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By Holly Cook | 06-09-2011 11:22 AM

What Will The Next Decade Bring for Fixed Income?

BlackRock's Rick Rieder sees the winding down of consumer, financial, and housing leverage as being a key driver of bond investing during the next 10 years.

Holly Cook: I'm Holly Cook for Morningstar and here at the Morningstar Investment Conference is Rick Rieder. He's going to help me navigate the fixed-income environment. Rick is chief investment officer of fixed income at BlackRock. Thanks so much for joining me Rick.

Rick Rieder: My pleasure.

Cook: Now, we've heard over the last couple of days, and a bit true to the U.S., the U.S. is dead. Do you think that the U.S. economy has changed fundamentally or is this a kind of blip?

Rieder: I think economists were too high in what their projections for U.S. growth were. If you go back two, three months ago, I think there was this assumption that you could create 4%-5% growth in an economy that has a tremendous amount of leverage on it, an economy that has structural unemployment that I don't think is going to go away anytime soon. I think the flip side of it is, I actually think economists now are going the other way in terms of seeing some of this growth fall off so quickly and saying we're going into a double-dip recession. I don't buy that either.

I think you've got an economy that is going to run 2% to 3% growth for a long time. I think many people are terming financial repression because of that leverage and unemployment and a housing market that is difficult; that's going to keep growth moderate for a long period of time. But do I think it's the end of the U.S., or do I think the dollar is going to zero as people have talked about? Absolutely not. The U.S. has incredible resources and incredible ability to tax and to tap into what is innovation and a growing economy and a corporate sector that's as strong as it's been in history. So, I just think it's going to be unsatisfying growth. We'd like to see 4% to 5% growth, but we are just not going to get it.

Cook: Now, I also believe that you are a little more sanguine on U.S. Treasuries perhaps than some of your peers. Are you neutral on U.S. Treasuries or underweight?

Rieder: So, we were more bullish on Treasuries, 50 basis points or 60 basis points ago on the 10-year Treasury, and we talked about if the 10-year Treasury rate backs up to 3.625% or 3.75% we will start buying again. But at these levels, we've moved a lot. I actually think we're still going to go lower in rates, and I think we'll probably go to 2.75% on 10-year Treasuries, but I don't think there's a tremendous amount of value you're going to garner from buying treasuries at these levels. I just think we are going to be in a range for a long time. There are a couple of factors at play; the economy being moderate is one. We think this inflation has happened because of commodity prices. You are not creating tangible inflation throughout the economy. So, I don't think that drives rates higher.

And I think there is a big factor at play that people in markets don't talk about: the demographics in the U.S., and many parts of the world, you have an aging populous. And this aging populous transitions to buying more fixed-income product, and that's going to be in place for a long time. And so the baby boomers are now hitting ages 45 to 65. They move from buying houses and cars and cribs, and they move to now buying fixed-income assets for retirements or anticipatory retirement.

So, I think that's going to keep a cap on rates for a long period of time, and I would say there is one last point: The last decade in fixed income was very different than what you are going to see in the next decade in that you had a leveraging environment. You could buy so many fixed-income products that are putting more leverage on, such as consumer leverage, financial leverage, and housing leverage. In the next five or 10 years, we are actually deleveraging. That means less fixed-income product. If there is less fixed-income product, then the supply/demand dynamic keep rates at a moderate level for a long time. By the way, do I think rates will drift higher by the end of the year? I do. But it's a drift. It's not a significant backup.

Cook: So, U.S. Treasuries aside, can I ask you to take me on a bit of a global tour, and are there any areas where you see kind of standout opportunity? Emerging markets and local currency debt, for example, is that still where the value is at?

Rieder: Yeah. I'd say we still like emerging markets. Part of this comment I made before about the deleveraging dynamic, we think the developed world has to deleverage, so it's not just the U.S., but also Europe. There is tremendous amount of leverage in Japan, too. So where is our opportunity? The emerging world is not overleveraged today; in fact is underleveraged at all parts of it, financial, governmental, and consumer businesses. So, there are going to be a lot of opportunities coming out of the emerging world. So, yes, we like the emerging world.

We are a bit more sanguine today in that there is a tightening process that has to take place because inflation has grown significantly--some of which, some would argue, is coming out of the U.S. or monetary policy in the U.S.--but yes, we think the emerging world is attractive.

We also think that there is a good part of the U.S. fixed-income market, such as high-yield loans, now with some pressure on the markets and some risk being instituted in the market as QE2 ends. You're starting to buy some or see some non-agency mortgages or commercial mortgage-backed securities to be attractive again.

We were going down a road three to six months ago that spreads kept compressing, value was going away, and the only way to create value is put more leverage on. That's just what happened in 2006 and 2007. That's not how we want to invest. We'd love to see valuations come back, and you're starting to see a bit of that now.

Cook: How do you feel about the credit environment? Are there any areas there where you're sort of more opportunistic? I'm particularly interested in banks, for example. I'm wondering if the fact that they're now being forced to hold more money, if that makes them more attractive from a fixed-income perspective.

Rieder: Yeah, literally today, we think that the financial sector has come under pressure in the last couple of weeks. The actual raising of capital requirements in the banking system, not just in the U.S. but Europe and other parts of the world, means there are safer fixed-income investments. So, we've started buying literally in the last few days. We started buying some of the financials that are backed up significantly.

It's a really different equity story versus debt story, and I think the markets tend to look at that when the equities go down. So that means financials are riskier. I'm not sure I totally buy that because that increased capitalization and the nature of the regulatory environment means that you're going to hold safer assets where we think the financials make a lot of sense, not just in straight unsecured senior credit, but there's also hybrid issuance that's come into the marketplace. We think more and more of that's going to come as banks have to capitalize more so.

We think Europe is actually one of the most attractive areas where you're going to see more bank capital come into the market. So, I think financials have gotten very attractive, and that's really been the last two or three weeks. But yeah, that's one of the places we're starting to invest in.

Cook: Looking further afield, the actual risk environment seems to have undergone a shift. Whereas before investors would assess their risk profile and invest within those parameters, now it's kind of "How much risk do I have to take in order to get a decent real return?" How does that affect the way that you actually manage your clients' money?

Rieder: Yeah, I'd say, part of the road we much rather go down is, we don't believe in taking on significant leverage to create return. So, we spend a lot of time thinking about where do you want to take credit risk and what are the areas we want to take credit risk. An interesting one that I don't think people talk about a lot is actually municipals, and in some of our accounts that are more crossover-oriented, we're starting to buy municipals. And we've only been buying municipals over the last three or four weeks.

People are talking about, "How could you be buying municipals? You are going to get tremendous defaults." We do think you'll get some headline defaults in some local municipalities. But we actually think there are some really attractive valuations in health care, essential services, and university debt that we think makes a lot of sense right now. So, that's where you get headlines that tend to be sensational, and they tend to create value in the marketplace. And some of that's happened recently in municipals, and as we talked about before, in financials. So, we're actually hoping at the end of QE2 that you are going to create some dislocation in the market, and I actually think you will. And that's going to create some pretty neat opportunities in fixed income.

Cook: Well Rick, thanks very much for a comprehensive global tour of the fixed-income environment.

Rieder: My pleasure.

Cook: Thanks to join me.

Rieder: Thank you.

Cook: For Morningstar, I am Holly Cook. Thanks for watching.


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