Regardless of whether Washington politics shuts the government down now or if that fight gets pushed to the upcoming debt ceiling debate, such high-stakes political bickering is usually bad for the financial markets, according Aaron Izenstark, chief investment officer at Iron Financial LLC, a $2 billion money management firm.
While Mr. Izenstark believes that the Fed could start dialing back its quantitative-easing program this year, he acknowledged that Washington politics could have enough of a negative impact on the economy to take tapering off the table.
InvestmentNews: How rattled should the financial markets be about the prospect of a government shutdown?
Mr. Izenstark: They should be rattled because of what's going on underneath. The latest data from the Investment Company Institute show that domestic bond mutual funds have had four consecutive months of outflows for a total of $100 billion. The market is fragile as it is.
InvestmentNews: Where are the biggest areas of risk in the bond market right now?
Mr. Izenstark: Longer-term bonds, or probably any bond with maturity of longer than 10 years. Specifically, some of the products that have been created to invest in things like a lot of below-investment-grade mortgages. If this gets ugly, there are no natural buyers for that stuff out there, and it leads to a liquidity issue.
Play or hedge bond market risk?
InvestmentNews: Are there ways to play or hedge bond market risk?
Mr. Izenstark: Everybody has the same problem right now. You either focus on short-duration bonds of two to four years or you have to invest in a strategy that can hedge the portfolio, either through interest rate or credit hedges.
Your best choices are going to be those funds that have big positions in below-investment-grade bonds because it will give you a yield that pays you something in this marketplace. You won't be able to do that with below-grade mortgage securities because there is no way to hedge those because there's no derivative that correlates to them.
InvestmentNews: What about a growth strategy in fixed income?
Mr. Izenstark: That will have to focus on combo or hybrid strategies and securities. With a short-duration convertible bond portfolio yields are at least 50% higher than the stock market index, but you also get the upside participation of the stock market.
InvestmentNews: What's your outlook for tapering of the Fed's quantitative-easing program?
Mr. Izenstark: Given what Fed has said, it could happen any month unless a government shutdown leads to some bad economic data. We're waiting for the news like anybody else. But it seems like the Feds knows something that is a lot worse than we're seeing, and that should concern the markets. Bottom line is, I see a better than 50% chance of tapering this year.