Searching for return in a tough bond world

Mar 24, 2013 @ 12:01 am

The following is an edited transcript of a March 12 webcast, “Finding Risk and Opportunities in Fixed Income,” which was moderated by InvestmentNews deputy editor Greg Crawford and senior columnist Jeff Benjamin.

InvestmentNews: Michael, from your perspective as a portfolio manager, what are the things that you are watching, perhaps the things that keep you up at night?

Mr. Mata: The challenges that we have are no secret to anybody. You look at where the 10-year yields are in the U.S. and Treasuries and they are still around 2%. That wasn't so bad back in 2011, and even in the beginning of 2012, because credit spreads were still relatively wide. You could buy investment-grade credit at 2% yields higher than what Treasuries were trading. That spread now between Treasuries and investment-grade credit is just south of 140 basis points, which over a long term is probably close to fair value.

But if you look across the different points on the curve in the short end — which is where people want to congregate now because of the fear of interest rates going up — those spreads are very compressed. So it is very hard to find value in the traditional U.S. fixed income, even in high yield. Though high yield has had a wonderful run to start out the year, spreads are at 440 or 450 and are close to fair value. Yields, as you know, are at all-time lows.

So it has really been a challenge to try and find value in the U.S. and we have done it in some securitized places, asset classes that aren't quite as large and take a little bit more specialization such as commercial real estate, non-agency mortgages and, of course, outside of the U.S. The big challenge, of course, is that in this type of environment there are really two risks: One is the risk of growth being stronger than expected and rates selling off in a very rapid fashion, which could precipitate an unwind in riskier fixed-income asset classes. Then there is the opposite end of the spectrum — a loss in growth momentum in the U.S. and globally, which would impact spread products or credit-risky assets in a negative fashion. In that case, you really want to have the opposite position of being much longer duration.

Even if you do have duration, are you going to get the kind of yield or diversification benefit you got the last few years where interest rates dropped several hundred basis points? Probably not.

So it is a very challenging environment. It is an environment that requires people to think outside the box when it comes to protecting principal and to stay a little bit more liquid because the expectations for the path still remain uncertain.

BOND FUNDS SAFE?

InvestmentNews: Brent, could you give us your perspective? What are you seeing out there in terms of risk factors?

Mr. Burns: Our firm views bonds in general as clients' safe assets — the ones they use to generate some income, but primarily to protect principal so when somebody needs to spend money out of their portfolio the amount they are looking for is there, regardless of what is going on out in the marketplace.

The biggest challenge that we see is the risk to principal. People view bond funds as “safe money,” and yet because bond funds and individual bonds are very different, people aren't protecting their principal in a way that they thought they were.

So that is, particularly for those approaching or in retirement, the biggest risk that they face. Their principal isn't as protected as they thought it was.

InvestmentNews: Michael, where do you see interest rates going over the next couple of years? Also, along those lines, where do you see the greatest risk in the fixed-income space now?

Mr. Mata: The consensus is that we will see a moderate pickup in interest rates this year. Over the course of the first half of the year, once we get past some more political noise with the debt ceiling, we expect growth to maintain its current trajectory so that we can get to 2.25% or so.

2013 GROWTH

Then there is the expectation that growth will be slightly better in the second half — perhaps closer to 3% than 2% — and that yields would track higher, potentially to 2.5% to 2.75%. As long as we can maintain this 2% to 3% growth and low 2% inflation, we think that the rise in interest rates will be gradual, at least for the next 12 months or so.

The risk obviously is that it is not gradual. Rates 100 basis points higher actually would be a positive thing for most financial institutions, and it would be a very good sign for the economy, but the pace at which it gets there is going to dictate how much pain there is.

So if it is a very rapid rise, it is going to be disruptive to the capital markets. I think it would start scaring some investors — especially retail investors — if they saw negative prints on some of their fixed- income funds.

InvestmentNews: Bill, could you give us your prediction on what interest rates are going to do and where you see the risk in that environment?

Mr. Belden: The biggest risk that I foresee dovetails off of some of the earlier comments. Michael talked about the pace by which rates may rise. The increase in yields associated with that is going to offset the principal loss that people experience by the value of their bond holdings going down.

Getting an understanding of that dynamic is something that we spend a lot of time talking about, because as those rates do creep up, when they creep up, depending upon where you are with your duration exposure, it is likely that the value of your holdings is going to decrease more so than the uptick in yield that you might be experiencing — by quite a significant amount.

There aren't a lot of opportunities out there, but there are pockets where you can actually capture yield and maintain relatively consistent levels of risk. That is what we are focusing on: finding those pockets and assessing where, within the fixed-income marketplace — whether it be particular points on the high-yield spectrum or within floating-rate securities or other asset-backed securities — there are opportunities that exist to achieve the type of return and yield profile that you need to match your expectations.

InvestmentNews: Before you go on, could you just explain floating-rate securities?

Mr. Belden: Floating-rate securities are those securities that will move or have reset features that increase the yield or the coupon that the security pays out in conjunction with the rise in rates. There are triggers that will allow for a rise in rates to be distilled via the income payments that come through the actual security.

InvestmentNews: Doesn't it sound like a no-brainer in a low-rate environment to jump on something that adjusts to rising rates and ride it all the way up?

Mr. Belden: Well, they are actually a very attractive part of the fixed-income marketplace right now.

InvestmentNews: What is the downside, if any?

Mr. Belden: I think you certainly have to get professional portfolio management there and the floating-rate strategy can operate or provide returns which, depending upon the market environment, don't necessarily correspond to what your investment objectives actually are.

So with a floating-rate product, you are certainly looking for rates to bump up and for your yield to correspond to that. But if there were a dramatic deterioration of the credit profile of the issuers, then that would be a risk to investors that have positions in floating-rate funds. Now, that is a double-edged sword where the benefit is that many of the floating-rate securities which are tied up in bank loan products have higher credit profiles within the corporate capital structure, but at the same time they are certainly not risk-free, whatsoever.

MUTUAL FUND CHALLENGES

InvestmentNews: Michael, can you talk about the duration challenges or the portfolio management challenges in a mutual fund in a rate environment such as this?

Mr. Mata: It is true there are challenges within a mutual fund structure when rates rise, and especially the velocity of the change can make it hard to manage.

The innovations in derivatives markets — the ability to use futures across the curve — really mitigate much of that risk. So, as an example, in our U.S. total return portfolio, there is approximately five years of duration, which is about where the benchmark is.

Probably only about half a year of that comes from what you would call U.S. Treasuries and the rest is going to be bonds that we expect not necessarily to mature but roll down the yield curve to less than two years in maturity. So the commercial-mortgage-backed securities that we own, which are down in the cap structure — non-agency mortgages, high-yield bonds, things of that nature — we basically traded credit risk for interest rate risk. So we like credit risk at this point in the cycle and we don't like interest rate risk so much, so we have invested the bulk of the bonds in maturities that have much less interest rate sensitivity.

CREDIT RISK

InvestmentNews: When you say credit risk, you are talking about higher yield, right?

Mr. Mata: Yes, credit risk means things like high-yield bonds or corporate bonds that are more sensitive to the economic cycle with respect to potential defaults.

InvestmentNews: And that is how you protect yourself from some of the movements in interest rates?

Mr. Mata: That is one way. The ability to use derivatives is another tool that we make good use of. If we thought the Fed was going to be actively raising rates, typically at the short end of the yield curve in a rate hiking cycle, a two-year point is the most volatile. In this case, we might be closer to the five-year because of what the Fed has done with Operation Twist, etc.

So being able to sell the five-year point while still owning the longer, the 10s and 30s, is a very viable way of protecting principal and protecting yourself against an active Fed hiking cycle. Those are things that we can do within our unconstrained portfolios and things that we would plan to do in that type of environment.

TREASURY STRIPS

InvestmentNews: I want to talk about something that I don't think Michael can do in his mutual funds: bond ladders. There have been some questions from the audience about Treasury strips, which are traditional tools for advisers and investors putting together bond ladders. You buy a Treasury strip that matures over the next several years, one per year, and as one matures you buy another one on the other end and you build this ladder.

Brent, this is pretty much your bread-and-butter, right? Does this still work in a low-rate environment because you are buying bonds that have very low yields: They mature and you have to buy another one with very low yields, right?

Mr. Burns: It's true, it does. Essentially, the interest rate environment that we are in now makes buying predictable income expensive, and you see that reflected in multiple markets. If you went to buy an immediate annuity, it is going to have a very low yield. The income is relatively expensive, and the same is true if you are going to build something yourself using bonds.

Obviously, Treasury strips are the easiest way to do that. What we see are some opportunities to pick up some yield, but it makes the math more complicated. It's difficult to build a paycheck portfolio, as pension funds have done for a long time, where they buy a series of bonds and immunize or protect that particular income stream so that they know the portfolio will generate the liquidity they need to pay pensioners.

PREDICTABLE INCOME

Since most people don't have pensions anymore, they have their 401(k), they become their own pension. So if you want to generate predictable income, it gets expensive. But you can do some things where you can trade some liquidity and still maintain that safety of the Treasury strip by buying things like CDs and agency bonds. I would argue they are nearly as safe and if any of those were to default, the economy would be in massive trouble anyway.

But because they trade less frequently and oftentimes in much smaller lots, there is a liquidity premium and so you get a higher yield for building out a portfolio using those. Unfortunately, the math gets more complicated because they have coupons. So in buying a strip, if you need $50,000, you buy $50,000 of face. That's not true if you are trying to lace together a series of individual bonds, but conceptually the same thing still holds true that you can time them out so that they generate the cash flows you need when you need it so you can go through the bad market cycles.

Mr. Belden: If I could just add to Brent's comments, too, because he described something that aligns with what we are seeing and I mentioned earlier; these target maturity ETFs that we have: The BulletShares suite of ETFs.

USE BY ADVISERS

We certainly see a lot of advisers using those to implement laddering strategies. Even with low nominal yields, we are seeing a lot of investment-grade BulletShares products and bonds in shorter duration, and it is not because they are seeking total return. They are seeking protection of principal and ease with which they can implement that laddering approach.

Again, we have investment grade, and high yield but we are certainly seeing the type of activity in investment grade that reflects increasing adoption and usage for laddering purposes. With the defined maturity, as they roll off at the end of each calendar year, we are seeing them both rolling down the curve, as well as just going to the next maturity, which, as you cited at the outset here, is a very low nominal yield.

Mr. Burns: To jump in on that, we really like the BulletShares. They are definitely a unique product in that they really do function very similarly to individual bonds and they are so much easier to access. It is a diversified portfolio. As you mentioned, it is professionally managed.

So we have been able to take these ETFs and create a tool actually where we are working with [Envestnet|] Tamarac to develop a retirement income model. It is so much easier to deliver the portfolio using these ETFs because they trade every day and they are incredibly liquid. It definitely changes the way that investors can access the bond market and really take advantage of the characteristics of individual bonds but in one product that is a diversified portfolio.

InvestmentNews: BlackRock Inc. is coming out with a similar product and already has some kind of target maturity ETF. Bill, what about the downside of these kinds of ETFs? Let's say if there is a run on serious flows into ETFs; say, bond yields spike or something like that triggers it. ETFs themselves are liquid, but when you are talking about bond ETFs, the underlying is not that liquid.

Bill, how does the ETF industry manage that situation?

Mr. Belden: On the investment- grade side, the underlying is pretty liquid. The bonds that make up the investment-grade portfolios are the most liquid part of the fixed-income marketplace short of Treasuries. So I think that certainly helps. But when transacting in ETFs, liquidity is always an issue, and we haven't been in a rising-interest-rate environment. There have been a couple of what I would call exogenous events that tested the market and in each of those cases, we have seen fixed-income ETFs priced pretty efficiently.

Spreads can widen. There is no question about that. So you certainly have to keep your eyes on that, but when you want to get execution, you can get execution. ETFs have really helped the fixed-income marketplace in terms of price discovery. You might think it should be the other way around, but in reality, when you have seen prices being set for bonds in the underlying that account for the net asset value of these funds, you really have seen a stronger transparency in the marketplace.

InvestmentNews: To be clear, these Bullet Shares are designed to be held to maturity, correct?

Mr. Belden: They are. We would love to see them used — and we do see them used in some cases — to hedge against duration risk taken elsewhere within a client's portfolio because the transparency and the known duration that comes with the product helps mitigate risk that you may be faced with elsewhere in your portfolio. But by and large, the use that we have seen for these products has been buy and hold.

BOND MUTUAL FUNDS

InvestmentNews: OK, that is some of what's going on in the ETF space but let's get back to Michael on the mutual fund side. Morningstar Inc. in 2009 introduced a nontraditional bond fund category because it saw so many bond funds coming out with more flexible strategies.

You made a reference to flexibility in bond strategies earlier. That seems to be the way the fund industry is responding to the current environment. Would you agree?

Mr. Mata: What we are actually seeing from institutional clients and on the retail side is a call for greater flexibility and a shift in mindset about what fixed income is really all about. We are seeing a demand for a total-return product in fixed income. Clients are looking for a product that has the flexibility to manage that duration; not necessarily short duration but very close to zero. Maybe an average of two to three years is a sweet spot in the yield curve.

InvestmentNews: You mentioned asset classes and we have had a couple of questions over the webcast here from advisers wondering about alternative asset classes outside fixed income. One is the master limited partnership space and the other is nontraded real estate investment trusts. Those have garnered a lot of press certainly, and I know there have been several MLP IPOs this year. Are those sorts of alternatives an opportunity to provide total return or some income in this sort of rising-rate environment?

Mr. Belden: Well, I will jump in on those. Many of those asset classes, again from a total-return perspective, can be fantastic and can fit into the growth portion of someone's portfolio. However, yes, they may deliver cash flows, but the cash flows aren't as predictable.

I think that dividends are a perfect example of that. There are some opportunities there to deliver retirement income and they are an important part of total return, but not as predictable retirement income. When things break down in the market, your mortgage doesn't go away. So you are going to need to generate income out of your portfolio to cover your living expenses, and you want to make sure that is going to be there when you need it.

REITS WILL RECOVER

So REITs, for example, suffered cuts in their dividends as they saw an increase in vacancies. They eventually recover and as part of a long-term total return portfolio can make perfect sense, but using that income as a paycheck worries me because they tend to break down right when you don't want them to.

Whereas if you are using CDs or agency bonds, that is why we like the bullet shares investment-grade portfolios because they are broadly diversified in investment-grade corporate bonds so you get the diversification at a relatively cheap cost. You still get that same kind of predictability, because they mature.

Visit InvestmentNews.com/ bondwebcast to listen to the full webcast.

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