Jason Stipp: I'm Jason Stipp for Morningstar.
The stock market has been no easy place to invest over the last few weeks, but the bond market hasn't exactly been a walk in the park, either, with prevailing rates still low, given economic concerns out there. But there is also the specter of rising rates on the horizon.
Here with me to talk about how they're investing in this difficult environment is Loomis Sayles' Kathleen Gaffney. She is a manager on Loomis Sayles Bond, this is one of Morningstar's favorite funds in the fixed-income space.
Thanks so much for calling in, Kathleen.
Kathleen Gaffney: Thanks, Jason.
Stipp: First question for you, it has been a difficult environment for bond investing and bond investors, generally. We've seen on the one hand that a lot of managers are preparing for an eventual rise in interest rates, yet we've also seen that given market shocks and news out of Europe, there has been a lot of flight to quality, especially in the third quarter, where investors have piled back into Treasuries, and we've see long-term Treasuries do really well.
It seems like there are two countervailing forces in fixed-income today. How are you managing in such an environment?
Gaffney: It really is bit of a conundrum, given the volatility and that need for liquidity and a safe haven. What drives our strategy, however, is always what our long-term view is. And when I look at U.S. Treasuries, the 10-year yielding less than 2%, that doesn't give me a whole lot of good feelings about what the total return prospects are.
So you are earning very little in terms of income, and I know it seems like a long time off, but eventually we will see rising rates, and so potentially we're looking at negative returns.
So the challenge as a fund manager is to maintain the liquidity, which is what is desirable about Treasuries, but also insulate the fund from lower return prospects. So we really look for other alternatives that are higher return, [and] that's leading us into the credit markets, but in order to provide that liquidity and safety, what we've done is we are using Canadian government bonds. They are doing double duty in the fund right now in that we do like the currency long term, so that maintains our positive long-term focus, and it's a deep liquid market. So we are trying to avoid the volatility and the whipsaw, which is also a challenge in the Treasury market currently with all these ups and downs.Read Full Transcript
Stipp: You mentioned there, the long-term view on interest rates and that eventually they will go up. We have seen recently the Fed reiterate that it's going to have a very accommodative policy at least for the foreseeable future. Do you have any sense of when these rates might go up? What are you looking for? What things on the horizon might indicate that this rising rate environment is going to tick up?
Gaffney: I do think it's a very long transition. When the Fed made the statement that they were going to be keeping rates low through 2013, I think they are doing the best that they can to provide a bridge to a stronger economy, and it's going to be a lot tougher to accomplish that without strong fiscal policy. And given the dynamics of Washington politics, we probably are on hold until at least 2013.
So we are trying to prepare for that long transition by earning yield and being patient. I do think it's quite some time off: 2013, maybe even later than that, 2015. The way I think that you deal with it is to have some yield, but always think where the value is in terms of eventually coming out of it and moving into a strong recovery.
Stipp: I know that you folks in your portfolio also have a pretty heavy stake in corporates. ... We've seen that the market has been whipsawed and the stock market is up 3% one day, down 2% or 3% the next day based on these macro headlines.
As you are looking at the fundamental strength, though, of the companies that you analyze, is all of this volatility warranted or is it just short-term noise? In other words is there anything that worries you given the headlines we've seen about the fundamental strength of the companies whose bonds you own?
Gaffney: That's a great question because uncertainties are macro-oriented. But the reality is, the fundamentals continue to improve. We've seen earnings throughout this year--they are coming in with very strong, good numbers. We know from a creditor's perspective that corporate balance sheets are in the best shape they've been in for decades. Companies have really taken advantage of the absolute low level of rates, and they've termed out their debt and refinanced at attractive costs of capital. That sets them up very well for the future. It's getting through this middling period and the uncertainty that's coming, one, out of Europe, which is the biggest risk to the market right now, and then finally I think the attention will come to the U.S.
Keeping with that long-term view, we do focus on the fundamentals and try to push away that noise and look at valuations, and what they are telling us, and they are very supportive given those fundamentals that this is a good time to be taking risk.
Stipp: So I wanted to follow up on that question, because ...the volatility can obviously give us a stomachache, but it can also create opportunities, and I know that your fund has executed very well as a bargain-hunting fund in the past.
So given that we have seen such big swings, have you been more active? Have you been finding some opportunities--whether they'd be European-based or otherwise--just because of all the volatility that we've seen.
Gaffney: Yes, that is our view that when you see volatility and uncertainty very often you are going to find good opportunities. We see that opportunity primarily in high yield right now. One, because of that significant yield advantage, but two, because of the positive fundamentals. The one challenge in the high yield market is that if we are in this long transition period where interest rates are lower for a longer period of time, that can be challenging for highly levered companies.
So we are trying to avoid the very low quality end of the high-yield market and really focus on the issue, the item selection, in taking specific risk. One way of doing that, that helps create more diversity within the fund is expanding that high yield universe to also include convertible bonds. And the ones that we are focused on right now tend to be more equity sensitive, probably because it allows us to find those good-quality companies regardless of their credit rating, that might have some additional upside through the underlying equity. And we think that makes sense in preparing for that eventual rising rate environment, because then you've got a fixed-income security that actually has the ability to rise in price, even though interest rates are rising. So high yield and converts look very attractive to us currently.
Then longer term, as inflation begins to build--which we think it will as a result of all the quantitative easing and steps that the central banks are doing in order to stimulate the economy--currency non-dollar looks attractive to us in the long run in those areas where the countries, the regions, are experiencing high rates of growth. That means that we are looking at Latin America and Asia, but even in the developed world, we think there are good opportunities from a currencies perspective, and that's with what I would call the "developed world good guys," the countries that have commodity currency, so they are very leveraged to that growth around the world--and that would be Canada, Australia, and New Zealand.
Stipp: Kathleen Gaffney of Loomis Sayles Bond, thanks so much for calling in today and for your insights, very compelling information. Thank you.
Gaffney: Thanks, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.