Top Bond Funds Win by Harnessing Most Dangerous Part of Market
(Bloomberg) -- In some ways, the managers of the Treasury market’s two best-performing mutual funds couldn’t take a more different approach.
On one side is Josh Barrickman at Vanguard Group Inc., which has become the world’s largest mutual-fund manager by offering low-cost, passively managed investments. His $884 million Extended Duration Treasury Index Fund earned about 23 percent in the first half of this year. On the other is Lacy Hunt, who helps steer the $488 million Wasatch-Hoisington U.S. Treasury Fund, which returned around 18 percent. He’s favored longer-maturity Treasuries for more than two decades.
While the former is an index fund and the latter is actively managed, they have one key thing in common: focusing on the longest-dated Treasuries as a stagnating global economy pushes inflation expectations toward record lows. The funds’ success in 2016 reflects investors’ voracious appetite for the safety and higher interest rates of long government bonds at a time when almost $10 trillion of sovereign debt yields less than zero.
“For a while, it was the common wisdom that rates had to go up at some point, but we’re seeing now that we can stay a lot lower for a lot longer,” said Barrickman, 41, Vanguard’s head of Americas fixed-income indexing in Malvern, Pennsylvania. “I don’t think folks are really afraid of inflation at this point, which is obviously the bogeyman when it comes to long duration.”
While lower interest rates are a boon to governments, they’re straining investors such as pensions, which count on bonds’ fixed payments to meet liabilities. A rallying debt market is also ominous because it suggests investors are pessimistic about prospects for the economy.
Duration -- a gauge of debt’s price sensitivity to interest-rate changes -- explains why the two managers in the first half outpaced more than 100 open-end U.S. government-bond mutual funds that don’t deploy leverage, according to data compiled by Bloomberg.
Securities with longer duration gain more when rates drop, and suffer stiffer losses when they climb. For both funds, the latest available data show that the metric is greater than 20 years, triple the level on Bank of America Corp.’s U.S. Treasury Index.
Investors have poured cash into such funds in 2016, betting against the Wall Street consensus that yields would rise as the Federal Reserve increased its target for overnight borrowing. Instead, the Fed has been on hold since its December liftoff, and yields on 10- and 30-year debt plunged to record lows this month amid a feeding frenzy that’s left bondholders with little margin for error.
Hunt and other bond bulls point to dimming prospects for a pickup in inflation, the bane of fixed-income investors. A Fed measure of inflation expectations starting in five years and going through the following five years is close to historic lows.
Holding long-duration Treasuries “is a strategy that, I must say, has worked very well, though it’s not always been popular,” said Hunt, 73, who’s based in Austin, Texas.
“While any one of many factors can cause the bond yields to rise over the short-run, we do not believe they can go up and stay up,” he said. “We do not believe that the secular low is at hand. We believe it’s in front of us.”
Other money managers see signs the rally’s gone too far.
Take the metric known as the term premium, which reflects the extra compensation investors demand to hold longer-maturity debt instead of successive short-term securities. For 30-year bonds, it dipped below zero for the first time this month, according to a Morgan Stanley index.
Jeffrey Gundlach, chief executive officer of DoubleLine Capital, expressed caution about duration amid the reach for yield. U.S. 10-year yields will eclipse 2 percent next year, from just below 1.6 percent now, and inflation is poised to quicken, he said in a webcast last week.
Yet cash has continued to flood in. U.S. long-term government bond funds gained assets in each of the first five months of the year, the longest streak since 2009, according to the latest Investment Company Institute data. Hedge funds and other large speculators boosted net bullish bets on bond futures to a record in the week ended July 12, data from the Commodity Futures Trading Commission show.
The Vanguard fund’s five-year track record explains the appeal. It’s produced average annual returns of 16.2 percent for the period, compared with 3.6 percent for the Barclays U.S. Aggregate Bond Index and 13 percent for the S&P 500 Index of stocks. Hunt’s fund has posted annual gains of 12.3 percent on average in that timeframe.
Hunt, whose firm was founded by Van Hoisington in 1980, has been convinced since the early 1990s that elevated government debt burdens would limit global economic growth and inflation, preserving the value of long-dated Treasuries.
His fund held eight securities as of March 31, of which seven were Treasuries maturing from 2042 to 2045.
Vanguard’s fund invests solely in Treasuries split into principal- and interest-only securities, known as Strips, data through June show. The demand for them is growing: outstanding Strips jumped in June to the highest in more than 17 years. Buying zero-coupon Treasuries is one of the most bullish bets on long bonds, because the lack of payment until maturity extends duration.
“This particular fund is really a little bit of a gamble,” said Barrickman, who joined Vanguard in 1998 and oversees more than $400 billion in bond assets.
The funds’ performance in 2013 shows the risk they entail. The bond market was rocked that year by the event dubbed the “taper tantrum,” when Treasuries tumbled after then-Fed Chairman Ben S. Bernanke signaled the central bank might slow its bond buying. Vanguard’s plunged about 21 percent, and Wasatch-Hoisington’s by about 17 percent. Their losses were steeper than virtually all their peers, data compiled by Bloomberg show.
Yet they roared back in 2014, returning 46 percent and 33 percent, respectively.
Bond managers pondering the remainder of 2016 are grappling with stretched valuations, especially on longer maturities.
Yields on 30-year Treasuries have plunged about 0.71 percentage points this year. The yield was 2.31 percent as of 1:07 p.m. in New York Monday, having dropped to a record low of 2.09 percent on July 11. Thirty-year yields are about 0.52 percent in Germany and about 0.18 percent in Japan.
For Hunt, the conditions are ripe for even lower yields.
“We’ve had this jaundiced view of the domestic and global economic situation,” he said. “If our economic problems persist and they become as feeble as they are in Europe and Japan, those provide an indication of where, over the next several years, the yields could move.”