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Jacobson: Don't Forget About Inflation Risk

Christine Benz

Christine Benz: Hi, I am Christine Benz for Morningstar.com. The Federal Reserve recently indicated that it would keep short-term interest rates down until 2014, causing bond investors everywhere to wonder what that would mean for their portfolios. Here to dig into that question is Eric Jacobson. He is director of fixed-income research with Morningstar.

Eric, thank you so much for joining me.

Eric Jacobson: I'm glad to be with you, Christine.

Benz: Well, I'd like to touch on this recent announcement from the Fed, Eric, and specifically address what it means for investors who are attempting to navigate this very difficult fixed-income environment. First of all, one group that has been particularly hard-hit by this very low-interest-rate policy has been people attempting to wring some sort of income stream from their very safe investments like certificates of deposit and money market funds. Does this mean that they really won't get any relief for the foreseeable future?

Jacobson: Unfortunately, I think that's probably the case. As you just said, traditionally people have been able to look to things like money markets and other short-term investments that are keyed off of these unfortunately very low Fed policy rates. So, I think you know the best thing for people to do at this point--something that we don't hear a lot about from the fund industry but makes a lot of sense--is to keep your eyes open for things like CD rates and other safe alternatives.

The one thing that you can say is that a lot of the banks in the industry have been looking for bigger deposit bases during the last couple of years, following some of the fallout from the trouble that we had in 2008. And banks that are seeking to have a more stable deposit base often are willing to offer a little bit more on CD rates. So, something that you may not have done before, if you've been dedicated to money market funds for example, might be worth a look.

Benz: So, online banks, for example, sometimes have very competitive CD rates?

Jacobson: That's right. Just again keeping in mind that certainly with the online stuff that you are dealing with the legitimate bank. Comparing to money markets, you are not necessarily talking about FDIC guarantees. But with banking certainly you want to be careful.

Benz: Right. So do your homework. Now, I'd like to address the other end of this spectrum. I think folks might look at this announcement from the Fed and say, "Well, if the Fed is going to have this benign interest-rate policy, why don't I take my fixed-income portfolio and just take it really long because presumably I may not get hurt with such a strategy." What do you say to people who might espouse such an approach given the Fed's policy?

Jacobson: I think you have to be very careful about making too big a bet doing something like going very long because I think that what you will find is that most managers think that in the near term it speaks to where we are with growth and inflation. But the fact that the Fed is planning on keeping rates very low for that long a time and the fact that there's at least the possibility, there is some debate certainly, but at least a possibility that the Fed may use additional measures to try and further stimulate the economy as we discussed offline--there is a little bit of a debate between different managers about whether or not we're going to have a third round of quantitative easing--that can spur inflation.

And if it does, it's the longer-term securities that are probably going to be hurt the first and the worst. So, what you are finding is managers are trying to sort of balance that by taking into account what it means to have low Fed policy rates at the front-end of the curve and at the same time the risk that longer-term securities could be vulnerable if we have a spike up in inflation.

Benz: So you are saying just because the Fed is saying it's going to keep rates low, it doesn't mean that you would be completely impervious if inflation jumped up? You could actually get hurt by maintaining a longer-duration portfolio?

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Jacobson: That's right, and I really should point out--because it's really important nuance to your question there--what the Fed, at this point, is signaling is that they are going to keep short rates very low. So, the market at this point actually controls what happens to longer rates.

Now, the Fed can influence longer rates by going out and buying bonds and doing other things, but at this point what they've really signaled they are going to do is this short-rate maneuver. At least for now as far as we know they are going to leave the long end of the curve alone in terms of not signaling any additional purchases that we are aware of.

And unless that happens, in which case you have different supply dynamics and  time to reevaluate, the risk that a really good quarter of growth could signal a little bit higher inflation can have a really strong effect on the long end of the maturity spectrum.

Benz: Now, Eric, I'd like to segue a little bit here. You cover PIMCO and the bond guru Bill Gross, at the big Total Return fund, and he is often viewed as kind of a bellwether on how people should be thinking about fixed-income these days. Can you talk about how he is positioning the big Total Return fund's interest-rate sensitivity in light of the Fed stated policy, as well as what he thinks could unfold?

Jacobson: Sure, and I think that this is sort of an interesting lens to look at the issue through because what PIMCO and Bill Gross are essentially saying is the Fed has signaled that they are going to 'anchor' the short-term policy rates for the foreseeable future, for a couple more years, in which case it gives you the flexibility as far as PIMCO is concerned to invest a little bit farther out on the yield curve, with the knowledge that rates are going to be, as I said, anchored there.

And what that means essentially is that, say, if you buy a five- or seven-year bond today, it gets a little older during the course of the couple years, and assuming that you have a fairly steep yield curve, in other words short rates are lower than longer rates, as those bonds age, their yields go down and their prices go up.

So, as long as those short rates are 'anchored' as they are saying, that gives the flexibility to invest a little bit longer without taking on, in theory, too much more risk because essentially the Fed is holding that part of the curve down. So, what PIMCO is doing is focusing their bond purchases on what they are referring to loosely as an intermediate portion of the yield curve, focusing at this point mostly on 7- to 10-year bonds and things like that.

Now, PIMCO is doing a lot of other stuff with other sectors and so forth, but in terms of their sensitivity to the interest rates, that's where they are focusing. But along with what I said before, PIMCO is not taking on a lot of what we would call regular Treasury Bond interest-rate sensitivity out of the long end of the curve; they don't want to own bonds out there because they are worried about the volatility that the results of this Fed policy could spark, kicking up a little inflation. And instead they see Treasury Inflation Protected Securities as a good value out there.

Benz: Interesting. Eric, how about other sectors that PIMCO is looking at or maybe avoiding right now?

Jacobson: They've been doing this for quite some time now, the last couple of years, looking for what they call safe spread. Now, it hasn't always been the safest, but for example the financials area turned out to be a lot rougher and more tumultuous last year than a lot expected. But they still have a long-term view that financials are a good place to go. So, they've got an overweight there within their corporate bond exposure. They have a small slice of high yield.

They've got some exposure to emerging markets. A lot of it is very short, relatively speaking, but they also have a good solid exposure running between 18% and 20% in the last several months in non-U.S. developed-markets bonds. They like to focus a lot on Canada and the United Kingdom, as well. So, these are areas where they think they can get a little bit of extra income, but these are what they call sort of the cleanest dirty shirts. In other words, all the governments in the developed markets are having some kind of budgetary troubles, but PIMCO is buying the ones that they think are the best-off.

Benz: Eric, well thank you so much for shedding light on this issue. It's a tricky time for bond investors, and it's always great to hear your perspective on some of these issues. So, thank you so much for joining us.

Jacobson: Great. Thanks for having me, Christine.

Benz: Thanks for watching. I am Christine Benz for Morningstar.com.