Gaffney Signals End of Era; Provides Alternative Strategies for Fixed Income Investors

During a frigid Chicago lunch-hour in late February, Kathleen Gaffney, CFA, spoke to a room of CFA Chicago Society members and their guests at the Willis Tower’s Metropolitan Club about the prospects of fixed income investing and potential income generating strategies during the eventual rise in interest rates. Her overriding message was one of reassurance; “We’ve been here before.”

Gaffney, the lead portfolio manager for Eaton Vance’s multi-sector bond strategies, began her presentation by discussing today’s current ultra-low interest rate environment and the risks associated with a Fed decision to increase short-term rates in 2015, which she expects in June, lest the Fed risk being behind the curve. However, she was quick to give the Fed credit for current policies and actions, which Gaffney labeled “bridge-financing” until the private sector can provide the momentum to move the economy forward. As the U.S. leads the world into economic recovery, while other world economies toddle, Gaffney is not concerned about inflation or rising long-term rates. Her forecast for the yield on the 10-year Treasury bond is 4% by the end of 2015, although she admits her forecasts for the 10-year have been incorrect in the recent past.

Besides the obvious risks to bond values in a rising rate environment, Gaffney also noted that nearly none of the fixed income practitioners operating today have experienced the magnitude of the long-term rise in interest rates that preceded the cycle’s peak in 1984. Additionally, regulatory changes have reduced Wall Street’s ability to put their own capital to work, resulting in decreased valuation support, reduced liquidity and very swift corrections in high yield, emerging and equity markets.   The end of the era will require careful asset allocation and alternative strategies that seek to mimic fixed income returns, while minimizing interest rate risk.

Gaffney encouraged the audience of investors and advisors to enhance portfolio flexibility by thinking broadly about the various “levers” that can be pulled to generate investment returns, i.e. credit, country and currency. She likened taking interest rate risk in today’s rate environment to driving down a dead-end road at 80 mph.  Rather, with her expectation of a secular bull market in equities, fixed income investors may consider “high-quality” equities with good dividend yields that will provide additional return on positive market movements, according to Gaffney. She also suggested that investors consider equity sensitive convertible bonds to mimic the returns of high yield bonds, while minimizing interest rate risks. Floating rate bonds were also offered as a reasonable alternative. However, Gaffney noted that floating rate notes introduce an additional element of repayment risk if rates rise too high or too fast, which she does not expect. The current strong dollar also provides opportunities to benefit from the potential growth from product importers to the U.S. Additionally, Gaffney proffered an idea that countries working to implement long-term positive structural reforms, including Brazil and India, have the potential for enhancing portfolio returns. However, she cautioned investors regarding new issuances encouraging investors to increase due diligence levels for new market entrants.

Gaffney finished the luncheon session with a question and answer session that included audience inquiries regarding duration assignments, the potential for negative deposits rates and, among other things, the performance of the her managed portfolios if the 10-year yield does reach 4% in 2015.

Distinguished Speaker Series: Kathleen Gaffney, CFA, Co-Director of Diversified Fixed Income, Eaton Vance

The Distinguished Speaker Series featured Kathleen Gaffney, CFA, and Co-Director at Eaton Vance who focuses on fixed income. Eaton Vance is one of the oldest and most distinguished investment management firms in the United States.  Gaffney warned that the “end of the era” of low interest rates is at hand and that more volatility will be the result.

The increase in volatility is due to more than just the expected rise in interest rates.  Gaffney warns that the broker/dealer community has been hard hit by new capital rules that prevent them from holding large inventories of bonds.  Due to the global financial crisis of 2008-2009, this “shock absorber” has been taken away.  Gaffney stressed that moving capital will be difficult, leaving the market vulnerable to sharp corrections.

Gaffney stated that she is convinced that the credit markets are ripe for correction.  The FED’s actions will most likely impact short and intermediate term bonds the most.  If the FED does not begin to tighten in June, it will be accused of being behind the curve. She believes that the fundamentals in the United States are good and that once rate hikes begin; the resulting yield curve will resemble a “bear flattener” as short rates will rise faster than longer term rates.  Inflation will result when economies outside the US continue their economic recovery.

Gaffney is convinced that duration risk is the greatest risk facing the US bond market.  It is her position that US interest rates are too low and that the 10-year treasury yield will approach 4% by year-end.  She also believes that high-yield and investment grade corporate bonds are currently expensive. In this environment, as part of a multi-sector strategy, Gaffney utilizes dividend paying equity substitutes in her fixed income portfolio.

Gaffney purchases equities that yield between 1.5% and 3.0% at prices that are more reasonable than current bond prices.  These equities have yields that currently compare favorably to the 10-year treasury.  The equities market at this time also offers more liquidity than fixed income markets, and she is able to use up to 20% of her portfolio for equities.

In the brief question and answer period that followed Gaffney stated that she is an optimist and that strong GDP numbers which she expects in the near future will be a catalyst for rising interest rates.  She assigns a 0 duration to the equity positions she holds in her portfolio. It was interesting to hear how a multi-sector strategy allows her to include equities in the search for yield.