While stocks are still enjoying one of the best bull markets in history since bouncing off the 2009 low, the fixed-income space is in a considerably less encouraging position. The bond market itself is coming off its own bull market, which spanned about three decades. For investors operating in a landscape of rising interest rates, the ability to find value and to generate an acceptable return can be challenging.
In our latest interview with Guild Investment Management, Equities.com had the opportunity to speak with Anthony Danaher, who serves as the firm’s president and manages the fixed-income portfolios. Danaher offers his thoughts on how investors should cope with rising rates, how he’s adjusting to the market, and opportunities that lie ahead.
EQ: Can you discuss your background and role at Guild Investment Management?
Danaher: I’ve been with Guild Investment Management now for almost 24 years, helping Monty grow the business. We’re primarily research and client relations focused here, and I primarily manage the income portfolios.
The income portfolios were a very small part of the firm, but since 2004, they’ve become a larger part of what we do because of investors’ need for income to be generated from something other than bonds. Our income portfolios use dividend-paying equities, ETFs, equity related bond proxies, such as real estate investment trusts, master limited partnerships, royalty trusts, and Canadian energy income investments if we can find them. We will use some bonds from time to time, but the goal is to seek income with some price appreciation.
EQ: In our interview with Monty Guild, we discussed the firm’s investment approach, specifically as it applies to the equities markets. Can you talk about the strategy in the fixed-income realm?
Danaher: Well, just like Monty may have discussed about our equity management, we are top-down, global macro thematic investors. We focus on getting very tactical and opportunistic with respect to asset classes. The tactic we have chosen with respect to bonds for the most part right now is one of avoidance -- that they just don’t offer enough potential reward or upside for the risk you’re taking.
Therefore bonds are a very small percentage of our income portfolios. Right now, we’re primarily looking at ways to generate the cash flow that the clients are looking for, but also provides the growth that will help keep the clients ahead of inflation, which is at historically low levels now, but we don’t believe it is going to stay at historically low levels forever.
EQ: So firm’s risk-to-reward ratio criteria is very much ingrained into your strategy in the fixed-income realm as well?
Danaher: Yes, we want to be able to model it to a three-to-one upside versus downside potential as we are investigating any investment. We are not going to hit that every time, but we want to keep our discipline tight.
So, as an example, we don’t want to go into an income-paying position with the idea that we can make 5 percent a year if we perceive a downside of 5 percent. It’s just not enough. We’d rather not play it, and prefer to just keep scanning the investment universe for alternatives for more upside if we’re going to be tolerating a risk of 5 percent.
So we still employ that three-to-one reward ratio in income-bearing instruments and fixed income. The only difference I would say is that Monty might look for a higher return in the range of 50 to 100 percent over 12 months in his equity investments, especially if he is looking to growth investments or to the emerging markets. We’re not going to be able to find that typically in the income space, but we can still stick to the three-to-one reward-to-risk ratio.
EQ: Typically, investors look at fixed income for steadier performance. Is there a rate of return that the portfolios are targeting?
Danaher: Investors don’t mind giving up some of the volatility that the equity markets provide when they are looking for income. For our Income style, historically, the worst year was in 2008, where the income accounts were down less than 0.5 percent. At the top-end, since we started these accounts in 2005, the highest annual return was about 12 percent. In general, our clients are usually looking for something in the range of mid-to-high single-digits out of income…with less volatility.
Now, if inflation were to pick up, their expectations would go up—as would the demand for many of the underlying investments that we’re investing in. But, in a very low inflationary environment, the mid-to-single digits to high-single digit returns are what the clients are looking for. They want to avoid the huge drops like the 45-percent decline that the S&P 500 put on from late 2007 to early 2009.
EQ: So in an environment where rates are expected to rise, it could be beneficial to the fixed-income space if yields are expected to rise with it?
Danaher: That’s correct, provided you are not long a portfolio of long duration bonds right now that is depreciating in value while rates rise. Rising interest rates can be good for income investors, but it can hurt the overall market. If the markets are not working, we tend to reduce exposure to the market, and increase the short‑term cash and cash-equivalent portion of our portfolios. That’s how we were able to protect people in 2008.
One of the challenges to our style of income investing right now is that we are willing to have the portfolios allocated to a large chunk of cash while we look for investments in a bad market…and in a zero interest rate environment, cash pays next to no income. It used to be that you can earn respectable interest on your cash balances; you’re not able to now. The short-term part of the interest rate curve is negligible.
And with interest rates as low as they are right now, we do not like bonds with long maturities. Our preferred strategy is for short-duration instruments. When interest rates start to rise, you will be able to take that money at maturation and put it back to work on a higher-yielding instrument.
So with their portfolios, there’s always going to be a desire to be defensive, but we’ll always look for investments that will pay you a certain return. Capital appreciation is a nice bonus on top of the income, and we’re always looking for that. But it depends on the market environment.
EQ: As you mentioned, you’ve incorporated other asset types into the portfolio given the challenges the bond market is facing. Can you talk about how that helps you adjust to the market’s behavior during this time?
Danaher: I’ll give you an example. Our most recent experience occurred when Chairman Bernanke first put the tapering topic on the table on May 22, 2013. Up to that point, REITs, MLPs, and income-focused mortgage REITs, and some other highly leveraged instruments were very popular and had been gathering assets. People crowded into bond funds for their higher yields. People were just chasing yields and they didn’t do much bottom-up research. They were just looking for the dividends.
On that date, everything changed. The 10-year Treasury note went from 1.60 percent to 3 percent over the next seven months and that 1.60 percent to 3 percent move on the 10-year Treasury note hit a lot of the bond-proxy investments hard. Many of them suffered 10-, 15-, 20-, and even 30-percent declines, and many have barely recovered, even as interest rates have backed off that level.
EQ: How did that affect your portfolios?
Danaher: Well, when I say that we’re opportunistic and tactical, this is an example of that. We owned some of those instruments, but our discipline was able to get us out of them over the course of the early parts of the summer during that decline. After weeks of decline, they bottomed, and many of them started to stabilize in the early fall. So, we dipped our toe back into them for the dividends they provide—but always with the idea that long-term interest rates are going to rise, and we need to view them as intermediate term holds.
After a 30-year decline in the interest rate curve, long-term interest rates are destined to rise. It may not happen this month or this quarter, but over the next couple of years, rates are going to be on an upward trend. As a result, that’s going to create a headwind for some of these bond-proxy investments like mortgage REITs. So we will be more selective.
It really puts us in a position where we have to do more bottom-up research on the investments, on the sub-sectors, and on the sub-groups to find out which ones are most adversely affected by the higher interest rates, and we plan to avoid those areas.
EQ: Do those assets still play a role in your portfolio going forward?
Danaher: We’re still going to use some of the same vehicles, but we will also add other assets and asset classes to them. Typically, if the interest-rate curves will be rising as we expect them to, some of the drivers will be because we have improved economic conditions, rising corporate earnings and stock markets. Within that environment, you can expand your income-equity universe from these bond-proxy types to other companies that have the ability to grow their dividends in a stronger economic environment.
That’s our preferred way to migrate from interest-rate sensitive equity instruments into other instruments that still pay income but are more protected from a rising-rate environment. In fact, some of these companies and sectors might actually benefit from a rising-rate environment, due to the typically faster economic activity and higher corporate profits.
EQ: What does the portfolio look like currently?
Danaher: Right now the portfolio has fewer MLPs and REITs than it had in the spring of 2013, and includes more growth companies that have growing dividend streams. The dividend payout of the portfolio is lower as they are not paying as much right now. The dividend streams that we own in the portfolio might be in the range between 3 and 4 percent annually versus something in the percentage of 7 to 10 percent annually you can get in some of those more bond-centric types of equities.
EQ: How did the tapering affect interest rates? The market was expecting the initial $10-billion reduction in December, but it seems a lot of people were caught a bit off guard by the subsequent $10-billion drawdown. In terms of the trajectory of how interest rates rise, do you see it being more of a gradual trend or sharp spikes?
Danaher: In some ways, I think the market’s effect may even affect future tapering decisions. We saw a very sharp spike in the beginning late last spring. People had to start factoring in that the stimulus from the Fed is going to disappear at some point. Up to that point, it had not been on their radar. So they started making massive portfolio adjustments and it compressed a lot of sell orders into a short period of time. Going forward, I think it is going to be more gradual.
The reason why the Fed has been buying treasuries is not only to fund the Treasury of the United States. They’ve been expanding their balance sheet to manage the interest rate curve, and to prevent interest rates from getting too high…high interest rates would cripple the recovery. If the Federal Reserve is buying 70 percent of the U.S. government’s issuance of bonds, it certainly helps keep a lid on interest rates.
The old adage has been that the Fed can’t control the long-term interest rate market; and that they can only control the short end. But if they’re buying 70 percent of the issuance, they have a lot of leverage on the long end too.
So what we’ll see is a steadier rise in interest rates. If it gets too fast and too spiky, then they will probably curtail their tapering. Right now, you have $65 billion a month in mortgage-backed securities and bonds being bought by the Fed. If the data remains on the current course of moderate economic improvements, primarily with joblessness falling within their range of 6.5 percent, and inflation not going beyond 2 percent, then they’ll steadily taper to the point where they are not expanding their balance sheet anymore. The inflation and unemployment targets however are not triggers. As we get to those numbers we’ll hear a lot of commentary about that. The Fed is still decisively dovish.
EQ: If the economy hits those targets, what do you expect will start to happen next?
Danaher: When the time comes, I think at that point, we may get assets actually running off the balance sheet at the Fed. They won’t be sellers. As assets mature, the Federal Reserve’s balance sheet could actually shrink. When that starts to happen, it will represent the removal of their involvement in the interest-rate curve and then you will be able to see where interest rates go from the market level.
The US bond market has a lot of other players. As long as you have problems in the emerging world, and as long as you have currency issues around the world, there’s always going to be an underlying bid for the global benchmark interest rate item, which is U.S. government treasuries.
As the world reserve currency (the dollar), it helps to keep our interest rates lower. So even with the U.S. being a highly indebted country, there’s always demand for treasuries, and that has helped keep our interest rates manageable relative to other indebted countries.
EQ: What do you think the market will look like once the Fed is removed from the equation?
Danaher: I’m hoping we get there by the end of this year. Our view is that the 10-year yield could probably be closer to the 3.75 percent or 4.00 percent than the 2.75 percent where it sits today.
Will this have a negative effect on stocks? If we go from 2.75 to 3.75 over the next year, the effect that will have on stocks will largely be determined by the pace of that rise, and the pace of economic growth associated. But I think the Fed wants it to be a measured rise in interest rates, unless the economy takes off.
However, a steeper yield curve is actually good for economic activity because it spurs the willingness to lend. Lending at the local level in the regional banks needs this. Our new head of the Fed is very much focused on creating jobs and economic activity at the local level. Local regional banks will be more inspired to make more loans, and therefore increase the velocity of money in the system if they can earn something on the money they lend.
So I don’t think the Fed is opposed to higher long-term interest rates, but they just don’t want it to be a disorderly market.
EQ: In regards to the Fed and its relation to the financial markets, how much attention do you think they actually pay to the impact they have given that it’s not officially part of their mandate?
Danaher: I believe they care and are aware of their effect on the markets, but I also think that they understand that the global financial system got itself into an awful pickle about five years ago and is still not completely out of it.
They have to be careful to provide the necessary liquidity to keep the banking system working because without the banking system, it doesn’t matter what else happens. The fractional reserve banking system is the pillar that holds up the economy, and they know it. So they have to make sure it stays functional.
EQ: You discussed the preference for shorter-term instruments right now in the fixed income space. What are some other opportunities that you’re looking to present themselves?
Danaher: Well, you do get opportunities in certain things. Last year, one thing that really caught our attention was that a lot of the money that came into fixed income came in via bond funds. Bond funds are not bonds. And when money crowds, you get dislocations in the market. When the rates rose, bond funds and Bond ETFs were liquidated…and then the bond funds and the bond ETFs’ NAVs fell. The outflows from those funds means the underlying assets get sold, and quite often, that selling that comes from fund or ETF liquidations is indiscriminate selling.
It can create value because of the illiquidity of the bond market. So we’ll look there for those dislocations to take place. Some items that used sell at premiums will sell at discounts, and we will be opportunistic in that case.
The key message for bond investors; what makes the most sense for us is to shorten your maturities. That applies whether they’re municipal bonds, foreign government bonds, U.S. government bonds, or corporate bonds. You will have opportunities to reinvest at a higher rate in the future. So that’s the recommendation we are making.
Let the governments be the buyers and owners of long-term bonds. The Chinese, Japanese, and UK governments own lots of long bonds, let them. But individuals should not be investing in long-term government bonds unless, of course, they are willing make a speculative play on the interest rate curve. Of course, if you think that interest rates are going to go down again, then buying some long-term bonds will make sense. We are not making that bet.
EQ: So if you’re very bearish on the economic outlook and you feel the need to preserve your capital, longer-term bonds may be attractive?
Danaher: The big argument for bonds is deflation. The central banks around the world are trying to avoid deflation. The jury is still out. The Japanese government is very aggressively fighting deflation. The U.S. government has been fighting it. The ECB has been dithering but are also very concerned about deflation.
If you believe that deflation will get the upper hand, and that the global social economic outlook is so poor structurally because of declining populations and over leverage in the developed world, then by all means, you can invest in bonds, because equity markets won’t survive a big deflation.
But the reality is that the printing of money and the expansion of the central bank balance sheets around the world is the prescription that is being applied to this deflationary concern. I won’t say it’s the cure, but it is the prescription, and the jury is still out as whether it will help pull the economies out of deflationary cycle.
EQ: So because of that concerted effort, it’s much more likely that inflation picks up in the near future?
Danaher: It doesn’t necessarily have to happen in 2014, but by 2015, you are going to see a lot of this money that was put into the financial system speed up in velocity in developed world. That will trickle through to the developing world, and you’ll get a reacceleration of global inflation. It’s already picking up. The emerging world has always had higher inflation rates, and at some point, those will find their way back into the developed markets, and we think it starts to show next year.
Even though we’re of the opinion that you want to avoid long-term bonds because inflation is coming back, what makes a market is different opinions. There are a lot of people that are still very concerned about deflation, and who feel that a 2.76-percent return on a 10-year Treasury is a fair return in a deflationary environment. If deflation is what we’re going to get, I would have a hard time arguing that, but I just don’t think deflation is in the cards.
EQ: Peer-to-peer lending is becoming a popular way for investors to invest in debt and fixed income. Does it have the potential to become something bigger?
Danaher: Financial services are changing, and an example of that is the growth of peer-to-peer lending. The world is full of innovation. There’s a lot of innovation taking place in a lot of industries. The once moribund energy sector in the last five years has been completely remade because of innovation. Technology such as mobile payments is another example of how innovations are changing how business gets done in financial services.
Peer to peer lending may be a new exciting avenue, but it’s hard to invest in it via public company. We’re going to find opportunities in a lot of key innovative areas…we will also be looking for income though. Our view is that equities have a better reward/risk outlook and are where one needs to look to invest. Bonds are an alternative and they have a place in a portfolio, but equities will be the place to invest for more growth. They have a good long-term track record for expanding wealth…and for beating inflation.
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