Opinion

Felix Salmon

How the pros see the fixed-income market

By Felix Salmon
April 6, 2011

Every year, the Loomis Sayles PR team drags its top fund managers down to New York for lunch with the wonkier end of the financial-journalism spectrum: there’s lots of talk of curve-flatteners in a rising interest-rate environment, that kind of thing. The main attraction for me is always David Rolley, the droll and super-smart fund manager on the global fixed-income side of things, and someone who’s always good at making you look at the world in new and interesting ways.

This year’s lunch took place yesterday, and kicked off with Loomis vice chairman Dan Fuss coming up with a very interesting macroeconomic point. Right now, he said, about 56% of Americans over the age of 16 are gainfully employed. If that percentage were to rise to 64%, Fuss reckons, then the budget deficit disappears entirely. We’re not going to get there. But theoretically it’s possible, if the unemployment rate comes down and if people retire later, as is happening in Japan. And more generally it’s an important reminder that unemployment is a fiscal issue, and that anybody who wants to take the budget deficit seriously should put a lot of effort into increasing the number of Americans with jobs.

Rolley then gave a short talk about QE2 and its effects, which he reckons have been large and global. It’s “the most important single factor that explains why markets are where they are now”, he said. And it was always intended to move markets: the idea wasn’t to move long-term interest rates, said Rolley, but rather to create jobs by sending stocks up and the dollar down. That way companies can boost employment through trade revenues, rather than from money made by selling goods and services to overstretched US consumers.

The result, said Rolley, is that “inflation tolerance globally is being recalibrated”: the Fed has succeeded in giving markets a bit more of an inflation appetite than they’ve had in recent years.

That was the good news. As for the biggest risk to the system, Rolley said that a huge amount of the liquidity pumped into global assets by QE2 was finding its way, in one form or another, into leveraged bets that China will continue to grow at roughly a 9% pace. Which is a reasonable assumption — nearly all forecasters believe it, and Rolley’s no exception. But in the unlikely event that China doesn’t continue to grow that fast, there could be serious repercussions, with a flight out of risk assets and into safer areas like Treasury bonds and JGBs.

Right now almost no one is betting that long rates in the US and Japan are going to go down rather than up, and as a result there’s a technical bias for government bond markets to rally. At the same time, however, as Dan Fuss pointed out, long-term rates are going to revert to the mean sooner or later, which means a significant rise in yields which could happen quite suddenly and dramatically.

All of which is very good reason for individual investors to shy away from investing in the bond market directly, and instead pick a big and sophisticated bond fund. Managing risks in this market is really hard at the best of times, and pretty much impossible if you have less than a few billion dollars to play with.

And one last thought from Rolley, who said that he was wary of single-name credit default swaps because managing the counterparty risk was so onerous. If such swaps became centrally cleared, he said, he’d write a lot more of them. And what’s more, such a move would be good for the banks as well, since his counterparty exposure to them would fall significantly, freeing him up to buy things like Coco bonds from them. I doubt many banks in the CDS market would buy that argument, though.

Comments
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>>All of which is very good reason for individual investors to shy away from investing in the bond market directly, and instead pick a big and sophisticated bond fund.>>

Top bond fund managers announce investing in bond funds is a good idea. Who could have imagined that?

Posted by 3oosion | Report as abusive
 

Risk management with bonds is easy. First determine when you need the money. Then buy a Treasury or TIPS that matures at that time. If you’re holding bonds only to reduce short-term volatility, then buy t-bills. If you want some extra yield, buy high quality corporates or munis instead.

Felix, Big Mutual Funds has captured you with fancy lunches and sophisticated PowerPoints. There is a mountain of empirical evidence showing that bond managers do not increase returns or decrease risk, they just leach yield.

Posted by Stevensaysyes | Report as abusive
 

interesting comment from rolley on the single names.

cds should be centrally cleared and exchg listed for transparency & ctpty risk. it will be sometime until that becomes mainstream… the bid ask monopoly that banks have is just too profitable.

its amazing to me that more market participants havent demanded a restructuring in this arena. ICE is not enough to prevent the dominos from falling again.

Posted by chaetodon | Report as abusive
 

A “big and sophisticated bond fund”?!? C’mon, Felix, you are giving the money managers WAYYY too much credit here.

If you give the typical bond manager money, he will invest it in bonds that match the stated philosophy of the fund. This is not meant as a recommendation that those bonds are a good buy — it is simply carrying out your orders.

If you invest in a long-duration bond fund you will get long-duration bonds. If you invest in a bond index fund you will get a little of everything. In either case, you will get crappy yields that will get washed out at the first hint of rising rates.

And a 0.50% management fee might not seem like much, but it pretty much wipes out any hope you have of a positive real return in bonds. Might as well stick with appropriately laddered Treasuries (through TreasuryDirect or your broker) and skip the management fee.

Posted by TFF | Report as abusive
 

“… bets that China will continue to grow at roughly a 9% pace. Which is a reasonable assumption — nearly all forecasters believe it …”

Are you quite sure about that? Eichengreen might dispute you: http://papers.nber.org/papers/w16919. More generally, China has bought growth by driving investment rates to unprecedented levels; haven’t you noticed that many people think this is both unhealthy and unsustainable?

Posted by Greycap | Report as abusive
 

@TFF, what proportion of the population do you think realistically has the ability to construct an “appropriately laddered Treasury” portfolio and then manage it over time while paying less than 0.5% in fees?

Posted by FelixSalmon | Report as abusive
 

TIPS absolutely, 15-20 year maturity.

Posted by maynardGkeynes | Report as abusive
 

Felix, what % of the population do you feel has any chance whatsoever the instant they deal with anyone other than Treasury Direct, an FDIC bank, or maybe, maybe, Vanguard.

Posted by maynardGkeynes | Report as abusive
 

Just as most anyone can manage to buy an S&P 500 index ETF, one can purchase TUZ, VGSH or SCHO and have an “appropriately laddered Treasury” portfolio for 0.08% – 0.15% in expenses. This certainly beats the average investor guessing which high-cost manager has the best interest rate derivative strategy. The consumer seeking a big and sophisticated bond fund to manage risk just might end up with the next Schwab YieldPlus.

Posted by Stevensaysyes | Report as abusive
 

“Right now almost no one is betting that long rates in the US and Japan are going to go down rather than up, and as a result there’s a technical bias for government bond markets to rally. At the same time, however, as Dan Fuss pointed out, long-term rates are going to revert to the mean sooner or later, which means a significant rise in yields which could happen quite suddenly and dramatically.”

Ah, yields will probably go up, but b/c people think they will go up, they will probably go down, but because people think they will go up but really think they will go down, they will go up instead!

CDS is still shunned by most of the real money community, despite there being very good relative value b/c the technicals drive many names. Increased transparency and exchange trading will do little for the liquidity of the market. What will increase liquidity is to bring back structured products, or get real money to play again. Both of which are pipe dreams.

Posted by quantacide | Report as abusive
 

“@TFF, what proportion of the population do you think realistically has the ability to construct an “appropriately laddered Treasury” portfolio and then manage it over time while paying less than 0.5% in fees?”

Do you mean “ability” or “understanding”? This isn’t rocket science!! It is far more straightforward than much of what is taught in High School. Any college graduate has the ability to manage their finances intelligently, as well as many of those who didn’t make it that far.

Unfortunately personal finance is rarely studied at any level. Instruction in personal finance is controlled by the sharks who hope to feed off the results. They don’t lie, exactly, but they only tell you those portions of the truth that will benefit them.

The financial world has changed in so many ways over the last sixty years. Our financial education has not kept pace. Instead of urging people to trust Wall Street, you ought to be urging people to figure out how to manage their own money. There is literally no other effective solution.

Posted by TFF | Report as abusive
 

I would say Felix’s advice is as bad as his fashion sense.

Posted by M.C.McBride | Report as abusive
 

@TFF: Andrew Tobias’ chapter title from TOIGYEN, the wittiest and best written investing book ever: “Trust No One.” You are right IMO, there is no other effective solution. Suze Orman does a pretty good job delivering this message too. There is hope.

Posted by maynardGkeynes | Report as abusive
 

Some reasons that well managed bond funds with low expence ratios will outperform buying bonds and holding them to maturity:

Pimco or Vanguard can reach for “safe spread” the AVERAGE individual probably shouldn’t. While TFF, DanHess, and Felix could all probably do a great job at putting togeather a laddered bond portfolio; most individuals would have in all likely hood have been looking at the credit ratings that said that Lehman Brothers was a A-credit a year before it failed.

In a normal yield curve enviroment it does pay to “flip that bond.” If a 7 year corporate pays you 4% and a 2 year pays you 2% than rather than holding that bond the last 2 years you can sell it for 108 and reinvest the proceeds in a new bond. Funds are better equipt to do that than are individuals because they are going to get dinged less on transaction costs.

Most bond funds charge too much… no argument there… but Bill Gross actually earns his money. I’m most impressed with his brass-balled advice to get out of bonds… you know a storm is comming when the worlds largest bond manager says bonds are a bad deal!

Posted by y2kurtus | Report as abusive
 

y2kurtus, I stay away from corporate bonds for exactly that reason. The investments I manage personally are exclusively in stocks, Treasuries/TIPS, and CDs.

Corporate bonds may offer sophisticated investors a slightly better risk-adjusted yield than Treasuries, but I’m not sufficiently sophisticated to navigate that swamp and the 0.50% management fee almost certainly eats up that difference. Investing in Treasuries is cheap (literally *ZERO* expenses when buying at auction) and easy to understand.

Instead of corporate bonds, I aim for blue-chip dividend stocks. The yields aren’t that much lower and while the risk is greater, it is easier for an unsophisticated investor to understand.

“Flipping bonds” that are near their expiration is helpful for investors who want to maintain a longer maturity, but it isn’t an essential technique. IMHO, it isn’t worth the typical fees.

Posted by TFF | Report as abusive
 

Yeah, I also remember that nearly all forecasters were predicting a slowdown not a crash in real estate. I wonder who investors will blame when they realise that all their money has been stolen by communist party insiders – rhetorical question, we all know who is to blame when people make stupid investment decisions…..

Posted by Danny_Black | Report as abusive
 

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