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A Brave New World for Bond Investors
After a three-decade bull market in bonds, investors like BlackRock’s Rick Rieder are using a variety of techniques to make money when rates start to rise.
It’s easy to get William Eigen III riled. Just ask him how fixed-income managers are rethinking their approach to investing now that a 30-plus-year bull market in bonds is not only coming to a close but will likely go down in economic history as a freak occurrence. Eigen, a longtime bond manager who is part owner of an auto service shop and restores American muscle cars like Camaros and Challengers, says most of his peers are stubbornly sticking with what’s worked for three decades. He believes that managers instead need to start using a mix of traditional and hedge fund techniques to make sure investors continue to get what they’ve always expected from fixed income: capital preservation, diversification and income.
Speaking to a reporter last July amid the lunchtime crowd at JPMorgan Chase & Co.’s Manhattan headquarters, Eigen ranted against big bond managers’ spending their days on CNBC, telling people that interest rates would never go up, even as the Federal Reserve was doing everything it could to convince the markets that it would soon be scaling back quantitative easing (QE) — Fed-speak for printing tens of billions of dollars to buy fixed-income securities. Traditional bond managers want to talk about what happens when interest rates rise (bond prices fall) almost as much as the babysitter likes to reveal how much she texts while watching the kids. It’s bad for business.
Nine months later, talking late one Friday afternoon from his home outside Boston, Eigen explains why it’s liberating to run absolute-return funds. Unlike conventional bond managers, who have to buy long-only securities and be fully invested, he is free to tell the truth about where he thinks there is — and isn’t — value in the market. Eigen says fixed income became a lazy asset class in the years interest rates were declining, as managers sat back and delivered the returns of the overall market — beta rather than alpha, the result of skillful investments.
“The fixed-income fund business hasn’t evolved because it hasn’t had to,” says Eigen, who oversees $36 billion in absolute-return and opportunistic fixed-income funds for J.P. Morgan Asset Management. “If rates fall for 32 years, you’re not going to evolve; you will stick with what worked in the past.”
Running a bond fund is about to get a lot harder. A generation of managers who honed investing techniques that offered stocklike returns during the long, unprecedented bull market in bonds — think Sherman McCoy, the bond-trading Master of the Universe brought to life by Tom Wolfe in his 1987 novel, Bonfire of the Vanities — now faces a future in which its skills are outdated and many of the products it used are relics of the past. Managers are racing to reinvent themselves and figure out how to make money in a world of paltry yields that is marked by a lack of supply of diverse fixed-income securities and the threat of rising rates. Unconstrained bond funds, which give their managers wide latitude when it comes to choosing investments, are the first steps that the industry is taking to remain relevant. The funds are a testing ground for managers to develop new strategies to make good on the historical promise of fixed income.
Rising interest rates aren’t the only risk for bond managers. Structural changes to fixed-income markets in the wake of the 2008–’09 financial crisis have created their own set of challenges. After the crisis regulators cracked down on banks, imposing a bevy of new rules, including game-changing capital requirements to bring down their leverage and limitations on the types of businesses in which they can risk that capital. Banks that have shuttered their proprietary trading operations are now watching the markets mostly from the sidelines, even when it comes to the daily job of matching up buyers and sellers of straightforward securities like top-rated corporate bonds. “That creates more opportunities for large pools of capital like unconstrained funds and hedge funds to step in and play that role,” says Michael Swell, co-manager of Goldman Sachs Asset Management’s Strategic Income Fund.
Unconstrained investing is the asset management industry’s answer to this once-in-a-generation change in the bond world. These investors sever their ties to widely used benchmarks like the Barclays U.S. Aggregate Index, invest globally and switch among securities like bank loans and high-yield bonds to find the best opportunities. By definition, these funds don’t have a standard template, but they often use short positions and derivatives to hedge out interest rate moves and other risks and even invest in private lending deals. While BlackRock, GSAM, J.P. Morgan and Pacific Investment Management Co. oversee the largest unconstrained strategies, managing roughly $100 billion combined, almost every bond manager is launching or thinking about opening similar funds.
“You could argue that the buy side has had it easy for 20 to 30 years,” says Richard Prager, who heads BlackRock’s trading and liquidity strategies and has become an outspoken critic of how the bond markets have operated since the financial crisis — and what needs to change. “It’s a good time for certain bond managers to retire. There are different skill sets required” (see "BlackRock Is Remaking the Capital Markets").
Prager’s boss, BlackRock CEO Laurence Fink, gave a shout-out to unconstrained investing in the announcement accompanying his firm’s first-quarter earnings release. “The fixed income landscape is undergoing significant change, driving both institutional and retail clients to re-examine their fixed-income strategies,” Fink said. “We continue to witness a shift toward unconstrained fixed income.” BlackRock, whose founders helped develop mortgage-backed securities and other structured products, still represents big money in bonds: More than one third of its $4.4 trillion in assets are in fixed income.
Rosalind Hewsenian, CIO of the Leona M. and Harry B. Helmsley Charitable Trust, is a fan of the unconstrained approach. She invested with J.P. Morgan’s Eigen in 2010, when she was setting up an investment program from scratch for the $4 billion, New York–based foundation. “I’m sitting here thinking to myself, Do I really want to invest in traditional fixed income?” Hewsenian recalls. “Because the one thing I know is that it’s much more likely that rates will rise rather than fall.”
Last spring and summer, when rates rose after former Fed chairman Ben Bernanke dropped the bomb that the central bank would start tapering QE’s monthly bond purchases, investors got their first taste of what life might be like after the bull market. They experienced losses across the board in fixed income, a part of their portfolios they had expected to be stable. The losses in 2013 were deeper than those from the other two sell-offs during the long bull market, including the one in 1994. Last year was different because investors had no yield in their portfolios to cushion the impact of a decline in bond prices — one of the ugly lessons of the Fed’s drive to push rates so low.
The 2013 spike in interest rates was a wake-up call. “We’ve had 30 years where fixed income has done everything that clients envisioned it to do — it was a great diversifier, a solid contributor of income and yield, and it even provided a total return,” says Edwin Conway, head of BlackRock’s $1 trillion U.S. and Canadian institutional business. “Last spring was the aha moment, when it became clear just how dangerous the current environment is.”
There is no place for investors to hide from the coming changes. If anything, retiring baby boomers and the U.S. public and corporate pension plans set up to take care of retirees will need a record amount of safe, principal-preserving fixed income. Like the family that hires the texting babysitter because she’s better than no babysitter, investors need fixed income in their portfolios because there are no alternatives for safety.
Unshackling managers from popular benchmarks presents substantial risks for investors. The Barclays Agg may have huge amounts of interest rate risk, but its behavior can be predicted. Unconstrained investing is new, and few managers have long-term track records that can show how they’ve performed in different markets. By definition, flexible managers reposition their portfolios frequently, sometimes leaving investors in the dark until the next reporting period.
Dan Roberts, manager of the MainStay Unconstrained Bond Fund and head of global fixed income at $80 billion fixed-income manager MacKay Shields, says investors and consultants are worried about the amount of risk that managers may take on with unconstrained strategies. He points to core-plus funds, which allow managers to invest in high-yield and other debt on top of government and investment-grade corporate bonds. In 2008 the median core-plus fund lost a whopping 10 percentage points more than the index, as most managers had loaded up on higher-yielding but risky assets in the lead-up to the financial crisis.
“They got smoked,” Roberts says. “Clients are saying, ‘I’ll give you all this flexibility, but can you turn that into alpha for me? Or are you going to bury me with it?’”
Still, investors can’t afford to sit on their hands. Rick Rieder, CIO of fundamental fixed income at BlackRock, takes issue with those who view unconstrained investments as riskier than traditional bond funds. “Eighty percent of the risk of core bond funds benchmarked to the Barclays Agg are tied to interest rates,” says Rieder, who comanages BlackRock’s Strategic Income Opportunities Fund. “They are predictable, but is that a safe investment?”
Interest rates have declined steadily in the U.S. since the early 1980s, not long after president Jimmy Carter appointed Paul Volcker chairman of the Fed with a mandate to tame inflation. During those decades of heady bond gains, most individual and institutional investors hitched their fixed-income portfolios to the Lehman U.S. Aggregate Bond Index (now the Barclays U.S. Agg). As a result, two factors largely determined bond fund returns: the level of interest rates and credit spreads (how much borrowers pay relative to Treasury securities to entice people to buy their debt). The approach worked: During the bull market in rates, bond investors made money in all but three years between 1982 and 2013.
Global central banks ushered in the end of the bull market with the extraordinary stimulus measures they used to try to kick-start growth after the financial crisis. From 2009 through the end of 2013, the Fed increased the securities on its balance sheet to $4 trillion from less than $50 billion, spurring inflation fears and pushing rates down to almost zero.
Last spring, when tapering talk started, GSAM’s Swell and co-manager Jonathan Beinner jumped in to buy municipal bonds, which individual investors were selling in a panic. The 30-year tax-exempt munis they purchased were trading at 125 percent of the yield of comparable-length Treasuries and at the same levels as taxable munis. At the same time, they hedged out the interest rate exposure of the munis.
To the two GSAM managers, the move was a no-brainer. “That’s a traditional liquidity-providing type of operation that investors are now doing as opposed to the Street,” says Swell, who ran fixed-income sales and trading at investment bank FBR & Co. before joining GSAM in 2007. As banks are getting out of the trading business, he explains, money managers like GSAM are stepping into the breach, scooping up profits while providing necessary liquidity to the market.
Ironically, Swell could see from industry data that the investors fleeing traditional fixed-income mutual funds — forcing their managers to sell securities at huge discounts — were rushing into funds like his instead.
With the banks benched, GSAM believes it can profit from relative-value strategies, essentially owning one security and shorting another. “You can generate as attractive or more attractive returns without taking a lot of interest rate risk and without purely taking credit risk,” says Swell, 48, who lives on the New Jersey shore, in Rumson, the tony home of bankers and Bruce Springsteen. He immersed himself in mortgage-backed securities as employee No. 35 at a still-fledgling BlackRock early in his career and spent a dozen years selling and securitizing mortgages at Freddie Mac before joining FBR.
Swell gives institutional investors credit for moving to unconstrained funds, even though the benchmarks they are measured against remain the same. For instance, if interest rates fall, Swell’s fund may lose money based on how it’s currently positioned and the value of the Barclays Agg will increase. And at the end of the year, the board of a pension fund will judge its performance using the Agg as its measuring stick. CIOs are taking the risk that GSAM’s skill will outperform the benchmark. “There is manager risk in this product that is meaningfully higher than in a core bond fund,” notes Swell.
Though Swell says GSAM’s Strategic Income Fund is absolute return and seeks to deliver a certain level of gains above cash, its performance has been more volatile than the average fund in Morningstar’s nontraditional bond fund category. In 2013, Swell returned 6.07 percent while the average fund in the category was essentially flat (up 0.29 percent). In 2011, a volatile year for the bond market, the Goldman fund was down 2.49 percent. January 2014 was a rocky month for unconstrained funds: Goldman’s fund lost 0.56 percent while the category was up 0.09 percent.
BlackRock’s Rieder has good timing, even if it’s not always perfect. In May 2008, Rieder, then head of global principal strategies and a 20-year veteran of Lehman Brothers Holdings, left the investment bank to start his own hedge fund firm, R3 Capital Partners. The hedge fund took $5 billion worth of securities from the troubled bank, which was struggling to calm investors’ fears over the value of billions of dollars in illiquid securities it held. On September 15, Lehman, which had given R3 Capital $1 billion in seed capital, filed for bankruptcy. A month later the failed investment bank agreed to keep $250 million with the hedge fund for three years.
In 2009 big money management firms were hiring Wall Street veterans with experience trading mortgage-backed and other distressed securities and gobbling up investments at fire-sale prices. BlackRock, which had been an original investor in R3, signed a deal with Rieder in April merging his R3 funds with its lineup. Rieder became head of its fixed-income alternatives portfolio team. He was promoted to CIO of fundamental fixed income in 2010.
Now 52, Rieder began his career in 1983 as a financial analyst at SunTrust Banks in Atlanta. Four years later, after getting his MBA from the Wharton School of the University of Pennsylvania, he joined E.F. Hutton & Co. In 1988, Hutton merged with Shearson Lehman Brothers.
Rieder is passionate about developing new ways to solve the fixed-income market’s problems, which he says became clear to him in 2010. In October of that year, Treasury yields dropped below 2.5 percent, and investors started thinking hard about interest rate risk and wondering whether their luck with bonds might be about to run out. In the great deleveraging that immediately followed the financial crisis, there was little need for companies to borrow money and create new fixed-income securities. All of the net supply that has been coming to market since then has been investment grade and Treasuries, which the Fed has been buying as part of QE. Each of the past two years has seen record issuance of investment-grade U.S. corporate debt. Apple and Verizon Communications are just two examples of companies that have issued large amounts of debt because they barely had to pay anything to get investors to trip over themselves to buy it. “I’ve been doing this for 27 years, and I’ve never seen so little diversity of assets,” Rieder says.
At the same time that supply has run low, it would be imprudent for people to sell bonds to go into equities, even if BlackRock CEO Fink told them to do just that in 2012. A record number of Americans are reaching retirement age. In a grayer world insurance companies need more assets to sock away to back insurance contracts they’re selling, individuals need to live off the income of a debt instrument, and pension plans need more bonds than ever to match their liabilities.
Rieder says it’s astonishing how little can be done to create diversification and income for fixed-income investors. Say what you will about bonds backed by individuals’ credit card debt — investors need a way to diversify away from the stuff packed into the Barclays Agg, where 80 percent of the risk is tied to what happens with interest rates. In 2006 and 2007, 95 percent of fixed-income securities yielded more than 4 percent. Last year only 15 percent did.
“People are dying for income,” says Rieder. “How do you dig deeper to get it?”
Rieder believes the limited supply of diverse fixed-income products and the resulting lack of income to satisfy an aging population are behind the growing popularity of unconstrained investing. BlackRock is putting a huge effort into the strategy because it sees investors hiring big and well-equipped managers that have the creativity and discipline to create new tools. The Strategic Income Opportunities Fund is about finding diversification in new and different places. “We’re looking to diversify like crazy,” says Rieder, who adds that if he had a slogan for the fund, it would be “I’m trying to make a little bit of money a lot of times.”
BlackRock’s Aladdin risk management system, which originally helped investors understand the risks of their multilayered mortgage-backed securities and which arguably powered the firm’s growth over the past 20 years, helps Rieder understand the unexpected interconnections among more-complex trades in far-flung locales in the unconstrained fund. BlackRock uses Aladdin to model all the component risks in a portfolio and analyze what specific trades will do to correlations among other securities and how they will affect the total risk of the portfolio. Aggregating data from various sources, the system can help the firm analyze 300 different asset classes and model how they should perform in a risk-on or risk-off environment, for example.
Because of the lack of supply, some fixed-income trades, like high-yield debt, have become particularly crowded with investors. At the end of 2011, Rieder was skewered by critics for buying Italian and Spanish bonds, but BlackRock rode the bonds up in price for two years before selling its position in January of this year; Rieder thought the market was too frothy after a $40 billion Spanish deal came to market that paid only 80 basis points above U.S. Treasuries. Instead, BlackRock rotated into smaller issues in Portugal and Slovenia, both of which could benefit more from recent rhetoric coming out of Germany on European countries’ needing to act together.
BlackRock has been buying bank capital transactions in Europe and the U.S. to take advantage of attractive yield opportunities in a more regulated and better-capitalized set of banking systems. Rieder also has been adding commercial mortgages, which he views as relatively more appealing than what’s available in the high-yield market today. He insists that investors need to be able not only to look at emerging markets but to get solid intelligence on specific areas like Indonesia or Mexico. He says his fund intends to profit by making a lot of trades in different corners of the world.
Rieder is pumped to discuss what’s next for fixed-income investors. His enthusiasm is rare for a market that is normally pretty buttoned-up. Not surprisingly, he emphasizes that asset managers need to be large, with the resources and people to scour the globe for investments and the expertise to handle derivatives and risk management for these portfolios. He draws ideas for his portfolio from 150 analysts at BlackRock.
The Strategic Income Opportunities Fund is meant to provide steady returns and diversification. Rieder is proud of its low volatility. In January, usually a good month for investors, the markets were extraordinarily volatile, with pressure on emerging markets and some economic indicators coming in negative. The BlackRock fund was up 0.14 percent. In May of last year, when Bernanke first talked of tapering, the fund was flat, but it lost 1.95 percent the next month, when all asset classes went down together.
BlackRock clients still have 25 to 35 percent of their portfolios in fixed income. “Our clients face a big dilemma,” says institutional business head Conway, who joined the firm in 2011 from Blackstone Group. “They have such a big pool of capital not really working for them anymore and not generating the returns or income that they need.” BlackRock expects its investors to put as much as one third of their total fixed-income portfolios into unconstrained strategies.
Rieder has put his stamp on the firm’s active fixed income, which was losing assets from underperformance during the financial crisis, when he took over, even as rivals such as William Gross’s Pimco were flooded with cash. Performance in active fixed income has improved under Rieder, with about 84 percent of his firm’s funds beating peers over a three-year period. But BlackRock’s big focus on its unconstrained funds may have helped it escape the woes of its competitors in the bond business: The firm was one of the rare winners last year, taking in new money from investors that were pulling a record amount from other managers.
Though he is managing billions of dollars for the rich families of JPMorgan’s private bank and other clients, Bill Eigen still sees himself as the working-class outsider who had to claw his way to the top. Eigen, who fought to work out of Boston, far from the influence of his company’s long-only bond managers, admits that the criticism he’s gotten over the years — including the contention that he’s positioned too conservatively now — just makes him work harder.
The son of an army mechanic who went into pension sales after attending college on the GI Bill, Eigen worked during his years at the University of Rhode Island, doing everything from interning at a brokerage firm to cutting bait on a fishing boat. After graduating in 1990 and joining insurer Cigna Corp. as a fixed-income analyst, he quickly figured out that he needed either an MBA or a chartered financial analyst designation. With no cash or connections, Eigen chose the CFA route, becoming at age 24 one of the youngest people ever to receive the designation, and then knocked on the door of Fidelity Investments.
By 1998, Eigen was a senior analyst at Fidelity, and he started managing some fixed-income money for the asset allocation funds, introducing a multisector rotation strategy, moving money among asset classes depending on the opportunities available at the time. The concept of active fixed-income management, which is the basis of many unconstrained funds today, was still fairly rare. Eigen took over Fidelity’s fledgling Strategic Income Fund in 2001, using the same multisector rotation strategy; by the time he left, in August 2005, he had built it into a $10 billion business. With risk premiums tight and rates low, Eigen no longer felt he could protect investors’ capital, because he had to be fully invested at all times.
“I loved my days at Fidelity, but my whole time there I had a fundamental disagreement with them on how fixed income was run,” he says, adding that his wife gagged when he told her he was quitting to join hedge fund firm Highbridge Capital Management. But he couldn’t sleep at night, thinking about how rising rates could hammer his Fidelity funds. He wanted to run a fund that gave him ways to mitigate interest rate risk and protect principal under any possible scenario. Instead of measuring himself by relative returns and hiding behind how well he did compared with the next hapless bond manager, Eigen wanted to gauge his performance by absolute returns — making money regardless of the direction of the market.
He immersed himself in shorting and hedging techniques at Highbridge and started a fixed-income hedge fund. In 2007 he was recruited by James (Jes) Staley, then CEO of J.P. Morgan Asset Management, which had bought a majority stake in Highbridge a few years earlier. Staley wanted Eigen to run the same strategy in mutual fund form, making it available to the masses.
Eigen, who has 19 people on his team, wants investors to know that he is an absolute-return manager — protecting principal first — and managers can’t do that without the ability to hedge or go short. His J.P. Morgan fund uses techniques from three distinct areas. First, Eigen can rotate among sectors to pick up potential market returns, or beta, just like he did at Fidelity. He also employs relative-value trades — going both long and short — to take advantage of out-of-whack prices to generate alpha. Last, he hedges to protect against large, unexpected downward price moves.
What Eigen gets criticized for, and what differentiates him from a lot of competitors, is his willingness to hold cash. He makes no apologies for that. He believes cash is the ultimate volatility and liquidity hedge; he hoards it if he doesn’t think there’s anything worth buying. In 2008 the J.P. Morgan Income Opportunity Fund, an offshore strategy launched in 2007, held about 80 percent of its assets in cash and had positive returns.
But for all the complexity, Eigen’s vehicle is an old-fashioned bond fund refurbished with a 2014 engine. Right now he is taking his cues from the sale in March of Greek five-year bonds at about 4 percent — 18 months ago people wouldn’t touch them at 44 percent. Eigen hasn’t seen investors reaching for yield like this since 2007, and he says it’s time to sell securities that he’s made a lot of money on over the past four years, including high yield, nonagency mortgages and leveraged loans. He says there is no margin of safety and the risk of loss is too high for him to own these securities. If spreads remain tight, he’ll sell all his high yield over the next few months. “Right now you can sell triple-C-rated crud with hair all over it, and you’ll have a bunch of willing buyers,” laughs Eigen, who has 55 percent of the J.P. Morgan Strategic Income Opportunity Fund’s assets in cash.
The J.P. Morgan manager says so many of his peers are using different approaches to unconstrained and absolute-return funds that investors need to be skeptical and look at how those managers have done during times of trouble. In today’s environment, Eigen says, it’s hard to make a bond fund behave like the anchor it should be — he aims never to lose money — and if managers are not using shorts, then they can’t be absolute return. The J.P. Morgan Income Opportunity strategy returned 1.63 percent last year, soundly beating the Barclays Agg, which lost 2.02 percent.
At the end of the day — and the end of the bond bull market — neither absolute-return strategies nor unconstrained investments may be a panacea for large traditional asset managers. Eigen says he could never manage $200 billion in assets. He’s not sure he even wants to manage $100 billion. “People have been too busy building empires and not focusing enough on what’s right for the investor,” he notes.
It’s time to retire Sherman McCoy. • •