Manager says predictions of soaring inflation, interest rates are overblown.
When most people think of a large Los Angeles area bond specialist, Pacific Investment Management Company (PIMCO) and its high-profile chief, William Gross, come to mind. Yet tucked away in downtown Los Angeles is a firm with a fixed-income focus that has more than $50 billion under management, a stable of bond funds with some of the lowest expenses in the industry, and a founder who is one of the most influential women in the investment management business.
Aside from a sunny location and a looming bond market presence, Payden & Rygel appears to have little in common with its larger, better-known Newport Beach neighbor. "I've run into Bill Gross from time to time at golf tournaments," says Brian Matthews, managing principal responsible for the firm's core bond strategies and lead manager of the Payden Core Bond Fund. "Our paths don't cross all that much."
Fortunately for Matthews, his path did cross Joan Payden's in 1984, when he was a 24-year-old analyst with Brown Brothers Harriman in New York City. "I liked her passion about the markets and her commitment to the business," he recalls of his decision to join her fledgling firm. "And I though it would be exciting to move to Los Angeles." He later became the first of nine managing principals in addition to Payden, most of whom have worked together for well over a decade.
Before meeting Matthews, Payden had left her job as managing partner for Scudder, Stevens & Clark's West Coast operations to start the firm with colleague Sandra Rygel in 1983. Five years later, Rygel left to do charity work. Payden stayed on and in the years that followed, Payden & Rygel gained a loyal following among institutional clients. It was one of the first firms to develop global bond strategies in the late 1980s, and launched a family of mutual funds in 1992. Its London office opened five years ago, and last year non-U.S. clients accounted for 25% of new business. A small but growing equity management arm, which accounts for some 5% of business, includes four stock funds.
"Inflation Is Yesterday's War"
In the 20 years since Matthews joined the firm, the bond market environment has run the gamut from tame to tumultuous, often within the same year. Today, investors face the prospect of rising interest rates to add salt to the wounds of bond market losses already sustained over the last year. In mid-June the Lehman Brothers U.S. Aggregate Bond Index was down 1.65% for the year while the Payden Core Bond Fund, a portfolio consisting mainly of investment-grade corporate, mortgage-backed and government bonds, was down about 2% over the same period.
Yet Matthews remains optimistic about the long-term future of the bond market and believes that, for the most part, the threat of rising interest rates and inflation has been overblown. "Some observers say this is a 70s-style market, and that we are destined for a period of hyperinflation and soaring interest rates," he says. "But things are different today than they were 30 years ago, or even ten years ago. The market has built-in mechanisms to keep inflation muted. We believe that inflation is yesterday's war that everyone keeps talking about fighting, and it is premature to suggest that price stability will turn into price increases." A number of factors, he says, point to an environment of moderate inflation in the 2% to 3% range over the next several years. Among them:
Moderate price increases. Matthews says that too many headlines fixate on rising commodity prices, which have been the driving force behind higher inflation numbers. The Personal Consumption Expenditure (PCE) deflator, the Fed's preferred inflation measure, increased at an annual rate of 3.2% in the first quarter of 2004, more than three times faster than its fourth quarter pace. But he says the acceleration is unlikely to continue in the months ahead, because after stripping out food and energy the core PCE rose at a tamer annual rate of 2%-well within the Fed's target goal of a 1% to 2% inflation rate.
Controlled labor costs. The impact of higher commodity prices will be muted because commodity costs are dwarfed by labor costs, which account for roughly two-thirds of the cost of a finished product. Labor costs, as measured by the cost per unit of finished goods, have been declining or flat in recent years because of increased worker productivity. "A sustained inflation is only likely to emerge when firms shift from squeezing more output out of each worker to hiring more workers," he says. "If wages stay in check, as we expect they will, inflation will be muted."
A tepid recovery. "The Fed is walking a tightrope, and there is still a lot of slack in the market," says Matthews. "The recovery is pretty anemic, considering it is over 30 months old. We've already factored in growth from the tax cuts and the refinancing boom, which put $150 billion into consumers' pockets. The question is, what's next? We don't see much of an increase in consumer spending because debt is at an all-time high. The economy will need to start firing on its own." In an effort to avoid stalling the recovery, he believes that the Fed will hold to its recent promise to increase rates "at a pace that is likely to be measured." He says market expectations are for an increase in the Fed funds rate from its recent 1% level to 2% to 2.25% by January 2005.
Historic norms. Matthews says double-digit yields on ten-year Treasuries were an historic anomaly that is unlikely to be repeated soon. Since World War II, the yield on ten-year Treasuries has generally fluctuated from 3% to 5 %. The recent yield of around 5% for ten-year Treasuries indicates that the market demands a real yield, or yield after inflation, of around 2%. If inflation chugs along at a rate of 2% to 3%, as Matthews expects, that means that ten-year Treasury yields will fluctuate in the 4% to 5% range over the next several years. An "overreaction" to Fed tightening might cause yields to rise to as much as 5.5% by year-end, he says. Efforts by the Federal Reserve to be more transparent about its intentions and the reasoning behind them should help keep market reaction to any rate increases more muted than it was in 1994.
Investment-Grade Emphasis
Matthews is adjusting the fund's portfolio of investment-grade corporate and government bonds in line with his firm's expectation of a measured rise in interest rates. Currently, mortgage-backed securities account for 38% of fund assets, up from 22% at the end of March. He added to the position in the spring as the spread over Treasuries increased from 80 basis points to about 100 basis points. Lower levels of refinancing due to rising rates add to the appeal of these bonds.