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How to use Fixed Income amid looming Fed hikes
Interest rates have been low for a record time. Watch as four experts discuss how a looming Fed rate hike and other macro factors are impacting the Fixed Income markets.
Andrew Chorlton - Head of US Multi-Sector Fixed Income at Schroders
Michael Livian - Chief Executive Officer at Livian & Co.
Rick Harper - Head of Fixed Income and Currency at WisdomTree Asset Management
J.R. Reiger- Global Head of Fixed Income at S&P Dow Jones Indices
Duration:
00:53:02
Transcript:
Courtney: Andy, I’d like to start off with you, a lot of investors are worried about the rising rates and the impact it’s going to have on fixed income portfolios. What are you seeing right now?
Andrew Chorlton: [00:00:08] It’s a good question. I think people are finally going to get the satisfaction they’ve been waiting for, for many years. Rates will rise. It’s been over-forecast and under-delivered on that front. For us it kind of depends on the time horizon and the investor, what kind of asset class they’re involved in. And there’s going to be, we think, areas of the yield curve, different sectors it could perform perfectly well in a rising rate environment. The challenge I think, this time around is we’ve never been this low before and we’ve never been this low for so long before. So that’s the one thing. And I think with the liquidity environment we’re in, we could be in for some turbulent times but it doesn’t mean we can’t make money.
JR Rieger: [00:00:45] Yeah. With the rising rates right around the corner, the question is what corner? You know, we’ve been there so long waiting for a rise in rates. And investors have gotten a little complacent on the long end of the curve, as well a little complacent on some of the riskier credits in the high yield market in particular, really reaching for yield.
Courtney: [00:01:03] So you think investors are looking a little bit more complacent, do you guys agree?
Rick Harper: [00:01:07] Yeah. If you look at the cushion offered by fixed income versus the interest rate sensitivity, it’s really at the most unfavorable trade-off than we’ve seen probably in our careers. And I think a lot of people have moved to the short end of the curve because that’s going to provide protection. And what’s bailed it out in previous tightening periods is the coupon income. If you look at 1994 and 1999, they had seven times the income they currently have, in the two year rates. So there’s a lot of sensitivity that investors, I don’t think truly appreciates. So we have been very vocal in take a look at your portfolio, are you comfortable with the interest rate race you have? If not, take a little bit off.
Courtney: [00:01:48] Michael, do you think that’s … do you agree with that?
Michael Livian: [00:01:50] It’s hard to disagree. But I think there are some qualifiers. Firstly, I’d like to quote some … read out some comments of Professor Schilder, a renowned expert in crashes. He went back to 1857 and he looked at the bond market crashes. And he says they are very unlikely and very rare. So the biggest bond crash we have had in investment grade long dated bonds is in 1980 and the year to year the correction was at 12%. So I think first this is something that needs to be contextualized, when an investor look at their portfolios. They are not going to lose 50% if interest rates go higher, so this is the first thing. Second thing, I think that you also have to quantify what the potential interest rate risk is, not only the instruments that they own but how much interest rates may rise in this environment. So when we look at that we look at two things. We look at the moves on the short end of the curve, that they’re really controlled by the Central Bank. And that it is clear they have announced it that they will take steps. If there are good ways to try to foresee how much they’re going to raise the rates, you can look at the Taylor Rule, that is a little bit faulty now. But it indicates could be within the next few years, one or two percent. You can look at the implied Fed Fund Futures, you can look at the spread between the [unclear] two years. The rates rises implied in all these forecasting tools, they’re pretty moderate. You’re not talking about big, big moves up.
The second thing you want to take a look at is what happens to the shape of the curve in long term bond yields. And also there if you look or borrow so to say, a page from Bernanke’s book, really look at the equilibrium level of 10 year treasuries. They’re a function of expected inflation rates, forward short and future rates and supply and demand of treasuries. So if you do a little bit the math, worst case scenario the 10 year treasury at an equilibrium level in the next three years is going to be at 3/3½%. So my take is the move is not going to be that dramatic, so investors certainly need to plan, they need to arrange their portfolio according to their risk tolerance, but they should not panic.
Andrew Chorlton: [00:04:15] And I think it’s an important point of the segmentation of the market. To Michael’s point, there’s pension plans waiting for the opportunity to buy longer date corporate bands, where you’ve got that natural structural demand. They’re looking at more than a relative return basis on absolute return. And as Rick said, you’ve got the shorter end, people who are hiding out in the one part of the yield curve, that’s actually most impacted by policy. They think they’re shortening duration, they are but they’re also shifting it into, in my belief, an area of the yield curve that’s arguably more sensitive than the [unclear] part, which there’s reasons people buy that other than short term quarterly returns.
Rick Harper: [00:04:48] And the perspective of … I went back to 1980, we’ve never had an annual return on the two year treasury that’s been negative. And we all know that a lot of people have come in at the one and the three year part of the curve and think as a cash substitute at times. And I think the prospect of a negative return, which is much more likely than it’s been in the past is something a lot of people aren’t ready to deal with. I don’t think anyone’s calling for a broad market route. But given [unclear], given the low margin [unclear] currently embedded in the prices, it doesn’t have to be that big of a route or that big of a selloff to really generate some negative returns, people haven’t seen in a while. And again, that comes back to the fact that the cushion or the income that’s been produced by fixed income is relatively lower than in most stages of, I guess, our careers.
RG Rieger: [00:05:45] But there could be other factors that will hold interest rates down, right. If we have a global uncertainty, the effects of Ukraine for example, and other things that aren’t predictable from this point of view, right. But you know, the risk off, risk on characteristics of the risk free rate, it may keep it down in and of itself.
Rick Harper: [00:06:04] Exactly. I mean there’s a lot of uncertainty. And what’s really unique about this period is I think all of us here have a little more experience than the typical bond manager. Since 2003, there’s pretty much been a script, The Fed in the 2003, 2006 tightening, went 25 basis points on a crack. It was like paint by numbers. And when The Fed induces a little more uncertainty than the next, how are, you know, these investors who aren’t as tested as my colleagues are here, going to react? And I think that’s an unknown now, a lot of people haven’t really considered.
Courtney: [00:06:43] You know, and when you speak to that with The Fed, if they do a one and done or if, depending on exactly how they do this, whether it becomes later this year or even next year, do you think this will have an impact on how you position your bond portfolios?
Rick Harper: [00:06:58] I think it’s going to have a position on how people view The Fed. Obviously The Fed’s going to go in sequential fashion, a lot of markets are really behind the curve. But it goes once, and the other thing that you have to consider is they have a huge balance sheet. They have a lot of reinvestment in treasuries. And something that hasn’t really talked about are mortgage backs and those are the two levers that they’re going to play. And that mix provides some uncertainty that we haven’t seen in the bond market for a while. So again, we come back to the theme, take an assessment of your risk. Are you comfortable with the position on what could happen? And if not, you know, take some of the gains you’ve made in this nice bond rally and you know, shorten your duration up a little bit.
Courtney: [00:07:41] And you mentioned mortgage backs, what are you seeing there?
Rick Harper: [00:07:44] Well, if spreads are tight, I mean I think, because most recently [unclear] it was about 20 basis points, which is extremely tight, given the fact that in past tightenings, mortgage backed durations have widened out a great deal, maybe not as much this time because we’ve been stuck at low rates for a long time, but there’s still some risk. It’s not inconceivable, if we get a backup in rates that the Agg, Barclays US Aggregates, duration … sorry, JR, goes [unclear] the sixth year, which would be the longest it’s ever been. So it’s a really unique … we like spread product here. We think [unclear] and credit still have value. But you’ve really got to do your homework.
JR Rieger: [00:08:27] I think you’re hitting on an important point, that as interest rates go up we can expect to see credit spreads widening for the weaker credits. Why bother going out of the risk spectrum if you can get a similar yield and a higher quality fixed income? So credit spreads should widen and that should be a double whammy for investors who have taken that leap of faith.
Andrew Chorlton: [00:08:47] I think it’s amazing how in sort of the recent sort of dynamic in retail investors, they’ve been more and more happy to layer on credit risk after credit risk as they expand from investment grade credit to high yield or EM or local currency EM. They kind of layer on the credit risk. But people are seemingly perpetually terrified of having any interest rate risk, even at the shape of the yield curve, to Michael’s point, if you’ve got a long enough time horizon, you can justify having a reasonable amount of interest rate risk, adding a cushion on top of the four markets that Michael referenced. But it’s that balance, people seem much more comfortable to go into the kind of the plus sector so to speak, to get that extra coupon yield, not realizing some of the additional risks they’re taking. It’s not … you don’t get the extra yield in high yield for free.
Courtney: [00:09:31] So yeah, so how can they take advantage of the changing shape of the yield curve right now?
Andrew Chorlton: [00:09:35] In our view you’ve got to look at the different market segments differently, mortgages we don’t own any of them broadly speaking, for our clients who are paying taxes in the municipal strategies. We think there’s a reasonably attractive part of the rolling yield curve between kind of seven and eleven year maturities where yes, you have some interest rate risk, but you’re getting a 3½% rolling yield, which if you have the right time horizon isn’t that … we don’t think is that bad a return in this kind of environment. The challenge is, if realistically you’re only willing to invest with a three or a six month horizon, you should be in cash anyway, you shouldn’t really be investing in any risk asset. But people fail to kind of capture that. They expect to get total returns each and every quarter, if they have a bad one, maybe that bad one this quarter will lead into some really good returns in the next four quarters. But time and the time horizon of the investor, I think is paramount … of paramount importance when you’re deciding what the appropriate strategy is.
Courtney: [00:10:30] That’s a really good point. And JR, has this reach for yield compressed credit spreads? I know you mentioned that before, but is that what’s…
JR Rieger: [00:10:37] Well, historic, when I look at yields of the S&P US High Yield Index and look at it over time, and compare that to Investment Grade, just the credit spread differential has come down so much. And you have to question whether you are getting compensated for that risk or not.
Courtney: [00:10:53] That’s a good point, yeah. So are people getting compensated broadly?
Rick Harper: [00:10:57] What’s really been [unclear] in the high yield sector, it’s new over the last year. So you’re starting to get some differentiation, right, Triple C’s have just been crushed lately, they’ve really widened out quite a bit. So there is a little more for a value investor, there is some opportunities to play across the credit spectrum in lower investment grades and high yield. Like the Triple C’s, to JR’s point, not only have spreads overall kind of depressed over the last few years, but Triple C’s are making more and more of a percentage of the High Yield Index as well. So, you know, high yield has even gotten a little bit more riskier as we’ve gotten lower rates.
JR Rieger: [00:11:39] Yeah. I’m kind of surprised at the riskiness of the IG actually, the Investment Grade, when you look at that, you know, that profile, and see how much of it is Triple B or…
Rick Harper: []00:11:50] It’s a single and a Triple B and it’s how we’ve [unclear] kind of thing.
JR Rieger: [00:11:51] Yeah. You know, it’s square in the middle of a target zone.
Michael Livian: [00:11:59] I think that in our opinion, I mean when we look at the corporate debt, both Investment Grade and the high yield is extremely expensive. And the only way to approach it in our opinion, when you look at it, it’s events driven or special situations. You have new debt issues, you have some M&A, there is some rating changes. And there may be small mispricing, but to access it as a whole it’s, I think, a lot riskier than buying long rated munis or treasuries, because the spreads both on a relative basis compared with their history, and using different models, they’re very, very, very tight, that especially in the US and in Europe, Europe is a new phenomenon, what’s in Europe now, the spreads have tightened massively on credit. But there are areas which are not the corporate quasi sovereign outside the developed world where you can find actually attractive spreads that compensate for the risk that you take.
Courtney: [00:12:55] Where are you seeing these?
Michael Livian: [00:12:57] We are looking … we’re investing in areas, I think, most investors would not want to go in those places. But if you go into Brazil, if you go in, especially Latin America, a lot of their commodity producers, commodity exporters that have now issues with the scandals, governments are involved, that they are … they still have large resources, most of these countries are going to structural economic corrections, not structural, cyclical corrections, but not structural. They’re being punished pretty harshly and I think if you do your homework well, and if you look at the foreign reserves and the fiscal balances you may find attractive opportunities, you know. So those are the areas that we look at now.
Rick Harper: [00:13:41] Yeah, that’s one of the things that we’ve noticed, there’s a lot of bad news priced in EM debt. And a lot of investors are sort of taken a look, there’s still a little anxiety before The Fed moves. But eventually the long term income story is going to emerge intact. And Brazil is a great turnaround candidate. You have to believe in certain things going on, but obviously you’re getting compensated in terms of yield. One of the unique things we’ve seen in EM over the last year is the market’s [unclear] differentiation and governments are doing the right thing. India and Indonesia are a great example. You know, there was a term called ‘The Fragile Five’, which included, you know, Turkey, South Africa, Brazil, India and Indonesia, it’s now The Fragile Three. So I think the market does reward proactive steps being taken by the government. Also I think Asian credit … Asian local debt has done far better than Latin America and Eastern Europe, still Poland has a yield around 2%. You know, it’s kind of … and you’re getting the yield levels in some of the countries that, you know, kind of beg a little more, look into Korea at 2%, 2% [unclear] as well. So you want to be really selective. There’s a great dispersion and opportunities in EM. But you’ve got to do your homework and you’ve got to be selective and you’ve got to do your digging.
JR Rieger: [00:15:06] We’re actually seeing demand for Frontier, you know, or how you classify China, but China to us is Frontier, and Africa, you know, all of a sudden that reach for yield has brought in other asset classes from other segments of the fixed income market for that very reason, of capturing yield. And China is an excellent example, as they crack open their doors a little bit RQFII, a little bit more, a little bit more, and giving investors on a global scale, access to onshore bonds. It’s not tremendous, but the yield that they, you know, a One to Seven Year Bond Index comes out with a forehand on the yield, that’s going to be interesting to a lot of investors.
Rick Harper: [00:15:48] It’s been wonderful to watch China over the last, we’ve had a fund in China since 2008, it’s been wonderful to kind of watch the process of internationalizing their currency. And one of the big announcements that’s expected is the inclusion of the Yuan in the SDR. You know, Michael mentioned the reserves, obviously China has tons of reserves. And there’s some really good opportunities in transparencies coming around the corner, it’s capital convertibility’s coming down the line. And if you watch, you look at their eight year game plan that they’ve put in place, they’ve just knocked things down, they’ve done a lot of smart things. And so why we tend to be a little more optimistic on China than a lot of people were and we see a lot of opportunities going forward there.
Andrew Chorlton: [00:16:33] I think the EM story, kind of there’s lot of cleansing almost the second half of last year. And now it’s the only thing that you look at and it stands out as being cheap. Our EM guys, they think liquidity has turned around, the points that they generally have made. I think the other thing that Michael sort of briefly touched on, but kind of EM’s a bit more interesting than Europe. And working for a European firm, the amount of flows you’re seeing from Europe coming into the US debt market could see more stability here than people really expect based off fundamentals. If you look at new issues in US credit, 25% of it seems to be coming from European investors because if you’re a credit manager in Europe, where do you make money?
Courtney: [00:17:10] Well, as long as, you know, Japan and Europe has QE, isn’t that just going to keep a lid on, you know, they’re just going to keep … it’s going to keep a lid on our yields because they’re just keeping pushing money into our US?
Andrew Chorlton: [00:17:19] I think it supports it for now, but it’s [unclear] some pain in the future because they’re not … they’re the absolute opposite in … for me, of a pension plan. A pension plan, US pension plan buying long dated US credit is a long term strategic investor. A European retail fund manager buying a new deal, 10 year US dollar deal is purely there for a trade. And that trade might last 18 months, I think one of you guy’s said. But they’re not there kind of as a structural allocation. They’re there until they can find another trade because it’s a big bet for them to make that trade. So I think that’s the one thing, and I’m sure we’ll get onto liquidity. But you stock up those kind of non-dedicated buyers with a diminishing liquidity environment, that means whilst it’s supportive for now, there could be some pain around the corner.
Rick Harper: [1 00:17:19 Yeah, it is, the bond market traditionally has been a spring that’s compressed and then it’s expanded really quickly, mortgage backs obviously being a great characteristic duration is compressed, obviously the blowout. And you could be seeing a lot of the same things, again I don’t think we see a route, I don’t think anyone sees a route. But there’s not enough cushion there to prevent a little bit of pain, that could go a long way. We’ve got a lot … a lot of people are retiring, a lot of people are more dependent on income and they’ve got lower yields to satisfy in their retirement.
Michael Livian: [00:18:36] And we, I think when we look at fixed income, we look at the role in the portfolio. So traditionally of two or let’s say three roles in a portfolio, one is risk mitigation. I think that is still there. I mean if you buy higher quality debt, intermediate longer date maturities, something happens, risk off around the world, the value of those securities are going to be preserved. If you’re looking for income or capital appreciation which now it’s quite a big word in the fixed income world, you have to be extremely selective and you have to be extremely creative. I mean you cannot just go to corporate bonds and think that you’re going to collect your retirement money there. And you need to go in equity like instruments, MLPs, preferreds, you have to go into emerging markets, you have to be a little bit more creative. But you’re not going to get your income from buying US treasuries, munis or corporate debt in America.
Courtney: [00:19:28] But it can smooth out volatility in the overall portfolio, so it has a really important place there. Andy, you touched on liquidity later, there’s a lot of buzz around it, what are you seeing there?
Andrew Chorlton: [00:19:36] Whichever metric you look at it and banks are putting out various liquidity meters with different names. But liquidity is not what it was and it seems to be getting worse and worse year by year. For us, if you add that to the compressed yields and some of the kind of, almost false liquidity that’s in the market, I mentioned European investors coming over here, for us it means that you want to have more liquidity in a portfolio because people have talked about it won’t be a route. But there could be some short term moves, even this year to date you’ve seen a big rally in fixed income risk assets in February, but they gave back a lot of it in March. But the moves are kind of more violent than you think. And the one thing that we feel pretty certain about is that if you want to take advantage of that move, you won’t be able to sell to buy, you have to buy from liquidity. And that might be treasuries, that’s when maybe I disagree with Michael, that there can be a role for some treasuries, because it gives you that liquidity as there’s some cash. But you can’t, if you think you’re going to take advantage of a selloff by selling one risk asset to buy a higher risk asset, the way that things seem to be working now where everything moves in parallel, it’s not a fundamental story, it’s a sentiment story. You need liquidity. We’ve probably got as much liquidity in the portfolios now as we’ve had at any time in the last six or seven years.
Courtney: [00:20:51] And, JR, within fixed income broadly, what assets classes if you drill down or spaces within fixed income are most sensitive to liquidity would you say?
JR Rieger: [00:20:58] Well, we’ve been watching the senior loan market because that’s what drew the attention of the US Fed and the treasury. You know, that speculation about how deep the liquidity pool is for senior loans, as well as fixed rate high yield. And they’ve also thrown in munis just to make our world more interesting, right. So when you look at the data, so far, you know, the Trade Association for Senior Loans is reporting pretty good liquidity. Now, liquidity can change on the dime, right, it’s just the market emotions and it can change that pretty quickly. But in the corporate bond market, we’ve been tracing the data, backward trace and at the [unclear] level, at the bottom level, 88% of the bonds in the Investment Grade Index trade during each month, 88% of them, but concentration of the volume probably is much lower, right, because there’s probably just a few names that are driving that par value, market value transactional numbers up. Munis, it steps down, Invest Grade Munis, about 66% of those bonds will trade during the month, much smaller in size as well, so liquidity does vary and it’s a very emotional reaction in the market that’ll drive liquidity, whether positive or negatively.
Courtney: [00:22:14] And I want to touch on municipals, what are you seeing in the municipal market in general?
JR Rieger: [00:22:19] Well, I think the yields are low, but in relative terms, they’re still attractive given where yields are for Investment Grade and High Yield Corporates. When you look at bonds from a taxable equivalent yield perspective, I’ve been an advocate that munis should be one of the core asset classes for our US investors. They shouldn’t be for the 1% of the most wealthy in the US. If you’re paying taxes look at munis because the yield when you look at it from a taxable equivalent yield it can be attractive. There’s one dynamic that’s not … that’s in munis that’s not in the corporate world, and that’s the supply demand dynamic. The new issue supply for munis is not truly new issues, it’s refunding deals. So they’re not … the market’s not getting swamped with supply, it’s getting some supply. And until that shifts I think we’re going to see yields be held down from munis because of that … just that technical nature of the muni market. Demand is there, taxes haven’t gone down, we’re all paying taxes, you know, and supply just hasn’t overwhelmed the demand yet.
Courtney: [00:23:22] Yeah. And, Andy, with the economy kind of growing at a relatively slower pace, how is this impacting municipals right now?
Andrew Chorlton: [00:23:27] I mean I agree with JR, the next supply of munis which is what is important, not absolutely supply that’s been declined which is positive, taxes aren’t going down any time soon, I think we probably all agree. The thing about the fundamental story of munis, there’s so many headlines about whether it’s Detroit or Puerto Rico or you can pick the headline story. But for us that doesn’t reflect the true broader muni market. As you say, yes, the economy’s not kind of booming, but it’s been growing steady now for a number of years, and that’s all positive. The housing market’s been growing steadily. It’s all positive for muni fundamentals. We prefer to stick to the higher quality names. But the one thing to kind of bridge liquidity and munis, if you want kind of a little insight into how much liquidity and sentiment and fear can overwhelm fundamentals, just look around to the muni market in 2013 into 2014, there was about 70 billion give or take, of outflows in muni mutual funds. And the muni market died on its feet. And we had European … our European colleagues coming in buying munis because the issue with the muni market is it tends to be a kind of one-dimensional market, there’s just traditional US taxpayers, obviously there’s insurance companies and banks, but broadly speaking, the marginal buyer is mom and pop or someone’s looking for after tax income, unlike a 10 year corporate bond by [unclear] where there could be investors all over the world.
But you saw the impact of kind of fear and the taper tantrum, all those things, encapsulated in the muni market in mid 2013 into 2014. And it wasn’t a nice place to be. It was a great opportunity if you could take it, but for me, that’s the one thing that fills me with fear about the rest of the market is if the muni market’s kind of given us that clip.
JR Rieger: [00:25:15] Yeah. The muni market though is driven by mom and pop sentiment.
Andrew Chorlton: [00:25:18] Yeah. But when they’re selling the mutual funds, there’s no one to buy.
JR Rieger: [00:25:19] Yeah. When they’re selling there’s no one to buy, and then the crossover buyers did come in because yields began to get attractive, just like we saw with Puerto Rico, was, you know, that didn’t go retail, that went into some guys who can take some risk. And they have incurred that risk from my perspective.
Andrew Chorlton: [00:25:36] Yeah, and they’re welcome to it.
Courtney: [00:25:40] Rick, I want to pivot a little bit. Fixed income has been one of the … or the fastest growing segment of the ETF market. I think it accounts for 15% over the past five years. What do you think attributes to this?
Rick Harper: [00:25:52] Well, I think it provides an option, an access point that investors haven’t had before. And there’s a simplicity in the transparency of the vehicle, really has encouraged a lot of adoption. And it’s transgressed not just the retail environment, but also it’s starting to really bleed into the group that’s [unclear] the greatest strides in evolution has been the institutional market. You know, our insurance company portfolio manager has 6,000 line items. They’ve finally seemly have gotten over the hurdle that we’re not coming after their jobs and they consolidate 5,000 of those line items in a single ETF trade. And I think that, and then focus their time on the trades that actually makes sense. And they actually develop and can develop powerful. And I think, thinking of ETFs as a tool, and how it can function within a portfolio has really been sort of the switch has been turned, I think that’s one of the reasons we’ve seen so much growth.
Courtney: [00:26:54] And do you think this is, JR, a period now that’s favoring more active or passive management?
JR Rieger: [00:26:59] Yeah. You know, in the market that’s anticipated to be volatile you would expect that active management would be able to beat indices, simple dumb broad based indices. But the history, the facts really show the opposite. You know, over a longer period of time, our active managed fixed income funds don’t outperform. But you know what, we’re in a new timeframe here, none of us have seen this before. So we’ll just have to wait and see, but history doesn’t show active outperforms the benchmarks.
Rick Harper: [00:27:32] I think one of the biggest casualties of the ETF growth that we’ve seen are the closet indexers in the mutual fund area. They’re really … they’re not really superstars in terms of active, there’s always going to be a need and always going to be a demand for a star manager, someone who’s really good or a firm that’s really going to evolve now for over time. But people that have hugged the indexes and charged a lot higher fees than ETFs, that’s where I think those of the investors or the investment professionals are most at risk with the ETF crowd. And as JR mentioned, you know, they’re also the ones that are underperforming passive [unclear].
Courtney: [00:28:10] And that’s true across all asset classes, not just fixed income.
JR Rieger: [00:28:15] Yeah. I think new products … I’m sorry, new products that come to market like vehicles like exchange traded funds, offer an efficiency that retail investors don’t have, like buying individual bonds today. There’s a friction in that transaction. If you’re buying 50,000 bonds, 50 bonds at a time, well there’s a cost to that transaction that’s built in to your buying that bond. And if you sell it before it matures, it’s the flipside, you’re paying it again, in regards to what price you’re getting. So that friction really is very erosive to overturn. And it’s much more efficient to buy a diversified basket as a result.
Courtney: [00:28:53] Michael, do you want to say something?
Michael Livian: [00:28:53] Yeah. I wanted to actually jump into this conversation of the liquidity and the ETFs because I think there’s a lot of ETFs that are out there. And I think as JR mentioned, that if a retail investor can get into the fixed income world in a diversified way, cheap way without having to pay, you know, the mark-ups and marks-downs. And they have a separate value, it’s fantastic. And we actually subscribe to that view. However, when you go to more arcane or credit sensitive areas of the fixed income market, when you go into emerging markets, when you go into high yield, when you go into those areas there are a lot of good ETFs out there. I think they have not been tested through the prism of time. My belief, my assumption, this is something that a lot of portfolio managers don’t take into account, is that in fact when you go into crisis mode the more liquid instruments, the more liquid bonds are the ones that’s offered the most because they’re the ones that can be sold most easily by the mutual fund managers. And when you have an index that has products that are not … the underlying products are not that liquid and everybody knows what they are, they may be front run very quickly be hedge funds and other managers. So you may really underperform in a crisis period if you buy those type of ETFs. So I think there are a lot of caveats. But for high quality investment grade type of instruments, ETF is probably the best way to go for ETF investors.
Rick Harper [00:30:17] Yeah. That’s one of the reasons why [unclear] emerging market debt ETFs, we’ve gone the strictly traditional active route or the structured active route with a focus on, first of course sustainability, liquidity, reducing external vulnerability. You know, in our emerging market local debt fund and our EM corporate fund, you know, it’s been very low turnover, very deep in the [unclear] kind of analysis. But the bias towards liquidity, I think any successful ETF is going to start out of the gate with a little bit of a bias towards liquidity because otherwise you can’t really function on a daily basis. And we have been … and we’ve had a lot of pit bumps along the way since launching in 2010. We have, you know, we have been surprised by how narrow the spreads have been, how low the slippage has been on turnover. So if you look at, especially in the local debt over the last five years, you’ve had a few episodes in which you kind of … it was a nice little stress [unclear].
RJ Rieger: [00:31:15] Yeah. With senior loans and passive investing you would think it wouldn’t work, right, because it’s an institutional market, you know, the settlement takes 21 days. All these objections as to whether passive versus active for the asset class and it’s been tested. And we had some serious downturn, you know, not too long ago and passive was tested, and the tracking there was pretty close, you know, it comes down to index design and making sure that you’re capturing, in this case, constituents that are senior loans, making sure you can capture them in your design that those loans are actually available to invest in.
Rick Harper: [00:31:55] It’s critical.
Courtney: [00:31:56] And I want to bring it back state side and ask you about the products that they allow you to capitalize on rates moving higher. But we keep hearing that there could be just a one and done with The Fed. If that’s the case does that still work?
Rick Harper: [00:32:11] Well, if it’s one and done, I mean we subscribe to the theory that the market’s currently view on the world has happened, right. And their perspective on the world has happened. And we’ve been here before on this, in fact last year we were in the same position, economic statistics were disappointing, all of a sudden we have a great rate surge. China is actually pumping their economy a month before they usually do because we always have the April China [unclear] it seems like. So we do think The Fed’s going to be a little more aggressive, if the market doesn’t go more than … if The Fed doesn’t go more than one and done, obviously you’re out the cost of insurance. But you know you need to be early as opposed to being late in terms of The Fed moving first, because the market’s going to react. Because they’re not going to have the one and done opinion before The Fed moves. So we do think there’s a short term, even if it’s one and done, there’s going to be a short term volatility. And you’ve seen historically in the six months before a Fed hike, markets have traditionally backed off, principally on the long end. So the sensitivity on the long end I think will surprise a lot of investors.
Courtney: [00:33:21] And I want to pivot a little bit, Andy. Are investors being compensated for the risk that they’re taking right now?
Andrew Chorlton: [00:33:26] I think it, again, it kind of depends which risk they’re taking I guess. It’s notoriously difficult to make money by forecasting the direction of yields. And the reason is you’ve got to get a number of different things right. You’ve got to get the macro side of things right, which [unclear] look at payrolls last week, they forgot that it had been cold in New York again. And there was a five standard deviation risk from what I’ve read. They’ve got to get the market reaction to that macro right. And they’ve got to get all the other moving parts, whether sovereign wealth funds are buying, whether the Europeans are coming over here. So it’s notoriously difficult. And you’ve got to get it right on the other way around. So we think you shouldn’t have a great amount of risk in that kind of directional … expressed in a directional way. It’s much more to do with the appropriate role of fixed income in that client’s portfolio. So if you’re … to JR’s point, if you’re a retiree looking for after tax income, munis are pretty tough to beat when you look at them on an after tax basis. And should you really care frankly, about a move in the next three, six, nine months or should you be investing much more long term? If you’re looking for a total return type product then it becomes a much, much more tactical game.
So I mean I think the market has got … to Michael’s point, there’s already a reasonable amount of Fed move priced in. And for each kind of period that they delay, you know, they were going to move in June, now they’re going to move in September, now some people are pushing it to next month. You’ve just given up six months worth of yield. The beginning of last year, so the beginning of 2014, every bank out there, all the experts were telling you that yields were getting higher, fixed income was the worst place to be. They didn’t just give up the coupon, they gave up double digit returns. So I think it’s a dangerous game and it all depends on the time horizon. I would argue that you’re being compensated for a certain risk at the moment. But for me, it’s more about liquidity. Liquidity environment today means that the prevailing level of credit spreads, whether that’s in high yield, EM, or Investment Grade or even in munis, has to be higher to compensate that your trading costs are higher, that the volatility’s high, what used to be fair value, I think fair value has now shifted a little bit higher.
Courtney: [00:35:32] Interesting. And, JR, do you agree, fair value’s shifted a little bit higher right now?
JR Rieger: [00:35:35] Well, I have to say there first, we have to look at it from the perspective of where is the risk? And it’s credit spread risk and it’s default risk. Right now we’re in a very low default risk cycle. But that could turn very quickly as all these institutions who have borrowed a lot of money over the last couple of years now have to begin to figure out what to do with that money to generate returns to pay off that debt. And that’s going to put stress on a lot of these entities that are now highly levered because they borrowed in a relatively low rate environment. So we can see default rates come up pretty rapidly. And that’s a risk I don’t think investors have planned for.
Courtney: [00:36:12] In a lot of a part of the world … I mean we talked about emerging, but in a lot of a part of the world, investors are facing negative yields. So why would they lock themselves in then [unclear]?
Rick Harper: [00:36:21] Well, some of them don’t have a choice, they’re restricted. You know, as Andrew mentioned, a lot of European investors, they come into the US and buying dollar assets. I mean they’re probably going to [unclear], you know, if we have another episode in which tail risks kind of comes down a little bit, I think they’ll be looking at EM as well, you know, for the yield advantage. But there are a lot of restrictions that prevent access and capital flows from moving. It’s interesting, the US is having a curve flattening with a short end rising, while Europe has just given the sovereign purchases, is pushing … is a bull flattener and is pushing the longer end of the yield curve down further as they get closer and closer to the negative 20 basis points. So it’s a really interesting dynamic. You know, what we’ve seen on the economy side is that European numbers have surprised the upside and US has surprised the downside. We anticipate that trend is going to start to reverse a little bit. And that, you know, we could be seeing … we could be seeing a little bit of pressure on US yields, the recent auctions have not gone well. And would suggest that demand is kind of reaching a [unclear] point, at the yields where we are.
Courtney: [00:37:36] And, Michael, when you take kind of a snapshot of the market, I believe 10 years are yielding 1.8%, if you look over in Germany, the Bund .17, what’s the market telling us and is this like unprecedented in terms of yields?
Michael Livian: [00:37:53] Well, in my recent memory or … it is a unprecedented, but I don’t know if they’re … in the great depression there were similar episodes, but of course it’s unprecedented. I think that the episodes of true and … I don’t think we are in one yet, and hopefully we’ll not be in one. But episodes of deflation in large economies are very, very rare. I mean you had the great depression in the US, you have the example of Japan, and so far there is a talk of deflation, there is a fear of deflation. As long as investors and economic agents, they don’t anchor their expectations on lower prices, you’re not really going to have deflation. But clearly in Europe, the core European sovereign issuers and if you talk about short and intermediate maturities, they’re sporting negative yields. That’s a reflection of the fear of negative inflation rates and then positive real yields. And so yes, it is … I think it’s unprecedented. I think as Rick mentioned, the fact that you have had a depreciation of 20% or 30% in the European currency, you have a very active European Central Bank that in addition to paying a lip service is actually now buying 60 billion dollar of Euros every month, of sovereign debt. And the fact that [unclear] are very dependent on the price of oil. Now they have like a 50%, that kind of shot in the arm in their consumption. That should somehow lift the European economy and allow for a kind of positive inflation expectations to come back and possibly these yields actually return positive over there. So I think there are some risks there. I think that the fears of deflation are over and done and so probably there are more risks there than in the US now, [unclear].
Courtney: [00:39:54] That’s an interesting point. And, Andy, have you been purchasing more energy bonds since spreads have widened and oil prices dropped, how has that kind of affected that?
Andrew Chorlton: [00:40:02] Yeah. We focused on the Investment Grade energy names where we feel there’s been more of a … you’ve effectively got loads of medium risk credits, medium to high risk prices has been kind of the way we’ve looked at it rather than going to the high yield space which in energy seems to be much more distinct winners versus losers. The Investment Grade there’s been a lot more perfectly decent kind of leaders in their industries trading at ridiculous prices because the entire energy complex got annihilated in the second half of last year. So that’s been our trade. It’s not to say there aren’t opportunities in high yield, but my team tend to be a bit more high quality focused. So we like that kind of trade. We had a kind of an interesting debate internally. We had the dedicated equity PMs and energy equity PMs, the high yield analyst, the small cap analyst, the large cap analyst and there’s, as you can imagine, an awful lot of different opinions in that debate. But one thing that came through is that the big liquid Investment Grade names, the ones with access to capital, the ones that can still do new deals, can ride this wave. And it becomes much less dependent on where the oil price is in six months or what OPEC says next on those kind of names. For my kind of client base, the more binary outcomes are not really what they’re looking for. They’re looking for us to get, as I say, a low quality risk at a high risk price, and that’s kind of how we kind of label it.
Courtney: [00:41:25] Right, right. So they’re less sensitive to anything in the energy complex, is there…
Andrew Chorlton: [00:41:30] Well, we just think there’ll be the noise, the fear. And fear dominates so much at the moment, but there’ll be the fear. And people [unclear] an energy company equals bad and that’s not the case. I mean look at Shell and BG Group today, they’ve managed to … Shell are going to come up with what, 60 billion dollars, I guess they’ve got access to capital.
RJ Rieger: [00:41:45] Yeah, I’d say.
Michael Livian: [00:41:47] Yeah. I think that we went exactly to the same exercise, last quarter of last year, we took all the high yield names, we have … one of our partners that you may know, Marty Fridson, he’s a big expert in high yield. We went to all the high yield energy names, we analyzed them one by one, you know, classified them and we use internal metrics to determine what the probability of default is, our own assess probability of default and what the prices are telling us. And in fact they were telling the truth. I think that they, you know, they had in the distressed space the largest amount of distressed names that joined the [unclear] group were energy names. They’re all smaller exploration companies, component companies, offshore drilling. You don’t have any real good solid name that can withstand a massive correction in the price of oil. So I think the opportunities over there are very limited. I think that probably Investment Grade, some crossover, some pipelines, maybe a handful of name. And I think that it’s the conclusion of a lot of other people have reached, you know, I think the last quarterly letter of Howard Marks, he was talking about how he’s looking into the energy space. And then I read on the press that said that in fact he did not find a lot of names that were distressed and worthwhile buying, so.
Courtney: [00:43:04] Yeah. Well, that’s an interesting debate because I mean I’m running an equity panel tomorrow and almost every value investor we have on there are saying, “We love energy right now.” So it’s a very interesting place.
Michael Livian: [00:43:15] It’s very different, if you a buy 500 million dollar market cap company that is developing the technology to go in Antarctica and extract some oil and it’s yielding like 16% a year and buying some value stocks that, you know, you do the fundamental work and you can…
Courtney: [00:43:32] Well said.
Rick Harper: [00:43:33] Well, I think some, you know, as Andrew mentioned, some of the IG companies and these are established players, there are household names, you know, as a bond portfolio manager, is the bond money good, right. Will they pay and will they pay for the bond and pay their coupons? And it had gotten to such a point that some of the IG names, there was questions of whether are money good or not. So they did create a lot of options and that’s … I really think there are some unique little select opportunities in the credit space like this, in which things have gotten thrown out with the bath water and some really good due diligence will poke up in these opportunities. But the beta strategies in the credit area is a lot trickier right now.
Courtney: [00:44:18] And I want to talk about issuance a little bit here. You know, we just talked about how ETFs have 15% over the past five years are going into fixed income. Well, we’ve seen issuance go from 70 trillion to 100 trillion in a kind of short period of time, JR. I mean that’s almost a … I’m sorry, a 50% increase, to what do you attribute that?
JR Rieger: [00:44:37] Low rates, straight up, you know, now the question is, what are [unclear] going to do with the money? Right, they were sitting on cash, they borrowed more, Microsoft doesn’t need to come to the bond market. They did, and they took advantage of the current rate environment. Now what do you do? Well, how do you generate income [unclear] return for your shareholders with that money? And these are serious questions, as these companies are sitting on a lot of cash.
Rick Howard: [00:45:06] Another question is, why hasn’t the US treasury come with a lot more long dated maturities?
Andrew Chorlton: [00:45:10] Can’t afford to.
Rick Howard: [00:45:11] At 2%, 3%, in terms of locking down, you know, locking down at 3% 30 year treasury, you know, so you’ve given the US government an IOU for 30 years at 3%, you know, I’d be issuing it all day.
Andrew Chorlton: [00:45:27] It’s interesting that, if you look at the dynamic of the treasury market, to your point, it’s just shortened, and shortened, and shortened because they can fund themselves. The debt service will remain more constant as the outstanding debt grows. And in contrast in Europe you’ve got 50 year bonds are now … 50 year bonds in the UK, Italy, France.
Rick Howard: [00:45:43] I think Mexico.
Andrew Chorlton: [00:45:44] Mexico did a 100 [unclear] today at 4/4½% or something, I’ll let other people buy that.
Courtney: [00:45:53] Well, we have a viewer question actually. I want to play that for you quickly. It’s from Carter Mansbach of Jupiter Wealth Advisory.
Carter Mansbach: [00:46:01] Good afternoon. So my question is on fixed income. Assuming that we are going to have rising rates, the bond markets should be able to [unclear] that. So what I’d like to know from the experts is what is best place to invest into fixed income in a rising rate environment?
Courtney: [00:46:20] Michael, do you want to take that really quick?
Michael Livian: [00:46:23] I think it really, really, really depends on the objective of the investor. If the investor has tolerance for risk and is a multiyear long term investor, there are a set of opportunities. Those opportunities are in emerging market, some munis, some preferred securities, if there’s tolerance for some equity risk, some Master Limited Partnerships that have tax advantage distributions, combination of those will provide a healthy flow of income and some type of protection. But may suffer from some volatility over time, but if you look at several years then some years you may have some small losses, some years you may have gains, you collect your income and you’re well off. If it’s a very defensive investor that wants a typical traditional fixed income portfolio then I think that the options are lot more limited.
Courtney: [00:47:13] Yeah. So fixed income and fixed income like securities?
Michael Livian: [00:47:16] Yes, exactly.
Courtney: [00:47:17] What are you saying?
Rick Harper: [00:47:18] Yeah. The first thing I would say over the short period, the first thing is you want to dial down your risk very quickly. And we have come up … and numerous other sponsors have come up with some duration hedged strategies which is simply taking a core or a plus component of a traditional fixed income, and extracting the treasury rate risk. And it’s a strategy that institutions have done for years, decades. And you can get dial down your interest rate risk very quickly in one trade. And you know, it’s a yield … basically you’ve essentially created a whole, a litany of potential portfolio options in which you haven’t changed your underlying thesis in terms of the bonds you want to invest in. You’ve simply dialed down the risk. So that’s one measure. I think, you know, the treasury floating rate – the new treasury floating rate issuance could be something that’s reasonably attractive, you could pick up about 8 basis points relative to a [unclear]. But if The Fed’s a lot more aggressive than people think that might be another place to park some money.
Courtney: [00:48:19] And you’re also getting dollar exposure if that’s what you’re looking for, through some of those.
Rick Harper: [00:48:22] Yeah. And alternative strategy, we’ve had a lot of success with, it’s a bit unique but it’s … fixed income in name only is a currency … a dollar bullish strategy on currency. You know, investor … US investors really can take full advantage of an appreciating dollar. And we do think we’re in a secular [unclear] for the dollar, it’s … we’re about two-thirds of the way through it we think. And it’s a really unique addition to an overall portfolio in which you can preserve a lot of your return and dial down a lot of your volatility, and typically when the dollar does well in rising rate environments [unclear] inflation, so that would be another thought.
Courtney: [00:49:01] Interesting. Well, I want to … we’re just about out of time. I just want to get everyone’s final takeaways. And, Andy, I’d like to start with you.
Andrew Chorlton: [00:49:07] I think there’s a lot of focus on rate rises, but the timing and the magnitude of those rate rises is really important, added to Michael’s point, the client expectations. The challenge that a lot of duration neutral and negative situation strategies have had recently is that they’ve been waiting for this imminent rate rise for so long, it’s cost them money. They’re eating their lunch so to speak, because there is a cost of putting those strategies on. So you have to marry the risk sensitivity of the client with the nature of the investment. And that seems to be key because if The Fed does like 15 September and then is done, it’s a very different environment if they do 50 in June and 50 [unclear] afterwards. So just raising rates in and of itself isn’t enough really, to answer the question of the call.
Courtney: [00:49:54] That’s a really good point. And, JR, your final takeaways.
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JR Rieger: [00:49:56] Well, given rising rates are somewhere in the future, we don’t know really where they’re going to be, but they’re somewhere out there. I’d be more concerned with the credit spreads widening and taking on more credit risk, because that can pop, you know, the Triple B spread can just pop from Triple A.
Rick Harper: [00:50:14] I think the big advice we would give investors, is take a real strong look at your portfolio and see, are you comfortable with the risk you’re taking. And that, have you accurately quantified the risk you’re taking? And a lot have seen their duration drift tire than what they might be accustomed to, you might want to dial down a little bit of the risk. You know, with floating rates, maybe something along the lines of hedging some of the interest rate risk out. But take a real strong look at your portfolio because there are some unintended consequences from an investor neglecting not looking at their funds.
Courtney: [00:50:51] Interesting. Michael, your final takeaways.
Michael Livian: [00:50:53] Final takeaways is that do not fear too much The Fed. I think that we are in the seventh year probably of an expansion, you know, we have to look at historical patterns, at some point expansion is … it has been very mild but it may moderate. I think that by raising interest rates, The Federal Reserve may actually slow down the economy. And that long term rates will respond. So do not fear too much interest rate risk, make wise investment decisions when it comes to credit. And take into account the fact that a 20% dollar move is almost like an interest rate hike when it comes to controlling inflation, I mean it’s really importing deflation, slowing down manufacturing, that is the factor, a monetary policy move.
Courtney: [00:51:40] Interesting. Well, these have been such great points, thank you all, gentlemen.
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