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BlackRock's Rieder on Today's Bond Market

Sumit Desai, CFA

Sumit Desai: Hi, I'm Sumit Desai, senior fixed-income analyst with Morningstar's manager research team. Joining me today is Rick Rieder, chief investment officer of Fundamental Fixed Income for BlackRock. He's a lead portfolio manager for BlackRock Total Return (MAHQX) and BlackRock Strategic Income Opportunities (BSIIX), both Bronze-rated funds.

Rick, thank you for joining me today.

Rick Rieder: Thanks for having me. I appreciate it.

Desai: Rick, obviously, the hot topic for all bond investors right now is the Federal Reserve and their expectations for when they'll raise rates. What is your view on the Federal Reserve? What are your expectations?

Rieder: I think there are a couple of things that the Fed has said that you have to take at face value. Number one is that they are going to be data-dependent--no doubt they are going to be data-dependent. Number two is they are going to be gradual in their process. Then, you try to take that and say, "What is uncertain from here until when they [raise rates]?" We think the payroll data is going to be good. And I truly think that we've hit the employment numbers that the Fed needs to see. As long as there's a reasonable 200,000 or so jobs [being created each month], then I think the Fed can move in September. Our best guess is that they move in September. The key to focus on is wages and some of the inflation data, because that still hasn't hit their goals, per se.

So, I think they are going to move in September. I think the data could have allowed them to move earlier, but I think they are going to go in September. But I think the most important thing to think about, with regard to when the Fed moves or how the Fed moves, is not so much the when but the pace. And they cannot be any more vocal in their opinion that they are going to be gradual. I think Janet Yellen used the word 'gradual' 14 times in a presentation recently.

I think what they are going to do is they'll move 25 basis points in September. Maybe they'll wait till December, although I don't think so. Then, they'll watch the data after that and move again, but I am convinced there is no path. We are going to move 25, then move another 25 in December, and then move another 25. I think it's going to be very data-sensitive. We think the data is going to be better and will give them a chance to move, and we'll continue down this path of getting the funds rate closer to 1%.

Desai: You mentioned inflation expectations. What are your expectations for inflation? I think there are a lot of competing factors--oil prices going one way and wages maybe potentially going the other way. How do you think the Fed navigates that and how do you navigate that?

Rieder: I think we are in a really different world from anything we've ever seen before. I think that we grossly underestimate technology's impact on inflation. I truly think the way data is measured is faulty. I think when we get the nominal aggregate GDP data or retail sales, it's this conglomeration of industries that are changing radically--energy is one you mentioned. If you think about how technology changed oil or if you think about how iPhone or Amazon (AMZN) has changed the inflationary impulse and consumption. I think long-term inflation stays lower than it has historically--and demographics is a big part of that.

However, I also think, in the near term, you could see some inflation. People have thought that inflation is dead for a long time. We've been adding a bit in terms of inflation protection, in TIPS. We use the inflation component within TIPS. We've been adding some of that recently. We've actually been adding it in Europe as well--so-called "linker bonds." So, longer term, we are not that concerned about inflation really accelerating. In the short term, though, we're adding a little bit of protection because I think, in the near term, while we think inflation will pick up a bit and people will say that we are coming closer to the Fed's and the ECB's targets, you are not paying much for that protection today.

So, we think, in particular, in the longer-dated TIPS--10-year, 30-year--that you are getting paid for taking that on, despite the fact that we don't think we'll be going through another cycle of significantly higher inflation for a while.

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Desai: You mentioned longer-dated TIPS. When you were here last year, you said that you were investing a little bit more in the longer end of the yield curve and avoiding the short end of the yield curve. How has that worked out in the past year, and where are you now from that point of view?

Rieder: It's a funny thing. We've been a big believer in the yield curve flattening and that the long end would perform, because we came off of this period--the "taper tantrum"--where long-end interest rates moved up so dramatically. So, we've been believer and, in fact, we felt that rates would drift higher, as they have been doing in the last few weeks. We still think rates will drift higher. We think it's led by the front end of the curve. In fact, last year, I would say our view wasn't that rates were going to move down, and then they did. But we ended up doing extremely well because the yield curve flattened so dramatically alongside it.

We think that you are not that far from fair value at the longer end of the rates curve. With inflation staying reasonably moderate, we think longer-end interest rates are OK. It's the short end of the yield curve that's priced wrong. We think that the Fed will start moving, and the front will move up, in a drifting higher-rate environment led more by the short end of the curve moving higher.

Desai: Could that be a risk for more shorter-term-oriented investments?

Rieder: I think one thing to factor in is that the Fed has been pretty clear about how it's going to be slow and it's going to be gradual. So, I don't think there is a lot of price pressure on shorter-dated investments. Recently, we haven't seen a lot of positive returns coming out--in fact, we've had some moderate negative returns coming out. But when we think about prior cycles when the Fed moved quickly and they moved very aggressively and quite frankly chronicled how they were going to do it--"We are going to keep moving, keep moving, keep moving in a stable pattern"--this Fed is not going to do that. So, I think the short end is going to drift up, but I don't think it's going to move up faster than the back end. I don't think there is real pressure on the front end with this Fed.

Desai: Another hot topic is divergent central bank policies--easing overseas, tightening over here in the U.S. How do you position to take advantage of some of that divergence?

Rieder: I think the difference between what's happening in the U.S. and what's happening in Europe and Japan is pretty remarkable. People have talked about better growth in Europe recently. And the growth is better, and we're encouraged that the growth is better, but you also just got a tremendous benefit from the currency--a 20% benefit from the currency--and an almost 50% benefit from energy and negative real rates. That's a whole lot of tailwind for Europe. It's going to be a long time before we can determine that Europe is on a stable pattern of stronger growth and higher levels of inflation. We're going to have to wait at least until September 2016, when the ECB has said that they are going to [potentially end their QE program]. And the same thing goes for Japan. It takes such a long time because of the demographics and corporate competitiveness to get aggregate demand up.

So, we think the U.S. is certainly achieving its goal, and we think the Fed will start moving. But we think Europe and Japan are going to be a long time. So, what do you do with that? One of the expressions we like--"long the dollar"--we're worried that everybody is long the dollar. So, keep that expression fairly moderate, but we do think the dollar is going higher. The other thing is that we like to take our interest-rate risk outside the U.S. to places like Europe--places like Italy, Portugal, and Spain. We like to take our interest-rate risk and own it in other parts of the world. Take your duration or interest-rate risk in other parts of the world, as opposed to the U.S., where we think rates are going to be in a drifting-higher dynamic. We'd rather own some of the credit assets, some of the spread assets in the U.S.--some things like commercial mortgage and so on--as opposed to just taking rate risk here.

Desai: Talk to me a little bit more about spread assets--the credit sector, specifically. What is your view on where we are within that cycle?

Rieder: So, there is a very, very distinct difference between high-grade and high-yield companies today. That's something that's pretty remarkable today. High-grade companies are particularly mature companies where your top-line revenues are stable and margins are stable. They are putting on more leverage to grow their [returns on equity]. Anyway, it's not scary because of the place we started from. Spreads have backed up a fair amount, and yields have moved up a fair amount recently.

So, we've started to add a bit of investment-grade for the first time in a while; it's one of the areas we haven't liked for a long time. We've started to add a little bit of investment-grade in the U.S. and a bit in the Europe and Asia. We have a core holding in high yield; it's actually pretty small in the U.S. right now, but in Europe and Asia. We just think they are good. The default rates will stay low, leveraging is not moving up that significantly, and the demand for yield is so profound. So, it's a core holding that we have. Like I said, the U.S. is pretty low today, but we have some high yield in Europe and Asia. It's a core holding in our position. But we've been adding tactically a bit of investment-grade recently, particularly long-end investment-grade, as these yields have moved up, which has attracted insurance companies and pension funds. We think, even with a bit of increased leverage, you are getting paid for it now, spread-wise.

Desai: Is there more interest-rate risk, then, within those positions if you are going longer date on the higher quality?

Rieder: So, we turn around and we manage our interest-rate risk there, and so we'll hedge our interest-rate exposure. 30-year investment-grade has really widened out, and the yields are pretty attractive. So, we'll try to neutralize a lot of that interest-rate risk and, as I said, we like to hold more interest-rate risk in Europe and in parts of [emerging markets] but keep more of that spread exposure.

Desai: Correct me if I'm wrong, but I think one of the key tenants of your process--maybe specifically within the strategic-income fund--is understanding the correlations between asset classes. How do you think about that going forward when those correlations may change, and how do you think about that within your portfolio construction?

Rieder: That, to me, is the Holy Grail of managing risk and managing your portfolio--trying to make sure you're making a little bit of money a lot of times and that no one expression is too large and making sure the expressions you have on loosely correlate or don't correlate at all with one another. And I think if you asked me what the risk was over the next couple of years, I'd say it's correlated risk. Some of it is because the system is deleveraging; there are not enough financial assets, and everybody is doing the same thing at the same time.

So, we try to diversify it extensively. Part of why we like munis in the portfolio is because they don't correlate that closely with European peripheral Italian debt. So, we like owning that because it keeps the correlations down. It's a big deal for us. We like to create an efficient equilibrium, a stable equilibrium within the portfolio. Have a number of expressions, try to find relative value a lot of times throughout the system, and then try to have those expressions not correlate. It's a big deal.

And I would say that one really important thing that people have to think about is this: Balance in a portfolio is different now and will be different than it was a year ago, and that's because when the Fed does easy monetary policy--QE or low rates--what can happen is stocks can go up and rates can go down simultaneously. So, the best portfolio is long duration--long end of the yield curve as we talked about before--and owning risk. Well, your interest-rate risk in U.S. may not help you anymore as the balance, so how do you think about that? What is balance now? I would argue that balance now is taking your rate risk in parts of the world that make more sense and taking your spread risk in parts of the world that are most efficient. But I really think balance is different today from what it was six months ago or a year ago as policy changes.

Desai: While we're hitting on some of the hot topics within fixed income, liquidity is another question that we get a lot about. How do you think about liquidity and how do the portfolios that you manage address the issues of illiquidity within fixed income?

Rieder: It is the hot topic, and it's one of the things we think about a lot in terms of how we manage the portfolio and how we transact in this market place in a few different ways. One is that you think about your entry and your exit into positions. The whole concept of if you tactically traded something before and thought maybe you could make two to three basis points and do it tactically--you don't do as much of that today. You look at core holdings that are going to be in your portfolio, and then you tactically move in areas like Treasuries or agencies or mortgages. Things like mortgages or investment-grade credit are more liquid today. So, we've been doing more in terms of that; we are oriented toward some of the more liquid parts of the fixed-income market--that's part one.

Part two: We like a barbell strategy. One of the things we've been doing recently is running more of a barbell--hold a fair amount of liquidity in the portfolio and then find the expression, parts of emerging markets where we like to take some risk. Or we can use options on parts of the equity market where we'd like to augment the return and just give up a little bit of carry to own some upside convexity. But be more thoughtful about running a barbell. What areas? And then position and trade where your transaction costs aren't that high, because in a world of low returns, don't kill a portfolio by eating it up with transaction costs.

So, we think about that a lot. We think about how and where we manage the portfolio. We use very complex analytics that look at beta and dispersion and correlations and diversification, but liquidity is one as well. We think about what your yield is and what your return is per unit of what we call liquidity. It's a really big deal for us because if you think about things like commercial mortgages--we love them--or even parts of the [collateralized loan obligation] market, we'll have small positions in CLOs, but you've got to think about the fact that there's a liquidity framework to that, too. So, we count that as a big part of how we think about risk.

Desai: Rick, thank you very much for joining us today.

Rieder: Thanks, Sumit. Thanks for having me.

Desai: Thank you.