Jeremy Glaser: From Morningstar, I'm Jeremy Glaser, joined today by Dan Fuss from Loomis Sayles.
Dan, I really wanted to start with talking about the Federal Reserve, obviously it's on people's minds. Do you think that their path of kind of the steady increases for years to come is really sustainable? Is that a plausible path?
Dan Fuss: Well, it's undoubtedly going to be bumpier. I doubt if there'd be many bumps on the upside. What is notable this time around, and it was detailed in The Wall Street (Journal) this morning, is that they finally got a little bit more optimistic about the future. It used to be they always pushed things out a little bit further. This time they brought it in a bit and they said, this is going to happen a little bit sooner, as far the rate increases.
Other than that, there wasn't much in there--you could infer one or two things, but that was significant, when you look at, they said, "OK, it's coming a little bit quicker than we used to think." Is it going to be three times, four times, two times, or what will interrupt it? That, I think, is the bigger question. What will interrupt it is a list of maybe, oh I don't know, 127 things. In other words, there are a lot of uncertainties out there.
Glaser: Of that big list of worries, which do you think are the most likely to cause problems?
Fuss: In my mind--now, this is not a universal thought--in my mind, I think the most likely things are geopolitical rather than domestic. Geopolitical can be something as near at hand as, say, the wall with Mexico or NAFTA or things like that. Those certainly could be problems for the Fed. Or at the other extreme, China pushes a little harder in the South China Sea. They're leaning much more heavily now on Taiwan. I think on, to be fair, on a few of their other neighbors. That could be a meaningful bump. Those two areas, I think, are out there. I would be surprised by a major difference from forecast into domestic numbers in any component of GNP of any size.
Glaser: Well, we're talking about the Fed raising rates, we're obviously talking about the short end of the curve. What about longer term bonds? What's your outlook there if we are in a rising rate environment?
Fuss: Well, I think we will. I think initially, first, say--let's assume for just a minute that we're in a several-year move here. None of us know at this point, but I figure the odds are reasonable that this could be a three- or four-year yield. The early part of that, the curve will--the yield curve will flatten. You would anticipate that twos to fives will flatten a little bit and that fives to 10s will flatten a little bit, and that 10s to 30s will flatten quite a bit as a the demand is met for the liability matching from the defined benefit area and from the life companies.
You'll get a flattening curve. Now, if it keeps going, then the curve becomes meaningless because the long end, in terms of new issue, starts to shrink a lot. That's probably a cycle or two out or more. Initially, the upward pressure is there, spreads actually narrow a bit. Then, of course, then they start to scatter and widen, particularly in the lower end of the quality spectrum as this progresses and yields go up.
Glaser: What impacts would the Fed reducing its balance sheet, even gradually, have on rates then?
Fuss: That's a good question. My answer is, I think if the Fed gradually shrinks the balance sheet, essentially letting it start to run off in present value terms, so that the income does not get reinvested, principle does not get reinvested, that brings it down gradually, maybe a little too gradually to satisfy a lot of people. I think it would be gradual and would have some impact, but not a lot, unless for whatever reason, something starts to interrupt in the international cash flows. Then they may have to stop doing that and become a net buyer again. I don't see that happening near-term. You never know.
Glaser: Do you see value in long-term bonds today?
Fuss: No. No, I don't. Again, long-end is very, very, very dependent on what is your goal? If you're liability matching then you'll find value relative to your goal. That actually gets a little better as yields go up--for number one, yields go up. Number two, as you have more of an array of discount bonds to look at, the present value of the issuer's call option diminishes which increases the value to you in the match. Other than that, the long-end, unless you have a severely mispriced item, which would be basically the lower-rated high yield area, the longer end is not all that attractive.
Glaser: I did want to ask you a little bit about high-yield. How would that sector perform in a rising-rate environment?
Fuss: Well, initially, high-yield is sort of OK. High-yield is pricey today. You can't come to any other conclusion than that when you look at the difference in between, say, high-yield and Treasuries, or even high-yield and investment-grade or between BB and B. Take any of the measures, and in general, high-yield is pricey. Is it pricey enough that the yield spread offsets the potential loss from bankruptcy? No, it's not. The bankruptcy rate could be up there, the default rate, whatever you want to call it, but you normally don't walk away with zero. If you project your loss reserve, if you're setting up loss reserves now, you'd be looking at this and it'd be a much bigger component of the income stream than it would if you had another 200 basis points of yield.
High-yield is not something to run away from in here, but as rates go up, the difficulty of rolling over debt if you're a CCC, or B, or even a BB credit increases quite a bit. It's been so easy. Then you get to these valuation extremes. You can't really deal with high-yield across the board anyways, but that's what it is. How does it line up against investment-grade? Sort of average. How do you deal with it? Wait for the bumps.
Glaser: Finally, more big picture, where are you finding value today then?
Fuss: Not a lot anywhere. What you can do, and what we are doing, is that you still have enough steepness to the yield curve that periodically you can add a little bit to the yield curve ride. Much like you would do in munis. In fact, in munis it's much easier, but you can do that in an investment grade corporates. In the high-yield area, you can do it, but it's really one-by-one and it's intermingled with so many other things that the certainty of it, or you might say the expected outcome, is not nearly as predictable. It's harder, much harder, to do in any sort of size. Is there a really cheap area of the market? No. Are there cheap securities within? A few. What are they? I never say.
Glaser: Dan, thanks so much for joining me today.
Fuss: Thank you, and for your time here.