Merk: Bond Market Too Good to Be True?

Nadia Papagiannis: Hello. My name is Nadia Papagiannis. I am an alternative investment strategist here at Morningstar.

Today I have with me Axel Merk, the portfolio manager of the Merk Hard Currency, Merk Asian Currency, and Absolute Return Currency Funds.

Thank you for being here with us today, Axel.

Axel Merk: Good to be with you.

Papagiannis: Axel, many investors are at a loss today as to how to protect and grow their capital, especially in the face of the equity markets, pretty much the collapse between October 2007 and March 2009, and then we're still seeing a lot of volatility in the equity markets, especially in April, May and June of this year. And so, as a result, they have piled into fixed income. Now, is this a good idea?

Merk: Well, people like to chase trends, and it does for a good cocktail talk, but it may not be very profitable in the medium term. The big challenge in the bond market is that even during normal times, the volatility in the bond market is far greater than we've seen recently. And so, you can have unusual events, especially you have the interest risk in the bond market. If interest rates were to go up, if U.S. Treasures were to plunge because of unexpected growth or because of foreigners selling the U. S. dollar, you can have very significant surprises in the bond market, and in any bubble scenario people are discounting those sort of risks.

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And so what we're telling investors is that, yes, by all means the equity markets have their challenges right now when you cannot invest based on fundamentals anymore--policymakers are throwing around trillions, access to credit is still difficult for many. So, you need to look for ways to diversify, and we try to do it on the currency side.

The advantage of currencies is that you have the liquidity, you have an asset class that by design can create a portfolio that has a low correlation to what you have already, and if you consider it as a special case of a fixed income product where you have a direction call in a currency, say, in the Hard Currency Fund, we have a commitment to the short end of the yield curve. The average maturity in our portfolio has never been over 180 days. Your typical bond fund measures maturity in years.

And so, if you think you want to take the scenario into account that interest rates may go up, why not allocate something that has a commitment to the short end of yield curve? Obviously, we add the currency risk to it, that's something that we add as a feature rather than, a bug, so to speak.

Papagiannis: So, let's go back and talk about what is the actual risk in the bond market right now. So, besides the fact that a lot of investors have piled in a lot of their assets into there, they are also chasing the longer end of the yield curve.

Merk: Yes, you have credit risk and you have interest risk in a typical bond fund, and obviously, internationally you have the currency risk as well. We see the currency risk as an opportunity there.

But what we have seen is that the supply of bonds has increased vastly, especially of government bonds. At the same time, yields have been going down. That is a clear indication that people are chasing performance. We see it also on the asset flow side. And so, that just should give somebody a moment to pause. And of course, bonds have been doing very, very well. But is there a risk that things will not continue that way, and if people agree that there is a risk, well, do you take it into account in your portfolio allocation.

Papagiannis: So then, let's talk about risk. So we have seen a lot of people measure risk in terms of volatility. And the volatility of the bond markets has been more stable recently. So, is that an indicator that it might blow up all of the sudden?

Merk: We believe that low volatility in any asset class is the best bubble indicator there is. We saw it in the tech bubble, we saw it in the housing bubble, and now we see it, if I can use the word again, in the bond bubble that we may be experiencing. And so, just when time seem to be too good to be true, odds are they are too good to be true.

Now, of course, you can argue that, while this may last longer because the irrational exuberance also lasted for many years, our argument is that, why not look for something where there is value, why not look for something where you don't have to chase a trend, because ultimately it's going to be extremely difficult to time the top of the market. We have our views, other people have their own views, but most people cannot forecast where the top is going to be. So why not take the prudent step and look for diversification now, why you still can, before we have a potential disruption in these markets?