Eaton Vance's Gaffney: Why bonds have become riskier

Investors reaching for yield have turned to investment grade and high-yield bonds, but the rate risk those investments involve could lead to a loss of principal, according to Kathleen Gaffney, portfolio manager at Eaton Vance Bond Fund.

[MUSIC] This week on Wealthtrack, an investment world turned upside down. Eton Vance's great bond investor Kathleen Gaffney explains why bonds have become the riskier investment, and stocks the safer one. Her unusual strategy for generating capital gains and income is next on Consuelo Mack Wealthtrack. The low interest rate environment that we've had, has really had an impact on the financial markets. What is the impact it's had on the bond markets? It's had a big impact. Because most people think of bonds, it's fixed income. Yes. Where do you go to get your income. You go to bond market, but treasuries yielding 1% or 2%, that doesn't get you very far. So investors have been reaching for yield going into the traditional credit markets. So investment grade, high yield bonds, that's a way to pick up yield. Get that income coming in, but there's a trap there because rather than being credits, companies, your taking on rate risk because it all boils down to what's your coupon, what's your maturity, and if rates start to rise, they're going to adjust. By prices going down. Therefore, if, unless you hold bonds until maturity, that you're gonna suffer a loss of principal. Yes. And that's gonna hurt a lot of investors. You have been managing the Eaton Vance bond fund since January of 2013, you launched it. And you've managed to negotiate all these land mines very successfully, I might add. So, so, what have, what have you been doing in the last, you know, year plus? Focusing on company fundamentals. Because the fundamentals are positive, I believe. Mm-hm. Lots of companies generating good cash flow. It's a question of valuations. Where are there more attractive valuations? To be honest, I think it's closer to equities. And that's why with Eaton Vance bond fund we do have flexibility to use equities. And I'm thinking of those positions. As great alternatives to expensive and potentially negative return generating securities as a good alternative to those types of bonds. Of course, traditionally, the, the bond market has been considered to be less volatile and as you just said, it's considered to be a, you know, kind of a volatility dampener in your portfolio. And it's been considered to be an income vehicle, and kinda stodgy and boring but reliable. And stocks have been the high risk asset because there's no, you know, there's no underline kind of floor on how low a stock price can be. Has that dynamic changed, do you think? I think it's changed very much. Really. A great example in the market today. Would be Caterpillar, so well know solid company the equity paid two and half percent in terms of its dividends yield. You look at where Caterpillar bonds are trading at comparable yields but with significant downside risk. When rates rise. Caterpillar has been issuing bonds recently. They've actually tapped the market with 50 year maturity bonds. Which is incredible to me. That's very unusual in the U.S. corporate bond market. There's a lot of demand for long dated bonds. It's a great deal for Caterpillar. Mm-hm. But not for those bond holders. If their turn to maturity is less than 50 years. So I would rather own the equity with a dividend yield of two and half percent and capture the upside because the valuation is more attractive. Valuations in the traditional credit markets are extremely over valued. Talk to me about liquidity in the bond market. I can remember talking to you when you were at Luma Sales during the financial crisis, and the fact that liquidity had completely dried up in the bond market which was really unprecedented in, in our lifetimes. What's the liquidity situation now? The ability to buy and sell, you know, bonds in volume. It's, it's been reduced significantly. And why is that? Well, it, it's human nature. We had a terrible event with the financial crisis in 08. So the regulators were committed to correcting it but as we all know from history sometimes what you do to make a correction feeds a new problem. Right, law of unintended consequences. Exactly, and what's happened is that with financial regulation, broker dealers, Wall Street has pulled capital. The capital that really made it easy for investors of different kinds, to buy and sell. Mm-hm. To stand in the middle and make markets. Because they are committing less capital, 2007, 200 billion and today inventory on the street is running around 40 to 50 billion. Oh, my goodness, that is a tremendous drop! So it makes it very difficult to trade. [MUSIC]

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