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Bond Investing in a Rising Rate Environment

Jason Stipp

Jason Stipp: I'm Jason Stipp with Morningstar. With interest rates very low yet the prospect of possibly higher rates in the not too distant future, fixed-income investors could be in a little bit of a pickle.

Here with me to talk about some income solutions for investors is Goldman Sachs Asset Management Chief Investment Officer and Co-head of U.S. and Global Fixed Income Strategies, Jonathan Beinner.

Jonathan, thanks so much for joining me today.

Jonathan Beinner: Nice to see you Jason.

Stipp: So first question for you. We've seen at Morningstar a lot of funds have been going into fixed income strategies. So a lot of the fund flows that we have seen have been targeted in that area. So I'm wondering from your point of view is that merited?

Is the risk-reward really so attractive in fixed income that all of these assets coming into it really should be there? What's the opportunity there?

Beinner: Well, look, we have definitely seen that same trend in our mutual funds. We have seen significant flows across really wide range of strategies. And we do think that will probably continue. I think the way you should look at it is really it's coming from two places.

One is from very short-term, very low-risk investments. Right now, money market funds are yielding, if not exactly zero, certainly very close to zero, given what Fed funds are. So you are seeing people push out from pure low-risk assets out a little bit to get some incremental yield in their portfolio and some income.

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And I think you are also seeing it somewhat from allocations that would have been made to the higher end of the risk spectrum: equities, basically thinking of them in that context. And the experience that we saw in 2008-2009 I think did get some investors shaken by the performance, both down and up, and recognition there's the lot of volatility there that's probably not going away.

So I think some of the flows are actually coming from assets that would have gone into equities, and they are going into fixed income. So it's a good place to be. You saw phenomenal returns in 2009 as we came back from 2008, particularly in anything that was considered to be a little bit higher risk: credit markets of various shapes and sizes.

That is probably going to be difficult to repeat, but still there are some attractive returns in a number of different areas.

Stipp: And one area of potential concern is the fact that eventually the Fed is going to have to take the foot off the pedal. There's probably going to be some higher rates coming down the line, which can have an adverse effect on some fixed income funds.

Is there a concern there with rising rates and how do you manage that when you are thinking about your fixed income portfolio?

Beinner: Well, when you think about fixed income as an asset class, interest rates are one of the key risk factors. So you always have to think about the level of interest rates and what is your view on where interest rates are going.

Also important to think about the shape of the yield curve because it's not just a question of are rates going up or down, but are they going up or down relative to effectively what's priced into that shape of the yield curve.

Right now, the yield curve is very steep. We think it will stay pretty steep for quite some time because we do think that the Fed, while they eventually will have to raise interest rates, we don't think they are going to raise them very soon. So we do think that we're going to see that very short-term rate anchored at again close to zero percent.

So we actually do think that it's OK to push out a little bit in maturity. We're seeing very significant interest in our shorter duration fixed-income bond funds. We have a series of them--our ultra short bond fund, our short duration government fund, we have a short duration tax free fund that invests in tax-exempt securities but again focusing on short maturities.

We think that makes sense. You are not going to get rich on it. You are not going to get huge returns, but you are getting a yield, which these days is actually saying something.

We are being somewhat defensive though about longer-dated bonds, because the question about the fiscal situation here in the United States as well as elsewhere and the question about does the level of interest rates have to go up at some point and in particular the level of real interest rates.

So the yield premium that people think that you need to get relative to expectations of inflation, people get nervous about inflation picking up some time in the years ahead. Long-term interest rates could actually go up even further.

So we are being defensive about bonds that have maturities that are well beyond 10 years, for example, focusing more on short and intermediate maturities. You see our investors doing the same thing.

Stipp: Sure, now on that inflation question, I mean, for folks who are worried about inflation, in the more further out future, what sort of steps could they take to perhaps offset that and to help bring the portfolio a little bit more in balance considering that we might see that inflation?

Beinner: Yeah, I think there're a couple things that you can do. First of all you can have short maturities. So whether that's a money market investment or a short dated fixed-income fund, that is a way to in some sense reduce your exposure to an inflation shock, because if you think about what's going to happen, if inflation picks up relative to expectations and so it starts to move up, then likely what will happen is interest rates will rise and obviously if you are in cash, that's a good thing. You are starting to get higher levels of interest almost immediately.

If you are in short-term bonds, maybe that reduces the net asset value somewhat as interest rates are going up but while you have been waiting you have actually been collecting higher levels of income.

So that's one way to control for that. The other thing is to own real assets, and there's a couple of ways at least as it relates to our funds that investors can take advantage of that. One is to own an inflation protected securities fund, which basically owns TIPS, Treasury Inflation Protected Securities, where the security pays a coupon rate but the principal actually grows with the CPI.

So again, if you have an inflation surprise, you are not necessarily going to make a lot of money but you will at least keep up with inflation which is obviously going to be important in that environment.

The other thing that you can do, and we are seeing interest here is commodities. And while the fixed income team we actually do manage a commodities strategy and that fund is taking advantage really of just the asset class itself. So it's a so-called enhanced beta strategy where we are utilizing the derivatives markets to get exposure to commodity markets, and it tries to match the Goldman Sachs Commodities Index.

That portfolio should do well in an inflation surprise because you are buying real commodities that should rally in an inflationary environment. One thing I would add also is--not so much an inflation hedge but--diversifying away from the U.S. market.

So you could argue there's inflation risk around the world and particularly in developed markets, but we're seeing a lot of interest in emerging markets as an investment theme, and there's a number of benefits for that.

One is that there's still yield there. So there's still a premium. Despite the fact that emerging market economies have actually been performing better than developed market economies. So there's a yield premium. There's a better fundamental story there. And also there's a lot of opportunity to add value, in terms of active management.

Stipp: You shared with us some interesting ideas. Thanks so much for your time today, Jonathan.

Beinner: It was my pleasure. Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.