BOSTON -- Longtime industry veteran Dan Fuss, the 76-year-old vice chairman and managing director of Loomis, Sayles & Co., knows that the Federal Reserve has to raise interest rates eventually. This could dramatically affect credit spreads, yield curves and other macroeconomic issues. But until such a move takes place, there is no need to get excited.
With the advantage of more than 52 years of experience in the financial industry, Fuss sees many similarities to previous recoveries and believes a careful, measured approach can position his firm and shareholders for long-term success. Money Management Executive Senior Editor John Morgan recently sat down with Fuss in his office in downtown Boston to talk about how Loomis Sayles' global outlook and how his firm is preparing for the inevitable shift in interest rates.
MME: Have emerging markets become overcrowded and overpriced?
Dan Fuss: No, but the term emerging markets is very general. We like Southeast Asia, plus Brazil, but there are many exceptions. Our basic guess underlying this is a secular uptrend of the interest rates in the U.S. dollar running 20 years or more. That quickly puts things into perspective. Once you have that guess, then a lot of other things quickly fall into place. If you have market risk going against you-such as interest rates going up-you can substitute specific risk or specific opportunities for market risk. For 30 years, you had interest rates going down. If I'd known that 30 years ago, I would have probably done things differently.
We are now in a stock-picking, bond-picking environment, not a general asset allocation environment. Asset allocators in this market got badly bruised because their models were built around specific opportunities and risks based on the last 30 years. Today, it's a whole different environment. We have to focus on specifics.
The comparability by rough-drawn asset classes just doesn't work, and you should try not to get caught up in it, although most people have to. Most institutional and individual mandates are drawn along these lines and don't have a choice. If the mandate says to buy bonds, they have to buy bonds, and if the mandate says to buy stocks, they buy stocks.
MME: Do you think a significant amount of capital will switch from bond mutual funds back into money market mutual funds when interest rates eventually rise?
Fuss: Probably, because when the yield curve starts to flatten, people have more incentive to go to the shorter end of the yield curve. It tends to be a mistake, but once in a while it's good. That's a different type of asset allocation. It's called "guess the market." Human nature will prevail. Treasury financing will be so heavy that it will pull people over there, whether it's to the money market or to short-term government bonds.
MME: Are you still worried about the heavy financing going on in the corporate bond sector?
Fuss: No, because on a net basis, it's not that heavy. We are in a very forgiving environment at the moment. Funds flows into mutual funds and life insurance companies are very strong, and there's a shift in the defined-benefit pension side to more fixed income. You put those all together against a low-net-financing corporate sector, and the new issue calendar and the corporate cycle-investment grade and below-investment grade-is humming as a result. This will probably continue for another year or so.
Eventually, you start to have a problem on the corporate side. Treasuries will garner more and more money, and the price will probably go up, along with interest rates. Eventually, you'll probably start to get rationing of credit by price.
The No. 3 and 4-ranked fund companies don't have the same economics or clout in the markets as the No. 1 and 2 market shares, so they will do the intelligent thing, which is stop expanding.
As the smaller firms pull back, the strong get stronger. The market leaders will access money and expand capacity. Cost-per-unit drops and profit margins widen. It becomes a very good environment for fewer and fewer companies.
This is not completely comparable to what happened in the late '60s and early '70s, because this time it's global, so it gets more complicated. You also have to consider what it costs to borrow money elsewhere, as well as where your own base of activity is. There are many different variables.
MME: What will happen to credit spreads when interest rates rise?
Fuss: They actually narrow, which is one of the confounding things for people. The Treasury itself becomes the incremental borrower of funds. As the net demand for funds in the corporate sector starts to diminish and net demand for funds in the government sector expands, the absolute level of spreads between one and the other narrows.
That doesn't mean corporate bonds will go up because interest rates are rising; they will probably drop less than 5% of Treasuries.
Credit risk, however, starts to rise. That's why you can't make too many generic statements here, because it depends on what happens with leveraged buyouts and private equity. Since many of them will drop out of the market as new borrowers, their balance sheets look better, for the time being. They will all go cash positive if they don't expand.
Electric utilities fall into a separate category, and so do telephone companies, to a lesser degree. The electric companies are local. If the demand for power expands, they borrow money. They're sort of in their own world, and those spreads are much harder to call. Even industrial and commercial real estate yields look different from Treasuries, because Treasury yields are going up.
Life insurance companies are very concerned with interest rates, as are defined benefit plans. I think they might get some sort of swing back towards structured deals, but not necessarily private placement or asset backed. I'm guessing somewhere in between. Public market deals will become more of a residual, and that's where you find your mutual funds, and of course the Treasury. It will be a fascinating market to follow.
MME: Are you worried that many target-date funds and absolute-return funds have high exposures to risky, high-yield investments?
Fuss: It would depend on the assets in them. The concept of absolute return certainly has its plusses and minuses. It sounds great to say you can provide an absolute return, but you better know what you're doing. You've got to be aware of asset correlations that you might not necessarily think of.
Personally, I am not much of a believer in absolute returns. You need the right skillset to deliver what you promise, and too many in the market don't have a clear enough understanding of what is required to deliver that.
My perspective is that absolute-return products are great in theory. In practice is where the concept has fallen down with poor product performance across the board in the absolute-return space, including some hedge funds. We think there is an opportunity and will strive to make a difference in this space.
MME: How are you preparing for this new competitive landscape and interest rate environment?
Fuss: [Laughing] I try to get a good night's sleep and watch my diet. It gets easier the longer you do this. Right now, there's no need to get in early. If you don't do anything today, the clients are happy because tomorrow the yields are higher. You want to buy the right securities at hopefully something close to the right price, but if you can't find the right price, no sweat. Just wait 'till tomorrow.
Seriously though, you will have to become extremely focused. When interest rates eventually rise, it will become our entire focus. I'm watching everything in the portfolio, staying focused on the specifics. I've prepared for this well in advance and positioned our portfolios for it, but not in an extreme way.
You also have to be very careful how you use the term of duration, which is very valuable when you're talking to the actuaries. You really want to focus on when you get the cash. That means you're going to look at the average maturity, the coupons. That's what you will be reinvesting, if you are reinvesting. It's a little different if you're in a situation where you're paying out the income, and very different if you're paying out income and principal. In other words, if you're in liquidation. You're still very focused on when you get the cash, but your time horizon really comes in.
If it's longer-term money that's going to be there not just for the cycle but the secular trend and beyond-and most of the money we manage falls into that camp-then you're focused on keeping the portfolio up-to-date with the rising level of interest rates. That's not all that hard. What gets difficult and nearly impossible in a hurry is if the purchasing power of money goes to pot. If inflation really kicks in, then it's really difficult to be in stocks or bonds, or real estate for that matter. Your political structure also becomes in danger with higher inflation. Hopefully that won't happen.
There are several ways to protect against this, with the most obvious being investing in something where you don't have that risk, where you have a different setting.
The basic thing driving this whole cycle is the mature social democracies of the world-Western Europe, the U.S. and to some extent Japan-and how the age distribution is going from a pyramid to an open-ended oval. There will be less young people to older people, proportionally. You younger people will have to take care of us older folks. It should balance out in about 20 years, though.
MME: Do you think the pending financial services regulation working its way through Congress will have any impact on mutual funds, and what pending regulatory issues are you most concerned about, and why?
Fuss: I'm sure they could potentially have an impact, but how, I don't know. Do I have a good grasp on the final outcome? Certainly not, nor does anybody else yet.
We are in one of those environments like predicting the season outcome of the Boston Red Sox. It's too early to tell. It could easily get out of hand or could turn out to be quite good. I'm hoping for the latter.
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