If there truly were a “bond king,” it would not be Bill Gross or Jeffrey Gundlach. It would be Dan Fuss, whose tenure in the fixed-income markets has spanned more than half a century. In a talk last week, Fuss warned investors to expect higher interest rates along with higher taxes.
Fuss spoke on October 22 at the CFA Institute’s fixed-income conference in Boston. Fuss is vice chairman of Boston-based Loomis Sayles and manages the firm's flagship Loomis Sayles Bond Fund (LSBDX).
“In the fixed-income markets, we have to deal with low rates and low inflation,” he said. “Both will rise. That is not a real good combination.”
This is not the first time Fuss has warned of higher rates. He did so in March 2015 and in October 2013, causing his fund to miss the full benefit of bond rally in 2014. In April 2012 he made a similar, but incorrect, prediction.
Nonetheless, LSBDX has performed admirably over the last 10 years, returning 6.73% and beating the AGG index by 2.05%, placing in the 8th percentile of its peer group, according to Morningstar data. Its performance this year has been less impressive, returning -3.32% and ranking in the 92nd percentile of its Morningstar peer group.
I’ll look at Fuss’ comments on the global economy and bond market and at his assessment of some asset sub-classes within the fixed-income universe.
The four Ps
As is his standard practice, Fuss reviewed the global landscape through his “four Ps”: peace, people, prosperity and politics – and a fifth dimension – the role of central bankers.
Peace – or lack thereof – dominates Fuss’ thinking. He expressed concern about developments in the Middle East and in Eastern Europe, but his greatest fears are with the developments in the South China Seas. Nonetheless, with regard to the latter, he said he was optimistic that issues with China will be resolved.
In terms of prosperity, his greatest concern is with the pending growth in the defense budget. He said it was “quite reasonable” when Defense Secretary Carter said “it’s about time to take the uncertainty away from the military so they know their budget.” That budget, according to Fuss, is “much too low to deal with the evolving situation in the word.” He said it’s been a long time – about 50 years – since the U.S. faced a gradual acceleration of defense spending, but it is about to do so now.
“Unless something really changes,” he said, “that will happen.” He forecast that defense spending as a percentage of GDP will increase by 1-3%.
Because of that, Fuss said the government will need more revenue. He warned that the tax on investment income will increase. He said that will carry implications for relative valuation between taxable and tax-exempt sectors in the bond market, but he did not say what those implications will be.
On the “people” front, Fuss said that across the developed world population growth is slowing or declining. Japan is the prime example because it is unable to maintain the size of its workforce population. In the U.S., he said, demographics will cause bonds to become more attractive than stocks for private-sector defined-benefit plans (and less so for public sector DB plans). Presumable, this will exert a downward pressure on rates, but Fuss did not say so.
Fuss was downbeat about political developments. He said it has become very difficult for Congress to deal with serious, time-sensitive issues like the debt ceiling. “Pressures are growing in the way our democracy works,” he said. He said there was a growing likelihood that the U.S. will go from a two- to three-party system, although the third party would not necessarily be led by Michael Bloomberg. “This will have an uncertain impact on financial markets,” he said.
“I have no idea what is going on in China,” Fuss said, “except that nature of government is changing.” He said that the power in Chinese government is consolidating to a smaller group of people, who are pursuing aggressive change. “History is not kind when it comes to centralization of power,” Fuss said.
Aside from quantitative easing, the major change Fuss has noted among central banks has been the extension of their mandates from domestic to international matters. That has happened over the last three to four years and most notably over the last two years.
Fuss recounted a significant development that happened in December of 2013 during ASEAN meeting in Tokyo. That was when the Bank of Japan established 10 bilateral currency swap lines with the other ASEAN members. This provided dollars or euros in the event of an unexpected currency outflow in those countries. It meant that Japan could lend money without those countries having to sell reserves. The fear, Fuss said, was that those countries would face a liquidity crisis if mutual fund or ETF investors decided to unexpectedly sell funds that held emerging-market assets.
Fuss said that in 2014 the Fed notes began to indicate that it was also considering issues such as the money flow out of Southeast Asia.
Bond market forecast
Fuss has no prediction for whether the Fed will raise interest rates. He acknowledged that there is “academic and industry pressure” both for and against a rate hike.
In the meantime, he said, the geopolitical situation carries negative trends for the bond market due to the budgetary needs of the military.
He said the risk in Asia is still high and advised investors to hold down exposures to those markets.
”Nothing would change the perceptions and the realities in the market more than a sharp change in the price of oil,” Fuss said. Even though the world is currently facing more-than-ample oil supplies, he said that a shock could happen if, for example, “Iranian speedboats torpedo a tanker in the gulf.”
Within energy-related credit, Fuss said there are “some bargains” if you assume $70/barrel oil, “fewer bargains” at $60, “a handful and a half” at $45 and “some even in the high $30s – but not many are left.” Valuations in high yield (excluding energy) have gone from “marginal at best” to “fair-value at best,” Fuss said.
Fuss likes bank loans “a whole lot more” than he did 10 months ago. But in general, he said, investors must be careful of protective quality afforded to lenders. He said the responsibility of the originating lender is unclear when so many loans have been re-bundled into CLOs. Those loans priced in the low 90s with good quality issuers are good substitutes for high-yield or even substitutes for BBB-rated bonds, Fuss said.
Emerging-market corporate debt (in local currency) can be a reasonable investment, but Fuss said investors should not rely on data from the ratings providers. Dollar-denominated bonds in those markets are very risky, he said.
Liquidity in the bond market is less than it has been historically, especially with on-the-run Treasury and corporate bonds. “This was unanticipated,” Fuss said, and has become a “big problem” with off-the-run investment-grade corporate bonds. Bonds can be sold, he said, but at an unacceptable price.
“Wall Street can no longer carry a huge amount of inventory,” Fuss said. “The regulators are at fault.”
Read more articles by Robert Huebscher
If there truly were a “bond king,” it would not be Bill Gross or Jeffrey Gundlach. It would be Dan Fuss, whose tenure in the fixed-income markets has spanned more than half a century. In a talk last week, Fuss warned investors to expect higher interest rates along with higher taxes.
