August 29, 2014

Great bond investor Kathleen Gaffney says it’s been the quietest summer bond market in her 20 plus years of managing fixed income funds. Is this the proverbial calm before the storm? Have years of low interest rates lulled investors into another false sense of security? Gaffney, Portfolio Manager of the Eaton Vance Bond Fund, is concerned about risks in the bond world and has adjusted her portfolios accordingly. She’ll explain why she thinks bonds are fraught with risk and why stocks and cash are now a big part of her portfolios.

CONSUELO MACK: This week on WealthTrack, an investment world turned upside down – Eaton Vance’s great bond investor Kathleen Gaffney explains why bonds have become the riskier investment and stocks the safer one for income. Her unusual strategy for generating capital gains and income is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack.

For those of us living in the Northeastern United States the summer of 2014 will be remembered as one of the most beautiful in recent memory. The days have been mostly sunny and clear with little or no humidity and many nights have been cool enough to forgo air conditioning.

This nearly perfect climate has been reflected in the financial markets as well. Stock prices have gone up and the bond markets have been remarkably calm. Some would say eerily so.

This week’s guest, Great Bond Investor Kathleen Gaffney says it’s been the quietest summer bond market in her 20 plus years of experience managing bond fund.

Is this the proverbial calm before the storm? Have years of low interest rates lulled investors into another false sense of security?

There are risks out there.

The Federal Reserve has said it is winding down its unprecedented monetary easing policies of the last five years. Its massive Treasury bond buying program is ending. Expectations are that it will raise short term interest rates from their current record lows sometime next year as the economy and employment continue to improve. One key indication of how complacent bond investors are about potential market risks is illustrated by this graph which shows how the difference or spreads between yields on risky junk bonds and those on top quality U.S. Treasury bonds have fallen to the lowest levels since before the 2008 financial crisis.

In layman’s terms investors seem to be willing to pay high prices for small rewards on risky debt, providing very little cushion if the market weakens. This week’s guest is worried about risks in the bond market and has adjusted her portfolios accordingly.

She is Kathleen Gaffney, Co-Director of Investment-Grade Fixed Income at Eaton Vance and the lead Portfolio Manager of the Eaton Vance Bond Fund, which she launched in January of 2013. The fund has beaten its Morningstar multi-sector bond category and market benchmark by wide margins over the last year, putting it in the top one percent of its competitors.

Until 2012 Gaffney was Co-Portfolio Manager of the Loomis Sayles Bond Fund with legendary bond investor Dan Fuss where their team was awarded Morningstar’s Fixed Income Fund Manager of the Year.

I began the interview by asking Gaffney to explain the biggest puzzle facing bond investors today – why interest rates have remained stubbornly low.

KATHLEEN GAFFNEY: When you look around the US in particular, I see a pretty strong economy. That’s good news. Rates should be higher. But there are some technicals going on and there are weaker fundamentals around the globe that are impacting US Treasuries.

CONSUELO MACK: What do you mean by technicals? What are the technicals that kind of can explain, you know, the subdued interest rates that we’re seeing in the US?

KATHLEEN GAFFNEY: Well, part of it is tapering itself.


KATHLEEN GAFFNEY: The Fed. Even though they’re buying less, as a percentage of Treasury issuance they’re buying more.


KATHLEEN GAFFNEY: So it’s hard to let interest rates go up when they’re participating at such a significant level.

CONSUELO MACK: So the supply of Treasuries has actually gone down as the deficit’s gone down, so the Treasury doesn’t need to finance as much.


CONSUELO MACK: So the supply treasury is going down, and even though the Fed is buying fewer bonds every month, their percentage of the treasury market is still huge?


CONSUELO MACK: Wow! I had no idea.

KATHLEEN GAFFNEY: So that’s keeping treasury yields low, and then you’ve got the carry trade. Who would have thought that US Treasuries would be part of the carry trade?

CONSUELO MACK: Right. Now explain the carry trade to our viewers.

KATHLEEN GAFFNEY: That you can pick up yield going from German Bunds, so their government bonds …

CONSUELO MACK: They’re about at one percent.

KATHLEEN GAFFNEY: Yep. We ticked just below recently, and the ten year US, 240 today.

So you’re picking up 140 basis points, AAA credit rating.

CONSUELO MACK: So people are borrowing in German Bunds, is that the way it works? And then they’re buying the Treasuries…

KATHLEEN GAFFNEY: And picking up yield.

CONSUELO MACK: … and picking up this yield. Now could those technicals … how quickly can they go away?

KATHLEEN GAFFNEY: Well, the challenge is what’s going on in Europe. You’ve got some really serious deflationary trends, and the geopolitical risk is adding to that issue.

CONSUELO MACK: You mean Ukraine, Syria, Iraq …


CONSUELO MACK: All of this stuff. Russia.

KATHLEEN GAFFNEY: Very important. Europe exports a lot to Russia. A weak Russian economy is going to be bad news for Europe, and that’s why yields in Europe are so low.

CONSUELO MACK: Even though the Fed is tapering and it’s not working out the way we thought it would, could it be that we are in for a prolonged period beyond what we’ve all thought of low interest rates?

KATHLEEN GAFFNEY: I hope not, and I don’t think so, mainly because I think there’s a lot of dynamism in the US economy. When I’ve been out on the west coast you see cranes everywhere. You see them in Boston, too. There’s a lot going on. It’s technology, it’s energy, and that I think is going to fuel our growth. We’ve been seeing lots of steps towards normal recovery. The recent M&A activity is one sign.

CONSUELO MACK: Right, Merges and Acquisitions, very active.

KATHLEEN GAFFNEY: Very active and usually after that you start to see corporations actually investing in spending. Good old capital expenditures. When that picks up, that has the potential to get a little bit of inflation going, but good inflation. The potential for wages to grow, and that would be great. And I do think that there is tightness in areas of the labor markets, particularly highly skilled areas like technology. Math, science, engineering. There’s a great demand for that. It’s going to take some time to fill that pipeline, but I think companies are thinking about different ways to get those skills now, and it might mean investing in people.

CONSUELO MACK: And therefore if wages pick up, the Fed will then feel much freer to raise interest rates.

KATHLEEN GAFFNEY: Exactly. Positive feedback loop that we’re all looking for.

CONSUELO MACK: Therefore, Kathleen … the low interest rate environment that we’ve had has really had an impact on the financial markets. What is the impact it’s had on the bond markets?

KATHLEEN GAFFNEY: It’s had a big impact, because most people think of bonds, it’s fixed income.


KATHLEEN GAFFNEY: Where do you go to get your income? You go to the bond market, but Treasuries yielding one, two percent, that doesn’t get you very far. So investors have been reaching for yield, going into the traditional credit markets, so investment grade, high yield bonds, that’s a way to pick up yield, get that income coming in. But there’s a trap there, because rather than being credits, companies, you are taking on rate risk, because it all boils down to what’s your coupon, what’s your maturity, and if rates start to rise, they’re going to adjust by prices going down.

CONSUELO MACK: Therefore, unless you hold bonds until maturity, that you are going to suffer the loss of principle.


CONSUELO MACK: And that’s going to hurt a lot of investors. You have been managing the Eaton Vance Bond Fund since January of 2013. You launched it. And you’ve managed to negotiate all of these land mines very successfully, I might add. So what have you been doing in the last, you know, year plus?

KATHLEEN GAFFNEY: Focusing on company fundamentals, because the fundamentals are positive, I believe. Lots of companies generating good cash flow. It’s a question of valuations. Where are there more attractive valuations? To be honest, I think it’s closer to equities, and that’s why with Eaton Vance Bond Fund, we do have flexibility to use equities. And I’m thinking of those positions as great alternatives to expensive and potentially negative return generating securities as a good alternative to those types of bonds.

CONSUELO MACK: Of course traditionally the bond market has been considered to be less volatile, and as you just said it’s considered to be kind of a volatility dampener in your portfolio, and it’s been considered to be an income vehicle and kind of stodgy and boring but reliable. And stocks have been the high risk asset, because there’s no underlying kind of floor on how low a stock price can be. Has that dynamic changed, do you think?

KATHLEEN GAFFNEY: I think it’s changed very much.


KATHLEEN GAFFNEY: A great example in the market today would be Caterpillar. So a well-known, solid company. The equity pays two and a half percent in terms of its dividend yield. You look at where Caterpillar bonds are trading at comparable yields but with significant downside risk when rates rise. Caterpillar has been issuing bonds recently. They’ve actually tapped the market with 50 year maturity bonds.

CONSUELO MACK: Which is incredible to me. That is very unusual in the U.S. corporate bond market.

KATHLEEN GAFFNEY: There’s a lot of demand for long dated bonds. It’s a great deal for Caterpillar but not for those bond holders if their term to maturity is less than 50 years. So I would rather own the equity with a dividend yield of two and a half percent and capture the upside because the valuation is more attractive. Valuations in the traditional credit markets are extremely overvalued.

CONSUELO MACK: Talk to me about liquidity in the bond market. I can remember talking to you when you were at Loomis Sayles during the financial crisis and the fact that liquidity had completely dried up in the bond market, which was really unprecedented in our lifetimes. What’s the liquidity situation now? The ability to buy and sell bonds in volume.

KATHLEEN GAFFNEY: It’s been reduced significantly.

CONSUELO MACK: And why is that?

KATHLEEN GAFFNEY: Well, it’s human nature. We had a terrible event with the financial crisis in ’08, so the regulators were committed to correcting it. But as we all know from history, sometimes what you do to make a correction feeds a new problem.

CONSUELO MACK: Right. Law of unintended consequences.

KATHLEEN GAFFNEY: Exactly. And what’s happened is that with financial regulation, broker dealers, Wall Street, has pulled capital, the capital that really made it easy for investors of different kinds to buy and sell to stand in the middle and make markets. Because they are committing less capital … 2007, 200 billion, and today inventory on the Street is running around 40 to 50 billion.

CONSUELO MACK: Oh my goodness! That is a tremendous drop.

KATHLEEN GAFFNEY: So it makes it very difficult to trade. What’s interesting about today is that most of the market wants to buy bonds.

CONSUELO MACK: Yes, and why is that? Why do they want to buy bonds?

KATHLEEN GAFFNEY: Search for yield.


KATHLEEN GAFFNEY: You can’t get an attractive yield in Treasuries. You’ve got everyone buying bonds. Well, that works for as long as companies want to issue and there’s been supply. The question is what happens when rates start to go up and investors look at negative returns? They’re going to think very differently, and then you have a market that is all sellers, but buyers who are far below that market. And the high yield market is really very much at risk I would say because the marginal buyer, the new buyer, someone like myself would be coming in at a price that’s much lower than where we are today.

CONSUELO MACK: Therefore so the declines that you might see in the bond market, it’s not just going to be based on fundamentals; it’s going to be based on what’s happening, the dynamics in the market itself for buyers and sellers.

KATHLEEN GAFFNEY: That’s the irony of it all, because we’ve all been waiting for signs of significant strength in the economy and for rates to move higher, which is a positive backdrop. But in that transition from low rates to high rates, really the short end of the yield curve moving up, that’s going to create some turbulence, and it could be significant turbulence because of that lack of liquidity. And that’s what I think investors may not be prepared for. It might look and feel a lot like 2008, yet it’s really good news that the economy is strengthening. That’s where I think there’s a huge opportunity ahead.

CONSUELO MACK: There is a positive to this? (Laughs)

KATHLEEN GAFFNEY: I’m always looking for where that positive opportunity is, so as a value investor I don’t see a lot of compelling value in the traditional fixed income markets today.

CONSUELO MACK: Neither in the Treasury or the corporate markets.

KATHLEEN GAFFNEY: Exactly. So what I’ve been doing is building cash. Cash today stands around 20 percent, and at some point …

CONSUELO MACK: And give me a sense of what 20 percent is. How defensive is that for you?

KATHLEEN GAFFNEY: It’s very defensive.


KATHLEEN GAFFNEY: Typical cash position would be five percent, so it’s a high position, and it could get higher if we stay with very low rates and corporate bonds look less and less attractive. But at some point, and history tells me that the market will correct and re-price. I think the economy is moving in the right direction, rates are going to rise. As the market re-prices, there’s going to be a great buying opportunity. There’s a lot of cash on the sidelines. In the last couple of weeks we’ve seen a bit of a re-pricing in the high yield market when there were outflows.

CONSUELO MACK: Yes, and when you say re-pricing, (laughter) you mean that bond prices in the high yield market … jump-ons went down significantly.

KATHLEEN GAFFNEY: Yes, that was a great opportunity to add. It didn’t last very long. You’ve got to jump in and be ready exactly when that selling pressure begins.

CONSUELO MACK: As far as other assets that you can buy, and the Eaton Vance Bond Fund, again you launched it in January of 2013, and so you were able to create it with the kind of mandate that you wanted, and so you call it a total return fund with broad flexibility. Do i have the right lingo down?

KATHLEEN GAFFNEY: Yes. It’s a multi-sector bond fund that has broad flexibility to go into lots of areas of the fixed income markets as well as the ability to go into the equity markets up to a maximum of 20 percent.

CONSUELO MACK: And I know that you also have other restrictions, so you can have, what, more than 35 percent below investment grade bonds, for instance?


CONSUELO MACK: So you’re not in this new hot category called unconstrained bond funds. You have constraints, but you’ve got a fair amount of flexibility.


CONSUELO MACK: What are the other things that you’re doing that would be different than a typical traditional bond fund?

KATHLEEN GAFFNEY: what’s different right now is I do think it’s a good time to take credit risk, but i’m defining it a little bit differently. So credit risk to me is good corporate fundamentals, a little bit more equity like, so we’re using equity sensitive concerts.

CONSUELO MACK: Convertible bonds. Uh-huh.

KATHLEEN GAFFNEY: That’s a great way for me to use that high yield flexibility, but not with traditional high yield but in bonds that are rated below investment grade but have an equity option. They’re going to respond more to changes in the underlying equity price. That to me is a more attractive sector of the market and gets me better diversification away from the traditional high yield market.

CONSUELO MACK: What about preferreds? Are you doing preferred stocks at all?

KATHLEEN GAFFNEY: We’ve got a few preferred stocks. Not the new issue preferreds that the market is more enthralled with, but looking for fixed to floating rate preferreds that are trading at a bit of a discount. It means you’re going to give up a little near term income, but you’ve got better total return potential when those securities actually start to float. So I’m looking at preferreds that will float in two to three years, not in ten years.

CONSUELO MACK: And total return, I should remind us, is capital appreciation plus the interest or income.

KATHLEEN GAFFNEY: Yes, more than one thing working for you.

CONSUELO MACK: Yes. And what about currencies?

KATHLEEN GAFFNEY: Currencies I think are going to be a good place to be down the road. We’ve got about 12 percent of the fund in currency right now, balanced between developed world and emerging markets.

CONSUELO MACK: And which developed and which emerging are you emphasizing?

KATHLEEN GAFFNEY: In the developed world we’re in Canada and New Zealand, so high quality commodity currencies. I do think there’s good global growth that’s going to continue. That doesn’t mean that commodity prices are going to stay down in the dumps forever. There still is strong growth.

CONSUELO MACK: So that’s the value investor in your again …


CONSUELO MACK: Where the commodities are sold off and therefore you’re into the currencies that are affected by commodity prices because they’re exporters of commodities.

KATHLEEN GAFFNEY: Exactly. And in emerging markets where I do think country selection becomes more and more important, because these countries are adjusting to rising rates in the U.S. and maturing as countries themselves, meaning they need to establish good economic policy. So where is the reform going to come from? Strong political leadership. We’ve seen that in Mexico, and I think that’s a country that has good value and appreciation potential with their currency. Also in India, which is interesting. India’s benefitted from the currency depreciation from tapering talks last year, and that cheaper currency started to play out in shrinking the current account deficit. You’ve got a western educated banker in Rajan. And then Modi, who was known as a reformer, actually achieved a landslide victory, which gives him a very true mandate to put reform through. So if India’s going to do it, now is the time, and at yields of seven and a half percent, a very compelling non-U.S. opportunity.

CONSUELO MACK: And if you invest in currencies, how do you do it?

KATHLEEN GAFFNEY: I look for bonds.

CONSUELO MACK: You do. Government bonds? Is that where you’re investing in? Or you’re investing in bonds denominated in their currencies?

KATHLEEN GAFFNEY: With india, it’s in super national, so the bonds are actually a subsidiary of the world bank. So AAA credit, but denominated in Indian rupee. The World Bank is committed to helping some of these markets open up, and one way to do that is by issuing debt under their credit but in another currency.

CONSUELO MACK: And are those liquid? Depends?

KATHLEEN GAFFNEY: It depends. You’re going to pay a liquidity premium for them, but at seven and a half, eight percent, I think you’re compensated for those risks.

CONSUELO MACK: There’s been a huge move, as you know, from actively managed funds such as yourself, to passive index funds. What’s your view of bond index funds at this point?

KATHLEEN GAFFNEY: I don’t believe they offer a whole lot of value. The bond market is a very different market, and particularly with the liquidity issues that we’re currently experiencing, it’s very difficult to actually replicate an index and be able to mimic the returns there. I think you can add far more value with active management on the fixed income side.

CONSUELO MACK: And what about the U.S. Treasury bond market, Kathleen, which has been the safe haven by investors all over the world?

KATHLEEN GAFFNEY: I think it will remain a safe haven, but with a fair amount of volatility, which means a portion of your fixed income, a small portion, should be there for those more turbulent times.

CONSUELO MACK: Because of the liquidity … that you can get in and out easily.

KATHLEEN GAFFNEY: Exactly. However, if we’re into a secular rise in interest rates, you’re going to want to stay far away from them as they transition from the very low rates today to where they’re headed, at least in this next cycle, which might be somewhere in the five percent area.

CONSUELO MACK: We at the end of every wealth track ask our guests for their one investment for a long term diversified portfolio. What would you have us on some of?

KATHLEEN GAFFNEY: I think today’s best investment is cash.

CONSUELO MACK: Really? Cash is not trash in your viewpoint.


CONSUELO MACK: Right. And why is that? What does cash do for you?

KATHLEEN GAFFNEY: It gives you the ability to act swiftly and find those opportunities and lock them in, but when opportunities aren’t present, don’t feel the pressure to be fully invested.

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