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A bond’s-eye view of the world

Wesley Phoa
Portfolio manager/investment analyst
Based in:
Los Angeles
Investment experience:

WESLEY PHOA: As you know, yields are extremely low across the board in almost all parts of the fixed-income market. In fact, the current level of yields would normally be consistent with a very severe recession or worse. In many markets, like 10-year Treasuries, they’re at historic lows. That is a concern, and I think we — like many other folk — have a modestly short duration position. But I also wanted to just mention a couple of unusual factors [that] have brought yields very low and are probably likely to keep them lower than normal for quite some time, at least several years.

What we’ve seen over the past few years is that there’s very substantial insurance value in owning bonds — high-quality bonds, especially U.S. Treasuries. As a form of insurance, that’s paid off in spades over the past few years — even this year. It’s very expensive insurance now; it’s not something that every investor wants or needs. But that value is still there. And if it’s used in the right way in portfolios, I don’t think that will change soon, while there are still lots of tail risks out there.

There are more concrete reasons why Treasuries are owned by folk who are not the same kind of investors that we are. There’s a high demand for Treasuries and other high-quality government bonds as collateral — for example, for derivative positions. Right now, about a quarter of a trillion dollars of collateral is being held against derivative positions owned by commercial banks in the U.S. And changes in regulation are going to force banks in general to own more Treasuries and more high-quality bonds and safe government bonds as they get phased in over the next couple of years under the so-called Basel III accords. The European banks alone could face a shortfall of $700 billion in liquid assets, which they’ll have to fill over the next five years or so.

And finally, Treasuries — and this is a longer term phenomenon — have become an important store of value for the surplus countries: countries like China who run large trade surpluses, and the commodity countries as well. They are participating in this market in very large size and are relatively return-insensitive. What they want is just a place to put foreign-currency reserves.

So where does that leave us, as investors? I think it leaves everyone in a kind of difficult position. What we’ve been trying to do is focus a lot of our internal research resources on working out what’s the best mix of different kinds of fixed-income assets to own; looking at agency mortgages, which is quite a diverse market, lots of different kinds of opportunities there; looking at various different places in the credit markets where there are some attractive credits that still yield substantially more than Treasuries; and in other places as well.

And finally, I think that it’s very important for us to temper our expectations of how much we can really expect from the fixed-income markets from here. Bonds will continue to be extremely important as a way of generating income, preserving value. But what the current low level of yields is telling you as well is that if you really need capital appreciation, you have to look elsewhere. We want to make sure that we’re using bonds for the right reasons.

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