Deutsche private wealth unit likes junk, emerging markets; less sold on 'classic' fixed income

By Paul Deckelman

New York, July 20 - Deutsche Bank Trust Co. Americas - Private Wealth Management - the unit of the German financial giant Deutsche Bank AG that manages money for wealthy North American individuals, their families and for select institutions worldwide - said that fixed-income investors will find much to like in some decidedly non-traditional areas including high-yield bonds and local-currency debt from emerging market issuers.

At the same time, it is taking a more reserved view toward what one of its top executives called "classic fixed income," such as investment-grade corporate bonds and U.S. Treasury issues. However, while the latter's attractiveness is constrained by the relatively low yields investors can reap, Deutsche Bank's experts believe it is still the world's premier "safe haven" investment and that the current Washington debt ceiling imbroglio that has threatened Treasuries' AAA rating will be resolved, as will the debt and spending problems weakening Greece and other European countries.

High yield is 'interesting'

During a briefing for the financial media on Wednesday, Benjamin A. Pace III, chief investment officer for Deutsche Bank Private Wealth Management in the United States, said that high yield is one of the asset classes that is "interesting to us."

He noted that junk bond spreads are now averaging north of 550 basis points over Treasuries, "so we think that with default rates being as low as they're expected to be, that's a reasonably good asset class."

His assessment was echoed by the company's head of fixed income trading and research, Gary R. Pollack, who declared that "high yield is cheap, relative to Treasuries. You're getting a lot of extra yield in the meantime while you wait. In corporate America, credit quality is actually improving."

Addressing the phenomenon of investment-grade investors looking for a little extra yield by venturing beyond traditional high-grade credits and buying split-rated issues, or even purely junk BB credits, Pollack said that "with rates low and improving corporate balance sheets, I think that the upper range of the high-yield space is an attractive asset class for fixed-income investors looking for yield and also possible upgrades eventually to investment grade."

Emerging markets intriguing

Pace also said that emerging market debt "is very interesting to us here, mainly in local currencies - we want the currency impact. But we're also looking at - with the [spread] tightening being over - extending duration" to get a little more bang for investors' bucks.

He explained that in the past, PWM, in structuring client's portfolios to include emerging market debt, had always favored "really short duration because the short-term interest rates are good in these countries. It's not like the 0% in the United States" where the shortest Treasuries trade.

He also noted that PWM "didn't want to get hurt by the fact that the yield curve could shift up based on the strength of these economies and the inflationary implications," but he added that "now that that's less of a concern, we're willing to go out a little bit more in the duration."

Pace said that in putting together an ideal balanced portfolio for an investor split 50-50 between equity and fixed income, he would allocate roughly 5% apiece for U.S. high-yield bonds and emerging market paper, or 10% total, translating into one-fifth of the fixed-income component of the overall portfolio.

The rest, he said, would be in intermediate-duration "traditional bonds," which could include such categories as Treasuries, investment-grade bonds or, especially for taxable investors, municipals.

Pace said that generally, "we've been cautious in counseling our clients that it's dangerous to stretch for yield by extending duration risk by going out on the yield curve. You probably would be better off by reducing credit quality. That just means not going all to junk, although we do have a high-yield weighting, but going from Treasuries to investment-grade corporates, maybe going down from an AA to a single-A. You'll probably do better, and it will be less risky for you doing that."

'Traditional' less favored

Right now, though, rather than favoring the kind of hypothetical 50-50 balanced portfolio that Pace described, PWM is giving precedence to equities over fixed income generally, with particular emphasis on stocks of large-cap U.S. issuers, emerging markets and, quite recently, Japanese companies. Pace noted that the nuclear crisis fears associated with this spring's disastrous earthquake and tsunami there have been largely resolved and the nation is in a rebuilding mode, which tends to favor equities of companies involved in the reconstruction efforts or their suppliers.

That emphasis on equities has, at least for the moment, pushed aside what he called "classic fixed income," which PWM has decided to underweight for now. Pace cited concerns about what economists term the "crowding-out effect" on private borrowers arising from increased government spending and borrowing.

He said that just a few years ago, PWM had "skewed our portfolios toward investment-grade debt and away from Treasury debt, with the thought being that you had debt strengthen in U.S. corporations for the most part. Spreads were really attractive a couple of years ago - you can argue that was a once-in-a-lifetime buying opportunity of solid non-financial investment-grade debt."

For instance, he noted, debt issued at that time by corporate bellwether International Business Machines Corp. was pricing at 325 bps over Treasuries, while Cisco Systems Inc. was at 250 bps over, "and we're talking about companies that make things, as opposed to financial companies." Now, Pace said, "it's probably more fair value." He said that non-financial investment-grade spreads "have come down so much that they're not really a classic buying opportunity."

As for the high-grade financials, Deutsche Bank is cautious on them from both an equity and a debt standpoint. Owen Fitzpatrick, a managing director at DWS Investments and head of the institutional U.S. large cap and small cap equity teams, told the briefing that the sector - already suffering from higher operating costs in a more heavily regulated environment in the wake of the financial crisis of the past few years - "is going through a re-valuation" based on its lessened ability to grow, a key factor in his decision to underweight those stocks.

As for the bonds of such companies, Pace cautioned that "you have to be a little careful about skewing your weighting too much towards financials in the investment-grade space because you can probably argue that those spreads are warranted, based on concerns as far as strength in the balance sheet, that the capital is going to have to continue to be raised.

"We're not that worried about U.S. financials from a cratering standpoint, but I think those spreads are adequate."

Treasuries lag behind

Looking at Treasuries, despite their perceived safety, Pace sees the asset class producing little in the way of return for investors. He described the government paper as "bonds that could have flat price movement, that will give you the 3% return on 10-year Treasury. Or worse yet, in this environment of 'crowding out,' with the big fiscal deficit and interest rates that go up, if they do go up 50 or 60 basis points, that could give you negative returns."

He said that compared to those kind of returns and the zero-percent return from holding cash, even the kind of high single-digit returns that PWM is projecting for equities this year looks good, "especially in this low-inflation environment."

Debt crisis will be solved

While Treasuries are out of favor because of their relatively low yields, the PWM advisers absolutely believe that the current Washington standoff over raising the federal debt ceiling and cutting the bloated deficit - and how to do it - should have little impact on the U.S. paper, despite scary-sounding headlines warning of a possible Aug. 2 default or ratings agency downgrade.

Pollock, for instance, asserted, "I know that the ratings agencies have their metrics that they must conform to, but at the end of the day, the United States of America is the world's only superpower. It is the world's largest economy, its currency is the reserve currency, and any time there is any concern globally about anything, there's one flight, and that's the flight to quality."

He called that tendency "a fundamental force of nature. There are four forces of nature: gravity, electromagnetism, the weak force [of atomic interaction] and the strong force. Here's a fifth force: the 'safe haven force.' And the United States still benefits from it."

Fitzpatrick said it might seem that progress toward solving the debt and deficit situation is maddeningly slow, especially when compared to the relatively quicker way that solutions were found to past debt events that threatened the financial markets, such as the Latin American debt woes of the mid-1980s and from the 1990s, the savings-and-loan debacle resolved by the Resolution Trust Corp. and the collapse of Long-Term Capital Management.

But he said that "I think we will get there. ... I think we're seeing the issue to some extent get resolved," although he acknowledged that "it doesn't feel like it, when you look at the back and forth between the two parties."

He said that "in essence, when you take a step back and look at what's going on here in the U.S. in the last year, the last 12 months," progress has been made, citing the way many state governments with out-of-control spending problems have managed to get on top of them. "So it is occurring - it's occurring even within the federal government. When you look at both parties now, they're getting a lot closer. Both are talking about some type of cuts, in terms of austerity measures, and most likely some type of reformatting of the revenue base in terms of the tax code."

Taking a longer view, Fitzpatrick said that if we were to project three years down the line, "I would be very surprised if the U.S. issues aren't resolved in the next couple of weeks." He said the same holds true for the thorny debt problems in Europe with the weak economies of Greece and other struggling countries like Portugal and Ireland. "I think we're getting a lot closer to a resolution in terms of having to ring-fence these debt issues and extract them so they don't fall over and hit all the other markets. We've seen that in every instance where we've had credit issues in the past, they were able to rapidly get it done. Here, obviously it's taking a lot longer."

"We think that with default rates being as low as they're expected to be, [high-yield debt] is a reasonably good asset class." - Benjamin A. Pace III, Chief Investment Officer for Deutsche Bank Private Wealth Management in the United States

"I know that the ratings agencies have their metrics that they must conform to, but at the end of the day, the United States of America is the world's only superpower." - Gary R. Pollack, Head, Fixed-Income Trading and Research at Deutsche Bank Private Wealth Management

"I think we will get there. ... I think we're seeing the [U.S. debt ceiling and deficit] issue to some extent get resolved." - Owen Fitzpatrick, a Managing Director at DWS Investments, head of the Institutional U.S. Large Cap and Small Cap Equity teams

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