Leading bond managers debate what's ahead.

A Financial Advisor Special Report

    At this year's Financial Advisor Symposium, a group of elite bond fund managers met on September 27 and held a panel discussion on the challenge of investing in fixed-income securities today. The panelists included Laird Landmann, a risk manager at Metropolitan West Asset Management, who manages many of their absolute return vehicles, including the Total Return Fund, which was Morningstar's "Bond Fund of the Year" last year; Bill Healey, head of interest rate products at GE Asset Management; Dan Fuss, manager of the Loomis Sayles Bond Fund, another Morningstar Bond Fund of the Year, and Jay Chitnis, managing director and chief investment officer at YieldQuest, which does a lot of managed portfolios and some mutual funds of its own. The panel was moderated by Financial Advisor Editor-in-Chief Evan Simonoff.

Simonoff: The economy has slowed significantly in the last two months and inflation indicators have moderated. Does this represent a major inflection point for the economy and the bond market or could it just be a statistical blip?

Landmann: The bond market is suggesting that we are at the inflection point here. Two-year rates are now over 50 basis points below the federal funds rate, very short-term rates, indicating that certainly the market is anticipating the Fed will be easing very shortly. We think whether this is an inflection point or isn't will depend on how hard the housing market or the real estate market, particularly residential real estate, reacts over the next six to twelve months. But our belief is that this Federal Reserve will be a little bit slower in terms of getting into an easing cycle here.
    Certainly when Greenspan was Fed chairman he talked about the three structural problems, structural deficits in the economy, and a very low savings rate in the U.S. and of course the speculative boom in the housing market. We have only begun to see those things correct very slightly, and our feeling is that Bernanke will wait and let this play out a little longer before we actually move into an easing cycle. So we don't think that we are necessarily at the inflection point for the economy, the economy is going to slow, 4%  growth is not sustainable when you have 4% unemployment. So certainly labor productivity is going to be strained here, and it is just natural that we will have a slower rate of growth for the next couple of quarters, not likely a recession.
   
Simonoff: Bill?

Healey: We think that this is a temporary slowdown. Look at what just happened with the energy market. Over the summer we were concerned about energy sapping the consumer and we have had a tremendous fall off in natural gas prices, heating oil, oil and in particular gasoline prices. So there are some things in the short term that will help the consumer rebound, fourth quarter, first quarter.
    But, in terms of inflection point, one of the concerns that we have is around the housing market. Some people have suggested 50% or 60% of the GDP growth over the last three years has been related to housing. And if you do get a major fall-off in housing, it could trickle into that recession that people are talking about.

Simonoff: Dan?

Fuss: Our basic thought is that the secular decline in interest rates ended in the second week of June of 2003, and we are just completing the transition cycle from a 20-some-year decline in interest rates to a long period of rising interest rates. Nobody knows the future, so I'll talk about the future. On a shorter-term basis the economy is slowing. When you get into a situation where the secular trend is changed, the behavior of interest rates by maturity completely changes. For 20 years the short rates led the long rates down-in other words it is the administered rate-and  the Fed rate was your lead.
    Now, as you go through a period like this it flips and the long rate in effect leads the shorter rates down. A natural outcome of that is that you are going to get an inversion that could fake you out. You will say, gee, the Fed is tightening. The Fed isn't tightening, quite the reverse. The open mouth is towards east, the action will lag so that the long rates lead you down. Use the ten-year as a point of reference, we peaked roughly at 5.25%. We are getting close to 4.50% now, a lot of technicals kicking in that ought to drive it below that on a choppy basis. But that 4.50% looks like a level for it to level out.
    It is the labor force that the Fed will key off of. There is weakness here and there, but it won't show up in the overall numbers. The rate of growth and employment in this past business cycle has really been terrible. The only one like it was in the early 1960s. So you would anticipate that the labor force growth won't drop too much; if it does the Fed will then act. Our guess is that there will be three Federal Reserve rate cuts but they won't start until over the wintertime, and next year at this time we will be at 4.50% and the open mouth policy will be swinging the other way.

Chitnis: It is a little dangerous being on the opposite secular side of the fence from Dan, but that is the position we find ourselves in and we think it is important to have a good grasp of the secular trend. We feel the secular trend is towards deflation, not towards inflation, for two reasons, which are very much related. There is an excess supply of capital in the world and an excess supply of labor in the world, and any time you have an excess supply of anything it leads the price of that commodity or item to come down. So when you have that excess supply of capital and labor, when you have a recession in the West, that is going to feed itself in the form of much lower interest rates.
    Whenever the next recession comes, it would not surprise us at all to see ten-year Treasury rates be below where they were in June of 2003, which was that 3.1% level. What you have seen in the last three months is how the bond market will react when there is even a whiff of deflation in the air. The reason rates went down by 75, 65 basis points in the last three months is, we believe, because of the secular backdrop of deflation vs. inflation.
    Fortunately we think that the Federal Reserve chairman understands the deflation threat and therefore there is a lower probability that it would happen. That in our opinion is the secular backdrop; there is a bias toward lower rates, not higher rates, at least getting into the next recession, which we think is this side of 2010, if not in 2007 or 2008. What you saw in June through this week was the way the bond market will react when there is what we think is a whiff of deflation. What you had is a slowdown in the economy, a deceleration in the inflation rate, perhaps a turning over, a cresting of inflation, and that's why we are where we are in terms of rates. On the flip side, we would agree with the first two gentlemen insofar as there is a feedback loop mechanism natural in the economy, whereby lower gasoline prices not only induce teenage children to drive more, they induce everybody to drive more, and even if they don't, they are going to Wal-Mart more and they have an extra few dollars in their pocket. There is a feedback loop mechanism in the economy that allows a little bit of reignition.
    There is also a feedback loop in interest rates. Just last week, The Journal reported that there was a "spike in refinancing." Folks have ARMs that are adjusting upward and they are refinancing, which is preventing higher mortgage payments. All of those things are redounding for the benefit of the economy.

Simonoff: Do you think the Fed has completed the tightening cycle, or is the jury still out? Dan indicated that he thought there would be three cuts starting in March.

Fuss: That's right, three cuts starting in March.

Simonoff: Do you think that we are done? When the Fed starts cutting interest rates, how far do you think they will go?

Chitnis: No, I don't think that we are definitively done because, as I said, this feedback loop mechanism. I think the Fed is going to be in a bit of a wait-and-see posture. The bond market is a little bit too far, too fast. The bond market is a little bit ahead of reality. The economic statistics have decelerated and they are showing signs of cresting but they're not at a point, other than housing, that would signal, in our opinion, a dangerous level of economic growth that would justify a cut in rates. It reminds us a little bit more of the late '80s than 1995, which has been the year that has been oft quoted-that 2006 would be a repeat of 1995, whereby the Fed finished raising interest rates-it was a soft landing, equities were up 30%, bond yield were down 2%, etc. We think there will be a bit of a pause, and then after that you see how this feedback loop mechanism responds, and if the economy reaccelerates even slightly then the need for interest rate cuts will be mitigated. It is [conceivable] that rates could rise in early 2007 if you get a strong Christmas and a reacceleration of some of these economic statistics.

Landmann: We are pretty closely in agreement with that outlook. We think the Fed is definitely on hold and we are not going to see rate cuts any time in the near future. The posture toward risk is very cavalier right now. Particularly, it has been in the housing market where speculative excesses have been built up to sort of a crescendo. One of the things that Greenspan was heavily criticized for was, quote "the Greenspan put." That is whenever our market got into trouble, Greenspan was there to bail out the speculators. It led to sort of an asymmetric response mechanism on the part of the markets. Our belief is that Bernanke is very aware of that and that he does not want to be in there bailing out the speculators in the housing market at the first sign of trouble. Obviously, if the housing market crashes very hard, and we get into mid-2007 and there is a lot of feedback between the housing market crash and other areas of the economy, you could see the Fed ease at that point.

Healey: Originally our forecast at the beginning of this year was that the Fed would have to go towards 6% on Fed funds, now obviously what changed was the reaction when we had a change in CPI, and it was just a minor change in CPI that started all that. Bernanke basically has a dual mandate, but he's not worried about inflation because he's a forecaster and he thinks that eventually it will go down. There's still that possibility that he is wrong on his forecast and that you do get the recovery, and given where he has set his target or comfort zone on inflation, core inflation at 2%, being at 2.5% now, the Fed, we feel would have to be forced to do the "credibility trade," which would be to raise rates. So, it's kind a bi-modal trade here. There's talk about 1995, which is kind of that Goldilocks economy, that soft landing. Soft landings happen once in a blue moon, and I think for people to think that the Feds' going to engineer another soft landing doesn't make sense. When the Fed goes, they go a lot.  I just don't see three rate cuts, I think that if it came to that, it would be a lot more.

Simonoff: As long as we've got you, let's go back to the future. What is the probability in your mind, Dan, of a recession in 2007/2008? If yes, will it be a severe or a mild one?

Fuss: My guess is that I don't think we will have one. But each time you get in a situation like this, like it or not, you have to extend and move the bond fund duration from 4.1 to 7.2. Jay's point, as you dig into the possibility of deflation, could this be Japan 15, 16 years ago? Yes, it could. There are a number of things that could cause that, the most severe being an unwinding of the extra liquidity the wrong way. So, it could happen. The reason we don't think that is a high probability-in terms of real GDP, a slowdown to 2% and then 1.5%-is because so many parts of the economy in fact are fairly strong. We never have had the employment growth that you would have gotten, say, in the '80s and '90s. The best comparison I can give in terms of history-and it is only about a 20% to 25% overlay but it's instructive-is the 1960s, and it gets very confusing when you have a situation where your underlying pressures are in fact inflation.
    Number two, the population dynamics have changed radically. They are not at all like the '60s, by the way, in such a way that it's the revenue collection. Look at the U.S. Treasury borrowing requirement. It is a function of the deficit, which in turn is a function between how much of GNP do you take in and how much do you spend. That's the key point. It looks like here we have had a wonderful, tremendous economy for a number of years, and none of my statements should be taken politically. I am a political agnostic.
    My guess is that until after the 2008 presidential elections you are not going to get an increase in taxes. You get a modest increase right now, but it is not an increase in the rate. Nor are you going to get a decline in spending. At the increment, and I hope I am wrong on this, more and more of your gross national activity is going to the war. The war includes people checking your bags at an airport. Our guess is that the Treasury borrowing rule/requirement is going to start to rise at an exponential rate. The cost of the debt, because of the rise in interest rates and the increase in spending, starts to accelerate, very much like the '60s. If that happens, your incremental borrower is the Treasury, which compresses your spreads. Capital spending holds back as the rate goes up. You get into a stagflation environment. I hope I am wrong. I pray I am wrong.

Simonoff: Jay. What's your probability-recession in the next 24 months or so?

Chitnis: In terms of 24 months, 2007 is not likely, and I'll tell you one of the reasons why is because everybody talks about housing. Housing imploding, housing crashing, etc. I am one of the few and perhaps the only manager here that manages bond funds and an equity fund, and we have noticed that the homebuilders' stocks are up, up, 20% in the last couple of months. The stock market, we have found, is a pretty good indicator of those kinds of inflection points, where homebuilder shares were down 50% from peak and they are now up 20%. So, if the housing market stabilizes, then the entire talk of recession is completely unwarranted in our opinion; 2007, we think the probability of a recession is low. On the contrary the feedback loop, if the feedback loop really works as we think it will, then growth may reaccelerate closer to the 3% level.
    2008 is also interesting because there is an Olympics happening half-way around the world, in Beijing.  It is our opinion that China will be a locomotive into 2008, so a global recession is a low probability going out into 2008. Now, once everybody leaves the Olympics in August of 2008, our question is, who is going to buy all the steel in the plants that China is building? Who is going to buy all those extra sneakers that they built the factories to produce? That's where we get into our recessionary and quasi-deflationary environment.
    So it is beyond 2008 that we feel the probability of a recession starts to spike up a little bit. We will also get to a point where if we have 24 more months of growth in the U.S. it starts constraining supply over here, leading interest rates potentially higher. As you go out closer to the 24 months the probability increases, but we still don't think it's greater than 50%.

Simonoff: Laird, you are from California-they never have recessions, do they?

Landmann: Being from California, we have a slightly different take on the housing market than Jay. We do see considerable vulnerability there. It is not just the homebuilders that will affect the economy overall, it's the people in the margins who bought too much house, who got caught speculating in the housing market. Those are the people who are going to be leading our slowdown in 2007 that we are calling for. We are not calling for a recession either in 2007, and 2008 I think is too far out in the spectrum.
    Something like 40% of all adjustable rate mortgages will reset upwards coming into 2008 from where we are today. That is going to have a tremendous drain on household incomes. We are not quite as macro-oriented as some of the other panelists. We look at what the microtrends are going on in the economy, and we certainly think there is going to be a lot of trouble in the asset-backed securities market by the time we get to 2008. I think that people have been very cavalier about the type of credit risk. People buying triple-B, asset-backed securities that are 150 basis points over the London Interbank rate are going to pay for those risks down the road.
    Those are the types of things that will most likely produce a slowdown, in our opinion, in 2007 and 2008. Whether that will turn into a recession really just depends on whether you can engineer a soft landing in the housing market. We don't think so. We agree with Bill that soft landings are a blue moon type of event, and most likely virtuous cycles become vicious cycles at some point. Maybe we are biased, but we see substantial downturns in those valuations that by 2008 could put us at risk for a recession.
Simonoff: Mention a soft landing in the housing market and Bill is shaking his head. Do you think that could be the tipping point?

Healey: The housing market will be the tipping point. Laird mentioned the marginal buyers. The homeownership rate is, 70% of the households in America own a home now. Traditionally that has been in the low 60s, say 65%. That last 5% is kind of dragged in by financial firms that go out of their way to get these subprime borrowers into houses that they basically could not afford, and now when the piper comes to be paid that 200-basis-point uptick in their ARM rate, it will be interesting.
The bigger issue, and this is directly from Janet Yellen, who is president of San Francisco Fed, is what she terms as housing as a piggy bank. It is not just these marginal buyers, it's people that actually own their homes that have seen this tremendous price appreciation. Like Laird out in California-I'm from Greenwich Connecticut and if you looked at today's paper, we were in the top ten there as well, the median price I think was $1.4 million. That has probably doubled if not tripled over the last four years.
     A lot of people are looking at this $1.4 million, and they look at their house as a big part of their retirement package. They believe they will be able to take the equity out of that house, trade down, and take that and go live off of the income. Now, with the savings rate negative, what have people been doing? It is similar to what happened with the Nasdaq bubble. The stock market was saving for them, so they can go out and spend it until there's a crash.
    Now look at the housing market. Similar things, if you look at the charts at how high prices have gotten and the amount of equity that people so called have in their house. If we get a 15%  to 20% drop in home prices, that paper profit that they thought they had, in some cases $200,000 or $300,000, is money that they are not going to have available, in their minds, to spend in retirement. So they will have to save the old-fashioned way. I think that could happen.
    On the recession, Jay mentioned it, the stock market, a good predictor in the past, says no way is there a recession. My biggest point on this is we don't know when it is going to be, but I will guarantee you that this recession, if and when it happens, will be nothing like 1991, where we didn't even know it happened. It will be severe, I think, because you haven't had a true recession dating back to 1991. I think you have to hedge for that, and Dan mentioned extending your duration. My point is when it does happen it is, unfortunately, I think it is going to be ugly.

Fuss: This is what makes markets, Bill. I agree with you and I don't. The part where we agree, you just have to, when you get in this environment, if you get caught by reinvestment risk, you have had it. So, if there is even a one in 20 chance you are going to extend, because once interest rates go down there is nothing you can do. If they go up that is good news. because you reinvest at a higher rate. The argument for a softer economy, but not a recession, is that you get these geographically dispersed rolling adjustments, slow business in Detroit, lousy home prices in Greenwich, California and a boom in the mountain states. With regard to the Fed, I might add that the Fed under Bernanke is not politically strong yet.

Simonoff: Let's look at the positive side. Jay, where do you see opportunities in the bond market?

Chitnis: Laird mentioned that risk premiums in the bond market are extremely low. We think that the areas where the spreads over Treasuries are narrow, where the problems could be, are areas like junk bonds and emerging markets. You aren't getting paid for the risk. So by default, Treasurys are looking pretty good as a residual of everything else looking not so good. The worst in the housing market may be over. One of the things we hang of our hats on is contrarian sentiment, and sentiment in the housing market is so poor we think relative value there may be pretty good as a result of all the bearish sentiment.
    One thing we are very bearish on is TIPS, by reason of our deflationary outlook. TIPS have performed very poorly for the last year, particularly in the last few months, so we think it may be time to dip your toes back in the TIPS market as a hedge against our deflationary bias. The mortgage marketing in a placid interest rate environment is interesting, so we've dipped our toes back in there. But if you believe in a deflationary environment over the next few years as we do, there is substantial prepayment and reinvestment risk out there.

Landmann: Good points, but we couldn't disagree more about the homebuilders. Many are concentrated in areas like Florida and California, and we think you have just seen the tip of the iceberg. Some homebuilders will take 12 to 18 months just to clear out excess inventory. What do I like? We agree about TIPS, there are pockets in the mortgage markets that offer nice spreads with good credit protection so you can add them for absolute return. Corporate bond spreads are tight, and we think emerging market bonds will be one of the worst-performing sectors over the next three to five years.

Healey: The pockets of pain will come first from housing-related investments. In the subprime  area, people just don't know what they're buying. A lot of these new structures haven't been tested. They will be. In the commercial real estate sector, we think you can't have a residential recession without having spillover into the commercial area.
For opportunities, I agree with panelists on TIPS though I think it's really a relative value and not an absolute value play. We do like munis, and one of the reasons is that we think this is as low as tax rates are going to be. Depending on what happens in November and definitely on what happens in 2008, there will be a new regime that tries to raise taxes. Demographics suggest that taxes will have to be raised. In emerging markets, we believe in the China story, we believe in global growth, so we think there are pockets of opportunities. Lastly, we think cash is not a bad place to park some funds for preservation of capital. You can get 5.25% in some of the short-duration funds. Given all the uncertainty, with ten-year Treasuries at 4.5% or 4.6% and the Dow about to set a new all-time high, sitting in cash at 5% isn't a bad alternative.

Fuss: I agree with the thoughts on munis and TIPS. I think TIPS are cheap based on our outlook, but they keep getting cheaper. As for emerging markets, we have a somewhat different view. Some emerging markets are stronger than others. But in Asia we like to split the currency from the creditor because the spreads of the local currencies are so narrow you don't make any money.

Simonoff: Jay, many of you have been able to realize some significant capital gains in bonds. Do you think the bond market over the next five years will be as conducive to that style of investing as the last few decades have been?

Chitnis: I would guess everyone here would agree on that point, because the bond markets are not efficient. So you have this oscillation between fear and greed and the opportunity exists in taking advantage of that oscillation, not in buying and holding. Yield is really a somewhat meaningless economic variable, although investors do have a demand for income. So you shouldn't let the income component wag the total return investing dog.

Landmann: Fixed-income markets are pretty inefficient and emotionally driven. I got a laugh recently when one of my colleagues suggested that this business does risk management much better today, so that explains why the recent  collapse of a few hedge funds with big positions in commodities caused so little damage. We actually think risk management is done as poorly today as it ever was, and you have all these hedge funds pushing the limits to get the 10% or 12% returns their investors are demanding. But these markets aren't volatile enough to earn those kinds of returns, so the heyday investors are expecting isn't going to come. The heyday is really protecting your capital and waiting for the deflationary cycle that Jay is talking about to come, when people panic and throw away very good investments. That's what you want to position yourself for.

Healey: If rates go down, say from 5.25% fed funds to 4.50%, there will be fairly significant opportunities to earn capital gains over the next few years. But one should also remind oneself that if they go all the way down 3.00%, that's not a good starting point so you have to rely on active management, and proper timing is important. It's all about when you get in.

Simonoff: Let's look at the long-term cycle and the forces we're facing, with three billion people joining the global economy and seeking jobs. Jay has mentioned that this is a powerful deflationary force. Dan has mentioned the demographic issues and the fiscal issues we face regarding the coming explosion in entitlements. Looking at these two megatrends, does one dominate the other?

Chitnis: Three billion people seeking work is just one side of this coin. Those three billion people also save 20% to 40% which just adds to the imbalances. In terms of the U.S. deficit, at the end of the day some of the entitlement issues you alluded to are just going to change. Social Security is an intergenerational promise. The promise is going to be broken. I'm 39, some of you are in your early forties, and all of us are preparing for it.  There will be a huge intergenerational transfer of wealth to people in their thirties and forties, so I think it's very hard to look more than a few years out, because things can change dramatically, legislation can change. We think it will change in the next half decade. We also think there will be a recession inside of 2010, so we think you want to increase your duration.

Fuss: When something like entitlements looks like it can't go on, it won't. These things do take time and no one knows what the political tipping point will be. When things start to get out of control and people start to talk about raising taxes, that's when the pressure will start to build on the spending side.

Healey: If Jay is right that we will see a recession in the next four or five years, then I think the bond market will retest the lows of 2003. After that, if world growth shifts away from being so U.S.-centric, and those three billion people start spending more and saving a little less and become consumers, then rates in the U.S. will have to be higher to attract capital. Now it's still the best place to invest, but as that changes the interest rate trends will change. I don't think that's happening in the next cycle.