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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 2 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. 3 Investors should carefully consider the investment objectives and risks as well as charges and expenses of a mutual fund before investing. To obtain a prospectus, contact your Financial Advisor or visit the fund company’s website. The prospectus contains this and other information about the mutual fund. Read the prospectus carefully before investing. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. 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