Paul Matlack is senior vice president, senior portfolio manager and fixed income strategist for Delaware Investments. His firm oversees $145 billion in fixed-income strategies, and Matlack co-manages Delaware Corporate Bond Fund (DGCAX), Delaware Extended Duration Bond Fund (DEEAX), Delaware Core Plus Bond Fund (DEGGX), and Delaware High-Yield Opportunities Fund (DHOAX).
I spoke with Paul on March 12.
What is your overall forecast for the U.S. economy this year, particularly with respect to growth and inflation? To what extent is that forecast already reflected in the bond market?
Let’s start with the economy and growth. The big drivers of GDP are consumer spending, government spending, corporate spending and, to a lesser extent, exports. There is tremendous slack in the labor market right now, notwithstanding the fact that the unemployment rate just fell to 7.7%. We tend to think that the true measure of unemployment and employment slack is more like the U6 measure the Labor Department produces. That focuses not only on unemployed but underemployed and people who have dropped out of the labor force. That number is somewhere in the mid-14s.
We have higher taxes, and it’s unlikely that you’re going to see consumer spending climb rapidly. As the main driver of GDP, we just don’t see that as something that’s going to be the catalyst for the economy moving much out of this 2% to 2.5% range.
Look at the other drivers of growth. At an aggregate level, both state and federal government spending is and will continue to churn down. With corporate and investment spending, there have been some glimmers of light in the last six months or so. But in general, companies have just been sitting on cash in the face of so much uncertainty out of Washington, Europe, China and the Middle East.
Frankly, that’s not a lot above stall speed. And so we certainly would be vulnerable to a shock coming from somewhere — maybe geopolitical — and unexpected slowdown in China , or Middle East problems, for example.
What does that say about inflation?
We have tremendous monetary stimulus in the system. But by and large, it’s sitting as excess bank reserves, and it’s not being lent actively out into the economy. You really need that. You need the banks lending aggressively to get that capital out to irrigate the economy and get growth rates higher, but also just to get any fear of inflation back into the system. With the way banks are exceptionally risk-averse right now, we just don’t see that as an inflation threat.
When you have high unemployment and resource slack, such as plants and equipment running only at 75%, it’s very hard to see how either wage or pricing pressure moves through the system. I like to say that if I go down the hall and ask for a big raise, they’re going to tell me just to go back to my office and think big thoughts. There are tens of thousands of people on the street from the Wall Street contraction in 2008. Certainly there are a lot of other industries that have excess labor. It’s very unlikely you’re going to get a lot of wage pressure outside of little pockets like the oil fields up in North Dakota.
We don’t see inflation taking off.
Given slow growth and low inflation, which direction are interest rates heading?
We don’t see interest rates really moving a lot out of this range that we’ve seen, from 1.5% to 2.5% on the 10-year. There isn’t any real catalyst to move us to a breakout level beyond that.
Having said that, we certainly are counseling advisors and everyone else that when rates are this low, fundamentally there’s only one major move they can make: That’s to the upside. Clearly, this is the time to start thinking about how you defend a bond portfolio against rising rates in the future. But we don’t think we’re looking at that. Bernanke has stated very clearly that he’s going to keep rates low for the next several years, and that’s a function of what he sees on the unemployment front.
You asked whether there would be a catalyst that would drive the bond market one way or the other. Do you think that the Fed will continue its quantitative easing throughout 2013 at least? How is that affecting your investing strategy?
Yes, I do. Not because I have tremendous insight, but because the Fed and the various members of its board who go out and speak have been very clear about that. They think they have to keep long rates low. They have to keep mortgage rates low. And the only way to do that is by continuing to buy. Certainly they’re going to keep short rates and the fed funds rate low for the next several years.
We continue to recommend intermediate-range fixed-income instruments, whether it’s high-yield or investment-grade bonds, which have the benefit of being invested in corporate America. That sector has the highest credit measures that we’ve ever seen. Intermediate fixed income is going to outperform things like floating-rate bonds and bank loans for the rest of the year, just because of their higher yields.
Backing way up to 30,000 feet, just think about bonds. We’ve had a 30-year decline in interest rates as a driver of bond returns. That’s over. All the spread widening that took place in 2008 has almost entirely re-corrected and in most cases is well inside their long-term averages.
Whether you’re talking about high yield, investment grade, mortgages, or emerging markets, their spreads off Treasury bonds are very narrow again. There are no major drivers of capital appreciation in the bond market left. We view this as a yield play. We’re telling advisors that bonds are back to what they did in the old days. They’re not giving you equity for returns any more. You’re going to earn the income.
Given that, fixed-rate intermediate-term instruments in a diversified portfolio will beat TIPS and floating-rate bonds, at least for this year. But then when the economy gains traction, and we believe it will, and rates move up, you want to be thinking about floating-rate options.
You mentioned that there is a potential, at least over the long term, for higher interest rates, and that many advisors are concerned about how they protect their portfolios against that. Have you put any defensive measures into your portfolio to protect against a rise in rates?
Yes. For example, in our flagship bond fund, which is Diversified Income Fund (DPDFX), we own high-yield bonds and bank debt — the senior debt of high-yield bond issuers. When rates are rising because the economy’s expanding — not because of some inflationary outbreak but because of better growth now and better expected growth in the future — then the more credit-oriented your bond investments, the better you’re going to do.
An extreme example is high-yield bonds, because they’re lower in credit quality. To the extent the economy’s expanding, the underlying companies are doing better. The value of those bonds tends to go up, even if higher interest rates are trying to push them down. When you step back and you look at the total return for high-yield bonds in a rising-rate environment, they invariably outperform all the higher quality tiers of the market, whether it’s investment-grade, mortgages or, as an extreme example, Treasury bonds.
In our diversified fund and in our funds where we can, we’re taking our credit exposure up. We’re taking it up in high-yield, bank loans, and within the triple-B component of the investment-grade corporate-bond universe. Those are all defensive ways to play an ultimate expectation of higher rates. And in the meantime, we’re clipping a higher coupon than we could in higher-quality sectors.
You mentioned earlier that you see the opportunities in the bond market this year focused on income and not on capital appreciation. With the 30-year Treasury yielding 3.3%, aren’t there still some opportunities for substantial appreciation at that end of the yield curve?
It all depends on your view of the world. Our take is that when you’ve got a duration at the 30-year of something like 21, if rates go up 1% at that end, you’re going to lose a fifth of your investment. Our view is that that there are much easier ways of getting that yield pickup without incurring that extreme interest-rate risk.
Certainly for corporations that are trying to fund the liabilities of their pension plan, things like very-long-duration investment-grade corporate bonds make a lot of sense, even though you have interest-rate risk there. But for an advisor thinking about a client, we here at Delaware are much more comfortable saying, “Don’t stretch for yield in Treasury bonds. If you need yield, stretch it in a credit instrument and keep your Treasury exposure short.”
I believe that the two largest holdings in your corporate bond fund are the 10-year and the 30-year. So you still are placing a reasonable bet on Treasury bonds at those two maturities. Am I correct?
Yes. At an issue level, you may find that those are our biggest positions, but in the context of the fund, they’re actually significantly underweighted via the index.
The other thing about Delaware is that we are almost invariably underweight Treasury bonds against almost any of the major indices and against our competitors. Over the long haul, you make a lot more money by clipping a higher coupon in the spread sectors of high-yield, investment-grade, mortgages, and asset-backed, as opposed to getting into Treasury bonds.
We think duration and betting on rates is a fool’s game at the end of the day.
Let’s turn to the corporate sector. You mentioned that corporations are in strong shape now, and you’ve written that both investment-grade and high-yield bonds will benefit from continued profitability in the corporate sector. But profit margins are at historically very high levels. What is the potential for a reversion to the mean in corporate profits?
One thing you have to bear in mind, which actually gives us an advantage as bond investors as opposed to stock investors, is that buying a corporate bond, whether it’s investment-grade or high-yield, you’re making a loan to that company. We don’t need their credit metrics to go to the sky. We just need them to be stable. The stock guys need to find companies where EPS, revenue growth rates, or some driver of EPS is always on the move up.
As we look at the corporate sector from a bond perspective, as you said, we have record-high profit margins. To a great extent that is because of all the people who were let go in 2008-2009 and have not been rehired, which gets back to the unemployment problem.
We had pretty nice revenue growth coming out of the trough, from 2009 to 2011. We saw that starting to flatten out last year as growth rates subsided to the high 1% to 2% range. That’s where we find ourselves right now.
We had pretty nice revenue growth coming out of the trough, from 2009 to 2011. We saw that starting to flatten out last year as growth rates subsided to the high 1% to 2% range. That’s where we find ourselves right now.
Your question is good: Are we at an inflection point? We certainly have squeezed the entire cost-cutting out of those income statements that we can. To get improved profitability from here on, we need it on the top line. To get it at the top line, we need the economy to grow more than 2%.
Having said that, I’m also perfectly happy if everything just goes sideways, because I’m making a loan to these companies. We’ve never seen credit metrics as high as we have right now in either high-yield or investment-grade. By that, I mean profitability and balance-sheet liquidity. All the cash these companies are sitting on they ordinarily would be spending. More importantly, what they’ve done with their balance sheets in this low-rate environment is refinanced all of their longer term debt at interest rates that we’ve never seen before — record low rates.
We have liquid balance sheets, interest costs that have never been this good, maturities pushed way out and fat profit margins.
But as long as this is an inflection point where growth is not going down — as long as we’re going sideways — it still makes the U.S. corporate sector the absolute best spot globally right now. In fact, we’re seeing a lot of institutional and retail inflows from overseas.
If you want yield and exposure to corporate credit in the bond market, you certainly aren’t comfortable yet with Europe. Europe is arguably still going down, and it really hasn’t fixed its problems. It’s just drowned them in liquidity. China is on the edge of a slowdown. Whether that plays out or not, we’ll see, but I think there are some signs. A lot of the emerging market countries are beginning to slow in some respects.
If you want exposure to the largest, most liquid bond market in the world that also happens to have the best credit metrics, you’ve got to come to the United States.
I want to talk about the high-yield sector. I believe that the yield on your fund is 6.79%. A lot of money has flowed into high-yield bonds over the last several months, and the spreads are historically fairly low. Do you still believe that high-yield bonds are a good value, say, relative to the 30-year that yields 3.3%?
If that’s your comparison, absolutely. When rates are where they are right now, then taking on a duration of 22 and that kind of interest-rate sensitivity is crazy. I would rather have a mid- to high-6% yield with an average duration of less than four, as opposed to a 3% yield and a duration of 20.
The dollar prices on high yields are almost back to a record high. Yields are clearly at a record low. Setting aside fundamentals, which we talked about previously, the only value indicator is that spread off of Treasury is still wide, relative to how narrow it typically gets at the peak in high yield. On a spread basis, you’ve still got a couple hundred basis points plus of additional spread cushion, which could be either capital appreciation or it could be there to absorb any interest rate increases. Given those other metrics I gave you — dollar price and yield — the spread in high-yield right now is not necessarily the best value indicator.
Last year, I would have said that high yield was the last double out there, in a baseball analogy, with all other fixed being singles. I’d say high yield is the highest yielding single now.
The fact that prices are so high means that they really can’t go much higher, because they’d be vulnerable to being called.
Yes. You’ve got prices that are two and three points above the average, typical call price. The only thing you’ve got going was a huge wave of refinancing back in 2009 and 2010. We had a huge wave of refinancing ever since, and we typically have four to five years of call protection before those bonds can get taken out. We’re not going to start to see the 2009-2010 vintage paper become callable until 2014 or 2015. You don’t have any near-term threat of wholesale calls of the bonds that have come out since the crisis, so we’re not worried about that.
Where are we in the credit cycle?
While we may be in the ninth inning of the capital appreciation story in high yield, we’re still in the fifth inning of the credit cycle.
The credit cycle usually starts out with huge default rates when you have a credit crisis, and that cleans out the true junk out of the market. Then as the economy grows, you have a lot of refinancing, and that improves balance sheets. At a certain point, when you get to the later innings, you get a heavy proportion of leveraged buyout activity and highly leveraged transactions, and that begins to sow the seeds of the next downturn. That tends to go hand-in-hand with very aggressive bank lending.
We’re not seeing any of that in any big way yet in high yield, and we’re certainly not seeing the aggressive bank lending. So while the big capital appreciation has happened in high yield, from a credit quality standpoint we’re still in the heart of the order.
Default rates are running at 1.5%. They literally, statistically, can’t go lower.
We’re not going to see credit problems become an issue in high yield, and that’s good news. The bad news is that the math is working against us in terms of additional capital appreciation.
What advice would you offer to advisors who want to be diversified, and want to hold 30% to 40% of their clients’ assets in bonds, but are worried about rising rates? What is the right strategy for constructing the fixed-income segment of their clients’ portfolios?
My very general words of guidance would be: If you need to be in the bond market, you want to be in a very diversified portfolio that can go in a number of directions. This is going to be a game of collecting nickels around the world. There just aren’t any huge homeruns left.
You want to stay at the short to intermediate part of the curve, because no one knows exactly when rates are going to begin to move. When they move, they could move violently. We have an inherent bias against reaching out anywhere beyond the 10-year space for yield.
You need to start making moves in a portfolio now from an insurance perspective. Start getting into things like floating-rate bond funds and bank loans. Our floating-rate fund not only holds bank loans, but it has higher investment-grade floaters. Use a floating-rate income component that will reset off LIBOR. As those rates move up, your income moves up. And those funds also have a duration that’s typically well less than a year.
What is unique about the funds that Delaware Investments offers, and what should advisors know about its fixed-income funds?
We manage about $145 billion in fixed-income, and we’re one of the largest players. We are almost entirely invested in cash bonds, and that’s a function of being in something of a sweet spot in our size. We’re big, but we can still express portfolio opinions almost entirely in cash bonds. We make very little use of derivatives.
Our greatest single expertise here is in credit. We’ve got 15 corporate analysts who do nothing but look at U.S. credit, from investment-grade down to high-yield, and we have a very deep staff in almost every other sector of the bond market. If you look at the big components of our funds, you’ll see that we tend to overweight exposure to U.S. credit, and that’s just a way of getting extra yield with less risk in general, and particularly right now.
If someone wants to pick up our portfolio, they can see and understand exactly how we have them invested. We tend, across the board, to be downside conscious or downside mindful. Across all markets, we tend to underperform in bull markets, but we tend to substantially outperform in down markets.
So we get to the same place. In fact, we get to a very high place in terms of rankings, if you look at Lipper, for example. But we do it by protecting to the downside and doing it with less volatility. That’s sort of the hallmark of our company’s style.
To the extent that one can say this about the bond market, we try to deliver sleep-at-night portfolios that solve problems for people rather than create them.
Read more articles by Robert Huebscher
