The possibility of the Federal Reserve raising interest rates doesn't seem to faze Matt Freund, portfolio manager of USAA High Yield Opportunities Fund (USHYX ). That's because high-yield, more commonly known as junk bonds, tend to outperform other fixed-income assets when rates rise, he says.
What's more, Chairman Alan Greenspan signaled on Apr. 20 and Apr. 21 that the Fed will be patient when it comes to raising rates. Freund says Greenspan indicated that the economy may slow in coming months as fiscal stimulus fades, since inflation pressures haven't been building and companies have been reluctant to hire workers and spend on equipment. "I think they want to keep rates where they are, since growth will be slowing anyway," says Freund. "If they could, they would prefer to wait and see how the economy reacts."
One of the managers at San Antonio-based USAA Investment Management Co., Freund's firm recently received the "Best Bond Group" award from fund-data provider Lipper -- an award made on the strength of USAA's taxable and tax-exempt bond funds, which bested rivals and achieved higher average consistent returns during the 3-, 5-, and 10-year periods ended Dec. 31, 2003.
USAA High Yield Opportunities fund returned 23.13% for the 1-year period ended Mar. 31, vs. a 19.71% rise for the average high-yield bond fund, according to Lipper. BusinessWeek Online's Karyn McCormack recently spoke with Freund about his strategy. Edited excerpts from their conversation follow:
Q: Why are high-yield bonds still attractive, even if interest rates are expected to rise?
A:Well, in an environment of an improving economy and increasing interest rates, high-yield is actually set to outperform the other fixed-income classes. Historically, high-yield has had a lower sensitivity to rising rates than Treasuries and higher-quality bonds.
Q: Why is that?
A:There are a couple of reasons. The biggest is that high-yield is a hybrid asset class. It has characteristics of stocks and of higher-quality bonds. And the stock characteristic, where the single security risk is, is the credit-risk portion, or the increased default risk that's in every bond. They're called high-yield, or junk, bonds because there's a greater risk of default -- and that risk is less sensitive to changing interest rates.
In fact, in an improving economy, the risk actually goes down a little bit. When you have a strengthening economic climate, and when you have lenders willing to lend, banks are providing liquidity to the market, and people are willing to take on more credit risk. Those factors will combine to make high-yield perform well.
Q: Why did junk bonds do so well last year?
A:Last year was really a perfect environment for high-yield. In fact, last year, the most distressed securities, triple-C securities, actually performed the best, and depending on the index you look at, they appreciated 55% to 60%.
Remember what the economy was like. We were in a recession. We didn't know when it was going to end. You had the war with Iraq. Everyone was on hold. And then that changed. And it changed pretty quickly, and liquidity came back into all the markets.
The economy started getting better, and it has been improving for quite awhile. It just hasn't shown up in the jobs numbers yet or the capacity-utilization numbers, but enhanced productivity and profitability is up. Companies, even high-yield companies, are repairing their balance sheets and are really the healthiest I think they've been in quite some time. In fact, Moody's recently came out with a default survey, and it sees defaults actually falling to the around 3.5% -- which is pretty low and is down significantly from the peak.
Q: What do you think about concerns that the junk-bond market is in a bubble?
A:Whether high-yield returns are attractive depends a lot on what your outlook is for other markets. If you think that stocks are going to return 20% again, high-yield is probably going to disappoint you. If you feel, though, that stocks are probably going to return a high single-digit return, maybe even get into the low double-digits, then I think the high-yield market is going to earn its coupon this year.
Q: What's the coupon?
A:For our funds, the SEC yield is right around 6.5%, and that's after expenses. So if we can earn the coupon, and if we do our jobs right, maybe a little bit more through proper securities selection, I think in an environment where stocks return 9% to 11% for the year, high-yield comes in between 6% and 7%. And then you've got the Treasury market which, if rates don't go up, is going to earn you the Treasury coupon of about 4.4%.
So if rates don't go up at all, that's what you're going to get. If rates do go up, your return is going to be less than that. So the only way Treasuries are going to win is if you think rates are going to decline significantly.
Q: What's your outlook for rates?
A:I guess I'm in the camp that the Fed is still probably on hold for a little while. If you look back historically, having negative real short-term rates is not normal. It's not what I would consider an equilibrium state of events.
Inflation-adjusted rates have been positive. And so where we are now is not something that's going to stay here forever. And clearly the economy is doing significantly better. We're seeing a lot of very positive things happening. So that's all going to come together, and short-term rates are going to rise.
Q: What if the Fed leaves rates alone?
A:The economy doesn't need the sort of stimulus that it's getting now. But I also think that's a very good thing because a lot of the stimulus which is occurring now is going to fade even if the Federal Reserve keeps rates right where they are.
What I mean by that is, right now the economy is benefiting from a refinancing boom that occurred, and I think we had a little bit of pickup activity the last couple of months as rates went lower. As rates have trended up a little bit, that's going to slow down. So that's the first thing.
The second thing is that tax cuts typically impact the economy for the first 18 to 24 months. The example I use is if you got a tax cut, you might buy an extra couple of Starbucks [coffees] today. But once you've adjusted your lifestyle for that increased income, you're not going to increase it again. You've adjusted to your new aftertax income, and that adjustment is now over. So that's no longer stimulative. Your level of activity is going to stay the same. You're not necessarily going to grow.
The third thing is the growth of the budget deficit is scheduled to slow down. The deficit is still here. It's not going away, but the rate of growth is slowing significantly.
The fourth thing is that Congress was trying to stimulate not only consumers but businesses as well, and they have some accelerated depreciation benefits for companies that phase out at the end of this year.
So the Federal Reserve doesn't have to do anything. And when we start getting into '05, we're going to realize that the fiscal stimulus really isn't there to the same degree, the refinancing stimulus is certainly not there to the same degree. I think companies are going to accelerate some of the purchases from 2005 into '04. If a company was thinking about buying it in '05 and could accelerate it, it would have access to the capital markets and have a tax benefit from doing it.
Q: How are you positioning your portfolio for higher rates?
A:We're not really repositioning for higher rates. What I mean by that is, the high-yield market has been much less sensitive to rising interest rates than any other fixed-income classes, and what we try to do is first of all maintain a strict dedication to research, try to analyze the risks, try to understand the risks, and then really look to make sure you're being paid for the risk you're taking.
Q: What do you own?
A:We own quite a few airline Enhanced Equipment Trust Certificates (EETCs) [these are securities used mostly by airlines to buy planes that are on collateral -- holders of collateral have first claim on these assets]. They've done very well for us, even though they have investment-grade ratings. Now they weren't priced like they were investment-grade bonds, and it wasn't too long ago that people were worried about the viability of the U.S. airline business. But again, it's amazing how things change so quickly.
We're moving away from some of the lower-coupon, some of the higher-quality high-yield securities. Those would be the most interest rate-sensitive.
Q: What about industrial sectors? Any auto makers?
A:We own a couple auto suppliers. It's a very tough business.... I think that you really have to look at that on a case-by-case basis, and it's very hard to generalize because, again, some suppliers are more commodity-like, some are more value-added.
One of the common themes in our portfolios is finding what I think are the hidden gems in the high-yield market. They're a little bit off the beaten path, but we're willing to go there if we think we're being paid for the risk that we are taking.
Q: What are some of the hidden gems?
A:Besides EETCs, which we've already talked about, we have positions in a lot of insurance companies, and when you think back a year or two ago, there was a lot of concern about insurance. You had 9/11. You had asbestos problems. You had workman's comp reserves and questions about that. And you had investment portfolios that were battered by some of the more notorious names that hurt the bond market and weak equities.
That's the bad news. The good news is that the companies had a lot of pricing power. We all feel the pain when our insurance rates go up, but that also shows that they were aware of the problem, and they were doing all they could to repair their balance sheets and get the reserves back in order. So we bought Farmer's Insurance. We own Markel (MKL ).
Q: What do you look for?
A:One of the things that I always try to do is try to find and look at industries that have pricing power. We talk to a lot of companies. We analyze an awful lot of companies, and it's very rare that you're going to have someone tell you that their product or their service isn't superior. Well, if it's superior, they should be able to demonstrate that by showing that they're either getting a premium price now or they've been increasing pricing.
That has been very, very hard to do, and so we've seen steel prices go up, we've seen energy prices go up, we've seen insurance prices go up. I'm sure there are some others that I'm forgetting, but it's a pretty narrow list. But in general, investing with industries that have the ability to raise prices has proven pretty successful.