US banks look like safe option

As an unprecedented era of rock-bottom interest rates in the United States comes to an end, finding a bond fund manager who is able to protect your money is more crucial than ever.

One of the best in the business says that, right now, there’s no better way to do that than by scaling back on US Treasuries, betting big on US banks and taking some risk in emerging markets such as Mexico.

Carl Eichstaedt, who runs the Western Asset Core Plus Bond Fund, says Goldman Sachs Group and Wells Fargo will be among the first to benefit as a stronger US economy prompts the Federal Reserve to raise rates for the first time in almost a decade. More stringent regulations also mean financial firms are taking fewer risks for the sake of shareholders these days.

“It’s a much less risky business model than it was during the crisis,” Mr Eichstaedt, whose fund has about 13 per cent of its assets in financial bonds – far more than the benchmark allocation of about 8 per cent, Bloomberg data show.

“It’s not necessarily good for the equity holder, but it’s music to the ears of a bondholder.”

Mr Eichstaedt, named 2014 US fixed-income fund manager of the year by the investment researcher Morningstar, backs his willingness to put on large positions with a lofty track record. His fund, which focuses on intermediate US investment-grade debt but has the option to invest in junk bonds and emerging markets, has returned 1.7 per cent in 2015, Bloomberg data show.

That is better than 98 per cent of similar funds, which are barely up this year. He is not just a one-year wonder. The fund has posted an average annual return of 4.5 per cent over the past five years, beating 94 per cent of ­rivals.

The stakes could hardly be higher than they are right now. After years of ultra-loose policies by the world’s central banks propelled bonds of all types, managers who are paid for their skill are suddenly falling short as those same policies start to diverge. And with the Fed about to end its zero-rate policy, the European Central Bank contemplating more-aggressive stimulus and China trying to spur flagging growth, the winners and losers have become more pronounced.

Actively managed bond funds have gained just 0.7 per cent in the past 12 months, about half the return for those that track indexes, Bloomberg data show. That is a stark contrast to the previous years, when active managers outperformed.

Chemical Bank

Mr Eichstaedt, who cut this teeth as a bond trader at Chemical Bank (now part of JP Morgan Chase) and did a stint at Pacific Investment Management before joining Western Asset in 1994, says the Fed will start tightening in December and raise rates to 1 per cent by the end of next year as the economy strengthens. The central bank has kept borrowing costs close to zero since cutting them in 2008 to combat the banking crisis.

While his estimate for how high rates will rise in 2016 is lower than the Fed’s own projection of 1.3 per cent, it’s still above what fixed-income traders are pricing in. They see the effective rate averaging about 0.79 per cent.

The probability the Fed will increase its benchmark by its meeting on December 15 and 16 is 70 per cent, according to data compiled by Bloomberg. The calculation is based on the assumption the effective Fed funds rate will average 0.37 per cent after lift-off, compared with the current range of zero to 0.25 per cent.

Slow and haphazard

“This recovery has been begrudgingly slow and haphazard, but we think it’s here to stay,” said Mr Eichstaedt, who also holds bonds of Bank of America, Citigroup and JP Morgan.

Stronger economic growth will boost loan demand while higher US benchmark rates will bolster banks’ net interest margins, he said.

Besides financial bonds, Mr Eichstaedt also sees opportunities in emerging markets, whose currencies have been among the hardest hit by a year-and-a-half rally in the dollar. Based on its holdings at the end of September, about 3.7 per cent of his fund’s assets are currently invested in debt from Mexico, the most outside the US.

Mr Eichstaedt anticipates peso-denominated bonds will benefit as higher interest rates in Mexico help the currency recover from its 11 per cent decline this year. Mexican central bank officials have repeatedly signalled they will tighten along with the Fed to preserve the nation’s interest-rate advantage and keep foreign investors from pulling out capital.

Underweight treasuries

Confidence the Fed will not upend the US economy as it nudges rates higher has also pushed investors back into risk assets, said Mr Eichstaedt, who is “underweight” in treasuries.

After lagging behind US government bonds in the first nine months of the year, emerging market sovereign debt has gained 2.5 per cent, junk-rated company bonds have advanced 1.6 per cent and investment-grade corporate securities have broken even this quarter, index data compiled by Bloomberg show. Treasuries have lost about 1 per cent.

Joe Higgins, a manager at TIAA-CREF Investment Management in New York, says the Fed’s “data- dependent” rate increases will be seen as a sign of confidence in the economy’s ability to generate jobs and consumer demand.

Consumer companies

Unlike Mr Eichstaedt, Mr Higgins prefers to focus more on debt issued by consumer-based companies in his TIAA-CREF Social Choice Bond Fund, which has outperformed 98 per cent over the past three years. That is because continued growth will pull more Americans into the labour force and fuel spending, while the increasing pool of returning workers will keep wage inflation low.

Some of his biggest consumer holdings at the end of the third quarter included debt issued by Harley-Davidson and Ford Motor. He also favours asset-backed securities from Domino’s Pizza, which are secured by franchise royalties.

“We can’t have animal spirits and a move to the more traditional pre-crisis economy until someone, somewhere demonstrates confidence,” said Mr Higgins. “We are seeing a bit of confidence in consumer spending. We still have not seen it in the corporate suite.”

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