| Jack Malvey |
Jack Malvey, chief global fixed-income strategist for Lehman Brothers, and I have something in common. No, I’m not a Yankee fan nor am I in the Fixed Income Analyst Society Hall of Fame. We’re both getting bored, frankly, with the national fixation of when and at what point the Fed is going to stop raising rates. This obsession is clouding some of the more interesting developments in the global fixed-income market, many of which Malvey, 54, a primary analyst for Lehman’s global family of indices, was happy to discuss. I recently met with Malvey to discuss his cyclical anxieties, creating the largest global aggregate index and the year ahead. This is an excerpt of our conversation.
InstitutionalInvestor.com: While you never made it to the Baseball Hall of Fame, you are recognized with some pretty impressive company – Martin Leibowitz and PIMCO founder William Gross – in the Fixed Income Analyst Society Hall of Fame.
Jack Malvey: It was a very unexpected and still amazing honor.
II.com: What’s the big story this year?
JM: In the global economy, capital markets, we’re celebrating the current regime. But we have these cyclical anxieties and worry about the countdown and a deceleration that some say could come as early as 2007.
II.com: What are the cyclical anxieties?
JM: First, [that some of] the election activity around the world will breed some minor balance in capital market volatility and possibly set the stage for significant shifts in capital markets and economic policy over the course of the decade. Second, geopolitical risk and commodity price expansion. And stealth inflation, which has a higher probability in the bond market.
II.com: What’s your take on the yield curve?
JM: The more interesting and somewhat bemusing anecdote from 1940 to the present, [is that] at any one time, certain parts of the curve from three months to 30 years have been inverted. In fact, 53% of the months over the last 65 years have had some period of inversion.
II.com: You started your career as a utility analyst at Moody’s rating agency, and then joined the fixed-income team at brokerage Kidder, Peabody before eventually making your way to Lehman Brothers in 1992. During your career, what has been one of your best calls?
JM: On a personal basis, the best calls professionally were to migrate from an analyst at a rating agency to a chief strategist.
In the 1980s, as the head of corporate bond research at Kidder Peabody, the chief positive calls I made were effectively to capitalize on busted utility preferreds: Gulf States Utilities, Long Island Lighting, Public Service of Indiana. During the 1990s I had some good calls on natural gas pipelines. In 1993, we ran a model portfolio and called it the holiday shopping list. We took 30 names and we outperformed our own Lehman Bond index by 600 basis points.
II.com: What was your worst call?
JM: We were very wrong in 2000, 2001 when we thought we would be in better shape by 2002. We underestimated the magnitude of the fiction that certain issuers used in terms of preparing financial statements.
II.com: What was your biggest oversight last year?
JM: We underestimated the tremendous, incredible demand for U.S. fixed income securities persisting at such a high-rate from Asia. We thought there would be some deterioration. We thought the current count deficit would begin to level off; it didn’t, it accelerated.
Also, the plan sponsor adjustment. We thought it was a strategic adjustment, but the reality was there really were institutions in 2005 who were beginning to extend duration in the derivative market and use more securities, which further tamed the U.S. curve.
Third, is the recycling of petro dollars. We thought that energy prices were vulnerable a year ago — that was one of the risks we identified. We were not at all convinced we hit the peak in 2004. Nonetheless, the peak to $70 was higher than we thought.
Last year, we were looking for dollar weakening, and got the opposite. We thought the long end of the curve would rise more than it did.
II.com: Do you expect the demand for fixed income securities to continue?
JM: Over the near term, definitively. The U.S. has higher yields. Second, there are not sufficient alternatives in magnitudes to satisfy such demand. Third, there is a political dimension.
II.com: I read that you moved to Lehman to “get your hands” on the Lehman Aggregate Bond Index. You helped launch the Lehman Global Aggregate Bond Index in 1999, which recently expanded. Where do you envision the global index?
JM: We’re trying to create a comprehensive map of the world bond market.
The take-up rate of the [global] index has superseded expectations. There’s about 14,000 securities and $22 trillion – ballpark – right now. On Jan. 1, the index [added] Taiwan and Malaysia. Last year, it included Eastern Europe – Poland, Hungary, Czech Republic. It has been an amazing ride.
II.com: Do you have any more additions planned?
JM: This year we’re adding a commodity index beginning in the second quarter; right now we’re playing with exact mechanics. We’re also adding a U.S. corporate loan index.
[Also] In the second quarter, we will launch an India Aggregate Index. Even though most investors and most of the folks that trade with us are not going to be using Chinese or Indian government bonds this year or in five years, having those indices provides us with the ability to provide standard comparison around the world; we think of these as strategic indexes.
II.com: Emerging markets have returned four-digit basis points for the last three years. What’s your opinion of emerging markets?
JM: Ambivalence. They’ve had a glorious decade, [and] some people say, ‘this time it’s different.’ This time it’s different: I heard that in 1976; I heard that in 1985; I heard that in 1993. We heard that again the late 1990s in some ways. I worry about that type mood in the market.
II.com: What about the Middle East?
JM: We do have dollar-denominated securities in the Middle Eastern indices. For instance, Lebanon, Morocco, Tunisia. Local currency is something we do give some consideration to creating a stand alone — not this year — maybe 2007, 2008. [They are] on our radar screen, these so-called Islamic bonds. It’s a unique asset class. By the end of this decade we should have some measure of these securities as well in the Lehman global family indices.
II.com: What are your predictions/recommendations for 2006?
JM: A stable world economy; a year of dollar deterioration; and [the Fed is going to] stop central banks tightening this year. Bond returns should do better than they have over the course of the last three years; we’re not looking at double digit returns, but instead of 4%, total returns should be around 5% for the U.S. bond market.
One of the stories of the second half of this year will be the encouragement of individual investors to turn to the bond market after a bit of a hiatus over the last several years, particularly the last two. In the credit markets, all credit asset classes could potentially underperform treasury securities in every major currency zone.
The high-yield market might be the exception; it will be confronted by more downgrades and increased defaults, moving up from under 2% this year to 3%. I like the securitized asset classes: very long asset backed securities, I’m 75% overweight. Very long commercial backed securities, I’m 100% overweight.