Between the bond market’s recent sharp decline and news of a fund trading scandal, even a veteran bond fund manager like Fred Cavanaugh is trying to catch his breath.
Cavanaugh has run the $1.4 billion J Hancock Strategic Income/A (JHFIX) since its 1986 inception. Today, he’s worried that people are expecting far too much from the U.S. economy and financial markets. So in his fund, where he spreads assets among U.S. and foreign bonds, he has a more than 60% position in foreign bonds, his highest stake ever.
What has rattled the bond market?
Cavanaugh: Many think we’re starting an 18-month period of fairly robust economic growth. I don’t believe that’s true, but some people in the bond market do, and that makes them more interested in owning stocks. The second concern is the budget deficit, which has blossomed again. The financing the Treasury will have to do over the next two to three years will be troubling to the market. Every time they estimate the cost of the (Iraq) war, it’s higher and higher. There doesn’t seem to be an end to that spending. Combine the budget deficit with our trade deficit, and they add up to about 10% of our GDP (gross domestic product).
Finally, there’s event risk. That’s the fear of some financial crisis, where a big bank or mortgage company has serious troubles. We’ve seen headlines about some instability at Federal Home Loan (FRE). There might be trouble there. You also have (New York Attorney General) Eliot Spitzer talking about some (allegedly improper) trading in mutual funds. I think there’s just a lingering concern that under the surface of all these issues is an iceberg. I’m not saying something out there will definitely blow up, but you have the feeling that something could.
You also can’t forget the perennial terrorism risk.
Your foreign bond bet has been quite high of late. Why is that?
The fund’s large foreign stake is driven by two factors. First, we saw a lot of value in those markets. Until recent weeks, you could pick up a lot of extra yield by investing overseas. In the spring, for example, we could buy a 10-year government bond in Germany and get an extra 0.35% in yield versus a similar bond in the U.S. We got an extra 1% on similar bonds in Australia and Canada.
Second, my colleagues and I think the U.S. dollar is on a long-term secular downtrend against most other currencies because of the large budget and trade deficits and other economic issues. Throughout the 1990s, foreign investors really helped finance our current-account deficit. But our financial markets aren’t as attractive today as they were four or five years ago. Our economy just isn’t as healthy. To draw those foreign investors back, we think either interest rates have to go up or our currency has to weaken. We don’t think rates will go up anytime soon, so the dollar is vulnerable.