Fixed-income fund returns have been within striking distance of many equity sectors since the beginning of the year. But then, that's not saying a lot. Leading the bond group have been high-yield, long government and emerging markets, the only three categories with 4%-plus returns.
But many factors may make it difficult for fixed-income funds to sustain their performance. Financial Advisor recently caught up with three leading bond-fund managers and asked for their views on what they are looking at as part of their decision-making process, and where they expect bonds to go from here.
Mark Kiesel, PIMCO
Executive vice president, a senior member of the investment strategy and portfolio management group, head of the investment-grade corporate desk and manager of corporate bond portfolios
"The big picture is that we're negative on the bond market in the near term because we think the Fed is going to likely raise the Fed Funds rate to 2% by the end of year," Kiesel says.
He believes inflation is accelerating, and he's keeping a particular eye on oil and the indirect effects it will have on consumer spending as well as the stock and housing markets.
But he's more optimistic about the longer term for the bond market. Toward the end of this year, he expects the ten-year to approach 4.75% and the bond market to become a buy. Why? He maintains economic growth is set to slow more than the consensus believes as higher interest rates impact today's leveraged economy by slowing economic growth.
"We're probably not going to have a recession. But here's the problem: We've been growing nominal GDP at 6% to 7%. I'm suggesting we'll be slowing down to the 4% to 5% range, closer to 5%. I'm also suggesting real GDP will slow to 2% to 2.5%, and we've been growing at closer to 3.5% to 4%. This will feel like a significant slowdown," Kiesel says.
He thinks a major factor contributing to the slowdown will be rising oil prices, which he believes will slow consumer spending. Rising interest rates over the next several months also will result in consumers tightening their belts, he says. A third factor, Kiesel says, will be an erosion of consumer confidence that will hurt the housing market.
Job growth, the stock market and housing prices drive consumer confidence, which is high considering poor job growth and weak equities, he says. "What's kept confidence high is housing. And here's the problem: What's caused the run-up in housing is rising debt levels," he says. "Here's the big thesis: Oil will now be the catalyst which leads to a deleveraging of the consumer balance sheet and a rise in the saving rate. The reason is that oil is an inelastic good; people need it, so they'll have less money to spend on other things. It will cause consumers to become more cautious, slow spending and take on less debt."
Housing will become increasingly vulnerable, he says, because what's supported the rise in home prices has been consumers' ability and willingness to take on more debt. Housing prices are now 10% to 20% overvalued, he believes. First we will see more houses for sale, and over the next several months offering prices will fall between 5% and 15%, he adds.
Kiesel says there's another issue related to housing. "Consumers have been using their house as an ATM machine. They've been withdrawing equity out of their homes, and these large mortgage equity withdrawals have supported spending despite weak job growth. Mortgage equity withdrawals should slow with higher interest rates and that, combined with a slower rate of debt growth, should subtract 1% to 1.5% from growth in consumer spending in 2005," he asserts.
As a result, the bond market will become a "buy" next year, he says, because the slowdown in consumer spending and housing will ultimately limit the rise in the Fed Funds rate. "The economy will put the Fed on hold. Right now the Fed is on a mission to normalize short rates to a more neutral level, and they probably will go to 2%. But the economy will put a stop to the Fed mission. Short rates will go up, but they will go up less than what the market expects," he says. What's priced-in now, he says, is 2% by the end of the year for Fed Funds, almost 3% by the end of 2005 and 3.5% by the end of 2006.
Secular, structural long-term reasons will prevent interest rates from rising sharply, Kiesel says. They include China's ability to export deflation through cheap labor and an almost zero cost for information and economic globalization. That's not to suggest we won't see inflation pick up on a cyclical basis, though, as a result of stronger demand from places like China, he adds.
Based on this economic outlook, how does PIMCO view different sectors of the bond market? Kiesel says some emerging markets are benefiting from higher oil prices, including Russia. "We are overweight or focusing on countries such as Russia," he says.
PIMCO is more negative on U.S. corporate bonds, because the spreads between them and Treasuries are tight, he says. High-yield bonds look a little more attractive than investment grade, he adds. The firm is cautious regarding companies whose business is cyclical or could be sensitive to higher oil prices, he adds; companies in retail, automobiles, airlines, lodging, real estate and even tech could be more affected by an economic slowdown. Instead, he's looking at more noncyclical businesses, such as media and cable, utilities, telecom, energy, health care and pipelines, because these sectors tend to be defensive, he says.
Dan Fuss, Loomis, Sayles & Co.
Vice chairman and co-manager of the Loomis Sayles Bond Fund
Fuss is monitoring four factors: the war in Iraq; the world economic outlook, including the price of oil and its availability; central bank policy in major currencies-specifically the dollar, euro and yen, but also a few others; and corporate earnings.
"Now you could say there's nothing new about those major factors. The one that's sometimes not there is oil. That's the general background. But we have a case in which the footnote is more important than the headline," he says.
The footnote is that the amount of leverage in the bond market is enormous, Fuss says, and that's a result of the U.S. central bank keeping the yield curve very steep in the face of an economic recovery. Short rates are still very low relative to longer rates and that provides an inducement to borrow short and invest long, resulting in a lot of liquidity for the economy, he adds.
But that liquidity could be sucked out if leveraged positions are liquidated too quickly because short rates rise too much too soon, he says. Although Fuss expects rates to rise, he doesn't think they'll rise that quickly. "All I can do about the future is guess, but based on the little I know about the present, I think we're in a modest cycle in interest rates. Mid-June 2003 was the low for 20 years or more. I think interest rates will go up quite a while and then down quite a while, and hopefully I'll be alive to see it," he comments.
He's guessing that during this interest rate cycle, the peak for short rates will be 3%; for the ten-year Treasury, 5.25%; and the 30-year Treasury, around 6.25%, but possibly higher if 30-year Treasuries are issued again, he says.
Rising interest rates won't be good for bond prices, of course, but they will be for funds being reinvested and new money entering the bond market, he says. The rate increases he expects imply a reasonable economy, Fuss says. Corporations aren't in a capital spending boom, so they probably aren't going to borrow a ton of money and get caught in a speculative frenzy, he comments.
The corporate bond sector, Fuss comments, is looking at decent credit trends for a long time. It's true that yields relative to Treasuries are narrow, but they are still quite wide compared with the last time Treasuries were at this level; that was 40 years ago, Fuss notes. "Corporates are a better place to be than Treasuries. You have a yield advantage, you don't have new issuance and you do have, sitting under the market, a tremendous reinvestment of coupons and other bonds presently held. And you do have strong offshore demand for U.S. bonds," he says.
While he does favor corporates over Treasuries, over the last two and a half years he's cut the duration of bonds held in the Loomis Sayles Bond Fund to a little over five from nine and the average maturity down from 19 years to ten.
Although he believes this interest rate cycle will be relatively mild, he thinks the next one could be far worse. "I see the potential for a conflict in the market between corporations and the government trying to raise money. ... I disagree with the forecasts of the administration and Congress because I think they are low balling federal spending, but if there's a strong economy it would help revenue, and if tax rates go up the conflict may not be extreme," he says.
Steve Bohlin, Thornburg Investment Management
Lead manager of Thornburg's Limited Term Income Fund, Limited Term U.S. Government Fund and the fixed-income portion of its Investment Income Builder Fund, an equity-income fund
Bohlin believes that two of the biggest issues affecting the bond market are rising interest rates and quality spreads.
At a minimum, he says, short-term rates have to go up because, at 1.5%, the Fed Funds rate is less than inflation. "We're running into a situation where Fed funds are at 1.5% and year-over-year inflation is at 3% if you use the CPI [consumer price index] and 2% by the PC deflator [private consumption deflator], so short rates at a minimum have to go up. A neuttral rate would be 100 to 150 basis points higher than right now," Bohlin believes.
If short rates go up, what happens to seven-, ten- and 30-year rates? "My personal opinion is we still have rates too low there. At a 3% inflation rate, a ten-year Treasury rate at 4.22 is not that attractive an investment to make," he says.
He believes interest rates will rise for at least another year, but at a measured pace. The wild card, he says, is price stability, and if that can't be achieved while rates go up, the Fed many have to raise rates more quickly than planned. However, he's figuring the Fed won't want or need to do that. First, the economy is strong, but it's not raging. Second, a huge percentage of it is involved in the finance business in some form, and as a result a rapid rise in short-term rates would cause a huge amount of pain.
Oil prices also are a concern as well, but an important question is whether higher oil prices will be inflationary or deflationary. Higher oil prices tend to slow consumer spending and reduce discretionary income, but oil prices also affect things that consumers can't cut back on so easily. "When you take into account simple things like food, 40% of the cost is in transportation. So it's a large question, whether $46 oil will be inflationary or deflationary," he says.
As far as quality spreads go, normally when the economy becomes attractive, quality spreads become tighter. "Unfortunately, we've already seen that. We've had tremendous spread tightening over the last couple years, to the point where you wonder where we can go from here. Any kind of perceived slowdown is going to force spreads out wider even as rates are rising. I think that's very negative for the bond market, and it will force new-issue rates to go up higher," Bohlin says.
As a result, he's staying shorter with his bond investments. "I still think the two- to three-year segment is attractive, but I just don't think the ten-year on out is attractive. I'm staying high quality. In high-yield and emerging markets, you have to use a sniper-shot approach as opposed to a scattergun approach. Two years ago, you could buy a basket; it didn't matter what you owned," he says.
Today, he says, he doesn't believe any bond sectors are cheap, although an occasional company will provide opportunities. Overall, he's steering clear of emerging markets and limiting exposure to high yield. "I think one of the best approaches in this kind of marketplace is to stay short and ladder out your maturities so you're not just sitting in cash and not just receiving a 1.5% yield, but you're not taking on all the price volatility of a ten-year or 30-year," he said.