Dan Fuss is a leading bond fund manager with one of the best and longest track records in the business. He is the vice chairman of Loomis, Sayles & Company and manages its flagship Loomis Sayles Bond Fund.
He has twice been named bond manager of the year by Morningstar and was inducted into the Fixed Income Analysts Society’s Hall of Fame in 2000.
Fuss speaks to IBTimes about his short-term and long-term outlook for U.S. Treasuries.
IBT: Can you tell our readers about your professional background, especially at Loomis?
Dan Fuss: I’ve been doing what I do for more than 50 years. I joined Loomis more than 34 years ago. Prior to that, I was a Naval Officer. Before that, a college student.
IBT: You have a very good and long track record. How do you stay in the business and succeed for this long?
Dan Fuss: I’ve been lucky to have good health. I’ve been very lucky with the people I’ve worked with. Those are the major contributors. I also happen to really enjoy the markets.
IBT: There is a debate out there about where the 10-year Treasury yield will be in 2011. What’s your view on that?
Dan Fuss: First, nobody knows what the future will bring. Anything I say about the future is a guess, and some of what I say about the present is a guess.
In the very, very short-term, Treasury yields will drop a bit.
When Treasury bonds are declining, say three or four price points, the resulting change in duration of mortgage-backed securities can be rather phenomenal.
For the last couple weeks, you had the 10-year Treasury drop [in price] quite a bit. You had the long-term bonds (maturity greater than 10 years) do the same thing. With the mortgage rates, as you tick up the level of Treasury rates, they [go up with it].
When mortgage rates go up, it means less people are inclined to prepay their mortgages, which means the average life of the mortgage [portfolio], or the duration, extends rather rapidly. People in the mortgage markets call that extension risk.
When that happens, then, if they’re leveraged – and anyone bundling these mortgages together tend to be rather leveraged – they have to bring down the duration of their portfolio. This drives them crazy and the rest of the market is aware of it.
Forced to Sell Treasuries
So they try to sell, say, a 10-year Treasury. They normally will not short in the cash market but use futures [instead]. So last Wednesday afternoon [Dec. 15, 2010], somebody went out and sold a bundle of 10-year Treasury futures, a huge amount.
In an already down-market that was feeling very, very bad, you had this happen.
So when you get an ‘outside-of-two-standard-deviation-event’ like that, we, on a reflex basis, become a buyer. That is strictly tactical. There is no other way to put it. Nine out of ten times, regardless of what the trend is, we’ll be a buyer.
IBT: So these tactical plays, do they always require some player in the market that’s forced to do something one way or the other?
Dan Fuss: Normally, the extremes do. Once in a while, like [in] the fall of 2008, and right now to a degree, it will be mutual fund flows. 2008 [represented] a vivid example of outflows.
Conversely, it can be true on the inflows in the thinner markets -- high-yield and emerging markets are good examples.
But mutual funds aren’t so bad because they have some flexibility, except for the narrowly defined ones. Emerging markets funds have a very narrow mandate, so they have to react reasonably quickly.
Where you have the trouble is the exchange traded funds (ETFs), because they have to react much more quickly. So far, this hasn’t had any major [impact] -- ETFs were not really a big factor in high-yields or emerging market bonds in 2008. But that is something that does worry us a lot, now that they’ve gotten much bigger.
So you can have this situation, like this poor guy [last Wednesday] who was trying to reduce his duration of a mortgage portfolio – and I think that’s what it was – he had to do it at the worst possible time. That threat is always out there for these ETFs in those narrow spaces.
In the broader spaces, it’s not so bad because they have all sorts of derivatives they can use to [adjust their portfolios]. But in the narrow places, like high-yield or emerging market bonds, they can really create havoc.
For the longer-term, [we think] interest rates will go up because of the amount of financing the federal government has to do going forward. No matter how we measure that, the best we can see is that the Treasury borrowing requirement – after we get back to a [normal economic environment] – is still approximately 4 percent of GNP. That’s a lot of money.
We’ve gone through something like this in the 1960s and 1970s. And it really does a number on financial markets because Treasuries get the money. So once [increased borrowing pressures start] rolling – we don’t think it will for over another year, because our own central banks and other central banks are buying Treasuries – we think interest rates will go up on a secular basis with cyclical interruptions every four or five years.
This is a guess, but we think [increased borrowing pressures and rising yields] will go on for about 20 years.
IBT: What will make central banks stop buying?
Dan Fuss: [For] our own central bank, that’s really a political decision. They’re concerned about the economy, and the level of interest rates. Because if they stop buying, the [Department of] Treasury’s job gets tougher because short-term rates go up. We have a [roughly] 5-year average life to our own debt, a large chunk happens to be in Treasury bills (which mature in one year or less). So the cost of carrying debt will go up rapidly, which increases the deficit, which feeds on itself.
So they have to feel comfortable, and see how strong the economy is.
Foreign Central Banks
As for the foreign central banks, it seems to be [those countries] with sizeable trade surpluses [with the U.S] who are buying Treasuries. But [the trade surplus] doesn’t even have to be with the U.S. because so much of the world’s trading, particular in raw materials and manufactured goods, is priced in U.S. dollars.
The central bank of China has said publicly they are trying to diversify their reserves in line with trade patterns. But there isn’t enough outstanding [non-U.S.] government debt to [allow them to do that].
In time, I would anticipate that every country will have their reserves diversified in line with their trade patterns. My further guess is that you will find more contracts [for trade] drawn in other currencies. But right now, the dollar [represents] about 63 percent of world reserves, so it will take time.
But as that happens, [diversification out of the dollar] will become a bigger factor [in the Treasury market].
Managing Bonds When Yields Rise
This [rising yield climate] is not the end of the world for bond managers. This is the environment I grew up in, actually. My first 23 years of doing this, interest rates, with a few pauses in between, always went up, and they went up a lot. Actually, managing bonds gets easier [in this enviroment].
Nominal returns of bonds, not inflation-adjusted, start to rise because you’re investing income and maturity of principal at higher rates as you go along.
Also, the higher the [yields] go, the deeper the discounts are, and the more specific opportunities you will have, [especially in the corporate sector].
It does, however, impact credit a great deal. You have to know what you’re doing on your individual credits. The higher nominal cost of money starts to become a negative for many corporations – it’s hard to see it in the early years, but once you get into the second cycle, [you’ll see it].
The same [logic] obviously applies to stocks. The early stages can be rather inclusive for stocks, but then, as the cost of money comes into it, you get a winnowing out in stocks.
So it becomes a stock-picker’s market and a bond-picker’s market.
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