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Trying to Hit Singles
in a Low-Scoring Game
August 2014
Given rates rising and thin yields, global bond investors should seek
modest returns with the right credits rather than swinging for the
fences, says Chris Diaz of Janus
Rising interest rates, combined with coupons that were
meager to begin with. The last year has given bond investors
something rarely experienced in the previous 30: losses.
Chris Diaz, head of global rates at Janus and lead manager
of the Janus Global Bond Strategy Fund, contends that the
run-up in rates has nearly run its course. But he cautions that
a return to an ultra-low-rate environment seems unlikely. He
suggests that appropriate fixed-income investors adjust to
less-fertile conditions by limiting their risk and return
expectations. Diaz is emphasizing credit in general and
investment-grade and high-yield paper in particular, while
avoiding big bets altogether—especially on the direction of
rates. Diaz recently discussed his outlook with Morgan
Stanley Wealth Management’s Tara Kalwarski. The
following is an edited version of their conversation.*
Tara Kalwarski: What are you broad thoughts on fixedincome markets and the current interest rate environment?
Chris Diaz: We’ve had a secular decline in interest rates in
which—except over short periods—the bond market has not
really lost money for the last 30-plus years. But over four
months last year we saw the 10-year Treasury rate go from
1.6% to 2.9%, which translates into a loss of roughly
10%.Last year people looked at their bond portfolios and
realized that they could lose money. I was surprised by the
speed and magnitude of the move. I was expecting
something a little more gradual. I think the rise was a
function of some improved economic data and the market
pricing in a tapering of quantitative easing. My view is that
the bulk of the rate move is likely behind us. Certainly we
received a surprise in the Fed decision, which was
unequivocally dovish. The market was expecting a light
tapering, to maybe $75 billion a month, but maybe the data
didn’t warrant it. My interpretation, from listening to Fed
officials, was that the decision wasn’t necessarily a function
of how good or bad the economic data was but more a
matter of the risk/reward balance. At this level of bond
buying, [The Fed seems] to think, we’re not really getting
the bang for our buck that we did in the first few programs,
so maybe we should put the focus more on forward
guidance, in terms of trying to get the unemployment rate
down. I think that means that the Fed will be on hold even
longer and that rates are probably going to stay [low].
Historically, the level of nominal GDP has had a decent
correlation to the 10-year Treasury. I think that we’re likely
to see an improving U.S. economy, but marginally and at a
slower pace. We could see another increase in rates in the
second have of 2014, but I don’t think that it’s going to be
anywhere near the size that many clients are expecting.
Kalwarski: What are you most concerned about?
Diaz: A real worst-case scenario for the bond market is if
the credit quality of the U.S. comes into question. Then all
of a sudden you could see yields start to rise for the wrong
reasons. The right reasons would be increased economic
activity that provides a reason for the Fed to remove some of
this accommodation and say, “O.K., we can raise rates, the
economy is on the right track.” If the economy’s not doing
well and rates are rising because people don’t want to own
Treasury issues because they’re worried about being paid
back, that’s the worst-case scenario, in my view.
We have a situation in Japan where there has been a much
grander experience, if you will, than in the U.S. with this
three-pronged approach. [Japan’s central bank is] buying
close to $70 billion of securities a month for an economy
that’s about a third the size of ours, and they’ve increased
their official inflation target to 2%. The second area is the
large amount of fiscal stimulus they’re using, and the third
area is structural reform to try to increase competitiveness.
Japan is a country with a debt-to-GDP ratio of well over
200%, the highest in the developed world. It’s also a highsavings country, so they can fund that deficit internally.
They don’t have to attract foreign capital the way that we do.
Their markets reacted very favorably in 2013. The yen has
depreciated significantly, helping their export market. The
stock market is up significantly, probably close to 40%, and
government bond yields have stayed very low; the 10-year
yield is under 70 basis points. Interest rates have been at
zero for 15 years there. There have been 15 stimulus
packages over the last 10-plus years and nothing has
worked, so the notion that it’s going to work this time seems
a bit of a leap. So my question, and I don’t know that I have
the answer, is what happens if the market starts to push back
and say: “Wait a minute. You said we were going to get to
2% inflation. That’s not happening.”? Inflation is still close
to zero. They’ve been mired in deflation for years.
So maybe the test case happens in Japan and we go through
another bout of worrying about the credit quality of what
was once a very highly rated country. That same prospect
concerns me in the U.S.
Kalwarski: How do you determine portfolio exposures with
your strategy?
Diaz: We’re trying to hit singles more than home runs. We
are very mindful of the volatility that can exist in this space,
so we pretty much have a credit focus. Unlike a lot of global
funds that are sovereign bond focused, we’ll have anywhere
between 30% and 50% of our portfolio in investment-grade
corporate credit. We do take currency risk, but it’s not the
ultimate driver of our strategy. We look at the Barclays
Global Aggregate Index, but we’re also mindful of the
significant limitations that exist in fixed-income indexes,
whether domestic or global; 17% of that index is
denominated in yen, but we have very limited exposure
because we’re concerned about Japan. As long as it’s
consistent with our principles of risk-adjusted returns and
preservation of capital, we will deviate very significantly.
We’re mindful of the overall volatility of the strategy, and
that’s what will guide positioning and position sizes within
the fund.
Kalwarski: Can you talk me through your current
positioning and explain how these positions reflect the broad
views that you described?
Diaz: We have been overweight in the U.S. dollar relative to
the euro and yen. That was based on a view that the U.S.
was going to have stronger growth over the next few years
than the euro zone and Japan. We were expecting interest
rates to be higher in the U.S. than in the euro zone and
Japan, too, and we thought that the Fed was going to be the
first to exit the zero-interest-rate policy. If you wait until
2015 that trade will likely be over; the market will certainly
anticipate that well ahead of time. The recovery is much
further along in the U.S. than in Europe and, particularly,
Japan.
We have been, at times, overweight in some of the other G10 currencies, in some countries that have stronger
fundamentals and stronger fiscal metrics and higher interest
rates— Norway, New Zealand, Australia and Sweden, for
instance. But those have been more tactical moves for us.
The core longer-term thesis still applies.
We are very hesitant about emerging-market exposure. That
would probably be the biggest differentiator, in terms of how
we seek to achieve returns, relative to the larger players in
the category. Emerging markets, including local-currency
bonds denominated in reals or rupees, have had phenomenal
returns. That has been a material source of performance for a
lot of folks. Emerging markets became the darling asset
class, with a lot of people saying: “There’s going to be a
secular sea change in who drives global growth. It’s going to
be these countries.” Large percentages of portfolios in this
strategy have been devoted to emerging markets. That has
raised returns but also volatility. We’ve seen months where
these currencies could be down double-digit percentages,
and we’ve recently gone through a six-week period where
emerging markets had a very difficult time.
Kalwarski: Was the sell-off in 2013 bigger than you
thought it would be?
Diaz: It was. I think that much of global market
performance, including in emerging markets, was tied to the
U.S. rate move and concerns there, but the speed and
magnitude of the move were much more than I would have
expected. It was not handled well at all in emerging markets.
For certain countries, for example Mexico, the increase in
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two-year yields was about double the U.S. move, and not
only are you getting rates rising, which is not good for bond
prices, but the currencies are depreciating, too, so it was very
challenging for emerging markets.
But those markets also had a number of secular or cyclical
tailwinds. China is now the world’s second-largest economy.
There has been stable global inflation and low core interest
rates. At the end of the day, their rates are going to move
with rates in the developed world, but emerging economies
were all deleveraging and improving their balance sheets.
That could all be over now if interest rates are headed
higher. China was growing at 14%; it’s now growing at 7%,
and the demand for all of the commodities that were being
exported to China may not be there, so the growth outlook is
really challenging.
We had the term “BRICs.” Now the term “fragile five” was
coined for Turkey, Brazil, South Africa, Indonesia and India.
Essentially these countries have significant current-account
deficits and need to attract capital. They have been punished
the worst. Although we did see a rebound in emerging
markets with the Fed decision, I think it’s going to be
challenging for the next few years because these tailwinds
that have existed are not likely to be there and could possibly
reverse.
Kalwarski: Given a muted growth outlook, where do you
see the best potential for opportunities?
Diaz: Just based on our philosophy, even if we thought there
were good opportunities out there, we would never be taking
on a level of risk that could give us really outsized
performance one way or the other. We’re generally going to
be looking for singles and doubles almost all the time. We
still like credit; over 40% of our portfolio is in investmentgrade and high-yield corporate credit. But I think the days
when you could throw money at credit—when all spreads
tighten, and you make money in high-yield and investmentgrade—are coming to an end. Not only are valuations much
more expensive. We’re starting to see companies engage in
shareholder-friendly activity, so they’re re-leveraging. That
typically happens at this stage of the cycle. They’re
borrowing money in the public debt market and using it to
pay special dividends and buy shares back. Fundamentally,
we’re looking for companies that are trying to de-lever,
improve the balance sheet. So you just have to be more
selective and more security specific. You have to do your
homework and the credit work.
We continue to see opportunities there [in credit], and we
see opportunities in peripheral Europe, although I’m
astounded that the European Central Bank has introduced
the Outright Monetary Transactions program and has never
had to purchase a single bond. It’s a testament to how deep
central-bank pockets are. Even though the Fed has been
buying bonds, the ECB has just said that they’re ready to do
it if they need to. We’ve seen significant improvement in
peripheral bond yields, at least in the major countries, Spain
and Italy. But there’s still room for a lot of spread
compression. They’re still meaningfully higher than
Germany, so I think there may still be room for
improvement as the fundamentals improve. We have
exposure to those bond markets and think that they can
generate strong, positive absolute returns, and then we have
selective exposure to other higher-yielding sovereign bond
markets, in places like New Zealand, where we can
[potentially] earn over 4% yields.
Kalwarski: How does this type of go-anywhere bond fund
fit into an overall portfolio?
Diaz: I think it’s a good complementary, core holding
product to U.S. oriented fixed income strategies. We have
the ability to invest all over the world and can tactically
reduce our interest rate exposure, as we are doing today in
the U.S. We have the ability, particularly in the credit space,
to take advantage of countries that issue debt in euros, gilts,
yen or other currencies. We have the ability to invest on a
hedged basis in countries that we think could have stronger
fundamentals and additional currency appreciation, plus the
yield. We also can invest in higher-yield markets. Much of
the developed world is running a zero-interest-rate policy.
And while other central banks have low rates, they’re not at
zero, so we can find higher yields. And if we have a view
that interest rates may be headed up, we’re not beholden to a
single interest-rate market. If we were to have the view that
interest rates are going to head up in the U.S. but not
anywhere else, we would be able to diversify that risk. We
have a lot of levers to pull, so it’s a nice complementary
vehicle in a [broadly diversified] fixed-income portfolio.
*Unless otherwise noted, the source for all information is
Janus as of July 2014.
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