Note: This is an excerpt from a previously aired webcast.
Christine Benz: Top of mind for so many retirees right now is fixed income. Retirees are looking at the possibility of higher interest rates and wondering how that should affect how they position their portfolios.
Miriam, I'd like to throw it to you and talk about what you're thinking about fixed income these days and also what you're hearing from the many fund managers you are talking to. How concerned should retirees be about rising rates and should they be taking steps at all to try to protect their portfolios against rising rates?
Miriam Sjoblom: Sure, Christine. For starters, a lot of intermediate-term bond managers, which make up a most of the core holding of most U.S. investors' portfolios for bonds, there are definitely many managers who are thinking about these issues and concerned about it.
Normally, after a big rally for credit sectors like corporate bonds, you would expect to see...when corporate bonds get really cheap, managers sell Treasuries and buy corporates, and now you've had this huge rally for more credit-sensitive sectors. What they'd normally do in that time is sell corporates and buy Treasuries.
So now this kind of placeholder, the U.S. Treasury, that you would normally move the portfolio to to get neutral, to get back closer to your benchmark, is suffering from some real risk of rising interest rates down the line. Treasury yields are still near pretty low levels relative to where they've been historically.
Then you've got the concerns of the U.S. growing debt burden and the problem of entitlements down the line. So, there are some issues that are impacting that decision that used to be so natural.
So, some things managers are doing are looking for ways that [they] can very carefully build a little bit of a yield advantage into the portfolio. One extreme example is a favorite fund of ours, Loomis Sayles Bond, but [managers] Dan Fuss and Kathleen Gaffney and the rest of the team there, they've been focusing more on: "how do we minimize market risk, which is interest rate risk, and focus on specific risk--use our 30-some-person credit research team to try to identify really mispriced bonds that also offer a good yield advantage over Treasuries."
In addition, they are thinking that the equity market looks somewhat attractive these days, so you're seeing them add more convertibles--that could be for a lower-quality issuer, but it could also be for a high-quality issuer. They've been talking about Intel a lot. They have added Intel convertibles. It just gives you some upside potential from the appreciation of the stock price.
So, you're hearing more and more bond managers say, "oh, we kind of think the equity market is attractive and doing some things like that. That's an extreme example."
Benz: That's a pretty aggressive fund, a very good fund, but very aggressive. Is that another idea, though, to potentially look at some of these go-anywhere funds, and there have been more of them cropping up recently where the manager really can do a lot more than just focus on high-quality bonds. Is that another idea for investors' fixed-income portfolios?
Sjoblom: Well, I'd say, in general, protecting against interest rates, rising interest rates, is a big focus these days. So you might see a lot of product launches, a lot of trendy, absolute return, go-anywhere, or take on negative short interest rate risks, that type of thing.
So, I think it's important to really be selective and go with a team that has a good track record, a long track record, a deep team. I think of PIMCO Unconstrained Bond as an example. Just sort of be a little bit of wary and selective, because these types of strategies haven't really been proven yet over the type of environment that we are anticipating.
Benz: So, PIMCO is one you like. Are there any other firms that you think are equipped to do a go-anywhere strategy, or is PIMCO pretty much it?
Sjoblom: Well, I think there are other firms that we do like, but I think PIMCO stands out, because we named Bill Gross, Manager of the Decade last decade. He has just built a real first-rate team around him, a real deep team, incredible expertise in all types of asset classes.
But you know, you don't have to necessarily be a cowboy, trying to work miracles with bonds, because let's not kid ourselves. Most bond funds have interest rate risk, and there is very little you can do to get away from that.
But what [the bond manager] can do is try to, on the margins, invest in areas that you think will be less sensitive to that. One thing we are seeing is some diversified bond managers are moving more into bank loans. I am thinking of specifically Fidelity has a suite of high-yield bond funds, and their bank loans have taken up a bigger portion of those funds over time. And typically managers have said, high-yield corporate bonds tend to be less sensitive to Treasury yields, but there will come a point where they will become more sensitive. We've seen the additional yield offered by high-yield bonds over Treasuries has come down. It's near the long-term averages, but as Treasuries rise, there is only so much more room before high-yield won't also be impacted. So, you're seeing some high-yield managers invest in bank loans to have a little bit of protection against interest rates. Some diversified intermediate term bond managers are doing the same.
Benz: So, let's quickly just explain how a bank loan works when rates go up. You do get that reset along with LIBOR of what the bank loan is paying out?
Sjoblom: So, bank loans are known to be floating rate instruments, but lately managers have been saying, with short rates just staying where they are, there is nothing floating about them; they have been more fixed lately.
...People will think, bank loans aren't necessarily attractive because they price off of LIBOR, which is very low right now, but a lot of these new loans that are getting issued are coming with LIBOR floors of 1.5% to 2%, which is above where LIBOR is now, plus in addition to that you're getting another 3.5% to 4.5% in coupon income. So, loans are yielding anywhere from 5% to 6%--not too bad given how low short-term rates are these days. So, you're getting a pretty attractive yield to start, but then once short rates eventually do start to rise, your income will adjust upward.
Benz: So, if someone is looking at a bank loan-only fund, are there any particular ones that you like right there?
Sjoblom: Well, we really are a big fan of Fidelity Floating Rate High Income, and it's on the conservative side. The challenge of investing through these open-end like mutual fund structures is, the bank loan market is not the most liquid market. It's a privately negotiated market. There are big operational hurdles to investing in bank loans.
So this fund tends to own more cash than its peers to be able to deal with inflows and outflows. So, it tends to stick with the higher-quality, large-cap type issuers, but we think for taking less credit risk, giving up a little bit of yield, this is a really good option.