“On paper it made sense (the experts’ advice to beware of bonds the past three or four years). In portfolios, not so much. In fact, the exact opposite occurred: Inflation failed to materialize, interest rates went down, and bond holders made money on their investments.”, New York Times
For Bond Investors, Ignoring Expert Advice Has Been Profitable
Chris Dillon, a global fixed-income portfolio specialist at T. Rowe Price, said global complexities complicated the debate. Credit Matt Roth for The New York Times
OVER the last three or four Januarys, the advice for investing in bonds has been remarkably consistent. It’s gone something like this: Beware of them, because inflation is going to rise, interest rates are going to spike and bond holders are going to lose enormous amounts of money. When it came to losses, comparisons were made to what happened to equities in 2008.
There were exceptions to this analysis, of course. But for the most part, this view was repeated year after year, with charts, graphs and reams of historical data marshaled in its defense. On paper it made sense.
In portfolios, not so much. In fact, the exact opposite occurred: Inflation failed to materialize, interest rates went down, and bond holders made money on their investments.
But for investors, knowing what to expect from their fixed-income portfolio is essential. Bonds serve as ballast for rough times.
This year, the call is for the Federal Reserve to raise the target rate midyear by a quarter- to half-percent and for trading to push the yields on the 10-year Treasury to around 3 percent. Will it happen? Maybe, but then again. …
Heather Loomis of J.P. Morgan Bank, said people are at risk “of throwing in the towel.”
Jonathan Mackay, senior markets strategist at Morgan Stanley Wealth Management, said recent predictions anticipated a normal recovery after a recession, which would have meant bond yields moving back to a range of 4 to 5 percent. The 10-year United States Treasury bond was trading this week around 2.2 percent.
“This doomsday scenario of significantly higher rates hasn’t happened,” Mr. Mackay said. “What firms got wrong, including us, is the pace of recovery has been slower than expected. Bond yields follow growth.”
But seen from another angle, the interest rate the United States has to pay to borrow money for 10 years is far higher than that paid by economies that are not as solid. This shouldn’t be. Germany and France both pay less than 1 percent on their government bonds; even weak economics like Spain and Italy have been paying less to borrow money, with both under 2 percent.
“People at this point are incredibly confused,” said Heather Loomis, director of fixed income at J.P. Morgan Private Bank. “This is the point where people are at risk of throwing in the towel.”
Ms. Loomis said there were at least three reasons for this situation. First, the global recovery hasn’t been consistent. Those low European borrowing rates have pushed investors in those countries to put their money into United States Treasuries, driving down the yield.
Second, the supply of bonds and safe fixed-income investments that investors could buy came down during the stimulus years. “You had the Fed buying 80 to 90 percent of all the paper, but the supply was remaining constant or falling in certain years,” she said of the Federal Reserve’s programs of buying Treasury bonds.
Third, that adage of never betting against the Fed hasn’t held true. “When the Fed says, ‘We’re going to raise rates,’ and they don’t, that’s also influencing rates,” Ms. Loomis said.
Of course, hindsight is perfect. Given the poor track record of recent predictions, how should investors think this year? “Money flows to the highest yield and that’s the U.S.,” said Marilyn Cohen, president of Envision Capital Management, which has $325 million invested in domestic bonds. “It won’t be exactly the same script in 2015, but it will sound very similar.”
She said that might not cheer United States investors who were used to much higher rates for decades. “Some mom and pops say, ‘Who would want 2.15 percent on our 10-year?’” Ms. Cohen said. “Everyone who is outside the U.S., that’s who.”
For investors worried about Treasury rates rising suddenly, Mr. Cohen advises clients to buy bonds with shorter maturities, like one, three and five years.
Chris Dillon, a global fixed-income portfolio specialist at T. Rowe Price, said this year could bring the return of the historical link between 10-year Treasury rates and gross domestic product not adjusted for inflation, known as nominal G.D.P. “That’s the alive and open debate for 2015,” he said. “What makes the debate more complicated is the complexities of what’s happening on the global stage.”
For example, conventional wisdom says that lower oil prices act as a stimulus to consumers, which is good because consumer spending makes up 70 percent of American gross domestic product. But Mr. Dillon noted that companies in the shale drilling and fracking parts of the oil and gas industry borrowed to expand their operations and now, with lower oil prices, they could struggle and hurt gross domestic product. Another weight on the economy could be if the nascent recovery in Europe petered out — or at least provoked anxiety.
“Ultimately, there is much uncertainty,” Mr. Dillon said.
Of course, Treasuries are far from the only type of fixed-income investment. Mr. Dillon pointed to bank loans, municipal bonds and, for at least this year, lower-credit-quality bonds for higher yields.
Mr. Mackay of Morgan Stanley, who says he thinks the Federal Reserve will not raise rates until 2016, is still counseling clients on taking credit, not rate, risk on their bonds. (Credit risk, for example, would be high-yield bonds, while rate risk would be a bet on how the yield curve on Treasuries might shake out this year.)
“You still want bonds, even though yields are going to be lower, as an anchor to your portfolio,” he said. “Inevitably you’ll get some clients who say equities have done well and that’s all I’m going to do. Down the road the equity market is going to collapse.”
Similarly, Ms. Loomis said she had been talking to clients about the need to manage their portfolios with fundamentals in mind, even though certain markets have not been obeying those rules.
“I’d rather say, ‘We didn’t make you an additional 50 basis points,’ as opposed to, ‘We were managing against this trend and it went against us and we lost you 6 percent,’” she said.
In a time of uncertainty for fixed income, unconstrained bond funds promote their flexibility. They don’t have to invest just in Treasuries, or in corporate bonds, or in any country or region. They invest in all of it as they roam the world searching for the best bonds. Some even add equitylike investments to the mix.
This is certainly true in some instances, but here skill matters: Just because a portfolio manager can roam the globe doesn’t mean he is roaming it in a profitable way, any more than a manager confined to one class of fixed income is good at assessing credit and rate risk in just those bonds.
David Hoffman, co-lead portfolio manager of Brandywine Global’s fixed-income strategy, runs an unconstrained global bond fund that since its inception has beat both the World Bond index and the Barclays United States Aggregate Bond index, according to Morningstar.
“We’ve done generally well because we’ve had the opportunity to select where in the world is the best area for bonds and not just select in one country and get the timing precisely right — that’s really hard to do,” Mr. Hoffman said. “More important for us is what we don’t buy. If you don’t own something, you don’t make money for clients, but you don’t lose money.”
But the style of these funds, even Mr. Hoffman admits, isn’t for everyone, particularly those investors concerned with how their investments are performing against a single benchmark.
Naturally, all of this thinking about fixed income may be wrong again this year — at least that’s the contrarian view of John E. Lekas, president and chief executive of Leader Capital and senior portfolio manager on the Leader Capital Total Return Fund.
“I’m going to tell you rates are going to stay low for a long time, longer than people think,” Mr. Lekas said. “Countries are not being allowed to grow organically because of free lunch programs.” Instead of inflation, he is worried about the risk of deflation, judging by indicators in the large and liquid markets for commodities, currencies and Treasury bonds.
“Those three pools of money tell me we’re heading to a slowdown and it’s going to hurt,” he said. “All of a sudden we’re going to get real pricing.”
His advice for this year is asset-backed floating-rate bonds because they have higher credit quality than similarly yielding bonds. But his biggest piece of advice, and one he employs in his own fund, is to have some cash set aside for fixed-income investments that appear during the year.
“If you’ve got the cash, you can really get ahead of the game,” he said. “If you don’t have the money to execute your strategy, it doesn’t really matter.”
As for who will be right, there’s only one way to know: Check back in 2016.
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