and Fixed Income Outlook
December 11, 2012
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. This article originally appeared on the CFA Institute’s Inside Investing blog here.
Loomis Sayles is undeniably one of the pre-eminent names in the world of bond funds. Its flagship $22 billion Loomis Sayles Bond Fund has returned 10.07% annually over the last 10 years, beating the Barclays Capital U.S. Aggregate Bond Index by a remarkable 4.66% annually. The big name at Loomis Sayles is its lead manager and vice chairman Dan Fuss, CFA, but his co-manager, Matt Eagan, CFA, plays a crucial role in managing the Loomis Sayles Bond Fund and other funds.
I recently had the chance to catch up with Eagan to discuss the fixed income universe, issues facing the global macro economy, and his multi-sector global opportunity Loomis Sayles Strategic Alpha Bond Fund. This fund is a go-anywhere, multi-sector bond fund that is managed to deliver low volatility relative to core bond funds. Given the uncertainty in the bond markets from central banks and geopolitical risks (such as in the eurozone), it’s a very appealing fund.
What follows is a lightly edited transcript of our conversation.
Tell me a little about your background and your time at Loomis Sayles.
I’ve been at Loomis Sayles for 15 years, managing portfolios for 12 years. My background is on the credit side. I previously worked for Liberty Mutual covering investment-grade corporates, high-yield, and emerging-market sovereigns. I came to Loomis as a research analyst in the early 1990s, and one of the first sectors they gave me was oil and gas. A lot of risks and opportunities existed in the oil and gas industry, with oil falling to $10 per barrel. They gave me some telecom credits, and I was also able to recommend corporate debt trading at attractive levels during the Asian crisis, such as Philippine Telecom.
In addition to being co-manager on the Loomis Sayles Bond Fund (LSBDX), you manage the Loomis Sayles Strategic Alpha Fund (LABAX). Take us through the purpose, objectives, and strategy of LABAX.
This fund style is very eclectic. It’s a multi-sector, global opportunity set, allowing you to go anywhere in the fixed income space. We don’t look like the benchmark. It’s a long-short fund, and, at its heart, it is multi-sector. It has a lot of flexibility to go where there’s value. The objective is to generate LIBOR plus 2 to 4 percent per year. When LIBOR is very low, like right now, we are looking to generate a return of at least 6% net annually for our clients over a three-year horizon.
We provide investors with an explicit target of where we want to be in terms of standard deviation, which is 4% to 6% on average. We do this because when you give money to a multi-sector fund manager, you aren’t exactly sure what you’re getting in terms of volatility. We want investors to know what volatility they will be getting. Core fixed-income funds usually run about 4% to 5%, so it’s a bit of a step up from a core fund. But, at the same time, it’s a long ways from long-only multi-sector global credit-oriented strategies, which run volatility of 6% or even up to 8%.
Can you go into some more detail with respect to your risk management practices?
We can go up to 100% long or 100% short. We use interest rate, currency, and credit-space derivatives to move the beta around. I spend a lot of time with risk management to disaggregate different risk factors.
I’ve always looked at the three Cs (credit, curve, and currency) in this type of multi-sector portfolio. We can build the portfolio based on our top-down views and broad opportunities, or we can be purely alpha-focused and pick from a bottom-up perspective. When we put the portfolio together, we measure the market risk that is embedded in it. For every bond, we cut up the risks into term structure, credit, and currency risks. All of these risk factors can be separated and looked at independently, but they can also be rolled up so we can see how they covariate. For example, in the high-yield and investment-grade spaces, where we see valuations stretched or “fair at best,” we can dial down the beta by shorting some credit derivatives but maintain the long exposure. A long-only fund cannot reduce exposure without selling the bonds at the risk of never seeing them again.
How does this type of volatility targeting benefit the average investor, particularly in this low-interest-rate environment?
The challenge I see is that a lot of people are tied up in funds that are benchmarked to the Barclays Aggregate. Embedded in this is a high degree of interest rate risk, because a large percentage of the aggregate index is in U.S. Treasury bonds, agency debt, and agency mortgage-backed securities (MBS). So naturally, this has a high degree of sensitivity to interest rates. The Barclays Aggregate correlation with interest rates is approximately 90% or more. The Fed is forcing people to make a decision to move out in maturity or move into credit and take a different type of beta risk, such as high-yield.
Speaking of that, let’s talk about the high-yield, leveraged loan, and collateralized loan obligation space. The high-yield and leveraged loan markets have had a strong year, returning 13% and 9%, respectively, year-to-date. Issuance has exploded, as investors seem to be chasing yield as they are pushed out of government securities, such as agency MBS and Treasuries, into riskier assets. Issuance of high-yield bonds and leveraged loans combined totaled $580 billion through November, which already exceeds the previous annual record, set in 2007. Meanwhile, defaults in these markets have been below 2% for the past few years. How do you look at these asset classes?
I agree, and I think it’s very fair to view high-yield bonds and leveraged loans together. It all starts out with the business cycle. Where are we in the default cycle? We think we are past the best part of the default cycle. Defaults troughed last year well below 3%. It doesn’t get much better than this. The capital appreciation has run its course in the high-yield market. If you were just looking at dollar prices, yields are fully priced. High-yield never really trades higher than par plus half your coupon. We’ll assume the typical coupon is roughly 8% right now. Because of the call option embedded in these high-yield credits, you cap out at about par plus half your coupon (about 104 or 105).
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