The co-mananger of FPA New Income fund discusses the outlook for bonds. By David Landis, Contributing Editor May 18, 2006 FPA New Income is a conservatively run bond fund even in the best of times. It hasn't lost money in any calendar year since Bob Rodriguez took it over in 1984. Several years ago, the fund (symbol FPNIX) became extremely defensive, building up cash and taking its duration (a measure of price sensitivity to interest-rate changes) down to about half a year. Normally, the fund's duration ranges from two to five years. (A duration of three means that the fund's price should increase by about 3% when yields fall by one percentage point and should fall by about 3% when yields increase by one percentage point.) The fund's cautiousness has paid off with total returns - 3.5% for one year; 3.9% annualized for three years -- near the top of the intermediate-term taxable bond fund category. Lately, the fund's defensive stance has softened somewhat. Duration is now up to 0.9 year and cash levels are significantly lower. We recently sat down with Rodriguez's co-manager, Tom Atteberry, to talk about the change. KIPLINGER'S: Back in 2003 you decided there was no value in the bond market and you declared a "buyer's strike." Are you still on strike? ATTEBERRY: We have poked our head out of the we-don't-see-value class. We're actually starting to see some value in the high-quality bond market. Toward the end of last year the Treasury Inflation-Protected Securities maturing in '07 started go down in price to the point where the real yield was 2.6%. We had had about 17% of the portfolio in this TIPS bond. We went from 17% to 40% percent in December. Our view was that with a 3% inflation rate and a 2.6% real yield, we're going to earn 5.6% for a one-year holding period in a Treasury. Looking across the spectrum of Treasuries, 5.6% is a darn nice return. So we took a lot of cash and put it to work that way. Then we got ourselves into February. The yield curve was extremely flat and everybody said the economy was going to slow. But economic activity so far this year is probably higher than people think. So we took 10% of the portfolio and bought 6.5% 30-year mortgage pools [bonds backed by home-mortgage payments]. Our view of how fast those prepay is that they have somewhere around a three-year average life. So you're earning 5.4%, 5.5% -- that's about 75 basis points [0.75 percentage point] better than the yield of a three-year Treasury. That makes sense to us. So we took more cash and put that to work. At the peak we had about 40% of the fund in cash. We're down to 19%. We continue to work it down. So we've gone from a buyer's strike to where we now are pretty comfortable with things that mature in two, three, four years. We are sitting in an open debate with ourselves about seven and ten years. We haven't decided on that yet. What would tip the scales? There are a couple of things you'd have to see. One, the market itself is arguing about whether the Federal Reserve is going to stop raising the Fed funds rate at 5% or 5.25%. So that's probably the first thing: Where does the negative sentiment carry the ten-year [Treasury note], the seven year and such? And that's an open issue at this point. We don't know what the Fed is going to do. The other issue is, does the yield curve stay flat? If we go back to March, you were looking at a difference in yield between two-year and ten-year Treasuries of anywhere from zero to minus two or three basis points. Now it's about 17, so the yield curve has gotten steeper. When it was zero, the whole yield curve was a flat line. Everyone was saying the Fed's got it under control, inflation's not a problem; I don't need to worry about inflation longer term. Now with 17 basis points, it's not a huge difference, but there's a least a minor perception change: Well, maybe inflation in the future is going to be more of a problem than we thought. So the other thing you're looking at is how steep does that curve get? The steeper it gets, the more fear there is of inflation. That could present the better opportunity to make a purchase. We're just not there yet. We've talked about Treasuries and bonds backed by government agencies. What about the corporate sector, where you're taking on more credit risk? We don't like high-yield credits. We've got a portfolio whose high yield exposure is roughly 5%. And at the end of the year it will be 4% because we've got two of them that are maturing. [He points to a chart comparing average yields.] The orange line, which is high yield, sits at about 8%. You can get 5% in a seven-year Treasury. That's 300 basis points. Historically that's the lowest it has been. Now remember, buying high-yield bonds is a lot like buying stock. But you're not getting paid like it's a stock. So we don't see any value in any of the credits. Investors have driven the price up, yield down. If you look at small- and mid-cap equities, you're looking at somewhere around a 12% long-term return. When you can get paid like that, high yield starts to look attractive to you. You get paid for the risk you're taking. When you declared your buyer's strike a while back, you said foreign bond purchasers were pushing long-term yields lower than they would be otherwise. Do you see that continuing? At this point, somebody outside the U.S. owns 49% of all outstanding Treasuries, twenty-something percent of all corporates. If they continue to accumulate in the way they have been accumulating, by 2011 they will own every Treasury. They also are going to own about 40% of corporates. That's a mathematical equation; obviously it's probably going to come out differently. But even if things stay where they are, you've got a different set of players that own half of it. Anybody who owns half of anything starts to control its price, I don't care what it is. Now you have a different set of dynamics in play. The Chinese are among the latest buyers of Treasury bonds. They're doing it because their banking system is not very good; it's immature. They say, "Well, if we bring dollars in - whether it's Treasuries or dollars bills, it doesn't make any difference -- it will add strength to our banking system. And people will want to do business with us. That's an economic reason, not total return reason. For 20 years we went through a period of generally falling interest rates and bond yields. Do you think we might be at the beginning of a new long-term period of rising rates and yields? If you look out longer term, what could be the fundamentals? We've got an aging population that is going to start to retire. By 2012, all of a sudden more money is going out of Social Security than coming in. What that means is at the margin, the federal government starts to borrow more money to pay the benefits. Demand for money is going to be increased. Europe faces that same problem to a higher degree -- its social safety net system is more institutionalized than ours. The Japanese government faces the same problem. It has an older population. So if the demand for borrowing increases on a global scale, why wouldn't the cost of it increase? That's not something that happens tomorrow. It happens a little more each year. But if you're thinking in terms of 20 and 30 years, it is a secular shift that is going on. That is a reasonable conclusion to come to.