BOND BETS Transcript 9/20/2013 #1013

September 27, 2013

CONSUELO MACK: This week on WealthTrack- with investors cascading out of bonds, is this the right time to launch a new bond fund?  Top rated manager Kathleen Gaffney guides investors to income sources in her new Eaton Vance Bond Fund. Keeping your bond portfolio afloat is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. This has not been a fun time to be a bond investor or a fixed income manager. Investors have been freaking out ever since May when Federal Reserve Chief Ben Bernanke suggested the Fed might start reducing, or tapering its massive $85 billion worth of monthly bond  purchases. It hasn’t done so yet but even a hint of diminished government support for the treasury and mortgage bond markets have sent interest rates higher and bond prices lower.

Investors across the country are taking action to avoid feeling anymore pain. According to Morningstar, they have been selling even the most successful bond funds.  The world’s largest mutual fund, PIMCO’s Total Return Fund run by famed bond guru Bill Gross lost more than 14% of its assets, or $41 billion worth in a recent four month period. Redemptions and price declines have also hit legendary fund manager Dan Fuss at the Loomis Sayles Bond Fund. Recent guest portfolio strategist Francois Trahan points out that rates are rising in many places around the world regardless of policy because either economies are improving as in the U.S. or  governments are tightening to fight inflation as they are doing in many emerging markets.


With bond markets are under stress. So is this any time to launch a bond fund? That’s what today’s guest has done. She is Kathleen Gaffney founding lead portfolio manager of the recently launched Eaton Vance Bond Fund. As well as co-director of the firm’s investment-grade fixed income area. She joined Eaton Vance in October of last year after spending more than two decades at Loomis Sayles where she co-managed the award winning Loomis Sayles Bond Fund with bond legend Dan Fuss. I began the interview by asking Kathleen how she felt about launching a bond fund in such turbulent times.


KATHLEEN GAFFNEY: That I might need to have my head examined. Actually, in January, it was a little bit challenging to think about, as a value investor, where am I going to find value in 2013.  It’s been an interesting several months, and actually, it’s getting a little bit easier.  And in some aspects, I think rising rates make it a great opportunity for investors that can be very flexible in their fixed-income allocations.


CONSUELO MACK: So what’s the opportunity?


KATHLEEN GAFFNEY: The opportunity is avoiding the risk. So the risk is interest rate risk. We all expect interest rates to start moving up, and that is most serious for U.S. Treasuries. That’s the ultimate arbiter of interest rate risk. So every bond, however, does have some component of interest rate risk. So my job this year has been to look across the fixed-income markets for bonds that offer what I would consider good corporate fundamentals, without a lot of rate risk. So that means going into corporate bonds, where there’s a little bit more yield. There’s also some rate risk there, so you do have to be careful, but looking at securities in non-U.S., both corporate and sovereign, and looking a little bit closer to our equity brethren, using convertible bonds, which I think is a great way to get that exposure to corporate fundamentals, without taking a lot of rate risk.


CONSUELO MACK: You wrote a piece recently basically saying that traditional bond strategy may offer investors little protection against declining values during a rising interest rate environment. So where’s the danger? What do you mean by a traditional bond strategy that could be a real problem for investors?


KATHLEEN GAFFNEY: When I say “traditional,” I’m thinking of the benchmark of government bonds, and high-quality corporate.  Those are the bonds that are carrying the most amount of interest rate risk, and so they’re really just subject to simple bond math, that as rates have come down, coupons have come down, and you still have different maturities. So as rates move back up, there’s a re-pricing of the market.


CONSUELO MACK: One of the things that you also wrote to your Eaton Vance clientele was that it’s probably going to be the most challenging environment at any time in three decades.  PIMCO’s Mohamed El-Erian just came out and said, you know, to say that bonds are under pressure is an understatement. I mean how challenging is the environment that we’re in? I mean how would you characterize it?


KATHLEEN GAFFNEY: Well, it’s challenging if you’re constrained to that benchmark. A great example is the recent issue in the market for Verizon. Huge, huge hit in the market. Just tremendous amount of appetite.


CONSUELO MACK: Right.  And let me just stop you there for our viewers who might have missed that. This was a record bond sale of $49 billion worth of Verizon bonds.


KATHLEEN GAFFNEY: Twice as big as Apple.


CONSUELO MACK: It was oversubscribed. So here we are in a bond market that everyone … you know, talking about people fleeing, and yet there was this huge appetite.  So explain that kind of contradiction.


KATHLEEN GAFFNEY: Well, for the traditional bond manager, the best way to add value is to add some incremental yield.  So Verizon comes to market, and they price their bonds to sell. There was a big sale going on that day, and a lot of people rushed into the market.


CONSUELO MACK: And they priced it to sell, in that they offered a higher yield than kind of equivalent corporate credits would offer. Is that what they did? So they gave you a little bit more yield.


KATHLEEN GAFFNEY: To incent you to buy.


CONSUELO MACK: Right. And people did.


KATHLEEN GAFFNEY: And they did. And they came out two times oversubscribed. So a lot of demand. But what you have to think about is if you believe that interest rates are going up, and the ten- year is around 3% today …


CONSUELO MACK: The 10-year Treasury Bond. Right.


KATHLEEN GAFFNEY: Ten-year Treasury Bond. We’re likely to see higher rates. I’d argue that we’re likely to see a 4% ten-year next year. So where would that Verizon bond be trading next year? Now, if it’s a good economy, it could have less of a premium. So the yield could come down relative to Treasuries. But if Treasuries move up 100 basis points, I really doubt that Verizon is going to be able to hold its ground that much. It’s still going to decline in price. And so the only thing that’s saving you is that coupon.


CONSUELO MACK: Kathleen, you just mentioned the word “constrained.” Now, you could have established any sort of a bond fund that you wanted to in launching a new bond fund in advance, but you chose to have a bond fund that you call unconstrained. What does that mean, and why was that so important in this environment?


KATHLEEN GAFFNEY: It’s important, because investors are really challenged right now to find those types of opportunities that will lead them to have returns in a rising rate environment. So flexibility to go into corporates, investment grade and high yield, to have full flexibility to go into non-U.S. corporates and sovereigns, because that’s likely to be where we see a lot of the supply coming down the road. However, for the time being, as we started out at the end of January, looking at what was going on in the global economy, I thought the U.S. looked to be in pretty good shape. At a time when I had full flexibility to go away from the U.S., I really was focusing much more on the U.S. market.


CONSUELO MACK: So unconstrained means basically that you can invest within certain parameters in a lot of different types of securities, in a lot of different types of fixed-income securities.  You also have the ability to invest in equity stocks, too, right?


KATHLEEN GAFFNEY: I do. Twenty percent flexibility, with the idea that, again, for investors, they’re going to be challenged, and one of the biggest challenges in a low-rate environment has been trying to find sources of income. When I think about investment ideas, and looking for good fundamentals, I’m really thinking across the whole capital structure.  So if there is a company, and it’s doing something strategic, and it’s generating cash flow, who’s going to benefit, the bond holders or the equity holders? And we’re at this interesting time where balance sheets are in good shape, so we’re unlikely to see bonds get any better, and yet, equities have the potential to pay dividends, or at least grow their dividends. So that, to me, is a good source of income, where there is stability of income, a great offset, as interest rates start that march up higher.


CONSUELO MACK: So when you launched the fund in January of 2013, so out of the box you looked at the U.S. and decided that the U.S. market was pretty attractive. So what did you do?  What was your strategy from the get-go?


KATHLEEN GAFFNEY: For the most part, U.S.  So looking around, what was driving the U.S. economy? Where were the best values? Clearly, if the U.S. is recovering, and I have lots of flexibility, but can’t quite go everywhere, looking in the investment grade area, lower quality, Triple B, so still investment grade, but companies that are more cyclical, so benefiting from a recovery in the U.S.


CONSUELO MACK: Oh, interesting.


KATHLEEN GAFFNEY: High yield, which is great for the yield. Not as much as we’ve seen historically, but a great place to benefit from improving fundamentals. Little concerned that the high-yield area had too much rate risk, so that problem again of bond math, the coupons are just too low to offset rising interest rates. But what I find interesting in the current market is that as the economy improves, we’re seeing more and more M&A activity.  So you have a number of credits that were investment grade going below investment grade. We like to call them falling angels.


CONSUELO MACK: M&A is Merchants and Acquisitions. And we certainly have seen a pickup in that activity. So give us an example of how you take advantage of a merger, for instance.


KATHLEEN GAFFNEY: A good example might be Dell, and not a merger, but a decision by the company to go private. So an LBO, which probably …


CONSUELO MACK: Leveraged buyout.


KATHLEEN GAFFNEY: Leveraged buyout. Which many people might think back to 2008 and think, “I don’t want to go back to an LBO candidate.”  But think about what’s going on.  Interest rates are now so low, because of the crisis, leverage is way down. Michael Dell is faced with an industry that’s declining. Nobody’s using PCs any more, but technology is what’s driving the innovation.  He wants the time and space to rework his company. The easiest way to do that is to go private. And if you think there’s a good franchise there, and good asset value, then there’s a great opportunity where you’ve got bonds that still pay you a coupon, but they’ve declined in price. So they do have the ability to give you some capital appreciation potential through corporate fundamental turnaround.


CONSUELO MACK: So these are existing Dell bonds that were out there, and if you’re taking a company private, and he’s doing it by issuing more bonds, and, therefore, the current bonds went down in price.




CONSUELO MACK: And you look at that, and you say this is a turnaround situation, and, therefore, the existing bonds out there are good bonds to buy.


KATHLEEN GAFFNEY: Exactly. You have to believe in the credit story. And so what you’re assuming is credit risk, and that is the risk that’s worth taking in this market. Avoid interest rate, but look for credits, or I will call it companies that offer good value, that are going to march to their own tune, that as interest rates move up, they’re not going to be as dependent on what’s the coupon, what’s the maturity, the math. It’s about the fundamental picture within the company itself. And there’s so many changes going on in our economy right now, there are great opportunities. So those animal spirits are creating those opportunities.


CONSUELO MACK: So you’re talking about animal spirits, but, you know, when you look at what happened when Federal Reserve Chief Ben Bernanke came out in May and announced that, in fact, the Fed might start withdrawing some of its bond purchasing program, and everybody completely freaked out, did you have to change your strategy when that occurred? I mean how did you deal with that in a new fund?


KATHLEEN GAFFNEY: I really didn’t because being a long-term investor and recognizing that the trend did seem to be positive, I think the Fed has done a really admirable job, and it is a good sign that they’re willing to taper, that it means the economy is in good shape. I’m positioned for that recovery, so I’m really sitting tight and looking at how the individual companies are managing through this time horizon. I want to hold on to bonds for as many years as I can, not necessarily to maturity, but that’s a way of earning that income and avoiding some of the volatility that will take place as interest rates move up.


CONSUELO MACK: So let’s talk about some of the other kind of nontraditional approaches that you’re taking, and you mentioned, you know, convertible bonds, and I know preferred stocks is something. So just talk to us about some of those opportunities as well again and alternative strategies.


KATHLEEN GAFFNEY: The great think about multi-sector is that it’s a large investable universe. So you’re not constrained, you’re really pushing beyond the boundaries, looking for where those opportunities that a lot of the market isn’t paying attention to. So convertible bonds are somewhat neglected, because they’re a hybrid, a little bit equity, a little bit bond. That is a good thing when it looks like the value proposition between Treasuries, looking at Treasury yields relative to dividend yields is so attractive. So I want to capture that equity upside, and a convertible bond will allow me to do that.  It’s also a great way, with high-yield exposure, again, a little bit concerned about the rate risk there, so convertible bonds are a way to diversify away, get exposure to sectors of the market that typically don’t issue in the high-yield market, because it would be so expensive, and I’m really thinking about tech companies here.


CONSUELO MACK: So for instance?


KATHLEEN GAFFNEY: So, for instance, a good name here would be Intel. Large cap company. Lots of potential. There’s upside there. Now, that’s a high-quality company.


CONSUELO MACK: But they issued convertible bonds, which are convertible at a certain price, into stock.  Is that right?


KATHLEEN GAFFNEY: Into stock. And so it tracks the price of that stock to a very large degree.  The below-investment grade side, another tech company, would be something like a Ciena. So that’s telecomm equipment. All these iPhones that we’re buying, and the semiconductors, and the networks that need to be connected, it’s all a part of what’s moving the economy, and this is a sector that’s lagged tremendously, because the large corporations that typically buy from them haven’t been spending, but we see that pickup and spending coming very soon.  So that’s a way to get exposure to a segment of the market that is high yield, that we think has better upside potential.


CONSUELO MACK: So you’re doing, you know, in-depth homework, right, on the individual issues that you’re buying.  This is not like buying a sector.  You’re really doing it one security at a time.


KATHLEEN GAFFNEY: Focused on those corporate fundamentals.  And so I’m very fortunate to be working with a great team in Boston that helps identify those great long-term opportunities.


CONSUELO MACK: So, you know, one of the things that I remember when you were at Loomis Sayles, and co-managing a much larger bond fund, and a long-established bond fund, was that you were investing in emerging markets, in local currency bonds, you know, local currency government debt of emerging markets, and you were looking at currencies as well. So what are you doing in the emerging market space, which has really been hurt during this period, the last several months?


KATHLEEN GAFFNEY: Great point. It’s an example of where tapering, which I view as positive, has not necessarily been a positive. And I’ve been focused on the U.S. for just that reason, that when we started out in January, looking at the global landscape, the value, the yields were very low in emerging markets, and it did seem that as interest rates move up that’s not necessarily good news, partly because rates are moving up here in the U.S., but because the fundamentals have started to erode. Think back a year ago, and everyone was worried about the developed world becoming submerged, and here it is the U.S. that’s really leading everyone out for a stronger global economy.

I do have concerns about the emerging markets. They’re adjusting to slower growth.  They’ve still got good growth, and I still think there’s a wealth of opportunities here. But I think investors need to be much more cautious in terms of not buying emerging markets, simply because they’ve been growing very fast. That reminds me a lot of the housing market here in the U.S., believing that the growth, the fast growth, is sustainable forever. It’s not. And I think what will separate the wheat from the chaff is countries that do have good economic policy, fiscal and monetary reform, to withstand a stronger U.S. and higher rates, because in the long run they benefit from a healthier U.S.


CONSUELO MACK: Now, this is actually a theme that we’ve just talked about with some other guests that’s very interesting to me, because, you know, at one point we were saying that China, for instance, was replacing the U.S. as the driver of economic growth, and there seems to … you’ve picked up on that same point. So in the emerging markets has the selloff in the emerging market debt created any opportunities? I mean are there countries that you look at and you say, you know something, I believe in their credit quality and in their currencies, and I think there’s going to be a turnaround potential there?


KATHLEEN GAFFNEY: I think there’s a very clear opportunity on the horizon.There are benefits to being small, and there are challenges, so being a small bond fund, I’ve got to be very patient about when I enter into those markets.  It would be very easy to fill a position when you’ve got lots of people exiting.  And so I think we all need time to sort out where are the countries that do have the good policy.  And it’s possible that this could be a brief selloff, but when I look at the fundamentals in India, and how difficult it is going to be for them to get on the right policy track, and issue debt, that could create some hiccups in the market.  So I’m being patient, but recognizing that there will be fast growth and good opportunities, but it’s important to sort it out ahead of time.


CONSUELO MACK: Now, one of the countries that you had I had talked about, about a week ago was Mexico. So what’s the story on Mexico? Is that attractive for bond investors, the Mexican government bonds, or …


KATHLEEN GAFFNEY: I do like Mexico right now, and two reasons why. In contrast to India, here’s a country that has really come through with reform. We’ve watched this nation for a very long time. Corruption with the drug cartels. Just very, very difficult, even though they were benefiting from growth.  And here you get a new leader in place that’s really able to put through solid reforms. That’s a big positive. And at the same time, still lever to a growing U.S. economy. So it both represents the ability to benefit from a stronger U.S., but it also represents a good citizen in the global economy and the types of countries we want to continue to identify.


CONSUELO MACK: So, you know, with the flexibility you’re talking about in the Eaton Vance bond fund, so if you had to pick One Investment… as you know, we always ask our guests at the end of a WealthTrack, or close to the end of a WealthTrack, what would the One Investment be?


KATHLEEN GAFFNEY: So the one investment, and it’s really hard to pick just one, but I am an optimist, by and large, and I’m a fixed-income manager, so I’m going to go a little bit off the edge to an area where I think there is a good opportunity. I’ve talked a little bit about it already just in the tech sector, and that’s Applied Materials. So part of what is causing the tapering and making many fixed-income investors uncertain is stronger growth. And what I’m looking for are those corporate fundamentals, markets that are really growing in the global economy, and tech is so much a part of it.

But the important part, as you mentioned, about digging into the individual companies, are finding the ones in tech, because obsolescence and the product cycles are so fast you want to identify the companies that have the right product mix, and Applied Materials is just that sort of company, growing in their industry, and we think looks like it has the ability to grow its dividends as well.


CONSUELO MACK: So is this a stock?


KATHLEEN GAFFNEY: This is a stock, coming…


CONSUELO MACK: This is a stock you’re talking about, coming from…


KATHLEEN GAFFNEY: … from a bond manager.


CONSUELO MACK: Right. But from an unconstrained bond manager. And my final question, Kathleen, is in the search for safe income, is there one sector, is there any area that… you know, does that still exist where we can find some yield, and that we can depend upon? Does that exist in the bond market anymore?


KATHLEEN GAFFNEY: It’s always going to exist in U.S. Treasuries, in terms of safety.  And as interest rates move up, that income rate is going to get higher. So a more conservative approach that would appeal to investors would be just laddering Treasuries.


CONSUELO MACK: So buying different maturities, and as they mature, and as interest rates go up, you buy other…


KATHLEEN GAFFNEY: And just roll back in at a higher rate.


CONSUELO MACK: Into a higher rate.


KATHLEEN GAFFNEY: So you come down the curve, and then roll back up… roll into higher yielding treasuries.


CONSUELO MACK: So interesting.


KATHLEEN GAFFNEY: And that’s a great way to protect your income.


CONSUELO MACK: And that’s a contrarian idea, so you’re saying do not give up U.S. Treasuries entirely, despite what everyone’s saying about them being such a dangerous investment.


KATHLEEN GAFFNEY: No.  And there are conservative strategies that work, and it’s one great reason to be a part of a team, where I may be unconstrained, but we’ve also got the ability to manage conservative-laddered strategies as well.


CONSUELO MACK: Right. Terrific. So Kathleen Gaffney, with the new Eaton Vance Bond Fund, thank you so much for joining us on WealthTrack. It’s great to have you back.


KATHLEEN GAFFNEY: Thanks, Consuelo.

CONSUELO MACK: At the end of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: stick with experienced bond managers with successful long-term track records. We are going through a major generational shift in bond market conditions right now. This is no time to be in passive index bond funds or ETFs completely subject to the vagaries of a volatile market. This is one of those periods when you need a steady, experienced hand at the tiller, who can make decisions based on market conditions, fundamentals and opportunities, not on crowd behavior. We are entering an era where judgment will really count.


Next week on WealthTrack, we will sit down with another next generation Great Investor.  First Eagle Funds’ Matthew McLennan will discuss why he is seeing financial fault lines around the world and how he is protecting his investors from them. Check out our website for past WealthTrack interviews, exclusive insights into our guests and research from our sources on WealthTrack Extra and please connect with us on Facebook and Twitter for WealthTrack updates, what we’re reading, and more. Thank you so much for taking the time to be with us. Have a great weekend and make the week ahead a productive one.









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