Monday, October 5, 2009

Dan Fuss: Bond investors have learned from experience…not

In some ways, famed bond investor Dan Fuss is pleased by how far the bond market has come during the last year. October and November 2008 made for a “horrific experience” he said. Since then, bonds have made an incredible recovery. However, their rebound has also brought back some of the behavior that fed their problems, said Fuss to the Fixed Income Management 2009 conference of the CFA Institute on October 1. Fuss is vice chairman of Loomis, Sayles & Company and co-manager of a number of institutional separate accounts for the firm’s fixed income group.

Fixed income’s bleak months in 2008, when it was difficult to get bids for even the highest quality investments left an impact on Fuss. On paper, October and November offered a fantastic buying opportunity. He spoke of a “50-year opportunity in bonds”  in November 2008. Unfortunately, instead bond funds struggled last autumn to sell in response to mutual fund redemptions. 

As a result, now Fuss pays more attention to liquidity of his investments, even if it means that “I’m fighting the last war.” Compared to 18 months ago, “I’ll give up something to buy something more liquid,” he said.

Until a few months ago, Fuss thought he wouldn’t see a repetition of the risky behavior that he illustrated with his fable of Colossal Corporation, the world’s largest maker of “colossals,” a product Fuss made up for the purpose of his story. Colossal Corp. began by dabbling in hedging the price of ore and the Australian dollar, and then went heavily into the carry trade. Eventually, it got burned by the credit crunch and decided to give up its speculative ways.

For awhile Fuss thought that the Colossal Corporations of the world had learned the lesson that they should stick to their business rather than speculating in financial markets. “I thought that was all history,” he said. However, over the last three to four months, he observed that “By God, this thing is starting to replay…. The people who skate on thin ice when they shouldn’t are starting to skate on thin ice again.”

Speculation is reviving because of the steep yield curve, said Fuss. There is an enormous incentive to go out the yield curve to pick up yield. He discussed a risky new product that made its debut in Japan in March 2009. The Japanese product is being copied by others. “I can’t believe this is happening,” said Fuss.

Recently, traders at Loomis Sayles told Fuss that he should act quickly if he’d like to get in on a B- credit that would pay a special dividend. “I thought it was a joke,” said Fuss. But it was not.

Susan B. Weiner, CFA
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Copyright 2009 by Susan B. Weiner All rights reserved


  1. Stephen Campisi, CFA, Intuitive Performance SolutionsOctober 5, 2009 at 7:44 PM

    There are even broader lessons from 2008 that seem to continue to be ignored. One important lesson is the difference between true liquidity and the assets that pretend to provide liquidity. How many managers and consultants are still looking at liquidity only in terms of the accessibility of money, instead of access to a stable amount of money? To say that one has daily liquidity (meaning a right to request a redemption each day) is a misleading, if not meaningless statement - IF the amount that could be delivered has the potential to be significantly lower than what was expected. True liquidity is quick access to a stable amount with little expense to transact (where expenses can be explicit, as in commissions, or embedded as in bid-ask spreads.) By this definition, when you need liquidity most, the only truly liquid bonds are Treasuries.

    This leads to an even more important, and even more ignored lesson: you need to look at the total portfolio in terms of client goals. What do most investors look at? Individual products in terms of benchmark returns! How silly. Look at the typical pension plan that held a 70% equity and 30% Aggregate bond allocation during 2008. The "outperforming" plan sponsor might have seen +300 bps relative to the benchmark (losing only 22% instead of 25%.) Great job! But compared with the corporate bond return of -8% that was used to value the liabilities, we see that the plan underperformed by 1,400 bps - a true disaster that pushed the plan even farther into an underfunded position.

    Have we learned anything from 2008? Not likely. We haven't seen any restructurings to increase liquidity, and we don't see anything from a regulatory standpoint to move the investment industry's focus from evaluating individual products in isolation, to evaluating whether the total portfolio is meeting each investor's needs. Even the GIPS standards for performance only address whether prospects (not clients) are given representative returns for individual products. No one seems to really be looking our for the client, whose money and financial future are at risk from these so-called "strategies." And it doesn't help that all we hear are stories from well-regarded managers of individual investment products. We remain lost in the trees and 2008 seems to have taught us nothing.

  2. Stephen,

    Great points about the importance of liquidity and evaluating investments in terms of clients' goals. But if Treasuries are the only truly liquid bonds, it seems as if it's worth sacrificing some liquidity for return potential.

    Thank you for posting!

  3. Funny that Fuss is coming in as the "conservative guy" -- the fund he manages is one of the more risky and I, for one, find it hard to believe that a leopard can change its spots.

  4. Paul,

    I imagine that Fuss believes he is taking calculated risks that he understands.

  5. Stephen Campisi, Intuitive Performance SolutionsOctober 15, 2009 at 8:35 PM


    You are correct in saying that we sacrifice some return to gain liquidity. After all, lower risk is accompanied by lower return. However, even a cursory look at long term bond returns shows that the highest returning bond sector is long term Treasuries. These have the best short term diversification potential, since they have the duration or interest rate sensitivity to post substantial gains when the equity market trades off - and they pay you a higher yield while doing that! Find me a better deal: getting paid higher returns to reduce short term total portfolio risk.

    The problem here is that you are looking at bonds in isolation, rather than in their proper context, which is the total portfolio. The other significant risk is having to "monetize" the downside of the market when you need to pull money out of the portfolio for spending requirements. Then you are making short term losses permanent because you can never recover on assets you have sold. Believe me, the 50 - 75 basis points of lost yield (assuming you insist on holding intermediate maturity bonds) is nothing compared to losing hundreds or even thousands of basis points of return from selling depreciated assets in a market downturn. If you want real diversification, you need to hold Treasuries instead of corporates which are simply equity risk with inadequate compensation for risk.

  6. Stephen,

    So you're saying that Treasuries--even if their prices seem high--should be valued for their contribution to the portfolio when the stock market tanks, as happened recently. Did I get it right?

  7. Stephen Campisi, Intuitive Performance SolutionsOctober 17, 2009 at 8:47 AM

    The issue of current valuation of any asset is irrelevant to the process of strategic asset allocation. When you set long term asset weightings, you have a goal and a set of expectations for each asset. You also control the variety of risk exposures and balance this against your overall return expectation - all in the context of your financial goals. What is the expectation for bonds? To be a source of diversification and liquidity while providing a modest real (inflation adjusted) return.

    Even a cursory look at historical returns shows two interesting things. First, the highest returning asset is long Treasuries. Their source of return is their maturity and inherent short term price risk. Second, this "risk" is reflected in the diversification they provide at times of short term equity stress (think 2008!) They are the best diversifier and they pay the highest yield while doing that important job. It doesn't get any better than that!

    Worried about high valuation? Rebalance the portfolio and redeploy the gains into the depreciated equities. That has been a winning strategy in 2009. Rebalancing also one of the fundamental assumptions of investment management. Want to take advantage of tactical opportunities? Go ahead; that's another source of value added from active management. It's not inconsistent with the strategic advice I've provided here. But we need to make tactical decisions about current valuations in the context of the long term plan, and not the other way around.

    What are corporates doing while equities are down? They're also down! What kind of diversification is that? Corporates fail you when you need them most. They behave like equities when you need them to act like bonds. They've proven themselves NOT to be a source of diversification, liquidity and stability. They have a weak risk premium that does not compensate you adequately for their risk. Your risk budget is better spent in equity - as long as you have adequate liquidity. It's clear that risky bonds are not a source of liquidity.


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