Specific Risk-Taking Means Doing Your Specific Homework
The CFA Institute Fixed-Income Management Conference is an annual event focused on global debt markets, fixed-income sectors, security selection, and portfolio construction. The Fixed-Income Management 2018 Conference will bring together researchers, analysts, portfolio managers, and top strategists in Boston, Massachusetts, on 11–12 October.
Dan Fuss, CFA, has been in the investment business for more than 55 years and has seen almost every credit cycle imaginable. At the Fixed-Income Management 2013 Conference, Fuss gave the opening keynote address and explained the four P’s — peace, politics, people, and prosperity — that he uses to build his global bond market outlook in his role as vice chairman of Loomis Sayles.
According to Fuss, we’re still in the foothills of a secular rise in interest rates, but there are always opportunities for those who do their analytical homework. With his special down-to-earth and endearing style, Fuss went on to discuss the specific opportunities that he found most attractive.
Peace (or Lack Thereof) and Politics
Defense spending in the United States has drifted down to about 3.5% of GDP, and there are about 800,000 active duty troops. As a former Navy lieutenant, Fuss is carefully watching two hot spots: the Eastern Mediterranean and the South China Sea. The key question Fuss asks is, “To what degree will the United States be involved?”
The primary driver of the government’s defense spending forecast is the plan to shrink US involvement in the Middle East/North Central Africa, even as turmoil and fragmentation continues to worsen. “If defense spending went to 6% of GDP, for example, then the Treasury has an impossible situation,” Fuss said .
Tension in Asia is different, but US foreign policy seems similar. Based on meetings with clients and companies in the region, Fuss concludes that there has been a significant breakdown of trust between the United States and Asian countries. The feeling is that our so-called “Pivot to Asia” is only talk, and they’ve observed a lack of commitment and follow-through on the part of the United States. “From their perspective, the world has changed, and they say they have no choice but to act accordingly,” Fuss said. Sovereign wealth funds in the region have already said they will diversify their reserves by trade patterns, but that may only be the first step. “It is a serious matter,” Fuss said. “After all, we do depend on Asia to buy a lot of our debt.”
“To the degree that people come into the formal economy, Federal revenues climb,” Fuss said, as he focused on the stagnant employed-to-total-population ratio (with his definition of population as anyone age 16 or over). “It even includes people like me,” said Fuss, who just turned 80 in September. The current period is nothing like the productive 1990s when the employed-to-population ratio rose to the upper 60% level as people moved into the work force, paid more taxes, and the Federal budget went into surplus.
From a demographic perspective, Fuss sees Japan not as a prototype but rather a forecast for the United States. Fuss referred to a study by Economist Magazine in 2011 that stated Japan gained 6 years on its retirement age while all other countries didn’t change. What happened? Even though Japan has a mandatory retirement age, retirees went back to work and collected both salary and retirement benefits.
Eventually, as the population ages, our “support” through benefits from employers transfers to our children. “There’s not a prayer that politics will reverse the situation where younger workers aren’t burdened to support retired baby boomers. There are too many of us and we control the next two generations [through voting],” Fuss lamented.
“In the short term, prosperity doesn’t mean much,” Fuss said. “My guess — and that’s what I do is guess — is that we’ll hit 3% growth in GDP next year and the Red Sox will win the pennant.” (On 30 October, less than two weeks after Fuss made his prediction, the Red Sox beat the St. Louis Cardinals 6–1 in Game 6 of the 2013 World Series.)
Longer term, the population growth trend is positive, but Fuss doesn’t see anything in the near term that restores US productivity to that of the late 1990s. In addition, he said short-term, capital markets around the world look reasonably good, and he expects the next peak in the 10-year Treasury bond to be about 4.25%.
In the Q&A, Fuss shared more insights on:
Fuss believes that fundamental change is happening in Japan. The time has come for Japan to be much more independent, yet still look to us for support. Abe has a high hurdle and lots of opposition, but Fuss believes he will surmount both.
Fuss believes the worst is behind us for the European debt crisis, but it’s not over. From a fixed-income perspective it is difficult to achieve excess return when you have high credit risk. The high yield market is even more overpriced than in the US, with too many people trying to capture yield. With good research however, investors can find specific equities in Europe that are attractive.
Emerging Market Debt
When it comes to analyzing emerging market debt, Fuss tries to segregate (1) country of issue or country of risk when it comes to corporates, and (2) currency. Fuss has reduced corporate holdings due to country of risk and because of all the scars he’s received from investing in emerging markets. “No matter whose law the indenture falls under, it’s where the assets are located that matters most. Ultimately whoever controls the assets decides what the creditors receive, if anything,” Fuss said.
US Municipal Bonds
Fuss does not currently manage any muni-bond funds, but he likes the sector as an area of study. “If you can keep a grip on the specifics, the best market I know of to deal with a rising interest rate environment is the municipal bond market,” Fuss said , “because of all the yield curve dynamics.” Fuss went on to say that assuming any state will pay for problems in a local municipality or venture within the state is not a good assumption. “When you take specific risk, you’d better do specific homework,” Fuss said. “But if you do that, I think the opportunities in munis could last for 4–5 cycles.”
Daily fund flows in high-yield markets are dominated by primarily ETFs and HY mutual funds and a newer entrant, public sector retirement plans. These big players often cause pricing distortions in the more liquid issues and so Fuss recommends going to bonds “off the run.” If dealers keep their inventories down and continue to reduce them, investment managers will have more opportunities, as long as you know the specifics.
Rethink Your Model
Fuss ended with a warning to credit and equity analysts. He said it’s time to rethink your models. “I always tell my analysts, it’s been a glor-r-r-rious time for credit. From roughly the last trading day in September 1981 to today, the underlying setting for credit has gotten better and better, because as rates came down refinancing was more and more attractive to people who borrowed money. Companies’ imbedded cost of capital came down and cost of capital became less and less a part of their competitive environment. Now on the flip side — and this is my guess — fixed cost of capital in nominal terms will be rising from here,” Fuss said.
How does this play out? In the past, companies that were No. 3 and No. 4 in market share, for example, were able to reduce their financial costs even more than the No. 1 market share company. But now, Fuss said, we’re in a reverse situation. As the cost of capital rises, it will harder and harder for No. 3 and No. 4 to compete with No. 1, who starts, by the way, with the lowest unit cost and lowest borrowing costs.
“So I’m telling my analysts, go back to the drawing board and redo your credit and corporate earnings models with a higher cost of capital. That’s what happens when you get old,” Fuss laughed. “You get to tell other people what to do.” As the conference moderator, Marc Seidner, CFA, aptly said, “We like being told what to do.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.