Tag: episode-1145

ROBERTS: UNCONSTRAINED FLEXIBILITY TRANSCRIPT

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.

DAN ROBERTS: Yes.

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?

DAN ROBERTS: We can.

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.

CONSUELO MACK: You would?

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.

DAN ROBERTS: Exactly.

CONSUELO MACK: They didn’t believe the recovery.

DAN ROBERTS: Exactly.

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 WEALTHTRACK.com 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.

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