Thornburg’s View of the Corporate and Municipal Bond Markets
|Christopher Ryon, CFA|
|Lon Erickson, CFA|
One of the core issues that advisors are confronting is whether U.S. interest rates have reached the end of the secular bull market and are beginning a long-term trend of higher rates. In a recent webinar, Jeffrey Gundlach said the bond market is “sniffing out” a long-term rise in rates. Do you share his views?
Chris: The thing I want to focus on are the risk metrics and how are they valued in the market. We are priced for the very best possible outcome and that will seldom happen. You have absolutely no cushion where securities are priced. Just look at the 10-year Treasury. If you see just a 25 basis point increase in yield, assuming the 10-year Treasury has a duration of approximately 7.0, you are going to give up a year and half’s worth of income in terms of capital loss. How many investors are comfortable with that at this point in time?
The yield curve has flattened dramatically as investors have moved out the maturity spectrum. This insatiable desire for income has caused people to take on more and more risk at higher and higher prices, and typically, that does not end well. I don’t know the timing of that event. But certainly, as Lon has outlined, going forward there could be some event that will cause rates to increase and the new marginal investor in fixed income will be extremely disappointed.
Lon: We don’t know when it will happen. A lot of bond market participants would have anticipated rising rates all along the yield curve already, and yet we haven’t seen it. We’ve just seen a continuous march downwards.
But the other part of that question is, how high? Perhaps we would generally agree that rates should be moving higher, but how high is the ultimate rate? Chris mentioned a 200 basis point real rate for the 10-year over the last period. Back in the 1990s, it was more like 350 or 400 basis points. But we are in a different economy here in the U.S. and globally. A lot of the developed countries economies are aging, so the demographics are in favor of a slower growth environment. That would say that we were not going to achieve the typical rates we have historically. The exact equilibrium point is anybody’s guess.
That idea is one reason, in our core bond portfolios, whether it’s the limited-term municipal or limited-term income, we like to run laddered portfolios. We get that refreshing of cash flows and we can redeploy along the yield curve where we see most fit, and that includes averaging into a higher rate environment.
Chris: Maybe we don’t get to the old norms. Maybe what we see is a 100 basis point real yield environment. That means investors should be thinking about losing four years’ worth of income rather than just one. When we say that the value metrics are such that the best possible outcomes are priced into the level of yields today, that probability of disappointment is quite high.
With the relatively slow growth in the U.S. economy and the persistently low inflation you mentioned, many advisors are questioning whether the Fed should raise interest rates. How high can the Fed raise rates before it would impair economic growth?
Lon: The Fed is a little bit behind the curve, not because we see rampant inflation, although there is some wage pressure. Some gauges are flashing yellow. That’s not to say it will spiral into an overall rise in core inflation. But when you look at the economy, people say we have a disappointing growth in the 1% to 2% range, even with the Fed targeting say at 1.8% long-term real GDP growth. But you still have inflation at 1.7% in the PCE. That argues for a low rate environment, but not 50 basis points, and maybe 300 or 400 is where you’d see it in a more typical recovery – definitely higher than 50 basis points. If they used the Taylor rule, in rate-policy-setting meetings they would argue for 1.2% to 1.5%.
The Fed has plenty of room to maneuver to get into the “normal spot” for this point in the recovery. The only reason people are worried is because the Fed hasn’t moved yet. The economy would argue for a bit more in terms of rates. We’ll get there. Fed will move slowly. The path will be shallow. It already is. Even if they move in December, it would be one move this year and one move last year. So one move a year is a pretty shallow path, and very digestible from an economic standpoint.
If we could get a little bounce in inflation, a little steeper curve and higher rates, it might help the financial system, not to mention more income for bond investors. It may be a temporary hit to bond prices but over time that reinvestment income at higher rates will provide them with a better income stream.
Chris: central banks don’t have to do anything to cause interest rates to increase. As Lon alluded to earlier, the 2013 taper tantrum was caused by Chairman Bernanke saying, “QE is not going on forever and zero interest rates may not go on forever.” You see the same thing happen currently coming out of the ECB as they talk about their exit strategies. It has caused rates to go up somewhat over the last week to 10 days.
How should advisors respond when clients ask about the impact of Fed policy on their portfolios?
Chris: Advisors should think about why they should have fixed income products in a well-diversified portfolio. The reason is quite simple; it helps diversification. In periods where we are now, where we have such high uncertainty, one of the best risk management tools an investor has is being diversified, owning stocks and bonds, because the bond portion of your portfolio will help dampen volatility in terms of monthly or annual returns.
The big risk is that over short periods of time all the correlations could go to one. If they do, everything is going to be going up and down at the same time. Advisors are going to have to be in a position to talk to their clients and help alleviate any potential panic.
Lon: Even if we do get a period where things are correlated together and go down, there is also the question of magnitude. The way we’ve positioned our portfolios is to lessen the risk if that should occur. We are staying shorter in duration. We’ve increased the quality of the portfolio so the credit risk component, within the historical range, is toward the low end. That would help in any adverse scenario.
When you think about bonds, maybe they don’t go down, maybe they go down just slightly. But that’s still a lot better than if your stock portfolios are going down say double digits. If your high-quality bond portfolios go down minimally, maybe a percent or so, that’s a diversifying effect, not to mention you would get income to spend on reduced-price securities that would help your overall longer-term investment process and portfolio positioning.
Chris: When you think about how your portfolios are positioned, you also should think about how they are structured. We ladder our core portfolios. We own a little bit of every maturity. That means we are diversified along the investment universe in each portfolio. That is one of the best risk-mitigating techniques for the period of uncertainty that we are in now.
One of the lingering issues in the bond market has been the lack of liquidity, particularly in the corporate and municipal bond markets where your funds are invested. What guidance do you offer to advisors who are fearful of liquidity in bond funds, particularly in the event of a period of heightened instability in the credit markets?
Lon: There is no way of getting around the issue that there is very low liquidity in many fixed income marketplaces at times. Liquidity is lower than pre-crisis, given banks’ capital restrictions. That said, we manage it in our portfolios in a couple different ways. We hold more cash than we typically would relative to pre-crisis. We also know very well within our portfolios what securities are most readily salable. It’s a pecking order, a liquidity waterfall that we are ready to act on, including starting from the very liquid Treasury market. There is some talk about how the Treasury market is less liquid. Perhaps that is true, but it is still an extremely liquid and very deep market. Then that gets us to some high-quality corporate and asset backed securities – all things that we believe can turn into cash pretty quickly.
The one nice thing about the way we construct our core portfolios is that we have a maturity structure that is designed for bonds to be rolled into cash. That helps mitigate that process as well. Even in our strategic portfolio on the taxable side, which is not in a ladder format, we are short in duration and have a lot of six-month to three-year-type maturity bonds that will help us manage that cash need as well.
We want to help advisors understand why we are positioned as such, not just relative to liquidity, but relative to all forms of risk. Our portfolios are very transparent. We buy only cash bonds in our funds and are very limited in the use of derivatives, so people can look at our portfolio and understand what risks we are taking. That helps advisors understand the difference between permanent loss of capital and temporary movements in pricing relative to a liquidity crunch.
Chris: One of the things that advisors should know is that they typically think, “Well, you are holding higher reserves. That must cost the portfolio income or performance.” Typically, reserves earn less than anything else you’ll find in the portfolio. On the municipal side, our reserve positions are those things that are called variable-rate demand notes that reset every day or every week and have liquidity functions so you can put them back to an intermediary and get cash every day. In March of this year, they were yielding one basis point. We thought that was cheap insurance then. But now as we approach October 14 and the new money-market regulations are about to be set in stone, the cost of that liquidity has been lessened dramatically because those variable-rate demand notes are now yielding 80 to 90 basis points. This is another example of how illiquid the market is.
As money funds have put these products back to the intermediaries, they are setting up for what they think is going to be a massive re-weighting of assets out of prime money market funds and into government money market funds. The intermediaries do not want to keep them on their books because the balance sheet space is so expensive. So they are raising the yields on those securities to clear the market so they don’t have to put them on their books overnight. It is great for us as investors, not so good for issuers who have big exposure to the short end of the yield curve.
Given this backdrop, I’d like to ask each of you, at a high level, where you are finding attractive risk-adjusted values in your portfolios. You’ve talked about the fact that you use a laddered approach, but how do you make decisions in terms of the way the portfolios are constructed?
Chris: I’ll start with how we put together the municipal bond portfolios. First, we take a top-down approach. We look at various risk metrics, real yields being one of them. We look at credit spreads. How much are investors getting paid to take credit risk? Prior to 2006, 50% of the new-issue municipal bond market was insured so investors weren’t getting paid to take a lot of credit risk.
After the financial crisis, credit splits spreads blew out dramatically; the spread between a 10-year AAA GO and triple-B revenue bond was about 300 basis points. Right now that spread is about 50 basis points, back to where we were prior to the financial crisis without an increase in insurance. There are no longer any AAA municipal bond insurers and municipal bond insurers represent 6% to 8% of the market. This is an example. As investors are stretching for income they are going down the credit spectrum at higher and higher prices.
We look at real yields, credit spreads and the slope of the yield curve. We decide what kind of credits we want to own. Where do we want to be positioned along the yield curve? We look to the primary secondary market for opportunities. We do basic fundamental, bottom-up credit research to see which type of securities will fit our credit profile that will provide the best chance of meeting the objectives of the portfolios as laid out in the prospectus.
We are keeping the portfolios at the bottom end of their relative-risk spectrums. That means we are keeping our duration low and credit quality high. We are finding the best value in terms of the credit spectrum, in general obligation and utility bonds in the high-A to low-AA rating category.
Lon: On the taxable side, our global fixed income process uses very similar approaches. Thornburg is very heavy on fundamental analysis and making sure you are getting paid appropriately for credit risk. We start with the general idea of saying, “Here’s the security. We do the fundamental work and understand if it really is just a good fundamental story. Do we like the risk presented by the assets and the cash flows?” If we say yes to that, then we look at relative value versus its own capital structure. We then look at a peer group, the portfolio and the opportunity set overall. If we say okay and this represents interesting relative value, we go on to the third step.
The third step is assessing the risk diversification this adds to the portfolio. Does it increase a risk position that we have? If so, is it better than something we own, so maybe we should sell that other piece? Or does it help diversify the portfolio further? If we can say “yes” and all those pieces come together, then we are wanting to invest.
Today, in a lot of those cases, we are falling down on the relative value piece. We just don’t see that we are getting paid to take a lot of risk, of any sort. When we are not getting paid to take risk, we are going to take less of it. Similar to what Chris just said, we have shortened the durations of the funds. Take the 10-year; it’s not producing any real rate of return. That doesn’t seem that intriguing to us. In addition, the term premium out 10 years is still pretty negative. That has a lot to do with what’s going on internationally; demand for U.S.-dollar securities is very high in the developed world.
We’ve increased the credit quality in our funds because of two things. One, if you look at corporate bonds, credit metrics have worsened while at the same time, because of the demand for yield, spreads have come down. Our compensation is less. Risk has gone up, so we are going to take less of it.
We have found ourselves with individual one-off credit stories that we still find attractive. We do buy those, but it’s a one-in-15 situation. We’ve tried to position ourselves in the front end. Over the last couple of years, we have positioned our high-quality portfolios with some floating-rate securities to take advantage of what we thought would be more of a rising rate environment.
As Chris mentioned, we have benefited from some of the money-market dislocation that has gone on. The banks were pretty big funders in the commercial paper market. That has dried up for them and has caused LIBOR to rise. It was at approximately 50 basis points, and then the money market dynamics drove it up to about 86 basis points. That positions it about the same place as the two-year U.S. Treasury. So we get less duration and about the same in rate risk, and then we add a little bit of credit spread on top of it. But this still is a place where your all-in yield is going to be somewhere between 1% to 1.5%. It is not a time to be taking a whole lot of credit risk. We are doing that with higher-quality securities across the portfolios we manage.
Chris: We have an inversion in the front end of the Treasury market. We are seeing the same thing in the municipal bond market. Variable-rate demand notes with daily resets are at 90 basis points. If you look at a AA-credit, you have to go out three to four years to get the same income. It doesn’t make a lot of sense for us. We’ll stay short and take on less duration risk and pick up the same yield.
Looking at the Thornburg Strategic Income Fund specifically, according to the latest data on Morningstar, it holds predominantly U.S. corporate bonds, and is overweight bonds rated BBB, BB or B. It has an average maturity of 4.8 years and an average duration of 3.21, both of which are lower than the benchmark. Have credit and maturity been the primary levers for your positioning of the portfolio?
Lon: As a static statement of the way you look at the portfolio today, that is true. I’ll make a few comments around how we think about those factors.
Clearly every portfolio is going to have a benchmark. But relative to a benchmark we are agnostic. It doesn’t drive our decision-making process. We are looking around the world trying to have a flexible perspective on relative value and how we achieve that. Coming out of the crisis, we had seen a significant opportunity in corporates, and so that had been built up to a significant position. From where we were a year and half ago, our corporate position has come down a bit and the quality of that position has increased. As we discussed, the payment for risk is lower, so we took a little bit of risk off the table.
To understand our positioning, you can look most explicitly at our cash holdings, which in this fund are a little over 10% and are countercyclical. When the market is roaring and yields come down, prices go up. Our cash position tends to build because we are finding less attractive value in the marketplace. We’re selling positions because they don’t make sense any longer from a risk-reward perspective. Our cash builds to allow us to be opportunistic should the market pull back. We did that in January and February, when the market got a little squirrely with what was going on with oil prices, as well as some of the things that China had done around its stock-market circuit breakers; that created some buying opportunities. At that time, our cash position went from approximately 10% to 11% down to about 6.5%. That was the kind of environment where we were getting paid to take risk, so we increased risk. But for the last six months all we’ve seen is a one-way trade, higher in price, lower in yield and lower in credit spread. We’ve taken some of that risk off and replaced it with some higher-quality asset backed and corporate bonds.
The triple-B and double-B space is something that we find attractive because it tends to be one of the spaces that is overlooked. Investment-grade funds don’t invest so heavily in triple-Bs because you’re one step from below-investment-grade. They tend to focus more on triple-B+, but also on As and AAs. Coming from the other end, high-yield funds tend to look further down the credit spectrum because they are more interested in earning more income and don’t pay as much attention to the double-B space. It’s still a fairly efficient market overall, but with some inefficiencies in those two ratings buckets because of those bifurcated investor bases.
Looking at the Thornburg Limited-Term Muni Fund, according to the latest data from Morningstar, the fund holds primarily AA and A bonds with an average maturity of 4.03 years and an average duration of 3.47. How has the composition of the portfolio changed since the financial crisis and what segments of the municipal bond market are particularly attractive now?
Chris: Let’s go back to where we were in the financial crisis and the measures we have from our risk metrics and how we position the portfolio. Real yields were hitting average levels at the beginning of the crisis, in 2008 through 2010. Credit spread had blown out. The spread differential between a 10-year AAA GO and a 10-year triple-B revenue bond was about 350 to 400 basis points. The curve was steep. We thought this was an excellent time to take risk. We were getting paid for it. In 2008, our limited-term portfolio had a duration in excess of four years. It was purchasing lower investment-grade bonds, and it was putting a lot of securities in that 10-year range of its investment universe.
As we went into 2009, markets began to normalize. We let our durations drift a little bit lower, but we were still getting paid to take credit risk. We were focusing on the lower investment-grade bonds. Then as we got into 2010 and 2011, Meredith Whitney was interviewed on 60 Minutes and told the world that the municipal bond market was going to implode. Everybody got worried about risk again. The curve steepened. Real rates increased. Credit spreads got wide. You got another bite at the risk apple. So we pushed our durations back out to four years, again focusing on lower investment-grade bonds.
Since that point in time, rates have been coming down. We’ve been evolving into a lower duration portfolio with higher credit quality, because we don’t think we’re getting paid a lot to take risk. So we’re taking less of it.
Lon: On the strategic-income side, our duration was right about 3.26. It’s a little bit lower than that today; it’s closer to three. But what’s important to realize about the way we position the strategic-income fund, and it gets to the point about being credit heavy, is that you can calculate a duration for any bond portfolio. It’s just a mathematical calculation. It’s really saying, “Okay, what’s going to happen to your price if yields move X?”
What most folks think about is what prices will do if the risk-free U.S. Treasury rates move. But that isn’t descriptive of the portfolio because in the strategic-income fund, the correlation of the risk-free rate to the overall portfolio is about .37 years, not 3.2. On an R-squared basis it isn’t that statistically significant. The reason is because the actual yield of the bond is comprised of two components: the risk-free rate and the credit spread. In good times the risk-free component increases, but at the same time, the credit spread declines. That is the dynamic that we’ve had in the strategic-income fund. The duration isn’t as descriptive as it may be for something more high-quality, like our U.S. government portfolio, or even our limited-term income portfolio, which is higher-quality and has more exposure to the risk-free rate.
One of the issues I’m sure advisors would like to hear about is the fate of the Puerto Rican bond market. Do you own any Puerto Rican bonds?
Chris: We do not own any Puerto Rican bonds in the funds and we have not since long before I got here.
The fate of Puerto Rico is anybody’s guess. As we do our credit work, we think fair value on the GO debt is half of where it is trading right now. It’s trading in the mid-60s. We think breakeven on that debt is somewhere in the mid-30s. We are not willing to commit capital to that area, to that security or any of the other Puerto Rican-related securities at this point in time.
I read a couple articles recently about how well those prices are holding up, but what the authors of those articles had neglected to say is that, subsequent to the July default, those bonds are trading flat, which means they are trading without accrued interest, which could represent at an 8% coupon or several points of all-in value.
One of the ongoing fundamental questions that advisors ask is whether they should build their own bond ladders with individual bonds or buy a bond fund. What guidance would you offer to advisors who are grappling with that decision?
Chris: I would ask them one thing, “How good a credit analyst are you?” Given what is going on in the municipal market in particular, doing fundamental, bottom-up credit research on an ongoing basis on your holdings is becoming more and more important. The cost of being wrong is so great. I’m sure that they may have other value-added things they have to do, rather than surveil their clients’ portfolios.
Buying a moderately priced, laddered portfolio with a lot of experience like the Thornburg limited-term portfolio is a better alternative.
Lon: Advisors could do that if they were buying a straight Treasury portfolio and were going to put an equal amount in a five-year ladder – 20% in each bucket – and just let it roll down and keep reinvesting. If you are able to maintain that discipline, that’s probably a good place to do it. But what’s interesting is even our limited-term U.S. government fund is all U.S. government-backed. We figure if somebody wants to buy a U.S. government fund that’s what they’re going to get.
But we do own government-backed mortgages and export-import bank bonds with sinking fund dynamics. There are components there that bring in other risks. Like with mortgage-backed securities, where you get prepayment, extension and convexity risk, things become harder to analyze. If you don’t have the time to analyze those components every day, then maybe it’s best left to someone who does focus their attention on that.
That’s how we spend most of our time, working from the bottom up, but also incorporating a top-down view of the overall market place and how we want to be positioned. That is ultimately what we get paid to do and the value that we add for our shareholders.
Chris: Depending on the total amount of money an advisor has to build a laddered portfolio for their clients, they could eat up a lot of potential return just on transaction costs if they are buying and selling small amounts of bonds. In a mutual fund we are going to take care of the accounting in terms of accretion of premiums and discounts, which have to go into the client’s tax returns. You also get daily liquidity at NAV at the end of the day, and that is an important feature.