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this chart, dealer inventories of corporate bonds have plummeted as banks and other traditional market makers have withdrawn from the market under pressure from new laws and rules put in place after the financial crisis.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

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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.

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