Leuthold's Doug Ramsey, Ariel's Charlie Bobrinskoy, and Tom Forester of Forester Value discuss the performance trends, fund flows into, and outlook for fixed income.
Dorsey: I wanted to ask you a question that's befuddled me all year. Bond fund flows, obviously, have been just off the charts this year and last year. I mean, investors are pouring money into bonds as if the bond market was going to shut down tomorrow, and they can never buy another one. This has befuddled me because I think if I can buy a 3.5% fixed coupon, an investment grade corporate, or I can buy 7% to 8% rising coupon, in terms of a free cash yield, the math doesn't seem real tough to me. I don't have a great explanation, other than performance-chasing for this. Do you have any insight you want to give me?
Forester: Well, one of our stocks that we like and has done well is Altria, and they've been paying a 6%, 7% yield forever, and they're only paying about 10 to 11 times earnings, something like that, and so for us, we like that a lot better than paying 2.5% or 3% now, but 2.5% for 10-year Treasuries. We think that the fixed income world has become, on a risk-reward basis, all risk, no return. So, we tend to shy away from that.
Dorsey: So, why has the money kept going in the bond funds, though? I mean, I agree with you, but every week I look at the fund flows and I just – I can't explain it, other than simple performance chasing. I mean, a 10-year chart of Treasuries looks a lot better than a 10-year chart of J&J.
Bobrinskoy: Usually we don't like to point to flows as the explanation, but that is the explanation here. It's entire classes of investors, particularly corporate pension plans, who've gone from being predominantly equities to much more 50-50, huge swings into corporate bonds. The Chinese, obviously, big buyers of corporate securities, and then retail investors, who just are risk averse and have seen the very good performance from fixed income. So the flows have driven. There is a limited amount of supply of high yield and municipal and corporate bonds that have just driven prices to what we think are levels that make no sense.
Ramsey: I was just going to say, I mean, unlike chasing the tech funds and the large growth in the late '90s, the additional thing that concerns me is I'm not sure on the part of a lot of the retail public, that there's an appreciation of the mechanics of a bond and its relationship to an interest rate, and you'll have people calling up, what's the interest rate on my bond fund? Well, it doesn't quite work like that. I mean, there's price exposure there that I think, sadly, that's going to be learned here in the next two or three years.
I think the other point is, I mean, there is a modern-era case of extremely low interest rates dropping in half again, and that's happened in Japan. So, it seems to me there's this asymmetric expectation that if we've now flat lined, in terms of economic growth or some especially bearish case of the, so to speak, new normal, yeah, there is certainly a case that the 10-year bond yield could go down to 1.5% in a very unusual scenario.
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Dorsey: So you're saying is that a high probability case?
Ramsey: No. It's not, not at all. We did it simple thought exercise, not a forecast. But if you take today's 10-year bond yield, weasked the question, well, what kind of action would you have to see over the next five years to get a 6% return out of that 10-year bond yield? Well, you'd need the 10-year, which is currently, let's call, it 285, you'd need that yield to go all the way down in the next five years to 17 basis points. You'd be collecting your coupons every six months and then you'd be looking at a five-year time horizon with trying to reinvest those proceeds into a five-year Treasury note at, who knows, 10 basis points. But just again, I think it's just this asymmetric return expectation. Yeah, I mean, there's a maybe less than 5% probability of a Japan deflationary spiral happening, but to make bonds work out you really need to bet on that happening.
Dorsey: So that's a great one that's just worth highlighting maybe for the folks watching. Because the 10-year return on the Treasury is around 6%ish, that to get that over the next five years you have to believe that the 10-year Treasury will trade at 17 basis points.
Ramsey: Correct. To get a 6% return, just a 6% return.
Dorsey: So do you think that?
Forester: I would say, lastly, then that one reason why I think that bonds did so well is that in the summer Bernanke came out and started talking about QE2 and basically saying we're going to buy 10-year Treasuries. And so he couldn't do that until after the election, but everybody else could start ahead of him. I think that a lot of the hedge funds started jumping into that trade, yields went down, prices went up, and as soon as you get some momentum going, everybody else kind of followed, and I think it was a self-fulfilling prophecy. And I think it's reversed now because it was buy the rumor sell the fact.
