Income investors have been crushed by the depressed interest rate environment. The 10-year yield on U.S. Treasuries recently fell under 1.40%, cutting yield income even further. And more investors have been flooding into higher risk areas like emerging markets debt and high yield bonds.
In certain bond sectors, yields are falling but credit risk is rising. How can advisors navigate their clients through a bond market packed with risk?
Jon Short, managing director, head of global wealth management and head of PIMCO’s New York office speaks with Research. Previously, he was head of PIMCO’s institutional business group. Prior to joining PIMCO in 2005, Short held a variety of senior distribution and portfolio management positions at Fidelity Investments and Putnam Investments. He has 26 years of investment experience and holds an MBA from MIT Sloan School of Management.
The interest rate on 10-year U.S. Treasuries has fallen below 1.50% to record lows. How much further can yields fall?
Several factors are holding the 10-year Treasury yield around this low level at the moment and likely will for some time: The Federal Reserve plans to keep interest rates near zero until the end of 2014, we still have very sluggish growth in the U.S. of only 1.5 to 2%, and of course Europe is still very much a concern. So the flight-to-quality bid continues to hold down the yield on the U.S.10-year Treasury. We’re not going to put targets on it because we are seeing some very volatile markets driven by global macroeconomic factors, but we don’t see any significant changes to these global concerns any time soon, so the 10-year will probably trade in this range for a while. [Relevant funds include: ZROZ or TENZ]
With global central banks buying sovereign debt, how much risk does this present for bond investors in the future?
Central banks have indeed embarked upon some extraordinary measures aimed at stimulating global growth. These unusual policy actions range from setting exceptionally low short-term rates and stating that they will remain low for an extended period of time to implementing various quantitative easing programs designed to lower longer term borrowing costs. As long as we continue to see sluggish global growth, or maybe even a slowdown, you can expect central banks to continue to deploy more policy tools to stem the pace of deleveraging and stimulate the economy. That said, even Fed Chairman Ben Bernanke has made the point that, although extraordinary Fed action comes with benefits, it also comes with costs and risks. Central banks are serving as a bridge, trying to help the global economy navigate this difficult period, but at some point the fiscal authorities need to get involved as well, otherwise the Fed’s actions could merely prove to be a bridge to nowhere.
The State Budget Crisis Task Force issued a report about trouble facing municipal bond investors. The unfunded liabilities for health care benefits for state and local government retirees ALONE amount to more than $1 trillion. If there are so many problems in the munibond market, how come it hasn’t yet showed up in their performance—which has thus far been decent?
We view municipals as a “safe spread” sector offering relative value within the fixed income market—that is, holding up within a wide range of possible economic scenarios. However, there are headwinds facing municipalities, particularly in the general obligation sector, so we have favored essential service revenue bonds, which are typically independent of taxing authority and retiree benefit concerns. Regardless of the exact size of the aggregate unfunded liability for government retirees, inaction could threaten the long-term solvency of many issuers. That’s a big part of why we favor revenue bonds over general-obligation bonds. Regardless of where you invest in the municipal market, however, the sector has become one of individual credits, as opposed to a credit market. What I mean by that is that idiosyncratic risk has greatly increased and more than ever you need independent research talent to identify the securities with the right fundamentals and the right risk-return profile. [MUNI and SMMU]
A number of high quality stocks are now paying higher yields on dividends to their stockholders than they pay on their corporate debt. That’s the case for AT&T and McDonald’s and it’s the case for others. Does this make a case for keeping dividend paying Blue Chips?