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Until Interest Rates Rise: What to Do
Money managers and investors alike accept the inevitability of higher interest rates, but the big question is what to do now. We discuss with our panel of experts:
William Martin, Portfolio Manager, Head of Fixed Income Portfolio Management - TIAA-CREF Asset Management
Robert Amodeo, Portfolio Manager - Western Asset
Duration:
00:52:13
Transcript:
Fixed Income Master Class 9 10 14
Until Interest Rates Rise
Evan Cooper: Here we are in our current low rate environment. Rob, give us an idea where things stand.
Rob: Certainly. We're at the low end of the interest rate cycle. We're well off the lows of just about a year ago. Everyone's been calling for rates to increase, it seems like, forever now. You really have to take a pause there and look at the macro environment. And the macro environment today is one of modest growth and modest inflation.
With that as a backdrop, I think you'd truly be hard pressed to see a spike in rates, or rates to rise very fast in a short period of time. It's going to take some time for rates to rise from where they are.
In short, we are in a low-rate environment. You can make the case that investors are not getting paid for that level of risk, perhaps getting paid more so for credit risk in the current environment. But still, you can't really make the case for a spike in rates given modest growth and modest inflation.
Evan: Bill, where does TIAA CREF see things?
Bill: At this point, we're encouraged by what we view as a stable to modestly improving economy. When we look at risk specifically within the fixed-income markets we segment it along many dimensions, not just interest-rate risk.
It's well published that we're in a relatively low-rate environment, one that's also influenced by factors outside of fundamentals. Certainly there are plenty of technical as well as geopolitical risks in the market right now.
When we look at our fixed-income portfolios across mandates, we really look at not only interest-rate risk, but sector-allocation risk and idiosyncratic risk that we can bring to add value into the portfolios in security selection. Any portfolio that can be constructed along those three dimensions to a certain liquidity profile, and I think for any investment advisor or investor in the market right now understanding the liquidity profile of each portfolio is as important as how they're positioned for these macro variables that Rob alluded to.
Evan: What's idiosyncratic risk? It sounds interesting.
Bill: Opportunities for uncorrelated or less correlated assets to really add alpha to the portfolio by performing against general macro trends in the market, be it a risk-on environment or a risk-off environment. Just adding diversification benefit through those security selections.
Evan: One of the factors that seemingly may keep interest rates where they are, even despite the Fed's intentions, is the international effect. In the past, it seemed that the US was an island in the world. There seems to be less of that nowadays. Talk about that a little bit.
Bill: Sure, happy to.
Really, it begs the question of how important technicals are versus fundamentals, to a certain degree, across the market. Geopolitical, as you mentioned, is just one aspect of that.
When we look at technicals in the market, you can look to, say, supply/demand technicals in the fixed-income product landscape. Within our portfolios, before I go into technicals, I'll say we have an underpinning of fundamental credit research that has to drive each individual position within any of our portfolios. It's that fundamental research that needs to be married by the portfolio managers with the top-down macroeconomic perspective, which will include an evaluation of market technicals.
Now, a question you could ask is, "Why are rates low when everyone appears to be positioned for higher rates going into 2014?"
If you look back at the market, even the futures contracts positions going into the year were in a short position, as well as the fund landscape. Technicals had a huge role in that. From a supply standpoint, if you look at, say, 2014 versus 2013, it's likely we'll end 2014 with gross issuance of US taxable fixed-income product one trillion below the prior year. We also look at net supply, which in some ways is a more meaningful supply metric because it factors in maturities as well as coupon reinvestment and the like. We estimate at this point time that net supply will be down in 2014 by probably over $300 billion.
Despite the fact that the Fed has been tapering and pulling some easing out of the market, you've had the supply technical going the other way as a counterbalance where there's just been more limited duration product in the market, fixed-income product for investors to buy. That's helped suppress rates.
When you compound that with some geopolitical tension out of the Ukraine or the Middle East, you have a general flight quality bid into fixed income, further compressing term premiums and further suppressing the yields across the curve.
The way we look at it approaching 2015 is that technicals will most likely trump fundamentals going into next year as they have for the better part of 2014 and even going back a couple of years in the post financial crisis era. That said, those technicals need to be married with a bottom up, very strong disciplined fundamental credit research perspective in which we look at across all sectors.
Rob: I would echo those comments. Since you covered the global perspective, within the municipal bond market or the public finance marketplace it's very much the same story. You have technicals that are driving valuations and in some cases driving them beyond the fundamentals. But the fundamentals, more broadly, in the public finance arena are improving. They're improving much greater than where they were just a handful of years ago.
I think three years ago, almost every conversation started, "Will California default or won't they?" Now, through good policy, California’s tax revenues are just superlative. They're coming in at levels well beyond budgeted, and in fact the ratings are beginning to improve. But there are still pockets of weakness.
But what happened is with their interest rates off the trough or out of the trough, there's less opportunity to refinance or take out the older, higher cost debt and replace it with new, lower cost debt. That's driven new issue supply down. With that and cash flows coming back into mutual funds, that's a positive. The demand has been outpacing supply, and as backdrop the fundamental's been improving. All those factors combined, which is very similar to the broader and more global landscape, it's been a good year for municipal securities.
Evan: Do you see that changing as we go into 2015? Technical factors seem slower to change that geopolitical risk, for example. Those technical factors, will they be in place for a while?
Bill: Geopolitical is very hard to predict, so we tend to focus more on technical factors that are far more driven by central bank policies globally. When we look at that as we enter 2015 we see a transition to the Fed beginning to pull off of quantitative easing.
But even with that, at the end of the October they'll finish the quantitative easing program, but they will still be reinvesting the mortgage paydowns off their mortgage portfolio, which at least out of the gate will be an additional investment in the market by the Fed of $15 billion to $20 billion per month that many speculate will be removed before they even institute their first rate hike.
You still have a run rate of reinvestment of their portfolio of up to $200 billion per year that will be post taper. The Fed's footprint in the market will be significant in the short run and even up to the intermediate run, depending on when they decide to raise rates for the first time.
Even if you assume that they'll raise rates earlier maybe than what the market is anticipating, you have the ECB stepping in now and further communicating that they're willing to pick up some of the slack that maybe the Fed is leaving them to provide stimulus to the markets.
Our general thesis entering 2015 is that central bank tendencies to provide support for the market certainly are not going away in the immediate term or the near term, and portfolio managers are being guided at TIAA CREF specifically to manage against that.
Rob: We have similar views in terms of technicals and the demand that's coming from central banks and so forth. From a fundamental perspective we're anticipating fundamentals to remain stable or just outright continue to improve with modest growth as a backdrop.
If you have an improved economic outlook, that would even bode well for even stronger fundamentals. We're expecting fundamentals to remain stable if not improving, even within a modest economic growth environment and technicals, although may wane a little bit, but we think the demand will be there.
Bill: I would say just for the point is to get overwhelmed by the technical discussion I think would probably miss the point as well because, as you mentioned, fundamentals even in the muni market have shown significant signs of improvement. Essential services in California are just one of many areas you can point to.
We've very constructive on spread sectors overall, because the backdrop to all of this and the reason the Fed is doing what it's doing is because we're in a moderate, arguably stable and lower growth than what people would like environment, but it is a moderate growth, low growth environment against a backdrop too of really extremely low volatilities in both the equity market and the fixed income markets. Typically when you have a low volatility market coupled with a moderate growth market, credit spread sectors have outperformed and done extremely well in that environment, and provide the opportunity for outperformance versus the rates markets, and the Treasury markets.
Sector positioning is very important. Fundamental positioning within portfolios is very important, even if the technicals from the central banks globally remain in place over the next 18 months.
Evan: It seems like you're saying is that the outlook is not as bleak as everybody's painting it. There are still opportunities and even if rates go up a little bit, we won’t see rip roaring, wildly increased rates or anything like that. So why do you think so many observers have said, "This is the time for investors to get out of bonds; we're at the end of the bull market; the only place to go is down from here; this is the end of the good times for bonds." Obviously you're bond people. What's your reaction to that?
Rob: The great rotation was the topic of the discussion last year; having to sell bonds and buy equities. I think you have to be mindful that they're all financial assets, and what you're trying to maybe avoid in the fixed income marketplace is the depreciation of value of your assets, your investments.
That's not to say that if the Fed embarks on a tightening cycle, or rates rise, there's a sense of heightened elevation, a heightened sense of inflation just around the corner, which would hurt fixed income. That would bring in the Fed and their tightening cycle. But that may not just impact fixed income; it may impact a lot of other sectors in the financial markets and alternative vehicles.
You really have to understand the dynamics of what you own. It's a good discussion to have, and I think it really brings into the discussion the value of diversification, and you really want to have a portfolio that's well diversified. I don't know if you necessarily want to avoid any particular sector, and I think fixed income, especially over the recent past, has really proven its value as part of a well diversified strategy, whether it's within a broad fixed income strategy or part of an even broader equity fixed income strategy, so there is a place for fixed income in the portfolio.
Obviously as an investor, you have to look at your risk, and then you want to tilt your risk to where you think the greatest value is, but I think exiting fixed income is probably exaggerated.
Bill: Agreed. We favor a balanced approach to diversification for any investor, guided, of course, where they are in their life, how close they are to retirement. The diversification glide path can change between equities and fixed income, but even for those young in age or far from retirement, we favor a fairly significant allocation to fixed income for the diversification benefits it can provide to any portfolio.
Evan: Given this scenario, what do you see in terms of portfolio allocation? What seems to make sense over the next six months, a year, or so, for those who should have a reasonable allocation to fixed income in their portfolios? What parts of the fixed income market make sense today?
Bill: Sure, and we'll give, I'm sure, slightly different answers, given I'm a multi sector PM and Rob manages municipals, but from a multi sector perspective, if you look at the market currently, the ability to asset allocate across sectors is one of the best defenses you have against a rising rate thesis or just a concern over interest rate volatility.
I manage a core plus strategy, as an example, where what that means is in the mutual fund, I oversee 30 percent of the assets can be allocated out of benchmark or out of index holdings. The plus sectors can be loosely defined as anything from high yield to emerging markets to non agency mortgage backed securities, as an example.
Evan: A kind of semi-constrained approach?
Bill: It is semi constrained, but again, up to 30 percent of the fund can go into these assets. I think that's important because I think we're in a new era of benchmark driven investing, where taking a step back, and looking at the market from a top down perspective.
If you start with the Barclays Capital Global Aggregate Bond Index, it's about a $45 trillion market size, yet that's predominantly driven, even at that scale, by developed market interest rate risk.
If you then sub divide that into where the most of the US mutual fund space is benchmarked, which is the Barclays Aggregate Benchmark [Barclays Capital Aggregate Bond Index], you're talking about a 17 trillion market out of the 45, so just by stepping into the US fixed income market, you're eliminating over 60 percent of the investable universe in the global bond fund space.
To make matters worse from a risk concentration standpoint, when you look at the Barclays Aggregate Index, let's say you go back to year end 2007. If you look at year end 2007 where the index was versus today, the Treasury component has increased by about 60 percent. You couple that with the post crisis era dynamic of the government effectively taking over Freddie Mac and Fannie Mae, 75 plus percent of the Barclays Aggregate now is essentially US interest rate risk driven.
The fundamental benchmarks that many funds are driven towards are...really, duration plays as much as anything else. There's very little latitude or wiggle room within the index constituents, so as a result, we favor using levers outside of the benchmark in the form of some of some of the sectors I mentioned.
Floating rate assets are a great way to build defense against rising rates as well, and we like sectors like senior loans, for example, where even floating rate mortgage assets, like non agency mortgage backed securities, as ways to build diversifying benefits to the benchmarks that we manage against.
From a risk perspective, I think traditionally it's always been somewhat intuitive to the retail channel, or advisors at times, to think that anything out of index is riskier. But the reality is when you have such a high concentration of an interest rate risk embedded in the global benchmarks right now that diversifying a way into what are very fundamentally sound credit sectors can have a really dramatic impact on lowering your risk or at least diversifying it away from the US Treasury market.
Rob: Yes, we're similar, very similar. Within the public finance arena, what we're doing is we're shifting away from rate risk, so we've reduced our durations, and right now we're much lower in duration than where we stood at the beginning of this year. Granted, we entered this year, 2014, in oversold conditions for the public finance marketplace, so it's an opportunity to move out in the curve. The curve is too steep and credit spreads were too wide.
More recently, we've reduced our rate risk by reducing our durations. Our curve exposures though, we're really maintaining a flatter curve environment. Our outlook really calls for a flatter curve environment so we have a flattener in our portfolios.
From a spread perspective, we like spread. It's not just unique to the municipal bond market, but we like spread across a range of marketplaces. We just think that the fundamentals are sound, they're going to continue to improve, but it is a credit picking marketplace, and you have to be active in your credit selection, so you have to look over a range of sectors, a range of credit qualities within those sectors.
For us, geographic diversification is key, it's important, but more broadly, if you just want to summarize it, take our rate risk. Keep a flattener. Tilt your risk towards spread or credit picking.
Evan: I'm just curious, when you lower your duration, and it seems that most of the money managers did that, who bought the long duration stuff?
Rob: A lot of folks. There are so many folks involved in our marketplace today. It's the traditional investor, which is the household. It's the mutual funds. Cash flows have come in pretty strong this year in excess of 10 billion. That's coming off a terrible year last year.
Also, we have these non traditional investors. The hedge funds are involved in our marketplace because municipals were too cheap, too taxable. Beyond that, you have other investors outside of the US who are involved in the municipal bond market today. The marketplace, although the demand still comes from the household sector, the ownership has been dispersed.
Evan: There's demand for munis from outside the US?
Rob: Yes, from a variety of pockets.
Bill: Absolutely. And I'd add from our perspective at TIAA CREF, which is an insurance company that has a mutual fund complex, I can tell you first hand that on our liability driven investment mandates and our retirement plan mandates, we have an ongoing need for duration assets, and that is to immunize those long data liabilities and lock in rates of return for them, so the insurance space in general is a large buyer of not only long Treasuries, but the longer duration tranches of the agency CMO market, as an example.
Evan: There's a shortage of that as well, isn't there? That's part of the problem for a lot of the pension funds, that there's not enough long duration, fixed income material bonds to buy?
Bill: Absolutely. If you look at where the Fed has been targeted, it's been actually out the curve in their program, so they've been decreasing that available supply. On one side of our business, we're very focused across the curve, and longer duration actually suits many of those mandates.
Then on the total return side of the business, where we have active and absolute return strategies, we still opportunistically, as Rob said, we'll position across the curve where we see the best relative value. I'd also add that positioning your long duration assets can be part of your overall risk profile.
We measure every portfolio manager at our shop on a risk adjusted basis according to their mandate. We have PMs managing a vastly different array of mandates from short term bond funds to long duration funds to active to passive. The risk adjusted blends allows you to look at their excess performance against the benchmark in a risk adjusted way that's appropriate for what they're trying to accomplish, but I relate it to the core plus strategy that I oversee.
I actually favor at times, especially during heightened times of geopolitical risk, long duration Treasuries because they act as a risk dampener to some of the lower credit quality, less liquid sectors, such as maybe below investment grade EM that we may be involved in or some pockets of high yield. You can pull levers in the multi sector fund out the curve that can actually benefit you from a risk diversification standpoint and leave you exposed out the curve, but in a good way.
Evan: I want to go back to Rob. A point about risk was that a lot of the headlines in the muni market have been about things like Detroit and Puerto Rico and areas that are just seemingly falling apart. But here are a lot of areas that aren't falling apart. Talk about how you make sure that what you buy isn't in danger, and how you are reacting to the problems in Puerto Rico and Detroit.
Rob: Well, we've looked at both of those situations, so to answer your question first, we look at the economics. We look at how well diversified the counties, the towns, the states, and cities are, how well they're managed. We want to look at how strong the cash flows are coming in, and if the cash flows are matched against expenses in a sustainable manner or are they just outspending their revenues in an unsustainable manner?
Policy really matters there, and how well diversified the economy is, and then all of the good old fundamental aspects that are attached to any marketplace come to the surface, so we watch very closely. Then we have a set of our own analysts, and we watch these metrics very closely.
There are high profile credit stressors in the municipal bond market, and the good news about that is it has drawn in these nontraditional investors. It's sparked curiosity, then they start following credits, and now they're more involved in the marketplace. With that, you could see more volatility in our marketplace because these trades, like a Detroit or Puerto Rico trade, which has now been sold mostly from mutual funds to the nontraditional investor, the hedge fund, the distress trader, they're not in it to own it for a long period of time. They're in it to make a profit.
You have to look for that type of landscape to lend to more volatility because they're in it for a tactical trade, not a strategic holding like they would have been in a mutual fund years ago. No doubt Detroit has reset the landscape here in the public finance marketplace. You'd be hard pressed to find an investor five, six years ago to say that GO is not going to repay 100 cents on a dollar, especially when it comes to the title in one of those GOs was "unlimited," the full faith and taxing authority, unlimited, not going to receive 100 cents on a dollar.
However, the way we looked at it, we looked at Detroit water and sewer as an opportunity. They trade it down to about 85, 90. We picked up some at those prices. The idea is that it's a revenue bond, and that revenue bond is supported by a revenue stream that's generated through a particular project — water and sewer projects. Kevyn Orr [the emergency manager of Detroit] wanted to get his hands on some of that capital, so he wanted to change the dynamics and basically subordinate the existing bondholders.
The way it truly unfolded was the existing bond holders will be made whole on a revenue bond side, and part of this Detroit water and sewer has been refunded by a new loan, so it was a tender program, and those who actually bought or held onto their bonds have been made whole if not actually were rewarded.
With regard to Puerto Rico, you cannot...it's difficult to talk about this without almost chuckling. It's so bad. The metrics are so bad. We all know the stories. People are leaving the island. It's the brain drain. It's the intellectuals are leaving for the better opportunities elsewhere, mostly here in the US, and it goes downhill from there.
It's really bad, but there are two credits on the island that we focus on. One is COFINA [Puerto Rico Sales Tax Financing Corp.], which is a sales tax backed bond, and the other is a G.O., and these are tactical trades for us, so when we see the bond, it ebbs and flows depending on the headlines, but small changes in demand for Puerto Rico lead to these marked changes in prices, and with that we're looking for a tactical trade.
We've been buying basically at 60 cents, and holding it to about 75, and releasing them around 80, 85, and that's a very broad statement, but that's generally what we've been doing. When you look at the fundamentals, and this gets back to fundamentals versus technical; the technicals in Puerto Rico are bad.
People are selling them when they can, and if they can't, then they're hitting down bids, significantly down bids, and then the buyer is the hedge fund, nontraditional distress trader, so they're not going to pay up for this holding, but when you look at the fundamentals of COFINA, the debt service is paid from collections of sales tax.
Sales tax this year is about $1.3 billion. Debt service is just about $700 million — $1.3 billion in collections for $700 million in debt service. Debt service is covered first, half the debt service, principal and interest. Then the money goes back to the general fund for the politicians to spend.
There's the fundamental story that if you can get through the technicals, and you can absorb that elevated volatility, and it's likely to remain elevated, and you watch the fundamentals closely.
By the way, if you go to Puerto Rico and you spend one dollar worth of sales tax, roughly only 50 cents gets to the state. The rest of it goes missing. They're improving the collection process, so even if the economy remains in the doldrums, and we are anticipating that it will in the short term, collection process is improving and collections themselves are likely to improve.
There is a fundamental story that if you can drill into the fundamental story, and accept the technicals, which is going to lend itself to higher volatility, you can extract a great deal of value. This year, Puerto Rico's one of the best performing sectors in the marketplace.
Evan: Obviously for investors who don't have the time or the knowledge to go looking into the nuances of these kind of bonds, is it better to steer clear, or is it better to say, "Let's trust you because you know what you're doing in this"? You wouldn't want to have an all-Puerto Rico bond fund probably.
Rob: No. You want to remain well diversified in no matter what strategy you have. You want to be well diversified across a range of risk. The municipal bond market used to be a set it, forget it, do it yourself marketplace. It's no longer a set it, forget it, do it yourself marketplace.
It's now a marketplace that's driven by fundamentals. It's a spread market, just like a corporate market or any other marketplace that you want to call out. It's a spread market that commands the surveillance of professionals.
Evan: Talk about the professional analysis in the general area that you cover, Bill. What areas do you see as offering particular value that may be overlooked? In the muni market, for example, there are so many nuances. I'm thinking particularly of Detroit, and how the surrounding areas and all of Michigan got affected, but there are plenty of parts of Michigan that are doing very, very well, and the municipal bonds of the Detroit suburbs, for example, became a terrific buy.
Where in the general bond market do these kinds of anomalies crop up?
Bill: Much of what Rob says really resonates in the multi sector framework as well, specifically even in municipals where I feel like you can't paint a broad brush over a market like municipals just by looking at Puerto Rico or Detroit. If you do, you miss some broader correlation with the investment grade corporate market or some other markets where, even entering 2014, there are two markets that we felt we had high conviction views on that they would add more value than some core investment grade corporate holdings.
One was the taxable municipal bond space up for essential services and select GOs, where our municipal team had their highest conviction ideas, and then pockets of emerging markets.
To summarize, in periods of low volatility like we've had, when you look at portfolio construction, security selection really adds the most value during periods of volatility, because when the markets are in a dramatic risk on or risk off move, that's when assets tend to correlate and will, generally speaking, move in the same direction.
In an environment like ours now, where do we see security selection in sectors, specific selection opportunities, I would suggest there are aspects of EM, even as others may shun EM because traditional theses into a rising rate environment emerging market economies struggle from a funding perspective, but similar to municipals, we don't think you can paint a broad brush across all EM.
We see select frontier economies as attractive, potentially an EM where they have just a lower correlation to the overall market move and spreads, and in addition, in emerging markets, you can play in local currency and local real yield markets, and there are a number that we find attractive from that standpoint as well.
Now that introduces risk that have to be actually managed by the portfolio managers, especially the FX risk if it's a US dollar based benchmark fund, but that is one way we would tactically allocate in this market.
Other aspects would include legacy commercial mortgage backed securities. We have a dedicated team there of five analysts. We really crack the ribs, on those securitization structures at the low level. And you really do have to roll up your sleeves in that market, and do low level analysis to expose value relative to the market and finding specific securities price appreciation potential and spread tightening potential.
But with the right focus we really like that market against a backdrop of, really, a gradually stabilizing US economy, if not improving economy.
Evan: Do you look into those tranches and see what the securities actually are? You break them open and see what's in there?
Bill: As a general practice, our structured finance effort overall really looks at the underlying collateral in ways that against a structural review of the cash flows, be it an asset backed bond backed by auto loans or a mortgage backed security backed by housing loans. We think non agency mortgage backed securities also offer tremendous value right now as a diversifier within portfolios and as a way to play the macroeconomic themes that we discussed earlier. A significant portion of that market is based off floating rate bonds, so you can enter that space with a low, what we'd say, effective duration or a low interest rate risk position from the coupon perspective, but at the same time play what we think is a steadily improving US housing market.
We don't think necessarily you'll get back to double digit gains that we witnessed over the last two plus years, but we think in a low to moderate single digit home price appreciation environment, that collateral will perform very well and continue to provide defense, again, against one of the paramount concerns in the market, which is the potential for rising rates.
Evan: In emerging markets, the last time they hinted tapering, it sent them crazy last year. What about if interest rates do go up? Do you think emerging markets would be affected the same way this time or to a lesser degree?
Bill: No. I think that risk will be persistent, and we've even seen that in just the last month or so on modest backups that is when some emerging market spreads will come under pressure, but it's not just a risk for emerging markets.
Even in July of this year we saw some outflows in the high yield market, but at a time also when rates were rising and there was general risk off theme even in the high yield market.
In the multi sector funds especially, the PMs have to be very cognizant of that, and that's really where you expose the benefits of diversification. One example would be a concentration of senior loans that we use as a diversifier for not only in our high yield fund but sprinkled throughout our intermediate bond funds.
In July, when we had that sell off in high yield, loans outperformed as they do episodically. They outperformed high yield cash bonds. They tend to outperform into those rising rate environments. This gets back to your earlier question of, "Should investors run for the hills against a rising rate backdrop and fixed income?" We don't think so.
It pays to stay diversified because they're in a prudently allocated portfolio and you can still generate a combination of income as well as potential capital appreciation, depending on the asset classes you're in, into a variety of interest rate environments.
Evan: Of course, there have been some comments that the high yield market is fully priced currently. What's your view on that?
Bill: At this point, if you look at the spreads in the high yield market, which I think would be the best indicator to weigh that view, we feel that, although they've come a long way, they still offer a fair amount of value against a backdrop of expected defaults, at least going into next year, in the low two percentage point range, where you're getting compensated within the high yield space by upwards of 300 to 500 basis points of spread, depending on the asset you're playing in.
We feel spreads are compensating you for the default risk embedded in the sector at this point, but a way from the sector specific default risk, we do have just the higher beta profile of those assets, the higher volatility profile of those assets, that you need to manage against what your overall risk appetite is for the fund.
Evan: What about the state of corporate health in terms of the balance sheets? You hear reports of companies sitting on so much cash, but then I've read things saying that corporations are highly leveraged, so what's your opinion as a credit analyst of where corporate America sits in terms of its balance sheet?
Bill: Our house view is that corporate America is in good shape. Profitability remains strong. It is true that leverage has increased over the last 18 months, but not to levels that would concern us at this point in time.
We do think investment grade corporate spreads, though, are fully valued against even high yield and select components of other sectors, such as securitized space, so we have some concern over how much tighter investment grade corporate bond spreads can go, but in terms of the economic underpinnings of the market, we think that US corporations are in good shape.
Evan: What about the states and the cities?
Rob: Well, states are in much better shape today when you look at tax receipts, although they're beginning to slow. That's a caution flag out there.
Evan: Is that, you think, is a result of the economy slowing?
Rob: No. It's a combination effect. One, people pushed income into, let's say, 2012 to avoid the rate increase in 2013, so we saw a lot of income get pushed into the prior year.
The challenge, though, is the personal income taxes have come in even below those reduced estimates, so it's actually turned negative in terms of when we look at the first quarter of 2014 versus the first quarter of 2013. It's slightly negative.
That's not the case for every state, so when you look over, as you say, you can't have this broad brush, and paint it, and say it applies to every state. There are some states that are doing very well, oil, oil related, mineral, high tech manufacturing...
Evan: North Dakota's the poster child for state health, right?
Rob: Exactly, so there's agriculture. There are parts of the country doing quite well. Even though there are areas that were hard hit by the housing downturn, they have rebounded, although it's plateaued slightly.
When you look at the various sectors within a municipal bond market, our view is that the revenue bond sectors are poised to continue to outpace the G.O. debt. Within G.O., we're going to focus on states because we just think there's a little more financial flexibility to weather a wider range of economic scenarios. You can make the case that local G.O.s are in better position today than where they stood a handful of years ago, but there's still very low financial flexibility at the local level.
Property tax receipts off their lows but still not back to levels that you'd like to see at this point in the recovery. Still low financial flexibility at the state level, which would put even further pressure into the locals as the Feds cut back to the states and the states cut back subsidies to the locals.
We're going to focus on the states and those very well managed local governments, but more importantly we think that the revenue bond sectors, although they outpace the GO sector, general obligation sector, by a wide margin this year, we think they're poised to continue to outpace the G.O., and the reason for that is when you look across, you see transportation.
The airports are doing quite well, although we're a little concerned about those airports with the recent consolidation and mergers in the airlines, those that had a large hub for a particular airline. That may reduce that hub exposure in that particular airport. Take LAX for example. It has a nice balance between cargo and passenger traffic. It's also not dominated by one single carrier, and it serves an international city. It may not be the case for a Chicago O'Hare, but it's still an important city. It's a global city. It's an important airport within a very important city.
Evan: Pittsburgh, for example, isn't doing so well.
Rob: Pittsburgh might be a little challenged, so you can't just say, "I like airports." I like airports but we like those that are in a better position than some of the smaller airports serving smaller communities. The marine ports, the West Coast is doing quite well. They can accept larger container ships.
On the East Coast, they're dredging like crazy. They're raising bridges in preparation for the Panama Canal to be retooled and to accept those larger containerships. We like them, but we like the West Coast ports currently a little more than the East Coast ports.
I'd say on the transportation routes, when you look at the roadways, we all talk about infrastructure, and infrastructure, that's what municipal bonds finance the most advanced public works system in the world.
When you look at our bridges and roads, we all know they need to be rebuilt, or retooled, or modernized, so we're favoring within the transportation roadways those that have less leverage, that have more pricing power, and I would say, from an investor's perspective, you really want to be very careful, if not avoid those startup toll roads. Those are very challenged projects. Very often they run into financial difficulty, the pricing power doesn't materialize as projected, the traffic doesn't materialize as projected.
Evan: Where are the new toll roads?
Rob: There's a couple in DC area you want to be careful with, but there might be some, say, in Texas that look pretty good, but just be careful and really understand the dynamics of the risk within those projects.
Healthcare, a big topic. We like those national, those geographically diverse healthcare organizations with good management. The standalone is a little more challenged. It's going through the competitive environment. The margins are thin. Obviously all the changes that are going on from the new laws that are in place make that a very challenged landscape.
I would say also that we like utilities, but it's a very difficult landscape. You really want a utility that has flexibility in terms of how they generate the power, if they can use high drill, then nuclear, natural gas, clearly coal...
Evan: Explain utilities in a municipal context.
Rob: It's a power company or water and sewer company.
Evan: It's owned by the municipality?
Rob: Yes. It's an investor owned utility, so you want someone who can generate power at a very favorable rate. On average, you'll go 11, 12 cents around the US, as opposed to, say, a PREPA, or a Puerto Rico Electric Authority, which is 27 cents per kilowatt.
You'll want a utility that has good management, can produce power at a very favorable rate, and has ideally, not every utility has this, has the flexibility to move, say, from oil to natural gas based on the price of those inputs.
Those are just a few sectors that we're focused on. We still see a great deal of value in those revenue bond sectors.
Evan: Which areas would you stay away from?
Rob: You want to be well diversified because there are various dimensions of risk, and you don't want to have concentration of risk, and clearly in the municipal bond market, it all looks the same. It's not, but it looks the same, so you want to diversify your portfolio, and we're going to maintain a well diversified portfolio.
The one area that we find challenged is the tobacco bonds, and these bonds are extremely volatile. Sometimes they're the best performing sector in the marketplace, and that's more recent. Sometimes they're the worst. It really is ebbs and flows. When you look at the dynamics of tobacco bonds, the way it works is the policy makers, back when they were trying to balance their budgets half a dozen years ago, almost a dozen years ago now, it seems shorter than that, what they did is they securitized the future payments from tobacco companies, the demand for cigarettes. And they took those revenues, and they used them as they will. Essentially what they did is they transferred the risk of demand for combustible cigarettes to the bondholder. On the flipside, they started increasing taxes on the packs of cigarettes, and from a policy perspective, it's an ideal situation.
You could actually reduce demand but continue to increase your revenue because taxes will increase by a greater amount than the reduced demand, but the reduced demand throws more pressure into the situation in terms of supporting the debt service.
For us, when we look at those bonds, and this has been documented pretty well, a large number of those bonds that are backed by a sale of combustible cigarettes are not going to repay principal, or the principal is going to be paid at a much later date than what's prescribed by the maturity date. For us, we just don't see the value in owning a bond that's going to extend 20, 30, 50 years, or perhaps never even repay principal. We understand the coupon payments are going to continue, and there's some inflation adjustment there, but we like to get our principal back, and we want to really look at our shareholders and say, "Your principal's coming back when due and on time."
Evan: Bill, what areas do you find riskier than you'd like?
Bill: Ironically, in some of the higher quality sectors, given how spreads have outperformed for multiple years now, we favor some of the less correlated, high spread product sectors at times than some of the higher quality spread sectors.
One thing we haven't really touched on in great detail, and it's a fixed income conversation, so it's a little bit surprising, is just inflation. You mentioned it towards the end of your remarks there.
I think inflation is a key thing to consider in that right now, the consumer is really 70 percent of the US economy, yet what would, in our opinion, significantly drive inflation forward would be substantial real wage increases that to date we just haven't seen at this point in time. We have a fairly strong fundamental backdrop, but to a certain degree there's still that missing link with the consumer. If that emerges over the next 9 months, 12 months, that's where we could see portions of the yield curve really react in pricing maybe sooner than expected. Fed hike would be one potential outcome if we saw those inflationary pressures.
I would say away from a sector, yield curve positioning actually is one area where we focus on where we think you're most compensated for risk taking.
If you look at the short, intermediate part of the yield curve, that tends to communicate more about what near term monetary policy will be, whereas the longer term portion of the yield will speak to longer run equilibrium estimates for GDP growth, unemployment, and the like, and just the fundamental macro story.
We are concerned about the very short end of the yield curve and positioning down there. We tend to underweight the short end of the yield curve across our sectors. We don't want to get too overweight, the belly of the curve, which at times can be easy to do in the fixed income markets because that's where the preponderance of supply is across all sectors, but at the same time, we still see value in rolling down the yield curve.
It's still very, very steep historically. If you look at the differential between the five year Treasury and the two year Treasury today, it's approximately 120 basis points.
From a portfolio construction standpoint, you want to be positioned where you can still benefit from the price appreciation as well as the income that is enjoyed on assets as they roll down a steep yield curve and repriced to lower and lower yields. But at the same time be cognizant of the potential for the curve to flatten on the short end should we get any upside surprises to inflation. I'd say that's a real risk right now in how a fixed income universe is priced.
Evan: When we talk about inflation, we think of wage inflation, but because of changes in the economy, what if we don't exactly get wage inflation in the way we used to get it, in that because of the global competition, and the fact the middle class is being hollowed, there may not be wage inflation. But there are certain other kinds of inflation: medical costs are going up, and higher education costs. There's inflation in certain areas but not in wage inflation, so what if wage inflation really doesn't much happen but some price levels go up. Is that inflation?
Bill: Well, it really comes full circle back to where we started this panel, which is I think we promote a diversified strategy across fixed income equities, a real full scope of the capital markets, because there are certain risks that we could be in a lower for longer rate cycle here.
If you look at break even inflation rates that are priced into the fixed income market, they've actually been turning down fairly substantially just in the last few months, so market expectations are certainly going in that direction, at least over the last few months.
Rob: It's going to be a challenge. It's really a micro story that you talk to because there could be pockets of wage inflation. Say, for auto manufacturers that are running at capacity levels, they might have to attract the next employee at a little bit higher level of pay, or there might be some other industries that may have to command to attract a town and may have to pay up for it.
If you look at inflation, and you make the case that it's a monetary issue, that if you have a dollar in your pocket and something costs you more, say gasoline on the corner costs you more, there's less in your pocket to pay for a pair of jeans, so there might be deflation and inflation at the same time.
Really, what you describe is the Goldilocks Economy, the modest growth in inflation. Yes, it picks up in some areas, but you see deflation or maybe improved productivity that can keep prices at check, or in check, in other parts of the economy, so you just go along in the modest inflation, modest growth, or even improved economic growth but modest inflation, so that's the Goldilocks economy.
Evan: Of course Europe is facing the problem of deflation. It seems that they're trying to inflate, like the cartoon where they run off the cliff and keep running and running, but eventually fall. If Europe goes into somewhat of a deflation, how would that affect us?
Bill: Well, I think we've already seen the impact in the sense of inflation can take many forms to the US consumer.
Financial obligations are a key component of inflation, and if you look at where rates are in Europe, and in the fact that one could certainly argue that the current US Treasury rates have been dragged down by the collapse in, say, the bonds market to point to one.
It has spillover ramifications for the US consumer from even an, I would argue, an inflationary standpoint in that their overall cost of borrowing continues to hover at extremely low levels across the board. As Draghi and the ECB fight what could be a potential recessionary, if not modestly deflationary, environment in Europe, it will have these spillover effects in the US.
Evan: We're reaching the top of the hour, so let's get some takeaways. After all our discussion, what should investors and advisors come away thinking about fixed income as we approach the last quarter of the year and going into the 2015? What should they think about?
Rob: I think they should think about fixed income as a strategic part of their overall investment policy, and the idea of exiting fixed income completely I don't think is a sound strategy.
It should be part of a well diversified strategy no doubt, whether it includes equities or not is another conversation to have, but within fixed income, our view is fundamentals are sound, if not improving, so stick with the income.
Shift your risk perhaps if you're fearful of a rising rate environment. Shift toward a fundamental story. Shift toward credit, or credit spreads and spread duration, and that's what we've been doing in our portfolio.
Yes, there are some risks out there. Those risks could be offset by some limitations in the economy. We just don't see a spike in interest rates in the near term because of the modest growth, modest inflation backdrop. But be vigilant, and be mindful that the risk of rising rates is real, but the idea of modest inflation and modest growth is probably going to be a dominant factor in tempering the ability of rates to rise significantly, along with the other risks that are around the globe and the deflationary scares around the globe.
Evan: Specifically in munis, they're in the pretty good shape.
Rob: Yes, but it's not a marketplace that you could just, you set it, forget it, do it yourself. It is a credit marketplace, and although the fundamentals have improved greatly over the past few years, there are pockets of weakness. There are stories that are still unfolding we didn't touch up on this. There are still pension issues, and the disparity between those pensions that are fully funded, or well funded, or poorly funded, the disparity is much greater at the local level, and we're not really focused on that yet. We're mostly focused on the state level. There are some challenges out there. I'm not saying avoid the sector because I think, even in the current anticipated rate environment, municipal bonds look very favorable toward even their taxable counterparts, and I think they should be an important part of most, if not all, investors' portfolios.
Evan: And you're watching out for the problems.
Rob: Yes. Yes, we are.
Evan: OK. Bill, tell us what your takeaway is.
Bill: Sure. I would simply echo the diversification themes, that fixed income is an important part of any comprehensive portfolio strategy, but then I would simply also layer onto a theme we talked about earlier, which is the fact that the composition of the fixed income market has evolved.
As investors, advisors, and the like look to allocate to fixed income to be cognizant of and take advantage of opportunities that actively managed funds provide to use fundamental research in sector allocations that are actually out of benchmark but capture the full global fixed income capital markets, because you can pick up immense diversification benefits from their sectors.
Evan: Terrific. Great insights, great overview of the fixed income market, and we appreciate that. Thanks, Rob. Thanks, Bill.
Bill: Thank you.
Evan: Thank you all for joining us. This is Evan Cooper for Asset TV.
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MASTERCLASS: Fixed Income - September 2014
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