Player:
Media Manager
Video ID:
15130
Video ID:
54071d28140ba076618b45be
Basic Info
Video Image:
Description:
Today’s bond markets offer neither the security of stable rates nor high enough yield, in some investors’ minds, to compensate for the risks they face. The result: a search for new flexible approaches to the asset class, unconstrained by traditional investment categories and benchmarks. Three fixed-income experts at Brandywine Global explain how their firm’s longstanding flexible approach, which includes non-U.S. securities, could potentially benefit investors.
David Hoffman, Managing Director & Portfolio Manager
Gary Herbert, Portfolio Manager
Richard Lawrence, Senior Vice President & Portfolio Manager
Duration:
00:56:20
Transcript:
Evan Cooper: Welcome. I'm Evan Cooper, and in today's Masterclass, we'll be discussing today's fixed income markets and the case for a flexible approach to investing in fixed income securities. With us to shed light on the subject are three fixed income experts from Brandywine Global Investment Management. They are Richard Lawrence, Senior Vice President, Portfolio Manager, who focuses on portfolio implementation; Gary Herbert, Portfolio Manager who focuses on the credit markets, and David Hoffman, Managing Director and currently Chair of Brandywine's Executive Board, as well as Co Lead Portfolio Manager for the firm's Global Fixed Income and Related Strategies. Welcome, gentlemen.
The fixed income market continues to act in a bull headed way, in both senses of the term. Interest rates, despite everyone's predictions to the contrary, keep on remaining steady or even falling, and the market continues to charge ahead.
Where does the fixed income market stand, and what should investors do? We have three experts, today, with us who will help give us some insights. Richard, let's start with you. Where are fixed income markets today? Richard, tell us where fixed income markets are today, and are they riskier than they were before?
Richard Lawrence: They're not necessarily riskier than they were before. That really depends on your perspective. They're complicated. When people talk about the fixed income market, they tend to talk a lot about the US fixed income market.
The US fixed income market is at a very interesting potential inflection point. It's been pretty much on a one way ride for the last 20 years, with yields declining. People recognize that we're at a point, now, in the cycle where we may start to see yields rising in a fairly secular nature, in the US.
It's important to point out when we at Brandywine like to talk about the fixed income markets, we always have a global perspective. That probably is what differentiates us a little bit from some other fixed income participants in the marketplace.
We've been managing fixed income for about 22 years, and it has always been with a global focus. When we talk about the fixed income markets, we're not talking exclusively about what's going on in the US, we're talking about 30, 40 markets around the world. We don't think there's any shortage of opportunities around the world, in fixed income, right now.
Evan: We'll go into some, but not all 30 or 40 of them. David, give us your view of where things stand today.
David Hoffman: Unlike a lot of people who have been in the press and things, we have not been bearish on bonds, but we are getting slightly more cautious. We think the artificial yield curves of the last five years since the financial crisis have kept rates at zero, but the central bank credit expansion that has taken place is just potential credit.
People have feared that it's going to lead to rapid inflation, but in fact, there's very little borrowing. It has not led to inflation. In fact, the majority of the developed world is in a very low inflation situation.
This year, we had long duration, and we're beginning to pare it back slightly. Less pessimistic than a lot of people, although I think it's going to get very interesting as the yield curve begins to normalize at some point in the next year or two.
Evan: Gary, what's your view?
Gary Herbert: I'll look at it from a credit perspective. Our view is that there are some interesting dynamics occurring, currently, in the marketplace. The broad based theme is disintermediation.
From a credit perspective, there are a lot of opportunities, particularly in markets like Europe and in Asia and even some Latin American economies. The traditional bank lending channels are broken, or bank balance sheets have had to de lever because of the global financial crisis.
It's created an opportunity to find value in distinct pockets of the credit markets around the world. It really plays on the global expertise that our organization has, that the firm has. Whether you take that risk in a particular country, in a particular currency, or in a particular credit, we're able to capitalize on it.
Evan: Richard, let's go back to some of the points you made about the global approach, the flexibility. Tell us more how Brandywine does things, and why is it different from the way other bond managers do things?
Richard: The very fact that we really view the world as our fishing pond that makes us fundamentally different from the way a lot of other managers approach the market. You hear a lot of talk these days about flexibility, about approaches such as unconstrained, absolute return.
There are a lot of approaches that offer credible solutions to US rising rates as a phenomenon. Our view at Brandywine is that flexibility is not just about the assets that you put in the portfolio, the positions you put on in the portfolio, or your willingness to deviate from a benchmark, but it's also very much about the fishing pond that you're fishing in.
That's probably, to us, the hallmark of what we do. We believe that ultimately, the flexibility we gain from having a constantly global perspective gives us a competitive advantage.
Evan David, Richard mentioned flexible approach, which in many investors' minds means unconstrained, an unconstrained bond approach, investing in bonds that way. What does that mean? What kind of flexibility do you have in an unconstrained approach?
David: It depends on what strategy it is, and all of our strategies are relatively unconstrained to the benchmarks. I think unconstrained means that you can pursue value for us where it exists. Or in some cases, some wraps or returns strategies, short something which is extremely overvalued so that you can make money both when things run down and when things go up.
With interest rates at the levels they are today, there's more probability of symmetry of making money in both directions than there was 10 or 20 years ago, when interest rates were very high.
Unconstrained is the ability to be long on one currency, short another, or long on an emerging market, bond market, short Japan, just doing things which create value for the portfolio. To us, unconstrained does not mean using highly sophisticated derivatives and getting a very complicated portfolio that's based on volatility and arbitrage, but really pursuing value where we see it and avoiding value, or shorting value, where it doesn't exist.
Evan: Gary, what about in the credit markets?
Gary: In the credit markets, it's interesting. I think most people have taken unconstrained and twisted it. They've essentially viewed unconstrained as a free license to simply buy bank loans, and typically bank loans are more less...rather, they're less liquid. It takes significantly longer to settle, and during periods of illiquidity you can see dealer counterparty bids evaporate.
From our perspective, unconstrained does not simply mean moving into bank loans. Rather, unconstrained to us in the credit markets means considering opportunities around the world, whether it's in the US market, our home market, or opportunities in the peripheral Europe, opportunities in the Philippines or India, and even further afield we have been considering opportunities in European mortgage backed securities.
We actually think those types of investments make more sense than actually owning US high yield, and most certainly they offer more value, in our view, than US leveraged loans. Unconstrained to us means looking far afield around the world, looking in structured credit, looking in global high yield markets, if you will, in local currency terms, and not just investing in US leveraged loans.
Evan: In terms of risk, we talk about markets, whether there's more risk, less risk, but what is risk these days? Define risk and talk about what kinds of risks investors are looking to take or to avoid.
David: That's a really good question because risk is in the eye of the beholder. Currently, traditional talk of risk is like benchmark risk, your tracking error risk, how volatile are you versus your benchmark. We believe the risk is the risk of losing money, so the benchmark might be a very risky investment. It might not. That's something we have to analyze at any time in history.
As bond investors, we're really lending money, so we're money investors. We're money managers. There are three risks when you lend money. There's the risk of getting your money back, or getting a return on your money, so if you have a high real yield, you can mitigate risk because you're getting paid a premium over inflation.
Inflation is the destroyer of money, a real yield is the preserver of money, so the higher the real yield, the better chance of you getting your money back in real terms, and that's money you can spend, whether you're an endowment or retiree.
There's the risk, if you're a global investor, of what is the value of the money you lend. If you don't lend in your home currency, is that currency going to be worth more or less when you either have the bond mature or you sell it?
Our goal is to buy markets that we think are fundamentally undervalued, where the currency is actually creating benefits for the society and the economy, and completely avoid markets where the currency is overvalued and creating economic stress.
The last risk is one that most bond investors spend most of their time taking, which is credit risk, which is just defined as the risk of getting your money back. When we lend money, default is the ultimate risk of not getting it back.
Our belief is that when credit is very cheap, as it has been at certain times, you want to take credit risk because you're being paid for it. Right now spreads are not extremely low; low enough that we find value other places.
Three risks to take. Protect the money you do lend, protect the purchasing power of the money in terms of the currencies, and take credit risk only when you're getting paid.
Evan: Your view on this, Gary? Where is risk in the credit markets?
Gary: I think risk in the credit markets is really prevalent in the US. While the recovery has been relatively benign, it is one of the longer economic cycles, and it's been boosted, if you will, by extraordinary monetary policy, so our individual valuation models, whether they're an investment grade credit or high yield credit in the US, indicate that those risk premia are about a half a standard deviation overvalued.
Our view is lending money to credits in the US, even though the US economy is recovering, you're not being paid appropriately. There are other places in the world where in fact you may find higher credit quality instruments that offer higher yields, and in a local currency you can even optimize that yield further. For us, risk resides in the US.
We did have a pretty significant allocation to the multi sector portfolios in US non agency mortgages, and that was as an outgrowth of the global financial crisis. Those positions have moved into opportunities, in a sense, peripheral European mortgage markets. That's one segments of the market where we currently see value and more limited risk.
Evan: One of the questions that comes up, maybe not the question doesn't come up, but certainly the thinking may. With unconstrained or flexible approaches, is that, it seems if not undisciplined, isn't it sort of you can do whatever you want to make it work? Then obviously that's not the case. You've talked a little bit about your methodology.
Go into that more of when do you have like sell discipline or how is it structured so it doesn't seem like, "OK, let's do this today" or as opposed to...
David: We're not short term traders. We don't look for what's the value next week or what's the currency going to do next week, because we don't know. Basically, though, we're looking for the fundamental valuations.
One of the key things that drives our processes, a mean-reversion process that takes place in bonds and currencies which may not take place in something like equities. Again, an equity analogy. If a P of a stock is five, it might be really cheap, or it might change management. But you can say for sure that's not going to increase sales.
The price of the stock and the external environment are unrelated, but...At least one doesn't affect the other. If the real yield on a bond is very high, it suppresses inflation. If a currency is very depressed, it improves their competitive positioning.
Interest rates and currencies actually are part of the economy, and they fold back in the economy and affect the economy, and the economy is what prices interest rates and currencies, so there is a feedback cycle which we try and take advantage of, and that's two, three, four, five years in duration.
Valuations can take quite a while to flow through, and you're getting paid a yield while you wait. We are what I would call patient value investors with conviction and a very different portfolio than an index, but not expecting it to change next week.
Richard: Valuations are obviously a big part of the sell discipline. The other thing that would cause us to sell a position would be something that we saw in terms of a fundamental deterioration. For example, a significant change in political climate in a country is something that could cause us to make a change as well.
Gary: In many of our multi sector income funds we have to weigh the opportunity set in a particular sovereign market, in an investment grade credit, a high yield credit, a structured credit, as well as an emerging market sovereign.
What we endeavor to do is value them across a standardized process. Earlier we had touched on an evaluation process that's based on high real yields in both countries and currencies, and on credit value relative to the default risk.
What we've done is create a process that allows us to weigh which of those particular segments of the markets offer more value. As David highlighted, we're not trying to just simply generate a lot of turnover or churn in the portfolio, but rather weigh that particular marker or that particular credit, which offers the most value.
When something is screening as particularly cheap, the research process is undertaken and that position will be included in the portfolio, either in a synthetic manner, or in a cash bond manner, as well if a particular credit or a security is screening overvalued, we'll then research and understand what's driving this misevaluation. Then if it's deemed to be over valued, we'll sell it. The process is more gradual in terms of buying and selling in our portfolios. It's based on that fundamental value approach that's based on real yields and risk premium given default risk.
Evan: In 2008, 2009 when there was lots of value, what happened? Did you buy?
David: We bought some earlier, around Bear Stearns, because that was also creating value. It took us, we had to hold our breath for a little while and reevaluate the world and make sure that it was going to merge. We decided the policies that were in place were sufficient, or at least mend the financial markets in the shorter generated term.
We added more credit, we added more non agency mortgages, we added more growth oriented countries. We had a tough nine months in '08, '09, but the last five years have been terrific. They've been involved in various changes.
I want to come back to the related question to what you just asked about. How do you manage risk, or how do you make decisions? It really depends on how you define risk. Do you define risk as the benchmark? We don't. If somebody is a benchmark plus manager, which has had indexing, if you think the benchmark is a rare risk then that's somebody's opinion, they can do that.
We don't look at it that way. We look at risk as the probability of losing money, because we think our clients are giving us money so they can spend more of it later. That's our job, that's framed. Create an increase in assets, not just create the benchmark. Or is risk volatility? Or is risk VAR? There are many ways you can define risk. We think that a lot of them are false idols.
Evan: Losing your money in the bond market. That's a big risk.
David: We think at current interest rates there's a lot higher probability that you could lose money. In 1984 when interest rates were 14 percent, all of the gurus on Wall Street were bearish on bonds. This comes to information risk and price risk. Really those were 10 percent. Inflation was four. It was virtually impossible to lose money on bonds over a period of several years. Every big house had a bearish case for bonds. My partner Steve Smith and I, in different places we're both extraordinarily bullish on bonds, and we think we're probably near the end of that. But we're not necessarily bearish. We're more like, rates my go sideways and fluctuate, and emerging markets and developing markets over the next 5 to 10 years make converge. They may not, but if emerging market governments do the right things, the better growth, better demographics, they could actually produce higher returns because they have higher yields.
You start with a yield and then you say, am I going to lose money? Are my interest rates rising? The higher the yield, the less money you can lose because you're already starting with a nice return. Where do I lose money on the currency? That's a matter of our economic analysis. Do we think there's enough stability there? How you define risk is really important.
Evan: Of course it goes back to the first question. Are other markets riskier? They're not really, they're just different.
David: It all depends on the approach you take to investing. I think buying a bond benchmark today that yields 1.3 percent is probably riskier in terms of your total return potential for the next five years than buying a bond yield 10 years ago and index that yielded five or six percent, or 20 years ago they yielded 10 or 12.
Those inflation risks, we don't see too many inflation risks. But you're limited by the yield of maturity if you hold to maturity. We think moving around the world is what we do. If you look at all bond indexes over the last 20 years, bond markets are really efficient over the really long period of time.
The global index, the US index, the credit index, it's almost the same return over 20 or 25 years. But over three or four years periods they can be extraordinarily different. That's really what we try to take advantage of, individually and across sectors.
Evan: In your management, do you use derivatives, hedging positions? How much leverage is involved in the bond portfolio, if any?
Richard: It very much depends on the strategy. When Brandywine went global we ran a variety of strategies from traditional, long only, go anywhere portfolios to absolute return portfolios. Then on the credit side we have both long only and then more alternative style. Evan, there's no simple answer.
I would tell you in general, as a firm, I think one of the hallmarks of our portfolios is they actually tend to be relatively simply constructed using a lot of cash instruments. We don't use a lot of exotic, derivative products. In our core, long only, global portfolios, currency forwards is about as sexy as it gets. We have the ability to use other instruments, but historically have not in our global, absolute return portfolios. We will also use bond futures to express a negative view on a particular yield curve. On the credit side we do use a slightly wider range of credit derivatives.
Gary: More recently we've been using various credit indices in the default swap market to amplify risk, or from time to time to hedge it. The HYCDX, or the crossover index, in Europe has been the indices that we've been using.
We'll also from time to time trade in single CDS. If a particular cash bond is hard to source, owning that risk via a credit default swap sometimes is more efficient than trying to source that particular bond and you have to overpay because of a scarcity effect.
Generally speaking, even our credit portfolios I think are relatively plain vanilla compared to many of our peers, but we try to use them, the derivatives, to just amplify risk modestly or take it away in periods where we see an over or under valuation in our portfolios.
Richard: We actually think that's a benefit because if you're an advisor and you're trying to explain to your clients the positioning of our portfolios, we think that's a relatively easy job for you. I'm not going to name names, but there are probably some managers out there that the advisor might have a significantly more difficult time explaining what was going on in that particular portfolio, given the extended use of derivatives.
David: If you actually just looked at the portfolio without a synopsis of what its characteristics were, you would understand it. We have many funds, and we've inherited portfolios which we didn't understand.
Five hundred different securities of ours may be long bonds, maybe an occasional hedge, but basically pretty simple; we don't think complexity is the answer to return. Good judgment is the answer. Putting the portfolio where you're getting value is the answer, and not taking advantage of Wall Street's new invention necessarily.
While we do take advantage of Wall Street as a liquidity provider, and I do the same to them occasionally, being complicated doesn't make it good.
Evan: What about currency hedging? Has that played an important part or not?
Richard: It absolutely does. We are definitely an active currency manager. Sometimes we like to own a foreign market on a non hedge basis where we'll just own the local currency bonds, but there are times where we'll like the bond market but think that the currency is overvalued and doesn't offer a source of return but rather offers a source of risk. We'll use a currency forward to hedge that exposure back, typically to the US dollar.
David: Oftentimes the currency is actually one of the factors that will make the bond market interesting. For instance, we owned the UK gilts back in 2004 and 2005, so back in history a little bit. The pound got up over two to the dollar. We felt that was going...It was inhibiting growth in the UK, but the bond market was still attractive, so we hedged the currency.
During the financial crisis the currency fell from over two to in the 1.30s. We bought the currency back and doubled our actual currency exposure. Because the currency net too high can actually suppress inflation and slow down growth, if you look at global markets, the worst performing markets each year are almost always caused by currency that is overvalued, and falls for some reason. Economic weakness caused probably by the currency.
The bond market in that country oftentimes rallies because it's tied into economic weakness where oftentimes interest rates fall when an economy's weak, with the exception of Europe and the solvency issues we've seen in the last few years. But other than that in all markets economic weakness tends to drop rates.
You can make money in bonds and lose a lot in currency if you're not careful.
Gary: I would like to add one credit as well. Currency management is an often overlooked segment of value creation. In Europe there's this intermediation trend that has been continuing. Many of these issuers are first time issuers, and they're issuing in Euro terms.
That's a currency that we think is overvalued, that needs to depreciate. You may need to make money on spread compression or of a rally in the underlying sovereign, but you could lose it on the flipside as the currency depreciates vis à vis the dollar. That's an important element of what we do, is in terms of mitigating that risk.
Another example could be emerging market credits, whether they're in India, Poland, or South Africa. Many of those credits will typically issue in a hard currency. US dollar, euro, or sterling. They don't have the ability, or there's not a deep enough credit market, to issue in ZAR, in rupee, or zloty.
What we'll do, because there's not as many investors willing to bare that local currency risk, if we deem it cheap we'll take that Polish risk in zloty terms. We'll take that Indian credit risk and bring it back to the rupee, or the South African risk and bring it to the ZAR. That's an incremental way to add value in credit as well as reduce risk by removing some of that euro exposure, if you deem that currency to be overvalued.
I think that's a really neglected element of credit risk management that we're able to take advantage of in our organization.
Evan: Part of a flexible approach seems like you zig when others zag, but there's kind of an emotional toll to that. When the whole world is saying, "This is going to fall apart and be worthless," you're saying, "Well, we think it's OK."
What goes on? How do you make the determination, and how do you keep your head straight at that time, or have the courage and the conviction to say, "No, the world isn't going to fall apart, and at some point the future will be OK, and these things look cheap now"?
David: Age helps a little bit because you've seen a few things, but it is about looking at the information risk, and the price risk, and keeping your head on. One example that I can tell you was painful at the time, we owned some Australian bonds during the financial crisis, and the Australian dollar being a commodity related currency was collapsing. It had been 95 cents to the dollar and it was in the low 60s, and we thought that was extraordinarily cheap. We thought it was cheap at 80, which in hindsight it might have been, but it took that path.
Our Australian consultants, who directed our Australian clients' money, were fearing that it would go to 40 cents on the dollar, and we just thought that that was a sign of excessive pessimism, and we ended up filling up to the degree that we can within our limits, which would be 14 or 15 percent in Australia, and more than that, but fear is our friend, because fear is what creates opportunity.
Evan: I think that if I just bought Australian bonds at 60 cents, I’d worry, "My God, am I going to look like an idiot if this goes to 50 or 40?" What do you feel like when that happens?
David: That's a very good question. I grew up climbing on a cliff when I was five years old without ropes. You learn to trust yourself. The uncertainty, the best trades are almost always ones where you feel uncomfortable doing them. Baron Rothschild said long ago, "You should buy when there's blood in the streets." Things are cheap...
Evan: There's not blood.
David: There's blood in the markets, but it's an analogy. Through experience you learn that sometimes it hurts to do a trade that's the right trade. A trade that's too easy and too comfortable is oftentimes one that you regret, because it's the idea of information risk and price risk. The information is really ugly, but the price reflects that. It's scary but it's cheap.
Evan: Gary, when were you scared?
Gary: More recently, we had the European solvency crisis, so buying peripheral European sovereigns at double digit yields, or buying European credits when consultants or clients were asking a lot of questions. In a sense, their question was, "If there's no solvency in the government, how on earth can you possibly buy this particular credit if you don't know what currency it's going to be denominated in?"
That fear is what often creates value, and that's where investing is both an art and a science, because you have valuation models, which indicate that there's value, but typically they don't always work as effectively as you'd like, so you get overshoots or undershoots. You buy when there's ambiguity, when there's fear, and typically, as David highlighted, that's typically when you can generate your highest alpha and your greatest excess return.
I think seeing many cycles, analyzing history, is very, very helpful, especially in this most recent economic cycle where we're now facing extraordinary monetary policies. We've looked back to what happened in pre World War II Japan, and looked at some of the monetary policies that their central banker, Takahashi Korekiyo, followed, and he pursued extraordinary monetary policies, and they effectively worked. We think that's created an opportunity in European credit as well.
Evan: A lesson from 1938? Is that what...?
Gary: Yes. History is important to study.
Richard: It doesn't repeat itself but it rhymes in investing. It's interesting. It certainly makes for some active debate around the table at investment meetings. I think it comes down to...often the real uncertainty is around the timing of what we do. I think there's rarely fundamental disagreement about the validity of an ideal, but there's often disagreement about the timing of the entry point.
Being value oriented managers, we tend to probably get attracted to things a little bit early, and we probably tend to want to sell things a little bit early, but the fact is that it's worked out for us pretty nicely over a 22 year period, so you always have that to fall back on.
The reason why I say there are not necessarily terrible ideas comes back to what David talked about, this whole idea of interest rates and currencies acting as economic regulators. Because of the feedback effects that they exert on the underlying economies, we have a high degree of confidence that, at some point, we're going to start to get mean reversion, but the timing can be very challenging.
Evan: What about from the investor's point of view? If they're investing in a certain sleeve, does the fact that you're global help them?
Richard: I think that really gets into the heart of whether people's whole asset allocation needs to begin to realign to reflect the fact that having a US intermediate fixed income traditional long only exposure within an asset allocation makes sense anymore.
Over the past 10 years, for example, that's been a great place to be. You've had returns of anywhere from six to seven percent, depending on whether you're invested passively or actively. More importantly, the standard deviation on a portfolio like that's been about 3.5 percent. We think that game's over, and because that game's over people need to start thinking more creatively about how they restructure their fixed income allocation for a very, very different fixed income environment.
I think the tendency has been for investors to do a couple of things. Number one is shorten the duration of their portfolio, which is something that can help protect the downside somewhat. It's really a defensive posture.
From a return perspective, you're obviously giving up something in the allocation of your portfolio when you do that, and the other thing we've seen is a lot of exposure to credit. We don't think that that's going to end badly imminently, but at some point we may move into a different environment for credit.
So that people who've shifted their exposure from traditional intermediate fixed income towards short duration or towards credit need to be thinking more long term about how you actually restructure your fixed income portfolio. Whether it's to take a larger allocation to global, to think more about areas such as absolute return, but we think that's the direction that the market is headed.
Evan: Tell us some of the thinking about those directions and what you're doing.
David: What we're doing really goes back to the way we think about how the bond market works and what it really is. I think a lot of people confuse...They don't confuse stocks and bonds, but they think about them in the same framework sometimes, which we think is incorrect.
If you buy a stock, you're buying an asset. You buy a bond, you're buying a series of cash flows. That's all you're buying. You're buying somebody's promise to give them to you. If you buy just US bonds, which is what many US investors have done, you have one yield curve, you have a credit cycle, so it's a very small number of dimensions you can work in.
If you look globally, you have the risk of currency change, you have interest rate risk, and you take credit risk, so we have multiple levels that we can pull. We're really money managers, because we're buying money through time. In interest rates and currencies, there's two different levers we can use. Our priced end of the bond market.
If you buy Brazilian bonds, you can get 12 percent, part of that is from taking currency risk, part of it is from taking credit risk. Is there risk here or not? It really depends on price. We are highly focused on the difference between the risk of the information that you're facing and the price at which you can buy the asset.
Sometimes when things look really ugly they might be very cheap. When things look really nice, they could be very expensive. That's the key thing. The willingness to take risk, and our portfolios will take zero investments in assets which we do not think are attractive, which is very unbenchmark like.
Evan: Gary?
Gary: I would add that, or add further about our investment process. The process in terms of delving into opportunities in these markets around the world, particularly with a focus on credit, involves that identification of value that Richard and David highlighted. Which of these countries offers a particularly high real yield and has a relatively stable or benign economic outlook. You're not expecting negative events on the horizon.
Additionally, we screen for currencies which offer the must value which are rich or cheap. We then provide a screen or an analysis on particular credits. What we delve into then are the details, or some of the minutiae.
In addition to determining which part of the world and which particular bond market offers value, and whether it's in local currency or hedging it back to a particular, or that particular client's home currency. We then determine which segments of the credit market offer value and which particular credits in particular in those markets offer value.
Our screening process revolves around many fundamentals that are happening in countries and currency analysis, but we then apply to credit. Covenant quality, position in the capital structure, recovery rate.
That analysis is applied to individual credits and compared to current valuations in the market. From that, we're able to ascertain which particular credits offer value in those various segments of the world, and then we'll do the deep dive research. Our process ends up being both top down and bottom up and allows us to determine where there's value in those particular pockets of the world.
Evan: Do the values change more rapidly these days? How much can you say, "Oh, there's value here," and how long does that sort of perspective last?
Gary: In credit it can happen very rapidly. I think longer term trends is always what our organization is looking for in terms of countries and currencies, and in credit, we piggyback off of that, if you will.
Credit markets tend to mean revert relatively rapidly. There's particular fear or concern due to a ratings downgrade, change of management, weak earnings or weak cash flow. Then when management gets their arms around the problem or corrects their issues, you can see credits spreads compress very rapidly. I would argue that mean reversion in the credit markets has been happening more quickly than in the past, but we've also been in a relatively benign environment over the last three years for credit.
Richard: I think another stock, bond difference is focusing on indexing. In the equity markets, indexes are meritocracies. Apple's up a hundred fold. If you didn't own Apple, I don't know how you did, but maybe not as well as someone who did in their benchmark. But bond indexes are driven by issues the most debt. Whether one country, especially globally. Our global benchmark, 90 percent of it is yen, dollars and euros. At the current interest rates of 0.5 percent in Japan, 1 percent in Germany and 2.5 percent in the US, it's a very low yielding starting place.
There are many other places in the world that have higher yields. They may be 10 percent of the developing index, but they're trillions of dollars. They're not micro cap stocks. Having a broader perspective and not being into the idea of passive investing, which can work OK in equities.
In bonds, we think it's a disaster, or a low return options. Let's put it that way. It could be a disaster, but it's not going to produce high returns at the starting point. Because the global bond index yields 1.3 percent.
Evan: You don't manage to a benchmark, but for clients or investors, how do they measure you? Is it an absolute return basis, then?
Richard: We're benchmark aware. Someone will say, "Here's the benchmark we would like you to be." The way I describe a benchmark, it's what you can do if you're not thinking. You can just put your money on the benchmark. We get paid to try and think about the markets and to position the portfolios that we manage where we think the best returns are.
We expect to beat the benchmark, but not by massaging or manipulating each subcomponent of the benchmark for the subcomponent to beat the subcomponent, but for the whole portfolio to win. Which means our portfolio can have a very different structure than the benchmark. Absolutely our job is to beat the benchmark, and we've done it by significant margins in the past. We hope to in the future. The future's always uncertain, but that uncertainty is creating great opportunities for us, I think.
Evan: Of course we talked earlier about the current interest rate environment. Richard, you said there's an anticipation that interest rates will rise. Let's look at the other cases. It's possible interest rates may not rise.
Richard: That's correct.
Evan: One, how likely is that, a situation where we don't have rising interest rates despite everybody's anticipation of them? Two, if that is the case, what do you do?
Richard: We're right now what I would call threading the needle between the very low interest rates in the developed world, Germany, Japan and not owning those markets, because we don't think there's value. It doesn't mean they have to collapse. We don't think the Japanese bond market is going to have a bear market, but earning half a percent is not exciting.
Someday we think they may blow up, or have a significant problem, whether it's three or five years or down in the future. But there are other markets that if we continue to do the stimulation and we don't have inflation that are higher yielding.
Or there's Brazil or Indonesia or Portugal where we swapped out of high yield bonds into Portugal, because it was a much greater value, so you're looking where the value is. Those kinds of markets can produce higher yields in a world that's benign. Those low yields might not go up. Inflation is not rampant yet.
There's a desire to create more inflation, and when the yield curve actually begins to normalize, the long end of the yield curve might not go up very much. Short term rates go up. Playing defensive by buying two year or three year notes might actually lose you money, because you're in a very small yield, and then you lose a small amount of principal. You'll have zero return.
David: We're also still in a period of extraordinary global monetary policy accommodation. There's been a lot of headlines about a potential shift in forward guidance from the Fed and ultimately rates beginning to move in the US, but we don't see any signs of that happening in Europe or in Japan.
There's been extraordinary easing measures undertaken in the Japan. In the UK as well, although it looks like they're coming to the end of their period of doing so. Meanwhile Europe looks like could potentially start engaging in easing measures now. We think there's lots of reasons why we could see yields drift sideways to potentially lower, certainly outside out of the US.
Gary: What I would or like to reiterate is that that concept of threading the needle brings to mind a note from Lewis Carroll. It's, "My reality is different than yours." If you look around the world, whether it's in Japan relative to Europe, relative to Latin America, relative to Asia, relative to the US, each economy is at a different point of the economic cycle. The macro, top down views of our organization capitalize upon that.
In economies where there's low inflation or fear of deflation, you've seen these extraordinary policies. People are reacting to these different realities and these people are the central bankers, and there's different ways to capitalize than on those opportunities.
If you think you're not entering into a period of sharp deflation and there's still relatively attractive credit risk premia or a high real yield in a particular government bond market, it pays to capitalize on that. That's maybe true as well in a particular currency, so that's something that our organization capitalizes on.
In the credit markets, where I currently see a lot of opportunity is in Europe. We've got a significant exposure there and we think that monetary policy will be effective. It will work with a lag, and that provides a lot of opportunities as these capital markets are disintermediating the traditional bank lending channel.
Evan: When you say Europe, do you mean peripheral Europe? Are the nations that are in trouble Spain and Italy?
Gary: Yes, so let's get a little bit more granular. I would say continental Europe as well as the UK. David highlighted and Richard highlighted these exposure to Portugal. The organization also has exposure to Italy.
Those have been high real yield markets where there was concern about solvency issues or growth rates. They haven't gone away entirely, but we've been able to capitalize on that. In particular, in the credit markets our exposures have been in the periphery, as well as in the UK.
What I highlighted earlier was the bank lending channel has effectively broken. That's why we've got a targeted long term refinancing operation. Effectively, what central bankers are trying to do is get credit to the small and medium enterprises. The small and medium enterprises drive growth in Europe, and they also drive employment. So you have high unemployment, low growth. Effectively you need to get the capital to the people who create businesses and create some wealth.
This is what the central bank is effectively trying to undertake. These high yield companies or sometimes low quality investment grade companies may offer opportunity in various countries throughout continental Europe, and by that we mean largely the periphery as well as the UK.
Evan: What about emerging markets? Does it look at the world? Where do emerging markets play a role in what you do?
David: They periodically play a significant role. Right now we have exposure in emerging markets. Through history, we've made good money on emerging markets, both by getting in and by getting out, which is an equally important concept. Sometimes you want to own something and sometimes you don't want to own it.
The stimulus that's running on the world, last year you saw a big falloff in emerging market prices, some big volatility when Bernanke threatened to tighten credit, which was not an unusual idea that eventually they might tighten credit, but the market seemed quite surprised. You had a big backup in yields. We ended up using that backup to lengthen duration and take more risk where a lot of people were running in the other direction.
We really think being a contrarian is one of the ideas, but really mean reversion. When things get very cheap, how do they affect the economy? In emerging markets right now, the currencies have fallen enough and global growth is beginning to show signs of improving. That on the margin should improve emerging markets.
It doesn't mean that a country like Brazil is a poster child for what you want to be doing. Actually, they're exactly the opposite in many ways. But it's priced into the security price.
Evan: So far this year they've had strong run up in the first half. Is that a signal to you being a contrarian that this may be a time to ease up on emerging markets?
David: Eighteen months ago Brazilian reals were 9, they got to 13.5, now they're 12. They've moved back some. We're not looking for them to go back to nine, but to some improvement. It's always a matter of what is discounted in the price. We describe that as information risk versus price risk.
I think one of the best examples, and since this is a bond talk, we can talk...In stocks, I think most people really understand this. In banking in the early 2000s the tech bubble was happening, and people who believe in technology and the Internet were absolutely right. The information was perfect. Everything they thought was true. If you brought someone from there to here, they'd say, "I told you so."
Look, it's changed the world. But they paid a hundred times too much for the privilege of knowing that. Really, it's a matter of not just what is happening in the economy, but what is the price or anything can be good at a price, and anything can be bad at a price. The underlying investment is only half the story. The price you're paying for it is probably the more important half of the story.
Richard: On the emerging market, I mean there is a tendency short term for the market to just fail to differentiate them and just treat them as a group of similar assets, which really doesn't make a lot of sense to us.
You look, for example, last year at the taper tantrum that occurred after Bernanke's comments to congress in May, from May to September. Look, all bond markets around the world sold off, but the EMs in particular were disproportionately effective. It wouldn't surprise us to maybe see a back hop in EM rates if and when we do get this shift in forward guidance or the Fed starts raising rates at some point next year.
We believe those highly correlated moves tend to be relatively short lived, and over the cycle we think that people start to evaluate these markets each in their own right. I think it's always important to keep in mind that the emerging markets of today look very different than the emerging markets that really underwent significant crises in the '90s.
They have significant levels of FX reserves. You've got credible central banks in many of these countries acting independently from the political wing of government. We just think that using our top down global macro value oriented approach in the emerging markets is as appropriate as it is in the developed.
Evan: Do you think in the emerging markets that there's been a change over time in that they're more reluctant to default. It seems like they've gotten more mature in that sense, and they just won’t walk away. Have they changed?
Richard: Some have. There are certain Latin American countries right now where the headlines would suggest otherwise, but we think, yes, in general, that the markets where you've actually seen credible, independent central banks and politicians acting more in line with how you would expect politicians to act in a developed world.
Mexico is a great example of that. You've got the current administration that is very engaged in a reform agenda across the energy markets, electricity, telecoms acting very similar to a developed economy.
Evan: What about the frontier economies? Where do they stand?
David: On their own. We don't purchase them. There's more political risk and there's more things that we think are unanalyzable from a macro point of view, and we leave those to some other people. We find that we can get lots of opportunity in countries that are BB and above graded, and we haven't felt hampered by doing so. I think our clients are comfortable with that risk range. Because we take a lot of benchmark risk, which we think is the right kind of risk to take as opposed to risk that we can't analyze.
Richard: Plus the liquidity in those markets tends to be not very good.
David: Right, very bad.
Evan: Of emerging markets and developed ones, which do you like now? Now, for the intermediate term, let's say. Which look good?
David: We have positions in Brazil and in Asia, Malaysia, Korea. There are a lot of definitions of what an emerging market is. Some of these countries are in both a developed market index and an emerging market index.
Evan: We'll leave that to the indexers to determine.
David: Portugal indexes, but it's a definitional thing. Five or six years ago I was joking to clients that the US might be the biggest emerging market. It used to be a structural thing. You have current account deficits and you ran a poor political regime. Now they have big surpluses in emerging markets.
In the developed world, we don't like Japan because we think the yields are extremely low and there's just, why would you buy a bond with a half a percent yield in a currency which we think we be flatter, potentially weaker. Recently it's been weakening. Versus some, I mentioned Brazil just because it's one of the higher yielding ones. If you're in 12 percent at Brazil, it takes you 24 years to earn that in Japan. That's a pretty good tradeoff.
That doesn't mean that it guarantees you make money in the very short term because there are price fluctuations. We think that the very low yielding developed markets are not necessarily imminent bear markets, but there's just no return that makes them attractive to own.
We've been in the long end of the US this year where yields have declined a lot, where intermediate bonds in the US have been flat. Where you are in a bond market's yield curve is equally important to whether you like the market as a whole.
Evan: We've reached the top of the hour. Let's go around and get some takeaway points, some things that you'd like to leave viewers remembering. Gary, let's start with you.
Gary: From a credit perspective, we take a global approach towards identifying value. In the credit space, people tend to be less flexible and tend to be much more domestic in terms of their focus on the opportunity set.
The strength of the organization is in global, so we're willing to look at opportunities in Europe, Asia, Oceania, Latin America, as well as in the US. We're willing to look far and wide for those opportunities.
Additionally, in terms of our approach towards credit, and this is infused across all of our portfolios in the organization is we're willing to move up and down in terms of where we are in the credit cycle, in terms of quality.
The right time to be buying the riskiest credits is when they're trading likely at the most distressed prices, so that's typically a recessionary or deflationary sort of environment. That's when you would look for us to be adding risk. We're willing to look outside of the domestic markets. We're willing to move up and down in quality. Again, because we're not a benchmark oriented firm, we take typically larger position sizes.
We ultimately, what does it matter reallocating an extra 10 basis points to a 500 line item portfolio. We're willing to be global, we're willing to look across the quality spectrum, and we're going to take more concentrated position sizes.
Then the icing on the cake, if you will, is to take some of those risks in local currency terms. I think that's a distinguishing factor, and it's something we can do when credit gets particularly cheap relative to sovereigns in various segments of the world. I think that's a key differentiator.
Evan: David.
David: I think for people who are wondering what to do in fixed income today, just to look for the opportunities there are. Whether it's investing for yourself or finding a manager, identifying one will follow the value. Because the value is not everywhere.
Using the old methods of the easy way of following a benchmark will not get you the results that might have gotten you in the past. Because the absolute yields that are available are just not there. Whether they go sideways or up, returns are going to reasonably low, they have many opportunities out there to go long or short or to be just long in markets that are more attractive and then rotate it into the other markets when they get cheaper.
Flexibility and a value oriented approach that takes advantage of the changing global landscape, which has got lots of things going on.
David: Richard, you had the first word, you'll have the last word.
Richard: I would just say that if I was thinking about where to place some assets from the fixed income perspective, given everything that you've heard today, one thing I think we're proud of is that we've been doing this exactly the same way now for 22 years, employing exactly the same process and investment philosophy with the same principles spearheading this team.
You think about the stability that that implies in terms of not just past outcome but potentially future outcome and you couple that with the whole idea of this virtually unlimited universe that we have? I think that's in some ways the most important part of this idea of flexibility.
Again, I'll reemphasize. Flexibility isn't just using more derivative products and just shorting one yield curve. Flexibility is looking at 30 to 40 yield curves around the world and at countries that are at different points in their economic cycles. The best part of all of this is that this isn't new. We've been doing it for 22 years.
Evan: Terrific. Richard, David, Gary, thank you so much for shedding light on flexible approaches to bond investing and to what Brandywine is doing and giving us some very good ideas about what to do in the fixed income markets. For asset.tv, this is Evan Cooper. Thank you.
Important Information:
The views expressed are those of the portfolio managers as of August 22, 2014 and are subject to change based on market and other conditions. These views may differ from other portfolio managers or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice.
Benchmark: Discussions of “the benchmark”, “the benchmarks” are referring to the Barclays Aggregate Bond Indexes, sub-sections of the Barclays index, and other indexes, including:
The Barclays Global Aggregate Bond Index is an unmanaged index of global investment-grade fixed-income securities. The Barclays U.S. Aggregate Index is a broad-based bond index comprised of U.S. government, corporate, mortgage and asset-backed issues, rated investment grade or higher, and having at least one year to maturity. The Barclays U.S. Credit Index is an index of publicly issued U.S. corporate and specified foreign debentures and secured notes that meet specified maturity, liquidity, and quality requirements. The JPMorgan Emerging Markets Bond Index (EMBI) Global tracks total returns for U.S. dollar denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, Eurobonds, and local market instruments. The Citigroup World Government Bond Index (Citigroup WGBI) is an index of bonds issued by governments in the U.S., Europe and Asia. Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.
Investment-Grade Bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.
Duration is a measurement that signals how much the price of a bond is likely to fluctuate when there is a change in interest rates. The higher the duration number, the more sensitive a bond will be to interest rate changes.
The yield curve shows the relationship between yields and maturity dates for a similar
class of bonds.
The Federal Reserve Board (“Fed”) is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Mortgage-Backed Securities (CMBS) are a type of mortgage-backed security that is secured by loans on real estate. An MBS can provide liquidity to real estate investors and to commercial lenders.
FX is an abbreviation of “foreign exchange”, referring to currencies.
Yield to maturity (YTM) is the rate of return anticipated on a bond if it is held until the maturity date, expressed as an annual rate.
The Markit CDX High Yield Index (CDS HY, or HY CDS) is composed of 100 non-investment grade entities domiciled in North America. Please note an investor cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges.
A basis point is one one-hundredth (1/100, or 0.01) of one percent.
A credit default swap (CDS) is designed to transfer the credit exposure of fixed income products between parties.
Alpha is a measure of portfolio performance vs. a benchmark, relative to the volatility of that benchmark. An alpha greater than zero suggests that the portfolio has outperformed during the period by means other than adding volatility.
ZAR is an abbreviation for the South African rand, the currency of the Republic of South Africa.
Standard deviation is a measure of the dispersion of a set of data from its mean or average.
----------------------------------------------------------------------------------------------
All investments involve risk, including possible loss of principal. Dividends and yields represent past performance, can fluctuate, and there is no guarantee they will continue to be paid. Past performance is no guarantee of future results.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed-income securities falls.
High-yield securities include greater price volatility, illiquidity and possibility of default.
Currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
International investments are subject to special risks, including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Derivatives, such as options and futures, can be illiquid, may disproportionately increase losses, and have a potentially large impact on fund performance. The use of leverage may increase volatility and possibility of loss. Potential active and frequent trading may result in higher transaction costs and increased investor liability.
Asset-backed, mortgage-backed or mortgage related securities are subject to prepayment and extension risks.
Diversification does not guarantee a profit or protect against a loss.
Equity securities are subject to price fluctuation and possible loss of principal.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity.
Active management does not ensure gains or protect against market declines.
©2014 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC and Brandywine Global are subsidiaries of Legg Mason, Inc. Asset TV is not affiliated with Legg Mason Investor Services. FN1413199
Disqus:
Disable
Company info:
Brandy wine exclusive
Advanced
Disable contact-me:
Show Contact me
Archive www.player:
0
Archived:
off
Structured:
Nonstructured
Quizzes
Quiz Code:
4GDJ4
<fieldset class="fieldgroup group-akade