Amid global turmoil, bond managers' patience is tested

Delaware Investments co-CIO says biggest focus is on the economy and interest rates

Jul 23, 2014 @ 1:45 pm

By Jeff Benjamin

From where Roger Early sits, overseeing a team at Delaware Investments that manages $130 billion in fixed-income assets, the sluggish U.S. economy and increasing geopolitical turmoil require patience more than anything.

The senior vice president and co-chief investment officer for Delaware Investments isn't terribly worried about the winding down of quantitative easing, or even the fact that the Fed will be saddled with a $5 trillion bond portfolio for as far as the eye can see.

But Mr. Early does believe bond fund managers should be on their toes as the reality of interest-rate hikes draw nearer and global strife continues to spread.

InvestmentNews: What's your outlook for high-quality bonds as quantitative easing winds down?

Mr. Early: I would simply say, I think the QE story is in the books. It is priced into the market. The fact that the Fed will be buying fewer bonds and then no bonds as we work our way through October is almost irrelevant at this point.

I also think soft inflation continues because it's not gearing up like some folks are talking about. And we've got surprisingly slow economic growth.

That all means bonds don't need to have another leg up in yields. If the economy is growing at best-case 2%, and if inflation comes in below the Fed's target threshold, I think we can stay in this range on rates for a while.

InvestmentNews: Once the tapering is complete, what is the impact of the Fed sitting on what has become a $5 trillion bond portfolio as the result of all that quantitative easing?

Mr. Early: About half of that portfolio is made up of mortgages. And I think the words the Fed has said suggest they will keep the reinvestment process in place until at least the point where they start raising rates.

Right now it's literally 60% to 70% of new issues of mortgages are being purchased by the Fed. Had they not begun to taper they would be approaching 100% of all new mortgages by now.

That same kind of thinking doesn't hold on the Treasury side. Operation Twist a few years ago moved them to longer-dated Treasuries, so it isn't as big a factor on the Treasury side.

But the Fed still is a meaningful investor in the market, that's true. They're going to have this massive portfolio. They have begun to talk about the timing or either eliminating or slowing down the reinvestment.

The QE question will in some sense be around for a long time. In my opinion, the most important factor is when and how quickly do they begin to raise short-term rates.

InvestmentNews: When do you expect the Fed to start hiking interest rates, and is there an investment strategy to follow as we approach that point?

Mr. Early: If you went to the Fed-member projections, you'd say the market is less than prepared for the impact on short rates moving higher. The change is going to be most significant on shorter-term rates.

We think the economy has surprised the Fed on the slow side. So you take the [Fed Chairman] Janet Yellen suggestion of six months after the end of quantitative easing to start raising rates and push it out another quarter and you start to think late summer early fall of next year.

Historically, the way to hide from the fear of rising rates was to own short- and intermediate-term product. But today the fear is rates on very short Treasuries are close enough to zero to still be a problem.

You probably would be better off while waiting for this to happen owning a combination of intermediate-term product and some floating-rate product.

Nobody knows exactly how this is going to play out. The economy could stay sluggish longer than anyone thinks.

InvestmentNews: What kind of an impact will rising rates have on actively managed bond funds?

Mr. Early: The worst case in a rising rate period would be somebody whose active management is oriented toward just income. At least if you have a total return objective you're trying to analyze interest rates, current income and credit risk.

If you are strictly in an index product, you are going to have more pain than in a well-managed, actively managed bond portfolio.

When rates are rising you want the ability to go into higher-income bonds, that's the cushion to the rising rates. They won't react as directly to the rising rates.

InvestmentNews: As a portfolio manager, how do you navigate the risk associated with increased geopolitical unrest around the world?

Mr. Early: The easy answer is, if you watch it, the markets have learned to react sharply the first time and less so as it goes on.

We've seen it so many times. The markets do seem to be able to say, 'Seen it before, the U.S. is still okay.'

In order for the markets to start reacting, I think it has to be a more serious scenario that draws in the United States. That changes it to a fear trade and creates a flight to quality.

If I position myself thinking something terrible is going to happen in the Middle East or Ukraine, and if I wait for that I'm probably going to miss a lot of opportunities along the way.

Right now the 10-year Treasury yield is around 2.5% and that's probably where we'll be for a while. And there is a legitimate possibility now with growing geopolitical risks that rates could dip further. It's not a high probability, but it is becoming a higher possibility.


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