Pramod Atluri: 'When This Storm Hit, It Hit Fast, and It Hit Hard'
The Capital Group fund manager discusses where bond investors are getting paid to take risk today and the role of bonds in an ultra-low-yield world.
Our guest on the podcast is Pramod Atluri. He is a fixed-income portfolio manager at Capital Group. Atluri began in the investment business more than two decades ago and has been at Capital Group since 2016. Before joining Capital Group, Atluri was a bond portfolio manager at Fidelity Investments, where he also worked as a fixed-income strategist and credit analyst. He began his career as a management consultant at McKinsey & Company. Atluri earned his bachelor's degree from the University of Chicago and his Master of Business Administration from Harvard Business School, and he is a CFA charterholder.
Pramod Atluri bio
"Four Actions to Take in Bond Portfolios," by Pramod Atluri, Mike Gitlin, and Karl Zeile, Capital Group, June 17, 2020.
"Answers to Your 5 Biggest Fed Rate Cut and Bond Questions," by Mike Gitlin and Pramod Atluri, Capital Group, March 17, 2020.
"Fixed-Income Outlook: Meet Uncertainty With Balance," by Pramod Atluri, Mike Gitlin, and Margaret Steinbach, Capital Group, Dec. 11, 2019.
The Capital System
"Capital Group: Multimanager System the 'Best of Both Worlds'," by Alec Lucas and Brad Vogt, Morningstar.com, June 16, 2018.
2020 Market Turbulence
Nonbank financial companies
"Enormous De-Leveraging in Bond Market Smacks of Margin Calls," by Stephen Spratt, Bloomberg.com, March 19, 2020.
"Treasury Bonds Sold Off as the Dow Sank Into a Bear Market. That's Not Supposed to Happen," by Alexandra Skaggs, Barron's, March 11, 2020.
Role of Bonds in a Portfolio
"Why Fixed Income: 4 Roles Your Bond Portfolio Should Play," by Kelly Campbell and Mike Gitlin, Capital Group, February 2019.
"U.S. Fund Flows in June Cap a Wild First Half of 2020," by Tony Thomas and Nick Watson, Morningstar.com, July 17, 2020.
"How the Great Inflation of the 1970s Happened," by Leslie Kramer, Investopedia, April 29, 2020.
Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar, Inc.
Jeff Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Benz: Before we get into the conversation, we wanted to share some exciting news. The Morningstar Investment Conference for investment professionals will be held virtually this year on Sept. 16 and 17. We're offering the same research, analysis and insight you'd get at the live event for a reduced price of $149. And the best part is you can join us from wherever you are. For more information or to register, visit go.morningstar.com/mic. Again, that website is go.morningstar.com/mic. I'll be speaking at the virtual MIC. I'd love to have some of our Long View listeners join us there.
Now, let's get into the episode. Our guest this week is Pramod Atluri. Pramod began in the investment business more than two decades ago and has been at Capital Group since 2016. Before joining Capital, Pramod was a bond portfolio manager at Fidelity Investments, where he also worked as a fixed-income strategist and credit analyst. He began his career as a management consultant at McKinsey & Company. Pramod earned his bachelor's from the University of Chicago and his MBA from Harvard Business School, and he's a CFA charterholder.
Pramod, welcome to The Long View.
Pramod Atluri: Thank you for having me.
Benz: Thanks for being here. You manage several funds for Capital Group, one of them being Bond Fund of America, where you share management duties with five other portfolio managers. Can you talk about how you form views as a team and make decisions, using the fund's duration positioning as an example to start with?
Atluri: Sure. The Bond Fund of America is a core bond fund. It sits in Morningstar's intermediate-term core bond fund, and it's Capital Group's flagship bond fund. The way the portfolio is structured--Capital Group uses a multimanager system. So, we don't have a single portfolio manager that manages the entire fund. We have a team of investors that manage the assets. Now, this team is structured so that we have analysts who manage a portion of the portfolio. Our analysts are not just researchers who look at companies and markets and interest rates, but they're actually investors in the fund; they manage a portion of assets. And so, we think of this sleeve as our 24/7 analysts who are managing the portfolio and generating ideas that then trickle up into our specialist portfolio managers. We have specialist managers that manage government assets, that run corporate bond assets, that manage emerging-markets assets. And the specialist managers, you can think of them as focusing on their individual sector and taking all of the ideas generated by our analysts and taking the best of the best and concentrating them in their portfolios.
Then we have a sleeve of generalist portfolio managers who can go across those sectors. And you can think of them as looking at those specialist managers and finding the best ideas across them, and then further concentrating in the ones that are most compelling while also keeping an eye toward the overall risk and composition of the fund. We think this structure allows us to get the best bottoms-up views from our fundamental analysts, as well as blending in top-down views from our generalists who also get ideas from our top-down research analysts and our portfolio strategy group--which is a team of mostly senior investors, who look across sectors, across assets to see what's going on in the world. And from a top-down perspective, is this a time when we want to be taking a lot of risk or which sectors have the most compelling relative value?
Benz: Looking at a decision like how you want to position the fund from the standpoint of interest-rate sensitivity, how would this team approach such a decision? How would a decision like that ultimately get made?
Atluri: We have a few different lenses. Our bottoms-up analysts, our interest-rate analysts, will look at the market and say, based upon what they're seeing, based upon their read of the Fed, based upon their read of the economy, based upon their read of technical--what is the most compelling part of the interest-rate market to take risk? Is that at the front end of the curve, because there's a view that the Fed may be lower for longer or may institute some form of yield-curve control? Is it the long end of the curve, because the Fed is going to be increasing their quantitative easing, focusing on the long end of the curve? Is it because of something else that's going on outside of the U.S., which is going to cause a bid for a duration or for interest rates to sell off? There's a lot of things that go into that. And our interest-rate team will look at that and say, "At this point, maybe we want to be neutral on interest rates, because we think that risk is somewhat balanced; the Fed is not going anywhere, they're going to be low for longer, so it's difficult for interest rates to sell off. On the other hand, with the economy healing, maybe interest rates aren't going to be rallying as much. There will be less of a flight to quality. So, maybe we want to be a little bit more neutral on the curve in terms of duration."
From a curve perspective, that gets a little trickier, because today we think that the curve, yield curve, is highly correlated with the direction of interest rates because the front end of the curve is mostly pegged near zero, because the Fed has committed to staying close to zero for several years as we heal from the current crisis. It's really the long end of the curve--call it 10 years, 20 years, and 30 years--that are going to be moving based upon sentiment. If the economic environment is improving, if fiscal stimulus is going to cause a glut of supply, interest rates might be selling off. But since the front end can't move, the yield curve will steepen and vice versa. If there's a big rally, there's a big flight to quality. Again, the front end can't really move that much, so it will be the long end that moves.
Then the question becomes, which we debate, the analysts debate on their own--we have an interest-rate team that will debate these with both the analysts as well as several of the portfolio managers. Do we want to take duration? Would we rather take curve? If we were to take those, do we want to do it in Treasuries, or do we want to do it in swap space? Do we want to do it with inflation duration? There's a lot of different ways to do this. And ultimately, when we take those recommendations and we implement it in the portfolio, it's not made in isolation. We have to look at what the rest of the portfolio is doing. If we were underweight credit risk, then maybe you would do something different with your interest-rate exposure, versus if you're overweight credit risk, maybe you would use your interest rates as a hedge against that credit risk, and thus you would have a different position. So, while we have our analysts with their fundamental view for what are the drivers of the interest-rate market, how we implement it in the fund will ultimately be a combination of that view as well as everything else that's going on in the portfolio.
Ptak: Do you make that call in quarterbacking the overall fund strategy?
Atluri: In our multimanager system, each of our managers are able to work independently to come up with a view. We believe that no one person has the right answer, but that when we all work together and implement the views that we're seeing in our respective areas, that the collective wisdom is better than any individual's insights. And, as the principal investment officer my job is to set the direction for risk and set the direction for tone. But we have a lot of guidance on how to effectively create a compelling portfolio and a lot of that comes from our portfolio strategy group, which is our top-down macro process of which I am one of the members. And that's a group where we meet two to three times a year. We have everyone in the firm come together to discuss what they're seeing in their respective sectors. And then, the committee of six members goes off, discusses, and comes back with some guidance on, based upon what we heard, what might be a compelling way to put the pieces together. Between that guidance, the direction of where we're sitting in the market in terms of how much risk we want, I think a lot of the investors in the fund are making appropriate decisions. There's very, very rarely, if ever, when I, as principal investment officer, would look to override someone's decisions.
Ptak: When you as a team think about the potential sources of value-add for a strategy like Bond Fund of America, how do you ensure that you're wielding the advantages that you feel like you possess the capabilities that allow you to exploit some sort of mispricing in the market? I would imagine there's a step back that happens where you have to ask yourself, OK, are we putting ourselves in position to press those kinds of advantages? And how does that work out in practice?
Atluri: Let me start with talking a little bit about the competitive advantages that we have at Capital Group. The Capital Group and the American Funds, which we're better known for, are blessed with several competitive advantages. With $2 trillion of combined assets under management and $400 billion in fixed income, we've got a very large size and scale, which allows us to make significant investments. Over the past decade we've invested heavily in technology, risk systems, operations, and most importantly, in our people. What this size and scale allows us to do is to have some of the best fundamental research analysts in the business. And we built dedicated teams that are focused across virtually every sector and geography of the fixed-income market.
Now, as I talked about a little bit earlier, these teams are directly embedded in the Bond Fund of America. We invest heavily in our people and we give them all the tools and resources they need to make good decisions, and then we empower them to make good decisions directly in the fund. Our shareholders get the benefit of all of that directly from the insights of our research analysts and our portfolio managers. We also benefit tremendously from our partnership with our equity colleagues. This allows us to collect insights from every part of a company to better build investment decisions. This integration, for example, helps us understand a company's balance sheet and cash flow priorities from multiple perspectives. Sharing insights across our fixed income and equity analysts makes both teams better. And this really comes across in some of the most important pieces of our portfolio, or at least the ones that bear the most risk and the most opportunity, which is in our corporate holdings.
If a company decides that they want to unlock the value of their balance sheet by levering up and buying back shares, that is often not something that they're going to say loudly when speaking to only fixed-income investors. But when you're in a room with one of the top two or three equity shareholders, that is something that they want to talk about, because that is one of the big drivers of value on the equity side for their equityholders. Being in the room and sharing insights across delivers incredible value for our fixed-income shareholders. I'd also say that as one of the lowest-cost active fixed-income managers, those savings go straight to our investors. And with yields this low every basis point matters. All of these advantages add up to providing strong and reliable results for our shareholders.
Ptak: Let's turn to macro, if we may. One of the things that we observe--clearly, the bond and funding markets got really hairy in February and March, and it took massive intervention to stabilize them. So, my question is, if you were a policy czar charged with examining the root causes of some of the breakdowns that we saw, where would you focus your attention?
Atluri: That is an excellent question. In the dark days of March, prices were really spiraling downward at an accelerating rate in the face of a healthcare crisis that created an economic crisis. And it was quickly becoming a financial crisis that could have easily turned a bad recession into another Great Depression. Now, some of these are echoes of what we faced in the 2008 global financial crisis. And what we learned then is that there was a lot of money held outside of the formal banking system that the U.S. economy has really evolved over the last 20, 30, 50 years from a banking-dominated economy early in the 1900s to one that is actually dominated by the nonbanking sector, whether that's bond funds like we run, whether that's finance companies and other companies. And the issue with that is the nonbanking financial system doesn't have a lender of last resort in the Fed. They don't have a buyer of last resort. They don't have deposit insurance. And so, this is a part of our market that because it doesn't have those backstops, have the ability to face runs. Like a classic bank run, you can use that analogy for the nonbanking system.
In this crisis in March, with the peak of uncertainty, and the peak of panic that was going on where the real economy we knew it was going to get hurt, but we didn't know how severe it was going to be and we didn't know which companies, which sectors were going to be able to withstand the pressures and see the other side. There were investors who were running from the nonbank financial system. Banks didn't see runs, but the nonbanking financial system did. And funds were forced to liquidate assets in order to meet these investor demands. The world had a balance sheet problem and needed a buyer of last resort to house assets that the financial system needed to unload. But with everyone in the same boat, no one was in a position to buy and prices fell beyond their, what I would call their economic prices, to fire sale or liquidation prices. Markets were fundamentally broken at some point in March.
In what will likely go down as I believe the most successful central banking rescues of all time, the Fed responded forcefully, quickly, and decisively. It was incredible. They used all the tools from the 2008 global financial crisis playbook and more. And so, by flooding the market with liquidity and becoming a buyer of last resort, they effectively stopped the run on the nonbank financial system before it caused lasting damage to the economy. And then prices quickly jumped from fire sale prices to prices that more adequately reflected the stress and uncertainty facing the real economy.
Benz: Thinking back to that period, what was the toughest decision that your team had to make during the sell-off that you wish you could do over again, if you had a chance?
Atluri: Our team actually navigated this crisis quite well. When this storm hit, it hit fast, and it hit hard. And it really shined a spotlight on which managers and funds take what we would call a true core approach to risk and those that don't. The only way to weather the storm was to enter it into a position of strength. There was no time to really adjust after the fact. So, with our approach, we pride ourselves on being disciplined risk managers and we’re unapologetically predictable. Our true core approach says that core bonds shouldn't be swinging for the fences. It's there to provide stability and diversification when our shareholders need us most, when equity prices fall. So, we're gradual contrarians.
So, we came into this year with an underweight position in risk and an overweight position in duration because we just thought valuations were not very compelling in 2019, both from a top down--our portfolio strategy group and our fundamental research analysts were telling us that equity prices and credit spreads were near all-time tight spreads but risk was not at all-time low levels. We actually came into this crisis well positioned. And then, when the rest of the world was coming to grips and scrambling to deal with the market volatility, massive outflows and portfolios that were offsides, we were able to be buyers when the rest of the world were sellers. That was a huge benefit and allowed us to move from being a very defensive portfolio in March to actually being overweight risk and leaning an offensive by the end of March and into early April. We were able to really swing our portfolio and navigate that really well.
If there was one or two things that maybe we could have done better--in hindsight, we probably could have been even more aggressive in how much we bought on the other side, and maybe we would have held on to those positions even longer. What your listeners may or may not know is like on the equity side, stocks have rebounded significantly. In the fixed-income side, our corporate bonds have rallied significantly as well. So, valuations have risen and, in some cases, all the way back to precrisis levels. As that's happened, as I mentioned before, we think of ourselves as gradual contrarians--as spreads come in, we start to reduce risk. And we've done that--over the past couple months we've reduced our risk. Now, in hindsight, we probably could have let it run a little bit longer. We're still overweight risk; we're still leaning toward an economic recovery. But we still see a lot of uncertainty out there. We still have really high unemployment. The economy is in a very fragile state. And if there is another shock from whether it's the virus or something else, whether it's election risk, whether it's heightened global tensions, there are a lot of reasons that could impact assets and make valuations reverse back down again. We want to make sure that we're in a position to take advantage of those opportunities, and then also to be there for our shareholders who are using fixed income as a ballast and diversification against their equity holdings.
Benz: Was it mainly in the corporate-credit-risk space where you found that there were a lot of compelling opportunities during the worst of the market pandemonium back in March?
Atluri: This was an interesting crisis because as markets moved violently, it was unique because of its speed and also because it rolled across the market at different times, first affecting the Treasury and repo market, then the mortgage market and then finally credit and everything else. Again, our multiple-manager system really shined in this type of environment because we had managers and the ability to focus on each part of the market as events unfolded, which made our fund quite nimble and allowed us to adjust in real time.
There were opportunities in every part of the market--in the Treasury market, both in terms of managing the overall duration and curve as interest rates moved down with the Fed interventions and the yield-curve shape changed. There were opportunities in being in on-the-run Treasuries, which are the most liquid Treasuries versus off-the-run Treasuries, which are Treasuries that have been issued years and years ago that are still trading in the market. Typically, those prices are pretty close to each other because a Treasury is a Treasury is a Treasury. But in this market, there was a flight to quality and a massive desire for liquidity. And so, little differences in liquidity created for the Treasury market big, big dispersions in valuations. And so, the ability to navigate those was also a great opportunity.
In the mortgage market, valuations swung really, really far really fast, which is unusual because again, in Treasuries and mortgages, these are high-quality, some of the most liquid markets in the world, valuations typically don't move that much that fast. But in this case, they did, because folks were trying to sell whatever they could, and the highest-quality assets were the stuff they could sell. If someone needs to sell, buyers get to essentially name their price. And so, we were able to pick up great value in the mortgage market. And then as the Fed came in with their quantitative easing programs, buying lots of mortgage assets, which drove prices higher, it was another opportunity to sell when those rallied, and then it moved wider again. There's been a lot of volatility, and for an active manager volatility is opportunity. We were able to generate tremendous value from being underweight mortgages coming into the crisis, going overweight, getting back to underweight, and now we are modestly overweight once again.
And then, of course, in credit markets, there were incredible opportunities. As bonds were being liquidated to raise cash, dealers would actually call us up saying that they had a seller who had to sell--HAD TO SELL--and we could name our price because we were the only buyers in the market. We were able to buy bonds down 10 or 20 points--dollar price points not basis points--from already distressed levels, which more than fully jumped back just a week later when the Fed and Congress acted to stabilize markets. There were opportunities in every part of the market. And it would be difficult for a single manager to stay on top of it and take advantage of all of those opportunities. We like to think that our multimanager system was really designed for this type of market.
Ptak: Let's shift to risk/reward in view of all of that and how you're positioning the portfolio. As you already alluded to, we've seen substantial rally, and I think the 10-year was recently hovering around 60 basis points; spreads have come in substantially from where they were during the crisis. It seems reasonable to say that the bond market is fully valued. I think some would say it's crazily valued. How are you working through that in balancing risk and reward in a portfolio currently?
Atluri: Our portfolio has undergone substantial changes versus the beginning of the year. As I mentioned in the beginning of the year, we were very defensively positioned, where we were underweight credit risk, mortgage risk, and we were overweight duration and focused on the part of the curve that was most sensitive to the Fed. Most of that has now been unwound. At some point, we were underweight duration. Today, because of the push-pull of the economy--probably healing, on a path toward healing--with a bumpy recovery over the next one, two, three years, that should push interest rates higher. On the other hand, you have the Fed still buying a lot of assets. You still have a lot of uncertainty. For us that push-pull of where interest rates are going to go make us less inclined to use a lot of our risk budget on interest rates in the curve. For the most part the portfolio is leaning a little bit underweight duration because rates are so low. But for the most part, we're not taking a lot of risk on the interest-rate side of our portfolio.
In the mortgage side is probably where we have our largest overweight. And again, this is not a sector that typically has a lot of volatility. But this is a part of the market where it's high quality, yields and spreads are attractive versus history, and you're right inside the Fed's circle of trust. So, if volatility should rise, this is actually a sector that could benefit, because the Fed would likely respond with greater quantitative easing and increased stimulus efforts, which could improve valuations in the mortgage market. They're in direct line to be a beneficiary of that. It's a good compromise for us because we get excellent yields, great spreads, very high quality, and it might even do well if volatility rises.
On the corporate side, that's the one where there is a lot of opportunity, but you have to be really careful. So, two months ago, three months ago, when spreads were 200 basis points higher, it was easier to just buy everything. As long as our analysts said that this was a company that they felt confident would survive to the other side of this crisis, whether that's one year or two years from now, if you just owned it, high quality or low quality, you felt good that you were being paid for risk, and that when valuations improved and sentiment improved, you would be rewarded. Lo and behold, we're already there. Two months later, and we're already there. And a lot of high-quality assets have fully recovered. That's an area where maybe it makes sense to lighten up, sell those because they're no longer pricing in, as we thought in 2019, spreads were not reflecting the risks that were in the marketplace--some of these bonds no longer reflect those risks. And, in fact, the ones that are still interesting or still look cheap and attractive are in the lower-quality part of the market. And that is where you got to be careful, because not all of these companies are going to recover like they were precrisis. Some of them might be impaired. This is true in credit, in high yield, in the commercial mortgage-backed market where a lot of these companies as they go out of business, a lot of the retailers go out of business, are folks going to need the office space, what are malls going to do? There's a lot of things that are going to be impaired. And so, even though they look attractive from a spread perspective, the fundamentals make it more challenging to take large positions in these.
There's a lot of opportunities still in the corporate market. We are leaning into that to some extent, but the size of our positions is a lot lower than they were a couple months ago. And we're trying to be really careful to stick with companies and investments that we think are going to be long-term winners. And we truly believe that the market is not fully healed. The economy is not fully healed. And we are patient long-term investors and we firmly believe that we will have more opportunities in the future to buy companies and investments we like at much more attractive valuations. We just need to be patient. And we need to make sure we're in a position of strength for when that happens.
Ptak: You mentioned the mortgage market. If everyone can see what the Fed is doing in that space, why does the risk/reward remain inviting enough for you to emphasize that? I would think it would be bid away.
Atluri: One, it's an extremely large market. I don't know the exact numbers, but we're talking trillions, maybe a $5-10 trillion market. It's a very, very large market. It is a market where there is continual supply. One of the beneficiaries of the Fed's actions to lower interest rates is the housing market. So, housing activity as consumers refi their mortgages, as turnover activity continues and people buy houses, there is a continual large supply that comes into the market every month, and that supply needs to be absorbed. As that happens in our market, when there's a large supply, you get some attractive valuations while that happens. The other part of the mortgage market that's tricky is the flip side of that, which is, mortgages have this embedded option that homeowners have, which is that they can refi. And typically, they refi when interest rates fall. When interest rates fall, bond prices rise.
What happens is, if you own a mortgage and you bought it at $100, interest rates fall, now it's trading at $110, you never know if that homeowner is going to refi or not. Because if they don't refi, great; you've gotten that appreciation, and you have some attractive yields and things are just fine. But at any moment in time, that homeowner could refi and they get to refi paying you back at par, paying you back at 100. So, your bond--you just took a loss going from $110 down to $100. So, whenever you're in an environment like we are today, where interest rates have fallen and there's a lot of refinance activity, investors need to be paid for that risk. And so, you get much more attractive valuations in this type of environment. And then, if you can layer in excellent research, fundamental research, looking at individual pools of mortgages. And if you can use your knowledge to pick pools in bonds that are going to refi less, or are going to get prepaid less than average, then you can generate incremental returns on top of that.
Benz: From an overall macro standpoint, can you explain why there's continued strong demand for bonds that offer so little reward today, or in some cases even require that the investor pay the borrower? On its face it seems really crazy.
Atluri: Let me start with the first part of that question, which is, with yields as low as they are today why are people buying fixed income? What is the role of fixed-income assets in their portfolios? So, I would say the role that fixed income plays in an investor's portfolio is really important and often overlooked and goes beyond yields. We call the roles the four roles of fixed income. Bonds provide diversification, capital preservation, income, and inflation protection. Only one of those, income, is really dependent on the level of interest rates. Depending on what type of bonds or bond funds you own, you'll get some combination of these four roles. With the government fund, you get diversification and capital preservation, while sacrificing income and inflation protection. While with a high-yield bond fund, you get more income at the expense of diversification and capital preservation.
Bonds allow investors to pick what fits their needs the best. And typically, a core bond fund like the Bond Fund of America, which sits in Morningstar's intermediate core category, a core bond fund really gives investors a blend of all four roles. They're typically two-thirds government-related securities and one-third higher-quality investment-grade credit. You get the benefits of diversification and capital preservation, while also generating some modest income and inflation protection.
As you point out, yields are quite low today. And this impacts each of those four roles in a portfolio. Some of these impacts are fairly clear. Capital preservation--that should be largely unaffected. Why do you own bonds? Well, if you're nervous because stocks are nearing their all-time highs again, while there's still a lot of uncertainty and a fragile economic state, where are you going to put your money? You can put it in cash but cash yields zero while inflation is positive and likely going higher. Or you can put it in a bond fund that will give you capital preservation, while giving you some modest income that should match or potentially beat inflation. And that may be a better place to be because the alternative is riskier.
The most interesting impact of low yields is on diversification. Bonds typically zig when equities zag, and that's because when a crisis strikes, two things happen. Investors flee risky assets and look for the security of bonds. And the Fed often responds to crises by lowering interest rates. I think both of these trends are likely to stay intact. The only difference is that the amount that yields can fall is much less than it used to be. Therefore, for a typical investor with a 60/40 or 70/30 stock/bond portfolio, low yields have actually increased the risk of their overall portfolio because the diversification benefit is now reduced.
This leaves investors with the choice to make. Do you change the composition of your equity exposure, as we do with our target-date funds? Do you reduce equities to bring your expected risk back in line? Or do you add to your fixed income to offset the lower diversification? This is actually what we're seeing in the market today. Investors are acting more defensive even as interest rates have fallen, and they're adding to fixed income. You can see this in the monthly Morningstar fund flows data where fixed-income funds have been seeing record inflows while equity funds have been seeing outflows. And when you put all this together, it helps to explain why investors would even buy bond funds in, let's say, Europe where interest rates are negative. And they do that for a couple of reasons.
One is, if you bought the 10-year bond when it was trading at zero percent a while ago, sometime last year, why would you do that? Well, you do that because in a flight to quality, interest rates went negative. And that zero-percent bond that you bought, actually returned more than 7%. It went up in value by 7%. So, the moves that interest rates can make will often dominate the very modest negative yield in there. And then, of course, you also get the security. So, if you're paying 20, 30 basis points a year, that is very little compared to stocks which can fall 10%, 20%, 30% very quickly. So, bonds are a lot more than the yield. And I would encourage investors to really think about the overall risk they want to have in their portfolio and the way bonds are there to provide ballast for the overall portfolio. It goes well beyond the actual yield of the bond.
Ptak: You mentioned inflation a moment ago. We're at a point where inflation has been dormant for so long that you'd almost look askance at someone that said they were building their strategy around inflation protection. Do you think we're sleeping on inflation? And to what extent does your inflation outlook inform the way you run money?
Atluri: Inflation is a tricky thing. Inflation has been on a downward trend for decades, both in the U.S. and around the world. And economists aren't sure exactly why that is the case. Now, the arguments for why inflation should rise from here are pretty straightforward. First, during this crisis, inflation has swung close to zero. If we have any type of recovery, it seems reasonable for inflation to move back into the range of where it was before, plus or minus 2%. Now, the argument for why it could go higher than that is because in response to this crisis, the Fed and the fiscal authorities have really tried hard to push money into the real economy, to flood the market with money. And it's possible that those actions are going to lead to greater inflation.
Now, my own view, and there's a lot of different opinions at Capital Group. So, this is not a house view; but this is my own view: is that we have too much debt in the system. And that debt, both in the U.S. and globally, continues to rise at a staggering pace. And this is going to lead to economic and financial fragility, low growth, and low inflation. Debt sucks growth out of a system. And with unemployment at 10%, 11% and likely to remain elevated for years to come, there's a lot of reasons to think that inflation is going to be muted for years to come. Now, will it be zero like it is today? Probably not. It will probably be higher. But maybe it will be 1.5% or 1.8% instead of to 2%, 2.3% like we thought precrisis. So, I think inflation is going to go higher from where it is today. But the long-run outlook for inflation, in my opinion, is still that the downward trend is going to be intact. And that's going to have a lot of implications for fixed-income portfolios. Because with low inflation and low growth and financial fragility, the Fed is likely to keep interest rates low for a very, very long time. And financial repression, which is another word for low interest rates, means that future return expectations should also be dramatically lower across all sorts of asset classes.
This has huge implications. It means that people who are savers and looking for retirement are going to have to work longer, save more, and spend less. These are all incredibly difficult things to do. And what we've seen in the past is that many investors resist these pressures and reach for yield by taking on a lot more credit risk. So, remember, we started with low inflation, but low inflation likely means low interest rates, and low interest rates means low returns across the world. And that means that investors, if they respond the way they have in the past, are going to reach for yield by taking on more credit risk. What that means in practice is that core investors move toward core plus, core plus investors move toward high yield and high-yield investors look to alternatives. All of these effects lead to risk being underpriced and creates greater financial fragility.
Low interest rates have several implications. But for us it means that fixed-income investors need to be really cautious because one is not being paid to take risk. If investors need return and income, our advice is, they should look to the equity side of their portfolio where they might be better compensated for taking risk. In a fixed-income bucket, they should stay true to the core, because we believe periodic bouts of volatility are going to continue to strike in the years to come until we deal with the vast amount of debt in our system. For us, low yields have no impact on how we manage fixed-income portfolios, low yields, and low inflation. Our true core approach is we think built for this type of environment. By focusing on the role of fixed income in a shareholder's overall portfolio, we're going to resist the urge to reach for yield and then wait for volatility to buy assets at better valuations.
Benz: Well, I love that real-world discussion of the environment that retirees are contending with today. Many of our listeners utilize constructs like the 4% spending rule in retirement. From your perspective, as someone who manages bonds for a living, is the 4% guideline supportable in a portfolio that consists mainly of fixed-income investments? Are you going to have to create a really incredibly risky portfolio to think about generating anything close to 4% today?
Atluri: This goes a little bit outside of my expertise in terms of financial planning, financial advice. You've had some excellent speakers in your podcast, like Jonathan Guyton, who has spoken about some of this stuff. And so, I might defer to that. But in terms of trying to generate 4% yield in today's environment, that's difficult. The only way you're going to do that is by taking on credit risk. The only way you're going to do that is to either own a whole lot of energy risk, because a lot of these energy companies where we're seeing lots of defaults, are still very stressed. And so, you get compensated for taking that risk, but you're taking risk. Or you go down into high yield, where you can find BBs at 4% or 5% yields, higher-quality BBs, or you can get 7%, 8% by taking on more risk there. But again, when you do that, you've dramatically changed the risk profile of your portfolio.
For some of these investors, who are later on in their careers, when they're either in retirement or getting ready for retirement, taking on that kind of volatility is risky. If you're going to do that, then, as I said earlier, I would encourage folks to work with their advisors to think about their equity side of their portfolio, because if you're taking a lot of risk on the fixed-income side of your portfolio, you should probably be reducing the risk on the equity side, maybe even going into higher-quality, higher dividend payers to again get more yield on the equity side so that your overall portfolio still gives you the amount of volatility that's appropriate for your situation. The wrong decision, in my opinion, is to only focus on the fixed-income portion of your portfolio, go for that 4% or 5% yield, and do nothing else. Because if you started off with a portfolio that had the appropriate amount of risk for you and your situation, changing your fixed income in that way is going to put you much more at risk. And when we look at the world, even with high yield giving you greater yields, a lot of us believe that investors might be better off looking for yield on the equity side of the portfolio. Like, in fixed income, I like to say that more yield in fixed income is a lot more risk; more yield in equities, it's not necessarily a lot more risk. A lot of times you're going into higher-quality, dividend-paying companies, and you're actually reducing risk in your portfolios. So, really thinking carefully about your overall portfolio to meet your income objectives is what my advice would be.
Ptak: For a final question, we'll shift our gaze forward. My question is, do you think in the future we'll come to look back on central bank's massive stimulus in the same way some have come to view the inflationary 1970s as a hinge point that ushered in a new policy regime? And if that is the case, what do you think the implications of a policy shift would be for bond investors?
Atluri: Sure. There are two ways to look at this. One is the benign way, which is the response to this crisis, and even the great financial crisis of 2008, was to take on a lot more debt into the system. And just like in World War II to face a global crisis, we took on a lot of debt. The response was not necessarily for inflation to run amok right away or things like that. But the response was that interest rates had to be kept low for a long period of time. You had financial repression, which let inflation run a little bit higher than interest rates, which allowed the debt to be worked off. Now, eventually, 20 years later, we got inflation into the system, which was very difficult for the economy. But I might argue that the reasons for that inflation are not necessarily due to that low interest-rate policy. It could have been for other structural reasons. I think the jury is still out on the causes of the 1970's inflation spike. By analogy, the debt we're taking on today, there's definitely a scenario where it doesn't lead to massive amounts of inflation. And what it leads to is just a prolonged period of time of very, very low interest rates and inflation that is a little bit higher while we work off the debt. So that's the benign interpretation.
The way we could face a regime change is because I think you're exactly right, which is, the 1970s was really traumatic for the Fed and for the economy. And in some ways, the last 20, 30 years of Fed policy has been about never letting inflation run high again. And really, what we've been facing for the last decade or longer is the exact opposite. We're not facing a world that we have to protect against inflation. We have a world where we've had to protect against deflation. We have a world where inflation is part of the solution, not the problem. And so, we are potentially at a regime shift where not only the Fed but central bankers around the world are now trying really hard to figure out how to create inflation. And it's not obvious that they have the ability to do so, at least for the large developed markets. Smaller economies, they do have the ability to generate inflation, but economies like Japan, Europe, the U.S. have not shown an ability to be able to do so. Now, today, we're starting to see the fiscal authorities potentially coming in to help with the inflation battle, to generate inflation. And you've seen things like Modern Monetary Theory, which argues that the fiscal authorities can take on a lot of debt without having to worry about inflation in the short run, that they don't need to necessarily raise taxes to pay for that debt, which I have a lot of sympathy for and I understand the arguments. But it's very, very different than how the U.S. has operated for decades if not hundreds of years. I think we are potentially in a regime change in how we think about inflation and transitioning from it being an evil to actually being something that's desired, and it's actually going to be a solution to some of our problems, at least in the short to medium term.
Benz: Well, Pramod, you've been more than generous with your time today. We really appreciate your insights. And thank you so much for joining us.
Atluri: Thank you. I appreciate it. I love speaking with you and I really enjoy your podcasts. Keep up the great work.
Benz: Thank you.
Ptak: Thank you so much.
Benz: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.
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Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)