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BlackRock CIO: Get Ready for Rising Rates

BlackRock's Rick Rieder says the Fed will still try to raise rates, and investors should diversify their fixed-income exposure and be thoughtful about where interest-rate risk is held.

BlackRock CIO: Get Ready for Rising Rates

Sumit Desai: Hi, I'm Sumit Desai, senior analyst at Morningstar's fixed-income manager research team. Joining me today is Rick Rieder. Rick Rieder is chief investment officer of BlackRock's Global Fixed Income Platform. He is the lead portfolio manager for the BlackRock Total Return Fund and the BlackRock Strategic Income Fund.

Rick, thank you for joining me today.

Rick Rieder: Thanks, Sumit. Thanks for having me.

Desai: So, Rick, as I mentioned, you run several funds within BlackRock, two of them that we cover are the Total Return Fund and the BlackRock Strategic Income Opportunities Fund. Can you explain a little bit how these two funds differ, and how investors should position their portfolio kind of between the two opportunity sets?

Rieder: They are quite different in terms of the nature of what drives return in those two funds. That being said, they are both trying to take advantage of where the opportunities are in the world, where the opportunity in fixed income is today. We live in a world--when people think about their fixed-income exposure, something historic in terms of how they think about it depending on the metric you use, half the market is at negative interest rates around the world. Those two funds, Strategic Income, allow you to go and look at credit risk, look at convexity risk, mortgages etc., look at interest-rate risk and trying to find the best opportunity in the world and run a very low interest-rate exposure historically. That's the way we run it. We tactically use long-end interest rates, use interest rates in parts of the world like Australia, Korea today, but be tactical about where I use it but home base for duration could be close to zero.

Total Return is where we run a more traditional aggregate-oriented, a more traditional core bond fund run about a five-and-change-year duration and you get more interest-rate exposure. The beauty of holding those two funds--and what many people do is they hold the two funds together--I believe in this dynamic today, that in fixed income today you want to diversify and you want to look at different ways. It's hard to create a lot of return in fixed income. But if you look at these two funds together, they've created a return that's beaten the aggregate index over since 2010 with no drawdown. And we think for fixed income that works going forward. Keep your losses down, keep your drawdown low, which could be a rising rate environment but also diversify how you hold fixed income.

Desai: So, you mentioned keeping your losses low in a rising rate environment, obviously, the topic of the year for fixed-income investors really a few years now. So, to the extent that the Fed raises rates at some point, and we can debate the timing and magnitude of those raises in the future, what does that mean for investors and particularly, because it can have a different impact on the short end of the yield curve versus the long end of the yield curve versus in the middle, in the belly. So, when we talk about rising rates, what does that mean within that context?

Rieder: So, it's a great question. I think we've lived in a world for 30 years on and off where rates have come down, but this one is probably the most unique over the last couple of years. And I would argue that the Fed has had an opportunity to raise rates and it's been deliberate in terms of doing it. We think they should have done it. Now, it's going to be harder for them to do it and the impact, what's influencing the decision largely comes from outside the U.S. and that's something very different. Financial conditions around the world, global growth being slow and the demand for interest-rate product in the U.S. that comes from places like Europe, Japan is extraordinary today.

So, how do you think about that within your portfolio? I think the Fed is going to try and go. I think the window has certainly closed much more significantly than it was a year ago or even two years ago. But I think they are still going to try and raise rates. There are two things that I think are critically important in terms of how investors should think about it.

One, it only takes a small interest-rate move to create a loss in a portfolio because the duration has extended, with rates as low as they are, has extended so long. People have to be really thoughtful about where they hold their interest-rate risk and how much do you have in pure interest-rate risk because small movements will create a loss.

Second thing, we believe investors should diversify their fixed income. They should think globally. U.S. investors tend to be very much U.S. agg or U.S. interest-rate exposure. Think about Europe and Japan, but particularly places like Australia, Korea, India, places that are going to keep rates here or lower for a period of time while the U.S. raises interest rates. I think people have to be when you diversify, the U.S. is going to grow faster and it's going to raise rates faster than the rest of the world, and even small moves can create a loss. Think about your portfolio globally, think about where you hold your interest-rate exposure. I would argue how much fixed income is an important concept but where you hold it may be more important for the next couple of years.

Desai: So, obviously, geographic importance--or geographic location of kind of where your investments are, is really important. But you mentioned Japan and parts of Europe, but that's where a lot of the negative interest-rate environment is. So, maybe we can talk one, like what does the negative interest rates even mean for the market and then how is it going to play out over the next three years, if you can bring out your crystal ball?

Rieder: Well, I need my crystal ball a lot of time because it is--listen, I don't think negative interest rates works. I think what it does is it creates distortion and it creates an incredible forcing people into risk, forcing savers to subsidize borrowers around the world, and I think you have to think in the back of your mind you're creating these aberrations in the system, how do you dull the volatility within your portfolio and how are you in assets that aren't as distorted.

So, what do I do directly within my portfolio or how do I think about it? So, I really believe in this diversify, diversify, try and dilute the distortion. So, I wouldn't be an advocate today of buying Japanese rates or buying German rates at negative, but I would be an advocate of places that are close by, meaning Australia's rates are significantly positive. They are back of the U.S. in many parts of the yield curve. I think that's important in terms of where do you--how do you think about your exposure, places like Australia, places like Korea where you're going to be a subject of where China is slow and their policy and trade is going to be slow that it's going to be easier in terms of rates.

And then layer in how do I diversify to take in yields, so things like--we like nonagency mortgages, commercial mortgages, asset-backed stable cash flow into the portfolio to try and keep your return consistent over time and try and get away from where is the risk-free rate so impactful on the asset because that distortion is so profound today, and I think you have to be thoughtful of that going forward because we're not going to sit at negative rates for a long time.

Desai: So, what you said--and kind of bringing it back to the U.S. a little bit, so do you views suggest that you should avoid U.S. Treasuries broadly or how do you kind of think about that?

Rieder: Yeah, you asked a great question before, I should have talked a bit about. If you take actually the long end of the U.S. interest-rate curve, 10-year Treasuries still in the mid to high-1s and if you take that in the global scale, it's a steal if you're investing in Europe or Japan. And it creates some protection in the portfolio which you're hedged against if you happen to create deflation, by the way, which I think will be exported from other parts of the world. So, I do think long-end interest rates make sense, things like long-end munis makes sense, the long end of the investment-grade market is now pricing at reasonable levels. So, I think, listen, what the Fed is going to obviously move is the front end of the yield curve. The front end of the yield curve has no value today in terms of upside potential. So, I think having some interest-rate exposure, again, within a diversified portfolio high-quality back end of the yield curve, within your portfolio we think makes some sense.

Desai: So, that being said though, you've been running a fairly low-risk kind of portfolio for a while now. Does that mean you're fairly bearish on credit overall? You mentioned long-term credit is attractive, but kind of more broadly speaking how do you feel about the corporate sector?

Rieder: So, I would say a couple of things. One, we've been running a conservative portfolio and generally, I think, the risk--and we're talking about distortion--I think the risk in the world, whether it's capital flight from China and the leverage being so significant in China, staring down the road of Brexit and then what it means for broader Europe is significant. U.S. election is significant. Global growth is moderate, which means when you have global growth that's moderating because of demographics and a variety of other reasons, it means idiosyncratic risk grows. I think no matter what--and by the way, the return potential in assets is lower than it's been historically. Meaning that risk/reward is not what it was.

So, we've been running a more conservative portfolio for two reasons. One, I do think the risks are significant. I think you got to be thoughtful about these exogenous influences in the world but I also think there will be more opportunities coming. And I think we're talking about where things have started to widen whether it's in the nonagency mortgage space where we've seen some opportunities because of there's been sellers in that market, I think you should be prepared for more opportunities coming. There are going to be bouts of volatility. There will be bouts of more volatility in 2016, no doubt in my mind and being ready and prepared, having a relatively conservative portfolio, particularly when the upside when we look at parts, we think the high-yield market will do its job, but the high-quality end of the high-yield market in the low to mid-4%, well, it is not a lot of upside potential. So, we like running more conservative than seeking out opportunities more deliberately.

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

Rieder: Thanks, Sumit. Thanks so much.

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