How one pro navigates a bond market that looks like a minefield.
Safe. Steady. Sleepy. Those are the words investors used to utter when discussing bonds.
But now that two global economies are on the brink of default and much of the market is poised to lose value, the world of fixed income is looking more like a minefield.
If the Federal Reserve raises short-term interest rates this year as expected, the move could set off a period of rising interest rates that would lead to price drops for many— if not most— of today’s bonds.
Of course, figuring out exactly when the bond market will turn is as risky as trying to time the stock market— and typically a losing proposition. That’s why Elaine Stokes, a vice president at Bostonbased Loomis, Sayles& Co., a firm known for its global bond funds, isn’t stressing the timing.
After cutting loose many of the long-term bonds that would suffer the most severe losses if rates rise— with some exceptions for corporate bonds— Stokes, comanager of the flagship $23 billion Loomis Sayles Bond Fund, is “sitting back at base camp” with extra cash on hand, waiting for the market to readjust.
She recently spoke with The Washington Post about how investors should navigate the bond market.
What are you watching in the market right now?
There are three things I think you have to deal with. The first would be the Fed. The second would be the credit cycle and where we are in the credit cycle, specifically in the U.S. credit cycle. Although we are global investors, we’re U.S. focused right now. And the third would be liquidity of markets.
Howare you dealing with the uncertainty of when exactly the Fed will raise rates?
We believe that interest rates are going up eventually and the bottom line is the Fed desperately wants rates to be higher, they just don’t want to raise them. So how do we get there? By that day when the market is disappointed that you’re not going to raise rates, that’s when you raise rates.
So there’s a lot of talk that the market is kind of saying, “Hey, you can move things up, we’re getting pretty ready.” Not yet, though, because Greece is still out there; we just got through a bout of economic weakness. Things have bounced back as we expected them to, but it’s still fresh on our minds. There are things that are still hanging over us that don’t allow the market to feel real comfortable. It could be the time by September, but it could not be the time until the first quarter.
Howdo you characterize the market right now?
I liken what’s going on in the markets to climbing Mount Everest. If you go up the mountain, when you start getting toward the top and things become more dangerous, your body doesn’t adjust to the new atmosphere. So you have to go up, come back down to base camp and adjust. And then you can go back up. That’s where we are right now.
We just had commodities adjust. We had a very difficult first quarter. We had the dollar move, the type of move thatwe sawin ’08 and ’09. So not the type of move you would have expected in this type of environment. We’ve had huge spreads in high yield. There’s definitely kind of a sea change going on in the Middle East. It’s becoming more acceptable to believe that China’s growth is going to be slower for a long period of time. A lot of things have changed.
But if you just focus on the reset in commodity prices and the reset in the dollar, that’s not just something we’re just going to be able to follow through. They’re part of adjustments that are being made in the economy. So we’re sitting back at base camp, we’re waiting for the adjustments to happen, and then we’ll be able to get on with it again. Now how long will that take? I don’t know. Six months? Five? Four? Maybe we’re ready by the end of the year, maybe not. All that means for us in the portfolio is we need to be aware of that headwind and take interest-rate risk out of the portfolio and focus on credit risk.
Howare you going about reducing that risk? Are you avoiding bonds with certain maturities?
We have been reducing the interest rate risk and overall rate sensitivity in our portfolios by taking down exposure to higher quality (i.e, investment grade) positions. We are not avoiding certain maturities; rather, we have a barbelled yield curve position with our cash/reserve-type holdings in the short end and our “best ideas,” [including investment-grade and high-yield corporate bonds] in the longerdated maturities.
Are you holding more cash while you wait for the market to adjust?
The reserves have ranged from 10 percent to 15 percent over the past year, but are closer to 10 percent most recently.
What are some areas you’re adding to right now?
High yield. We are absolutely adding to high yield as of November through January. For us, high yield is yield, income. Some credit upside but a little bit more income. The spread compression we hope to offset the rising rates. The thing we are doing with our credit portfolio is focusing more on industries that have a secular trend, versus cyclically driven. Health care, technology, anything to do with wireless. Financials, I think, fall into that category.
What are some of the cyclical sectors youmay be shying away from?
I think within technology, there are parts of technology. Maybe PCs aren’t a place to be.
A true cyclical like chemicals. I think energy is a different story because of how cheap values are.
Let’s talk about that. When oil prices fell, it was something that was good for consumers in away but also threw the market for a loop, right?
It was such a dramatic move. When consumers started to feel money in their wallets, they didn’t feel like it was going to last. So they didn’t spend it. The heating bill went down, but you think it’s just going to come back up.
What is your perspective on oil, then?
It was definitely supply-driven. Weak global growth combined with all the supply coming on, it was setting up for a good [adjustment.] Our view probably didn’t change very much. We just went through it. We were at $100 [per barrel] and thought we were going down to $75, but it went down to $40. So I don’t know that our view changed that much but the value changed. And we started to add on.
Lastly, how much should we worry about Greece? How does that affect your everyday strategy at this point?
It doesn’t. If they do exit, we’ll see a reaction. We’ll probably see an outsize reaction in specific asset classes— the euro and peripheral bonds. but the fact that the Eurozone is already doing quantitative easing, I think, is a good thing.
So how do you position to be ready for whatever happens there?
We look at it as a relatively shortterm phenomenon. If there’s a reaction, that would be the kind of thing thatwe could take advantage of. Maybe that would be a good time to buy some European credit. It’s more of a wait-and-see approach to see what opportunities present themselves.
“We need to be aware of that headwind and take interest-rate risk out of the portfolio and focus on credit risk. ”
Elaine Stokes of Loomis, Sayles & Co.