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Which Defense for Rising Rates?

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

With the threat of both rising interest rates and rising inflation looming large, many bond investors are rightly concerned about what the future holds for their bond portfolios.

Here to discuss what to look for as you conduct a checkup of your bond portfolio is Eric Jacobson; he's Morningstar's director of fixed-income research, and he's on the phone with me today.

Eric, thanks so much for being here.

Eric Jacobson: Hi, Christine. Glad to be with you.

Benz: So, Eric, I think a lot of investors are keenly attuned to this notion of having a bond portfolio that's not fighting the last war. So, we've been through a couple of decades' worth of declining interest rates, which has provided a tremendous tailwind for bond investors. What are the key themes they should be thinking about as they assess their portfolios right now?

Jacobson: I think a lot depends on how folks reacted after the crisis. Those who have done really well with their bond portfolios more than likely either piled into things that had a lot of risk or hung onto things that did through the crisis and after the crisis to make it back, there are a lot of people anecdotally we know who got onto the sidelines entirely‚Ķ

Benz: So, sitting in cash?

Jacobson: In cash, absolutely. It's a little hard to tell, certainly, because the flows in the last couple years have been gigantic into bond funds. So I think we've got a lot of different stories out there, different people, and I think the most important thing is for each of those groups to kind of rethink where they are now, as I think you're suggesting.

Benz: So, you want to be diversified obviously across different bond market sectors. How about interest rate sensitivity? I've talked to some investors who have said--and we've talked about this strategy in the past--"maybe I should just hunker down in cash until this whole rising rate thing blows over." What do you think about such a strategy?

Jacobson: I get a lot of pushback on this, but I think it's kind of a dangerous idea, if for no other reason than there really isn't anything to make in cash right now, as you know, because short-term rates being held very low by the Fed are so low that if you sit around in cash and we have any inflation whatsoever, your so-called real return, in other words that's your return after the effect of inflation, are going to be negative, and you're going to lose purchasing power.

And although that may seem kind of trivial in a short period of time, we really don't know when short-term rates are going to go up. We've gone back and forth over the last couple years in terms of the signals that we've been getting from the marketplace, because economic growth has gone up and down, and we also don't know quite what's going to happen after the effect of "quantitative easing" rolls off and so forth.

There is good reason to think, in fact, that if we slip a little bit later in the year in terms of the economy that the Fed could keep rates very, very short for a lot longer.

So, hanging onto cash could really be a drain on your portfolio.

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If I could, let me jump back then to your earlier question and address a little bit more concretely your point about diversification. I think one thing that is really important for bond investors to think about right now is that if you are very index-like in your approach or have been historically to bonds, you want to consider the fact that regular market-cap-weighted bond benchmarks are now very Treasury and government oriented. It's not entirely a bad thing, actually, because there are lot of mortgages in that universe, and they do offer some extra income over the Treasury market, and they're probably not as risky and dangerous from an interest rate perspective, but the Treasury debt issuance that we all know about, because it's being talked about so much in the media, does find its way into the indexes. That means that there is a lot of it out there and a lot of it in very index-like portfolios. What we are finding, however, is that managers, active managers, are generally accounting for that somewhat in the way that they run things. Some of them very differently than others, but the bottom line point is, if you have an active manager, at a minimum, somebody's making a decision that says, "Well, maybe I don't want these be all that index like."

Benz: So if you are in an index fund, should you consider getting out of it and opting for an active fund or where do you come down on that question?

Jacobson: I know that's probably heresy to a lot of index investors, but one way to look at it may be "OK, even if I don't want to get completely out of indexing, should I change up the mix a little bit?" And so a baseline way to look at it is this: the Barclays Aggregate U.S. Bond Index is more than likely your core choice in bond indexing, and the beef that I think a lot of active managers probably have with that index in terms of trying to mimic it, is that it doesn't really have any high yield in it, it doesn't have any non-dollar bonds, whether they are high quality or emerging markets or the cuspy things or what have you, and it's so overly concentrated right now in Treasuries--and, like I said, mortgages as well--there is obviously U.S. investment-grade corporates in there, but that is a relatively modest slice by comparison.

So, the next step away from that would be something called the BarCap U.S. Universal. There are others, of course. There's a Multiverse. Unfortunately, you're not going to find a lot of index funds probably mimicking those more diversified indexes. If you don't, then another way to go would be to sort of mix and match a little bit. So maybe take a portion of your core index fund, so let's say, for example, you are using the Vanguard Total Bond Market Index. You might want to take a slice of that, and I am not necessarily talking about a lot, but if you are a die-hard indexer and the idea for you is not to go active, then maybe take a 10%, 15% and cleave that off, put it into something that you are comfortable with that does have a little bit more diversification away from U.S. Treasuries.

Now, ... there are good ways and bad ways to do that. Unfortunately some of the sectors that a lot of active managers we like really go for these days are not easily found in index strategies, but those that are might be high-yield, maybe some non-dollar exposure.

I'd be real careful with that, though. They are not always the most liquid, easiest markets to manage, particularly high-yield is the one I'm thinking of there. But there are ways to do it.

Benz: Okay. So Eric, I want to follow-up: If someone is concerned about the threat of rising rates, are there any other things that they should be looking for, any other ways to assess their portfolios and think about what kind of rate sensitivity that they are courting?

Jacobson: Sure. And I almost think of it in two steps: The first one is--assuming that you are in active funds to begin with, of course--look at what your managers are doing and make sure that they are not already taking care of that for you to some degree. What I mean by that is, if you are in, for example, PIMCO Total Return, you may or may not have been following news lately, but [Bill Gross] has been pretty negative on the Treasury market. And although the talk has been about how anti-Treasury he has been, the fact of the matter is that on a net basis, it really is just that he's kind of backed away from them. He is not really betting against the Treasury market that heavily.

He is replacing those exposures with other things. So, he still has a lot of U.S. mortgages, and he's got more emerging markets, credit, and things like that, even at higher quality, some lower quality, high-yield, stuff like that.

Same thing with lot of other big managers. BlackRock has a similar kind of orientation, although they've got more Treasuries. They have some more securitized things, like asset-backeds and commercial mortgage-backeds, and things like that.

So, again, the point there being, check out what your managers are already doing. They may be handling it to a large degree for you. Now if you do that and either way you are not comfortable with how aggressive they are being in trying to protect you from interest rates, what a lot of people are doing these days, for good or bad, and I'll explain why in a minute, is buying these either unconstrained bond funds that have sort of a tacit, kind of implied goal of avoiding that interest rate volatility. Lot of people are buying funds that are maybe called unconstrained, but also absolute return. In other words, the idea there is to try and get all the wonderful benefits of being in the market without any of the problems by perhaps avoiding a lot of interest rate risk, a lot of the other risk, and having a nice steady return. That's a little bit of a holy grail that's really hard to achieve. Some can do it with certain strategies, but the overall point with both of these now, whether they are unconstrained, absolute return or both, is that you want to be careful if you go that route that you just don't wind up jumping out of the frying pan into the fire. What I mean by that is jumping out of the interest rate frying pan into the "other risk" fire, credit risk, foreign bond risk, whatever the case may be. There are a lot of other things going on in those portfolios that don't involve a lot of interest rate risk, perhaps, but over the long-term could make your overall portfolio a lot riskier.

Benz: That's a follow-up question I have for you, Eric, because one thing we've seen in terms of monitoring fund flows is a lot of inflows into these more credit-sensitive bond sectors, so bank loan, high yield. What's your take on that given that those sectors aren't exactly as cheap as they were a couple of years ago?

Jacobson: I think that on a tactical basis there is a certain logic to it, and if you look at the underlying portfolios of the core active managers we were talking about, a lot of them are buying or nibbling in those spaces because they have felt that there is still value there. You are starting to see that turn a little bit in the sense that they're not all agreeing anymore, some are becoming a little more cautious because they think, as you suggested, that the valuations are getting a little tight, but there still tends to be an opinion that there is some value left in, for example, the bank loan space, even though it's a lot richer than it was, and they are also looking to that floating rate situation. In other words, the bank loans tend to have these very short reset floating rates that protect them in the event of a rising rate situation.

So it does have a certain logic to it in terms of investors flooding money into them. The danger, of course, is pouring all that money in--trying to ride it out to the last minute, sticking it out through a rising rate period, for example, and then getting bitten on the other side because you've really engorged your whole portfolio with too much risk.