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May 15, 2015

CONSUELO MACK: This week on WEALTHTRACK, drilling for profits in the energy field. Portfolio managers Gib Cooper of Western Asset Management and Chris Eades of ClearBridge Investments discover opportunities created by falling oil and gas prices next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. One of the biggest stories of last year was the dramatic decline in oil prices and every asset class connected to them. Prices of energy stocks plummeted, prices of energy company bonds, particularly in the high yield category, those with below investment grade credit ratings cratered. As you can see from this chart of America’s benchmark, West Texas Intermediate Crude Oil, a barrel of oil was over one hundred dollars last summer before being cut by more than half earlier this year, falling to a six year low.

As several savvy WEALTHTRACK guests reminded us at the time, when oil rebounds in this cycle, which it inevitably will, it will move quickly. And so it has. Although it is still nowhere near last year’s highs.

Meanwhile oil investments remain under pressure.

According to this week’s guests the decline in energy related securities represents an opportunity for investors particularly in two areas. One is in what are known as energy Master Limited Partnerships, specifically those that invest in infrastructure companies, the pipelines and storage terminals which depend on the volume of oil and gas flows not their price. MLPs as they are known have been extremely popular with investors because they are legally required to pay out most of their income to investors and their distribution rates to investors have been very attractive in a low yield environment.

The other area is the bonds of energy companies, particularly exploration and production companies which have issued billions of dollars of debt in recent years to fund their production costs. Energy bonds makeup about 15% of all high yield debt.

Our guests are J. Gibson Cooper, Analyst and Portfolio Manager at Western Asset Management, one of the country’s largest fixed income managers and winner of the Morningstar Fixed Income Manager of the Year Award last year. Cooper oversees the high yield portfolios at Western. Chris Eades is Portfolio Manager of several Master Limited Partnership portfolios at ClearBridge investments, including the flagship, ClearBridge Energy MLP fund, a closed-end fund.

I began our discussion by asking them how much of a game changer the decline in oil prices has been.

GIBSON COOPER: Well, I think it’s a game changer really from the standpoint in our market and the fixed income market. It’s certainly been one of the largest contributors to the oversupply situation. So to the extent that the oil prices declined, that’s certainly taken a lot of wind out of the sails of the high-yield market in terms of providing capital to energy companies, in terms of activity levels that are declining. So it is a game changer, and we’re seeing a real rapid and aggressive response to the oil price within the companies that we research and invest in. So it is a game changer from the standpoint, at the company level. For the market overall, it is a little bit of a typical cycle we think. We think that it is not much different than other cycles we’ve experienced.

CONSUELO MACK: In oil and energy.

GIBSON COOPER: In oil and energy, and we are biased to a recovery in the price, but it will certainly take time.

CONSUELO MACK: So Chris, just a typical cycle? You’ve seen this before. Don’t get upset by it. Not shocking.

CHRIS EADES: We’ve done this many times. These are commodity markets. There’s going to be volatility. There’s going to be down markets. There’s going to be up markets, and this to me is, despite the severity of it in terms of the magnitude of the decline in the price of oil, it’s kind of a textbook commodity correction. The way the commodity markets work and certainly the way the oil market works is that if there is more supply than there is demand, that last barrel of oil that’s being unsold in the marketplace sets the price of oil for the entire market, and we had an oversupply last summer. Oil prices peaked in August, and obviously we’ve been in a big downdraft since then, but it’s natural given the oversupply that we had in the market, but I would also note that despite the fact that we’ve had this decline some of the self- correcting mechanisms that we typically see to the up side as well as to the down side are certainly a play. As Gib mentioned, we’ve seen a rather severe change in behavior from the E&P companies in terms of their drilling, in terms of their …

CONSUELO MACK: Exploration and production.

CHRIS EADES: Exactly. Exploration and production companies.

CONSUELO MACK: So you mean they’re cutting back on their drilling.

CHRIS EADES: Severely.

CONSUELO MACK: They’re firing people.

CHRIS EADES: In five or six months we’ve seen the number of rigs drilling for oil in the United States decline by 56 percent.

CONSUELO MACK: Wow. They move that quickly.

CHRIS EADES: It was huge. They do, they do, and that’s a short window, and that eventually is going to have an impact on supply which help tighten the market up a little bit, and then I think what gets lost on a lot of people right now is everyone keeps talking about the supply side of the equation. Demand’s responding as well. We are now seeing in the United States significant gasoline demand growth for the first time in five or six years. I read an article yesterday that indicated that global oil demand was estimated to be up around two percent in the month of February.

CONSUELO MACK: Is that a lot?

CHRIS EADES: It is. I mean typically most analysts right now are kind of thinking we’re going to have anywhere between one and maybe one and a quarter percent demand growth in 2015. If it in fact ends up being two, that alone would completely absorb the oversupply that we have in the market. I would have argued two months ago that it was going to take more than a couple of months for oil prices to recover. We’ve had a nice recovery in oil prices. We bottomed around 43. This afternoon or today rather they’re around 57. However, it’s not a question of if they’re going to recover. It’s a question of when they will, and it just takes a little bit of time for all these self-correcting mechanisms to work. So to me this is a textbook commodity correction.

CONSUELO MACK: Gib, one of the game changers that you mentioned to me in an earlier conversation was that there is no longer an oil cartel. Explain what you mean by that.

GIBSON COOPER: Well, for the first time in 50 plus years, even going back to the period of time when the Texas Railroad Commission controlled price and production and then later on OPEC was created, for the first time we don’t have really anybody in charge of the cartel in charge of the oil price. The market is in charge of that price.

CONSUELO MACK: What happened? Why aren’t they in charge?

GIBSON COOPER: Well, there’s a lot of answers to that question, and it’s probably all of the above. It serves geopolitical purposes. There’s intra-OPEC fighting. There’s issues with Iran and Russia, and then certainly they’ve studied U.S. shale, and they certainly acknowledge that it’s a real phenomenon. The U.S. is very efficient. We’re getting oil out of traditional oil basins more productively, and we’ve grown oil production three to four million barrels a day more over the last five years.

CONSUELO MACK: So we’re the new supplier, the big supplier on the block.

GIBSON COOPER: We are the new supplier. So for the time being we think the shale barrel is the marginal source of supply.

CONSUELO MACK: Right, and so has Saudi Arabia basically withdrawn involuntarily or voluntarily as the swing producer, or what’s their role going to be? I’m just trying to figure out what’s going to happen with oil prices with this dynamic going on.

GIBSON COOPER: They certainly voluntarily have given up on controlling price for the time being. I think we have to operate with that assumption going forward, and the Saudis will no longer serve to adjust their own production to meet the falloff in demand or excess supply. As Chris mentioned, we would agree that we don’t believe that the imbalance is that large.

CONSUELO MACK: Between supply and demand.

GIBSON COOPER: That’s right. That’s right.

CONSUELO MACK: Even with the U.S. being a new big producer.

GIBSON COOPER: That’s right. Globally the imbalance is probably running somewhere between a million and a million and a half barrels a day. As Chris mentioned, demand is better than forecast. The EIA and the IEA both have increased their global demand forecast this year by nearly a million barrels.

CONSUELO MACK: And therefore, so what should oil be trading at?

CHRIS EADES: In our view at ClearBridge, and I don’t think it’s dissimilar to what Gib’s going to say either …


CHRIS EADES: We think we need oil prices somewhere in the 75 to 80 dollar range just to have enough oil to meet normalized demand growth. Demand’s going to go up and down. It’s a little bit cyclical obviously, but on a long-run basis that’s the price we need, and the reality is … and this is why when oil was in the 40s a few weeks ago and even today with it in the 50s, global oil economics don’t work at 40 or 50 dollar oil. I mean on our math roughly two thirds of the world’s oil fields, it’s uneconomic to drill a new well in those fields with oil at 40 or 50 dollars a barrel.

CONSUELO MACK: So Gib, would you agree with what Chris is saying, that $70 a barrel, number one, is the price where oil should be and that eventually we’ll get there because of the dynamics of the market?

GIBSON COOPER: We would agree completely. Think of it this way. Chris mentioned the oil demand growing roughly a million barrels a year, but you also have depletion issues.


CONSUELO MACK: And depletion is?

GIBSON COOPER: Just natural declines of reservoirs. Lose pressure and there’s less oil produced the following year. So that alone is probably three to four million barrels a year. So you add that to the million barrels you need from new demand. So the world needs probably four to five million barrels per year more every year, and so we would agree with Chris. It’s not going to get it at $50. Not many basins work globally let alone in the United States at 50 to 60 dollars. Some do. The core of the best basins do work to some extent, but you won’t get the level of investment at current prices because you simply won’t have the cash flow, and the capital markets likely are not open to the extent they have been in the past to get that production. So we would agree that that marginal barrel probably needs to be supplied at around $70 or more, and it’ll take time to get there. We have seen a constructive tone developing over the last few months in the oil fields. Certainly Chris mentioned the decline in the rig count. It’s been very aggressive. I think it’s certainly running lower than I think the broad consensus had thought it would. Certainly seeing contraction in capital, capital markets being largely closed to raising capital to actually …

CONSUELO MACK: For energy companies.

GIBSON COOPER: Well, really for the E&P, for the exploration and production companies.

CONSUELO MACK: For the exploration and production companies.

GIBSON COOPER: To the extent that they can borrow money and issue equity to drill and produce more oil, that is significantly lower than where it was even six months ago. So basin level data is starting to cooperate. You’re starting to see the major shale basins in the United States, the Bakken and the Permian and the Eagle Ford begin to slow their growth rate. In fact, we think the Bakken and the Eagle Ford probably roll over and stop growing fairly soon and the Permian probably shortly thereafter.

CONSUELO MACK: What’s the impact on the debt issuers, the high-yield debt issuers in the exploration and production space which is sizable? Right?

GIBSON COOPER: That’s right. Like you started the session here, it’s been a game changer. Companies have relied on the capital markets, both they high-yield market, the investment grade market as well as the equity market.

CONSUELO MACK: Oh, it’s equity and debt.

GIBSON COOPER: Equity and debt has got us to where we are today by providing capital to grow and improve production by three or four million barrels a year. Without the capital markets, we wouldn’t be in this position. So today the markets are largely closed within the high-yield market. Some of the best…

CONSUELO MACK: And tell us about the high-yield market because energy is a sizable component of high-yield market.

GIBSON COOPER: It’s roughly around 15 percent of a 1.4 trillion high-yield market. So call it 200 billion.

CONSUELO MACK: So this decline in oil prices has really hit the high-yield market overall and especially the energy sector the high-yield market really hard.

GIBSON COOPER: That’s correct. Roughly half of our issuers are within the E&P space. Again really the theme within energy, within the high-yield energy space is simply capital preservation and liquidity preservation. The name of the game is not grow. Preserve capital. Preserve liquidity and make it to the other side of this cycle.

CONSUELO MACK: That’s the mode the companies are in.

GIBSON COOPER: That’s right. So management behavior is very important to us as fixed income investors. Chris mentioned it early on. Management teams are reacting very aggressively, more aggressively than I think consensus thought they would. They’re getting rewarded for not growing, for preserving capital, preserving enterprise value and waiting for oil prices to perhaps improve over the next couple of years, working off hedged cash flows, retaining capital, and for many companies that’s really prevented them from paying dividends, prevented them from buying stock back. And they’re getting rewarded for managing the balance sheet, and that’s why it’s particularly interesting for fixed income investors. It’s an interesting time to invest in the sector.

CONSUELO MACK: So the quality of management is going to matter a lot to you, and we’ll talk about that in a minute.

GIBSON COOPER: Absolutely.

CONSUELO MACK: So in the Master Limited Partnership space where you’re investing in MLPs, what’s the dynamic there? How have they responded? What difference does it make in the kind of companies that you invest in?

CHRIS EADES: It’s a very different world than what Gib is talking about for exploration and production companies on either the equity side or the debt side. I’m investing in the infrastructure, the pipelines, the processing plants, the storage terminals, those sorts of assets. Those assets by and large generate their cash flows irrespective of what the price of oil is or even what the price of natural gas is. What’s important for these assets is not the value of the commodity but the volume of the commodity moving through whatever infrastructure asset it is that we’re talking about. That being said, MLP stocks have been weak. I mean they haven’t had this severe decline that we saw in exploration and production companies nor as bad as what we saw in the oil field service companies but they still did decline. In peak to trough they were down around 20 some odd percent, and that would compare to exploration and production companies and service companies which were down around 50 percent. So not nearly as painful, but it shouldn’t have been as painful because the cash flows that these assets are generating are really largely unchanged. These are often regulated assets. These are assets that are backed up by long-term contracts, fee-based business models and not really dependent on the underlying price of oil and/or natural gas.

CONSUELO MACK: So has the distribution of cash which of course people invest in MLPs, the reason they’ve been such an attractive vehicle, is because they’re really great income streams. So how has that been affected?

CHRIS EADES: It actually has not shown up in the numbers yet. In fact, I was looking this morning.


CHRIS EADES: Well, it could, and I think it gets down to the duration of how long this oil price weakness lasts. I would argue that the rebound that we’ve seen to date has come quicker than I would have thought. If it’s sustained then I think fears about slowing distribution growth for MLPs are going to be proven wrong, but what we’re seeing right now, most of these companies have already reported their first quarter 2015 distribution rates. It was very solid, over 10 percent distribution growth on average year over year. That with an asset class that’s now yielding north of six percent, that’s where the total return proposition for owning MLPs is irrespective of people’s perceptions that these are quasi plays on oil prices or natural gas prices for that matter.

CONSUELO MACK: So should they be cutting back their distribution?

CHRIS EADES: No, no, no, no, no.

CONSUELO MACK: Protect their business or … ?

CHRIS EADES: I would not look for distribution cuts on average for the infrastructure- oriented MLP stocks that we invest in at ClearBridge. It is plausible that we could see a slowing of the growth rate but not that the growth rate goes negative. That’s a very important distinction that I think a lot of MLP investors …and this is still an asset class that is largely dominated by individual investors. They are fearful of cuts in income, not a slowing in the growth rate of income which is a very different dynamic of play.

CONSUELO MACK: And you’re saying there might be a slowdown in the growth in income, but there won’t be cuts in income.

CHRIS EADES: Not for infrastructure assets. Correct. For upstream assets, exploration and production assets?

CONSUELO MACK: Sure, that’s happening. Right?


CHRIS EADES: It’s happened many, many times and will likely continue, but for the infrastructure assets, the transportation-oriented assets, that has not happened. Let’s be honest, We’re almost nine months into this oil price correction, and we’re still seeing very healthy distribution growth, income growth from MLP companies.

CONSUELO MACK: Gib, so in the high-yield space, number one, are you more concerned about defaults among energy companies and their debt? And also is this more risky now, or is it more opportunistic?

GIBSON COOPER: Well, it’s certainly more risky, and I think that’s certainly evident by the higher yields in the marketplace for energy credit. Energy historically has traded well inside actually the high-yield market, typically around 100 basis points or one percent below the yield of the market. That’s reflective of its higher asset quality, typically higher ratings, lower default experience, and certainly hard assets underneath these companies. Today it trades around three percent higher than the overall market, and energy today yields roughly around eight and a half percent. So that’s reflective of absolutely a larger likely default experience. Back in December we felt that the market was overestimating the ultimate default rate these companies would experience over the next couple years and really underestimating management teams’ ability and to some extent the capital markets’ ability to enable companies to provide bridges and pull levers to create liquidity and preserve capital to get to the other side of the cycle. So yes, the yields are indicative of a higher default rate. We would certainly expect defaults to go up. We don’t think that’s a 2015 event. We think that’s more of a 2016 event if oil stays lower for longer.

CONSUELO MACK: And at Western Asset you actually think that the energy sector of the high-yield market is attractive. Right?

GIBSON COOPER: That’s correct. We do. We have broadly speaking in our funds, both institutional and retail, a healthy overweight to energy at the moment. A lot of that was put on in the last five months or so. Certainly we find that the spread difference between energy and the market today, within the market we can find very good opportunities at say in the seven to ten percent yield area that provide good current yield as well as potentially good total return opportunities. If we’re right in that, this is a cycle that will play out over the next couple of years, and oil will necessarily go back to where it needs to be to attract future supply growth.

CONSUELO MACK: And infrastructure companies? Do you think that they’re undervalued right now?

CHRIS EADES: Oh, certainly. We wiped out almost two years of gains in these stocks. We have a growth story that’s largely not impaired by this oil price environment. So I think it’s a very attractive environment, and we’ve actually been putting some money to work in this space. CONSUELO MACK: Final question to each of you; one investment for a long-term diversified portfolio. What would you have us all own some of? Gib?

GIBSON COOPER: I think one of the best stories that we’ve been researching quite a while is California Resources Corporation. Ticker is CRC, both the equity and the debt. It was spun out of Occidental Petroleum late last year, and it holds all the mature California oil assets in a single entity. This is a fantastic asset, world class asset, roughly 700 million barrels of reserves, long life, mature, not unconventional shale assets but conventional. So very low decline rate production which means relative to a lot of the high-yield shale producers, the company doesn’t really need to invest a lot over the next couple of years to maintain current production levels. So it’s very important because they can preserve capital, preserve liquidity and manage through a down cycle perhaps better than their higher decline rate brethren in some of the other shales in the United States.

CONSUELO MACK: Chris, what’s your one investment?

CHRIS EADES: Well, my one investment is going to be an infrastructure name, not surprisingly given what we’ve talked about thus far, and when I look at infrastructure companies, I really want three things. I want very strong balance sheets. I want companies that have strong growth opportunities both organically and perhaps even through acquisitions, and I want companies that have strong distribution growth or distribution coverage which again means that they’re generating more cash flow than they’re paying out, and the one name I’m going to highlight here is Plains All American. The ticker on that is PAA. It’s a company that yields around five and a half percent. It’s well positioned to deliver mid to high single-digit distribution growth not for one year but for multiple years down the road which position Plains to deliver total returns in excess of 10 percent for the foreseeable future. It’s a stock. It’s going to be volatile, but the assets that they’re invested in have stable cash flows, just the sort of thing that can be exploited given the weakness that we’ve seen in infrastructure stocks here over the last few months.

CONSUELO MACK: Thank you both for two very specific ideas which I know our viewers appreciate, and also thank you so much for being on WEALTHTRACK. Chris Eades from ClearBridge.

CHRIS EADES: Thank you.

CONSUELO MACK: And Gibson Cooper from Western Asset Management. Thanks for being here.


CHRIS EADES: Thank you.

CONSUELO MACK: At the close 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


May 1, 2015

Dan Roberts Co-Portfolio Manager Mainstay Unconstrained Bond Fund

Seeking higher returns and protection against an eventual rise in interest rates, investors have been turning to non-traditional “unconstrained” bond funds. According to Morningstar, nontraditional bond fund assets have more than doubled to a record $151.5 billion last year, from $62.5 billion in 2011. On this week’s WEALTHTRACK, an exclusive interview with an award winning portfolio manager who is an expert in this field. Dan Roberts of the five-star rated MainStay Unconstrained Bond Fund explains why investment flexibility is so critical in today’s complex markets.

CONSUELO MACK: This week on WEALTHTRACK, escaping the bonds of traditional fixed income investing. Award winning fund manager Dan Roberts reveals the strategy secrets of his MainStay Unconstrained Bond Fund in a rare interview next on Consuelo Mack WEALTHTRACK.

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

Ever since the financial crisis we have been talking about the unprecedented steps central banks have taken to pump money into the world’s financial system, thereby lowering interest rates and making borrowing more affordable to companies and countries.

The trend continues. As you can see from this chart, courtesy of this week’s guest, the balance sheets of major central banks have exploded since pre-financial crisis days: up more than 500% at the Federal Reserve, neary 500% at the Bank of England, nearly 300% at the Bank of Japan and almost 200% at the European Central Bank.

One of the consequences of these policies has been to lower interest rates, which simultaneously drives up the prices of bonds. By just about any measure bonds are expensive and their yields around the world are historically low.

That combination challenges the primary reasons for owning bonds in the first place, for their income and price stability. It’s also created a serious dilemma for investors. What to do with their bond portfolios?

One answer is to consider nontraditional bond funds, also commonly known as “unconstrained”. These are fixed income funds that can invest just about anywhere in the world, in many cases can invest in other asset classes like stocks and can go short. They have become very popular with investors searching for higher returns and protection against an eventual rise in interest rates.

According to Morningstar, nontraditional bond fund assets have more than doubled to a record $151 billion last year from $62.5 billion in 2011.

This week’s guest co-manages one of the highest rated ones. He is Dan Roberts, Co-Portfolio Manager of the MainStay Unconstrained Bond Fund which carries a five-star rating by Morningstar and has for the second year in a row received a Lipper fund award for its “consistently strong risk–adjusted performance relative to its peers”.

Roberts, a PhD economist is the Head and Chief Investment Officer of Global Fixed Income at MacKay Shields which he joined in 2004. But his bond team has been together for more than 20 years and has specialized in managing asset allocation funds, high yield bond portfolios and also long/short strategies which have recently become widely used in that now very popular nontraditional bond fund category.

MacKay Shields is a wholly owned, but independently run subsidiary of WEALTHTRACK sponsors’ New York Life/ MainStay Investments. Roberts is here because of his recognized track record.

I began the interview by asking Roberts what difference having an unconstrained bond fund rather than a traditional one makes in today’s markets.

DAN ROBERTS: When we think about the traditional bond funds and we think about unconstrained, first of all the differences between the two are that the unconstrained bond fund and the traditional bond fund have different durations.

CONSUELO MACK: And durations is interest rate risk, but explain to our audience who might not understand what duration means, what that means.

DAN ROBERTS: Yes. So duration is as interest rates go up or down, how does that affect the price of the bond, and so a higher duration means that the bond price as interest rates go up and down affects the price of the bond more.

CONSUELO MACK: Got you. So a high duration is not a good thing necessarily because it gets affected more.


CONSUELO MACK: The price of the bond gets affected more.

DAN ROBERTS: If interest rates go up. Exactly right. So when you’re looking at the differences then, which then we can come on to what are the good things, what do we like about unconstrained. The differences are, number one, is that the durations are different, and generally with the traditional bond fund the duration of traditional bond funds tend to be five and a half years or longer, whereas with an unconstrained bond portfolio it’s usually about a half year. So the risk is significantly less. Now the second major category of difference between the two is the flexibility. With a traditional bond fund, generally traditional bond funds use the benchmark of the Lehman Aggregate or the Barclays Aggregate now, and with the Barclays Aggregate the sectors in the Barclays Aggregate are basically investment grade bonds. Now many times you will be allowed to invest maybe 10, 20 or 30 percent outside of the Aggregate in other things, in other sectors like emerging markets or high yield or non-dollar bonds.

CONSUELO MACK: But always in bonds.

DAN ROBERTS: But generally in bonds.

CONSUELO MACK: You’re long bonds.

DAN ROBERTS: Yes, exactly. Generally in bonds. Now with an unconstrained, however, you don’t have that constraint of zero to 30 percent that you can only have in bonds that are outside of the Barclays Agg.

CONSUELO MACK: So you’re limited in a traditional bond fund. You’re limited to only having up to 30 percent outside of what’s in the Barclays Aggregate.

DAN ROBERTS: Exactly. Exactly.

CONSUELO MACK: That’s the only leeway you’ve really got.

DAN ROBERTS: That’s right. So what would be one of the natural advantages then? Well, you have all this flexibility. As a portfolio manager, you can invest where you see value, and you aren’t constrained by the 10 or 20 or 30 percent. I believe that’s where the name unconstrained came from.

CONSUELO MACK: And how unconstrained are you with the MainStay Unconstrained Bond Fund for instance? I mean you can invest in equities. Right?

DAN ROBERTS: Yeah. It’s just a very small portion in equities. Where we have most of the flexibility is in typical bonds, so in investment grade, in high yield, in emerging markets, obviously Treasuries, investment grade corporates. So we do have a lot of ability to move among bond sectors. We have a little bit of abilities, just a small amount with equities but really not much. It’s very, very much focused on bonds.

CONSUELO MACK: But also you can short. Right?


CONSUELO MACK: And that you cannot do in a traditional bond fund.

DAN ROBERTS: That’s right. That’s right, and the shorting sometimes is very, very useful. Over the last number of years we haven’t used much of the shorting capability, and the reason for that is the market’s been going up. It wasn’t a good thing to short, so we haven’t been shorting it. Now we have been doing shorts, however. We’ve been shorting for example the two-year Treasury. Just very recently we started shorting the 10-year bund because …

CONSUELO MACK: That’s the German sovereign debt, the 10-year note.

DAN ROBERTS: That’s the German sovereign debt, and the reason that we’ve been doing that is because of the upside-downside tradeoff is so attractive. So let’s look at the bund for a second. The bund has been trading anywhere recently between let’s say five and fifteen basis points. So that means that if you’re short you don’t have a lot of risk to the down side even if the bund goes negative like the rest of the German curve has. You don’t have a lot of downside risk, but you have a lot of upside opportunity, and your carry cost is not nearly as expensive as in the U.S. market. One of the things that is important to us in making this kind of decision is what’s going on in the European economies right now, and that is the ECB has been very loose. It’s one of the reasons why interest rates are negative right now is that the…

CONSUELO MACK: European Central Bank has done this quantitative easing program. They’re buying a ton of bonds.

DAN ROBERTS: They’re buying a ton of bonds.

CONSUELO MACK: Injecting lots of money into the financial system.

DAN ROBERTS: Exactly. Exactly right, and when any central bank including the ECB tries to stimulate the economy, they work on our markets. They work on the bond markets, and so they’ve been buying European sovereign bonds, and so they’ve been buying quite a lot of them, $60 billion a month, and so what we see then is that we see that yield, and yield is dropping as prices rise. So that’s one of the reasons we have this very native yields now in Europe, which then is attractive to us not as a long investment but as a short investment.

CONSUELO MACK: So here we have the European Central Bank is easing, and the Federal Reserve is saying that they’re about to start raising rates which is going to make money a little bit more expensive. How does one adjust to that dynamic?

DAN ROBERTS: What’s happening now isn’t all the peculiar, and that is if you go back through time and you look at what the ECB was doing from a policy perspective and what the Fed was doing from a policy perspective, and you plot their policy rates, what you’ll find is that the Fed leads and always has led the ECB. So what we’re seeing this time is not all that strange. What is strange this time is that the ECB really waited for a long time before they started to react, and when they reacted they didn’t react nearly as much. So they are behind the Fed, and the Bank of England, if you look at the policy rate for the Bank of England you’ll see that it followed the Fed very closely. So what we have is we have the Fed and the Bank of England leading the rest of the world.

CONSUELO MACK: And their economy is actually doing better some say because of that.

DAN ROBERTS: We would agree with that.


DAN ROBERTS: Yes, absolutely, and you look at Japan and you look at Europe, and you look at some of the charts that I believe you’ve generated, what you see is their monetary stimulus is way behind the U.S. and England’s and their growth has been behind. We don’t think that that’s random. We think that there’s a very close correlation there.

CONSUELO MACK: Therefore, in an Unconstrained Bond Fund like you run, what kind of flexibility do you have that a traditional bond fund wouldn’t have to take advantage of those two different trends?

DAN ROBERTS: So for example, back in 2009 we started investing in the Unconstrained Bond Fund at the end of 2009 and at the beginning of 2010, and what we believed was at that time when the Fed was easing that that would be very, very stimulative to the U.S. economy. That would be good for corporate bond holders, and it would be very good for investment grade corporates. It would be very good for high yield, particularly good for high yield. So what we did is we put a fair amount of the portfolio into high yield at the beginning of 2010.

CONSUELO MACK: And that’s of course when a lot of people thought that the world was still falling apart.


CONSUELO MACK: They didn’t believe the recovery.


CONSUELO MACK: And therefore, high yield was considered to be high risk.

DAN ROBERTS: Exactly. Exactly right. Exactly right. And that’s one of the reasons performance is different among managers. Isn’t it? Or between people. We very much believed that high yield represented real value at pretty low risk actually because the Fed was stimulating so much that as they stimulated, as the Fed goes out and they purchase bonds, they raise the price of Treasuries, lower the yield of Treasuries, and people like us say, “Yield’s too low in Treasuries. We need to go to the corporate market,” which is what we do. So what happens is we start buying corporate bonds as done everybody else. That pushes up their price and their yield down too, but if you can get in there first before everybody starts feeling comfortable, you can make a good return on those corporate bonds, and that’s what happened with us.

CONSUELO MACK: Well, that turned out to be right, but now fast forward how many years later and, in fact, we’ve had a decent recovery in the U.S., and you’re assuming the recovery is going to continue for several more years? Is that … ?

DAN ROBERTS: Yes, exactly, and we still really like corporate bonds, and we like them for a number of reasons. Number one is we get a pretty good yield on that vis-à-vis Treasuries or agencies.

CONSUELO MACK: A pretty good comparative yield and also the real yield because inflation is so low that you actually get a pretty good yield over inflation, too. Right?

DAN ROBERTS: Exactly. Exactly.


CONSUELO MACK: So that’s a good deal for…

DAN ROBERTS: It is. People are making real returns. So number one then is we had a pretty good yield. Number two is default rates are very low, and that’s why you get a spread over Treasuries with corporates is to pay you for the default rates, and default rates have been pretty low. And three, particularly in this environment now, what we see is that corporations are doing well. They’ve refinanced their debt. They’re in pretty good shape, and a real kicker for us, something that we think is a real advantage is that towards the end of this kind of recovery, what we generally see is that as unemployment falls, as capacity utilization rises is we generally see that inflation starts to creep into the system, and as inflation creeps into the system it causes nervousness among the central banks. That’s why people are thinking the Fed’s going to raise rates. So what happens is rates start to rise. Now what’s particularly interesting in the corporate bond arena is corporate bonds are made up of two pieces. They’re made up of Treasury rates plus spreads that you get for the default. Well, those two pieces actually their yields, their interest rates move in opposite directions in a period like this, in a recovery. So when you look at the overall yield that you get for example for high yield, those two things are negatively correlated, and high yield then is protected at least to some extent against rising rates which makes it a really very attractive investment at this particular part of the cycle.

CONSUELO MACK: But if Treasury rates are rising, why does that make high yield more attractive?

DAN ROBERTS: Okay, it’s because high yield is simply a combination of those two things. You add one of those things. You add interest rates on Treasuries to that credit quality spread you’re talking about. You add those two things together.

CONSUELO MACK: Oh, I see. All right, so that’s why high yield … right.

DAN ROBERTS: Exactly. So in a recovery as interest rates here, Treasury rates rise, the quality spread comes down, and you add those two things together to get high-yield yields which determines prices of high yield, and so those two things are moving in opposite directions. That’s a wonderful thing. There are very few bonds that we know of that have this built-in negative correlation.

CONSUELO MACK: Dan, one thing about high yield is that it’s become very popular. A lot of investors in the search for yield have gone into high-yield bonds. The high-yield bond sector has done extremely well. How much life does it have left?

DAN ROBERTS: Well, high-yield spreads today are about 450 basis points, so that’s four and a half percent. That’s a little bit low relative to average but not very far from average.

CONSUELO MACK: And again that’s four and a half percent over the equivalent Treasury.


DAN ROBERTS: Over that Treasury. Exactly right, so over Treasuries. So we aren’t that far actually from the average spread. Furthermore, the world economy seems to be picking up some, particularly in Europe. The U.S. we’re doing fine. Europe is it appears starting to pick up some. We know that Japan is following a loose monetary policy. India is following … they’ve lowered rates. We know that the Chinese just recently lowered the reserve requirements by one percent. So the rest of the world is in stimulus mode. The U.S. has not yet started to raise rates, so the world really is very much in stimulus mode, and what we believe was when the world is in this kind of stimulus mode, what we believe is central banks are still out there buying bonds. They’re still driving prices up. People are still running from sovereign bonds like Treasuries to corporate bonds. Why they need yield? If you’re German and you’re getting a negative yield, well, getting a spread over U.S. Treasuries of 450 basis points is pretty attractive.

CONSUELO MACK: We keep mentioning Treasuries and one of the things that traditionally Treasuries are considered to be the least risky in the bond world because you’re guaranteed to get your money back in maturity. But you are saying the opposite actually that Treasuries are in fact, what, among the riskiest or the riskiest?

DAN ROBERTS: Treasuries have us worried. Treasuries have us worried. Why? We are entering into a period right now where the Fed is starting to raise rates, and have we seen rates rising over the last several years? At the short end of the curve we have. The two-year rate has in fact gone up. Why is that? It’s anticipating that the Fed is going to raise rates. So that’s one of the reasons why we have shorted the two-year Treasury in the U.S.

CONSUELO MACK: When does high yield become less attractive? When do you make that switch from high yield to other types of bonds? I’m not sure what the switch logically would be.

DAN ROBERTS: Okay, well, let’s talk about it. In 2006 what we did is we started making that switch, and one of the reasons we made that switch is because we no longer found value in high yield, and we will do the same thing this time. We’re not going to hold these high- yield bonds forever. We don’t want to hold them forever. At some point we’d like to take them to zero if there’s no value left. So in 2006 what happened is high-yield spreads became very, very narrow. In the credit markets there was over-leveraging going on. We thought..the risk… we weren’t being compensated. Two hundred fifty to three hundred basis points that we were getting in the high-yield market just didn’t compensate us for the risk that we saw in the world. So what did we do? We took our high-risk beta or high-yield risk down, and that’s we’re looking to do this time as well, but not yet.

CONSUELO MACK: The traditional view of a bond portfolio is that it provides income and stability. Is that still the case overall in the bond market? Income is pretty low. Stability, if rates start to go up, is going to be less stable. It’s going to be more volatile. So what should we expect from a bond portfolio?


DAN ROBERTS: Right. Well, you’ve put your finger right on it. I mean that’s the million dollar question, and that’s what everyone is asking themselves. If we back up here for a second, we say the central banks have stimulated so much. They’ve poured so much money into the bond markets because the bond markets are the transmission mechanism between the central bank and stimulus. They’ve bought so many bonds. They’ve pushed the prices so far up. Isn’t it risky? And the answer is it is risky.

CONSUELO MACK: It is risky.

DAN ROBERTS: It is risky, and that’s one of the reasons we’ve come up with the Unconstrained Bond portfolio.

CONSUELO MACK: To manage that risk.

DAN ROBERTS: Is to try to manage that risk. Is to give us the flexibility to manage around that risk but at the same time hopefully trying to give clients a pretty good income at the same time.

CONSUELO MACK: My last question is the one investment for a long-term diversified portfolio. What should we all own some of in a long-term diversified portfolio?

DAN ROBERTS: I think a great investment right now is a currency hedged European equity portfolio, and the reason we like that is because we think that what the European Central Bank is doing, the ECB is doing will stimulate the economy. I go to Europe a lot, and the Europeans are one of the ones that are most skeptical about this. So there are a lot of people believing that this increase in growth won’t happen. So that creates an environment that we think is very conducive to rising prices in the European equity market.

CONSUELO MACK: So Dan Roberts, thank you so much for joining us from MacKay Shields and the MainStay Unconstrained Bond Fund. We really appreciate your being on WEALTHTRACK.

DAN ROBERTS: It’s just been a pleasure. It’s been fun. Thank you very much.

CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. It turns out one way to do that is to invest in actively managed bond funds. This week’s action point is check out established actively managed bond funds. According to Morningstar over the last decade, unlike stock fund managers, bond fund managers have outperformed index funds and bond indexes.

For instance the percentage of actively managed intermediate term bond funds that outperformed the benchmark Barclays U.S. Aggregate index over the last three years was 71%, over the past five years was 70% and over the ten year periods was 56%.

Whereas the percentage of actively managed large cap stock funds that outperformed the S&P 500 was only 29% over the last 3 years, 20% over the last five years and 27% over the last decade.

As we just discussed with Dan Roberts, bond markets are so huge and complex that human judgement can actually add value.

Next week, we will be talking to a Financial Thought Leader who always challenges the status quo and is entertaining to boot. Cliff Asness, Founder and Chief Investment Officer of alternative investment firm AQR Capital Management will join us.

To see this program again as well as our exclusive EXTRA feature with Dan Roberts go to our website and keep connecting with us on Twitter and Facebook.

Thank you for watching. Have a great weekend and make the week ahead a profitable and a productive one.


April 24, 2015

Katy Votava Founder & President

It’s estimated that 95% of seniors are paying too much for Medicare coverage. Today, men and women who retire at 65 can anticipate living another 25, 30 or even 40 years – all of those years receiving Medicare benefits and contributing to them. On this week’s WEALTHTRACK, healthcare expert Katy Votava, president of and author of Making the Most of Medicare explains what you need to know to maximize those benefits and avoid overpaying.

The opinions expressed on Consuelo Mack WEALTHTRACK are those of the guests and do not necessarily represent the views or opinions of Consuelo Mack or MackTrack, Inc.

Founder and President of reads the charts of costly Medicare benefits and writes a prescription for a life time of savings. Maximizing Medicare benefits is next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. This week on WEALTHTRACK we are focusing on maximizing Medicare benefits for you and your loved ones. It is estimated that 90-95% of Americans pay too much for Medicare coverage. We want to make sure you are not one of them.

Our mission on WEALTHTRACK from the beginning has been to help you build financial security for a lifetime. The greatest unknown, in planning for that goal, is life expectancy. Today, men and women who retire at 65 can anticipate living another 25, 30 or even 40 years, all of those years receiving Medicare benefits and contributing to them.

The life expectancy of a 65 year-old man increased two years between 2000 and 2014 alone, from 84.6 to 86.6. Longevity for a 65 year-old woman rose 2.4 years during the same period from 86.4 to 88.8.

Needless to say, every individual is different. But one thing is certain, as we age we use more healthcare services. We see more doctors and visit them more frequently. We take more medications. We undergo more procedures and frequently we need more help. Older Americans cite medical expenses as their largest expense outside of food and shelter, much higher than the general population.

This week’s guest estimates that Americans 65 and older spend an average of 13% of their after- tax income on out-of-pocket health-care expenses. At the core of those expenditures is Medicare, which is why understanding Medicare and maximizing its benefits is so important in the financial planning process, yet it is often taken for granted and overlooked.

No more. This week’s guest is Katy Votava Founder and President of, a healthcare consulting firm for individuals, small businesses and financial planners. Votava is a registered nurse with a PhD in Health Economics and Nursing. She is a regular columnist for InvestmentNews, a leading publication for financial planners and the author of a new ebook, “Making the Most of MediCare, a Guide for Baby Boomers”.

I started the interview by asking Votava why it is so important to figure Medicare into retirement planning.

KATY VOTAVA: For many people, it’s going to be the largest expense they have outside of maintaining their home. And for so many people, it’s their biggest worry. So it’s like anything in life: if you plan for it, then you have a scheme of where you’re going to go, what you’re going to do, and if you don’t plan ahead, you’re going to be super-shocked on what the costs are. And people, I’ve seen people get all the way to retirement and say, “I didn’t know it was going to cost me this much,” because Medicare is not free and it doesn’t cover everything.

CONSUELO MACK: Talk to us about Medicare not being free. The age-old assumption has been you turn 65, you’re eligible for Medicare, you sign up kind of when you want to, and the you start going and presenting your Medicare card, not that simple, right?

KATY VOTAVA: No, it isn’t.

CONSUELO MACK: All right. So how do we approach Medicare to begin with? I mean, who is eligible for starters?

KATY VOTAVA: Okay. People are eligible for Medicare when you’re 65 years old if you have enough Social Security credits, and the vast majority of Americans do whether it’s through their own work history or a spouse’s. There are people that qualify under 65 due to medical disability as well. But once people qualify for Medicare, then there are three major parts to Medicare; they have to decide which parts and pieces they need and when because not everyone needs everything all at the same time. And there certainly are costs: Medicare A is the hospital component, and for most of us, there is no fee for that because we have prepaid for that. But Medicare B does have a premium, and when Medicare started 50 years ago, it was five bucks a month. No one noticed it; people didn’t even know it was being taken out of their Social Security tax.

CONSUELO MACK: And what is Medicare B?

KATY VOTAVA: Medicare B is the outpatient benefit. It covers all things outpatient: seeing your doctor, laboratory tests, chemotherapy, outpatient surgery, so it’s a big benefit. But there is a cost to it, too, and that cost is based on folks’ income. It’s a sliding scale based on income, and the base fee for people, most people in the United States, is about $105 a month per person. But it goes on up to over $300 a month per person.

CONSUELO MACK: And is that monthly fee, can you deduct, can that be taken out of Social Security, for instance, or is that, that’s going to be paid with your after-tax discretionary income or your retirement income, that’s a cost that you have to bear in order to get Medicare coverage for all your outpatient services?

KATY VOTAVA: It is a cost you have to bear for all of your outpatient services. I recommend people budget it into what they’re going to need in retirement. They actually can have it deducted from Social Security if they’re taking Social Security.


KATY VOTAVA: Many folks now are waiting to take Social Security until later. So if you’re going on Medicare when you’re 65 but you’re not taking your Social Security until later than that, they will send you a bill and then you pay that bill. But make sure that you pay the bill.

CONSUELO MACK: Right. And make sure, so Medicare Part B is another essential?


CONSUELO MACK: You’ve got to get Part A; you’ve got to get Part B.

KATY VOTAVA: Got to get Part B. And the third leg of the stool is Medicare Part D for prescription drugs, and that is required as well. And it’s regulated by the government but it’s insurance that’s offered by private companies, and there is a fee for that and it varies: it could be $15, $30 a month; it could be $80 a month, depending on the plan. But there is a huge amount of variation in plans of which plan covers what medication at what cost. So that’s where it’s critical for people to be smart shoppers and look for a plan that’s going to cover their medications at the best possible cost. In every person’s opportunity to look for Medicare D coverage, they will look and see 20, 30, or 40 plans that are available to them, so it can be overwhelming, when you go to do that shopping.

CONSUELO MACK: Let me stop you and ask you about the enrollment period because the enrollment period is very important, it turns out, which I did not know and I’m sure a lot of other Americans before they enrolled in Medicare didn’t know, too. Why is the enrollment period, understanding that’s so important?

KATY VOTAVA: It is key for people to know when they need to enroll in Medicare or when they could delay enrollment. And that initial enrollment period is when we turn 65 years old, three months before and three months after: that’s your window of opportunity to get in without any penalties or any other problems down the road. If you don’t get in then, you may not need to take Medicare if you’re still working and have employer coverage, and you’d have to be working for a company that has 20 or more employees.

CONSUELO MACK: So it doesn’t help if you’re working for an employer who has 20 or less or fewer employees, so small businesses …

KATY VOTAVA: Small businesses.

CONSUELO MACK: … the vast majority of small businesses, they’re at a disadvantage, right?

KATY VOTAVA: The fact is that if it’s under 20 employees, you must have your Medicare A and B. You may not necessarily need the D plan, but you must get Medicare A and B, and that’s the thing that people often don’t realize until it’s a little too late.


CONSUELO MACK: Why is it so important to enroll within that window?

KATY VOTAVA: It’s critical to enroll in that window because that’s your opportunity to get in without penalty and have your coverage start right away. And if you’re allowed to defer, you’re eligible for a special enrollment period later. But if you’re not, then your opportunity to get in is very narrow and you could wait long periods of time to get in for your coverage.

CONSUELO MACK: One of the things that’s so interesting, you mentioned that when you’re signing up for the private insurance for the Medicare Part D, that’s your drug prescription insurance, is it that you should think about what your medications are when you enroll? So of course, that’s going to be a moving target. You’re going to need different medications as you get older. How do we handle that? There’s not just one kind you sign up for and that’s it for the rest of your life.

KATY VOTAVA: Absolutely. How we handle it is do your best shopping when you go in to your first plan; get the best coverage available at the time.

CONSUELO MACK: For your needs.

KATY VOTAVA: For your particular needs, right, because one medication will be very expensive in one plan, not covered in another, but covered fine in another. So do the best you can to get in, and then, once a year during annual enrollment, that’s a time in the fall, October 15th through December 7th, where anybody can shop and look to see, okay, where am I now? How has my health changed? Are my medications costing me more than they necessarily should? And also, by the way, if a person gets a new medication during the year that’s not covered by their plan, they have rights to appeal it, have it added to their plan; the plan has to deal with them in a short period of time. And then, if there, it’s not really dealt with, for example, say that medication isn’t added, the person may have opportunities there and then mid-year to get a different plan.

CONSUELO MACK: How responsive do we expect the system to be to our individual circumstances?

KATY VOTAVA: I think that it’s key right now that you are an advocate for yourself, for the people you’re caring for, because notices roll in and they just come out of insurance companies, and it’s your responsibility to speak up on your behalf. And then, that’s tricky because you may be caring for an elder family member; you don’t even know if these notices are coming in.


KATY VOTAVA: And so, I do recommend that people go online and sign up for, and can then look at their own account and understand what’s going on in that account. You can see what bills are coming through, and it’s a really good resource for people who like to work online and particularly for caregivers.

CONSUELO MACK: That’s a great recommendation,


CONSUELO MACK: Talk about the supplemental coverage. What kind of supplemental coverage should we consider? What do we need?

KATY VOTAVA: Right. Well, we’ve got those three basic parts of Medicare.


KATY VOTAVA: We’ve got A, B, and D. And then, two main ways to put it together: one rolls into a package called a Medicare C or Medicare Advantage plan, and that does offer some supplemental coverage, and it puts all your Medicare parts and pieces together, the A and the B and the D. The thing is that it works heavily with networks, so it will work well for a person whose care providers are in that network and hospitals are in that network. You always want to make sure, best as possible, you can get out-of-network coverage, but that supplemental will cover a lot of the co-pays and costs in Medicare. The other main way to go is with something called a Medigap plan, and that’s more of an old-fashioned indemnity plan and it covers on a set schedule the different costs in Medicare. There are ten styles of Medigap plans, so that in and of itself can be overwhelming for people. They’re offered by private companies; my recommendation is that it’s a Medigap plan F style.

CONSUELO MACK: And what does that mean?

KATY VOTAVA: F as in Frank; that’s all it is. It’s a label for a type of plan regulated by the government, and F, I would think about it as F as in full; it’s the most full supplemental coverage you can purchase. It’s offered by a variety of companies, and it’s all the same benefits, so you want to look at the company that your doctor will process with most readily. Prices will vary amongst companies, so that’s another place to do your shopping.

CONSUELO MACK: When a client comes in to you and says, “Look, do I get the Medigap plan, do I get the Medicare Advantage,” what do you, is there a general rule? What do you tend to recommend? Or do you recommend one over another?

KATY VOTAVA: Well, health care coverage is very unique and individual.

CONSUELO MACK: Yes, and it really is; even with these big government programs, it is?

KATY VOTAVA: Yes. And so, here is a basic preference that I want to know from people is do you mind going within a network? And it’s not just do you mind; we’ll do research and say, “Are your health care providers in most of the networks in the area?” And if they’re not, that Medicare Advantage plan isn’t going to buy you a whole lot. You’re going to wind up wanting to go out of network and that’s actually sometimes difficult in a Medicare Advantage plan, and if you want the optimum level of choice, you want to go with a Medigap plan because Medicare itself has no particular networks. That can be more costly but not necessarily so. It also depends on where people live in the United States. In certain parts of the country, upstate New York, the Medicare Advantage plans are what I will call very robust. Most of the health care providers participate in the hospital as well. So it’s comprehensive coverage. In some other parts of the country, you find that the hospitals you want to go to and the doctors you want to see are not participating in those networks. And so, in those situations, a Medigap is going to be more suitable for people.

CONSUELO MACK: So is every state different? Is that basically the way it works?

KATY VOTAVA: Medicare varies down to the county and zip code level. So it’s not just state, it’s regional and down to the county and zip code level. So it is a complicated thing.

CONSUELO MACK: That’s why you’re in this business but …


CONSUELO MACK: How does the layperson figure out that my county and my zip code, that these are the kinds of plans that are being offered to me?

KATY VOTAVA: There is a pretty decent tool called, and you go on that website and you can do shopping. And for many people initially, I think it can be a bit overwhelming. You can also call 1-800-Medicare, and 24 hours a day, real people answer the phone and they will answer your questions, and a lot, they will actually help people sort and sift to a certain degree and help them identify what’s a drug plan in your area because that can be very complicated. The other really great resource for people is, I recommend they go to, and on that website, you put your zip code in, and that will direct you to the state health insurance information system in your area. Every area in the United Dtates has something called an Area Office on Aging. It has a different name depending on where you live, but they will tell you where to go, and there are specialists right at those organizations who for free will help you sort and sift through this.

CONSUELO MACK: Why do 95 percent of people pay too much for Medicare? I read that in some of your literature?

KATY VOTAVA: And that comes from well-done studies from major universities in the United States, and it is shocking. CONSUELO MACK: Ninety-five percent pay too much.

KATY VOTAVA: Ninety to ninety-five percent of people on Medicare pay too much, so they’re wasting money. So here we’re saying, boy, we feel our budgets are tight, but we could do better. And how it happens is two main things: the doctors aren’t necessarily in the network, we talked about that, but the big thing is medications. You don’t want to pick a plan just on premium; you want to pick it based on benefits.


KATY VOTAVA: And so, it’s individually looking to say on that website, you enter your medications into the system there, and it’ll hold it and it gives you an ID number, it’s not personally identified with you, and then you can use that list to shop and really compare those different plans. So that’s a good place to start. I don’t recommend people stop there because you then want to, if you see a couple of plans, go specifically to those plan websites because most of the time, the is pretty updated, but it does change and it can change. So you want to verify with those companies. But it’s very individual and that’s how people overspend.

CONSUELO MACK: So the biggest mistakes that people make in handling their Medicare, one is, you just mentioned it, is overspending and that the drug expenditures are the area where they make the most mistakes …


CONSUELO MACK: … is that right?

KATY VOTAVA: Predominantly. That’s one of the two. The second is the network issue, is who are your care providers, not just your doctors but you go to laboratories; ask ahead of time. I’ve had people say, “I’m sent to an MRI; I didn’t realize it was out-of-network.” Well, you have to ask. That’s all there is to it. And so, necessarily ask ahead of time to say, “Where I’m going to for these various tests and treatments, my physical therapists, are they in the network?” All of these care providers will have a network affiliation or not, and it’s very individual based on the coverage that you have, and it can change year to year. It doesn’t necessarily mean that what you have this year, that the networks won’t change next year, and we’re seeing that more and more that they do change.

CONSUELO MACK: So I’m thinking of, for instance, lab results. I just got a physical.

KATY VOTAVA: Uh-huh, yes.

CONSUELO MACK: I should know the lab that my blood tests are being sent to, right?

KATY VOTAVA: You should not only know that, you should know ahead of time if it’s, particularly when you have a Medicare Advantage plan, it’s key; when you have a Medicare Advantage plan, you really must ask ahead of time unless it’s a real emergency, “Is this laboratory in my network?” And it’s really relatively easy to do. There is a customer service number on the back of the card. You call them up and say, “Here’s the lab that’s been recommended for me; is this in the network?” If it isn’t, then get a list, and they’re on the websites, too, and take that back to your health care provider and say, “Is there a lab here that will do just as well?” Most of the time, there is.

CONSUELO MACK: How many mistakes does the Medicare system itself make? I mean, how carefully should we monitor all of those, I’m thinking about all of the things that my mother gets from Medicare …


CONSUELO MACK:… is that I just, it’s kind of overwhelming.


CONSUELO MACK: Should each one of those pieces of paper be read carefully, and should I make sure that the services that she is being billed for that Medicare is paying for, that in fact, she was there that day for that service?


CONSUELO MACK: I mean, is there a lot of kind of fraud or waste within the system itself that we should be monitoring?

KATY VOTAVA: Yes. So there are two different questions here.


KATY VOTAVA: One is fraud in Medicare, which actually is a big national problem.

CONSUELO MACK: So I understand, uh-huh.

KATY VOTAVA: And people really need to look at their explanation of benefits, and if there is something there that you absolutely didn’t receive, you should report it.


KATY VOTAVA: But how many times are there errors? There aren’t as many errors with traditional Medicare and Medigap, but you really want to look, particularly I think with Medicare Advantage plans, to make sure, are things properly being coded in the right way so that it’s categorized and paid for properly? And whenever a person is being asked to pay a bill, be very careful and look at that ahead of time as say, “Does Mom really owe this portion?,” because sometimes they’re catching up with pieces and parts of billing. So that’s another place where that site can be helpful because it will show you what Medicare has paid on her behalf, and then, the insurance company will have its own separate site. So it’s one of those things, too, it does take a little time to put it all together.

CONSUELO MACK: I’ll say. Do you have a view on AARP? I mean, anyone who turns 50 starts getting literature from AARP, and certainly, this is a huge business for them.

KATY VOTAVA: Yes, it is.

CONSUELO MACK: I mean, do you, is that kind of an, is there any such thing as a no- brainer in going for an insurance coverage by an organization like AARP? Or should we really shop around?

KATY VOTAVA: You know, AARP is a great organization and they have a great reputation. But in fact, what they do is they sell their name to an insurance company. So it is an insurance company, United Healthcare predominantly, that provides the health coverage under the AARP label, whether it’s an Advantage plan, a drug plan, or a Medigap plan. And so, that’s what it is, and United Healthcare is a fine company. So beyond that, really, people want to have a brand name that they like; there are some other major brand names of insurance companies. The problem with that is that’s where you can really make a mistake to say, “Okay, I know about that company; I feel comfortable with that name.” And if you don’t shop and then you’re finding out that you’re overspending, that’s a real problem. And yet, I understand why people do that because it’s easier initially to go that way. But stay with reliable companies; that’s key because your things will get processed in a more timely fashion. And so, I think that that’s an important thing: if you see no-name company you’ve never heard of, be very careful. I have seen some and they’re probably fine in some regards, but particularly if they’re new on the market, one of the biggest problems they have is their networks are so small. I have seen brand new companies that you really haven’t heard of, and there isn’t a hospital within 100 miles, honestly, that the coverage works for, and what good is that for you?


KATY VOTAVA: You know?

CONSUELO MACK: Last question – one investment for a long-term diversified portfolio, we, every guess gives us one, what would it be in this area, Katy?

KATY VOTAVA: In this area, I have a structure to recommend for people to save for their health care and retirement, and it’s called a Health Savings Account, and it’s actually the most tax-preferred savings vehicle we have in the united states today. Money goes in tax-free, grows tax-free, and comes out tax-free when used for your health care, and people can contribute to that in their younger years and accumulate a balance. I recommend people contribute up to the full amount every year, and they’re going to be surprised how much money they have for their health care in retirement.


April 17, 2015

David Rolley Co-Portfolio Manager, Loomis Sayles Global Bond Fund

In an era of negative bond yields, it has rarely been more challenging to make money in the world’s fixed income markets. On this week’s WEALTHTRACK, veteran Portfolio Manager, David Rolley of the Loomis Sayles Global Bond fund explains how he and his team are both protecting their portfolios and seeking outsized returns in some out of the way places.

CONSUELO MACK: This week on WEALTHTRACK, Loomis Sayles Global Bond Fund Manager David Rolley is finding more valuable plays in places like India and Brazil and tells us what other international investments are music to his ears. That’s next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. A recent Wall Street Journal headline put it succinctly: “New Era in Bonds: Zero Yield, or Less”. For the first time ever a country, in this case Switzerland sold a 10-year bond that gives investors a yield below 0%.

That negative yield means investors who bought the bonds when they were issued will not get all of their principal back in ten years, they will actually lose money. That’s not supposed to happen when you buy a top rated government bond. It also turns the whole borrower/lender relationship on its head. Why are investors paying Switzerland to lend the country money?

It’s a question we will discuss with this week’s veteran bond manager guest.

Another phenomenon with the potential to roil the bond markets is the relationship between supply and demand. It has changed dramatically since the financial crisis and the changes are not favorable to investors. Liquidity, the ability to trade bonds easily has deteriorated.

As you can see from this chart, dealer inventories of corporate bonds have plummeted as banks and other traditional market makers have withdrawn from the market under pressure from new laws and rules put in place after the financial crisis.

But while dealers reduce their supply the size of the market has soared as more companies issue bonds and more investors buy them. The problem is without big dealers it is getting harder to buy and sell bonds quickly, particularly in size.

These are just two of the challenges facing bond investors today. This week’s guest is more than up to the task.

He is David Rolley Co-Team Leader of Loomis Sayles’ Global-Fixed Income Group and Emerging Market Debt Group. Rolley is the Co-Portfolio Manager of several funds including the Loomis Sayles Global Bond Fund since 2000, which is a Morningstar silver medalist and the Loomis Sayles Global Equity and Income Fund which is ranked four-star by Morningstar, and which he has co-managed since 2008 with bond legend Dan Fuss.

Loomis Sayles is a long-time sponsor of WEALTHTRACK but Rolley has more than earned his spurs as a global investor for over three decades.

I began the interview by asking Rolley how hard it is to find investment opportunities around the world.

DAVE ROLLEY: Well, Consuelo, the reality is it is probably as difficult today as it has ever been, and it’s difficult for a reason. Our yields are very low. This is not, you don’t need an expert to know that interest rates are low in the United States; and they’re not just low in Europe, they’re negative in Germany, negative interest rates. This is unprecedented, and this has happened for a reason, and the reason is that our markets, the bond markets, are, you might call, collateral damage in central banks’ attempts to speed up the world economy, but they’re doing it with interest rate suppression. That’s really what quantitative ease is: they’re buying a lot of bonds that drives up the price for the short term, but it drives down the interest rates, and that’s across all the yield curve, and it’s true in the United States, it’s true in Europe, it’s true in Japan, and I think it’s increasingly true even in China.

CONSUELO MACK: Central banks are that powerful? We’ve got a global market; it’s very complex. They have that much power to determine really the level of interest rates?

DAVE ROLLEY: The answer is yes, given the growth and inflation environment that they are dealing with today. That would not be the case if, let’s say it’s 1997 and you’re central bank is Argentina, Argentina facing a rising inflation rate. In that case, their power to suppress interest rates would be very limited and they would not be able to do it. But here where the growth outlook is challenged, where most economies have excess capacity, where headline inflation rates have had one handles in the United States, I think the headline CPI …

CONSUELO MACK: That’s one percent. Right.

DAVE ROLLEY: … was actually just, the all-product CPI was actually zero where it has been negative in Europe, where it has been negative in Japan. Yes, yes, in that world, you don’t have countervailing forces and they can do what they want.

CONSUELO MACK: Right. How long do you anticipate this to continue, this kind of interest rate suppression?

DAVE ROLLEY: I think the answers are going to be different in different economies and …


DAVE ROLLEY:… the market consensus, which we agree with, is that the first to extraordinary policy will be the United States because from the crisis, we have kind of done the best and we are the closest to being healed and healthy.

CONSUELO MACK: Now, so you agree with the consensus that, in fact, that Janet Yellen and the other Fed officials are going to raise interest rates sometime this year.

DAVE ROLLEY: I think our current working guess is September.



DAVE ROLLEY: And it will be driven by the data.

CONSUELO MACK: And when they do start raising rates, is it going to be a very gradual process? And what, you know, people talk about kind of the natural rate of what interest rates should be, what the ten-year Treasury note should be, so what would be a normal rate under regular circumstances without the Fed keeping interest rates low?

DAVE ROLLEY: That’s a good question. And we have a lot of history of interest rates, and if you look at the history over time, you’ll notice that there are certain relationships that reappear over and over again. One of them is that most of the time, the inflation-adjusted interest rate, the real interest rate if you want to call it that, looks something like the real growth rate.




DAVE ROLLEY: Of GDP. Why would that be? If you think about it, the simplest way is that there is an arbitrage: if you can grow faster than what it costs you to borrow, you ought to borrow the money because that’s what you can get on your investment. But if it costs you too much to borrow and you’re not growing that fast, borrow less because you can only get what the GDP is going to produce.


DAVE ROLLEY: That’s not true company-by-company, but when you add everything together, it kind of holds, and what you see is you see GDP trends correlating with real interest rate trends, not just over time but across countries. So Japan was slow-growing and it had a really low inflation rate, it had a really low yield for a long time. High-growing countries tend to have higher interest rates over a really long time. So if you wanted to pick one metric, one rubric that most economists would agree with most of the time, the real growth rate should look like the real trend, real yield in the bond market.

CONSUELO MACK: So our rates right now in the U.S., for instance, are far below, right, the real growth rate?

DAVE ROLLEY: Oh, yes. Oh, yes. We’ve got two-handled growth. So you might think that, add one-and-a-half percent on inflation, you might think that fair value for the ten-year Treasury might be three-and-a-half percent. Well, it’s been a long time since we’ve seen three-and-a-half percent on the ten-year Treasury. And quite frankly, most people would now put fair value at something between two-fifty and two-and-three-quarters, maybe three percent max. That’s all pretty much what anybody expects until we have a different world.


CONSUELO MACK: How do you manage, let’s just start with the U.S., so number one, your view of the value of the U.S. Treasury market and value of the U.S. bond markets, for instance, what is your assessment? Very rich?

DAVE ROLLEY: I think …

CONSUELO MACK: Fairly valued?

DAVE ROLLEY: … our short version of that is that when we look at all of the markets, we see the equity markets as fully valued and we see the high-quality bond markets as overvalued, and that was overvalued for a reason. It has to do with excess central bank liquidity that will go on for a while, but as that liquidity is gradually withdrawn, our bias is to expect high-quality interest rates to rise a bit. That means you have to worry about capital losses. So the longer the maturity of your bond, the bigger your risk exposure to capital loss is, you know?


DAVE ROLLEY: If a 30-year bond sells off, it’s a lot more painful than if a two-year bond sells off. So what we have been doing is we have been deemphasizing Treasuries except for liquidity reserves; that’s your buying power you keep on the side. When something else gets alarmingly cheap somewhere else, you need to have something to buy it with, and we don’t lever portfolios. So we always keep a little cash around if we want to go shopping. But we have then been looking at essentially mid-quality credit, and that means we look at asset- based securities and we look at corporate bonds. When we look at corporate bonds, we tend to like triple-B, which means they are investment grade but not the best, so they …

CONSUELO MACK: So the lowest tier of investment grade.

DAVE ROLLEY: … lowest tier of investment grade.


DAVE ROLLEY: And we like the highest tiers of the high-yield market. We don’t want to go down to a triple-C market most of the time because that really requires a very strongly- growing economy for those guys to grow into what is probably a very challenging capital structure. Now, you’ve asked about the U.S. corporate market, and quite frankly, most investors now would break that market into two parts and that would be oil names and everyone else.

CONSUELO MACK: Right, and explain that, that very important demarcation in the markets right now, not always the case but right now.

DAVE ROLLEY: It has to do with the fact that the price of oil has fallen by half, and the businesses that work at $100 oils may not work so well at $50 oil, particularly if you’ve borrowed a lot of money to invest in an oil services business or to drill a new field. And in those kinds of businesses, they can be very, very sensitive to the oil price; it’s the difference between a cash flow that’s positive and losing money every day.

CONSUELO MACK: And energy bonds are a large chunk, right, of the high-yield bond market?

DAVE ROLLEY: I believe they’re something north of 15 percent, in the range of 15 percent of the entire high-yield market was energy-lending. And so many of these folks are, they’re not quite wildcatters, but nonetheless, there was a lot of optimism about the drilling prospects that they’re following up, but there’s a lot of leverage.

CONSUELO MACK: Therefore, because the entire high-yield sector has been hurt by the decline in oil prices and the perception that therefore, all of the energy bonds could be vulnerable to default or whatever. So tell me how you’re assessing the high-yield sector and opportunities.

DAVE ROLLEY: Consuelo, you’re absolutely right, and you’ve actually pointed at two different opportunities and they’re both investable; and they both represent value but they’re different values and they have different kinds of risks associated with them. The first is the oil sector itself, and because almost all of the oil names have been driven lower, you can then look through them and say, well, who are the survivors here and at what price? And you can stress-test these companies and say, well, what do they look like at $30 oil? What do they look like at $50 oil? And if you think oil is going back to $65 in a year or two, you can look at those.


DAVE ROLLEY: And we look across those names and we found some companies that we think are survivors. I won’t mention the names on the show, but that is an interesting area. And furthermore, there’s another way to get paid there. It is that if all of your oil reserves have been marked down by 50 percent in value, there are other very powerful oil companies, household names, your Exxons, your Chevrons of this world, that might find acquisitions to be a way to rebuild reserves. I don’t know …

CONSUELO MACK: For themselves, exactly.

DAVE ROLLEY: … exactly.

CONSUELO MACK: So they can get them cheap.

DAVE ROLLEY: I don’t know if you know, but all of the biggest oil majors, and no one’s worried about their credit risk, what people are worried about is their long-term business risk. All of them, their biggest business challenge is replacing their existing reserves, and they have been awfully good at that for a long time, but it becomes increasingly difficult over time. If they can make an acquisition and replace reserves with a company that they are buying that they think might be at a substantial discount to its long-term value, that’s probably a good business bet.

CONSUELO MACK: So therefore, there’s a stock opportunity there as well.

DAVE ROLLEY: What happens is that the equity guys could get paid a whole lot of money, but the bond guys who buy their bonds at a discount because they’re borderline triple-B or high-yield, going from double-B to single-B because of this price pain, you might wake up and discover that you’re owned by Exxon and, wow, suddenly you have an A-rated security, and that’s not a bad day.

CONSUELO MACK: Sure it isn’t, right.

DAVE ROLLEY: We won’t make as much money as the equity folks, but a re-rating of the ownership of a bond can represent 10 to 25 price points of capital gain the day the transaction might be announced.

CONSUELO MACK: Wow. That’s pretty impressive.

DAVE ROLLEY: It’s a good day for fixed income.


DAVE ROLLEY: You’ve mentioned something else though, and I think this is actually almost as interesting in terms of making money. You talked about the effect of oil price weakness on the entire high-yield market. It was 15 percent of the indexes. Some people sold high-yield ETFs. Some people reduced positions in high-yield mutual funds. That put pressure on the whole high-yield market. So now you can find better values for securities just because they had the same rating as the energy names. They’ve been sold, but they have no oil exposure whatsoever. They could be in the health care business, and we’re taping this at a medical library, so that seems like a reasonable industry to think about, and some of those names have become more valuable as well. And so, we have increased our high-yield exposure across all of our portfolios not just in energy names, but certainly with a bit of an energy concentration.

CONSUELO MACK: Let me ask you about something that you mentioned earlier, which is that in some countries, for instance, Germany, that we are seeing negative interest rates, which in my experience on Wall Street, I’ve never been in an environment where we’ve had negative interest rates.

DAVE ROLLEY: Across Europe, a number of the North European bond markets, not just the German bond market, have negative yields. Now, I asked a very senior European economist who was visiting our offices recently, why would a European investor buy a German bond with a negative yield? And his answer was very simple: it was, “Because they’re afraid it might get more negative.” I said, “Well, I guess that’s what you might call a momentum strategy, not a value strategy.” And he said, “We call these technical markets.” And we had a long conversation about why people like buying negative yield in securities, and it has to do with maybe they can’t buy anything else, and that’s either because they are a central bank and the Euro forms part of their reserves.

CONSUELO MACK: Right. So they have to hold these.

DAVE ROLLEY: And they have to own some.


DAVE ROLLEY: But they’re not probably increasing their share. Maybe they’re a bank or an insurance company where they want to own government bonds because it doesn’t have a capital charge against the investment, whereas if they owned common stock in any of a dozen high-performance European companies, they would have to allocate equity against their equity position, their own, they have to have a less-leveraged company because people see stocks as risky.


DAVE ROLLEY: That’s what the regulators have said. Well, I tend to think that a well- performing company’s equity is less risky than a negative-yielding bond because with a negative-yielding bond, I am certain that I have permanent loss of capital. I’m pretty sure of that. And the other stock, it might actually grow. So it’s not clear that what the regulators are doing makes sense, but those are the laws and that is how they have to allocate portfolios. So what we have is we have trapped capital, and the trapped capital is stuck in some negative- yielding securities. That doesn’t mean we have to jump into that box with them.

CONSUELO MACK: Right. And so therefore, at Loomis, Sayles, you are not jumping into that negative interest rate box.

DAVE ROLLEY: No, no, no. We think that makes no sense whatsoever.

CONSUELO MACK: Right, what’s your assessment of the opportunities in emerging markets?

DAVE ROLLEY: I think they’re interesting and they’re going to get more interesting. And that’s true on both a fundamental basis and a cash flow or investor positioning basis. Let me talk about some fundamental markets that we kind of like but which it’s hard to invest in. India is, I think, an improving story. India is not an oil exporter; they don’t depend on the price of iron ore.

CONSUELO MACK: Like China does. Right.

DAVE ROLLEY: They depend on essentially whether governance in India gets better. The Indians are very entrepreneurial; they have good businesses. They have a massive domestic economy; there’s over a billion people there. This is a huge economy that could grow very rapidly with relatively moderate changes. We have a world-class central banker who is relatively new in the job and has just a host of good ideas that he is in the process of implementing. So I think Indian financial markets have responded positively to that. We have the new administration, and while they, I don’t think they can do everything they want to in 100 days, they are committed to growth, and I think that they’re going to find their way to get it. So in that world, your best ideas are probably equity ideas, but where you can find rising improving Indian companies that issue bonds outside of India, that’s a very interesting investment for us.

CONSUELO MACK: Oh, interesting.

DAVE ROLLEY: And we hold those positions. And in many cases, we’ve already seen credit upgrades in the names that we own, so that’s worked very well.

CONSUELO MACK: So these are, Indian companies that are issuing bonds.

DAVE ROLLEY: … Indian companies issuing dollar-pay bonds …

CONSUELO MACK: Dollar-pay bonds.

DAVE ROLLEY: … in global markets.


DAVE ROLLEY: There are some offshore Indian rupee securities, and we use those from time to time, and we can buy the Indian currency outright through the forward markets and we do some of that as well. But I would say for most investors most of the time right now, the equity story is the most obvious form of access and might have the highest return.

CONSUELO MACK: So in the Global Equity and Income fund, Loomis, Sayles Global Equity and Income Fund, of which you are a co-manager, so Indian securities are an area, and I know …

DAVE ROLLEY: Yes we do own…

CONSUELO MACK: …and I know you are very careful about specific Indian securities, so it’s very important what you’re buying …

© 2015 MackTrack. All Rights Reserved Page 9 of 10


CONSUELO MACK: | WEALTHTRACK Transcript 4/17/2015 – Program #1143

DAVE ROLLEY: But yes, India is …

CONSUELO MACK: … that that’s an area of opportunity for you.

DAVE ROLLEY: … yes, India is an important country in the portfolio now.

CONSUELO MACK: Loomis, Sayles Global Equity and Income Fund, my understanding is that you have a maximum position in that fund in equities …


CONSUELO MACK: … right now.

DAVE ROLLEY: Yes, we’re at our equity limit.

CONSUELO MACK: Yes. So explain why you are at your equity limit.

DAVE ROLLEY: Because we think that ultimately, when we look at the stocks that we hold name-by-name, we think their horizon return will be not just positive but could very possibly represent double-digit returns. And you look at the bond opportunity, and, well, there is just a lot of pain ahead probably. You have very low yields that will at some point renormalize. You do not renormalize without a loss of capital, re-pricing that security down. So if we own it at 100 cents on the dollar today, we’re going to own it at 92 cents on the dollar the day after tomorrow in many parts of the bond market, and that’s an eight percent loss. And if you’re only getting paid one or two percent in terms of your coupon income, that’s a tough investment to justify. Now, we are finding value, but the opportunity set is still bigger on the equity side than it is on the fixed income side because you don’t want to build an entire portfolio out of energy, distressed metals, and Brazilian securities. That’s not diversified enough.

CONSUELO MACK: Yes. But in a global bond portfolio, or even in the international bond portfolio, you have to be invested in bonds.


CONSUELO MACK: So what’s your bread-and-butter investment in a bond portfolio?

DAVE ROLLEY: The core structure, you know, we wake up every day, the global team sort of sits together, and in this kind of interest rate environment, very low yields, a relatively strong dollar, our first job is to do no harm. We are overweight dollars, but it’s a risk- controlled overweight. We have very little in terms of European high-quality securities because I don’t like negative yields. We are looking selectively across the entire opportunity set of over, I think, 1000 investable companies around the world to find companies that can.


April 10, 2015


Few investors have the prescience of this week’s Financial Thought Leader guest. Long before the 2008/2009 financial crisis he identified the powerful and destructive rise of what he called the “Shadow Banking System”, the unregulated institutions funding the housing and credit bubble. He also coined the phrase “Minsky Moment”, after the economist Hyman Minsky’s theory that financial stability ultimately leads to financial instability, as people and institutions take on more risk. That is exactly what happened. This week’s WEALTHTRACK guest is legendary bond trader, Federal Reserve watcher and economist, Paul McCulley who spent many years in the top ranks of bond giant PIMCO. What financial forces does he see gathering now?

Paul McCulley Economist & Fed Expert


CONSUELO MACK: This week on WEALTHTRACK, globe trotting economist, Fed watcher and Great Investor Paul McCulley gives us the big picture view of the world’s economies and markets and what it means for your portfolio, next on Consuelo Mack WEALTHTRACK.

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

Few investors have the prescience of this week’s Financial Thought Leader guest, which is why we have asked him to come back to WEALTHTRACK and give us an update on his views of the state of the financial world and markets. We will also ask him to make a few portfolio suggestions!

He is Paul McCulley, former Senior Partner at PIMCO. Founding Member of its Investment Policy Committee along with firm founder Bill Gross, Author of the influential monthly “Global Central Bank Focus”, and Manager of PIMCO’s huge short term trading desk where he oversaw an estimated $400 billion dollars in assets.

McCulley retired from PIMCO in 2010 to write, think, speak and otherwise lead a more balanced life, which he did until last year, when he was lured back to PIMCO for a few months as Chief Economist by his former boss and close friend, Bill Gross before Gross abruptly left the firm for another. We’ll discuss McCulley’s decisions in our extra session on our website

I mentioned McCulley’s prescience. Long before the 2008/2009 financial crisis he identified the powerful and destructive rise of what he called the “Shadow Banking System”, the unregulated institutions feeding the housing and credit bubble. And he coined the phrase “Minsky Moment”, after economist Hyman Minsky’s theory that financial stability, as this country had during the Alan Greenspan era, ultimately leads to financial instability as people and institutions take on more and more risk. Well of course, that is exactly what happened.

We asked McCulley what forces he sees building in the economy now?

It’s a fascinating question, because the whole mosaic of Minsky I can talk about for hours, and we don’t have hours. The “Minsky Moment” is the culmination of excesses where you have a sudden stop in the markets, and you have a massive recession. And technically speaking, what you’re doing is you’re ushering in something called a ‘liquidity trap.’ Which is that your central bank takes interest rates to zero, but nothing much happens. Because the private sector is checked into the Nurse Ratchet center for balance sheet rehabilitation. So it’s not the price of debt; the private sector has got too much of it. So they’re delevering. So the central bank, quite appropriately, goes to zero, but nothing much happens because you’ve got delevering. And that is known technically as a ‘liquidity trap.’

CONSUELO MACK: And so where are we in the liquidity trap? Then are we out of it?

PAUL MCCULLEY: Well, fortunately America is on the cusp of exiting.


PAUL MCCULLEY: And actually it’s been an amazing journey over the last six years, because as you note, we have been stably at zero for short-term interest rates for the last six years.


PAUL MCCULLEY: And that’s not the textbook answer to getting out of a liquidity trap. Conceptually, what you should do is you could go to zero, but you should have the government do the opposite of what the private sector is doing.

CONSUELO MACK: So it should stimulate, the government should stimulate.

PAUL MCCULLEY: The government should borrow. If the private sector is delivering, the government sector should lever up. Now, other people would derisively call that ‘deficit spending.’

CONSUELO MACK: Right, it’s a Keynesian…

PAUL MCCULLEY: Keynesian. So you’ve got all sorts of back…

CONSUELO MACK: John Maynard Keynes, right.

PAUL MCCULLEY: We did some of it the first couple of years, and then the Tea Party captured the Republican Party and we had austerity. Which is not just boneheaded; it’s stupid. When you’re in a liquidity trap and the private sector is in self-imposed austerity, the last thing the government should do is join them. But we did. Which meant that all the burden was on the Fed and they got us out of the liquidity trap. That can work, but actually has some saddle benefits or liabilities, that are not particularly attractive.

CONSUELO MACK: So let’s talk about those, one of the things it’s created is that as we all look for returns on our money, we’ve got to go to other markets, because we can’t get them in our savings, we can’t get them in the fixed income markets, right? So there’s this asset inflation that everybody talks about.

PAUL MCCULLEY: Yes, effectively getting out of a liquidity trap with monetary policy alone, with actually fiscal policy going the opposite direction, requires inflating asset prices.

CONSUELO MACK: Right, so stocks, bonds, and what, real estate.

PAUL MCCULLEY: And real estate are the big three.


CONSUELO MACK: So those are the three major ones, yes.

PAUL MCCULLEY: But just remember, a “Minsky Moment” is because you have too much debt relative to income and asset values. I mean, the housing sector you ended up with a notion of the debt’s higher than the value of a house, called an ‘underwater mortgage.’ So a debt problem is not just an absolute debt issue. It’s debt relative to assets. So if you want to get out of a debt problem, either you can write down the debt or you can drive up the price of the asset.

CONSUELO MACK: So that’s what we’ve done, that’s the path.

PAUL MCCULLEY: We’ve driven up the price of the asset, which actually internally delevers the system, because everybody’s asset-to-debt ration improves, because capital gains on asset prices don’t have an offsetting liability. They’re the free lunch in the game. So it sounds all delightful.

CONSUELO MACK: It does. So what’s the problem?

PAUL MCCULLEY: The problem is that it is undemocratic, and doesn’t pass a smell test of social justice. Because if the way you get out of the soup is to drive up asset prices, that’s going to benefit the people who…

CONSUELO MACK: Have assets, right.

PAUL MCCULLEY: … have assets. Poor people don’t have assets.


PAUL MCCULLEY: Middle-class people have assets, and particularly their 401(k) and their house. But the people who really have lots of assets and particularly stock? Are rich people. So getting out of a liquidity trap, which is wonderful to do; no criticism of Ben Bernanke whatsoever. It beats the hell out of the alternative, which is a depression. But if you’re going to get out of this way, it will … the way he had to do it … I stress he had to do it this way; it wasn’t a choice, he had to do it … you will end up, when you get out of the liquidity trap having a more unequal, unjust society than when you went into it. It is quite bluntly a form of trickle-down. And trickle-down doesn’t pass my progressive sense of social justice, but it does work.

CONSUELO MACK: Right, and it doesn’t pass Janet Yellen’s sense of social justice either.

PAUL MCCULLEY: No it doesn’t. CONSUELO MACK: Because she is a progressive.

PAUL MCCULLEY: Yes, she is.

CONSUELO MACK: I mean, she admits it, and so here we are, we’re looking at the employment. And the unemployment rate has come down. So where are we, as far as the employment situation, and the economy going still subpar growth for a post-World War II economy? How are we getting out of that? What’s the outcome going to be there, Paul?

PAUL MCCULLEY: We’re getting out of the liquidity trap, but we’re not getting out of the economy that’s still not performing up to its potential.


PAUL MCCULLEY: And we’re not easily getting out of the economy that has got the most unequal income distribution and wealth distribution of our lifetime. And it’s a huge concern of Janet Yellen’s. And the easy answer is to ignore Wall Street’s cries about the notion that we’re going to have an inflation problem if wages move up. I mean, I spent so much of my career literally on Wall Street, south of here, this whole notion of, you know, if the labor market is high, then the Fed’s behind the curve and I need to tighten up and throw somebody out of work.

CONSUELO MACK: But we’re so far from the labor market being hot.

PAUL MCCULLEY: We’re so far from that, and Janet’s perspective is very straightforward. If the average Joe gets a raise in America that’s above inflation, that’s called a solution, not a problem.

CONSUELO MACK: Yes, and that’s a low bar now, because inflation is below, well, two percent, by whatever measures.

PAUL MCCULLEY: Exactly. Exactly.

CONSUELO MACK: So aren’t we kind of getting there, though? So aren’t we starting to see?

PAUL MCCULLEY: We’re getting there very incrementally, but it’s a wonderful thing. It’s not a problem. And actually this phrase that I’ve been around all of my life from Wall Street, of ‘wage inflation,’ as it’s just mean, nasty, ‘we’ve got wage inflation.’ Excuse me, we never talk about profit inflation. Wage inflation, no. We’re going to see the Fed underwrite, under Chair Yellen, an increase in the return to labor. An increase in the return to labor.

CONSUELO MACK: So do you think that Janet Yellen and the Fed can do that alone? I mean, are we on our way there?

PAUL MCCULLEY: Actually I think that they now have the phrase, and I think Bill Dudley actually put into the lexicon the phrase: ‘let the labor market run hot.’


CONSUELO MACK: The president of the New York Fed.

PAUL MCCULLEY: Yes. And so they’re going to let the labor market run hot, which means that we’re going to have a four percent, as the first number on our unemployment rate, I think. Perhaps we could go to the low fours percent.

CONSUELO MACK: Before what?

PAUL MCCULLEY: Before the Fed would consider it to be a problem. Now, there are a couple of implications as we think in terms of markets. Just because the Fed’s willing to let the unemployment rate go to the low fours, which is a principal populous I say hallelujah to …

CONSUELO MACK: And this is a whole new target for them. It used to be, I remember when unemployment reaches six percent.

PAUL MCCULLEY: Six percent.

CONSUELO MACK: Right, then we’re going to start raising rates.

PAUL MCCULLEY: We’re going to start raising rates, to keep it from going any lower.

CONSUELO MACK: And now it’s like, you know, it’s in the fives.

PAUL MCCULLEY: We want it to go lower because we want to get the inflation rate back up to target. We’d also like to see an increase in real wages, which means we need to have wages faster than inflation. So I think the Fed’s going to underwrite that scenario.

CONSUELO MACK: And so meaning underwrite, what does that mean for policy?

PAUL MCCULLEY: Which means that once they get off of zero, it’s going to be a very tepid increase in interest rates. Everyone’s been focused on what day are they going to have liftoff? And that day’s going to be sometime this year, I think. Unless there’s some shock that I’m unaware of. And I think that would be consensus for the Fed. The big issue now is not the day of liftoff; it’s what happens after liftoff. And Chair Yellen gave a fabulous speech a week ago, well last Friday, in San Francisco, pounding the table that it’s going to be a kind and gentle trajectory for interest rates after you get off of zero. And I think that a couple of years from now, we’ll probably have short-term interest rates at somewhere between one and two percent.


PAUL MCCULLEY: Not two and three, and not three and four. So we’re going to get off of zero.

CONSUELO MACK: And why? Why is that?


PAUL MCCULLEY: It depends upon where essentially the equilibrium or neutral real short- term interest rate is. And actually there’s close alignment between Chair Yellen and Larry Summers on this whole issue. Because the “secular stagnation” thesis that Larry has popularized is the notion that it’s really hard to get to full employment unless real interest rates are very low, because our economy tends to want to save more than it does to invest. So therefore, I mean by definition in an accounting sense, they have to equal each other. But looking forward, there is a higher propensity to save than there is to invest. In order to get savings and investment to equal each other at full employment, you have to have an exceedingly low real interest rate, and the “secular stagnation” thesis of Larry is actually it needs to be negative.

CONSUELO MACK: Interest rates need.

PAUL MCCULLEY: In real terms.

CONSUELO MACK: In real terms, right. Ex inflation, right. There are a lot of things that are positive about having low interest rates, correct?

PAUL MCCULLEY: There are a lot of positive things about low rates.

CONSUELO MACK: Except for savers. When you get very low return.

PAUL MCCULLEY: Well, a particular type of savers. But it’s not just people who are getting low short-term interest rates. This is a very wonky subject, but has profound implications.

CONSUELO MACK: Right, and that’s what I’m trying to figure it out.

PAUL MCCULLEY: For everybody. And I’ll tell you the two implications right up-front. Number one is the existing level for bond prices and stock prices, the ten-year where it is. And it’s not just a yield, it’s a price. And the stock market, where it is, which is a price and a yield and a PE multiple. Existing valuations for bonds and stocks only make sense if John Taylor is wrong.

CONSUELO MACK: And when you say John Taylor is wrong, that is?

PAUL MCCULLEY: That four percent is not where the Fed’s going. That two percent is more likely to be the terminal point.

CONSUELO MACK: For the Fed funds rate.

PAUL MCCULLEY: For the Fed funds rate. And you put a term structure on that, which implies that the ten-year should be somewhere between two and three, which is where it is right now. So essentially the marketplace has already discounted zero real Fed funds rate, as the “new neutral”. Therefore, it’s priced into the markets. Which means that bonds and stocks are not in a bubble. If you were to work through the math and say: No, John Taylor’s right, when the Fed starts tightening, it’s going to keep tightening until you get four percent? The stock and bond markets are both in bubbles. You can make no rational case for a two percent ten-year with a four percent overnight rate. And if you can’t make a case for the two-and-a- half percent zone for the ten-year, you can’t make a case for the PE multiple on stocks. So the great news for the average investor who’s been involved in this market is that he’s not playing a bubble.

CONSUELO MACK: If you’re right. If you’re right about interest rates.

PAUL MCCULLEY: Right. And if I am wrong, it’s not a matter of my ego. If someone thinks I’m wrong, they should sell every stock and bond they own and get long canned green peas and small firearms, because all hell is going to break loose. We’re going to go back into liquidity trap, as the Fed force-marched us up to four percent short-term interest rates. It’s just I don’t think it’s going to happen, but if you think it’s going to happen, and then you shouldn’t be anywhere close to stocks and bonds right now. If you buy into the consensus in the market, which is essentially zero real, then the good news is you’re not in a bubble. The bad news is you have a rich asset class that have low yields going forward.

CONSUELO MACK: And this is in the bond market.

PAUL MCCULLEY: And the stock market.

CONSUELO MACK: And the stock market.

PAUL MCCULLEY: And the stock market.

CONSUELO MACK: It’s so rich, so what’s rich?

PAUL MCCULLEY: Well, it’s not so much that it’s …

CONSUELO MACK: Fully valued, overvalued?

PAUL MCCULLEY: It’s fully valued relative to the cash alternative.

CONSUELO MACK: Okay, right. Stocks and bonds are fully valued relative to what you can get in cash.

PAUL MCCULLEY: Cash, both now, which is zero, obviously.

CONSUELO MACK: Right, nothing.

PAUL MCCULLEY: But the forward curve says the Fed’s going to go to two. So stocks and bonds are valued fairly to current and expected short-term interest rates, but current and expected short-term interest rates are very, very low, relative to history.

CONSUELO MACK: Right, at least recent history.

PAUL MCCULLEY: So therefore, I think the news to our generation, we’re really talking about the Baby Boomers that are really sort of what the hell’s going on here? I’m on the cusp of retiring, and what are expected returns going forward? And expected returns are going to be mid-single-digits at best for stocks, I think, going forward. And less for bonds. Simply because the starting point is a very lofty valuation. And a very simple answer to that when people ask me: what’s the return going to be in the 10-year Treasury over the next ten years? It’s very simple, it has a coupon on it.

CONSUELO MACK: So you’re going to get the coupon, essentially.

PAUL MCCULLEY: You’re going to get the coupon, and the coupon’s real. And the biggest danger right now in the marketplace is people haven’t accepted that going forward returns will be the coupon. Because for the last five years, they’ve gotten capital gains when we’ve moved from five coupons to low coupons. And the core reality of people in investing is they don’t read the disclaimer that past returns are not indicative of future returns. Human beings tend to drive through the rearview mirror in investment returns. And that’s just how they work.

CONSUELO MACK: What do we do as investors?

PAUL MCCULLEY: Fascinating question because …

CONSUELO MACK: I want to make money.

PAUL MCCULLEY: You want to make …

CONSUELO MACK: What do I do to make money?

PAUL MCCULLEY: You want to make money. And you don’t get to go to heaven twice for the same good deed.

CONSUELO MACK: Right, don’t expect.

PAUL MCCULLEY: Don’t expect …


PAUL MCCULLEY: … future returns in the United States. You think in terms of who is in a liquidity trap now. And it’s Europe. And they’re not going to escape the liquidity trap for a very, very long period of time. Therefore, the revaluation of assets in Europe is in the early stages, relative to the United States. Because we’re talking about the Fed getting off of zero here in 2015. And if you ask Mario Draghi when do you think you’ll ever get off of zero? He will look at you with a very odd look. He just went to QE, and it’s open-ended QE.

CONSUELO MACK: Right, quantitative easing, right.

PAUL MCCULLEY: And so therefore, European stocks in local terms have dramatically outperformed U.S. stocks this year. So this is a theme that I’ve been articulating for over a year, out on the hustings, I had this part-time job at PIMCO last year that I do a lot of speaking, is European stocks hedged into dollars, is the short answer to your question, is you need to play the revaluation game on the back of a ultra-uber easy monetary policy outside the United States. Japan is giving you an opportunity, but I think the best opportunity is in Europe. And I think the bull market in European equities and European real estate has got a long way to run. European bond markets less so. But the equity market and the real estate market in Europe are incredibly attractive relative to the United States. And relative to the forward-looking monetary conditions.

CONSUELO MACK: And dollar hedge, do not buy in local currency in Europe. So to explain.

PAUL MCCULLEY: The United States, the U.S. dollar is in a secular bull market.

CONSUELO MACK: Right, secular bull market; that’s a long-term bull market.

PAUL MCCULLEY: Long-term bull market. So therefore, if you’re going to be protected exposure in Europe, you simply want to hedge it back into dollars. You want European equity exposure; you do not want a euro exposure.

CONSUELO MACK: One investment for a long-term diversified portfolio, what would you have all of us own some of? As specific as you can be.

PAUL MCCULLEY: As specific. Actually I like European equities and real estate hedged into dollars, intensely. And it’s performed really, really well for the last year. So trying to be a value investor in dislocated and distressed assets in Europe is my favorite thing right now. And it’s not just right now, but over the next three, five years. Because I don’t think you’ll be having the ECB hike interest rates in the next five years. Whereas I think Janet and company could be hiking interest rates in the next five months.

CONSUELO MACK: But not by a lot. And that’s the …

PAUL MCCULLEY: Not by a lot. But the act of hiking is huge. And I look at the act of hiking interest rates, just simply to act is declaring victory. A valedictory for the central bank that they got us out of the liquidity trap, because the defining characteristic of a liquidity trap is you’re pinned against zero. So just getting off of zero is a huge, huge deal.

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