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| Robert DeLucia |
DeLucia is a senior economist and portfolio strategist at Prudential Retirement in Hartford, Conn. He helps plan strategies for $20 billion of fixed income in retirement portfolios. DeLucia started at Prudential (then CIGNA Retirement and Investment Services) in 1979 as a stock analyst before moving to fixed income in 1991.
Where are your portfolios invested?
The portfolios I'm responsible for are invested in corporate bonds, private placements, commercial mortgage-backed securities, mortgage-backed securities and asset-backed securities.
How do you think the bond market will perform this year?
I think the domestic fixed-income market could suffer its first year of negative total returns since 1994. Last year, the Lehman Brothers Aggregate Bond Index came in at 4% because the 10-year ended the year about where it started. This year, I think rates are going to be slightly higher, but enough to produce enough of a capital loss, so I don't think the risk/reward is very favorable. In 1994, the last time that happened, the [Federal Reserve] raised interest rates from 3-6%, and Treasury rates went from 5.5%-8%, an increase of about 250 basis points. The Lehman index was off by 3% in total return, one of the worst years in bond market history.
What challenges does the bond market face in 2005?
We're in a scenario right now where economic growth is slowing on a global basis. It's also slowing in the U.S. I think we'll probably get 3.5-4% growth for the fourth quarter and get a slower rate of growth for first couple of quarters for 2005.
I also see the spectacular growth in company profits slowing down. Combined with the single digit growth for 2005 and the Fed raising rates, it will be a challenging year for the bond market. I feel very strongly the current rate cycle will end sometime in the first half of next year.
Valuations are pretty rich on corporate bonds in high-grade, high-yield and emerging markets, but I think this is justified by the fundamentals. Default rates have come way down, credit quality is very high and credit risk very low. Unless we get a financial crisis of some sort, whether it's the emerging markets or a company runs into trouble, I wouldn't expect spreads to widen very dramatically.
How can portfolio managers make money in this rising-rate environment?
If your portfolio is invested in domestic-only bonds, then high-grade bonds with less default risk on a risk-adjusted basis are more attractive. In addition, I would recommend maintaining a relatively short duration: I'd rather be in the two- to three-year sector rather than the five- to 10-year sector. The second thing is that since the dollar is going to continue to decline versus other currencies, investors should invest in non-dollar fixed income. I think further weakness of the dollar is possible against Asian currencies, although not much against the euro, pound or Canadian dollar. Over a several-year period the dollar has further weakness ahead of it. Part of the weakness is based on valuation, and on a trade-weighted basis, the dollar is still overvalued. The second thing is our trade balance is still very negative and the weaker dollar is the adjustment mechanism to bring the trade account closer to balance. However, it takes a long time to change export patterns, especially when talking about a decline in the dollar.
Do you think this year will also continue the low volatility we saw last year?
This year the 10-year could trade between 4% and 4.5% or go to 4.75% for the first half of the year. Where you want to be in a stable interest-rate environment is mortgage-backed securities. Right now MBS are more attractively valued than corporates. The risk in MBS is not credit risk, it's interest-rate risk and I think interest rates in the near term are going to be relatively stable and bond yields will be in a fairly narrow range.
I think low volatility will continue because of the unlikelihood of a major change in economic conditions, because inflation is going to trend a little bit higher and the big drop in the dollar won't continue. If you believe that rates are fairly stable, then you're better off in plain vanilla pass-throughs. However, if you see more volatility on the horizon, collateralized mortgage obligation PACs are the best structured product to protect investors against changing interest rates.