Wary of Deflation

Quick Take: While many investors are expecting an economic recovery, deflation could dash those hopes, says Michael Cheah, lead manager of SunAmerica Income GNMA/A (GNMAX). A “big picture” investor, Cheah thinks investors should position themselves for a deflation economy where holding debt causes pain, and people are rewarded for doing nothing with their money as its purchasing power grows.

Stocks don’t provide a better alternative to bonds, according to Cheah, because of unresolved problems with corporate accounting. This leads him to recommend Ginnie Mae and U.S. Treasury securities. Ginnie Maes, mortgage-backed securities issued by the Government National Mortgage Association (GNMA), offer protection because they are explicitly guaranteed by the U.S. government, Cheah notes.

For the one-year period through June, Cheah’s fund rose 8.3%, versus a gain of 5.4% for its peers. For the three-year period through June, the fund gained 8.6%, on average, versus a 7.7% rise for the average mortgage-backed fund. Though it edged out its peers, the portfolio has exhibited more volatility.

The Full Interview:

S&P: What are the main features of your investment process?

CHEAH: The key is keeping it simple. My process is from the top down. I try to reduce my analysis to supply and demand. Focusing on global sectors and Federal Reserve policy differentiates me from my competitors.

I have a minimum of 80% of the fund in Ginnie Maes. The proportions of the fund in Ginnie Maes and Treasuries is a function of the yield spreads. I see the Ginnie Mae market connected to the U.S. Treasury market and Japanese government bonds.

S&P: How exactly are these market connected?

CHEAH: The Ginnie Mae market is influenced by the supply of Treasuries. With a Federal tax package, the supply of U.S. Treasury bonds could increase by $300 billion to $400 billion. To protect their currencies, many foreign central banks are buying Treasuries.

A great increase in the supply of Treasuries would raise Treasury yields and mortgage rates, which would increase the yields of Ginnie Maes.

S&P: What are the characteristics of your portfolio currently?

CHEAH: Right now, about 82% of the fund is in Ginnie Maes, which is pretty neutral. Our Ginnie Mae holdings have an average coupon of 4.8%. The bulk of the mortgage finance market is refinancing, so I don’t want to be caught holding high coupon bonds, which are more likely to be refinanced.

The duration is now 4.5 years. Many of my clients have said they want me to be conservative. They are saying, whatever you do, don’t lose my money.

S&P: Would you hold any fixed-income obligations other than Ginnie Maes and Treasuries?

CHEAH: I don’t invest in corporate bonds because their accounting is still too opaque. If I can’t trust the accounting numbers and can’t do my homework, then I would just be gambling if I invested in corporate bonds.

S&P: What’s your view of recent moves toward reform of accounting and corporate governance?

CHEAH: I am not aware of any sufficient changes. For example, a company recently issued securities with 7.5% in borrowing costs to fund their pensions. The company assumed a 9% return on the securities, and booked the 1.5% difference as income without any certainty of these returns. Situations like these are disasters waiting to happen.

S&P: What’s your view of current Federal Reserve policies?

CHEAH: The Federal Reserve’s main concern is the potential for deflation. With deflation, the economy would enter a twilight zone where consumers would buy less because they expect prices to fall further. It would also discourage entrepreneurship because people with money wouldn’t invest or build businesses. If investors did nothing, their money would still continue to gain purchasing power.

S&P: Do you think the U.S. will be able to avoid Japan’s problems with deflation?

CHEAH: We shouldn’t presume that we will be more successful than Japan in avoiding deflation. I don’t feel that the Federal Reserve will do better than the Bank of Japan in avoiding deflation.

S&P: If deflation is likely, what should the average investor do?

CHEAH: For my own money, I am avoiding debt burdens of any kind. As we approach the deflation twilight zone, debt burdens could lead to great pain.