There’s also an ample dose of floating-rate securities in the form of non-agency mortgages and collateralized loan obligations, two areas where the benchmark has no presence and demand by investors is strong. Miller and Rieder complement the portfolio with risk control tools that are rarely found in an intermediate-term bond fund, including U.S. interest rate derivatives and put options on the S&P 500. The puts, he says, are useful for cushioning the drop in high-yield bond prices that often occurs when stocks go down.
Risk controls and attention to macroeconomic forces have helped the fund earn a Morningstar “Silver” designation and a four-star rating. The fund underperformed its peers in 2011, the first full year that Miller and Rieder took over as co-managers. But since then it has outperformed its average peer in Morningstar’s intermediate-term bond category every year. Over the last five years, the fund has captured 114% of the upside of its benchmark index but only 89% of its downside.
Battling Headwinds
For Miller and Rieder, playing defense now is critical with the number of headwinds at play. One of those is a decoupling of the traditional seesaw relationship between bonds and stocks. Historically, bond prices have tended to rise when stock prices fall as investors flee the volatility of equities for the safety of the bond market. But over the last few months, that hasn’t always happened. At some points, investors have moved into bonds when the stock market has dropped, which boosts prices. At others, both the stock and bond markets have moved down in tandem.
Miller thinks the image of bonds as safe havens during stock market turmoil has diminished somewhat because investors are becoming increasingly concerned about the growing budget deficit. He questions why there’s been so much fiscal stimulus in the form of tax cuts and spending when the economy has already showed strong signs of upward momentum. “The federal government promoting stimulus at a time when we’ve reached full employment? That hasn’t happened since the mid-1960s,” he says. “That’s a powerful motivator for inflation and interest rates to move modestly higher. I think the political process recently has been unusually shortsighted.”
If the Treasury issues a flood of new bonds to pay for all the tax cuts and spending increases, government buyers may not be eager to absorb all that new supply. “Deficit spending and concerns about the market’s ability to absorb new issuance is spooking the bond market,” he says. “Politicians are underestimating the degree to which the private sector will need to step in to buy government bonds.”
Moving into below-investment-grade bonds is also less appealing as a way to soften the blow of rising interest rates. Under normal market conditions, these securities tend to be less interest-rate sensitive than government or investment-grade securities, making them something of a fixed-income shelter when rates rise. But with more investors tapping the high-yield market in recent years, both prices and yields have become less attractive than they were in the past. “With credit spreads so tight, the potential for high-yield bonds to absorb interest rate increases is minimal,” Miller says.
Inflation’s Up, But Under Control
Yet another problem is investor perception about the threat posed by increasing inflation. Over the last few years, new technology that streamlined the production, marketing and distribution of everything from food and apparel to recreational goods has kept prices low and inflation modest. With greater efficiencies, prices could rise more slowly than they would have in the past—and if wages are kept in check. But over the last year, the dollar’s sliding value against other currencies has added to inflation by making some imports more expensive. And with unemployment at historic lows, the signs of upward pressure in wages are surfacing.
“We’re keeping a close eye on wages growth as a key determinant for predicting the Fed’s movements this year,” Miller says.