Last year it was hard to go wrong in the bond market by sticking with plain vanilla Treasury securities, a haven for investors seeking the ultimate in safety in an uncertain economic environment. By contrast, prices for corporate bonds, and high-yield corporate bonds in particular, sank amid economic and credit concerns, and the performance disparity in the fixed-income markets widened toward the end of 2008 as those concerns grew. By mid-November, Morningstar reported that the average high-yield corporate bond fund was down more than 24% year to date, while the average intermediate-term government bond fund was up nearly 3%.
But investors expecting Treasury securities to lead the pack in the years to come may be disappointed, says Andrew Stenwall, chief investment officer for taxable fixed-income at Nuveen and the manager of the firm's Multi-Strategy Income Fund, who believes that over the next 12 to 18 months high-yield bonds are likely to outperform other taxable fixed-income sectors, possibly by a wide margin. "It's possible we'll see annualized returns in the high yield market of 17% to 18% over the next two to three years," says Stenwall.
At the same time, he believes that this is not an optimal time to be buying U.S. Treasury securities. With investors around the world flocking to them because of economic uncertainty (and despite the government bailouts), prices have risen and yields have fallen to levels that "rank somewhere in the middle globally" of other established government bonds.
High-yield bullishness may seem out of sync with his firm's dour outlook for the economy over the next year, since these bonds tend to perform best when the economy is at the beginning of an upswing. But Nuveen's economic forecasts call for flat or sluggish GDP growth of 0.5% to 1% over the next 12 months as consumer expectations meander at recessionary levels and businesses struggle with weak overseas growth. Weak equity and housing markets, elevated energy prices, the fading impact of tax rebates and rising unemployment will push the country into a recession, if it is not already there. Energy prices have dropped, but still remain 40% to 50% higher than they were last year. By the end of the third quarter of 2009, Stenwall expects the unemployment rate to rise 7.1%, slightly higher than current levels.
Although the federal bailout is a step in the right direction, Stenwall is not sure just how it will solve the liquidity crisis plaguing the markets. It is still unclear how the government will value failing assets, or whether banks will be able to raise capital after the bailout. He has mixed feelings about how President-elect Barack Obama will handle economic issues and his ability to lead the country out of recession. "I'm a Republican, so maybe I'm the wrong person to ask," he jokes. "But my hope is that the new president will rationalize government, reduce spending and deficits and rein in pork barrel projects. Obama has pitched himself as a liberal, but he is seeking advice from smart centrists about the economy like Paul Volcker and Warren Buffett, and that's encouraging."
At the same time, he also believes that the beaten-down prices and high yields in the high-yield sector reflect an overreaction to economic stress, which has dragged these bonds' prices down to bargain basement levels. According to Standard & Poor's, high-yield bond spreads rose to a five-year high of 1,375 basis points, or 13.75%, over U.S. Treasurys at the end of October, bringing the yields on many speculative-grade credits to an eye-popping 16% or more.
Mounting redemptions by institutional investors and hedge funds, as well as investor worries about defaults or the bankruptcy of corporate borrowers, contributed to the cavernous spreads.
Eventually, when the market stabilizes, investors will become less skittish about investing in corporate bonds, and then prices should improve and spreads should narrow. "This is not the 1920s, when 25% of all banks went under," he says. "Sure, things will be ugly over the next 12 to 18 months. But the government is moving in the right direction. This is not going to be another Great Depression."
Stenwall believes that while default rates are likely to rise, the huge coupon cushion will provide protection from downside risk. Next year, Standard & Poor's expects the default rate for speculative credits to rise to 7.6%, up from its current 3% level. Stenwall is even more pessimistic. "Going out a year to 18 months, we see the default cycle peaking in the 8% to 10% range, but that is still well below the default level currently being priced into the market," he says.
Because the fund is designed to touch most bases in the taxable fixed-income market, it also owns a broad mix of Treasurys and other government securities in addition to its corporate and asset-backed holdings. Specialists work on each bond sector and then contribute to the portfolio's investment strategies, which are developed with a 3 to 12 month time horizon. "Most fixed-income managers make or lose money because they may have hefty sector or duration bets, but that is not what this fund is about," he says.
At the end of the third quarter, mortgage-backed and asset-backed securities accounted for 47.3% of assets. Agency debt weighed in at 22.1%, high-yield corporate at 9.8%, investment-grade corporate at 9.4%, Treasurys at 7.4% and global bonds at 2.9%. The portfolio, which has an effective duration of 5.5 years, is overweight in two- and ten-year maturities and underweight in the five-year portion of the Treasury curve as the managers anticipate a steeper yield curve. It has 82% of its assets in triple-A-rated bonds, 12% in bonds rated BB or lower, and the rest in credits somewhere in between.
Despite generally unfavorable fixed-income markets, the fund's total returns ranked among the top 10% in Lipper's intermediate investment-grade debt funds category over a recent one- and three-year period. Part of its resiliency came from its substantial position in mortgage-backed securities which, surprisingly, performed better than most corners of the fixed-income markets. Even as delinquencies and defaults climbed, the market responded positively when Fannie Mae and Freddie Mac were seized by government regulators after the biggest surge in mortgage defaults in at least 30 years. Stenwall says the fund sidestepped some of the group's problems when he began unloading securities backed by subprime mortgage pools back in 2006. "We recognized the whole thing as a Ponzi scheme. It took a good 18 months before the market saw that, but eventually it did."
With more defaults and delinquencies likely, the mortgage-backed securities market will continue to face challenges this year. Stenwall expects continued volatility, and if interest rate spreads widen he says he may consider increasing the fund's allocation to the group.
He also maintains a presence in short-duration asset-backed bonds carved from pools of credit card and automobile loan receivables. In November, U.S. Treasury Secretary Henry Paulson announced the government's intent to support the asset-backed securities market, which includes debt backed by various types of consumer loans and provides roughly 40% of U.S. credit.
With weak consumer demand and growing unemployment, Stenwall is cautions about asset-backed securities but believes solid structures and attractive yields make them a good value. "These are time-tested securities that have been around for more than 20 years, so people know how to model them to be fairly safe," he says. Holdings in this group include securities backed by credit card receivables from American Express, Bank of America, Citibank and Bank One.
In the corporate sleeve, he prefers sectors that are resistant to a recessionary environment such as health care, utilities, commodities, and aerospace and defense contractors. His holdings include issuers such as Duke Energy, Petrohawk Energy, HCA, Healthsouth Corp., Tenet Healthcare, Freeport McMoran, GlaxoSmithKline, American Electric Power, Lockheed Martin and Halliburton. Most of the maturities in this group are at the shorter end of the yield curve because it is easier to forecast payoff capability, he says. He also had limited exposure to weaker areas such as automobiles, lodging, retail, and financials, and his minor presence in the last group helped him avoid fallout from the collapse of once highly rated firms such as Lehman and Bear Stearns.
The portfolio has a smattering of global government bonds, but it's the fund's smallest sector. Stenwall believes that these bonds have become less appealing for diversification because of the increasingly global nature of the fixed-income markets. Given the decline in commodity prices and the expectations for the credit crisis to spread even further outside the U.S., he expects global interest rates to decline. Meanwhile, he is taking advantage of the variance in Central Bank policies to capture higher interest rates available in some countries, and recently he had positions in short-term government bonds issued in the U.K., Australia, Turkey and Mexico.