Bonds, Bernanke, and Beyond

{Q} Seven out of the last 10 times when the Fed has gone through a tightening process, the yield curve has inverted—in other words, short-term interest rates have become higher than long-term rates, presaging a recession. Are you worried about that?

{A} There is a risk for inversion, but I don’t see any inversion being deep or protracted. It doesn’t seem like the market condition needed to sustain a deep and protracted inversion is around. While global liquidity remains high, we’ve seen, and will continue to see, a moderation in buyers’ willingness to pay any price for yield.

Another potential condition that could drive an inversion is aggressive pension reform that forces corporations to sell stocks and invest in long-maturity bonds, which would further drive down yields and increase prices. I think we’ll get pension reform legislation in ’06, but I think it will be modest and phased in over a number of years. Finally, if you look at prior experiences of inversion, overall rate levels were much higher; it’s tough to extrapolate from those past experiences.

{Q} Do you think the bond market will price itself any differently given Mr. Bernanke’s expressed interest in specific inflation targets?

{A} I think that inflation targets could result in even lower volatility. To the degree that he is able to start targeting inflation, that increases the level of communication to markets, which would give the markets more certainty about the direction of prices. Certainty lowers risk.

{Q} What does this all this mean for investors and for your portfolio in particular?

{A} I think the curve stays flat into the end of tightening. Rates should head higher. The Fed’s confidence in the fundamental resilience of the economy has been validated. Combine that with their nervousness about inflation expectations, and we think the Fed has more work to do. Setting aside inflation targeting, you could make a case for higher volatility in ’06. Bernanke is not an unknown entity, but he is less well known than Greenspan. Second, you are replacing what has been called Greenspan’s benevolent dictatorship with 12 voices on the FOMC [Federal Open Market Committee, which sets interest rates] and potentially more public airing of those views, and that could cause some consternation for the market.

{Q} The Morningstar service gives your fund a very respectable four out of five stars. But you experienced a significant drop in your net asset value a couple years ago, where the net asset value of your fund dropped from above $10 to $8 a share or so. What happened there?

{A} The fund had a significant capital gains event when it was converted from what we call a common fund into a mutual fund. That one-time payout to shareholders of the previous fund resulted in a drop in the overall net asset value of the fund. The actual performance of the fund, however, has been steady over the entire existence of the fund.

{Q} So you anticipate that bond prices are going to go down, correct? Shouldn’t a person pull their money out of the bond market and put it in a money market fund?

{A} You could argue that. But the lessons of ’04 and ’05 tell us that rates can stay relatively stable, and it can be hard for investors to time the peak of market yields. And for ’06, we’re not looking for rates to be markedly higher. Our call for the 10-year treasury is maybe a half of a percentage point higher.