A quartet of bond managers ensconced in a glistening tower in Newark, New Jersey, say historically low long-term Treasury yields are here to stay. And they’ve got a growing pile of money backing that view.
For the crew at PGIM Fixed Income, there’s no bond bear market in sight — though they say they’re getting defensive in the face of rising volatility. As if the firm’s $709 billion of assets wasn’t enough to get the market’s attention, Morningstar Inc. crowned the group its 2017 fixed-income manager of the year for shepherding the Prudential Total Return Bond Fund. It gained 6.6% last year, beating 87% of peers, data compiled by Bloomberg show.
The ‘stay calm and carry on’ view on rates, which they’re applying across the firm’s assets, is far from consensus. Many investors say there’s nowhere to go but up for Treasury yields, with central banks unwinding post-crisis monetary stimulus and America’s fiscal picture deteriorating. So far this year, the bears are winning out: U.S. 10-year yields are close to a four-year high just below 2.9%, and the PGIM fund is suffering steeper losses than most rivals.
The group’s chief investment strategist and “macro guy,” Robert Tipp, who has an aura of calm that may come from his stress-relieving practice of tai chi, rattled off the global forces that he expects to cap yields.
“We look at the world with the trends that are going on, with aging, and rising debt levels, leading to an environment that has pretty low and stable inflation and pretty moderate growth,” he said in an interview this week at the Prudential Tower, less than 15 miles (24 kilometers) west of Lower Manhattan.
The bond bulls’ case has gotten even more difficult to make in 2018. The U.S. is ramping up issuance to cover widening fiscal deficits, just as the Federal Reserve is trimming its balance sheet and signaling further rate hikes ahead. And then Wednesday’s U.S. consumer price report suggested inflation is heating up.
For Tipp, the data still fit into their macro view, which has 10-year rates topping out around 3%. The lower-for-longer camp has other followers, of course. But perhaps none wields as much money as PGIM Fixed Income, part of the investment-management arm of Prudential Financial Inc., which as a whole oversees $1.39 trillion.
Tipp runs the Total Return fund along with Michael Collins, Gregory Peters and Rich Piccirillo. The managers have a century of market experience between them and have guided the fund through a period of striking growth. Assets have climbed to $31 billion, from about $3 billion in 2013. It added $9.5 billion last year, behind only the Pimco Income Fund among active bond funds, according to Morningstar.
They benefited in 2015 from investors fleeing Pacific Investment Management Co.’s Total Return Fund after Bill Gross departed the prior year, and then from an effort to be included in companies’ 401(k) retirement plans and mutual-fund advisers’ recommended offerings. The PGIM Total Return fund’s performance has bolstered their case. It’s averaged almost a 3% annual gain over the past five years, better than 82% of peers, Bloomberg data show.
But their bullish view on interest rates, which paid off in 2017 as yields failed to move higher for much of the year, is backfiring in 2018. Even though the team says their broad macro view accounts for just 10 to 15% of performance, the fund is down 2.3% this year, trailing around 90% of peers.
‘February Is Worse’
As bad as January was, “February is worse,” said Peters, a senior portfolio manager. He’s the newest team member, joining four years ago from Morgan Stanley, where he was chief global cross-asset strategist. The challenge is building because, in addition to Treasury yields grinding higher, credit spreads have also started to widen.
The broad macro call is always the most difficult, said Peters, who credits PGIM Fixed Income’s arsenal of over 100 fixed-income analysts and managers for the group’s success. Most sit together in a large trading room on the tower’s seventh floor. On Mondays around noon, many gather in a conference room and connect with overseas colleagues to brainstorm on investment plans.
As part of building the portfolio, the firm also uses security selection, sector allocation and duration views, and it frequently taps derivatives to adjust to the desired duration and yield-curve view.
A big chunk of the 2017 performance came from anticipating narrowing spreads in investment-grade and high-yield corporate debt, Tipp said.
Their conviction that rates will remain low is evident in the fund’s duration, a measure of sensitivity to moves in interest rates. It’s about a half-point longer than the benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, which has a duration of about 6.
There are also areas where they’ve pulled back.
The team has cut by about half over the last year its allocation to high-yield debt. They’re also avoiding agency mortgage-backed securities as they anticipate low returns given tight spreads, and prefer top-rated securities with similar credit risk such as commercial MBS and collateralized loan obligations. Combined, they’re underweight government securities, which includes Treasuries and agency MBS.
Yet given they’re long duration relative to their benchmark, they stand to benefit if yields stop rising. In their view, pensions, insurers and even individual investors will find the higher yields too good to pass up — especially as stocks falter.
While that has yet to halt the losses in government bonds, Collins, the senior investment officer, is undeterred.
He’s “the most optimistic fixed-income guy I’ve ever met,” Peters said. The group dynamic is “low ego,” and if they’re not unanimous on a viewpoint, they’ll debate and scale it accordingly, Peters said.
That makes the conviction for persistently low Treasury yields all the more impressive.
“We’re setting up for probably better returns going forward,” said Collins, who’s been at Prudential since the 1980s. The higher benchmark yields, coupled with their strategy, means “you’re starting to look at total returns that are close to the mid-single-digits, which could very well be competitive with stocks over the next 10 years.”
—With assistance from Charles Stein.
— Read PGIM’s Peters Sees Only Downside in Bank Loans, Favors Junk Debt on ThinkAdvisor.