With current bond yields on an upward trajectory from September through early November – a recent tapering off not withstanding – it’s fair to wonder how investors should proceed with their fixed income strategies.
To gain some insights into what investors may want to consider in this environment, we recently spoke with investment grade debt team member Peter Strzalkowski on the OppenheimerFunds World Financial Podcast.
As portfolio manager and co-team lead of our investment grade debt team, Peter is essentially tasked with finding reasons to worry even when the markets suggest there is nothing to worry about. During our conversation, he made clear that he believes long-term equity investors should continue to build their equity positions and maintain exposure to the asset class.
When it comes to fixed income, Peter is steadfast in his view that investors should stay the course and maintain plain vanilla investments in investment-grade fixed income. In our wide-reaching conversation, he explained what he thinks investors are failing to grasp about the fixed income markets, his view of the limitations of index investing, risks to the global investment outlook and why he is unfazed by the U.S. government’s debt being north of $20 trillion.
Here are some highlights from our conversation.
Gregory Brown: What’s the one thing that most investors are missing about this fixed income market right now?
Peter Strzalkowski: That at a basic level, when the cost of funding goes up as directed by the Federal Reserve, every asset class has to re-price to a higher discount rate. Usually, that means prices have to come down. That’s just simple math – finance 101.
But the duration and end game is to get rates higher.1 Even if they stop at 2 ½, that is going to have an effect on everything. One thing people don’t think about is, nowadays, capital is global. We’ve had a lot of asset purchases, especially corporate bonds from overseas over the last year.
There is a need for yield everywhere, globally. When you take a 30-year corporate bond that a Japanese company would buy – Wal-Mart for example – when the funding rate goes up, that means the hedging rate goes up on those short dollars.
So that buyer in Japan who has to hedge their U.S. bond back to yen, just lost all the spread – all the benefit of holding it. At which point they can hold it, and maybe start losing money because they have to pay more for it. Or they’re going to have to sell it. If enough of that happens – and I don’t want to scare people – you’re going to see pressure on debt investments.
Brown: From a risk perspective, what are your thoughts on lending based on the underlying companies within an index?
Strzalkowski: Lending based on what is in an index is the worst possible thing you can do risk-wise. Let’s say Company XYZ, which has an A rating, issues $3 billion of an issue. The ETF manager will go out and buy that portion of that debt because it’s in the index, irrespective of what the spread is. They don’t look at whether it’s a good deal. If it’s in the index, they’re going to buy it.
I’m going to look at it and say, ‘hmm.’ You know, at $120 for 10 years – doesn’t really do anything for me. I can look at other places. I can buy agency-sponsored mortgages and I’ll get the same spread. Six months go by and Company XYZ gets downgraded because they’re having a capital shortfall and now they need to issue $6 billion. Now they’re rated BBB-minus. So they went from A to BBB-minus.
They issued $3 billion – now it’s $6 billion. Guess what the ETF manager is going to do? He’s going to buy the initial issue because it’s in the index. I haven’t bought it, so I’m okay. I can go somewhere else. Not to say we don’t make lending mistakes – we do. But we have a way of reducing the risk by selling it.
Levitt: At the beginning of 2016, then-Federal Reserve Vice Chairman Stanley Fischer was discussing four interest rate hikes. The dollar had rallied significantly. There was an earnings recession in the U.S. – the 10-Year Treasury goes down. By February 2016 the Fed backed off, and we saw a recovery as the dollar stabilized. Then came Trump’s surprise win in November. Interest rates go up to 260 because we’re talking stimulus, government spending and tax reform.
But in Jan. 2017 they decide to focus on health care. It’s hard to get anything done given the House Freedom Caucus. The 10-Year goes back near 2%. Health care doesn’t pass and now the focus is tax reform – and maybe infrastructure spending.
Why wouldn’t we think the Fed can gradually raise rates as we do some stimulus, and the short-end and long-end of the yield curve can kind of move up together?
Strzalkowski: Perhaps – if we get a tax deal and we add another $350 billion - $400 billion in deficit spending on top of the current $600 billion, rates will go up. It’s going to make it harder for the government to borrow since the Fed isn’t going to sell the balance sheet – but it’s going to stop buying. They’re going to let maturities roll off, so I don’t know if we’re going to see a crowding out like we did 20 years ago. Where the deficit really pushed everybody out and rates rose.
What is possible though is that because the Fed is raising rates, even though we will see an additional issuance of Treasuries, the curve will go flat, or invert. The market, in my opinion, thinks the 10-Year should be trading close to 3% right now as it is. Because it knows the Fed is going to tell us, “we’re at 150, we’re going to go to 175 and then another 50 next year to 225.” The 10-Year should be trading 15 north of that – it should be at 275, maybe heading towards 300 just in case they get more aggressive.
So what the bond market is telling me is – there’s a real chance we’ll go into the big “R.” I don’t want to spook anybody, but the term structure is telling me we can actually go into a recession. At which point the 10-Year will actually rally even though we’ll see more issuance, because there is no safe haven.
Levitt: I have a question about U.S. government debt. Are you worried about the U.S. given the day of reckoning we hear about – with the government now more than $20 trillion in debt?
Strzalkowski: I am not worried. The simplest way I can say it is – we have a $20 trillion economy, and that debt is $20 trillion. We have one-times earnings debt, which would be the equivalent of someone making $60,000 a year having a debt, after taxes, of $60,000. You wouldn’t be alarmed as long as that person can generate those earnings of $60,000. The U.S. government can definitely generate those earnings.
On top of that, the U.S. owns vast swaths of land and resources – and probably the biggest thing, huge reserves in terms of human capital. If anything, with technology productivity will continually go up and my guess is the standard of living will go up.
Don’t miss the next episode of the OppenheimerFunds World Financial Podcast! Tune in to Episode 22: “Backup in Yield – Real or Another Head Fake?”
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- ^Duration measures interest rate sensitivity. The longer the duration, the greater the expected volatility as interest rates change.
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