Interview
SATURDAY, SEPTEMBER 28, 2013
Where to Find Value in Today's Bond Market
By LAWRENCE C. STRAUSS
Mohamed El-Erian, Pimco's CEO and Co-CIO, advises fixed-income investors to focus on shorter-maturity bonds, five years and under.
Mohamed El-Erian, the CEO and co-chief investment officer of Pimco, is often sought out for his thoughts on the world, particularly when it comes to the confluence of geopolitics, central-bank policies, and investing. Part of his allure stems from a broad background in asset management. In addition to working at Pimco, the $2 trillion global asset manager known for its expertise in bonds, El-Erian has put in 15 years at the International Monetary Fund and two years overseeing Harvard University's endowment. Trained as an economist, he earned a master's degree and doctorate in that subject from Oxford University. But for all of his training and experience, El-Erian hasn't encountered anything like today's markets. "The most important thing to realize is that we haven't been here before and that we haven't had this degree of experimental policies before by central banks," he says. To find out how he's proceeding, Barron's recently spoke with El-Erian by telephone.
Barron's: Earlier this month, Federal Reserve Chairman Ben Bernanke caught markets by surprise when he said that he wasn't ready to start cutting back, or tapering, quantitative easing. What's your assessment?
El-Erian: The first thing is the extent to which markets are sensitive to different signals out of the Fed. Hyperactivist and experimental Fed policies have resulted in a disconnect between fundamentals and the prices of financial assets. The policy view is relatively simple: Artificially elevate financial asset prices in order to trigger the wealth effect, animal spirits, and financial engineering, which in turn help lift fundamentals and validate the high asset prices. It's a win-win situation—or that's the hope. The reality is that the Fed has repeatedly succeeded in lifting asset prices, but it hasn't succeeded in getting the economic fundamentals to "escape velocity." So, with such a persistently large gap, the markets have become more sensitive to every indication of whether Fed support will remain strong for asset prices.
What do you mean by "escape velocity"?
Since 2008, Pimco has maintained that, unfortunately, after the economy recovered from the immediate impact of the global financial crisis, it is likely to operate in a new normal. And that new normal was characterized by unusually sluggish real growth of about 2% and persistently high unemployment, and this is exactly what has occurred. So, for the past four years, the economy has been stuck in second gear, and there are a few issues with that. First, that kind of growth has a small impact on the unemployment problem, as reflected both in a 7.3% unemployment rate and a participation rate that has fallen to levels not seen in 35 years.
Second, lower growth discourages companies from investing, because they need to have some assurances of buoyant demand for their products. Otherwise, they will not expand capacity aggressively. So, despite very low interest rates, companies have been very hesitant to deploy that cash. Third, low growth contributes to political polarization. We continue to see this, and this particular polarization not only limits the tail winds to our economy but also creates head winds. So, for example, we are going through, yet again, a congressional drama over the funding of the government and the debt ceiling.
What are your takeaways about interest rates?
More than ever, rates today—particularly the 10-year Treasury and even more so the 30-year bond, but anything with a maturity beyond, say, five years—are a function of four things: the outlook for the economy, policies, risk preferences, and market technicals. So today, with the 10-year at around 2.7%, [the valuation] is fair—if not somewhat attractive—relative to an economy with an outlook of just 2% growth and inflation that is stubbornly stuck for now well below 2%. It would also be relatively fair if a Fed taper, which means less balance-sheet support for the 10-year Treasury, is effectively countered by more-aggressive forward guidance policy that succeeds in convincing the marketplace that interest rates will remain low for a long time.
What could hurt the performance of Treasuries?
The 10-year bond is vulnerable on the third and fourth factors that I mentioned. After a massive inflow into fixed income—in fact, the highest inflows were in the first quarter of this year when the 10-year yield reached as low as about 1.7%—there were significant outflows from fixed-income.
This reflected a change in asset preferences that had overshot in favor of fixed income, pushing up prices and lowering yields. In addition, there were a number of unfavorable market technicals that usually eventually prove temporary and reversible, but they tend to amplify the effect of outflows.
So, for example, the shorts positions during the summer were the highest they had been in the past three years. Higher volatility forced ruled-based risk-parity investors to delever their fixed-income holdings, triggering a lot of sales. There was also selling on the part of foreign central banks that were forced to defend their currencies using international reserves. And limited appetite on the part of broker-dealers to accumulate inventory further amplified the price moves. So all of this is why fixed-income investors should be concentrating on shorter-maturity bonds, five years and under. These holdings are anchored well by the Fed's low policy rates and its forward guidance; they are also consistent with the sluggish economic outlook.
What else besides the shorter end of the yield curve makes sense for bond investors?
There are three characteristics that are particularly attractive in the bond market, and you find them in different places. As I mentioned, the first is the relative attractiveness of shorter-dated, high-quality bonds, including Treasuries as well as Mexican sovereign debt denominated in the local currency.
These holdings are anchored by central-bank policy rates that aren't going anywhere. The roll down [whereby the price of a bond increases as it approaches maturity] is very attractive. Also attractive, though volatile, are parts of the bond market that have been technically damaged. So, for example, you can find triple-A, very high-quality municipal bonds that are tax exempt. And yet their tax-equivalent yield is priced at 110% to 120% compared with Treasuries. So they are cheaper than the Treasury equivalent, even though they have a tax benefit. And they are considerably cheaper; these ratios should be more like 80% to 90%, not 110% to 120%. That is because the sector has been damaged by talk about Detroit and Puerto Rico, the backup of rates, and patchy liquidity.
Barron's: Earlier this month, Federal Reserve Chairman Ben Bernanke caught markets by surprise when he said that he wasn't ready to start cutting back, or tapering, quantitative easing. What's your assessment?
El-Erian: The first thing is the extent to which markets are sensitive to different signals out of the Fed. Hyperactivist and experimental Fed policies have resulted in a disconnect between fundamentals and the prices of financial assets. The policy view is relatively simple: Artificially elevate financial asset prices in order to trigger the wealth effect, animal spirits, and financial engineering, which in turn help lift fundamentals and validate the high asset prices. It's a win-win situation—or that's the hope. The reality is that the Fed has repeatedly succeeded in lifting asset prices, but it hasn't succeeded in getting the economic fundamentals to "escape velocity." So, with such a persistently large gap, the markets have become more sensitive to every indication of whether Fed support will remain strong for asset prices.
What do you mean by "escape velocity"?
Tim Wegner/Redux
"Low growth contributes to political polarization, and that not only limits the tail winds to our economy but also creates head winds." -- Mohamed El-Erian
Second, lower growth discourages companies from investing, because they need to have some assurances of buoyant demand for their products. Otherwise, they will not expand capacity aggressively. So, despite very low interest rates, companies have been very hesitant to deploy that cash. Third, low growth contributes to political polarization. We continue to see this, and this particular polarization not only limits the tail winds to our economy but also creates head winds. So, for example, we are going through, yet again, a congressional drama over the funding of the government and the debt ceiling.
What are your takeaways about interest rates?
More than ever, rates today—particularly the 10-year Treasury and even more so the 30-year bond, but anything with a maturity beyond, say, five years—are a function of four things: the outlook for the economy, policies, risk preferences, and market technicals. So today, with the 10-year at around 2.7%, [the valuation] is fair—if not somewhat attractive—relative to an economy with an outlook of just 2% growth and inflation that is stubbornly stuck for now well below 2%. It would also be relatively fair if a Fed taper, which means less balance-sheet support for the 10-year Treasury, is effectively countered by more-aggressive forward guidance policy that succeeds in convincing the marketplace that interest rates will remain low for a long time.
What could hurt the performance of Treasuries?
The 10-year bond is vulnerable on the third and fourth factors that I mentioned. After a massive inflow into fixed income—in fact, the highest inflows were in the first quarter of this year when the 10-year yield reached as low as about 1.7%—there were significant outflows from fixed-income.
This reflected a change in asset preferences that had overshot in favor of fixed income, pushing up prices and lowering yields. In addition, there were a number of unfavorable market technicals that usually eventually prove temporary and reversible, but they tend to amplify the effect of outflows.
So, for example, the shorts positions during the summer were the highest they had been in the past three years. Higher volatility forced ruled-based risk-parity investors to delever their fixed-income holdings, triggering a lot of sales. There was also selling on the part of foreign central banks that were forced to defend their currencies using international reserves. And limited appetite on the part of broker-dealers to accumulate inventory further amplified the price moves. So all of this is why fixed-income investors should be concentrating on shorter-maturity bonds, five years and under. These holdings are anchored well by the Fed's low policy rates and its forward guidance; they are also consistent with the sluggish economic outlook.
What else besides the shorter end of the yield curve makes sense for bond investors?
There are three characteristics that are particularly attractive in the bond market, and you find them in different places. As I mentioned, the first is the relative attractiveness of shorter-dated, high-quality bonds, including Treasuries as well as Mexican sovereign debt denominated in the local currency.
These holdings are anchored by central-bank policy rates that aren't going anywhere. The roll down [whereby the price of a bond increases as it approaches maturity] is very attractive. Also attractive, though volatile, are parts of the bond market that have been technically damaged. So, for example, you can find triple-A, very high-quality municipal bonds that are tax exempt. And yet their tax-equivalent yield is priced at 110% to 120% compared with Treasuries. So they are cheaper than the Treasury equivalent, even though they have a tax benefit. And they are considerably cheaper; these ratios should be more like 80% to 90%, not 110% to 120%. That is because the sector has been damaged by talk about Detroit and Puerto Rico, the backup of rates, and patchy liquidity.
Any other good opportunities in fixed-income?
This environment of artificially depressed rates by the Fed encourages a lot of financial engineering, and investors will have opportunities like Verizon [ticker: VZ], which recently raised $49 billion in what turned out to be the largest corporate-debt offering in history. You can just see how well the Verizon bonds have done to show you how powerful these opportunities can be. The prices on that debt have moved up significantly.
Will rates stay low for the foreseeable future?
The immediate future is particularly uncertain, given the range of confusing and conflicting signals from Fed officials and the volatile technicals. We've had different types of statements that are not consistent. At his press conference on Sept. 18, Bernanke came out ultradovish and gave the impression that the taper would not occur until the end of this year or even next year. But other Fed officials have made conflicting statements. So there is a lot of confusion, and I suspect the Fed will try to regain control of its narrative.
What should investors be focusing on right now?
The fundamental question is: How long are they comfortable riding the liquidity wave? It has been a very profitable trade because, as I mentioned, the Fed has been able to disconnect financial markets from underlying fundamentals. As a result, the price/earnings multiple of the Standard & Poor's 500 has gone all the way to 16½, and people expect it to go up even further. So even though earnings are facing head winds, people are putting that aside, because the liquidity wave has been so profitable as an investment strategy.
So what should investors be doing?
If I may, because I live in California, let me use a surfer analogy that Bill Gross came up with. If you are in a surfing competition, the key thing is to take the right wave and ride it safely, which means don't bump into people riding the same wave. It also means you have to kick out before the wave hurts you, and then go back and ride another wave. There are two types of errors you can make. The first error is never taking a wave because it is not perfect, which is the equivalent of staying in cash.
Staying in cash, with a negative real rate, eats away at your principal. The other mistake is to take a wave that is too crowded and you are not able to get off it safely. For the past few years, we all have been riding the central-bank liquidity wave, and as investors we need to figure out how to safely continue to do that, because it is a very crowded wave. So if there are any signs of weakening, there will be a lot of people rushing to the door, as we saw last May and June [when stocks sold off].
And what are you advising your clients to do with their surfboards?
First of all, we are trying to focus on those parts of the liquidity wave that are more robustly anchored. So I spoke about shorter-dated debt in certain sectors. Second, there are sectors that are not being embraced because of liquidity issues. So I mentioned certain municipals and certain emerging-market bonds, especially in local currency. We are also focusing on companies that have very solid balance sheets and are generating a ton of cash, because they are giving that back to the equity investors. So, dividend-paying companies likely to increase their share buybacks are attractive. An example of that is Microsoft [MSFT].
With rates rising, it's put pressure on bond investors, often leading to losses. How has that affected Pimco?
After a record first quarter of inflows, we experienced three things. First, we had outflows, which is unusual for Pimco. The last time we experienced outflows was in the fourth quarter of 2008. And we've experienced negative total returns in our core bond products because of the selloff in the bond market, and we've experienced a series of critical articles in the financial press.
Because we are such a large part of the bond market, we are used as a benchmark for what has happened in the bond market. We've been here before, most recently in the fourth quarter of 2008, and our focus was then—and is now—on safeguarding and enhancing our clients' assets.
Are there any particular countries that look appealing?
We are attracted to sovereign debt of Mexico first and then Brazil issued in local currencies. In equities, we would recommend a diversified approach that emphasizes countries with strong international reserves, low debt vulnerability, and growth. Those are the three factors investors should screen for.
What looks attractive in international markets?
At current prices, we have reduced our exposure to European peripheral bonds. So we were able to take advantage of the normalization in the European bond market. That includes sovereign debt issued by Italy and Spain, in particular, where valuations are now fair to rich.
What's your assessment of opportunities in emerging markets?
Any investor in emerging markets has to take the technicals very seriously. It has to do with what we call the tourist dollars. Emerging markets, just like some other asset classes, have a very small dedicated investor base, relative to what is called the crossover investor base, or the tourist dollars.
Like a tourist who visits a developing country, the minute there is some instability, the inclination of the tourist, as opposed to the resident, is to go immediately to the airport and fly out. They lack an understanding of the asset class, and it isn't a core holding. So the result is that the emerging markets tend to overshoot on the way up and on the way down. On the way up, they attract way too many tourist dollars. And on the way down, the tourist dollars flee very quickly, with limited liquidity.
Right now, when you look at the performance of emerging markets relative to the U.S. and Europe, we have reasons to believe that emerging-market equities and fixed-income have overshot on the way down. However, you have to take into account that there are still further bad technicals ahead of us. So we'd recommend a very gradual scaling in to emerging-market holdings.
Do you have any closing thoughts?
Investors have to ask not just the comfortable question, but also the uncomfortable question. The comfortable question is: How well can I do? The uncomfortable question is: If I end up making a mistake, even though I'm trying my utmost not to make a mistake, how quickly can I recover? And that is a really important question to ask yourself when you look at asset allocation and your risk tolerance. This past May and June should serve as a reminder of how quickly things can change, and nothing actually happened in May-June, other than a different narrative out of the Fed.
Thanks, Mohamed.
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