March 30, 2010The prevailing winds for interest rates are shifting. For three decades, interest rates were a tailwind, meaning the prevailing direction was down. This made life seemingly easy for bond investors since principal held up well and even grew for the most part. But, this was no free ride. The cost of this tailwind was steadily lower coupons. This re-investment rate risk is a bondholder’s worst enemy. One of the best ways to confront this type of risk in a bond portfolio has been to maintain a long duration with good call protection. That is what we have done in our multisector portfolios. The good news is that re-investment risk appears to be waning. The tailwind from declining interest rates is likely to reverse and eventually become a headwind. We see the world entering into a long period during which interest rates will rise on a secular basis, with cyclical interruptions every four or five years. Why might this be good news? The prospect for rising interest rates means bond investors can look forward to earning potentially better yields. The challenge will be to reach that higher level of yield while preserving, or even growing principal. We believe our multisector approach to investing is well suited to navigate the change in the prevailing direction of interest rates. Our current strategy revolves around four key themes:
1) maintain a yield advantage 2) maximize specific risk 3) minimize market risk 4) go global
THE ROAD TO RISING RATES
The question on the tip of everyone’s tongue is: What is the timing and magnitude of the move higher in rates? At the moment, we are in a transition period. There are still powerful disinflationary forces at work in the world economy, but the seeds for higher interest rates have been planted. Here’s how we see the first cycle on this road to rising rates unfolding.
Interest rates should begin to normalize in the early stages of this cycle. The primary source of disinflation right now is the significant amount of slack that exists in the global economy following the bursting of the real estate bubble. The Federal Reserve has used full force to confront the crisis and is essentially sitting on the US Treasury curve to prevent rates from rising too high and choking the economic recovery. It has accomplished this on the short end by targeting the Federal funds rate at, effectively, zero. Long rates have been kept down through quantitative easing (i.e. direct purchases of US Treasury and agency debt). These actions have helped revive economic growth. The Fed now faces the tricky task of removing its accommodative policies. We believe they will do so very cautiously. In our view, quantitative easing will be lifted first, followed by increases in the Fed funds rate, but probably not until late 2010 or early 2011. The main point is that rates will rise to a more normalized level as the Fed eases its foot off the gas pedal. Inflation pressures should remain benign at this point. As the cycle progresses, economic growth should flatten out for a time in response to the Fed’s less accommodative stance. However, the slack in the economy will eventually dissipate. Businesses and consumers will start spending more freely and the demand for loans will revive. This is when life can start to get really difficult for central bankers. The need to get ahead of or keep up with inflation grows, yet the political unpopularity of raising rates and snuffing out growth remains high. As such, the policy response is likely to lag. Tax increases and spending cuts tend not to keep up with an overall rise in spending. The Fed’s ability to be very tough on inflation is hamstrung by a need to consider employment. The upshot is that interest rates will likely begin to rise in earnest once the private sector demand for loans starts. The Fed will then be forced to tap on the brakes and eventually moderate the upswing, thus completing the first cycle of a multi-year upward trend in interest rates. DELVING DEEPER: WHAT DOES A BOND INVESTOR DO IN A RISING RATE ENVIRONMENT?
Our multisector strategies have the latitude to adapt to broad changes in market conditions. While the underlying investment process remains constant, the themes and securities that populate the portfolio shift as conditions necessitate. Again, the four ways by which we seek to position the portfolios for the possibility of higher interest rates are maintaining a yield advantage, maximizing specific risk, minimizing market risk, and going global. Let’s take a closer look at each of them. BUILDING A YIELD ADVANTAGE
Yield advantage is a powerful offset to the headwinds of rising interest rates. We strive to build portfolios with a significant yield advantage over what might be earned by a portfolio that is similar to, say, the Barclay’s Capital Government/Credit Index. Consider a hypothetical example using a single bond. In today’s market, assume we’ve identified a 7-year, BB-rated corporate bond, with a 7% coupon, that is trading at a yield-to-maturity (the percentage return paid if the security is held to its maturity date and coupons are reinvested) of 6.95%. Let us also assume that the bond’s coupon payments are reinvested at the stated rate of 6.95%, representing a roughly 400 basis point yield advantage over a US Treasury note with a comparable tenor. The US Treasury note has 4.625% coupon, and a yield-to-maturity of 2.97%. In a rising rate environment, that yield advantage is very important, here’s a hypothetical example showing why: Assume the yield of both bonds increases by 75 basis points, negatively affecting the price of each bond, as interest rates generally begin to move higher. The total return on the corporate bond after one year would be +3.49%, even after the rise in yield. The total return on the US Treasury note would be -0.75% after the rise in yield. Since the income received from the Treasury note was not sufficient to cover the capital loss from rising yields, the total return of the US Treasury was negative. In the case of the BB-rated corporate bond, the yield advantage provided greater protection against the rise in yields, resulting in a positive total return.
In addition, the spread, or risk premium, on the corporate bond of roughly 400 basis points could increase by an additional 93 basis points (which could happen if there were a negative credit development for the company, or a trend towards risk aversion in the market) before the return on the corporate bond would be equal to the return on the US Treasury note. See the chart below for a graphic representation.
The message here is that yield advantage can be an effective counter to rising interest rates, but the benefits of this yield advantage have to be weighed against the associated risks. Balancing these opposing factors can generally be done through proper risk controls, broad diversification and careful security selection. MAXIMIZING SPECIFIC RISK—A BOND PICKER’S MARKET
Security selection has always been at the heart of the multisector strategy. We approach each investment idea wanting to know its potential to produce a positive return. In our minds, a good bond picker is a good judge of specific risk. What exactly is specific risk? Every bond investment has a set of risk factors that drive its total return. There are risks associated with the broad market, like interest rate risk, spread risk and liquidity risk. These market-related risks explain some portion of a bond’s return. The remaining portion is attributed to specific risk, or the risk factors that are unique to that particular bond. Not all bonds are influenced by all risk factors. For example, a default-free US Treasury security is dominated by interest rate risk. Its return is highly sensitive to general changes in interest rates. On the other hand, the typical high yield bond is dominated by spread risk, and a change in the US yield curve tends to have little effect on its return. Any additional risk premium above and beyond these market risks is related to the unique circumstances of that bond’s issuer. We scour the markets for bonds that are dominated by specific risk. We then employ our deep fundamental research capabilities to judge if the risk is priced accurately. Risk can be mispriced for a variety of reasons. For example, the market might fail to see the possibility of a multi-notch upgrade to a bond’s credit rating, or the market could react in an overly pessimistic manner to a surprising headline. Our aim is to understand specific risk better than the market and to capitalize on any misperceptions. An experienced bond picker can often counter the headwinds of a rising interest rate environment. This requires a deep understanding of a company’s fundamentals and the ability to zero in on where the greatest impact may be felt in the capital structure. Company fundamentals benefit different parts of the capital structure. Our strategy will be to look where the cash flow is going—to the bottom line (equities) or to pay off debt (bonds). We have the flexibility to look at both. Research is essential and our analysts are hard at work doing the fundamental analysis that will be necessary to perform well in the current environment. We are currently on the hunt for securities with positive corporate fundamentals, including: • companies with strong market demand and a global reach, including emerging markets • fast growing companies that can deleverage and be eligible for upgrade • opportunities across the entire capital structure • new, innovative industries MINIMIZING MARKET RISKS—WHERE AND WHEN TO PLAY DEFENSE
Since we are focused on maximizing specific risk in our portfolios, it perhaps goes without saying that we also strive to minimize market-related risks. In a perfect world, we’d prefer a portfolio to have no market risk (i.e. 100% specific risk). In reality, this is impossible to achieve except in rare situations. As such, we do have to consider a portfolio’s sensitivity to market risks. Let’s focus on interest rate risk. Many financial textbooks teach that reducing duration is among the best prescriptions for protecting a bond portfolio from rising interest rates. However, this advice leaves out a couple of important points. First, timing is important. The slope of the yield curve is exceptionally steep at the moment (the 10-year US Treasury yields approximately 280 basis points more than the two-year US Treasury). Dramatically shortening a bond portfolio’s maturity therefore would carry a penalty in the form of a large yield give-up. Our interest rate outlook suggests it may be simply too early and too costly to significantly shorten duration at this point. While we have trimmed some longer bonds at the edges in recent months, we don’t believe another significant move is likely to take place until later in this cycle. The second point is that diversifying the sources of duration can reduce the sensitivity of a portfolio to any one market risk such as changes in the general level of US interest rates. Using duration as a measure of sensitivity assumes that all yields move in tandem. The multisector portfolio is comprised of securities with MAXIMIZING SPECIFIC RISK—A BOND PICKER’S MARKET
Security selection has always been at the heart of the multisector strategy. We approach each investment idea wanting to know its potential to produce a positive return. In our minds, a good bond picker is a good judge of specific risk. What exactly is specific risk? Every bond investment has a set of risk factors that drive its total return. There are risks associated with the broad market, like interest rate risk, spread risk and liquidity risk. These market-related risks explain some portion of a bond’s return. The remaining portion is attributed to specific risk, or the risk factors that are unique to that particular bond. Not all bonds are influenced by all risk factors. For example, a default-free US Treasury security is dominated by interest rate risk. Its return is highly sensitive to general changes in interest rates. On the other hand, the typical high yield bond is dominated by spread risk, and a change in the US yield curve tends to have little effect on its return. Any additional risk premium above and beyond these market risks is related to the unique circumstances of that bond’s issuer. We scour the markets for bonds that are dominated by specific risk. We then employ our deep fundamental research capabilities to judge if the risk is priced accurately. Risk can be mispriced for a variety of reasons. For example, the market might fail to see the possibility of a multi-notch upgrade to a bond’s credit rating, or the market could react in an overly pessimistic manner to a surprising headline. Our aim is to understand specific risk better than the market and to capitalize on any misperceptions. An experienced bond picker can often counter the headwinds of a rising interest rate environment. This requires a deep understanding of a company’s fundamentals and the ability to zero in on where the greatest impact may be felt in the capital structure. Company fundamentals benefit different parts of the capital structure. Our strategy will be to look where the cash flow is going—to the bottom line (equities) or to pay off debt (bonds). We have the flexibility to look at both. Research is essential and our analysts are hard at work doing the fundamental analysis that will be necessary to perform well in the current environment. We are currently on the hunt for securities with positive corporate fundamentals, including: • companies with strong market demand and a global reach, including emerging markets • fast growing companies that can deleverage and be eligible for upgrade • opportunities across the entire capital structure • new, innovative industries MINIMIZING MARKET RISKS—WHERE AND WHEN TO PLAY DEFENSE Since we are focused on maximizing specific risk in our portfolios, it perhaps goes without saying that we also strive to minimize market-related risks. In a perfect world, we’d prefer a portfolio to have no market risk (i.e. 100% specific risk). In reality, this is impossible to achieve except in rare situations. As such, we do have to consider a portfolio’s sensitivity to market risks. Let’s focus on interest rate risk. Many financial textbooks teach that reducing duration is among the best prescriptions for protecting a bond portfolio from rising interest rates. However, this advice leaves out a couple of important points. First, timing is important. The slope of the yield curve is exceptionally steep at the moment (the 10-year US Treasury yields approximately 280 basis points more than the two-year US Treasury). Dramatically shortening a bond portfolio’s maturity therefore would carry a penalty in the form of a large yield give-up. Our interest rate outlook suggests it may be simply too early and too costly to significantly shorten duration at this point. While we have trimmed some longer bonds at the edges in recent months, we don’t believe another significant move is likely to take place until later in this cycle. The second point is that diversifying the sources of duration can reduce the sensitivity of a portfolio to any one market risk such as changes in the general level of US interest rates. Using duration as a measure of sensitivity assumes that all yields move in tandem. The multisector portfolio is comprised of securities with different sources of market and interest rate risk. For example, non-dollar denominated securities do not have the same sensitivity to changes in US interest rates as US Treasuries. The important takeaway is that we believe the diversification embedded in our multisector portfolios minimizes the exposure to changes in US interest rates. Treasury Inflation Protection Securities (TIPS) are becoming a popular way to hedge against an inflation-fueled rise in interest rates. Our view on TIPS is that on a relative basis TIPS may outperform nominal Treasury bonds significantly. However, unless inflation ramps up very quickly in the next couple of years, we do not believe TIPS offer enough absolute return potential to warrant an investment. Given their low coupon, low yield, and the absence of a clear near-term inflation trigger in the markets, we would likely not utilize TIPS in our portfolios at this time. GOING GLOBAL Another way to sidestep inflation risk in the US is to gain exposure to non-US dollar denominated bonds issued by sovereign, multilateral or corporate entities. We are not necessarily universally negative on the US dollar. In fact, we think the greenback should fare well versus the other major reserve currencies, the yen and the euro, which are tied to countries with slower growth rates and weaker demographic trends. But we do see the US dollar adjusting lower to currencies tied to the faster growing regions of the world in Asia and Latin America. We favor the Australian dollar, the New Zealand dollar and the Canadian dollar, which are collectively referred to as “commodity currencies.” These small, resource-rich countries can directly benefit from any growing demand for raw materials coming from emerging markets. We believe building positions in sovereign and corporate debt denominated in these currencies can assist the portfolios by acting as a natural hedge against inflation expectations in the US. OUR LONG-TERM VIEW We continue to employ a process that analyzes each individual investment. We invest opportunistically, with a focus on long-term performance, canvassing many markets to find appropriate ideas for the portfolios. Maintaining a yield advantage will be very important in this new marketplace, however, the emphasis will shift to having yield advantage in the right credits. It has become true bond picker’s market, which makes research vital. As we enter this period, we are confident that we have the tools, expertise and historical perspective to continue to provide long-term value to our clients. Barclays Capital US Government/Credit Bond Index is composed of all bonds that are investment grade (rated Baa or higher by Moody’s or BBB or higher by S&P, if unrated by Moody’s). Issues must have at least one year to maturity. The index is rebalanced monthly by market capitalization. You may not invest directly in an index. This material is provided by Loomis Sayles for informational purposes only and should not be construed as investment advice. Investment decisions should consider the individual circumstances of the particular investor. Any economic projections or forecasts contained herein reflect subjective judgments and assumptions of the author and are subject to change at any time without notice. There can be no assurance that developments will transpire as forecasted. Historical data and analysis does not represent the actual or expected future performance of any Loomis Sayles product. Accuracy of data is not guaranteed but represents our best judgment and can be derived from a variety of sources.
(c) Loomis Sayles
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