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).
Are you saying high-yield bonds are negatively convex?
Yes, they are negatively convex. You aren’t able to generate high capital gains as yields start to come down further, because the companies will begin to refinance the debt out of 8%, 9%, or 10% bonds into 5%, 6%, or 7% bonds. We are at the point where the return profile is very negatively skewed. The upside is basically your yield; but that’s nothing to sneeze at.
A lot of people say spreads on high-yield bonds are still cheap at over 500 bps.
I hear that a lot, too. I’d probably argue that, given how low Treasury yields are, the spreads are less meaningful here.
They are less meaningful to an extent. Compared with Treasury bonds, the data indicate that high-yield assets are a very good income generator. I don’t think the credit cycle will turn sharply here, though. We are at a point in the credit cycle that I’d call a “benign point,” where defaults just bump along. Underwriting since 2008 has been relatively decent, and the use of corporate proceeds hasn’t been egregious. There’s been some silliness, but, by and large, it’s been okay, and it takes time for problems to surface.
We’ve started to see more and more payment in kind deals surface, but at what point do you start to say things have gotten too frothy? The technicals in spread markets are very bullish here. Net supply for spread products in 2013 is projected to be negative, even before accounting for the impact of the Fed’s purchases continually pushing people out the risk spectrum. What stage of the game are we at here?
We’re at a stage where you want to be very picky when it comes to the credits in which you invest. It’s become a bond-picker’s market. There are plenty of one-off opportunities. From a complete top-down perspective, the most you’ll likely get in high-yield is your yield. With silly season in underwriting just starting, it takes time as the seeds are being sown. The minefield is being laid for the next credit cycle to get worse down the road. You don’t know which payment-in-kind deals will blow up, but some will. The seasoning period takes two to three years before the defaults escalate.
Getting back to your comment about the benchmark being broken, another way of looking at the spread is to compare the absolute yield of high-yield bonds with CPI. If you back out CPI and look at your real yield, you get a CPI-adjusted yield. This gives you a result of 300–400 basis points over Treasury bonds, which is well within the normal range in real terms.
Are there any specific names you’ve been long or short?
In the credit space, we have been playing the convergence trade in Europe. We started buying these credits late last year, focusing on investment-grade corporates – particularly large names like Telefonica, Finmeccanica, Telecom Italia S.p.A., and others that are in the wrong zip code, so to speak, by being in peripheral countries.
What appeals to us is that these companies have a lot of financial flexibility. Look at a name like Telefonica: It’s one of the largest telecom companies in the world. It has holdings in Latin America, and you have a 70-billion-euro market cap below your debt as a cushion. Debt was trading at cents on the euro, with yields up to 8%, that is, trading as cheap as high-yield. We loaded up on those late last year and into this year. We had to take a longer-term view that the eurozone would not fall apart. We ran a sensitivity analysis on each country, and projected that, even if they left the eurozone, these credits would lose their investment-grade status.
But guess what? They’re trading cheaper than bonds that have never been investment-grade.
So, are you looking at what these companies would look like if their respective countries exited the eurozone?
I’m old enough to remember the Brady bond crisis, and I’ve approached the eurozone crisis the same way. You have too much debt, so you’ll see some restructurings. I’m always thinking about what my margin of safety is. If I can at least have a roadmap of the worst-case scenario of what it can trade down to, then I can make an intelligent decision about at what price it looks compelling. I don’t avoid situations. There’s always a price at which it makes sense. We took each country and put them into restructuring, and we asked, “What would it take to fix each country’s debt structure by knocking off a certain amount of debt?” I’m always thinking, at what price?
The European Central Bank (ECB) has seemingly thrown the kitchen sink at the problems it has encountered. Do you think the downside “fat tail” risk has largely been taken off the table?
There were two key announcements in Europe that have taken the fat tail risk out of play. The first was the Long-Term Refinancing Operation (LTRO), which took the systemic banking crisis off the table. The second was the ECB saying that it would not tolerate too high of a convertibility premium in the periphery. It didn’t want the monetary transmission to be blocked to the periphery. That’s how the ECB came up with the Outright Monetary Transactions (OMT). It has removed, to a certain degree, the risk of convertibility, such as Portugal and others leaving.
Now, you look at Portugal-type names, and let’s say maybe the embedded convertibility risk gets taken out and they start trading more in terms of a spread to core names – then Spain, Italy, and Portugal start to look attractive, and that’s what has happened from where we were in July. Spreads have ratcheted down enormously. We’ve been long Spain and Portugal plus the investment-grade corporates. So, we captured all of that, and there’s more to come.
The next thing that could come is a triggering of the OMT, but our underlying premise is that the eurozone will stick together. It’s more of a range trade. We think the convergence trade theme will continue with peripheral yields coming down and the core names selling off as the flight-to-quality bid fades.
Michael Pettis’ commentaries are among my favorite to read. He recently remarked that, “For now, Spain has implicitly chosen the option of unemployment, in the hopes that it will be able to adjust in one or two years and eventually resume normalcy. No country, after all, can bear the pain that Spain is bearing today without a serious deterioration in the social and political fabric. If Spain wants to continue along its current path, it must be prepared to suffer at least another five years of extraordinarily high unemployment, an erosion of the productive capabilities of its economy, and rising political chaos. Or it can leave the euro. Given how rapidly the political environment is deteriorating, I have little doubt it will leave the euro. Unfortunately we will have to wait a few more years for Madrid to drive the economy into the ground and to rip apart the country’s social fabric before they choose to devalue. But I fully expect they eventually will.” Do you agree with his assessment of the options?
I agree with what he’s saying. The policy decision of austerity is the wrong one for Spain, or anyone else in the periphery for that matter. Spain is facing a balance sheet crisis, and the last thing you need when the private sector is deleveraging is for the public sector to deleverage too. That is a policy mistake, and that’s becoming well understood now. The complexity comes from the political situation, where the core doesn’t want to throw good money after bad.
Germany has kept the pressure on these countries, not austerity for austerity’s sake but, rather, to make big structural changes and fiscal reform, moving toward fiscal centralization. They are trying to get countries to give up their sovereignty over their fiscal policy, which is a big leap for them to make, and broad labor-market reforms. That’s what Germany is really after; they are keeping pressure on these countries so they are forced to make the hard decisions.
It feels like some progress is being made, but, in my opinion, it will get worse politically and socially before it gets better.
Slowly but surely these policies are being enacted. They are playing a delicate game, and they need to be careful what they say politically. Pettis is right that it’s a dangerous game to play, as there’s a certain amount of hubris in saying you can do this without causing a crisis. But the lynchpin is the ECB.
The ECB, through its OMT, can keep the market from getting too unhinged to the downside and setting off a crisis. The funny thing about the OMT program is that it has worked well. Looking at Spain’s yields, they’ve come down without ever having to trigger the OMT, and the OMT has reduced borrowing costs. It has allowed Spain to not ask for the OMT. It’s a bizarre situation, but if push comes to shove, Spain will come back to the ECB and agree to the core government requirements. There may be some tests along the way, and it’ll go on for years, but eventually, the north will have some control over the budgets of the south.
Eventually, the current-account-deficit situation in the south will need to be repaired for true healing to occur.
We are already starting to see big changes in current account deficits. I think Portugal has a current account surplus at this point. That’s not because it is becoming competitive on its exports, like Ireland is, which is the poster child for positive reform. Portugal has a current account surplus, a knowledgeable workforce, and low tax rates. The other countries don’t have that; the way Portugal’s surplus happened was a collapse in its imports, and that’s not necessarily a good thing. But that does build the adjustment in. It will be painful, and the risk is that it can lead to social unrest.
You’ve said that your base case is for the eurozone to stick together, but how, if at all, should investors go about hedging tail risk?
A lot of it is trying to figure out how many of these macro risks are priced into the market. You don’t want to be hedged paying for insurance when the risk is already out there in the market. This time last year, the risks seemed high, but you were already being paid for it.
We are in a transition market right now. The global economies are deleveraging. The private sector debt has ended up on the balance sheets of the public sector. The public sector’s fiscal budgets are tapped out, and they are being forced, in the best case, to be non-stimulative and, in the worst case, to undergo some austerity. A weak private sector and a public sector with handcuffs on it mean that the underpinning impulse of the economy is very disinflationary. In Europe, you have the possibility of deflation in some places. The only reflation game in town is through the central banks, and they are doing their best to keep it going.
The way out is through reflation and debt monetization. Historically, they get solved through inflation down the road, as debt as a percentage of nominal GDP gets eroded or monetized away.
I’m glad you bring up the central banks. As a portfolio manager myself, I have seen firsthand how much the Fed has affected asset prices through its quantitative easing (QE) programs.
We are in the late stages of a “risk-on” rally. The effectiveness of Fed policy diminishes over time. The Fed has flooded the economy with money, and as risky asset valuations have gone up we have started to layer in hedges. We’ll go toward neutral in credit and take our beta down to zero. We won’t go short, because of the risk of getting hit by the Fed.
I’ll present a counterargument to that. Although many areas of the credit markets have rallied substantially, as measured by inflows, investors have not been pushed substantially into stocks yet, which is arguably one of Bernanke’s main goals with QE.
That’s a fair statement. The risk premium can come down in equities and multiples can go up. The thing that people may misunderstand is that QE-infinity does not have a shelf life with a date. I wouldn’t be surprised to see, at its next meeting, the Fed buying more U.S. Treasury bonds as Operation Twist ends. You’ll probably see $40 billion of Treasuries in addition to the $40 billion of MBS from QE3.
What’s interesting about another Treasury-bond buying program is that it would be balance sheet expansion. Operation Twist was “sterilized,” as they were selling one maturity and buying another. They were adding duration, but it was still sterilized.
Exactly. It’s pure balance sheet expansion.
Real yields have continued to go lower, and I’m waiting for the 30-year real yield to turn negative as well. What is the catalyst for those yields to become less negative and eventually positive? And does the fact that they are negative here (except for the 30-year) imply that Fed policy is working?
The Fed will move toward a targeting mechanism. They might currently use inflation and employment as dual mandates, but really what they are targeting is nominal GDP. They are distorting the yield curve very successfully. The idea is that they will keep long-term yields low until they hit their targets – closing the trillion-dollar nominal GDP output gap, which we think could take a few years.
The first impact would be that the yield curve will start to rise and steepen. It will steepen initially as the numbers get better. People won’t be looking for a certain date; they’ll be looking for economic forecasts. Rates will rise on a secular basis from here. The first cycle will be relatively benign on an inflation basis. It will be more painful from a real-rate basis as real rates move from negative to positive, and inflation will pick up more steadily after that.
In my view, a large percentage of market participants confuse base money supply and broad money supply. Bank loan demand has picked up, but it’s still extremely challenging here. Consumer and real estate loans are largely flat. Commercial and industrial (C&I) has picked up.
This is a key point. The money multiplier is not working right now. The money that is pumped into the banking system from QE is being stuck as excess reserves at the Fed and not lent out.
Lacy Hunt likes to say that the money multiplier is negative at the margin here. Would you agree?
Yes, I would. If they pump a trillion dollars into the monetary base, even if the money multiplier is negative, it will still expand nominal GDP at some level. Eventually, the deleveraging will turn around, and the private sector will start to borrow. You need to watch when lending starts to pick up again. That will be when those excess reserves start to leak out. The Fed is saying it will be able to rein that in by draining the reserves or raising interest on excess reserves (IOER).
I am not a big believer that IOER will be a very effective tool if things started to overheat. For instance, at the margin, I don’t believe lending decisions are being made over whether IOER is at 25 bps or 225 bps.
It’s some hubris that the Fed thinks it can do that. I agree; those reserves will leak into the economy at some point, although I can’t tell you when.
That’s all the questions I have. Thanks for your time.
Thank you.
David’s conclusion
Going forward, fixed income investors should be aware of the risks they are taking in their bond funds. Coming off of the heels of substantial gains in both government and credit bonds, investors need to understand the risk-reward tradeoffs that various fixed-income classes have going forward. Investors who are willing to look at alternative bond funds should consider the Loomis Sayles Strategic Alpha Fund (LABAX). In addition to having a great grasp of the macroeconomic issues, I like that Mr. Eagan has a strong credit background, which shouldn’t be underestimated in a time when yields are at all-time lows and competition for spread assets is so high. While this type of fund is not for everyone, it could be a suitable part of a portfolio for a fixed-income investor seeking attractive absolute total returns with low volatility.
Copyright 2012, CFA Institute, Reproduced from the Inside Investing Blog with permission from the CFA Institute. All rights reserved.
David Schawel, CFA, is based in Raleigh Durham NC and works as a fixed-income portfolio manager. His blog is Economic Musings and you can follow him on twitter at @davidschawel.
