Bond investors are regularly accused of reaching for yield, that is, earning too little for the risk they are taking. Kenneth Leech, chief investment officer at the $465 billion Western Asset Management, argues that this is too simplistic. Investors are responding to a global economy that is growing but growing slowly. Speaking from the firm’s headquarters in Pasadena, California, Leech says that despite likely interest rate hikes next year, he still favours spread sectors, including junk bonds and emerging markets debt.
The Federal Reserve is steadily reducing its asset-purchasing programme. Hawks on the Fed’s board such as Charles Plosser [Philadelphia] and Richard Fisher [Dallas] are suggesting the timetable for a rise in interest rates could begin in the first quarter of next year. How do you see it?
Ken Leech: The Fed has been optimistic about economic growth. It was optimistic about the US achieving 3% GDP growth when it first announced [that] it planned to taper its asset purchasing in 2013. But that growth didn’t emerge, which held back the Fed’s initial move to taper. It was optimistic when tapering finally began but the revised figures for Q1 2014 show that GDP growth came in at minus 2%. That’s a substantial miss from the Fed’s 3% forecast.
But the Fed still remains optimistic. Q2 growth – the quarter that has just passed – came in at 4% thanks to the bounce-back from the terrible weather that caused negative growth early in the year. So that’s a good number and it’s reasonable to ask whether we can extrapolate accelerating growth for now on.
What’s your expectation for US growth rates?
We estimate it should be around 2% to 2.5%. Even with that strong Q2 performance, over the course of the first half it evens out to only around 1%. It’s going to be the second half of the year that tells the tale and determines what the Fed will do. They are already trying to steer the market towards believing the Fed will start to raise interest rates some time in the middle of next year and I feel that’s still the case.
Despite some noises from the more hawkish members of the Fed’s board?
I feel that the key people to watch are the Fed chair [Janet Yellen], the vice chair [Stanley Fischer] and the president of the New York Fed [William Dudley]. They have shown no inclination to expedite that schedule.
What about the potential degree of rate hikes?
We have a long way to go before the middle of next year. The Fed’s goal has been to telegraph the idea of a rate hike so far in advance that it hopes the bond markets won’t overreact when it finally occurs. I think they might achieve that. If the economy continues to improve the Fed may be able to inch up the federal funds rate without sparking a run in the bond market.
That would certainly be helpful to bond fund managers. How is your flagship global strategy positioned?
Early this year we were overweight US duration and emerging markets – a little against the consensus. But we were sceptical of US growth and believed conditions would continue to favour spread yields. That view worked out for us. Now we’ve shifted to neutral on US duration. But we continue to maintain our overweight on emerging markets. We felt this would be a good place for bondholders, given challenges to emerging-market growth rates and the possibility of rising interest rates in the developed markets.
What about credit in developed markets? Is it oversold?
We continue to be overweight investment grade corporate bonds in the US, especially senior bank bonds, as well as high yield and structured bonds. Investment grade has been an important overweight. Today most of the spread compression is behind us but I still expect spreads to drift a little more narrowly. Senior bank bonds are the best place to be because of regulation: US authorities have made it clear [that] they will never allow banks to get society into trouble like they did in 2008. That is positive for bondholders because it means the degree of risk in bank debt is limited. And that is a long-term trend. Among corporate issuers, many of their bonds have done well and we won’t see any more huge gains, but it’s still a safe sector for bond investors, where at least we can clip the coupons.
Next: Ken Leech on US high yield, China and the Japanese yen.