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Protecting Capital in Today's Bond Market

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Tom Atteberry; he is the portfolio manager of FPA New Income. We're going to look at some risks facing bond investors today and also what he is doing to protect capital in this environment.

Tom, thanks for joining me today.

Tom Atteberry: Thank you.

Glaser: Let's start by looking at Treasuries. How do you think about the attractiveness and general valuation levels of government bonds today?

Atteberry: Let's start with the Treasury market. Where am I today? What am I looking at? And that's where the distortion and the difficulties start to show up pretty rapidly because you look at the situation where say, I'm just going to use as an example a 5-year Treasury at the end of the quarter had a 77-basis-point yield. But if I look back at history and I go back on to Fed website and looked at what's been the median yield for a 5-year Treasury looking at a cost-to-maturity Treasury index, I can go back January of 1962, and that number is 609 basis points. So, wow, a huge difference. So then, you go further and go "What am I really looking at whether I make a stock investment or a bond investment?" I'm trying to make some return greater than inflation. I'm trying to get a real return. Obviously, the more risk I take the higher to real return I'm supposed to be receiving.

That 5-year Treasury historically is about 250 basis points, or 2.5% real return. In today's environment it's negative. So, you already are looking at fact that you've got a large distortion of real return versus historically, and you go "OK, the base place I start with interest rates is overvalued and by a fairly significant amount."

Glaser: So, if investors think of Treasuries as being this kind of safe-haven asset, it sounds like you wouldn't agree with that, you think that there is more risk in Treasuries today than possibly elsewhere?

Atteberry: Yes. So, the first thing you realize, the safe haven, which is where I took no credit risk--I took interest rate risk, right, depending how far out on the curve I was--but I was receiving a positive real return, and thought "OK." But depending what my view was, of where I thought rates are going to rise, or were they going to fall and what the absolute level was to begin with you, I sort of went "OK, I can engage what interest-rate risk I'm wanting to take," but now you can't do that because you realize you are also accepting a negative real return to begin with, which historically you said that doesn't make sense. It should be about 2.5%. Right now, it's depending on how one wants to look at inflation, we'd issue as a Treasury Inflation-Protected Securities bond, as just a general element, a 5-year TIPS Bond is sort of a roughly 1.5% negative real yield. So, your whole premise, your whole basic building block of looking at the fixed-income market is distorted and overpriced.

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Glaser: So then, a lot of this is being driven by of course the Federal Reserve's policies. What does that mean for other investment-grade securities? You look at mortgage-backed bonds, potentially other asset-backed bonds.

Atteberry: So, if I take that same analysis, I look at parts of the Barclays Capital Aggregate Bond Index, and I just break out the credit component of the Barclays Aggregate Index--I don't have the data as long. That index started really publishing this kind of data in January 1973. But that Barclays Credit Index has a median yield from 1973 forward with 7.83% and a median real yield of 4.11%, and if I look at just the fixed mortgage component of that mortgage aggregate index. The data there starts in January '76, and it was a 7.58% yield in a 4.4% median return.

You look at those today and that credit index is yielding 2.76% and that mortgage index is yielding 2.52%. So, you look at the real return that you might get from those, while they are positive, they are extremely low. They too show overvaluation, and this is just general sense. It's just looking at a broad index.

To your point, what's causing that? Well, we think the major reason that's being caused is you have a Federal Reserve Bank that has stepped in and says "I'm going to buy long-dated Treasury bonds. I'm going to buy fixed-rate mortgage pools, in order to drive their price up and drive their yield down, in order to facilitate some economic behavior." So that distortion is carried from the Treasuries now they have actually gone and done the mortgage. Now, keep in mind, it would take a lot from them to say "I'm going to go buy corporate bonds. They really don't have the mandate to do that." But the point is they're using the Treasuries to distort this, and they are intentionally trying to distort the marketplace.

Glaser: So, you mentioned corporate bonds there, when you look at investment-grade corporate bonds or even high-yield corporate bonds, did those also look overvalued right now?

Atteberry: The Barclays Credit Index that you find embedded in the Barclays Aggregate Bond Index is all investment-grade. If you want to look at the Barclays High Yield to look at high yield credit, that index, since they started publishing it with good data in January of '87, has a median yield of 10.26%. You can get a median real yield. Do the math and get it, which is about 7.64%, but you got to keep in mind if I'm looking at something that has a lot of equity characteristics to it, so it's not purely just a real return investment. So it's not in a pure sense, but it does give you a sense of where value is if on average it's had a 10.25% yield, and right now where it is at the end of the quarter, it was 5.67%.

So even this policy that's gone forth where we've started with your base Treasury yields and see that the negative real return you are getting there, it has filtered itself through and it's manifested itself within high-yield space as well. And now you are getting a 5.67% yield at the end of the quarter on an index with a single B rating that's supposed to have a lot of equity characteristics to it.

Glaser: So it sounds like overall, one of the big risks right now for fixed-income investors is that overvaluation, that there aren't a lot of good values out there. But when you think about other risks, rising rates for example, how impacted would some of these different securities be by rising rates? What's your thinking around when rates could start to go up there?

Atteberry: So, the difficulty is "when," because it would appear today that as long as the Federal Reserve Bank continues to buy, they are probably keeping that rising of rates from occurring to any significant manner. You just don't know how long can they keep this up. If you look at this indexes in general, you realize that a rise in rates that maybe looks like 30 or 40 basis points, in a 12-month period, can easily produce zero returns for them, total returns. So you realize there's very little movement that can occur and you get a zero return.

If you sort of start to do the experiment, I'll just give you an example, and said, "What if I just took in a 5-year Treasury at 77 basis points, and I assumed that I return to its normal relationship with inflation?" So, if I said inflation was 2% and it had a 2.5% real yield historically, that the 5-year Treasury went from 77 basis points to 4.5%. And I said it takes four years for that to occur. The total return an investor will get is minus 14 basis points.

I'd go through that illustration and said that's the type of interest-rate sensitivity that a bond investor finds themselves in today if they start to think through where should this whole Treasury yield curve should be if it returned to its more normal relationships with inflation in the economy. So there's a tremendous amount of interest-rate risk within the bond market space.

You know obviously if I looked at Barclays Credit Index, it would even be worse because it tends to have a longer duration [a measure of interest-rate sensitivity] and it has more of rising yields than it has to go through. If I look at the high-yield index and ask historically what should I get for a yield, it tends to more like 10% not 5% and change.

So you realize there's a tremendous amount of risk involved in the market. And what you are looking at is that I can identify the risk and I can quantify the risk. The thing that I don't know is, when does this event start. And that's the piece you don't really have the answer to, or which a lot of people discuss. But we look at it and said, well if I can identify what my risk is and I can quantify what my risk is, and it's a very acute risk, I am less concerned about when is it going to start. I know eventually it will, and when it does, it's a very ugly event. So shouldn't I position myself to be able to survive that negative event in the bond market because I really all I don't know is just when is it going to start.

Glaser: So in your fund you are aiming to produce that positive real return, that absolute return. How do you do that in this environment then if it seems like most of the major areas of the bond market seem like they are overvalued to you or seem risky?

Atteberry: So we sat down and looked at it from two aspects. We looked at it from its interest-rate risk aspects and that told us we didn't really want to own anything that had a maturity longer than five years. And we wanted to have a portfolio that would tend to have sort of a 2.5-year average life to it. It would have a duration that would sort of go between 1.00 and 1.75 years, and the yield toward on the portfolio would be greater than the duration. And the reason for that is, is that would mean at least we knew we could take a 100 basis point increase in rate and still have a positive return in the 12-month period.

The other reason we sort of looked at the one- to five-year range, is we said, this will enable us to always have cash coming back into the portfolio whether its interest, whether it's an amortization on a mortgage or an amortization on automobile loan or just a maturity. So, you would always have cash coming back in to reinvest. So our portfolio has been set up to where over the next five years 80% of its assets will come back to us in that form. So, if rates start to rise, we have that money coming back through those elements and we're able to go out and reinvest before they're rising and obviously we think about a better opportunity.

From a credit aspect, we looked at it and said credit was more of looking at the economy and what you thought was going to be growth in the economy and how fast it was going to be, and we had some concerns about that and we had concerns about leverage and delevering. We decided, well, let's be secured, let's be secured by an asset of some sort that's critical--house, car, airplane, shipping containers, various things--that we could value. And if things didn't work out, we could take that asset sell it off and get paid back the amount on a bond. Again getting our money back.

And so we constructed it from those two aspects realizing that in the interim, we may underperform if rates continue to move down as they did over the last couple of years. But we looked at the valuations and thought this doesn't really make sense, and so let's position ourselves to what we see as the next big risk and protect ourselves against that risk. So, we've constructed this portfolio that way and realize that rates can rise on us. We still produce a positive absolute return in a 12-month period. And we've been able to generate yield in this sort of 2.25%, 2.50%, 2.75% range, which means the investor is at least earning inflation if not a little better. So, you've protected real buying power of your client's assets as well and just said and, "I'm going to ride this out in this manner until things get more attractive," what would be, we sort of call it a yield curve that looked more normal.

Glaser: You mentioned inflation there. Is that something that worries you?

Atteberry: In the interim it doesn't worry us a tremendous amount. So, we're thinking it's sort of in the 2% kind of range. We realize that the Federal Reserve will do things that will try to make it go up. They are very fearful of deflation. So, we sort of use a general tendency of around 2, and say that's kind of what we expect in the interim.

The fears that we have to a degree and the concerns that we have revolved around the fact that one of things you are going to look at for inflation and define it pretty quickly for people is, too much money chasing too few goods. We have a Federal Reserve Bank that's created somewhere to the range of roughly $1.7 trillion dollars which is new money. So, we look at that on a longer-term basis because that has the potential to be a real inflationary problem. We're not, now finding out the only central bank that's decided to create lots of money. The Japanese seemed to have joined the party. The British have joined the party, as well.

So, we look at more of the intermediate and longer term, and we see inflation being greater than 2% as becoming a higher probability. And that steps you back to asking if inflation is sort of from here flat to up over an intermediate length of time and interest rates are showing you negative real yield, really in the long term you look at that as a negative pressure on yields.

Glaser: Well, Tom, we really appreciate you taking the time to talk with us today.

Atteberry: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.