Equity markets continue to rally as global inflation gathers steam. In this environment many investors have adopted a pessimistic view toward fixed-income investments. Mark Beischel, co-manager of Ivy Global Bond A, provided us with a trench-level view of the bond market. Beischel acknowledged the challenges facing fixed-income investors in 2011, but noted that opportunities remain amid the turmoil.
Many expect that this will be a tough year for bonds. What’s your take?
We’re concerned with international developments. We’re concerned about inflation, rising interest rates and the massive compression we’ve seen in credit spreads since they peaked in 2008. That compression has been a function of the first and second rounds of quantitative easing (QE1, QE2). A tremendous amount of capital has entered the bond market, chasing yields and pushing spreads to levels that we think are unjustifiably tight. In the last three or four weeks, investors have withdrawn capital from the bond market in favor of chasing returns in the equity market.
We could see credit spreads widen and interest rates move higher. If I can capture a 3.5 percent yield in this environment, then 2011 will be a very good year.
Some analysts believe that emerging-market nations have tighter monetary and fiscal policies than their peers in the developed world. Is that true?
At the outset of the credit crisis many emerging-market countries were in a better fiscal position than developed nations. Now a massive deleveraging is occurring in the private sector, particularly in the U.S. and in the U.K. These governments are taking on enormous amounts of leverage -- a cause for concern among investors.
The U.S. has a structural deficit that will be $1.5 trillion this year, following last year’s deficit of more than $1 trillion. Developed markets must come to grips with this situation and devise a credible plan that’s going to address those structural deficits. If they don’t, it will lead to problems with interest rates and the U.S. dollar.
However, the fiscal position of emerging-markets countries is totally different. A lot of these countries were in relatively good shape in terms of their deficits-to-GDP, current accounts and capital flows for fixed asset investments. Their monetary policies were also fairly stimulative.
Now we see inflation starting to rise in these economies. These governments don’t have a lengthy history of managing their monetary policy, and they’re trying to constrain inflation with different tools. Obviously the question is whether they will be able to maintain a fairly smooth level of growth while keeping inflation at bay. That’s something we’re watching closely.
Why were these countries better prepared for the financial crisis?
The Asian currency crisis absolutely brought them back into line. That crisis happened so recently that they haven’t had time to fall away from the policies they put into place at that time.
What countries face the greatest inflation risk?
Inflation isn’t out of control right now. But there’s some reason for concern in Indonesia, India and Australia. Food price inflation is a big topic right now, but the Chinese government is implementing policies to tame inflation and target rising prices in the property sector. Brazil has some problems with inflation, as does Russia. The only country that hasn’t experienced high inflation is the U.S., but it’s starting to creep up globally. In Europe many investors are concerned that the European Central Bank will start raising rates at a time when the EU is trying to provide liquidity for the troubled PIIGS countries (Portugal, Ireland, Italy, Greece and Spain).
What regions and types of credit are most attractive?
Not sovereign credits. The rates you receive in developed markets such as the U.S., Canada, the EU and the U.K., don’t compensate you for the risk of inflation. If you look at the PIIGS, the 10-year Greek bond yields north of 10.5 percent today. But that’s fluctuated as the EU is formulating a plan to solve the liquidity problem. We just don’t think that you’re being compensated for the risk incurred if you buy into Europe’s peripheral countries.
The rates aren’t high in the developed markets. They’re very high in the PIIGS but you’re not being adequately compensated for the high risk of a default. In the emerging-market sector, if you wanted to buy a Brazilian U.S. dollar-denominated sovereign bond, those spreads are so narrow that you won’t be compensated for the risk. Local market bonds have a much higher yield but the government has levied substantial taxes on investments in local currency.
We’ve tilted the portfolio toward corporate bonds that are domiciled in the emerging markets. These will continue to benefit from higher growth rates in emerging markets. We’re buying Brazilian, Indonesian, Chinese and Chilean credits. These credits typically have maturities of three to five years and are fundamentally sound.
Basically, you anticipate that 2011 will be a very challenging year.
Very challenging. Who would have thought at the beginning of the year that we’d be concerned about unrest in Egypt? People have speculated that the turmoil was ultimately caused by food prices, but there was also a spark of social unrest, which is something you can’t predict.
Still, you’ve got a very young, poor, fairly radical population that’s had it with the regime and has been able to promote change. One hopes it will change for the better, but we’ll have to see how the situation unfolds. There’s absolutely an element of that to be found in Europe. The austerity programs that will have to be implemented in Greece and Ireland and Portugal could also translate into turmoil similar to what we’ve seen in Egypt.
Japan and the U.S. are going to have to make some very difficult choices over the next year to address structural deficits. If the U.S. doesn’t reduce unemployment, the situation could get messy. President Obama has a year at the most to bring the unemployment rate down to 6 or 7 percent or he’ll likely be voted out.
Do you see any value in dipping down into credit quality to pick up extra yield?
We’ve put the fund in a defensive position because we are concerned about rising rates and widening spreads. We’re focused on liquidity and credit quality. We also have a quarter of our portfolio rolling off on a yearly basis, allowing us to reinvest at higher rates.
We like corporate bonds, so we are dipping into the lower credits, particularly in the emerging markets sector, which makes up about 30 percent of our portfolio.
Our credit analysis is very thorough and diligent, and we typically buy credits of companies that hold the No.1 or No. 2 position in their country or industry. We require a very sound balance sheet and predictable earnings, which translates into cash. These companies must have proved themselves through an economic cycle and have management that is aligned with the holders of equity and bonds.
This rigorous analysis allows us to buy credits that might be rated "BB" because of the country in which the issuer is domiciled. However, these credits are fundamentally sound and might be rated "BBB" if they were domestic credits. We’re able to get additional yield while taking on less risk.
Is there any good news for 2011?
The global fixed-income investor should be looking for yield. Many of the companies we own are tilted toward growing economies, their balance sheets are very solid and they’re going to be able to pay back their bondholders. That’s what I’m looking for as an investor. We’re cautiously optimistic for 2011 but we’ve positioned our portfolio in a defensive manner that should protect it if interest rates stay at current levels or if they rise.
The equity markets have rallied substantially over the last three months, primarily in response to QE2. We’ve had some fairly good economic data that we hope will continue; otherwise we may see another round of quantitative easing.
When we started debating QE2, President Obama was enacting a liberal agenda. As the Democrats have lost the House of Representatives that agenda has been tossed aside. We’ve seen the continuation of the George W. Bush-era tax cuts. The capital markets have responded positively to the change in philosophy in Washington. But QE2 will finish up in June, and we hope the economic data will continue to support the equity markets.
What’s your best piece of advice for investors?
Understand the risk that you incur when you buy a fixed-income portfolio. That risk is basically interest rate risk, credit risk and currency risk. Many people have jumped into the fixed-income markets on the assumption that they’ll just receive income. They don’t always appreciate the level of risk involved. The key is to understand that risk and make sure you’re being adequately compensated for it.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.