Staying a Step Ahead of Inflation

Michael Herbst: I know oftentimes investors sometimes view yield and income side by side, especially for income-oriented investors. At Morningstar, we get concerned sometimes when people equate the two; because it seems to me the yield measure can either hide or reveal weaknesses or problems down the line.

If you're thinking from an income perspective, looking out say over the next two to five years or so, what are some of the traps that investors should look out for, or at least some of the risks that they should be aware of when seeking an income stream from bonds?

Kathleen Gaffney: Well, it's less of an issue for the bond fund, given that it's investment grade overall. But, the high-yield market, in particular, when I look at the characteristics of that market, the average yield to maturity is in the mid-teens right now. But, if you look at how we're positioned with our credits, we're giving up yield.

And typically, we don't like to give up yield, because it's a great cushion to continue to build in the fund. But we're willing to give up yield, because I think that that number in the mid-teens is not reality, given the massive deleveraging that we're expecting and the increased default risk. So, with 25% of the high yield market in CCCs, a lot of that yield can be eroded very quickly with defaults.

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Herbst: On that theme of say the next two to five years, the consensus seems to be that the ride from here is going to be anything but smooth. Some of the near-term risks have been taken off the table to some extent. But, it seems to me that with all of the government's efforts to essentially reinflate the capital markets--and what that means for say Treasury issuance, the U.S. dollar, or the potential for inflation a few years out from now--if you take one step beyond the immediate present, what are some things that you're concerned about, again say two to five years out?

Gaffney: Sure, that's a great question. And the market's really picking up on that in the last week or so with Treasury yields really backing up at the long end. So, the fears of inflation are really rampant. And while in the near term, I think that the market should be more concerned about deflation, clearly with all the issuance and potential demand coming out of the emerging world, inflation is clearly percolating.

So, as a fixed-income manager, you want to be a few steps ahead in thinking about that next cycle and what inflation can do to a bond portfolio. It's one of the reasons why we continue to hold our non-dollar exposure. And the emphasis in those positions continues to be the commodity currencies: Canada, Australia, New Zealand. I think those will be great inflation hedges, because those are currencies that will benefit from upward pressure on commodity prices on natural resources.

Herbst: It seems to me in the inflationary environment--for investors holding portfolios of U.S. government bonds in one form or another, Treasuries, agencies, et cetera--it seems to me that what was considered safe in '07 and '08 may not be considered safe at this point or, again, looking forward in the next couple of years. Is that a fair assumption?

Kathleen: Yes. I couldn't agree more, and it's funny how markets can turn on a dime. But clearly, rates are very low. And with the amount of issuance and the amount global growth that we eventually see, the upward pressure on interest rates is going to make Treasuries, I think, a very unattractive market for the long term.

Herbst: Well, thank you so much for sharing your time with us this afternoon. It's much appreciated.

Kathleen: Great to be here, Michael.