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With continued Fed uncertainty where do Fixed Income markets stand? Watch as four top experts discuss the state of the markets and where investors can find opportunity
Raman Srivastava, CFA - Co-Deputy Chief Investment Officer and Managing Director at Standish Mellon Asset Management Company LLC
Tony Rodriguez - Co-Head of Fixed Income at Nuveen Asset Management
J.R. Rieger - Managing Director, Global Head of Fixed Income at S&P Dow Jones Indices
Joseph Higgins - Fixed Income Portfolio Manager at TIAA-CREF Asset Management
Duration:
00:57:43
Transcript:
Courtney: Alright, Raman I want to kick off with you. How should investors be thinking about global Fixed Income opportunities in today’s markets?
Raman Srivastava: [0:00:06] Thanks, Courtney. Well, with respect to global Fixed Income, I think there’s a couple of ways to look at it. First there’s structurally, so there’s a couple of reasons I think investors might want to consider global Fixed Income. First off quite simply is diversification. I mean when you’re looking at Fixed Income to the extent that a lot of your exposure is based in the US, one of the basics tenants of investments is you want to diversify into other sources of, in this case, duration of exposure. Second main reason is opportunity set, you know, increasingly what we have seen is a shift to more and more issuance coming outside of the US. The US at this point makes up roughly 40% of the global Fixed Income market which is, you know, much lower than it was 10 or 15 years ago. So that’s the structural part of it. The cyclical part of is if you look at where we are now in the Central Bank cycle globally, particularly in the developed world you do see some pretty striped differences, you know, we’ll debate I sure, you know, about The Fed and when they’re going to start tightening, at the same time we may debate how aggressive the ECB or the Bank of Japan might be in easing. So that’s … and as we all know, Central Banks have a very powerful effect on Fixed Income markets.
So that’s, I think, some of the considerations, the one thing to be weary of is currency risk. You know, currencies to the extent you’re investing in global Fixed Income unhedged, currencies can introduce a tremendous source of volatility. So you know, I think it’s careful to think about how you might want to hedge some of that perhaps undue currency exposure, particularly within emerging markets. But in that … but having said that I think global Fixed Income is worth considering at this stage in the cycle.
Courtney: [0:01:36] Yeah, really good point about currency hedging.
Tony Rodriguez: [0:01:38] Yeah. You know, Courtney, I mean I agree with that, that I think the diversification [inaudible] and so much we’re a part of the market. And so investors should be exposed to that from a strategic standpoint. I also agree that when you’re thinking of the risk you’re taking, the duration element of it is, there are better markets than in the US to be taking duration risk, so that’s a great opportunity. Totally agree on the currency side though that you have to be careful, with many of our strategies we’re able to do … take currency risk. You know, we’re really negative on kind of yen, euro developed country currency versus the dollar. And we’re also in contrast to maybe two years ago, negative on most emerging market currencies as well as most of those countries are obviously having a difficult time dealing with the commodity route that we’ve seen and some of the global growth pressure. So the currency element of it which oftentimes is one of the attractive components of the global side, I would say right now fewer opportunities there from that standpoint.
JR Rieger: [0:02:31] Yeah. I would say that we can’t underestimate the power of a slowdown in China, the ripple through or rippling through the Latin American or emerging markets in regards to commodity producing countries and companies. So it’s a real unknown and we’re pretty early days here. So it’s one of the risk areas that investors need to consider.
Courtney: [0:02:51] Absolutely.
Joseph Higgins: [0:02:52] And you talk about, you know, that affecting the bond market, but of course it could even have a bigger impact, and certainly we’ve seen some of it in the equity markets. So when we talk about global bonds and the value that lies therein, we really also have to talk necessarily about other asset classes, equities and the like and the diversification across them really is quite compelling.
Courtney: [0:03:12] Well, where do you see the correlation between the bond markets and the equity markets right now?
Joseph Higgins: [0:03:15] Certainly, Courtney, during periods of extreme volatility, correlation always arises. So in the post Lehman bankruptcy crisis we saw extreme correlation. We’re seeing more correlation now. I think that a Fed increase is probably going to be more problematic for bonds than it will be for equities. And what’s key there is how earnings come out and the impact of, for example, on the S&P of the dramatic strength of the US dollar and other items. But the correlation will come and go. You still want to be of course, you know, in multiple asset classes.
Tony Rodriguez: [0:03:54] Yeah, Courtney, one of the things I find interesting, when we look at the markets now, what’s being priced in and clearly there’s a lot of fear and certainly around global growth led by China, around kind of policymaker activity, particularly The Fed when they launch. When we look at the markets, we look at the equity market, we think, well that’s certainly off, right. We’ve had a down year so far. The valuations there are not as pessimistic and have not priced in as much downside as what we see in some of the credit markets, investment grade corporate bonds, high yield corporate bonds, even in the emerging market space. Where there we think valuations have discounted a more severe economic environment. So when looking across those assets our view is that maybe the better risk return opportunity lies in taking your risk actually in the Fixed Income space, taking on the credit risk there where the valuations are now more compelling when we’re looking in some of the equity markets.
Raman Srivastava: [0:04:48] No, definitely I’d go back globally, because if you think about in the US and other markets, what has supported not just bond markets but equity markets have again been, you know, very accommodative Central Banks. And to the extent that now, you know, in the US you’re starting to see, in anticipation of a pullback. To some degree that’s already been factored into a fair amount in many of the credit markets. And if you look globally you’re not dealing with this dynamic. And everyone is dealing with a low growth dynamic across a developed world, but at least in some of these other regions you still have fairly accommodative, in some cases extremely accommodative Central Bank policy which is generally good for both bonds but also risk assets like equities.
JR Rieger: [0:05:26] I think it’s important when we talk about asset classes that we’re not throwing the baby out with the bath water. Within the US high yield markets, some of those high yield credits are just grinding along and paying back their loans and investors are earning pretty decent yields relatively to risk free rates. But there are segments of that pile of bonds that have elevated risk over the last year/year and a half. And energy would be an excellent sector to highlight that risk right now, the credit spreads are popping for energy. And we’re seeing defaults rise in the bond markets, particularly here in the US.
Joseph Higgins: [0:06:05] Right. And so when correlation increases it becomes really a credit picker’s market to your point, you have the baby thrown out with the bath water sometimes. And the importance of fundamental analysis and careful asset allocation really shines through as a way to create value.
Courtney: [0:06:20] That’s a good point. And you mentioned earlier, Tony, that if you wanted to play duration the US wasn’t the best place, where do you see the opportunities?
Tony Rodriguez: [0:06:28] Well, in the US is because we’re not very bearish on US rates. We do think that you’ll see just a very slow modest upward pressure on rates whereas as we were talking before about some of the global Central Banks, when you looked at the European markets, particularly larger liquid markets like your German bond market. We don’t see the ECB moving towards less accommodation any time soon, given the growth and inflation dynamics going on in Europe. We don’t see the Bank of Japan becoming any less aggressive. So we think in terms of large global bond markets those are a better placed situation. The low yield is obviously a little bit of a deterrent. That is part of what will continue to keep a lid on US rates. And from a comparative perspective we are the highest yielding in a very low yielding world. But I think the duration bet in the US is probably one that’s not going to pay off for investors. You’re going to get hurt a little bit particularly in high quality assets like treasuries versus again, in the European markets we expect more stability there on rates.
Raman Srivastava: [0:07:26] One thing to remember is what … depending on where you are in the world, what can be bad for growth it can actually be good for bonds. So if you think about, you know, we’ve alluded to China a little bit, I’m sure we’ll get into it. But there are parts of the world that are going to be hurt from a global growth perspective in terms of what’s happening in China. And in certain emerging market countries that can be extremely disruptive, Brazil’s a good example of one where both stocks and bonds will be negatively affected by that. In developed market countries, so you know, to answer the question, if you had to choose a market outside of the US, well, if you look at a country like Australia, triple A country. The cash rate there is 2%, plenty of room for the Reserve Bank of Australia to decrease rates, dealing with a slowing economy, highly tied to China. That’s a market where we’d say, you know, it actually … it’s counterintuitive, but a slowing China and a slowing growth of [inaudible] Australia actually helps the bond market because again it keeps the Central Bank extremely easy.
Courtney: [0:08:21] That’s interesting. And it is such a global picture, do you think that globally, there are a lot of inflows to US treasuries, is that going to keep a lid on yields?
Tony Rodriguez: [0:08:30] Yeah. And I do think that’s one of the factors. I mean there’s obviously more of inflation in the US, there’s obviously moderate growth. So you’re not getting a lot of pressure there, where there’s wages or other inflation pressures. But we have a very low yield. You know, the real return on the 10 year treasuries are historically low. It should be low, we think a little bit higher than here. But again there’s a lot of demand not only coming from non-US investors who when seeking liquidity and safety they’re still the largest safest most liquid market and happens to also be the highest yielding amongst those large liquid markets like Germany, like Japan. So that helps keep a lid. There’s a lot of demand coming in the next couple of years from long duration investors who are liability hedging, and their pension obligations and retiree obligations and healthcare obligations. So that’s also, you know, people estimate multi trillion of dollar demand for long duration high quality assets. So the global piece is certainly one of the elements that’ll help I think make it a very shallow gradual rise in rates, not only from The Fed’s policy perspective but from the longer end of the market as well.
JR Rieger: [0:09:37] Yeah, risk off, risk on, is a double edged sword. You know, we use the term RORO for risk off, risk on. But it really is that … that other side of the sword is very sharp and what I’m referring to is it’s pushing investors to extend risk just to get incremental yield of even 50 or a 100 basis points. And that elevated risk may not be compensating those investors over long periods of time for that incremental basis point return.
Raman Srivastava: [0:10:07] I think just take the other side, I mean there’s definitely demand for US treasuries from pensions that need to be hedged. There’s two important dynamics that an investor should think about which is going to be different and one of them is happening right now, which is China which has been in a period of reserve accumulation, treasury accumulation has begun to shift that out. Now, we don’t think it’s going to be a rapid, massive fire sale of treasuries. But it’s worth noting that this long term trend of one way flow from that part of the world anyway is now shifting. And the other one obviously is The Fed. So The Fed, again, The Fed has not announced any sales. But over time we would expect The Fed balance sheet to be shrinking as opposed to growing. So those are just two major players in treasuries specifically which again, already have begun to sort of shift the other way.
Courtney: [0:10:59] Well, to pick up on something you said, Raman, I mean there is a note from the sell side that recently came out suggesting that we would see quantitative tightening, you know, China sold a lot of US treasuries to support the yuan, it would amount to tightening on our end. There’s been a lot of debate about whether that will or won’t happen, what’s your view?
Raman Srivastava: [0:11:18] Well, I think that’s right. I mean the debate though is the magnitude and the speed. I think that and who know because if you think what China’s dealing with overcapacity, high levels of debt, you know, reserve depletion, capital outflows, aging demographics, you know, other than that it’s fine. But I think it’s a big question I guess to what degree are they going to be able to need to keep reserves in order to meet these capital outflows. But no matter what it is in that sense quantitative tightening, in the sense that you are now, you know, decreasing that reserve level, there’s three and a half trillion, let’s just say roughly in reserves, is it a trillion that comes out over a year, over two years? You know, how disruptive is it? Our base case is it’s actually not all that disruptive for the US treasury market. It shouldn’t cause a, you know, a spike in yields or anything like that. But again it is a changing dynamic, we don’t have this bid to treasuries that you’ve had consistently for years now from China.
Courtney: [0:12:15] And so not that disruptive, what do you think Tony?
Tony Rodriguez: [0:12:17] Well, the other point … I agree it won’t be that disruptive in our mind. It’s going to be a continued pressure. And you know, the recycle of the petrol dollars is another element of that where, you know, they’re obviously earning less than half of what they were in many of the oil producing countries, particularly in the Middle East. So those are all elements that will help to kind of reduce some of the demand. But again, the yield pressure that comes from investors globally, insurance company, pension, that we think will certainly provide that offset. And again globally we look more attractive. So it’s part of what causes us to, while we’re bearish on rates, think that we’ll see a rise. We don’t think it’ll be dramatic, it’s not going to be sharp, it’s not going to be fast, it’s not going to be large. But it will be a gradual pressure. So if you’re sitting in treasuries, we would say you’re probably going to see, you know, anywhere from very, very low single digit zero returns to modestly negative returns kind of at the longer end of the market.
Joseph Higgins: [0:13:08] Yeah. We would say as well there’s probably more risk in select deep credit securities, perhaps even still at this point after a significant correction, triple C type high yield for example than there would be potentially in treasuries. And in fact we have of course US buyers stepping up; we have banks, unfortunately or fortunately adding significant amounts of treasuries to bolster their balance sheets for Fed reviews and the like, so. And of course China is a major holder if not the largest, but Japan is close in size. So the potential disruption, as I think we all agree, it’s pretty De Minimis.
Courtney: [0:13:42] So De Minimis, okay. JR, did you want to jump in on that?
JR Rieger: [0:13:45] I can’t add.
Courtney: [0:13:47] Okay. I want to pivot to liquidity and volatility, big topics in Fixed Income right now. We’re seeing more volatility, less liquidity, Joe, tell us why and what’s the implication for bond investors?
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Joseph Higgins: [0:13:57] Well, generally there are periods of illiquidity surrounding systemic or secular changes in the market. We’re seeing perhaps the end of several super cycles in the likes of commodities and you could argue high credit risk bonds perhaps. There’s currency shifts taking place that may be secular in nature. We’ve had some significant headlines in the corporate space, VE, Glencore, we have issues that have been touched upon and weakness in China, weakness in Brazil. A lot of cross currents and a lot of investors are basically taking a step back and waiting and see, you know, waiting for direction, direction from The Fed, could potentially create a bit of a rally. We are in a situation where there is perhaps less liquidity than there has been historically with the street making less in the way of markets. We don’t think there is kind of any systemic problem there though. But it’s something that as an investor you want to be paid for and in fact you have to assume that for your deeper quality investments that liquidity will not be there when you want it. You really have to hold things to maturity sometimes.
Tony Rodriguez: [0:15:03] I think that’s a good point, I mean there’s definitely less liquidity in the market, fewer dealers, smaller balance sheets. There’s more volatile flows, a lot more investors in ETFs, more active managers. And so I do think we’re going to be in a structurally lower liquidity environment for the next few years. But I do think that … I don’t see it creating any large systemic, you know, financial market seizure. But it is something that investors need to grapple with just on a daily basis. And it does lead to a couple of things of, you know, smaller position sizes, maybe a larger liquidity premium when you’re entering into a trade, a more diversified portfolio. And very importantly, as you mentioned, having that more medium term horizon, so really being able to do your fundamental, whether it’s macro research work or credit research work, so that you can ride through the inevitable periods of volatility and maybe zero liquidity during certain market hiccups by virtue of your strong research to be able to see through that, pull up your position. That I think allows you to really take advantage of that liquidity premium that’s in the market. So there are opportunities as a result of it but it does require more careful, you know, research perspective being brought to bear on the market.
JR Rieger: [0:16:12] Liquidity is one of the elephants in the room for Fixed Income, it really is. And we have done a backward looking review of liquidity on the investment grade indices, the broadest ones in the corporate world, about 88% of the bonds trade on any given month, that’s pretty good. It really is a pretty good number. When we step down to more opaque markets like investment grade municipal bonds which are many more bonds, they’re much smaller in deal size, it drops down to about 66% of those bonds trading on any given day. So are you getting paid for that incremental change in liquidity is the real…
Joseph Higgins: [0:16:53] That’s the operative question, right, yeah.
Raman Srivastava: [0:16:53] It’s also the opportunity. I mean I think you know, so it’s obviously important to focus on the risks associated with liquidity. And as bond guys we tend to be negative. But I think there’s also a, you know, there’s an opportunity there. And the opportunity which was touched on is if you just think conceptually, what has happened? So there’s been a lot of regulation which has prohibited dealing, has prohibited hedge funds from gaining capital to the extent they used to. And these are two examples in the market, it used to be liquidity providers and get paid for providing that liquidity to the extent that those have stepped back. What that means is as has been alluded to, spreads are wider, yields are higher. That benefit should flow through via asset managers to our clients, so that is a positive, so that’s one thing. The second thing which I would absolutely agree with is retail flows have become a lot more important for specific parts of the market in particular, you know, high yield bonds being one of them. So you could just sit back and ride it out and deal with the higher volatility or you could be conscious of the fact that they are going to have these pockets of volatility and again try and be the liquidity provider in times of these pockets of disruption to actually benefit from some of that. So it’s easier said than done. But volatility creates risk but it also creates opportunity. And I do think in some of these gyrations, there is some opportunity, not to mention just the structural benefit of having higher spreads.
JR Rieger: [0:18:12] And I think with the advent of ETFs, you know, you’ve introduced that retail investor emotional decision to move in and out. You know, so that does change the dynamics where the mutual fund investors would, you know, invest for longer periods of time.
Raman Srivastava: [0:18:27] Or an institutional investor, I mean in high yield as an example, you know, the retail, you know, between ETFs and mutual funds now represent over 20% of the market, that used to be mid single digits 15 or 20 years ago. So you just have a much higher proportion out of the hands of institutions which tend to be, you know, multiyear horizons as opposed to, you know, multi months.
Tony Rodriguez: [0:18:47] And we always said that in that environment when price becomes a shock absorber. So there isn’t the market makers to be a shock absorber. So therefore you get prices that move further from fair value in those periods of stress and that’s the opportunity to take advantage of. And I do think that that used to be monetized more by the street, by professional investors. And really that opportunity now sits really often with the retail investor. They often have the time horizon and the patience to be able to sit through that and put money to work, when the price shock absorber is in effect that it’s 10 points below fair value. And it happens obviously to a larger extent in less liquid markets, being high yield emerging markets etc. So I do think it’s a big opportunity that now has become available really to a broader set of investors, it used to be taken advantage of mostly by just the street.
JR Rieger: [0:19:34] And bonds are becoming much more tactical with the tools now retail investors have versus a few years ago, the ability to trade in today and take a view in today. That wasn’t there when I was growing up as an analyst, all those tools now help create a little bit of transparency, additional transparency and give some advantages to those who are paying attention and willing to take the risk.
Joseph Higgins: [0:20:02] But I think we all agree the present situation is more price volatility and less liquidity potentially than historically was the norm.
Tony Rodriguez: [0:20:10] Absolutely yeah, I think so.
Courtney: [0:20:11] And with liquidity, when you look at the banks and they have these new regulations, is there anything on the horizon that could potentially change those regulations and allow banks to carry more debt on their balance sheets?
Joseph Higgins: [0:20:22] Well, I mean certainly The Fed is aware of the situation. And I think they have made comments to the effect of, you know, there is no systemic risk currently posed, which certainly we would agree with. I think it’s to be determined as we touched upon before. There are certainly … the street remains more than able to be an intermediary between large investment firms, that is, you know, and this earlier you touched upon, you know, will react to price movements and you know, put on the [inaudible] and whatnot. Flows though out of funds could potentially force hands of sellers and you know that remains a risk, but something certainly much less than systemic.
Tony Rodriguez: [0:21:01] Yeah. I would think that there probably will, we would expect and hope some easing of the regulatory burden, not only the financial services industry, maybe more broadly. But I don’t envision it being dramatic. I don’t envision us going back to kind of pre crisis days of leverage in the financial sector, availability of capital too, investors like hedge funds and others. So maybe some modest easing but I wouldn’t see it as a really dramatic C-Change, capitals will still be required to be high, liquidity levels are going to still remain relatively onerous on a comparative basis to pre crisis.
Raman Srivastava: [0:21:35] Unfortunately crisis is the key word there. I mean it took a crisis for this regulatory change. And it is difficult to reverse it. We haven’t touched upon the money market fund industry. But there are some, you know, fairly dramatic changes happening in our market. And they are all on the regulatory side, tighter. You know, so you have a Fed who’s doing all it can to be as easy as it possibly can and then at the same time you have, you know, a much tighter regulatory environment. And personally I think unless you have a crisis on the other side where you have, you know, something really disruptive in either the money fund industry or the mutual fund industry in general, I think it’ll be tough to see a wholesale change, it will be with the gradual at best, you know, shifting in these regulations.
JR Rieger: [0:22:17] Go back to liquid asset classes, you know, the definition of high quality liquid asset classes I think has to be broader. I think it’s unfair to exclude certain asset classes like investment grade munis, with a very low default rate, maybe there is a drop in liquidity, you can argue about the liquidity. But you can certainly reward the banks for investing in the infrastructure of the US by allowing them to include high quality municipal bonds as a liquid asset.
Courtney: [0:22:51] Interesting. And I want to turn to sectors, JR, where do you see the opportunity set, in which sectors and where is the yield worth the risk?
JR Rieger: [0:22:58] Yeah, that’s an excellent question. So we’re breaking out sectors now based on the S&P 500 sectoring in the US world. And energy right now still evolving in my mind. But there’s interesting opportunities in the financial sector. I mean when you look at the financial bonds versus the aggregate investment grade pool they’re still driving what’s going on in that market. So to me looking at that is important. And then there are dislocations in how consumers are spending. So the consumer discretionary sector is fascinating to watch because that does dislocate from the general market at times as you and I buy less or spend more, it does impact that particular sector. So we’re able to track it now and these are relatively new tools for us.
Courtney: [0:23:48] Yeah. And it’s interesting. Are you seeing a transition with especially the lower end consumer getting savings at the gas pump, is that translating into more consumer spending and then flowing of course through the capital markets?
JR Rieger: [0:23:59] Well, we’re not seeing that. But we’re actually seeing a little bit of a bump because we track how retail folks, you and I pay off our credit cards and pay off our mortgages, both first and second mortgages. And there’s been a little bit of a bump up in new defaults on the mortgages, which is fascinating. But you know, from my perspective it tells me that maybe those jobs that are being created aren’t as robust positions as the federal government would like to see us recognize here. While unemployment may be dropping, is it the right level of employment that’s being measured.
Courtney: [0:24:40] It’s a good point. Joe, what sectors and regions do you like?
Joseph Higgins: [0:24:43] You know, in this volatile environment we find value in almost every single sector. But we have as well been focusing to a large extent on US centric investments where the consumer is certainly gaining strength. So that would include quick service, everything from quick service restaurants to subprime [inaudible] which you touched upon, Courtney, commercial mortgage backed securities where there’s more people residing in buildings, we’re in favor of as well. Even in the high yield space there is a lot of US centric high yield issuers outside of oil and gas, that can be debated on the value front, that have turned out their maturities in this liquid environment. And really have very little in the way of [inaudible] risk, so we find value there as well. Even in the EM space there’s winners and losers and we are certainly benefitting broadly from lower gas prices as a net importer, a significant importer of oil. And then you have the exporting countries whose consumers and indeed economies are suffering a lot and likely will continue to do so. But a lot of value to be had for a fundamental approach and a credit, you know, picking approach.
Tony Rodriguez: [0:25:49] And I would agree with that, we like those areas. I definitely think credit markets in particular have repriced to a point where they’re attractive broadly. We still like financials, they haven’t repriced so much, but there the credit quality is very stable. We like going down in cap structure there, so going into the preferred space, we think there’s still quite a bit of value. When we look at things like the high yield market we do think that everything has really underperformed but there’s certain areas that have obviously been at their worst, like the metals, mining, energy space. Anything in the lower quality space where you can find a good credit without high refinancing risk, decent cash flow, right now is being priced very attractively from a risk reward. Because although we think defaults rise, we don’t think they’re going to go to recession like default levels. In the energy space we think there are many, many companies there that have been priced to bankruptcy that will survive a $40 or 50 oil price environment with maybe some modest rise in energy prices in the second half of 16. So those major ones that we think you can begin to dabble with, so energies, we always say there’s no bad bonds, just bad prices. So some of the energy bonds have clearly been priced to default already and that’s an exaggeration. Many will default, and you want to be a little worried of those. And it gets back to our earlier point about the fundamental credit research in a credit picker’s market. But that is a fertile area because it’s really all been sold off aggressively.
Courtney: [0:27:14] Where’s the better opportunity set, metals and mining or oil?
Tony Rodriguez: [0:27:17] I would think that energy probably more so as we’re seeing more, there’s more opportunities, more companies, so there’s more options there really, because there were so many companies that really entered the energy space. But that said, certainly in the metals and mining there are a few opportunities as well. But energy is a little bit larger on a playing field.
Joseph Higgins [0:27:33] You know, I’ll tag onto Tony’s point if I may, on value and high yield and in the energy sector in particular. Generally the market is pricing that companies will not react, will not cut CAPEX, will not issue stock in limited cases or sell assets. And so there really is some significant dislocation there that can be monetized, to your point.
Raman Srivastava: [0:27:54] So we’ve been devil’s advocate. So first I would agree with that actually. So we would agree that there’s value in credit markets, there’s value in CMBS for example. And you mentioned 40-50 oil, you know, I think one of the lessons learned is in particular given the uncertainty around China, is to the extent you’re evaluating companies and you have a distribution of assumptions on various metals or oil or various inputs. The range has to go wider. I mean just because, you really don’t know. You really don’t know whether China’s going to be slowing to 6½%, 6%, 5½, you know, and at what speed. So you do need to evaluate companies around a range, not of say just 40-60 in oil but actually 30-70 maybe or, you know, let’s look at how companies do at 180 copper, you know, at these levels certainly in the past, but seem unfathomable. And when you do that you still actually do find companies in both of the markets, you know, high yield and higher grade that makes sense. So I absolutely agree with the point about fundamental work in selection.
The other thing, you know, just the way you phrased the question, you know, what sectors are attractive. We do tend to think of these sectors. And I think one of the things we’re seeing now with respect to the emerging market sector is this idea of, you know, very much divergence. And I know I mentioned, you know, India and as an example of one of them. There’s also less followed examples, you know, places like within eastern Europe, you know, a country like Morocco which, you know, grows at, you know, a very high rate with low inflation and they’re really benefitting from the decreased energy prices of the import a lot of it. But these are less followed markets, less liquid in some cases. But you’re getting paid at this point a significant premium because of the, you know, just the mass of selloff across the board in these sectors. So there’s plenty of opportunity and you know it seems again counterintuitive because yields are low. But there’s actually plenty of opportunity in global Fixed Income markets today.
Courtney: [0:29:51] And I want to circle back, you mentioned China a few times, where do you see the best opportunity sets, both risk and reward, taking that into account in a slowing China?
Raman Srivastava: [0:29:59] Well, I think one thing, time horizon is very important. So China, you know, it’s not going to be … we don’t think it’s going to be a straight one way down collapse. There’s plenty of tools they have to mitigate this. And in fact even if you look at the response to the reaction – the market reaction in August when they, you know, changed the, you know, lowered effectively the value of their currency, I think the subsequent market reaction was surprising for them and really for a lot of us. And the reaction to that was appropriate. And I think has stabilized the market, you’ve seen the PMIs and you’ve seen other areas. They have this ability. So if you’re on this, you know, the steady decline you’re going to have belts of volatility, almost by definition because what they’re trying to do is extremely difficult. So I think the opportunity then is in … is reacting to that. You know, recognizing when there is an overreaction in the market to a policy decision, an economic release, something to that effect and taking advantage of that. There’s also going to be an opportunity in like I said before, understanding the ranges of these potential distributions on input prices or other things. A lot of, you know, you need to do your work. And if you can do your work you can get fairly comfortable with countries and companies that will survive irrespective of whether it’s a, you know, a fast decline to 5% or a gradual decline over time.
JR Rieger: [0:31:17] But to do your work you need to have the companies that you’re lending money to be transparent.
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Raman Srivastava: [0:31:23] Well, it doesn’t necessarily need to be Chinese companies, you know, it could be Glencore, you know, it could be companies that are, you know, that are transparent, where you do have that. Yeah, it doesn’t necessarily just have to be, you know, Chinese companies.
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Tony Rodriguez: [0:31:32] Because I think the market has … there’s so many now macro traders and fast money in the market that when there’s some fear on China there’s a large amount of selling across multiple global capital markets that result from that, just from the uncertainty of well, how fast will they slow down for example. And so I think that’s where the opportunity is, how much of markets … again, my argument earlier had been that, I think the credit markets in Fixed Income have reacted more strongly to that, negatively to that than say global equity markets. So when you’re looking at that risk reward and where valuations are for any given scenario of China and I’m sure, you know, everyone has a slightly different view. We think it’s slowing but not collapsing, we would agree with that view. It’s looking at those markets that have overreacted and feel like maybe China is going to be hitting … really hitting a brick wall on growth, not having any policy response and leverage. Again we would agree with the view that they do. There won’t be a brick wall, so those markets that have reacted that way that’s where the opportunity is. And we’ve talked about a lot of those already but that’s I think the way to kind of look at the China situation and try to take advantage of it in the capital markets.
Raman Srivastava: [0:32:39] It is an enormous bond market, it really is. And the major challenges that we have seen is the access to data, access to that trade data or good clean data, data people can be comfortable with. I don’t want to say that people have a hand in everything, but then the government does control a lot of those markets. And it may mask some of the important information that investors need to know about those markets. When you look at money markets coming out of China, very highly rated by local ratings agencies but at an 8% yield it doesn’t match, you know, it’s a disconnect.
Joseph Higgins: [0:33:21] Indeed, even the quality of their economic releases is often suspect and has to be taken into account in trying to figure out exactly what is going on there. We do feel there is a tail risk essentially that a significant slowdown in China, not a base case by any means, you know, could be deflationary on a global basis and be good for bonds up to a point. And then also at some point from a tail risk perspective, you know, really cause a lot more in the way of problems and defaults.
Courtney: [0:33:49] Yeah. The last GDP number they posted was what, 7%, I think that was very much called into question, right? And also what was really interesting I thought was the Chinese domestic corporate bond market rallied around their easing. But like people are arguing that’s overheated.
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Raman Srivastava: [0:34:04] Yeah. But there’s a lot of debt in China. I mean, you know, overheating again it … there’s a lot of also government intervention. So there’s a lot of support through land sales etc for debt servicing in local government debt as well as other debt. We would have some concerns on the corporate side, just on, you know, so if you think about China and other emerging market countries where corporations have lent in, you know, either dollars or in this case a currency, you know, highly pegged to the dollar, to the extent you … and your revenue’s in that local currency to the extent you have depreciations in that currency. You have to, you know, roll over your debt based on US dollars. There’s a bit of a mismatch there. And if you haven’t hedged it which hardly anyone does, then that creates a risk in the market, usually for corporations. So there is that concern. You know, I think the … but like, you know, has been mentioned here before, there’s a lot of response that can be, you know, stimulus is already being done in China. The other thing they haven’t touched on yet is just regionally again, there’s winners and losers from this. And so when you have currency depreciation, you know, in the US we all look at it versus the US dollar. And certain countries, even Brazil, you know, you’re seeing some benefits in the current account from the fact that the Real’s down 15%.
What’s interesting to me is if you look at Asia ex China, you know, countries like Korea or Philippines or Taiwan, their currencies have fallen a lot versus the dollar, but versus each other not as much. And you actually aren’t seeing a big rebound in export growth yet, which is kind of really troubling, you know, the fact that you actually had a currency adjustment yet you haven’t had a response in the current account. So again we’ve talked a lot about doing your work but there are definitely going to be winners and losers, it’s going to mean different things for equities versus bonds. You know, you could argue that again like Australia, this dynamic’s actually good for the bonds, maybe not for the currency and perhaps not for equity. So it does, you know, it is a bit complicated when you go to the global space. But there’s … like I said before, there’s lot of opportunities around this.
Courtney: [0:36:08] Alright. Well, we’ve talked a lot about global Central Bank intervention, let’s talk about our own Central Bank, The Fed, Tony, what do you think is going to happen?
Tony Rodriguez: [0:36:15] Well, our view is that they will most likely begin liftoff in December and the market’s still not pricing that in as the base case. We would have preferred to see them start in September. We think they’ve missed an opportunity. But we also think that the more important thing to focus on is not the date of liftoff, whether that’s the next meeting in December or in the first quarter of next year. It’s really about what the path will look like, how aggressive will they be? How fast and over what timeframe? And there we are strong believers that they will be very patient, very gradual and it will be a very shallow rate lifting campaign for The Fed. So we would say December, but we think the economy no longer needs kind of the emergency measures of zero rates. We certainly aren’t in the camp where the economy needs to have, you know, restricted monetary policies. So these are going to be accommodative. But at 25-50, at 75 basis points it would still remain accommodative. So we think they start the process and we think that there’s been too large of a focus by investors on the actual day of liftoff. It’s really much more about the path and there we’re very confident that it’s going to be gradual and shallow. And therefore not disruptive, importantly to the capital markets, not only the US but globally, certain markets will suffer more. I mean emerging markets are kind of a [inaudible] for people worrying about tightening from The Fed so to speak.
Emerging has already priced in a lot of that risk in many places, in the currency side and the spread side and credit and the equity side. But you know there are certain places like that that may suffer more. But again we don’t think it will be disruptive for the capital markets outside of the very near term occasion of the tightening where the market seems so focused on it. And so wanting to have a knee jerk reaction to that, but that will certainly create some volatility.
Courtney: [0:37:58] Alright, so smooth trajectory, mostly priced in, you said it was priced in, in emerging markets, do you think it’s priced in pretty much everywhere as well.
Tony Rodriguez: [0:38:05] I do think that in the credit markets they will be able to withstand the increase in rates without any problem at all. So fundamentally won’t alter the credit risk. Near term volatility is again of the focus on the actual date, whether it will be in December, earlier or later. But in terms of the fundamental impact we don’t think it will be disruptive to the US credit markets.
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RJ Rieger: [0:38:24] And we’re actually seeing institutions come to us to create indexes that are long duration and long intermediate duration exposures, which tells me that they are waiting for out there, anticipating a low slope to rising rates.
Courtney: [0:38:41] Yeah. So I mean when The Fed does raise rates the short end of the curve will be under pressure, I guess this is creating more demand on the long end. Are you seeing a lot of that?
JR Rieger: [0:38:47] We’re seeing actually very long duration demand. And it’s all about tactical exposure for those particular institutions. If they see something being priced relatively cheap or historically cheap they want to be able to tactically move in to the longer duration in that area and switch out of another asset class, so long duration not just in corporates, but in global sovereign as well.
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Joseph Higgins: [0:39:11] It makes some sense when you think about it as even The Fed at this point is certainly not behind the inflation curve and to the extent that they start raising as we expect in December as well. You know, the long end becomes all the more attractive potentially as the ultimate threat of let’s call it entrench inflation diminishes further. We even think bonds are poised … spreads are poised to rally when Janet Yellen does announce. And part of that, and more importantly than … I think Tony had touched on this, you know, the amount of the increase, 25, 50 or 75, it’s really the tone of her language and the power of her language to offer some stability and direction, most importantly, to markets.
Raman Srivastava: [0:39:50] Yeah, I’d say, it’s interesting, you know, at the beginning of 2014 after the 2013 rise in rates, everybody expected rates to go up. You know, now it seems like the entire market has shifted to this new debt, rates aren’t going up. You know, it’s going to be gradual, there’s really no inflation in the market. I actually think if you look at what’s priced into the very front end of the curve, even though I would agree, I think it’s going to be, you know, they’re not going to be hiking [inaudible] 1994 or 2006. What’s priced in right now is too gradual I think. You know, there’s not enough priced in. And people say, “Well, how can you possibly say that, you know, inflation’s low, you know, all this disinflation enforces, how could you possibly think that, you know, two or three hikes, which is what’s priced in now, between now and the end of 2016 is too low?” The reason is, and as The Fed has alluded to, policy acts with lag. And the lag is anywhere from 1-1½ years. And we’re still in the US sitting here, and we can argue what narrow is and then they continue to revise it down. But the reality is, we’re going to be knocking on 4% unemployment, you know, on the big measure, [inaudible]. But even on the broader measure, it’s going to be coming down even if there are more part-time workers, etc. So at some point there is going to be inflation.
And if you have a lag of 12-18% and we’re at these emergency levels, you don’t necessarily need to only hike once every year, which you know, or one and a half times every year. I think you can be a bit more aggressive than that and still not disrupt, you know, financial markets, credit markets etc. So we’d agree with the gradual. I just think that there’s a bit too much complacency I think at the very, very front end of the yield curve. And that’ll be interesting to see how currencies and other markets react to that.
Joseph Higgins: [0:41:32] Raman, do you feel that way even with wage growth having been so low, will we have, in your view do we have a lot of the warning from seeing wage growth start to rise, you know, for The Fed to react or…
Raman Srivastava: [0:41:43] No. Well, the wages typically are lagging. I mean usually, you know, you want … wages will fall or if you wait for the … if you actually wait for, you know, 2½/3% wage growth, by that time you’re almost behind, you know, you have become … that’s where you could have a steepening of yield curves. And so you almost want to … you want to get ahead of it. In fact, you know, Janet Yellen has mentioned that, you know, we don’t necessarily need to see inflation be at our targets to begin hiking, especially off of emergency levels. We just need to be confident or comfortable with the medium term view that we will eventually get to you know, our targets. So you don’t necessarily need to wait for the recent speeches of, you know, talked about a lot of things, but seeing inflation is not one of them. You know, they’ve talked about stability in the dollar. They’d like to see stability in commodity prices, stability in global market developments and they specifically mentioned China. Of course they’re all related. But I think if you have, you know, but they don’t talk about we need to see, you know, a rapid rise in wage inflation before we hike because the reality is you need to, you know, because there’s a lag you need to get ahead of it.
JR Rieger: [0:42:44] And rising rates isn’t a bad thing for fixed income. You get to reinvest at a higher rate. So for reinvestment investors they’ve been dying for those higher rates.
Raman Srivastava: [0:42:54] I agree with the sentiment, that would be a good thing for risk assets. They removed one of the major uncertainties in the market, not completely, but it reduces one of the major uncertainties in the market.
Courtney: [0:43:03] And, JR, does this make you think about alternative Fixed Income, the opportunities out there?
JR Rieger: [0:43:09] Yeah. So the world’s changing, Courtney. You know, we saw a lot of interest in beta exposure and there’s a lot of money shifted towards simple core assets, core sovereign inflation and then core credit. What we’re seeing now in today’s world is a world that attempts to outperform the market. And we’ve seen smart beta, whatever that definition is I don’t know yet, factor based investing for Fixed Income, all designed to outperform beta. So we are being pushed and pulled to create benchmarks based on smart beta concept. It is very interesting to me as a bond guy because what you’re doing is really taking some of the equity factors that the way folks look at the equity markets and try to dissect the Fixed Income markets and look for those one or two key drivers of the return and try to systematically invest in that. I think it’s more like active management, that’s my own personal view when you look at smart beta. But it is a hot topic. I think a couple of years down the line, Courtney, let’s meet and talk about how it’s performed because we don’t know yet.
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Courtney: [0:44:20] Alright. Well, let’s take it a little bit deeper on active versus passive investing in this environment in Fixed Income.
JR Rieger: [0:44:25] Courtney, I’m surrounded by active managers. So I’ve got to be real careful, you know, these guys, they hire the best portfolio managers, have the best information, have the best traders, have the best systems. And theoretically they should outperform an index, right, an index is just a simple rules based basket of securities that intend to represent the market. But really is very sound, and when I joined the index organization eight years ago I was asked to talk about this very fact of active versus passive. And I said to the senior management, “You want me to tell the world that the active managers don’t outperform the benchmark?” And they said, “Yeah, here’s the facts.” And year over year we’ve published the S&P Index versus active report. And it should show a lot of funds outperforming in the Fixed Income world versus the benchmark, it should. It doesn’t, it has a lot to do with credit selection, interest rate decisions and duration management and the timing of those decisions. The index doesn’t worry about that, it just selects bonds based on the rules of the index, the active managers have to worry about that, real recently, the most recent report that we published, June, of June 2015, you would think US treasury fund managers should be able to outperform the US treasury bond index. Well, 70% of them did not for the 12 month period in June.
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Raman Srivastava: [0:46:04] I believe that. I believe that because…
JR Rieger: [0:46:06] They made the wrong call.
Raman Srivastava: [0:46:07] Well yeah, I would agree. I mean, sorry, you needn’t get me started because I have a very strong opinion on this. But in the treasury market that doesn’t surprise me because there’s a fee element. And then also your space is limited. So really you’re just making a view on duration and curve which tend to be pretty efficient. But I think when you broaden it out I do think there’s some structural reasons why active management makes sense in Fixed Income versus other asset classes. And as you mentioned, the indices are rules based. One of the rules is around ratings. So to me, Fixed Income markets are efficient to the extent that rating agencies are efficient. And raise your hand if you think rating agencies are efficient, so that’s one. The other thing is if you look in … and there’s a few of them but I won’t list them all, but there’s some structural, a lot of people in the US have taken on a mortgage. They’ve had the ability to prepay that mortgage or repay it. That costs something, that’s a cost yet no one really knows what that cost is. The reality is that cost is about 10% more than it should be. And that’s again, a structurally embedded premium in the mortgage bond market that you can earn over time. So there’s a few of these things that exist in, new issues, when new issues come to the market they don’t go into the index at the new issue price, they go in at the closed price. New issues tend to come at a discount. So when you add up all these … now, I get it for a treasury mandate, I understand why you might have an average, you know, underperform. But once you broaden out the opportunity set it seems like you’d have to be a fairly poor Fixed Income manager to underperform benchmarks.
JR Rieger: [0:47:39] Yeah. So do the same analysis for US corporates, US high yield corporates and US municipals and US senior loans, very similar results, not as heavy in the underperformance.
Raman Srivastava: [0:47:56] Maybe as we get bigger it gets…
JR Rieger: [0:47:57] But it certainly is … there’s underperformance. And I would say, yeah, there are some good reasons, right. The index doesn’t have any transaction cost, there’s no friction in adding a bond at any point in time or deleting [inaudible], it’s just a deletion from the math. So that could be key piece of the puzzle there is that friction, you know, and that’s pretty much unknown. And we’ve studied that friction. And there is, you know, when you’re talking about a 30 basis point [inaudible] spread for size, for certain bonds, and that goes to 60 and 90 for other types of bonds, that is friction. And that over time that does impact the portfolio in regards to performance.
Courtney: [0:48:46] Go ahead.
Tony Rodriguez: [0:48:46] I was going to say, one of the other things, we think a lot of investors really are still geared towards kind of the more traditional older benchmarks in the marketplace which have pretty enormous concentrations around some of the highest quality sectors like treasuries and mortgages. And as we all talked about the global Fixed Income markets have expanded dramatically over the last couple of years. The opportunity set has risen and really the market, there are indices that have kind of tried to keep up with that. But the assets tied to indices have not moved as aggressively. So it becomes a really poorly diversified portfolio typically, that’s [inaudible]. So I think there’s an opportunity to outperform. There’s also the element of from an active manager’s perspective, you are going to outperform or are more likely to when the opportunity set, the risk and reward opportunity is larger. So in markets where you have tight spreads, limited volatility, then I would think the differential is going to be pretty narrow. And we’ve seen that in fact maybe underperformance by [inaudible]. But in a market with larger opportunity sets, we’ve all talked about where those are, given the kind of dislocations over the last 3-12 months that we’ve seen across commodities, equities, fixed income. I think you’ve set up for an environment where we’re going to see a significant amount of outperformance by the kind of active management community, particularly those with strong research capabilities are going to really pick through some of the rubble.
Raman Srivastava: [0:50:06] Yeah. I think the office generally found [inaudible] index components over time.
JR Rieger: [0:50:11] Yeah. And I think it’s unfair, if we’re all measured against the US Act, well, that’s an unfair measure because most likely we’re not all investing that heavily in US treasury, US agency and those kind of risk off asset classes. That’s most likely not the way our portfolios are constructed. So the right index versus the investment objective is absolutely critical.
Courtney: [0:50:36] Okay. And I want to get your opinion on something. We’ve seen spreads between treasuries and corporates really widen, we saw that before in 97/98, in 2007/2008. Is this a harbinger of something that’s to come in the markets? What can you interpret from this?
Tony Rodriguez: [0:50:54] You know, again my view on it is that we’ve clearly priced in a more dire outcome than what we expect to occur form a growth perspective, an earnings perspective, a cash flow perspective. So we think it’s opportunity. And we don’t think it’s a harbinger of another kind of fall of 08/early 09. We think though however that it’s clearly justified from the standpoint of uncertainty. But it’s just gone a little bit overboard. So that’s where the opportunity is. We don’t think you’re going to recover in spreads to the, you know, tightest levels of pre 08/09, nor maybe even to the levels that we saw back in early 2014 necessarily. But we do think there’s quite a bit of room for tightening from here, that will generate very, you know, I think attractive returns on an absolute basis in a low yield zero rate environment, and I think very competitive, if not in fact better than equity returns. So I do think the Fixed Income market offers some pretty attractive, you know, opportunities now for a global asset allocation perspective.
Courtney: [0:51:58] Yeah, that’s really interesting. And we don’t have the leverage issues that we had in 08, so that’s off the table as well, which is an interesting differentiator.
Raman Srivastava: [0:52:05] To some degree, I mean the only thing I’d add is, it depends on what part of the credit market. I mean some of this isn’t pure just fear, I mean the reality is we’re dealing with record supply and particularly investment grade credit markets. And that’s due to the environment that we’re in where there’s a tremendous amount of M&A. And we would expect that to continue. So you do have these headwinds which aren’t related to a harbinger of, you know, of over excess leverage or anything like that or you know, some systematic calamity. But it is, you know, it is telling you that when you have, you know, this much supply coming into the market, that is going to … that is a pretty big headwind. And I think it’s one of the reasons for example we prefer high yield over investment grade credit because, you know, you do have this issue much more so in an investment grade credit, much more in the US investment grade credit as opposed to, you know, European or parts of Asia.
Joseph Higgins: [0:52:54] Tail risk in spreads though does remain mitigated by the enormous amount of global liquidity that’s, you know, underway. Even as The Fed is shifting rates, the balance sheet as we all know remains, you know, enormous essentially generation liquidity, that really helps reduce kind of … and certainly in 08 and other periods where spreads widened, it was a harbinger. That’s another reason why that’s unlikely in this case.
Courtney: [0:53:16] What’s the scene in the primary markets, a lot of deals are getting ratcheted back in Fixed Income, is that a good thing for Fixed Income investors?
Raman Srivastava: [0:53:24] It’s good and bad. I mean it’s good in the sense that it temporarily alleviates the, you know, the supply issue, which can help calm markets, you know, foreseen or jamming deals down a market which isn’t ready for it. On the other hand it is telling you again that the vol, you know, given that the markets are volatile, companies would like to come but they can’t, so that’s not a great environment for markets in general. And usually it’s not that they’re cancelling deals, they’re just postponing them, and a lot of these are eventually going to come at some point. So you know, yes, it’s temporary, you know, it’s nice that they can pull back and maybe temporarily give the market some rest. But the reality is, that’s going to have to come, you know, at some point.
JR Rieger: [0:54:00] Yeah. But it could give a chance for the buyers to put in covenants that are a little bit more stringent. I think if we break the corporate bond market down by ventures, 2012 and 13 issuance probably had better covenants for investors than late 2014 or early 2015 issuance.
Raman Srivastava: [0:54:19] And that’s a good point, it’s a bond buyers m