Markets still underpricing risk

By Steven C. Johnson

NEW YORK (Reuters) - Financial markets are still underpricing risk, and investors who neglect to diversify their portfolios may get burned, three leading fixed-income and equity portfolio managers said.

Despite a recent surge in U.S. government bond yields that some have ascribed to rising risk aversion, "too many people think risk is dead, that they can't lose money anymore," Tom Metzold, who runs the Eaton Vance Municipals Fund, said on Monday night at the Reuters Investment Outlook Summit in New York.

With spreads on junk bonds and emerging market debt at record tight levels, Metzold said he has steadily upgraded the credit quality of bonds in which the fund invests -- even to the point where it has slightly underperformed some competitors.

"We're selling stuff that (others) continue to buy and it narrows in spread even further, but the spread can't go to zero," he said. "There has to be some spread between a triple-A and single-B security."

As long as investors have not lost money, he said, they continue to buy questionable credit quality instruments, further tightening credit spreads. "But that usually ends very badly," he said.

Dan Fuss, who runs the $10.2 billion Loomis Sayles Bond fund, conceded that he has "never been as nervous about a market as I am now, specifically the credit market."

He said stress may come first to the loan market, which along with U.S. high-grade and junk bond markets, soared to record levels last year as private equity firms acquired companies using debt.

Low interest rates and abundant liquidity has contributed to a high risk appetite among investors in recent years, and asset classes from emerging market stocks to high-yield U.S. debt and loans have soared.

But Chris Orndorff, who oversees $50 billion in assets at Payden & Rygel Investment Management, said emerging market stocks continue to look attractive thanks to the developing countries' rising share of world economic activity.

"What we're seeing is not so much risk as a transformation of these markets," he said, adding that developing countries account for 45 percent of world economic activity today, up from around 10 percent in the 1970s.

CHINESE RISKS

Assets in China, however, are a different story. Orndorff said that by keeping its currency, the yuan, undervalued against the dollar, China runs the risk of inflating asset bubbles that could destabilize the economy.

"They've got some real issues, and if they don't start to let the currency appreciate, they will have a real asset bubble, not just in land but in stocks," he said.

To keep the yuan down, China's central bank has to buy a lot of dollars, and that's caused its currency reserves to swell to $1.2 trillion.

He said a growing money supply in China tends to be connected to stock market gains, while slower money supply growth coincides with slower stock gains.  Continued...