High-yield bonds funds.
In the past few years, those words haven't exactly been considered sexy, especially since they're averaging about a 1% loss over the past three years. However, when you also mention predictions of 20% returns this year, it starts to sound a lot better. That's just what Barry Evans, chief fixed-income officer at
John Hancock Funds
, expects from the junk bond sector in 2001. Further out, he sees the sector turning out solid gains for the next two to three years. (If, right now, you're asking, "What's a bond again?" check out the
Investing Basics introduction to junk bonds.)
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Evans also weighs in on a host of other subjects, ranging from his belief that consumer confidence and the
are synonymous, how much the
will cut this year, and what he expects from the
in Y2K1. Read on.
TSC: After a lousy three-year stretch for high-yield bonds, are they this year's easy money?
I don't think there's ever easy money, but I do think the relatively cheap market right now is probably the value market, and the value markets in bonds are generally high yield.
Bonds really only have two gods to pray to, one is interest rates and one is credit. Regarding interest rates, most of the Treasuries are anticipating these rate cuts. So it's real hard to say you're going to make a whole lot more money there.
That really only leaves the other god, the credit god. And just looking at the
high yield index,
Global High Yield Index
, it's eight percentage points, or 800 basis points, above the Treasury, so you get eight percentage points more in credit.
Let's say all of the Fed liquidity leads to an improvement in the perception of the economy. Let's say all this monetary policy, and the fiscal policy we anticipate from a tax cut lower the market, and we tighten the credit spread
the yield difference between Treasury bonds and high yield bonds. So let's say the spread drops from eight percentage points to half that. When yields go down, bond prices go up.
That appreciation, plus your 13% income that junk bonds are presently offering, you've got a 20% return. So the appreciation from tightening the spread halfway back to the average of the past five years, plus the coupon, gives you a mathematical gift of a 20% return.
I think that's a reasonable forecast this year, to anticipate close to a 20% return on high yield indices.
TSC: How do you see high yield bonds faring further out, over the next three years?
There are two events that might help us figure out what might happen over the next three years. The first is the 1990-1991 banking recession in the U.S., when Michael Milken lost his job and Saddam Hussein got caught invading the wrong country.
All of that happened when credit spreads widened. Then you had a good run for high yield bonds. The first year coming out I think it had a 40% return. In that period, high yield ran for about 3 1/2 years.
Next, let's look at 1993 and 1994 when the Fed raised rates and the Mexican peso crisis happened. You had a good year and a half there of high yield outperformance.
What has now happened is this sort of strange period where first we had the Asia crisis in 1998, then we had the Fed raising rates and even a Middle Eastern crisis.
Now, finally, we've got the U.S. slowdown and I think you can get a good two years out of this, maybe three.
TSC: Many investors get their bond exposure through a broad index fund, like the (VTSMX) - Get Report Vanguard Total Bond Market Index fund. Those folks beat the S&P 500 handily last year; what should they expect this year?
I think you can get a return in the 9% range. It might hit 10%, but I think that's a stretch, and it's the higher end of the range.
these funds have been very nice places to be following a crisis like we're seeing now. You get the two-barreled benefit of wide credit spreads and falling interest rates, but I think the market had already rallied for a falling interest rate environment because of the buy back in Treasuries, so your return cycle on higher growth rate bonds will be a little less than in other cycles.
TSC: What do you think the S&P 500 will return this year?
Well, stock returns are kind of tough. The real problem in stocks is, since about the middle of 1997, we've had profit margins deteriorating. We've had leverage increasing, and that's been holding our return on equity kind of on a slight, upward trajectory. And return on equity is really a proxy for earnings per share growth.
I think that I can see stocks getting to a double-digit return. I can easily see that bouncing out of a bad year last year. We've already taken earnings per share growth down and there's plenty of room to move it back up later in the year.
So I can easily get earnings per share growth to around 10%. You throw in some multiple expansion because the Fed's lowered rates, and things are looking better, and that gets that return back out to maybe the mid-15s. I can't take it much further than that.
TSC: Are you one of these folks that's seeing or hoping for a gloomy first half followed by a stronger second half?
I think this is one of those years where it's very important to separate what the stock market is doing from what the economy is doing.
Why? Because we will be forecasting the benefits of a change in monetary policy, which frequently has up to a two-year lag, and of a change in fiscal policy, which sometimes has even a greater lag.
I think the economy will probably turn a lot quicker than folks think, but I don't think it will do nearly as well as most think. I think we've clearly moved into a situation where we're trying to get from a 1%-2% growth rate to maybe back up to 3%, but I don't think you'll see the 6% and 7%
GDP growth numbers we've seen before. I do think the Fed's right on here. The Fed has recognized that very strong correlation between consumer confidence, retail sales, and -- let's just say it right out -- the Nasdaq Composite.
Those three have been kind of blood brothers here. Every time I read consumer confidence, I substitute Nasdaq and retail sales.
TSC: How far down do you see rates going this year?
I think another 50 basis points will start to turn things around. I think a 150 basis point drop has a huge psychological benefit and it has a huge mathematical benefit, and I think that should prove enough when combined with the tax cut.
TSC: Your point about the correlation between the Nasdaq and consumer confidence is intriguing. With so many folks in the market, some say a cold for those markets is pneumonia for the economy. What do you think?
You know, there's probably been a role reversal here. Back when you and I were reading with textbooks, in the '50s and '60s and '70s, we used to look to the economy to see where the manufacturing-driven stocks and the largely manufacturing-based US economy would go.
And now, we look to the stocks to see where the wealth effect is impacting what is largely a service-driven economy. So there's clearly been a cause and effect reversed and I think a lot of folks struggle with that.
When Greenspan talks about inventories and consumer confidence, he's saying "I can move the Nasdaq and retail sales to get it all going again." He wants us to buy more cars.
TSC: Have you noticed rising flows to your bond funds and falling flows to your stock funds?
Oh, yeah. I mean surely, we saw investors getting a little more defensive and the first step is they just stop buying the aggressive funds. Then you start seeing the money moved from Point A to Point B.
TSC: From money market funds into the longer-term bond funds?
Yeah, And then now, what we're seeing actually very good money going to high yield and going to value stock funds. And I think that's the right place.