By David Schawel, CFA
is undeniably one of the pre-eminent names in the world of bond
funds. The 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. While the big name at Loomis Sayles is the lead manager
Dan Fuss, CFA
Matt Eagan, CFA
, plays a crucial role in managing the Loomis Sayles Bond Fund and
I recently had the chance to catch up with Matt 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 relatively low volatility versus core funds. It's a
very interesting fund given the uncertainty in the bond markets
from central banks and geopolitical risks (such as in the
: Tell me a little about your background and your time at Loomis
: This multi-sector bond 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 + 2-4% 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. In this
portfolio, we are going to provide investors with an explicit
target of where we want to be in terms of standard deviation, which
is 4-6% 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 4-5%, so it's a bit of a step out 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
more, even up to 8%.
: Can you go into some more detail with respect to your risk
: We can go long and short. We could go 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 are measuring 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 HY and IG, where we see valuations
on the stretched side 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 into this
is a high degree of interest rate risk because a large percentage
of the aggregate index is in U.S. Treasuries (USTs), agency debt,
and agency MBS (mortgage-backed securities). So naturally, this has
a high degree of sensitivity to interest rates. The Barclays
Aggregate correlation with interest rates is somewhere in the
neighborhood of 90% or more. The Fed is forcing people to make a
decision to move out into term structure 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 CLO (collateralized loan obligation) space. The HY and
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 USTs, into riskier assets.
Issuance of HY and loans of $580 billion through November has
already exceeded 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 HY 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 HY. If you were just looking at dollar prices, you
would argue that yields are fully priced. With HY, you never really
trade 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 HY credits, you cap out at about par plus half
your coupon (104-105).
: So you're saying the bonds are negatively convex here?
: Yes, they act 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, 10% bonds
into 5, 6, 7% bonds. We are at the point where the return profile
is very negatively skewed. The upside is basically your yield;
however, that's not something to sneeze at. A lot of people say
"spreads are still cheap at over 500 bps."
: I hear that a lot, too. I'd probably argue that, given how low
UST yields are, the spreads are less meaningful here.
: They are less meaningful to an extent. Compared with USTs, the
data indicate that HY is a very good income generator. I don't
think the credit cycle will turn hard here though. We are at a
point in the credit cycle that I'd call a "benign point," where
defaults just kind of 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 PIK (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 about the
credits you're in. It's become a bond pickers market here. There
are plenty of one-off opportunities. From a complete top-down
perspective, the most you'll likely get in HY 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 what PIK
deals will blow up on you, but they will come. The seasoning period
takes 2-3 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 HY absolute yield with CPI. If you
back out CPI and look at what your real yield is, you get a
CPI-adjusted yield. This gives you a result of 300-400 over, which
is well within the normal range in real terms.
: Is there any specific names you've been long or short that you
would elaborate on?
: In the credit space, we have been playing the convergence trade
in Europe. We started buying these credits late last year, focusing
on IG corporates - large names like Telefonica, Finmeccanica,
Telecom Italia S.p.A., and others (that is, IG names that are in
the wrong zip code by being in peripheral countries). What appeals
to us is that they 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 kind of 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 go to non-IG. But guess what? They're
trading cheaper than non-IG.
: So, are you guys 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 in
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 said, 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 ECB (European Central Bank) has seemingly thrown the kitchen
sink at the problems it has encountered. Do you think the "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 LTRO (Long Term
Refinancing Operation), 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 peripheral. It didn't
want the monetary transmission to be blocked to the peripherals.
That's how the ECB came up with the OMT (Outright Monetary
Transactions). 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 in enormously. We've been
long Spain and Portugal plus the IG corporates. So, we captured all
of that, and I think 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 I
think that's becoming more well-understood now. The complexity
comes from the political situation where the core doesn't want to
throw good money at 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 also 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 to say you can do this without
causing a crisis, but the lynchpin is the ECB. The ECB, through its
OMT, can keep the threat over the market from getting too unhinged
from the downside that you'd fall into 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
it, and it 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 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 is in a positive current account surplus
at this point. That's not because it is becoming competitive on the
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 its surplus happened is a collapse in the 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 they go about hedging tail
: A lot of it is trying to figure out how much 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 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. We
think 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
: I'm glad you bring up the central banks. As a portfolio manager
myself, I have seen first hand how much the Fed has impacted asset
prices through its QE (quantitative easing) programs.
: We are in the late stages of a "risk on" rally, and you really
want to fade it, as we know the underlying picture really hasn't
changed. There's been a shelf life for central bank activity.
They've 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 due to risks 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 through QE.
: I think that's a fair statement. I think the risk premium can
come down in equities and multiples can go up. The thing that
people may be misunderstanding is that QE-infinity does not have a
shelf life with a date. I wouldn't be surprised to see at the next
Fed meeting, that the Fed would buy more U.S. Treasuries as
Operation Twist ends. You'll probably see $40 billion of USTs in
addition to the $40 billion of MBS from QE3.
: What's interesting about another UST 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 them to become less negative and eventually positive? And does
the fact that they are negative here (except for the 30 year) imply
that the Fed is working?
: The Fed will move toward a targeting mechanism. They might
currently use inflation and employment 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 them
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. I think rates will rise on a secular basis from
here. The first cycle will be relatively benign from 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, there's a large percentage of market participants who
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. C&I (Commercial and
Industrial) 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 through draining the reserves or raising
IOER (interest on excess reserves).
: 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.
: I think it's some hubris that the Fed thinks it can do that. I
agree; I think those reserves will leak into the economy at some
point, although I can't tell you when.
Going forward, fixed-income investors should be cognizant 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 nature 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 ((
)). I like that in addition to having a great grasp of the
macroeconomic issues, 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.
Please note that the content of this site should not be construed
as investment advice, nor do the opinions expressed necessarily
reflect the views of CFA Institute.
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