rated fund. And he's going to tell us a little bit about his take on the fixed-income market today.
Dan, thanks for calling in.
Dan Fuss: You bet. Good to be here. Thank you.
Stipp: First question for you. Bonds were off to a somewhat tepid start overall in the first quarter of 2013, but we did see investors continue to put some money to work in bonds. And, of course, the flows into fixed income in recent times have been tremendous. So my question to you is, at this juncture what is a good reason, what is a bad reason, for someone to put money to work in fixed income today?
Fuss: Well, I'd like to say, there's never a bad reason, but the reality is that interest rates are very, very, very low, and I don't know the future anymore than anybody else. The odds, I think, highly favor a rise in interest rates going forward whenever the Fed stops buying Treasuries or slows it down. So that doesn't mean you avoid bonds. It does mean, however, that you have to focus on an approach to bonds that can deal with a rising interest rate environment. And that's very, very different from what the focus is when you have a declining interest rate environment.
Stipp: And, of course, a declining interest rate environment is something that investors have gotten used to, I think, over the recent past, as well as several years into the past. What about investors' expectations for their bond holdings? We've heard some folks talk as extreme as that we're in a bond bubble, which could be very painful for investors. You said there's not necessarily a reason to avoid fixed income altogether. But what should investors be expecting out of their fixed-income holdings, if, as you say, we're going to at some point see that rising rate environment?
Fuss: Well, what happens is, you have a bad news/good news [situation]. The bad news is interest rates go up, bond prices go down, depending on how far in the future you get your final payment--in other words, the average maturity of the fund if you're using a fund, or the absolute maturity for an individual bond.
The good news part of it is to the degree you're re-investing the coupon flow, for example, your income also rises. I grew up in the business for 23 years when interest rates always went up. It's a very different way of managing a bond portfolio. From a total return viewpoint, the total return lags the rise in rates. The income gradually goes up with a lag also with the rates.
So you have to be very careful not to be out, say, buying extremely long pure market risk, long Treasuries or Treasuries zeros, which works wonderfully well when rates go down. On the other hand, you can't come in and sit in Treasury bills, because you have no income. So you're somewhere in between. And if you're in munis, you ride the yield curve, doesn't work so well in taxables, and just pay attention to the bond portfolio. It's actually not a high turnover environment. It's bond-picking instead of taking market risk is a simple way to look at it.
Stipp: … When we hear commentators say things like "bond bubble," we expect that there'll be a period of sharp pain, where we will see potentially somewhat sizable losses in fixed-income funds. Is that a possibility that investors should be prepared for, for their fixed-income investments?
Fuss: Well, I think you have to be prepared for that at any time with any investment. Where bonds are different is, let's say the price drops 20%, which would be very extreme for bonds. The bond is still there--you're still getting your income--and on the final payment date, you'll still get your money back. So that's the good news.
The bad news is you feel rotten. You look at [your bond] and say, now, why didn't I sell that and just buy it after it went down 20 price points. Now, a 20-price-point drop could certainly occur with a 30-year Treasury zero. It'd be very unlikely with a six-year corporate. If you're reinvesting your income flow right now, then you say, well, this is good news, because I'm going to make more money in nominal terms than I had planned on.
So the "bond bubble" statement… you have to be careful [saying "bubble"] when you're dealing with fixed cash flows. If you have uncertain, like you would with real estate or stocks or most things, that's another matter. Then you can get bubbles. With bonds, I call it overpricing. It's semantics, but it's important.
Right now, bonds are, relative to history and expectations, overpriced in general. In specific, you can deal with it, but you can't just go buy the bond market.
Stipp: So we've been talking, Dan, a lot about interest rate risk and what can happen is to fixed income. Let's talk about credit risk.
So in the first quarter, riskier fixed income did a bit better than the fixed income market in general. This is an area of expertise for you and your fund … you've been very good at investing in the credit sectors. Right now in the fixed-income market, are you getting paid for some of the credit risk, and where do you have to go to make sure that you get the kind of return that's commensurate with the kind of risk that you're taking? Investors seem to like some of these riskier sectors. What's your take?
Fuss: There are several riskier areas, the most common that people focus on is below-investment-grade. An acronym for that is "junk bonds"; that's a misleading acronym.
The below-investment-grade area has been receiving phenomenal inflows, earlier in the year on the institutional side, and then also on the mutual fund and the ETF side--particularly the ETFs. And it's expanded out; it includes emerging-market debt and things like that. As a result, you had new offerings in the high-yield and the emerging-market area to meet that demand.
In my own opinion, and this is hard to prove one way or another, I think as a general statement, high-yield and emerging-market both are very, very pricey relative to the credit risk. The difference between Treasury yields and high-yield and emerging market is still reasonable. But the problem you have is the Treasury yield is so low, if you're looking at a five-year, you have a 0.70% yield on Treasuries. That kind of difference from there to, say, a 5% on a high-yield bond is a reasonable difference, but you have to allow for the fact that as interest rates go up, credit trends turn negative. So it's time to be more cautious on credit risk, I think, and we are being more cautious on credit risk. You don't run away from it, but you have to become very selective and you can't just buy an index of a high-yield market.
Stipp: So, Dan, what does that mean in practical purposes for where you're finding opportunities for the portfolio right now? So if high-yield in general, on relative basis, looks in line with historical, but on an absolute basis, as you said, isn't really necessarily paying you for that risk, where are you putting money to work in the portfolio?
Fuss: It's been in some non-U.S., very high quality, relatively short Australia and New Zealand government bonds. For example, Canadian government bonds is our biggest holding, but very short maturity, because … once U.S. rates start up, that's going to affect the other markets. But we like the outlook for the currencies, and we also like somewhat higher yields in the U.S. That's one.
The key thing, to use, say, Loomis Sayles Bond as the indicator, way back when we were just wildly bullish on the bond market, I think we had an average maturity of perhaps as long as 19 years. In more recent years, it was around 10.5 or 11 years. Right now it's 7.8, or something like that. That's a meaningful difference. We don't have a lot of discount bonds, because there aren't many discount bonds around. All I would say, 70% of the fund is what would fall in the category of "special situation." It doesn't mean necessarily low credit. Some of them are, in fact, AAA credits; not many, but a lot of AA, A, and BBB. It's item picking. That's the way we've gone.
I would not, at this point in time, be an aggressive buyer of credit risk. Short-term, life is wonderful for the lower-rated credits, because they can refinance their existing debt at lower and lower rates, because of the supply/demand in the market. As long as the Fed keeps buying Treasuries, that's probably going to continue. But once they slack off, then there is the area of the market you've to be very careful in.
Stipp: Last question for you. Dan, you talked about how you look overseas for certain opportunities. I'd just like to get your take on some of the extraordinary measures that we've heard coming out of Japan and their monetary policy. What's the effect, potentially, not only just for Japan, but could there also be knock-on effects as far as currencies in other parts of the world, because Japan is really taking some extraordinary measures now?
Fuss: They really are. I happened to be in Tokyo right before they did that, and the degree of the action by the Central Bank there really surprised everybody, I think, or nearly everybody.
They're joining the other major central banks in what they're doing. So that you have the U.S. Central Bank, the Japanese Central Bank, Great Britain, Europe in a different way, all following reflationary practices that are strong, because they're trying to support their economies, and in Japan's case, [they are] particularly afraid of deflation.
Japan's situation is different, very different, a declining population, declining and aging. So it's a very different setting, but the practice is pretty much the same. Now, as a result, you say, well, jeepers, normally in this situation, the currency would just drop through the floor. It has come down a long way in recent months, but only getting back to the levels it was before that. So you've taken out the spike, most of the spike in the currency, there is a little more to go, and nothing more than that.
From an investor's viewpoint, and this is already starting, you would expect local investors in Japan to start to head toward other markets, because they have very, very low interest rates, lower than ours, and a weak currency relative to ours and relative to most any other currency you can imagine.
There's been an unexpected spurt in foreign holdings of New Zealand government bonds, and some people call us up and say, "Was that you?" I say, "No, no it wasn't. That's the fund flows, that's the central banks." For all I know, it's the Japanese Central Bank, I doubt it, but it's others.
So people anticipate and deal with that.
If you want to be a worrywart, and I am in this regard, I would say you have to question the long-term viability purchasing power, from a purchasing power view, of all of the major reserve currencies. That's probably what's coming.
Stipp: All right. Dan Fuss, manager of Loomis Sayles Bond, a Gold Analyst Rated fund here at Morningstar. Thank you so much for your insights. It's always great to hear your take on the fixed-income markets.
Fuss: Thank you very much. Appreciate it.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.