September 3, 2013
by Natalie Pace.
Interview with Kathy Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research.
Outflows out of bond funds, particularly muni bond funds, have caused the term Bond Exodus to be the new media buzzword. So, is this just hyperbole, or is 2013 just the beginning of the popping of the great Bond Bubble? For answers, I turned to bond expert, Kathy Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research.
Check out my with Kathy from August 30, 2013 below. We both took time in a deserted New York City office building on the Friday before the last, long summer holiday weekend, to discuss something that affects every professional, but puts most people to sleep! It’s rather refreshing to see an expert who beams as she recalls staying up late to read Fed minutes dating back to 1918. This is the type of rigor that Kathy Jones brings to her job, which is why her commentary is essential to read today, at a time when bondholders must be concerned about preservation of capital and outflows from the bond market.
Read Kathy Jones’ ongoing bond market commentary on Schwab.com.
Natalie Pace: We’ve all been hearing about the Bond Exodus. Is this really an exodus. Or is this just press hyperbole?
Kathy Jones: There’s a fair amount of hyperbole, however there certainly has been an outflow of bond funds, primarily muni bond funds and long-term bond funds. I wouldn’t call it a mass exodus.
Where’s the money going?
Into shorter bond funds or into bank loan funds, floating funds, or into cash. I would characterize it more that the numbers aren’t out of bonds, but in rotation within the market. We’re calling it Duration Rotation. People are taking money off of the Long Duration table and putting it on the Short Duration table.
Detroit forces us to look at muni bonds with a much sharper focus. Legacy costs are not limited to older corporations. Our cities and states have these liabilities, too. What’s your take on the muni bond market? So many people have purchased muni bonds for the triple tax free status, without ever considering that they might lose some of their principle.
We generally think the muni bond market, from a credit perspective, is fine for most people – in the investment grade. We’re going to have some credit events like Detroit and Stockton, California, like Harrisburg, Pennsylvania, as a result of the legacy issues that are going on. So, there will be those problems, and they might be scary to people from time to time, and there are some areas that we are concerned about. We generally think that people who are invested in high-quality munis, and particularly revenue-backed bonds, are just fine from a credit perspective. There will be some interest rate risk.
If you are purchasing a long-term bond, how do you know what it is going to be like in 30 years? Detroit may have felt fine 13 years ago. Can a credit rating really protect you?
Keep in mind that Detroit has been a high yield issuer for years now, and Detroit’s problems have been coming on for decades. It’s highly unlikely that if you are an investor you didn’t know Detroit had some problems.
Is the interest rate risk heightened in munis? It’s unusual to see a short-term muni-bond.
Municipalities usually fund themselves long-term. So, it’s not like a corporation that will often have short-term debt to roll over. Even as rates rise, they may not be affected that much because their cost of funding isn’t rising – particularly a higher credit quality issuer probably managed that well, and refinanced their debt at low rates. And if they were smart, they’ve locked them in.
Is there a revenue bond that you like more than others? Muriel Siebert, may she rest in peace, talked up water revenue bonds. On the other hand, some nuclear power plant revenue bonds have been meltdowns.
Sewer and water are the classic revenue bonds that people go to because generally speaking people need water and sewage systems. Parking revenue bonds might be a little riskier than water revenue bonds. You clearly have to know what you are doing. You have to look at the credits and you have to be comfortable with them. Or buy a fund where you have confidence in the fund manager, or get a separately managed account and have someone managing it for you.
You were drawing parallels between our economy today and post-World War II. What lessons can be drawn from that comparison?
I drew the parallel between the 40s and the 50s because it’s the only time in history that I know of, that I could find, when the Fed had expanded its balance sheet to such an extent, and was basically using a lot of tools to try to cap interest rates at the same time. I spent weeks reading minutes from Fed meetings back to 1918, including the annual president’s report to the President of the United States and Congress. The parallel is that the ratio of Fed holdings to GDP was about where it is today. So, we’d gone from about 4 percent up to about 20+ percent, just as we’ve done over the last couple of years. The purpose was to hold down rates to finance the war debt. We had a big run-up in debt relative to GDP, and they were concerned that if interest rates went up that would be very costly to the treasury to finance the debt. I don’t know if that is the main motivating factor for the Fed now, but it clearly is a risk as well. Then they capped long-term rates at 2.5% and kept short-term rates at 3/8 of one percent. So, now we’re at zero to 25, and trying to hold rates down through quantitative easing. Same story basically. What was interesting was that when they finally came to an agreement between the Fed and Treasury to stop capping long-term rates and to allow the Fed to raise rates in 1951, rates didn’t really go up very much.
Hmmm. That’s quite interesting. What caused the rates to stagnate, instead of escalating?
There was this tremendous concern that inflation was going to get out of control and people were going to abandon the bond market, such as it is today. And it didn’t happen because they raised rates a little bit and the economy sank into a shallow recession and rates actually came down. So even though short-term rates had gone up to about 1.5%, it took 18 years from the low for long-term rates to go back to where they were before this maneuver.
Well, you can certainly see how that is possible today. It just happened in Europe!
So, history doesn’t repeat. And I’m not promising that it will be 18 years from the low back to 5%. We’ve been through a period, the worst period in terms of the economy, since the 30s. And, we’re doing many of the same things that we did in the 40s. It strikes me that people are trying to equate this cycle with more normal cyclical behavior, rather than unusual economic circumstances.
In that scenario, if you have credit-worthy short and medium term bonds, you should be just fine. Am I reading the tea leaves on that scenario right?
Everyone is fine if you can hold the bond to term and the issuer remains credit-worthy. However, if you are 50 or 60 and have "gotten safe" in bonds and then have a health event and the trade-in value has gone down, that could be a disaster. You might have to liquidate some of your investments and take a loss on your principle investment. So, what about long-term bonds, if we end up with a 1950’s type scenario. Are those okay?
We just don’t think the risk-reward in longer-term bonds is that attractive. So, you can see the case maybe in munis because the credit quality tends to be a lot higher. A lot of times, retail investors who dominate the muni bond market are laddering their bonds. So they may hold some longer-term bonds but it is part of a bond ladder, where they average the duration down, which we think is perfectly fine. That is a good way to manage through a cycle when you don’t know when rates are going up. But just going out and buying long term bonds, like ten years and beyond, at this stage, seems to me that the risk-reward of these yields just isn’t that attractive. We prefer people, depending upon their portfolio, to stay a little bit more in the short term or medium term. Because it does seem that rates are going up to some extent.
Bond funds were not a big part of the picture in the 1940’s. Are there any bond funds that are more attractive than others, or bond funds that are trying to position themselves as "better" which might be riskier than investors know?
There are new types coming out all the time. There are a couple of crazes. Anything "floating rate" seems very popular right now. "Unconstrained," where the manager can go anywhere and do anything, which I think they are promoting as, "We’re professionals. We can manage through any environment." The problem is that you don’t really know where you are invested then. One of our tenets is, "Know what you own." In terms of a bond fund, know what kind of bond fund you own. Know what it owns. Understand what the strategies are. How much leeway does the manager have? For example, Barron’s recently ran an article on Puerto Rico’s municipal bonds. We’ve been warning about the problems in Puerto Rico and their municipal bond market and how risky it is for a while now. They are at risk of a downgrade, perhaps below investment grade. What people weren’t aware of, until they read the Barron’s article, is that many bond funds own Puerto Rican bonds, even if it is a state-specific fund. They do this because their mandate allows them to buy outside of their state because the yields are so attractive. For instance, you could own a state of Maryland muni bond fund that actually has a high allocation to Puerto Rican bonds. That’s the kind of thing we think investors should know about. When we say, "Know what you own." We say, "Go on the website. Pull up their Top 10 Holdings." You can do that on Schwab.com. You can do that on the Internet. Go to the provider’s website and see what they own. And make sure that is something that you are comfortable with.
Financial literacy is very important. But, people might be thinking, "How would I ever know that Puerto Rico is a "no," and Maryland is a "yes?" How would I know that Texas or North Dakota is better than Detroit? As I start on this journey of knowing more, where do I get the good information? There is so much noise out there. Whom do I trust?
There’s more good information out there than people realize. Schwab publishes a lot of information. FINRA has a tremendous amount of information that is completely unbiased because it is coming from the regulatory authority. The MSRB also publishes information. If you want to educate yourself, you can. We run a lot of workshops. We have bond specialists who will talk with clients about their portfolios. There are a lot of resources. If you are not comfortable making those decisions, then, yeah, turn it over to somebody who does that for a living. But that is where you have to take that leap of faith and say, "This is the right fund manager. This is the right asset manager for me." But the guidelines should be something that you pay attention to. For instance, if it is a fund, you should know what percent that Maryland fund can go outside the state of Maryland. There will be some that can go outside 5% and some that can go outside 25-30%. There will be some unconstrained. You can ask those questions and you can find that information, if you look.
Particularly if you are trying to make sure that you have a lot of your nest egg "safe," this becomes very important…
The bigger percentage of your portfolio, the more you rely on this for income, the more you should participate in the process.
Capital preservation is important!
There are Treasury bonds. I know everyone loves to hate the Treasury market, but there are Treasury bonds that can help you with that.
Schwab content is very high quality. However, not everyone is aware of that. People are turning on financial news 24/7. Or they are scouring the Internet, and they just don’t know which "expert" to believe. There are literally opinions across the board. And someone who works for I Just Started My Fund Yesterday dot com can be offering her "expert" opinions, too.
It is hard to parse through. I often tell people to turn off the TV. To some extent, a lot of the people who get on television are there because they have extreme points of view. And they are selling something. So, you don’t want to just make a decision based upon just one person who has a face on television, or on the Internet, is telling you. You wouldn’t buy a house that way. You wouldn’t buy a car that way. And you shouldn’t buy bonds that way.
This is the first of my two-part interview with Kathy Jones, the Fixed Income Strategist at Schwab. Tune into the October 2013 ezine, when we discuss some very important Do’s and Don’ts for Bond Investing in Today’s World, including a warning on bank loan funds and a possible Moody's downgrade on banks.
About Kathy Jones
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