Whichever side of the fence fixed-income asset managers are standing on regarding the Federal Reserve’s decision to finally raise interest rates from the zero bound, they haven’t had to scramble to adjust to the new reality. Most got their bond houses in order well ahead of the Fed’s rate hike in December, its first since 2006.
But let’s be clear about something. Although they expect the pace of future hikes to be very gradual, which the Fed has emphasized and because they don’t foresee much inflation that would warrant doing otherwise, they warn against hitting the snooze button. Being vigilant and selective may be more important than ever, as exemplified by the recent failure of Third Avenue Management’s junk-bond fund.
Steve Huber, portfolio manager for the global multi-sector bond strategy at T. Rowe Price, with $1.2 billion in assets under management, isn’t troubled that the Fed has begun raising interest rates. It’s a positive for the bond markets, he says, “because it’s been a risk that’s been out there and now it’s behind us,” he says.
What does concern him, he says, is that illiquidity is likely to cause more volatility in bond prices. Also, the U.S. is nearing the end of its credit cycle, so fundamentals are deteriorating a bit. And he continues to be concerned about growth in China. These risks will affect all the financial markets and “fixed income won’t be immune,” he says.
“Guardedly” is how Huber says he’s approaching 2016. His base case scenario is that the U.S. economy will continue to improve and the global economy will work through some of its issues. “The wild card is commodities,” he says. “I think commodities are going to be one of the largest drivers of what happens in the global economy.”
Commodity prices also feed into the credit sector, he says, noting that roughly a quarter of the J.P. Morgan and Barclays high-yield indices is commodity-related.
In recent months, T. Rowe Price has increased its liquidity by reducing exposure to corporate and emerging market bonds and investing more in higher-quality, more liquid sovereign bonds. “This is about as high as we’ve ever had global sovereigns,” says Huber, “and this may be one of the lowest that we’ve had our credit exposure.”
He has approximately 30% allocated across credit sectors, including 7% to 9% in each of three different categories: U.S. investment-grade corporate bonds, U.S. high-yield securities and U.S. bank loans. He’s more concentrated in U.S. credit because it’s offering higher yields and wider spreads than investment-grade and high-yield offerings from the euro zone.
Huber has 30% to 35% in global sovereign debt. Much of it is higher-quality government-related debt in the U.S. and Germany, but some Asian and Eastern European markets are also represented. “You’re getting a little bit of extra yield there, he says, “but are still safely away from the pure credit risk market.”
He also has about 20% in securitized sectors, including agency and non-agency mortgage-backed securities, asset-backed securities and commercial mortgage-backed securities. The agency mortgage-backed and asset-backed names offer liquidity and provide some level of safety and stability, he says.
The remaining 15% to 20% of Huber’s portfolio is in emerging markets—a combination of dollar emerging market debt, emerging market sovereigns, emerging market corporate bonds and emerging market local debt.
Seeking Credit
Peter Palfrey, a member of the fixed-income group at Loomis, Sayles & Company (which oversees approximately $200 billion in fixed-income assets) and co-manager of the Loomis Sayles Core Plus Strategy, took the recent rate hike in stride. “We had been expecting a Q4 liftoff of the Fed tightening process for really the better part of the last year,” he says.
Palfrey and his colleagues expect the Fed to raise rates three times in 2016, initially late in the second quarter and again around September and December. The hikes, each projected to be 25 basis points, will be very data-dependent, he says.
He anticipates front-end yields will likely rise faster than longer-term yields. “The net of it is that we don’t think investors from a total-return standpoint are going to find much value in the government market,” he says.
During the third quarter of 2015, when fear of slow global growth triggered a huge pullback in the risk markets, “Investors flocked to the government market and that caused us to underperform very severely,” he says. “But since then we’ve started to see stabilization in some of these risk markets, and we think going forward it’ll be all about not looking like the Barclays Agg, not looking to the government market for return and really going to other markets which we think are quite cheap.
“We think in a low-yield environment like this, and a backstop of improving economic activity in the U.S. and other major developed markets, we will be compensated by being in higher-yielding credit-oriented securities, or securities with some kind of spread over governments,” Palfrey says.
He and co-manager Rick Raczkowski have allocated 30% of the Loomis Sayles Core Plus Bond Fund to government securities, well below the 70% weighting in the Barclays U.S. Aggregate Bond Index benchmark. They’ve increased exposure to Treasury Inflation-Protected Securities (TIPS), which Palfrey says are priced more attractively than Treasurys. He also thinks long-dated TIPS (10- to 30-year) are underpriced because they’re pricing in inflation expectations that he believes are too low.
The Loomis Sayles Core Plus Bond Fund also has approximate allocations of 35% in investment-grade credit, 10% in investment-grade securitized debt, 20% in high-yield securities, 3% in non-U.S.-dollar markets, and 2% in cash and other securities.
“We think there’s an extraordinary opportunity to be involved in high-yield securities—fixed-rate high yield, as well as bank loans, as well as emerging-market securities which have gotten very, very beaten up here,” says Palfrey. His allocation to the non-U.S.-dollar market is in emerging market currency, which he says also offers great opportunities given its recent sell-off.
Investors who must be allocated to the government sector will be best served, he thinks, by using a laddered strategy—staggering the maturity date of bonds owned—or by investing primarily at the front end of the yield curve. Front-end securities should be able to withstand a modest rise in rates over the next year or two, he says.
The Three Cohorts
Tad Rivelle, chief investment officer for fixed income at the TCW Group, which manages approximately $145 billion in U.S. fixed-income assets, has been studying the past 25 years of economic history and won’t forecast economic growth or interest rates.
“Meaning no disrespect to those who do, I think it’s kind of a silly exercise,” he says. “I think what you’re really supposed to be focused on is recognizing where in the cycle you are.” And that, he thinks for the U.S., is the last third of its economic and credit cycle.
“You’re already seeing signs of age and you’re seeing volatility in the market, which is usually a sign that you’re relatively late cycle,” says Rivelle. “If you put a gun to our head, I think we would say that probably within 12 months you’ll probably see that the cycle is coming to an end.”
Rivelle and his team divide the fixed-income universe into three different cohorts—risk-off assets, breakable assets and bendable assets.
Risk-off assets, what investors seek when they want to avoid risk, are basically Treasurys and agency mortgages. Breakable assets are stressed and “in the event of a more generalized retrenchment in the capital markets, will adjust in price in a nonlinear, catastrophic-type fashion,” he says. Those he is currently trying to keep out of his portfolio include metals and mining companies and the exploration and production space of the energy sector.
Bendable assets, which provide yield and spread, “I think are where you actually want to be focused on in your portfolio,” says Rivelle. This includes “AAA”-rated mortgage-backed securities, auto loan securitizations and credit card securitizations, and investment-grade corporate bonds.
“For your typical large-cap investment-grade company, you’ll find that the risk premium reliably widens during periods of stress in the capital markets,” says Rivelle, “but it’s not going to go bankrupt, and the probability of restructuring is considered to be sufficiently remote.” He has recently found some value, he says, among money-center banks, REITs and utilities.
“Like many things in fixed income, it’s really a matter of trying to run ahead of the pack and finding inefficiencies in the pricing of the marketplace,” he says.
Simply Tacking
Bob Andres, a 40-year veteran of fixed income and the chief investment officer of Andres Capital Management, a Berwyn, Pa.-based independent RIA firm launched last summer and managing approximately $700 million in assets, spent more than half of 2015 arguing there wasn’t an economic justification for Fed tightening. “I think they boxed themselves into a corner by talk, talk, talk,” he says. “We’ve had schizophrenic GDP growth for the last four years.”
Fortunately, “the bond market is not dead,” he says, “but you have to keep an eye on the factors that could cause inflation to rise,” including wage pressures and a rebound in oil and commodity prices. “If you’ve ever sailed, we’re running into a little wind here,” he says. “What we need to do is simply tack.”
Several factors are fueling his continued positive stance on bonds. “I think U.S. bonds will continue to offer a distinct yield advantage over our European friends,” he says. He sees a possible flight to quality as geopolitical events heat up. “We’re having words of war with an awful lot of people,” he says, including North Korea, Iran and Russia. Furthermore, “equities are going to get hit, in my judgment,” he says, because the stock market is overvalued.
Andres also thinks the U.S. Treasury Department will adjust its funding schedule this year, putting more weight on Treasury bills and reducing the issuance of notes and bonds in order to lower the duration of its borrowing portfolio and help reduce its overall costs.
He and his colleagues like U.S. Treasurys, particularly in the long end of the curve (10 to 30 years). They also like investment-grade corporate bonds, municipal bonds and select names in the high-yield market.
Ted Palatucci, a leader in the municipal bond industry for 40 years and a partner and portfolio manager of Andres Capital Management, suggests caution regarding bond funds and bond ETFs.
“Irrespective of the near-term direction of rates, if you are a long-term holder of a bond fund, you’re at the mercy of the market every day,” he says. “That’s not really the case with individual bonds because they’re all date-certain events.”
And when investors pull out to defend themselves in a period of rising rates, that behavior erodes the composition of a fund, he says. That’s because fund managers running out of cash and credit lines must start liquidating positions to raise sufficient money.
To help diversify bond portfolios, he and Andres encourage independent advisors to seek out subadvisors willing to work with them even on their smaller accounts. They also suggest looking at “A”-rated essential service bonds, which support electricity, water and things that people need to live.
William Belden, head of ETF business development at Guggenheim Investments, pointed out during a recent Charles Schwab conference call for journalists that some fixed-income ETFs now offer defined-maturity dates and that more ladders are being built into the investment-grade and high-yield space.
By using laddering to take a barbell approach that ties shorter-duration and longer-duration exposure, he said, “you can end up with a pretty attractive portfolio construction that should perform well in the market that we’re in right now.”
Andres emphasizes, “Every basis point counts in a low rate environment.” And, he says, “Even if the Fed raises rates two, three, four times, we’re still going to be in a very low interest rate environment.”