Vanguard, Eaton Vance chart diverging paths on interest rate risk

The investment management industry is divided on just how devastating the impending rise of interest rates will be on bond portfolios.
Managers from across the business weighed in Wednesday as investors turned their focus to a gathering of central bank leaders in Jackson Hole, Wyo., that gets underway Thursday.
The Federal Reserve has been keeping interest rates low in an effort to encourage companies to invest, leaving bond investors searching for ways to enhance reduced returns without increasing risk. But as economic growth picks up, the easy-money policy is likely to be tightened.
Two investment firms on opposite sides of the issue illustrate the broader industry divide.
On one side is the Vanguard Group Inc., which last month became the world’s largest bond fund manager, and believes that traditional diversification of bond portfolios is likely to sustain their value for investors.
On the other are benchmark-busting bond buyers like Kathleen C. Gaffney, former right-hand manager to Loomis Sayles & Co.’s Dan Fuss. Ms. Gaffney said Wednesday that corporate debt is overvalued, with investors having taken on additional risk to juice returns. When rates rise, “it’s going to be a problem for the traditional credit markets because they’ve actually taken on a lot more rate risk than they normally would at this juncture in the cycle.”
The managers are on opposite sides of an debate about the utility of investors’ delegating to fund managers the ability to make a wide variety of choices about where to invest, how much bond duration to take on and how much credit risk to exploit.
Investors willing to do so have turned in droves to “go anywhere” funds, including Ms. Gaffney’s Eaton Vance Bond Fund (EVBAX), which can invest in stocks and all manner of bond markets. Over the last year, the funds have attracted nearly $53 billion, according to Lipper Inc.
IN VOGUE
“Multisector is definitely becoming very much in vogue,” Ms. Gaffney said. “The classic benchmark … is not where investors want to be.”
But Gregory Davis, who took over Vanguard’s fixed-income group from firm veteran Robert F. Auwaerter earlier this year, said his team, which manages $594 billion in bond funds and ETFs, sees little value in the “go anywhere” bonds.
“A lot of it is a bit of marketing hype from the standpoint that people have been concerned that rates were going to rise and this was a nice way to say, ‘Don’t worry about rising rates,’” Mr. Davis said. “They haven’t been around long enough to assess how enduring their strategies are and how good they are at making those types of calls.”
Mr. Davis is of the view that the market has already priced in the risk of interest rates rising, with a yield curve that slopes upward, increasing in value from the present to the future. (Yields move inversely to prices.)
He believes that investors should pick a duration that fits with the time horizon of their investments, avoiding longer durations if they have a short time horizon, for example. In the meantime, as rates rise, bond investors can reinvest the interest they earn at the higher rates offered by the market.
“For most investors, a broadly diversified intermediate-term bond fund is going to be a nice diversifier and, over time, a solid income producer for them,” Mr. Davis said.
Ms. Gaffney is among the investors who believe that prices on corporate bonds are too high, given the risks entailed, including interest rates, but also credit and liquidity. She has been buying commodity-related debt, bonds in selected emerging markets such as India and Mexico, as well as bank loans, municipal debt and convertible bonds.
“Traditional credit markets are extremely overvalued … they are more than due for a re-pricing,” she said.
Ms. Gaffney started the Eaton Vance Bond Fund in January 2013. The fund, which can go almost anywhere in search for return, has grown to $1.4 billion in assets. The fund’s institutional share class returned 17.25% over the 12-month period ended Aug. 19, putting it in the top 1% of funds in its category, which returned 8.36% on average, according to Morningstar Inc.
She hopes to deliver 6% to 7% annual returns to her investors, taking on additional volatility to do so, compared with significantly lower returns and increased volatility for “traditional fixed income.”