A bond manager who says all the selling is a good sign
The biggest bond fund managers have watched assets bleed from their funds over the past four months. And it's not just Bill Gross of Pimco.
Take Loomis Sayles, which manages $170 billion of its $192 billion in assets under management in fixed-income strategies. Its flagship bond fund had outflows of roughly $1.4 billion from June through Sept. 9, according to Lipper—far less than the almost $8 billion that left Pimco's flagship Total Return Fund but a significant retraction.
You would think that a big bond fund manager might be bothered by the recent action—or like Gross, plead for understanding while pitching a "throw the kitchen sink at the problem" bond-investing strategy.
(Read more: The world's most expensive asset class)
Not Tom Fahey, associate macro strategist for Loomis Sayles. For one, he thinks the bond fund upheaval is a good sign for the economy. He also takes a measured approach to anxiety about the Federal Reserve tapering plans and rising interest rates. Yes, rates are going higher, but that doesn't mean investors' only move with bonds is to sell or make a wholesale change in their investing track.
CNBC recently spoke with Fahey about the Fed and bond market opportunities.
CNBC: What is more unprecedented, the Fed's long exit from the latest round of quantitative easing or bond investors' response?
Fahey: The reaction we have seen is typical of an environment when investors are trying to factor in when the Fed will be raising rates, yields rising, bond prices coming down.
Are people overreacting to how high rates will rise, how much they will pull off the QE gas? We're not thinking rates will go much higher from current levels when we look into 2014, maybe 3.5 percent at the end of 2014. Rates will be rising from here, but not as aggressive and in such a short time frame as we have seen. If we get to 3.5 percent, investors are looking at a real yield of roughly 2 percent and over the long-term in 10-year treasuries, that is quite normal. Given inflation just above 1 percent, rates don't have to go much higher to hit the equilibrium level.
CNBC: You've written that the way the Fed hinted at tapering was a "filthy pitch," more or less "brushing back" hitters who were crowding the plate. What did you mean by that?
Fahey: The filthy pitch was a reference to what I found confusing, or surprising, in the tapering talk. The Fed has two mandates: maximizing full employment and price stability. But there was a third element that crept into the talk—the level of risk-taking in the bond market. It looked like the thirst for yield driving interest rates lower on high-yield and emerging markets debt, along with the rise of 'covenant-light' bonds echoed the 2007 leveraging and huge risk appetite environment, and that popped into the Fed analysis.
They are missing on the inflation target by almost a full percentage point, and the same with the 6.5 unemployment target. So it's early to be thinking about tapering and they seem to be focused much more on a cost/benefit analyst of QE. So I find it more challenging to figure out where they are coming from.
If you recall the last two times QE ended, both happened to coincide with swoons in the economy and a larger bond rally in what was a risk-off environment. I'm not saying the end of QE was directly responsible for that risk-off environment, but it coincided with an economy that was still fragile. We're starting to see some real good traction in the economy in terms of housing. Every major post-war expansion has been led by housing, and housing market construction has an important multiplier effect. We're seeing real signs of life there.
CNBC: What happens to bond markets on the day that Larry Summers is selected as the next Fed chief?
Fahey: It's impacting the bond markets already. Summers is the favorite now, and I think the uncertainty of the Fed reaction function—how much more aggressive Summers will be compared to Bernanke, the perception that he might be more hawkish—is already impacting the market. Yellen and her policy—her views on QE and the state of the economy—are much better known.
CNBC: Bond managers have suffered outflows over the past four months, but you think the bond market action is a healthy sign? Healthy for whom?
Fahey: I think fixed income over the past five years been a big gravy train. We've been highlighting to our clients that 2012 was a bonanza for fixed income—yield up 15.8 percent, investment grade up 9.8 percent. It's clear that couldn't keep up, but what has surprised us is the change in rhetoric from the Fed and the uncertainty regarding the balance of their function between their mandated targets on inflation and unemployment, with the newer focus on risk-taking. Yields have adjusted here and maybe there is still a little more to go, but we've probably seen the worst for now.
The gradual rise in rates is a sign of a healthier economy and other assets doing better. That's not something to be feared. Investors are shaking their risk aversion. And as capital starts to reallocate out of fixed income, maybe it goes into capital investment projects, equities, or hiring more labor, and we get a more sustained economic expansion. It's a sign of healing from the global financial crisis and finally getting escape velocity.
Bonds aren't dead as an asset class. This is a valuation adjustment, and a healthy one. There's a growing demand for income, and the relative certainty of income that many fixed income assets can provide will always be attractive for investors. For some investors that yield threshold may be an interest rate of 3.5 percent on the 10-year Treasury, or maybe it has to be 4 percent for other investors, but the relative certainty of income makes bond investing attractive. It's similar to pension fund liability investing. You have future liabilities to fund, such as maintaining income in retirement or sending the kid to college, and that will continue to support fixed income assets.
CNBC: Where are the best opportunities today in the bond market?
Fahey: Right now, convertible bonds are doing well. Bank loans are offering a decent yield in the 5 to 6 percent range without interest rate risk. European high yield has done well. .... We're not a big fan of high-quality treasury bonds because we do expect rates to rise further. If you're a taxable investor you can look at municipal bonds which have been punished lately but might be crossing that yield threshold for some investors. Just one example, City of Boston municipal bonds are highly rated and the taxable equivalent yield for some issues is north of seven percent.
Overall, investors are looking to shorten duration, which is helpful when managing bond portfolios to reduce interest rate risk. High yield and investment grade can absorb a rise in rates given the spread over Treasury bonds, but our shorter-duration residential mortgage-backed and commercial mortgage-backed securities teams are seeing demand for their products because of the short duration, good credit quality, decent spread, and real estate market rebound.
Bank loans and securitized higher yielding rank as our favorite markets.
CNBC: Emerging markets have experienced a bloodbath. Is it a good entry point for emerging market bonds?
Fahey: EM currencies have been hit really hard. The asset class is looking more interesting, but as global demand and export growth have slowed, vulnerability ... will remain, and you really need to do the credit work. We still like Mexico as a conservative, fiscally disciplined market, and we don't think the peso is overvalued. There may also be additional foreign direct investment related to its energy market. And Colombia is going through some notable reforms. But it's an entirely different kind of asset class when you bring currency into the equation.
We look at China as being more volatile. It had this amazing run of growth with low inflation and a credit boom that facilitated it and now needs to slow that credit growth, and it will be a much more volatile economic environment. We're seeing it in commodities. The growth profile of the emerging markets has an underlying volatility, and the question of whether China can deleverage properly and smoothly will add to the volatility.The higher volatility is demanding a higher risk premium from investors and that is causing a valuation adjustment in emerging market asset prices. Eventually, emerging markets become relatively cheap assets, but that's a market where we are still waiting for our pitch.
CNBC: We haven't touched on Europe.
Fahey: Europe continued to move through different sequences of crisis, response, improvement and then complacency throughout 2011 and 2012. The central bank and policy makers have responded and worked hard to reduce the acute part of the crisis and now we see some improvement but we can't become complacent. We've always said that the European economic crisis is a chronic illness and the only way to cure it is through economic growth.
So it's wonderful that we are seeing the green shoots of recovery, but we need good solid growth to generate profits and incomes to service debt. It's not a green light flashing in terms of a healed Europe yet. But this is part of the sequence and will be with us for a long-time. We are more positive, but still cautious on how fast Europe can grow and whether they can generate sufficient profits and incomes to service the debts in the future. If that becomes suspect then Europe will hit the acute part of the crisis once again.
—By Eric Rosenbaum, CNBC.com