When To Consider Getting Aggressive in High Yield

Thursday, July 5th, 2012

by Russ Koesterich, Chief Investment Strategist, iShares

Here’s my take: I believe high yield bonds are close to fair value, I hold a neutral viewof the asset class and I advocate that investors generally maintain a benchmark weight.

That said, in the following three instances, I’d advocate investors consider being more aggressive buyers of high yield:

1.) If spreads widen. The spread between high yield bonds and the 10-year Treasury has generally fluctuated between 500 to 600 basis points this year, about where high yield should trade given the sluggish economic environment. However, assuming no further deceleration in the US economy, any further widening of high yield spreads back toward a premium of 650 to 700 basis points over the 10-year Treasury would represent a good buying opportunity, especially considering that many corporate balance sheets generally have been extremely strong and default rates have been low.

2.) If they have portfolios with high income needs. With a yield to maturity a little under 7% and volatility of less than 10%, a fund like the iShares iBoxx $ High Yield Corporate Bond Fund, (NYSEARCA: HYG) is an efficient way to add incremental yield to a portfolio. As such, investors may want to consider adding high yield bonds to their fixed income portfolios as their demand for income rises. For instance, while risk adverse investors may only want to hold around 10% of their fixed income portfolios in high yield, investors willing to take incremental risk to earn additional income may want to consider holding as much as 30% of their fixed income portfolio in high yield.

3.) If they are worried about rising rates. Investors who are worried about rising interest rates may also want to add high yield as a substitute for long-dated Treasuries. High yield bond funds currently have lower durations than Treasury funds, meaning that Treasuries are far more sensitive to interest rates. If interest rates rise even modestly, Treasury funds are likely to suffer larger losses than high yield bond funds.

Source: Bloomberg, iShares.com

Russ Koesterich, CFA is the iShares Global Chief Investment Strategist and a regular contributor to the iShares Blog. You can find more of his posts here.

The author is long HYG

 
The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com. For standardized performance for HYG, please click here.
Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Tags: 10 Year Treasury, Aggressive Buyers, asset class, Basis Points, Bond Fund, Chief Investment Strategist, Corporate Balance Sheets, Corporate Bond, Deceleration, Default Rates, Fixed Income Portfolio, High Yield Bond, High Yield Bond Funds, High Yield Bonds, Hyg, Neutral View, Rising Interest Rates, Treasuries, Treasury Funds, Yield To Maturity
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Bond ETF Idea: Deconstructing the Agg

Friday, June 8th, 2012

by Matt Tucker, iShares

Its building block time again! I recently wrote a post about different ways that ETFs can help investors meet their income objectives. The two options were: 1) “No assembly required,” through a pre-packaged ETF of ETFs such as IYLD (the iShares Morningstar Multi-Asset Income Index Fund), and 2) “DIY,” using individual ETFs as building blocks to construct a customized portfolio. My main point was that a pre-packaged solution can be a great option for investors who don’t have the time, expertise, or inclination to create and continuously manage a portfolio on their own.

For investors who don’t have those challenges, a DIY approach to managing a fixed income portfolio may be the way to go. Each of our fixed income iShares ETFs is essentially its own building block, and they can be combined in a variety of ways to create a wide range of fixed income portfolios.

Why take this approach? For one thing, within the “fixed income” category, there are a variety of sectors that have very different risk and return characteristics. And since fixed income investors can have very distinct goals, meeting portfolio objectives typically requires more than a one-size-fits-all approach. For example, a portfolio that’s designed to generate income should look very different from one that has a goal of delivering alpha.

One strategy we are always talking about with clients is taking a broad benchmark like the Barclays US Aggregate Bond Index (“the Agg”), buying ETFs that represent its various sectors, then tilting exposures based on market factors, sentiment, and/or research calls. It’s kind of like constructing the toy vehicle shown on the building block box, and then giving it your own custom modifications.

The reason investors typically start with the Agg is because it’s generally considered to be a good representation of the broad US fixed income market. It combines six unique fixed income sectors – Treasuries, Agencies, Credit, Mortgage Backed Securities (MBS), Commercial Mortgage Backed Securities (CMBS) and Asset Backed Securities (ABS). As you can see below, each sector has a unique risk and return profile:

Components of the Aggregate – Relationship Between Yield, Duration & Credit Risk

Fixed income ETFs are a great tool for implementing this kind of strategy because, in addition to typically being low cost and tax efficient, there’s such a breadth and depth of products available today. For example, an investor might start with a strategic allocation that mimics the breakdown of the Agg (which is updated on a regular basis here), using ETFs to represent each sector. Then, they can customize based on their specific objectives. If income is the goal, they might lighten up on the lower yielding sectors in order to overweight those that are yielding more. In fact, investors can use our free Fixed Income Portfolio Builder tool (demo here) to explore fixed income portfolios that have the same duration characteristics as the Agg, but with the potential for higher yield. Investors can also make adjustments based on how much credit or duration risk they’re willing to take, or make tactical plays based on the current market environment. The idea is that the fine-tuning is in the investor’s hands.

You have all the blocks, what do you want to build?

Matt Tucker, CFA is the iShares Head of Fixed Income Strategy and a regular contributor to the iShares Blog. You can find more of his posts here.

Source: BlackRock, as of March 2012. Tickers shown in the table are related iShares ETFs that correspond to each index. Indexes used are: iBoxx $ Liquid High Yield Index (HYG), JPMorgan EMBI Global Core Index (EMB), iBoxx $ Liquid Investment Grade Index (LQD), S&P Nat’l AMT-Free Muni Bond Index (MUB), Barclays Capital U.S. Aggregate Bond Index (AGG), Barclays Capital U.S. 1-3 Year Credit Bond Index (CSJ), Barclays Capital U.S. 3-7 Year Treasury Bond Index (IEI), S&P Short Term Nat’l AMT-Free Muni Bond Index (SUB), Barclays Capital U.S. 1-3 Year Treasury Bond Index (SHY), BofA Merrill Lynch 10+ Year US Corporate & Yankees Index (CLY), Barclays Capital Emerging Markets Broad Local Currency Bond Index (LEMB), Barclays Capital U.S. Corporate Aaa – A Capped Index (QLTA). Yield represents the average YTM; Duration represents the effective duration

Index returns are for illustrative purposes only and do not represent actual iShares Fund performance. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. For actual iShares Fund performance, please visit www.iShares.com or request a prospectus by calling 1-800-iShares (1-800-474-2737).

Bonds and bond funds will decrease in value as interest rates rise.
Transactions in shares of the iShares Funds will result in brokerage commissions and will generate tax consequences. iShares Funds are obliged to distribute portfolio gains to shareholders.

Copyright © iShares

Tags: Alpha One, Asset Income, Block Time, Bond Index, Customized Portfolio, Distinct Goals, Diy Approach, ETF, ETFs, Fixed Income Portfolio, Income Category, Income Index, Income Objectives, Index Fund, Market Factors, Matt Tucker, Morningstar, Packaged Solution, Portfolio Objectives, Risk And Return, Time Expertise, Toy Vehicle
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High-Yield Bonds—Extra Income, But Added Risk

Friday, June 8th, 2012

by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Key points:

• In a world of low interest rates, high-yield (or sub-investment-grade) bonds can be a source of added income in an individual investor’s portfolio. The yield on the Barclays U.S. Corporate High-Yield Bond Index is currently 8.2%—more than double the yield on the Barclays U.S. Intermediate Corporate (investment grade) Bond Index and more than 7.0 % greater than US Treasury bond yields of comparable maturity.¹
• Over the past few years, improving economic growth and easing strains on financial markets have resulted in strong returns in the high-yield market.
• With interest rates on Treasury bonds near 40-year lows, higher coupon-interest payments have been especially valuable during the past few years. When reinvested, the compounding of interest income can help reduce volatility in a portfolio.
• However, extra yield comes with added risk: Companies that issue high-yield bonds are, by definition, less credit-worthy than investment-grade companies and are therefore more likely to default. In addition, the market for high-yield bonds is less liquid than for other types of bonds, and high-yield bonds tend to be more correlated with the stock market than with Treasury bond prices, potentially changing the overall diversification of your portfolio.
• We advise limiting the amount of aggressive income investments in a fixed income portfolio to 20% to help reduce potential volatility and losses.

With the Federal Reserve holding US Treasury yields near 40-year lows, investors seeking income often expand their search for higher yields into riskier sectors of the bond market. One such sector is high-yield bonds, which are rated below investment-grade because companies issuing them are less credit-worthy. The issuers may have more balance-sheet debt and weaker earnings power, and/or they may do business in more-volatile sectors of the economy, making their earnings less predictable.

Lower Credit Quality Corresponds with Higher Default Rates

Source: Schwab Center for Financial Research, with data from Standard & Poor’s 2011 Global Corporate Default Study. The study analyzed the rating and default history of 14,654 US and non-US companies first rated by Standard & Poor’s between December 31, 1981 and December 31, 2010. The 15-year cumulative average default rate is calculated by weight-averaging the marginal default rates in all static pools. Past performance is no indication of future results.

Because of these risks, less-credit-worthy companies must offer higher yields than those offered on investment-grade bonds. As of May 31, the yield on the Barclays U.S. Corporate High Yield Bond Index—where the average maturity is four years—is 8.2%, compared to 2.8% for the Barclays U.S. Intermediate Corporate (investment grade) Bond Index, with an average maturity of 5.3 years.

Over the past 25 years, the average ratio of the high-yield index yield to investment-grade was 1.74 compared to the current ratio of 2.92. This higher-than-average ratio implies that the market is pricing in a higher degree of risk in high-yield bonds than the historical average despite the fact that default rates for high-yield issuers are currently below the long-term average.

Default rates among high-yield-bond issuers have declined since the peak of the financial crisis, and the ratio of upgrades to downgrades within the sector has improved. The most-recent figures from Moody’s indicate that average default rates are running at 2.2%, below the long-term average of 5.6% and significantly below the recent peak levels of 17.1% in 2009.

As the chart below illustrates, the high-yield market can be volatile. During times of financial distress such as the financial crisis in 2008-2009, or in the aftermath of the technology-stock bubble bursting in 2000-2001, yields spiked sharply higher—with prices declining steeply. When financial markets are under stress, liquidity can be scarce—both for companies seeking loans and in the high-yield market itself, as buyers retreat.

Recent improving financial conditions, as shown by the decline in the St. Louis Financial Stress Index, have been supportive of the high-yield bond market. (The St. Louis Fed’s index is comprised of indicators such as interest-rate yield spreads and volatility indexes that measure ups and downs in the financial sector of the economy.)

St. Louis Financial Stress Index Versus Barclays High Yield Index

Source: Barclays Database and St. Louis Federal Reserve Bank, monthly data as of April 2012.

To some extent, the high-yield bond market has been experiencing a positive cycle. As interest rates have fallen and economic conditions have improved, companies have been able to refinance debt at lower levels, which has improved the measures of their financial performance. As those measures improve, investors seek out the bonds, pushing yields lower, which in turn allows for more refinancing.

Income is important

A potential benefit of high-yield bonds in the current environment is the relatively high level of coupon income. It’s obviously helpful for investors looking to use that income to meet expenses, but it can also be beneficial when reinvested, because it can help dampen volatility in an overall portfolio when interest rates rise. In a rising-rate environment, higher-coupon bonds tend to decline less than bonds with lower coupons because the current income can be reinvested at higher interest rates, all else being equal.

Tags: Barclays, Bond Market, Corporate Investment, ETF, ETFs, Extra Income, Fixed Income Portfolio, High Yield Bond, High Yield Bond Index, High Yield Bonds, Income Investments, Individual Investor, Interest Income, Interest Payments, Investment Grade Bonds, Low Interest Rates, Risk Companies, Sectors Of The Economy, Treasury Bond Prices, Treasury Bond Yields, Treasury Bonds, Treasury Yields
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Decoding Duration to Better Understand Your Portfolio

Tuesday, April 24th, 2012

by Ravi Mattu and William G. De Leon, PIMCO

• Duration is often used as a shorthand way to communicate the interest rate risk of a fixed income portfolio. It is important to note that this sensitivity measure is related to, but not identical to, a security’s or a portfolio’s expected volatility.
• We frequently encounter duration quotations presented as though no subtleties exist. These quotations average duration exposures across maturities and across currencies, implicitly assuming that yields across maturities and currencies are equally volatile and perfectly correlated.
• We approach the task of understanding interest rate risk with a more complete view of the risk dynamics driving interest rate sensitivity.

Duration, or the sensitivity of an investment to interest rate levels, is the single most important risk metric for a fixed income portfolio. It is important to note that this sensitivity measure is related to, but not identical to, a security’s or a portfolio’s expected volatility. Yet even though textbook treatments of duration present it as a simple, unambiguous concept, in fact numerous factors influence interest rates and hence the measurement of “duration” can be nuanced.

Two factors contribute to this complexity. First, the measurement of an individual security’s interest rate sensitivity may depend upon complex valuation models that are approximations to the actual economic value delivered by the security. Second, for portfolios that are exposed to multiple interest rates across both the maturity spectrum and different currencies, quoting a single “duration” requires balancing the relative volatility and correlation among these interest rates.

Despite these nuances, we frequently encounter duration quotations (for example, published durations on fixed income benchmarks) presented as though no such subtleties exist. These duration quotations average duration exposures across maturities and across currencies, implicitly assuming that yields across maturities and currencies are equally volatile and perfectly correlated. Additionally, securities with credit risk are often treated as having no default risk when calculating duration.

These assumptions are what economists call heroic, and while they may facilitate coming to a single quoted figure for interest rate risk, they are not the whole story. At PIMCO, we approach the task of understanding interest rate risk with a more complete view of the risk dynamics driving interest rate sensitivity, and we encourage our clients and other investors to do the same.

Our approach aims to incorporate sophisticated security valuation analytics drawing on our proprietary research on interest rate dynamics, mortgage prepayments, defaults, and other factors determining security cash flows, as well as empirical research into the relative volatility and correlations among interest rates across maturities and currencies. To be sure, the markets are dynamic and we dynamically revisit our own methods to find better ways to measure and manage risk for our clients and their portfolios. While we are always striving to provide better metrics, we recognize that a number of these advances depart from industry conventions. Looking at the portfolio through a prism that breaks the risk into finer gradations adds to our understanding and ability to manage risk, but we still maintain more traditional measures in our systems for comparability with other sources and for those clients who match fixed income assets to liabilities calculated using more traditional methods.

The factors cited above may be understood as corresponding to, in the first place, a subtlety related to the proper measurement of security-level interest rate sensitivity, and in the second, a subtlety related to the proper estimation of portfolio risk.

• Interest rate sensitivity: Given a specific mathematical model of security cash flows and capital market variables such as interest rates, the measurement of a security’s interest rate sensitivity is, indeed, an unequivocal mathematical exercise. But the specification of the mathematical model for security cash flows and capital market variables is a highly non-trivial task. Different market participants make different choices about modeling callability; prepayment behavior; the likelihood, timing, and payoffs associated with corporate defaults; and interest rate volatility, to name only a few variables that enter the equation.
• Portfolio risk: If interest rates were all perfectly correlated and equally volatile, then the average of security-level interest rate sensitivities would provide a good representation of interest rate sensitivity for portfolios. However, because interest rates are imperfectly correlated and differentially volatile, the notion of “interest rate sensitivity” of a portfolio is a subtle concept. By interest rate sensitivity, should we mean the interest rate sensitivity of the portfolio to a change in the five-year U.S. Treasury yield, to the 10-year Treasury yield, to the 10-year bund yield, or to something else? At any particular time, these yields move by different amounts and may move in different directions – what is the “correct” interest rate sensitivity of a portfolio with exposure to all of them?

We do not mean to imply that there is absolutely no consensus on these points in the market. Indeed, academics and industry practitioners agree broadly that duration should reflect the factors we have named: callability, prepayments, defaults, and interest rate volatility, along with other factors. Academics and practitioners also certainly agree that global yield curves and yields of different maturities are imperfectly correlated and differentially volatile. However, the consensus falls far short of specific agreement upon or synchronization of the details or the models used, and the differences, in some cases, are large enough to create substantial differences in stated durations.

Duration isn’t so simple
Duration is often used as a shorthand way to communicate the interest rate risk of a fixed income portfolio. Textbook duration is defined as the percentage change in the price of a portfolio for every 1% (100 basis points) change in all interest rates. If the entire yield curve were to move in parallel – along with global yield curves moving in tandem – and the timing and magnitude of cash flows were known, then duration would be an unambiguous measure of effective interest rate exposure. This measure does not account for initial conditions and allows for negative yields. While the market has occasionally observed negative yields, most market participants consider zero the lower bound and calculations which use negative rates may be misleading in determining rate sensitivities.

Furthermore, all interest rates are not equally volatile, and bonds have both embedded options and default risk. At PIMCO, we adjust for these effects by modifying the traditional measure of duration in an effort to more accurately convey the interest rate risk of a bond or portfolio.

Some of the most important factors that PIMCO considers in assessing the interest rate exposure in the context of variable interest rate volatility and default risk are:

1. Bonds with default risk have a shorter duration than that implied by their stated maturity. It would be naive to assume that a portfolio of bonds issued by highly levered companies would earn the promised yield with certainty. An analogue to this is that the effective maturity of a credit portfolio may be shorter than its stated maturity because some of the bonds will default (with investors receiving the recovery amount). The higher the default risk of a portfolio, the more what we refer to as traditional duration will overstate the interest rate risk.PIMCO uses a two-factor model of rates and spreads to estimate the interest rate sensitivity of corporate bonds, Build America (municipal) Bonds and bank loans, as well as foreign-currency-denominated bonds of emerging market sovereigns. Default rates are imputed from current spreads, and the default-adjusted duration is calculated on these expected cash flows, not on the promised cash flows.PIMCO’s standard duration uses this model in computing security- and portfolio-level durations as we believe it is a more accurate measure of the overall sensitivity of credit-based securities to changes in rates. PIMCO durations may differ from other vendors’ calculations as a result.
   
2. Yield volatilities of various maturity government bonds are not equal. With central bank policy rates extremely low, the short end of government yield curves are close to the zero bound in many countries. Since the Federal Reserve in early August 2011 said it would not raise rates until at least the middle of 2013 (and in January 2012 said it would hold rates low until late 2014), the two-year Treasury rate has exhibited almost zero volatility, while the five-year yield has been 75% as volatile as the 10-year yield. Conventional measures of duration will overstate the volatility of short-maturity bond portfolios relative to longer-maturity portfolios.PIMCO’s measure of cyclical duration adjusts for the relative volatility of various maturities by assigning a yield beta to various parts of the Treasury curve based on our forward-looking estimate of their volatilities. We use the five-year point of the U.S. curve as a reference point. Therefore, our cyclical duration measures the projected percentage change in the portfolio for a 100-basis-point move in five-year U.S. Treasury yields, while accounting for the varying levels of volatility across the curve.
   
3. Yield volatilities of sovereign curves are not equal. Just as short rates are currently less volatile than long rates, yields on similar-maturity government bonds vary across the world. Simply aggregating security durations to measure interest rate risk across countries implicitly assumes that yields across the world are equally volatile and perfectly correlated. This is clearly not the case even for countries with close trade linkages, similar monetary policies and very little sovereign risk. For instance, Japan has historically had lower inflation than the U.S. and does not need overseas investors to purchase its debt. Consequently, Japanese government bond yields are lower and less volatile than yields on comparable-maturity U.S. government bonds. In 2011, Japanese government bond yields (for maturities exceeding five years) exhibited approximately 20% of the volatility of U.S. Treasury yields. Thus, traditional duration will overstate the volatility of a yen- vs. a U.S.-dollar-denominated duration fixed income portfolio.PIMCO estimates yield betas of yield curves in all currencies relative to the five-year point of the U.S. sovereign yield curve. These betas are then used in calculating the movement in country-specific rates relative to the U.S. For some sovereigns with significant default risk, these betas can even be negative. The cyclical duration of a global bond portfolio estimates the return volatility for a 100-basis-point change in five-year U.S. Treasury yields.
   
4. Credit spreads tend to be negatively correlated with rates. The empirical duration of corporate bonds tends to be even lower than that suggested by the model. The risk-on/risk-off mode in which the markets have traded recently has accentuated the effect of this negative correlation between rates and spreads. PIMCO uses the option-adjusted spread (OAS) of a security as an indicator to determine the forward-looking correlation between rates and spreads. The hard duration of a portfolio estimates the return volatility for a 100-basis-point change in yields assuming that spreads are negatively correlated with rates.

In addition to these factors, PIMCO also combines the concept of cyclical duration and hard duration into a single measure which we refer to as “hard cyclical duration” (see term definitions in sidebar). This measure incorporates both the concept of forward-looking sensitivities of yield curves and the sensitivity of credit spreads to rates.
Duration takeaway
In comparing portfolio risk to its benchmark, investors should ensure that they are using consistent measures. Further, in the current environment of extremely low global policy rates and the emergence of sovereign risk in developed economies, some traditional measures of risk may have lost some of their usefulness in the risk management of portfolios.

PIMCO’s investment process seeks to ensure that changing macroeconomic conditions are reflected in both portfolio construction and risk management.

The authors would like to thank Peter Matheos, Riccardo Rebonato, Susan Wilson, Roger Nieves and Barbara Callao for their many valuable suggestions and comments.

All investments contain risk and may lose value. This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC. ©2012, PIMCO.

Tags: Amp Nbsp, Approximations, Benchmarks, Correlation, De Leon, Duration, Economic Value, Factors Influence, Fixed Income Portfolio, Interest Rate Risk, Interest Rate Sensitivity, Mattu, Maturities, Maturity Spectrum, Nuances, PIMCO, Ravi, Relative Volatility, Shorthand, Subtleties, Valuation Models
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Understanding Recent Market Developments

Friday, August 26th, 2011

Capital International Perspectives
Understanding Recent Market Developments

Fixed-income portfolio manager Wesley Phoa shares his insights on the implications of recent market developments, including the downgrade of U.S. debt and the ongoing European sovereign debt crisis. Wesley is based in Capital’s Los Angeles office and manages portfolios for U.S. investors. He is also an investment analyst covering U.S. government bonds and has responsibilities for fixedincome quantitative research. He received a PhD in pure mathematics from Trinity College at the University of Cambridge.

by Capital International Asset Management

What does Standard & Poor’s downgrade of U.S. debt really mean for bond investors?

The impact of the rating action has been muted. Demand for Treasuries is still very strong. Investors did not stop buying Treasuries, and bank and insurance company regulators have said that the downgrade is not going to affect their treatment of U.S. Treasury bonds or other government-related securities. In essence, this downgrade will mainly affect sentiment. It should be a wake-up call for politicians and motivate them to make some constructive reforms — if so, it could actually have a positive impact in the long term.

The debt dynamics of the U.S. have been deteriorating for over a decade due to a range of government policies. However, things got dramatically worse during the last recession in 2008–09 because federal tax revenues fell sharply and there was a significant fiscal response in the form of increased government spending and tax credits. So there is a genuine long-term debt problem in the U.S. But the key point is that the economy is not broken. It is not too late to fix those problems as long as we implement sound policies.

What does this downgrade mean for Treasuries in the long run?

Even after the downgrade to AA+, U.S. Treasuries remain a large, distinct asset class that is among the most highly rated and most liquid in the world. Moreover, the investor base for Treasuries remains well diversified. Treasuries are owned by central banks, private investors, mutual funds, insurance companies and other banks throughout the world. These investors want an asset that is relatively safe from default and is universally recognized as a sound and highly liquid investment.

In addition, the U.S. dollar is the global reserve currency and it does not seem likely to be displaced from that role any time soon. If you want to keep your money in the world’s reserve currency, you would likely want to keep it in the safest asset of that currency.

Foreign central banks are the largest holders of Treasuries. They have been net buyers as they try to contain the appreciation of their own currencies by selling local financial instruments and buying U.S. dollar–denominated assets with the proceeds. While they may diversify their holdings in the long term, they are likely to continue buying Treasuries in the near term. In the last week of July, when the potential for a U.S. debt downgrade was known in the markets, the Treasury auctioned two-, five- and sevenyear notes totaling $99 billion. Foreign central banks bought 35% of these bonds compared to 30% in June.

Does the U.S. credit rating downgrade in fact diminish the reserve currency status of the dollar?

A one-notch credit rating downgrade from AAA to AA+ does not change the status of U.S. Treasuries as safe, liquid assets in the reserve currency of choice. This could be the case even if the other two main rating agencies, Fitch and Moody’s, follow S&P’s lead and cut their ratings for the U.S.

While I don’t think it is a good thing to have a global system that relies solely on U.S. dollars and U.S. Treasuries — it has not imposed a good discipline on the United States — I don’t see any sudden shift away from the current status of U.S. Treasuries or the dollar.

Is this 2008–09 all over again? What’s changed and what hasn’t?

We are in the middle of a very big debt hangover that is going to take several years to recover from. Some companies are going to prosper a lot in this environment, but I don’t think that developed markets will see a rising tide as in some previous economic expansions. In my view, the big developed markets will continue to struggle even as the developing economies continue to expand at a fast pace. It will be even more important than it has been in some of the past expansions to invest in companies that have the greatest potential to prosper, and to pick enough of them so that investors have a diversified portfolio that will hold up under different scenarios.

We are also seeing a lot of unexpected connections between different markets. These linkages are becoming more important and more complicated. Investors need to take a holistic view of markets. At Capital we have spent a lot of time in the past couple of years building better connections, finding more ways for our equity, fixed-income, money market, and macro analysts to work together. I think that as the market keeps evolving we will keep developing even more ways for our investment professionals to collaborate.

In what ways will the move affect sentiment in a market already unnerved by the debt crisis gripping Europe?

There is little doubt in my mind that recent events will bring about more market volatility. There is a very intense focus on political risk and policy risk, which are inherently difficult to predict. We are also seeing pressure on the banking system in Europe, which in itself creates financial market volatility because those institutions play such a big role in the markets. This has been a pretty fragile economic recovery and expansion, primarily because recoveries from financial crises tend to be more tenuous.

Furthermore, a big problem with a fragile recovery is that it is quite vulnerable to bad luck and policy mistakes — and we’ve had to deal with a lot of both this year, ranging from the oil supply shock in Libya, supply chain disruptions after the earthquake and tsunami in Japan, and the lack of strong, effective political leadership in both the U.S. and Europe. In Europe, there has clearly been a lot of uncertainty over how the sovereign debt crisis has been playing out, and it is very important for investors not to fixate on a single scenario.

There are several different potential outcomes to the European sovereign debt crisis. As portfolio managers, we need to be prepared for various scenarios, or at least have clear ideas on how to respond as things unfold.

Is there anything more U.S. policymakers, and the Fed in particular, can do to underpin the economy?

As we’ve seen, there is a big difference between what policymakers can do and what they will do. They can, in theory, still do a lot. The Fed has in recent days made a conditional commitment to keeping interest rates extremely low for an extended period, to 2013. To give a specific time frame and say that rates will be exceptionally low until the middle of 2013 — that is a big step for the Fed. It is new and it was probably a tough action for the central bank to take. However, this is not an unconditional commitment. It is not a promise to keep rates low under any circumstances. It is based on how the Fed expects the economy to evolve.

Among other steps, the central bank could also make a commitment to keeping the balance sheet large for a long time. It could even expand it some more by resuming large-scale asset purchases, as it did last year. Or it could extend the maturity of its Treasury holdings. The underlying message from the Fed is that it is paying attention to the U.S. economy and that it takes its dual mandate — that of delivering both price stability and full employment — very seriously. The Fed understands that the labour market is very weak and that monetary policy needs to continue to be supportive.

Still, it is not the Fed or fiscal policy that is going to get the U.S. out of an economic slowdown. It is households and businesses going out and spending and investing. As investors, we spend more time focusing on these trends and less on what the Fed is doing.

What should policymakers in the euro zone do?

First, and probably most urgently, policymakers need to stabilize the European banking system and improve the banks’ funding situation. They need to find ways to give more explicit protection to the banking system and to depositors, which is one of the things they have struggled to do so far. There are other actions policymakers can take, but those will probably occur over a longer time frame.

Investors also want a clearer picture from policymakers of who will bear the cost of bank refinancing and whether equity stakeholders will have to suffer dilution of their existing shares through capital raisings or if subordinated bondholders will have to take losses on their investments. A key step in Europe will be resolving those uncertainties. Everything does not need to be done at once, but there does need to be a plan for the next few years, not just a series of interim support measures that tide things over for a couple months.

A very important part of making sure this process works is building political support from voters in different countries. The problem is that the market wants these things to happen far more quickly than the political environment can allow them to happen in Europe.

How are investment professionals getting a clearer sense of the risks and opportunities in Europe?

We are thinking through a number of different scenarios. Some of them look at the potential impact of controlled government debt restructurings in the peripheral euro zone economies. Others factor in more aggressive intervention by the European Central Bank, which would probably imply a big devaluation of the euro. There is also the possibility of more coordinated action from the G20 group of nations, which could help stabilize markets. The worst-case scenario, which in my opinion has a very low probability of occurring, could see the breakup of the euro zone, which in the near term would impose very significant economic costs on the most debt-burdened nations.

We’re thinking all of these things through. The important thing to remember is that there are enough potential benign outcomes. If policymakers become very focused in Europe — and the market is forcing them to do just that — then I think we could see a positive resolution, although it is going to be a very bumpy ride because this will take some time.

Aside from the prospect of better policymaking, what else do investors have to be encouraged about?

Unlike in 2008, many companies have exceptionally strong balance sheets and very little organizational fat. They are operating very efficiently and have highly focused managements who understand how important it is to make sure that their companies are positioned not just to grow earnings but also to survive through different potential economic scenarios. So there really is no reason why even another round of bad luck should push us into a recession. But the most important investment theme continues to be the strong, secular growth of the developing economies — not just China, but a range of countries such as India, Brazil and Indonesia that are in a multi-decade process of growing and improving their living standards.

Although we will probably see exaggerated business cycles in these areas, we should not get distracted by those cyclical fluctuations. The broader secular picture in the developing world is highly positive, which is one of the things that will help the developed world recover and get the U.S., Europe, and even Japan through the problems of today.

How do you and other fixed-income portfolio managers think about mitigating risk in this volatile market environment?

We try to have a good combination of assets — government bonds, corporate bonds, a mix of currencies, a mix of different credits — so our portfolios are robust in the face of volatility. In the most recent period, we have seen a decline in the price of some corporate bonds issued by financial institutions while at the same time U.S. and German government bonds have rallied. As markets recover, we may see a recovery in financial credits. Hence, maintaining well-diversified portfolios is the best approach in my view.

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