Merrill Lynch guru bonds with investors

A select group of investors leaned forward from plush leather chairs as bond guru Martin Mauro from Bank of America Merrill Lynch shared his global view of the gripping question the drew them to the Canoe Club in Whitefish on a recent sunny evening.

What should a fixed-income investor do for a better income with today’s anemic interest yields?

His answer offered no magic bullets but a bond buying game plan including extending maturities, moving down in credit quality, looking outside the United State and accepting some uncertainty about when principal returns.

Mauro acknowledged that people may not want to make these moves, but said staying in cash pays virtually nothing while losing ground to the 3 percent rate of inflation.

“For investors, it’s tough. For retired people, it’s tough,” Mauro said. “I speak to people in this situation all the time. They retired and they expected to live off the income that they generate from their portfolio. They were thinking of a 5 or 6 percent income return per year. We’re not seeing anything close to that.”

The managing director and fixed income strategist for Global Wealth Management at Merrill Lynch, Mauro backs up his recommendations with a doctorate in economics from Cornell University and 30 years of experience including working for the Federal Reserve Bank of New York and flying around the world advising clients on bond strategy.

His visit to Kalispell reflected the success of this  Merrill Lynch office as the Associate Office of the Year in the Utah Intermountain Complex. Mauro spoke informally but with the authority of a seasoned professional.

He began by reviewing why the country fell into this protracted cycle of slow economic growth compared to other economic cycles.  

“The big difference is we are going through a de-leveraging — a debt deflation,” Mauro said. “It’s called by difference names but it’s really the outgrowth, the repercussions of the enormous buildup in debt that the U.S. economy has had since the late 1970s.”

This included housing mortgage debt, credit card debt, local, state and federal government debt and obligations.

He said that now debt has begun to shrink, personal savings have gone from zero to three or four percent and governments have cut back spending.

Mauro called these things positive but pointed out that they bring economic pain in reduced spending by consumers and layoffs of 650,000 people in the public sector.

According to Mauro, the debt deflation began in 2007 and continues.

“History tells us it can take a long time. It can take 10 years for debt deflation to work its way through,” he said. “We’re a few years into it and we probably have a few years more.”

To battle a recession, Mauro said the Federal Reserve set interest rates at zero and purchased Treasury notes, bringing rates to historic lows of below 2 percent for the 10-year rate and about 3 1/4 percent for the 30-year rate. Large reserves were pumped into the banks to stimulate credit expansion, but a large amount of reserves stayed in the banks.

Mauro said banks facing tougher regulation tightened up lending criteria and people, saddled with too much debt, did not want to borrow.

“The bottom line is that the Fed is pushing all these reserves into the system and it’s not having the effect that textbooks tell us it should have and it’s not having the effect that history tells us it typically has,” he said. “Again, this is all part of the debt deflation. So, it’s a problem that’s going to be with us for a while. At some point, the economy is going to get better. I think it’s a few years away.”

Mauro bases his forecast on the Fed’s forecast of short-term rates not rising at least through 2014. To find better returns to offsets low rates, he recommend extending maturities, but not for too long.

“What I think is the happy medium — the place to go to get better yield without taking on an undue amount of price risk — I think is around five- to 10-year maturity rate,” he said. “Another way is to move down in credit quality.”

With the Federal Reserve and foreign central banks artificially keeping Treasury rates so low, Mauro recommends conservative investors move into investment-grade corporate bonds that yield about 3 1/2 percent for the most highly rated and about 4 percent for triple B, the lowest category.

“I think that below investment grade, the high-yield world is good place to be with a portion of your portfolio,” he said. “Not the portion that you need to be sure of being able to preserve your capital.”

Below investment grade pays about 7 percent but brings credit risk.

Mauro also discussed investment options outside the United States in emerging markets. He broke these into dollar-denominated debt, which eliminates currency fluctuation risk, and local currency debt, which can work for the investor if it strengthens against the dollar or against if it weakens.

Dollar-denominated debt (Brazil, Mexico) has an average yield of 5 percent compared to local currency debt that pays an average of 6 percent. Mauro said local currency has less credit risk but carries the currency fluctuation risk.

“This is not for people in the conservative category,” he said. “How much you put in there depends on your tolerance for risk.”

His third recommendation was to look at products such as mortgage-backed securities where the issuer has the option to call the bond (order it to be paid back) when it suits his purpose. Mauro said these are not the structured products that failed in 2008-09 but securities such as Fannie Mae.

“You get a little bit of yield pickup over Treasury securities,” he said. “The only disadvantage of those things is you don’t know when your principal will be returned. It depends on when the homeowners prepay on their mortgages.”

Mauro also discussed preferred securities that pay in the range of 6 percent but the issuer may call them in five years, reducing yields to 2 or 3 percent.

“That’s better than you would get with a Treasury security — an attractive spread but you have to be willing to accept uncertainty about when you get your money back, when the security will be called,” he said.

Mauro advised higher-income-bracket investors to look at municipal bonds, adding the federal tax saved to the interest earned even with state taxes paid on bonds issued outside Montana. He said a few municipalities have credit concerns.

 Mauro said the default rate for investment grade municipal bonds remains below one-tenth of a percent but investors still need to exercise caution.

“Even though everything has been very calm with respect to municipal default, I don’t think you can completely rule out the possibility that there could be trouble with municipalities,” he said.

Dan Short, manager of the Kalispell office, said Merrill Lynch recommends that moderate-risk-profile investors allocate 60 percent of their portfolio to stocks, 5 percent to cash, 35 percent of their portfolio to bonds with 13 percent in treasuries and CDs, 9 percent in mortgage-backed securities, 9 investment grade corporate and preferred securities, 2 percent in high yield (below investment grade) and 2 percent in international bonds.

 Reporter Candace Chase may be reached at 758-4436 or by email at cchase@dailyinterlake.com.