Market participants have been closely following everything related to the change in the Fed’s leadership over the recent past. Kevin Cronin, chief investment officer, fixed income, at Putnam Investments is among those investment professionals that have been preparing for the transition period we are about to witness.
“It’s been a long time since we had a new Fed chairman. I am probably the only one in the bond area old enough to remember Paul Volcker,” Mr Cronin jokes. “During the transition from Volcker to Greenspan there was a lot of market volatility. We had the market crash in 1987 and all of the trouble in the equity markets as people questioned the Fed’s management situation.”
Market tests
Mr Cronin comments that Mr Bernanke was the market’s preferred choice over the two other main candidates Martin Feldstein and Glenn Hubbard. However, this does not mean we will see volatility in the markets over the near future. “We do think the market is going to test Mr Bernanke over the coming months,” he says.
For Mr Cronin, who looks after some $66bn (€56.2bn) of fixed income assets under management – representing a third of Putnam’s total assets under management – Mr Greenspan’s contribution over the last two decades has resulted in higher levels of confidence within financial markets, raising the credibility of central banks globally. “People have now greater confidence that coordinated central banks intervention can lead to robust economic growth and low inflation.”
Apart from the appointment of a new chairman for the Fed, Mr Cronin says that the consequences of the recent hurricanes in the Gulf region and the war in Iraq are precipitating higher inflation in the US which would mean the Fed is likely to continue with its tightening cycle. “The massive reconstruction needed will take several years, which will be economically stimulative but also will contribute to a worsening of the US budget deficit,” Mr Cronin comments.
The current pressure on US interest rates has been translated into changes in investment strategies for Putnam. “We have been more favourably disposed to non-US investments over the last 15 months. Europe is well behind the US in both the economic and the monetary tightening cycle and we think that what is going on in the US and in Japan is likely to push interest rates higher globally.”
On the strength of this view, Putnam has generally been defensively positioned both from an interest rate and a credit standpoint.
“We are more favourably disposed to investment grade bonds and European high yield because we think there is less upward pressure on rates in Europe.”
In order to develop new products and strategies suitable for the different needs of investors across the world, Mr Cronin’s Boston-based team is divided into five different units, including a high yield division based in London to cover the European market.
“Then we have a portfolio construction team that is responsible for deciding how much we have in mortgages or government versus high yield and so on. This team is also responsible for making sure that the level of risks that we have in our portfolios is commensurate with the environment that we envisage and the opportunities that we see in the market place.”
Confirming current interest in further developing its capabilities in European high yield, Putnam has just announced the appointment of two new analysts to work in this area. The new employees will be part of the Putnam New Flag team, formed in 2002 after the acquisition of London-based New Flag Asset Management, one of the first dedicated European high yield bond managers.
In the US, and for investors who are concerned about interest rates, Mr Cronin’s team has been working on offering them short-duration products that seek to generate excess return and that hedge against that duration. “In addition, we are seeing an increasing demand for floating rate and credit products,” he adds. “In Europe and Asia we are also seeing more interest in bank loan products and we are launching a floating rate bank loan in Japan in November.”
Mr Cronin says that one of the reasons why they’ve become more defensively positioned is that there is currently a lot of leverage in the credit markets, with spreads narrowing versus government bonds. “This has been precipitated by over weightings in the credit market but also by a dramatic increase in hedge fund activity in this market with the advent of credit default swaps – CDS and other derivative products.”
Changes in the way corporations work have not always benefited bond holders as Mr Cronin explains. Over the recent past corporates have been working hard to repair their balance sheets in a way that was more shareholder friendly. “So we are seeing more leverage being applied to balance sheets with more companies exploring strategic options or selling private equity to investors. All this is helpful to the recovery of equity returns at the expense of bond holders which means in general we have become more wary of credit in the US.”
Robust growth
Outside the US and in the emerging market debt area, Mr Cronin comments that the underlying economic fundamentals for some of these countries should remain strong. Robust economic growth and moderate inflation added to high commodity prices is set to benefit countries such as Brazil, Venezuela, Mexico and Russia, where credit quality is clearly improving and valuations are getting to more of a fair value now.
“We have been overweighting higher quality markets like Mexico and Russia. The run up in energy prices has benefited both countries since they are both exporters of oil. Russia is a more economically stable country now than it was a few years ago although there are still some political challenges.” On the other hand, two countries Putnam has been largely avoiding due to lack of political stability are Turkey and Venezuela.
In the same way that investment opportunities across the world change all the time, investors’ appetite towards fixed income investment vehicles is also continuously evolving and becoming more diversified.
“It really depends on the region and on the underlying investors. We continue to see Asian investors putting in a lot of money and we think that’s largely a consequence of the poor equity returns in Japan,” he says adding that in the Asian region the demand for fixed income is mainly coming from Japan, Taiwan and Singapore, with Australian investors asking for more aggressive investment vehicles.
“In Europe, we see a change in what people want from their fixed income portfolios. In the UK there is a lot of concern about asset liability matching so we see the demand for specialist, longer duration mandates trying to achieve long gilts plus 100 to 300 basis points of excess return,” he explains. Hedge fund strategies, he adds, are also more accepted by UK and French investors than US pension funds.
“It is growing in the US, but the UK has more of an equity mentality and they’ve been more willing to embrace hedge fund strategies than the more traditional US mandates,” Mr Cronin comments. He says that in the US more investors are now asking for longer duration liability matching strategies, something that UK investors have been doing for the last three or four years.
The use of longer-duration bonds is likely to become more popular as more governments go ahead with the issuance of new notes, which for Mr Cronin is a strategy that makes perfect sense.
Lock in debt
“We are close to a 30 or 40-year low in interest rates and we think it makes economic sense for governments to lock in long-term debt as a way of being fiscally responsible in terms of managing their debt supply. In addition, with an ageing population and the underfunding of pension funds, there is a greater demand for longer duration instruments.”
Mr Cronin says that he was really surprised when four years ago the Bush administration decided to eliminate the government’s 30-year bond. “We think that was a politically-motivated and short-sighted decision. Somehow the Bush administration decided to let US citizens believe that the budget deficit was a temporary phenomenon.” Mr Cronin describes as very positive the fact that the treasury has finally decided to resume the sale of 30-year bonds starting in February next year, saying he is certain it will attract strong demand from investors.
KEVIN CRONIN: THE MAKING OF A CIO
MBA from the E. Carrol School of Management, Boston College
1988: Joins Liberty Mutual Insurance Company as an analyst. In 1991 he becomes a portfolio manager for the firm.
1993: Joins MFS Investment Management as vice president and portfolio manager.
1997: Joins Putnam Investments as leader of the mortgage team.
2001: Following a series of promotions, he is appointed as CIO of Putnam’s fixed income team.
