Mon, 15 Apr 2013
There are fundamental reasons why rates are so low today, but that doesn't mean there aren't potentially significant risks to holding bonds, says Western Asset's Steve Walsh.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.
I'm very pleased to be joined today by Steve Walsh. He is the chief investment officer of Western Asset, and we're going to look at some hot topics in the fixed-income world.
Steve, thanks for joining me today.
Steve Walsh: You're welcome, Jeremy. Good to be here.
Glaser: So, we've seen a really substantial amount of flows into bond funds over the last couple of years. What do you think is driving that continued interest in fixed income? Is it a search for yields, or is it a search for safety? Why are investors allocating to bonds right now?
Walsh: Jeremy, I think it's probably a little bit of both. The one common factor across the world, really not just in the U.S., is we're in a very low, low interest rate environment, and you've got a world that to a large extent is pretty income-starved. So, I do think the moves into fixed income have been partly a desire to find some yield in a marketplace that doesn't offer it in cash. There is no really safe place to just put your money and not effectively lose money through inflation, so there is certainly a demand for yield across the world.
I do think given the last decade or so of fairly volatile stock markets that there is an element that is also driving these flows, which would be a demand for a little bit greater safety or security in their investments than what retail investors certainly have experienced over the course of the last 10 or 12 years in stocks. So, I think it's a combination of both of those.
Remember, I think especially if you look to the Federal Reserve, a desired outcome of their monetary policy is to get people to take more risk. They take interest rates down to zero to try to encourage people out the risk spectrum. They're getting the desired response, which is: Hey, I am earning zero in my cash, and I better go find another asset that might at least give me something.
So, that's sort of ripple effect across other sectors of the fixed-income markets is, again, exactly what the Fed is trying to do. And, again, you see interest rates below one in Europe, you see in the U.K. Obviously, you see the same thing for over a decade in Japan. So, I think all of that together is leading to just a lot of demand for fixed-income products, even at these relatively low yields.
Glaser: So do you think investors have reasonable expectations for the kind of returns they can expect in fixed income, or do you think people have outsized expectations there?
Walsh: Well, I guess I'd like to think that people are dialing back their return expectations. I mean, we certainly are going out to clients and saying, hey, it's unlikely just the way math works in bond land for you to continue to get double-digit returns. So, high yield, for example, is up 16% or 17% today. Well, that could happen again in, say, this year, for example, that spreads really come even further in than they already have. But the likelihood is that return expectations are going to need to be dampened, and I think investors are slowly coming around to that.
I suppose if there is a fear or a risk, it's that investors, and again, maybe a little bit more on the retail side, might not fully appreciate the impact of what a lot higher interest rates would do to bond returns. Again, if you gave an exam to folks that, what if interest rates on the 10-year note, for example--I am not saying they're going to--but if they were to go back to 4.75% from the 1.75% today; 4.75% historically in the U.S. has been a fairly low interest rate, that your 10-year note would lose 25% of its value.
I don't know that that sort of appreciation for principal loss on securities, given changes in interest rates, might be appreciated. But I'd like to think generally institutionally and overall, people recognize that the sort of flamboyant returns bonds have given investors over the last few years are actually probably not repeatable, but that's a good question. The one area that I'd be most concerned with is whether investors really appreciate the potential for what changes in interest rates can do for return patterns in bonds.
Glaser: So, what do you think of this talk of a bond bubble? Is that somewhat misguided no matter what happens with rates?
Walsh: Misguided might be a little aggressive. Remember, … the old adage was always stocks for the long run, and that was just kind of a well-used phrase, and [with respect to] the end of the bond market, I feel it's kind of the same. I think it's overused and over-expected that that's the end of bonds. Bonds have been in a 30-year bull market, we all get that. But I don't know necessarily that I'd embrace the sort of thinking that says bonds are in a bubble.
I mean, it's a difficult market. We all recognize it … Treasuries specifically, maybe agency mortgages that are clearly being bought in huge quantities by the Federal Reserve. Remember, the Federal Reserve is not an economic buyer. They're not looking for valuation or looking for good investments. They are just putting their money to work to try to, again, get investors into other sectors. So those two sectors in particular, I think we all would recognize that the prices in those securities are being manipulated or set by Central Bank policies. So those look a little--you might want to be cautious about investing in those sort of instruments, and they might be a little bit closer to "a bubble."
But keep in mind, the interest rates are low today, and spreads are on the narrower side. But there's a reason for that. Bubbles to me are when, "hey, I don't get why we're here" kind of thought process. We have very low and sluggish growth in the United States. We have low and fairly stable inflation today, and we have had over the course of the last four or five years. Low growth, low inflation, is not a recipe for much higher interest rates, and thus the sort of returns that would be negative.
So we can debate a little bit, and I think that's good discourse to have, about have bonds run too far or not. But I think it's often important to stand back and say, OK, why do we have interest rates down here? OK, maybe the Fed buying trillions of dollars' worth is impacting them a little bit, I'll accept that. But there are also some very clear fundamentals--very sluggish growth across the developed world, and low inflation. We could talk about the fear of inflation in the future, but the reality today is we've been in low-growth, low-inflation, and that is a recipe for a relatively low interest rates. So, again, certainly one needs to think about how much farther bonds can run, but the bubble I think is a little bit premature.