Thu, 11 Apr 2013
To the extent that the Fed has been the helping hand of the bond market, when that helping hand is removed, conditions are likely to change considerably, says Met West CIO and manager Tad Rivelle.
Jason Stipp: I am Jason Stipp for Morningstar. It is the future of Fixed Income Week on Morningstar.com, and we are checking in today with Tad Rivelle of Metropolitan West to get some big picture ideas on where the bond market may be headed. He is also a co-manager on our Gold-Rated fund, Metropolitan West Total Return.
Tad, thanks for calling in.
Tad Rivelle: Thank you so much. We appreciate the opportunity.
Stipp: The first quarter for bonds was a somewhat tepid quarter, starting off 2013, yet, we still saw some investors were putting money to work in fixed-income funds, and of course the flows into fixed income funds have been, as you're aware, pretty tremendous in recent times.
So, I am wondering at this point, given that we saw bonds pull back a bit or at least have a tepid performance in the first quarter, what are the right reasons for an investor to consider investing in fixed income, maybe in a fund such as yours, and what are some of the wrong reasons for investors to be putting money to work in fixed income?
Rivelle: Well, after three or four years of debt-induced quantitative easing policies and zero rates, obviously, we find ourselves at a point at which so much of the fixed income market is priced at, really, yield levels that are almost absurdly low, certainly below their long-term equilibrium, and in many cases they represent negative real rates.
So, the wrong reason to be investing in bonds--or at least a diversified-bond type fund--is with an expectation that you are going to see anything like the kinds of returns that you've seen in prior years. Obviously, we've lived through in an environment where a couple of years ago, 2011, the Barclays Aggregate, a broad measure of performance in the fixed-income market--a little bit like the S&P 500--was able to put in returns along the lines of 8%, last year it dropped to about 4%. And thus far, as you pointed out, we are tracking an annualized return rate of about 1%.
So, what are right reasons? Well, one of the right reasons is because bonds still carry positive relative to cash. We are still living in a world of financial repression. The Fed is utterly committed to a continuation of its policies that are holding down interest rates. And as a consequence, at least for now, one is able to earn some incremental return, and I think that relative to the 0% cash, it is still not bad, particularly when you consider asset classes such as non-agency mortgages and leveraged loans and some emerging markets, at least in relation to some of the poorer-priced asset classes, like Treasuries.
Stipp: And when you see the kinds of fund flows that we have seen into fixed income, do you think that the reasons behind them are valid? So, as you said some folks who maybe were in cash and seeking a little more yield have moved into fixed income. Maybe some who are worried about the stock markets have moved into fixed income. Do you think fixed income is sort of overbought, or that people are over-allocated, just because we are seeing tremendous money flow into that asset class?
Rivelle: You are right. The Fed has actually induced that conduct. It has essentially incentivized a portfolio allocation shift in the direction of fixed income, in part by punishing people who have held their funds in the form of cash. One way to think about it is that the quantitative easing policy, money printing policies, are an inflation management tool, one that the Fed has used to maintain levels of inflation somewhere in the 2% to 2.5% range. So, when you are backward-looking, one should view almost the holding of cash as one that has been punished through a savers' levy, a savers' tax, that has cumulated to about 10%.
There has probably been an artificial quantity of funds that has gone into fixed income, and while that money may be relatively secure and in an environment as we mentioned a moment ago where the Fed is so strongly supporting the fixed-income market, I think it is fair to say this: That quantitative easing is an extraordinary measure. We've gotten very used to it because we've lived through it for the last few years, but quantitative easing will end. And when quantitative easing ends--it may not happen in 2013--there will be an abrupt and significant rise in interest rates, in our opinion, and that will produce some messy returns in fixed income and other places as well.
Stipp: To that point, Tad, we've had some commentators tell us that they feel like we're in a bond bubble, and they think what's going to pop that bubble is that rise in interest rate that you just mentioned. What's your take on characterizing the situation as a bubble? What's your feedback on that, and do you think that investors really need to set different expectations for fixed income than perhaps they might have in mind in the current environment?
Rivelle: I guess, to the second part of the question, yes. All investments ought to be calibrated to an appropriate time horizon for each investor. As I mentioned or alluded to a moment ago, one of the nice things about bonds is that they carry positive relative to cash. But, all of us should never forget that positive carry is not the same as long-term positive rates of return. It may help you in here and now--today, tomorrow, next month--but that isn't to say that if quantitative easing ended just, for example, in a year's time, that there wouldn't be a negative return environment associated with bonds.
So, that has to be factored into, I think, each investors thought process. You have to take a hard look at the trajectory of Fed policy. There is a very long shadow that the Fed is casting over this market. Is it a bubble? Well, that's arguably … maybe that's a terms of art. There does not appear to be an excess of speculation and leverage that are typically characterized … bubble conditions in an asset class. But as alluded to, that doesn't mean that you can't lose a lot of money or lose a significant amount of money notwithstanding a non-bubble-type arrangement.
Stipp: And that's certainly that – something that investors perhaps aren't used to seeing in their fixed income portfolios for a while anyway, right?
Rivelle: No, indeed. … I think, is of course looking for the income, hoping for some price appreciation in many instances, but also looking for diversification from asset classes that are perhaps a little bit more levered to economic condition, such as equities and to a certain degree, I suppose, from real estate as well. There was a certain amount of flight from that, given the depredations of the housing market in years that went by. But, as we suggest, to the extent to which the Fed has been the helping hand of the bond market, when that helping hand is removed conditions are likely to change considerably.
Stipp: Tad, let's talk a little bit about your fund's performance. So, you did have outperformance in the first quarter. Generally overall, in an absolute sense, returns were muted across fixed income, but you did better than the Barclays. What was behind that?
Rivelle: Well, a lot of it is a continuation of trends that have been in place for a year or year and a half. We've seen some good price appreciation in our allocation to non-agency mortgages. These are, of course, the non-Fannie Mae, non-Freddie Mac guaranteed mortgages that actually are legacy from the prior period. There hasn't been any appreciable origination of these types of mortgages in recent years. So, effectively we are still continuing to squeeze the lemon, so to speak, of 2005 and 2006 origination. That's been helpful.
Another area that's been very helpful is an allocation to leveraged loans, some allocation to a class of securities that probably can only be described as off the run asset-backed type securities. So, what I'm getting at is that the types of securities that are most closely affiliated and represent the largest portion of the bond indices, things like Treasuries and agency mortgages, are not really the places that are propelling this fund, or any other for that matter, in the current environment.
Stipp: One of the areas that we did see do well in fixed income in the first quarter were more of the credit risk areas such as bank loan funds and high-yield funds. When you are looking at the credit risk that you take in the portfolio, do you think that investors are really getting paid back for taking on the kind of credit risk that's out there when they are looking beyond the safety, the credit safety, of Treasuries, for example, or other government debt?
Rivelle: Right. To talk about the first quarter basically encompasses perhaps a larger discussion of 2012, which as we may recall, had very nice returns in credit and very good returns in riskier credit, in particular. And much of that was an outgrowth of the repricing in late 2011 because of the euro crisis fears that went on at that point that particularly damaged pricing in the financial sector and the weaker tiers of the high-yield market.
So, the first quarter of this year, essentially, the riskier the better as it relates to the performance of corporate bonds and high-yield instrumentalities. So, in the first quarter, high-yield bonds, roughly speaking overall returned about 3%, which of course would annualize to 13%, 14% something along those lines. But within the high-yield asset class, the CCC, the lowest tier, the lowest rung of quality within the high-yield market, put in almost a 6% rate of return, which is extraordinary, obviously, when we are to annualize it out, which we don't think is all that feasible.
Also within the context of both 2012 and the first quarter, we saw a very nice return from the financial sector of investment-grade bonds as well.
But now when you look at the entirety of the fixed-income market, or the credit markets, in particular, you should take away a few observation: The all-in yield of the high yield market is 5.7%. I don't know if it's ever been this low before, and certainly I don't think it's reasonable to believe that it can stay at these levels on a sustained basis. It is being buoyed because we have cheap credit and low default rate in that marketplace. So, I wouldn't necessarily anticipate any obvious catalyst to reprice it. But some of the things that concern us are that 40% of the high-yield universe is trading to its next call date, and consequently if rates were to rise, much of that market would reprice to its maturity date and consequently would lose a certain amount of value.
The investment-grade corporate market is spread at about 130 basis points, 1.3%, to the Treasury market. That's historically not a bad spread. But when you put it, again, into a larger context and look at that all-in yield, that all-in yield puts it something on the order of about 2.8%. Again, these are getting to be, while not maybe relatively such bad numbers, in an absolute sense they're pretty paltry.
Stipp: And you're talking about those spreads obviously against Treasuries. I wanted to ask you about the Treasury market specifically, and how you think about Treasuries in your portfolio. We got some signs, although they were mixed, that the economy was at least chugging along at its sort of slow pace in the first quarter. Treasuries did not do well overall in the first quarter. When you are thinking about the role that Treasuries are playing in this environment in your portfolio, what are some of the big takeaways there?
Rivelle: Well, the biggest takeaway is that most of the Treasury market is at a negative real yield condition. As we stand here today, the 10-year Treasury at 1.8% provides you less yield than the presumed underlying rate of inflation. So, it is a losing proposition, albeit, it doesn't lose quite as fast on a carry basis relative to cash.
But I think that the proper, and in a sense, the only question that needs to be answered by investors as it relates to the Treasury market is when do you think quantitative easing ends, or when do you think that the market discounts that reality?
Importantly quantitative easing, I think, can end for perhaps more than even the couple of reasons that I'll give you. The first reason is that quantitative easing will end because the Fed will declare victory and agree that its target, whatever those are--they're a bit nebulous--but whatever targets that it is looking to achieve in the labor market have been reached, which is to say that if we have growth and prosperity, quantitative easing ends that way, and rates go a lot higher.
What happens if all of this quantitative easing, as many of its critics maintain, is actually doing more harm than good? What if all of this money printing is distorting capital allocations, causing relative mispricing, making the economy less efficient, benefiting those who are closer to the money at the detriment of those who are further away from the money? Well, in that case, we may be heading toward some type of a stagflationary environment, or even I think you could imagine, one in which maybe the housing market just gallops off to the races, decouples from the rest of the economy, and the Fed has to end quantitative easing prematurely because it's creating reprising imbalances in that market that it doesn't view as sustainable.
But until that happens, you get the positive carry, and when it ends, I think, you are going to see some negative return to investors that are holding particularly longer-dated Treasuries.
Stipp: What about the role of Treasuries had in the flight to safety that we sometimes see, because of a geopolitical event? Do you see a value to holding Treasuries just because when everybody freaks out, they invest in Treasuries?
Rivelle: Well, that's been true, obviously in recent years. There are many flip ways to characterize it, that the dollar so to speak or the Treasury market is the least-dirty shirt in the drawer, or something along those lines, and at the moment that continues to be the case. Obviously, the problems that exist in the U.S. are significant, and they may be even worse, I suspect, than many give it credit for. But nonetheless, our situation is far better, of course, than the deflation or the structural impediments to growth that exist in the European theater. Of course Japan is now beginning to experiment with some rather extreme measures of its own to basically wake up that economy from 20 years of ongoing deflation. So, will the Treasury market continue to be a flight-to-quality? Probably. And so it does, in a sense, serve that role that it is a kind of put, I suppose, on the equity market, that if you saw a global decline in equities, it probably would be good buying of the Treasury asset class.
Stipp: Tad Rivelle, CIO at Metropolitan West and a Manager on MetWest Total Return, a Gold-Rated Morningstar fund--thanks so much for calling in and giving us your insights on the bond market today.
Rivelle: Thank you.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.