actively managed bond funds in a rising interest rate environment

During my working career as an equity portfolio manager, I experienced the US bear markets of 1980-82, 1987, 1990-91 and 2000-2002. Because I spent the majority of my career as a global manager, I also lived through the collapse of the Japanese stock market (then by far the largest in the world) in 1989 and the currency-triggered bear market in many smaller Asian countries in the late 1990s. I started writing this blog as a way of helping myself think about the bear market of 2007-09 and what would follow.

In other words, for equity managers there have been lots of bad times to help us along with the painful process of being able to, as they say, make the critical distinction between brains and a bull market.

Also, the bad periods themselves have been long enough to force us to recognize that different investment styles (growth or value) work best in different economic circumstances.  We certainly won’t change our overall philosophies.  However, successful equity managers all realize that for them there are some times to be in fifth gear with the gas pedal to the floor and others to be in second gear and tapping on the brakes.

 

Looking at the bond world from the outside, it seems to me that little of this has been the case for bonds and bond managers since the early 1980s.  Yes, junk bonds or emerging markets debt may have gotten ugly now and again.  Nevertheless, the continual decline in interest rates from the early Volcker years to the present has made for a remarkably smooth, and consistently bullish, ride for bond investors and managers.

The amazing part is not a long bullish period–after all, equities in the US had that for most of the 1990s–but the fact that the benign environment lasted over thirty years.  To have experienced an ugly time for bonds comparable to what happens to stocks every business cycle, you would have to have been a bond manager in the 1970s!

This is my main concern for actively managed bond funds.

We’re (already) in a period in which interest rates are not going to decline.  They may fluctuate for a while, even a long while, but the new main trend is going to be for rates to rise.  And we haven’t had circumstances that have forced bond managers to cope with a situation like this for decades.

Instead, the recipe for success over the past thirty-five years has been to throw caution to the winds and bet as heavily as possible on continuously declining rates.  The most successful managers would have been the most aggressive, the ones willing to double down on any bet gone wrong and to stack their portfolios full of risk.  Brash, bold, stubborn, no sense of nuance, not the brightest crayon but tenacious.  Think Jon Corzine and what happened to him.

 

Will bond fund managers be able to adjust to the changing trend?  I don’t know.

Bill Gross is another interesting case in point.  He became the “bond king” by betting aggressively on lower interest rates.  My reading of his results for his last several years at Pimco is that he tried to keep his performance numbers up by layering on extra amounts of risk to the main bet that had stopped providing results.  That didn’t work so well, in my view.  Since leaving for Janus, where he could express his ideas in his portfolio without an outside sanity check (outside interference?), he’s done poorly.

This is not about old dogs and new tricks in the sense of age but only in having the temperament and mental flexibility to adjust to changing circumstances.

 

bond funds when interest rates are rising

This past weekend, the Wall Street Journal published an article in its Business and Finance section about what happens if interest rates rise and holders of bond mutual funds and ETFs start to sell in large amounts.  The article is based on a research report written by Barclays and co-authored by that firm’s co-head of fixed income research, Jeff Meli.  The article isn’t identified further.

Maybe that’s not so strange, since, as reported in the WSJ, I find the research itself to be weird.  Its conclusions seem to me to be either not that relevant or just plain wrong.  The article does, however, touch on a number of points that are important for bond fund holders to consider.

 

The report starts out by assuming what I guess the researchers think is a worst-case scenario:  the junk bond market drops 10% in a day, and a given mutual fund receives requests for redemptions equal to 20% of its assets.

It concludes that:

–the fund’s net asset value would fall by 12%

–the fund would sell its most liquid assets to meet redemptions

–the remaining assets would be mispriced at a value higher than the value they could be sold at

–therefore, the first investors to leave would receive more than fair value and would be the best off; later redeemers would get less than fair value for their shares

–ETFs don’t have these problems and should be preferred to mutual funds.

my thoughts

I think this is a very unlikely set of circumstances.  The most damning constraint would seem to be the “single day” provision, which is intended to give the junk bond manager in question the least possible time to raise funds to meet redemptions.  However, the other two conditions haven’t come anywhere close to being triggered on a single day, either in the downturn following the internet bubble or during the 2008-09 recession.  Some kind of gigantic external shock to the economy would seem to be necessary for either to happen– not something specific to a given type of asset.

In such a case, it’s not clear that any financial markets would be functioning normally.  It’s conceivable that trading in many/all financial instruments would be halted until calm was restored.  So the pricing of a given junk bond fund would be a moot point.

For at least the past quarter-century, junk bond funds have generally been priced by third parties at “fair value.”  I’ve seen them work for illiquid stocks or for NY pricing of stocks trading abroad.  My judgment is that they work incredible well.  So I don’t think fast redeemers get the best pricing.  The opposite may well be the case.

Fund families have lines of credit that they can use to meet unanticipated redemptions.

No portfolio manager worth his salt is going to sell only the most liquid assets first.  On the contrary, it’s better to sell illiquid ones while there are still buyers.

In the past, big investment companies have ended up buying the most illiquid assets from junk bond funds they manage at a price determined by a neutral third party, in order to make redemptions easier and shore up confidence in the fund.

In general, fund management companies have no incentive to price a fund too high.  If anything, they should want to price it too low.  That way, they can send the extra to redeemers once they find their error.  No one is going to send anything extra back.

I don’t get the ETF stuff at all.

More tomorrow.

 

surviving the next twelve months (iii)

In the past in the US when the Fed has raised interest rates from recession-emergency lows, bonds have gone down and stocks have gone sideways to up.

Will this time be an exception?   …another way of saying, Will stocks go down this time around?

The generally accepted explanation of the divergence between stocks and bonds while the Fed is normalizing interest rates after a downturn is that the negative effect of higher rates is offset, in the case of stocks, by the positive effect of strong earnings growth.  Bonds–other than junk bonds, or municipal bonds–don’t have this offsetting factor.  So for Treasuries the news is all bad.

(There are at least two reasons why interest rates matter for stocks:

–broadly speaking, people (me being a possible exception) don’t actually want to own stocks.  What they want is to own liquid long-term investments so they can fund their retirements and send their kids to college.  Those can be either stocks or bonds.  A decline in the price of bonds makes them more attractive, taking some of the shine off stocks.

–in broad conceptual terms, the worth of a company should be related to the value in today’s dollars of its future earnings.  To the extent that investors use today’s interest rates to discount future earnings back to the present, rising rates will result in lower present values.)

 

I remain squarely in the “sideways to up” camp, but I can see, and am monitoring, two possible worries that may weaken the case for s-t-u:

–in what has been to date a sub-par rebound from recession, earnings growth may not be as strong as in prior recoveries, and

–the S&P 500 is a global index, about half of whose earnings come from abroad.  Even if US-sourced earnings are great, the same may not be true for foreign-sourced.  In particular, an increase in the value of the dollar vs. the euro caused by increasing interest rate differentials (the worry of the IMF and World Bank) could mean a lower dollar value for EU-sourced earnings (which make up about a quarter of the S&P 500 total).

More tomorrow.

 

want index underperformance …try an actively managed bond fund

Indexology

‘For a while I’ve been following the Indexology blog written by S&P.

As the name and source suggest, the blog extolls the virtues of indexing–after all, S&P makes them and sells information about them.  I find the posts to be generally interesting.  My only quibble is that the Indexology people seem to be true believers in a strong version of the efficient markets hypothesis.  They’ve all drunk the Kool-aid and don’t stop to question how it can be that basically every professional active manager underperforms   …nor do they try to imagine what circumstances could create even a temporary burst of outperformance.

I’m well aware of all the figures about equity manager underperformance.  However, I’d never thought much about bond funds, the subject of the Indexology post of March 12th.

The numbers are stunning.

bond fund (under)performance vs. benchmarks

Here they are:

–in 2014, 97% of the government bond funds underperformed, as did 98% of the investment-grade corporate bond funds

–in both categories, over 95% underperformed over the past five- and ten-year periods

73% of the junk bond fund managers underperformed in 2014; over the past five years, 88% underperformed; over the past ten, the number is 92%.

Bright spots?:

–among actively managed senior loan funds (which don’t contain bonds;  they hold pieces of syndicated bank loans to non-investment grade corporate borrowers), 70% outperformed last year.  Over the past decade, though, underperformers and outperformers are just about equal in number.

–61% of municipal bond managers outperformed in 2014.  55% did so over the past fie years.  However, over the past ten, 70% underperformed.

reasons for this woeful showing?

Indexology offers none.  Personally, I have no firm ideas.

Looking only casually at the results of Bill Gross over his years at Pimco left me with two impressions of the former Bond King:

— he continually bet very aggressively (and correctly) that interest rates would fall–sort of like an intelligent version of Jon Corzine, and

–a large chunk of his outperformance disappeared through the high fees Pimco charged for his services.

Indexology doesn’t talk about fees, which can’t have improved the situation for bond managers generally–and I presume the Indexoogy numbers are after them.

The better areas for relative performance are smaller and contain less liquid securities.  I wonder what role pricing–which I presume is not based on daily trading but on the theoretical models of third-party experts–plays?

 

the Mainstay Marketfield fund (ii)

I’ve been thinking about the Mainstay Marketfield fund. The I shares (the ones with the longest track record) = MFLDX.

Is this a risky fund?

A lot depends on what you mean by “risky.”  And a lot depends on the time frame you use.

The standard academic way of assessing risk is to equate it with the short-term volatility of returns.  The idea has some initial plausibility.  All other things being equal, and for everyone besides roller coaster junkies, a smooth ride is better than a bumpy one.  Greater assurance that the price tomorrow isn’t going to deviate much from the price today sounds good, as well.

The main virtue of risk-as-volatility, though, is that it’s easily quantifiable and the data for measuring it are readily available.  There’s no need to delve into the actual investments and make potentially messy judgments about what a security/portfolio is and how it works, either.

On this way of looking at things, MFLDX isn’t risky at all.

During late 2008 – early 2009 the fund declined less than the S&P 500.  From the beginning of the bull market in March 2009 until mid-2013 it tracked the S&P relatively closely.  Less volatile in down markets, average volatility in up markets.  Not a bad combination–if this is all risk is.

Regular readers will know that I’m not a fan of this academic orthodoxy–which is, by the way, also universally accepted by the consultants who advise institutional pension plans.  It isn’t only that you don’t need any practical knowledge of the products you’re assessing–just a computer and a data feed.  Nor is it that my portfolios routinely had part of their excess returns explained away by their greater-then-average volatility.  No, it’s that, in my view, for an investor with a three-, five- or ten-year investment horizon whether a security goes up/down a little more or a little less than the market today and tomorrow has very little relevance.

Risk-as-volatility has done serious damage in financial markets in the past.  For years, academics and consultants regarded junk bonds as relatively safe because their volatility was close to zero.  They didn’t realize that the prices never moved  because the securities were highly illiquid and seldom traded.  In fact, during the 1990s, i.e., even after the junk bond collapse of the late 1980s, Morningstar continue to have junk bond funds in the same category as money market funds.  Since NAVs never moved, the former got all the highest ratings.

Back to MFLDX.

Suppose we look at the fund in a commonsense way.

Marketfield’s website portrays ithe firm as consisting of three principals who concentrate on macroeconomics.  The career descriptions indicate that only the director of research, who arrived in 2011, had any prior portfolio management experience.

The group runs a highly sectorally concentrated portfolio.  MFLDX can be both long and short.  It has a global reach.  It can own/sell short stocks, bonds, currencies, sectors, indices.

Despite having all these potentially return-enhancing weapons at its disposal, the fund was unable to outpace an S&P 500 index fund during the first four years of the bull market.

Yes, short-term price fluctuations were not extreme.  And I’m not saying that one could have predicted that MFLDX would be down 12% in 2014, in a market that is up 13%–sparking massive redemptions.  But it seems to me that risk-as-volatility didn’t come anywhere near to capturing the risk elements present in this fund.