<p>Central bank divergence, search for yield, and liquidity concerns are driving the fixed income markets. Watch as five experts discuss where investors should look for opportunities.</p>
<ul>
<li><p>David A. Daigle - Fixed Income Portfolio Manager at Capital Group/American Funds</p></li>
<li><p>Kenneth Monaghan - Managing Director and Head of Global High Yield at Amundi Smith Breeden</p></li>
<li><p>Stephen M. Liberatore - Fixed Income Portfolio Manager at TIAA Global Asset Management</p></li>
<li><p>Jeff Moore - Portfolio Manager at Fidelity Management & Research Company</p></li>
<li><p>Fran Rodilosso - Portfolio Manager at VanEck</p></li>
</ul>
Video Image:
Duration:
0000 - 01:20
Recorded Date:
Thursday, September 8, 2016
Transcript:
Courtney: Gentlemen, welcome. Advisors and investors want to know how and where to allocate in fixed income in this environment. David, I want to start off with you, what do you see as the opportunity set right now in fixed income and how to invest?
David A. Daigle: Well, my primary responsibility is in the high yield part of the fixed income markets at capital. And we think the opportunities there are still reasonably good. It is an environment where we want to be somewhat cautious because we're dealing with historical lows in treasury yields and near historical highs in equity prices. So we are behaving somewhat defensively, but with the market yield at 6% we still find plenty of places to invest in high yield in a low rate environment 6%, even if you earn a little bit less than that, and you end up with 4-5% after defaults, and maybe some gradual rise in interest rates. It still sounds like a pretty good return in this environment.
Courtney: Indeed. Ken, what is your take on this? I mean we're going to get into rates later on, but what's your overall view of the fixed income market and how to invest there?
Kenneth Monaghan: Well, if you look at the overall view of what's going on, you know, when we started the year we had issues surrounding rates and risk and then accommodation. So from a rate perspective, treasury rates, the risk-free rate was certainly much higher than it is at the moment. We also had risk in the middle of a selloff on the back of what was going on in commodities in general, but specifically, or more specifically what was going on in energy. And the third element that's kind of changed the picture from a fixed income investor’s perspective since the beginning of the year is the accommodated policies of the ECB. And the fact that the EBC has been buying corporate bonds, at least investment grade corporate bonds, has meant that people have had to look further afield to get yield into their portfolios. And that's pushed investors into emerging markets; it's pushed investors that might otherwise have focused on Europe into the United States. Thank you.
Stephen M. Liberatore: I think right now the interesting part, when you look at the fixed income market, especially the investment grade part of the market, is I see very stressed, a very stretched valuation, very compressed yields and spreads. So I think at this point in time you really want to be looking at securities that give you that relative value versus the risk profile and maybe looking a little bit more up in quality, as we've seen such dramatic shifts in such performance out of lower quality, higher risk type security across the curve. So at this point in time, I think you really want to be very focused on, you know kind of global impact of where we are in yields. And I don't expect yields are going to rally, are going to sell off too much from here, just from our own domestic data as well as the global impact that's keeping our rates down. So maybe looking again maybe a little further out the curve as well as at maybe some higher quality assets to kind of combat that high compression we've seen in spreads.
Jeff Moore: Yeah. I would go on and say that we think volatility's actually pretty controlled, pretty contained. We see global growth, not a lot, but some. And so we think default levels will stay kind of in the range where they are. And if you put inflation on the side where, you know, we have great fears that someday, somehow it might rise, it hasn't yet. And so this all is sort of the backdrop in our mind where you may not like valuations exactly where they are, but it's probably setting itself up to be an okay year in terms of positive returns in most asset classes.
Fran Rodilosso: Yeah. Well, investors have been put in a position where they need to add risk in one form or another in order to get higher yields out of their portfolio, some doing it through equities, some through high yield, some through longer duration than they're used to. You can take on currency risk, credit risk or duration risk as I mentioned. I think high yield valuations are not necessarily stretched from a point of view of where risk premiums are. And we feel the same way about emerging markets debt, that those are also a set of asset classes, emerging markets where inflows are sure, though they've been heavy, have really just started to scratch the surface and sort of recovering from outflows over several years. So there's still value or relative value outside the core, outside developed markets, but it does come with added risk, liquidity risk is one other one I should have mentioned.
Courtney: Yeah, I mean what we're hearing is that people are pushing out further on the risk curve in order to get yield. I want to bring up a chart of the 10 year, year to date. So right now we're yielding a little over 1½$, you know, we think that there's a possibility of a September rate hike, although that, you know, sentiment has been dampened down a little bit with recent data. What's your sense of how to allocate around this environment, specifically with respect to the 10 year?
David A. Daigle: Well, the 10 year yield looks really low relative to historical US yield, but it looks really high relative to sovereign risk-free rates in the rest of the world, so relative to Japanese government bonds, or German government bonds, 1½% is very high. I think we're all concerned about the general low level of interest rates, and what that means to peoples’ willingness to go out on the curve and extend into risk, whether it's liquidly risk, currency risk, credit risk, whatever. But in order to get hurt you need to have some level of yield increases throughout the system. Our view internally is that that's not going to happen with the central banks pursuing the policies that they're pursuing. So as long as you have the major central banks of the world funding the markets with liquidity that they're doing today, and it's pretty widespread from Asia to Europe, we think in that environment it's really hard to get yields to move much higher. The thing that could move yields much higher would be a rise in realized inflation. We haven't seen that yet. We are concerned about it, we watch it very carefully, as I'm sure our other guests do. But we've not seen signs that there's any sustained level of increase in inflation, which would precipitate a yield ... a rise in yields.
Jeff Moore: Yeah, and I would just add to that, one of the reasons still to have treasuries, even though I would probably agree with the rest of the crowd where, you know, pushing out for yield, one of the things that risk-free rates still provide you is with tail risk, a hedge at this level. And if you think where the stock market is, the S&P’s up, let’s call it, 20%+ in the last three years cumulative, it has a high valuation. If there's any kind of pullback in stocks for whatever reason, maybe it's inflation, maybe it's something else, this could be the only game in town in terms of generating an offset or a positive return.
Kenneth Monaghan: I think if you had asked most people where the 10 year would be, at this point of the year, and then told them it was going to be at 1½ or 1.6%, and not a company buy or selloff of risk, that they would have disagreed with you. Because I think most of us would have assumed with rates where they are at the moment for treasury bonds that we would have had a massive selloff of the risk, and we've not. And I think really what that says, as David has pointed out, is it really relates to what's going on elsewhere in the world. And the fact that government bond yields outside the United States, actually forget just in government bond yields, investment grade bond yields in Europe are largely negative. And that search for yield, that demand for yield really provides a ceiling on how high US treasuries can go. Now, that doesn't mean you can't break through that ceiling, but you need to have something significant that's a catalyst and that really relates to inflation. And I don't think any of us see that in the cards at the moment.
Fran Rodilosso: We're rooting for it in a way, so for risk asset classes, for credit, for equities, we'd love to see a scenario where 10 year yields were forced moderately higher in the very least, and where central banks saw a need to start raising rates. So I think it comes back to what you said, it's your perfect hedge in a way, in terms of owning 10 year treasuries, aside from the fact that they, you know, in a way represent value versus other developed market yields. But it's not necessarily the scope of a move, if it's much grander than any of us could imagine in a short period of time, it's obviously not great for a lot of risk asset classes in the short term, but a more moderate move higher over the short to medium term, isn't necessarily bad news for other fixed income asset classes.
Courtney: Yeah, and as Ken you mentioned, I mean we have all these negative ... we have the zero bound outside of the US. We have over 11 trillion in negative yielding assets globally. And like you mentioned, that's keeping a lid on rates here in treasuries. Is that predominantly why we're pushing out further on the risk curve in other sub asset classes and fixed income, and in other asset classes?
David A. Daigle: Yeah, I would broaden it to other asset classes because I think you're seeing similar trends and themes in commercial real estate, in investment grade bonds and high yield bonds, emerging markets bonds in dividend paying stocks. You're seeing it in the yield curve itself with term premiums being at historical low levels on the yield curve in treasury securities. And all of those speak to this liquidity that has been injected in the system. It also speaks to something more broadly which is the central banks trying to push against a set of economies that for various reasons are not growing at the pace that people would like. That could be partly related to demographics, it could be partly related to the debt accumulation that we've had over many decades and world economies, whatever the source is, the central banks are trying to pursue growth in a world where it's difficult to come by. Now for us in certain parts of the fixed income markets, a world where in the US at least real GDP growth is 2%, and you know equities are behaving pretty well, rates are behaving pretty well, there's limited volatility. That's a pretty good world for many parts of the fixed income universe where you can generate not great, not double digital total returns, but you can generate good solid risk adjusted returns even at low yield levels.
Stephen M. Liberatore: Yeah, And I think that speaks to really one of the concerns that we have, which is that what we've all been discussing here is people have to buy more yield, they have to take more risk to get more yield. And I think people are ignoring the fundamental situation that we're in, that chart that you had really doesn't speak to not just the impact of foreign buying and foreign level or rates, but also domestic weakness. We don't have a rapidly expanding economy as mentioned; our GDP is below 2%. We have very low average hourly earnings growth which is slowing even more so. In August you saw the ISM data come out today, supposedly in the stronger portion of our economy on the services side come in at a six and a half year low. So when you start looking at a variety of data you're starting to see that the economy, despite extraordinary monetary policy hasn't really expanded as you would have seen in other ... as you've seen in other recoveries. And what you have is in the US especially, a consumer generated and consumer led economy. But you have very low wage growth, 2.4% year over year. And you also have a consumer who is not making more money, but they're also becoming much more conservative in the approach that they take to managing their own balance sheets, they're not leveraging up. You see it in the personal savings rate above 5% for two straight years. So what you have here really I think is a situation where there is a lot of complacency, very low volatility and because of that the risk going forward is extremely high.
Jeff Moore: Well, the only issue I have is, you know, there’s just this whole story since 08 we've had enormous amounts of banking reform. Some people can say regulations have gone a little bit too far. But in the main we've added a lot more capital to the banks. I don't know if the banks have made a bad loan in the last three or four years. So there's no sort of, you know, sort of big event coming where the volatility probably spikes, even when we had a little bit of a default surge with energy, it went away pretty quickly because a lot of the energy companies either defaulted, or they fixed themselves pretty quick and got themselves in place. And so I'm kind of in the view that where we're at is actually this positive growth, low default world, fairly safe lending standards that we're here because we kind of put ourselves here. We got our banking systems a little safer, demographics, we’re much older, and we have an enormous number of savers to borrowers. So I don't feel like there's a bend around the corner, in fact I feel like asset prices are pretty reflective of where the world is. And I go one step further, I'm not sure central banks are price setters. I think they may be just taking the prices that are set in the market and going with the flow a little bit and saying, “We can't do anything about this, there's no inflation which is for almost every central bank a primary goal.” And on the employment front if you’re The Fed, you can sort of say you could throw the mission accomplished flag.
But you probably feel there's a little bit under employment. So I think in the market today the asset prices, there's nothing around the corner to be really scared about unless we get something like a surge in inflation from somewhere, somehow wages accelerate really quickly, and we all get caught flatfooted. But away from that, this world feels like one where low valuations to be sure, but a lot safer than probably 2006 to 2008 where, you know, Greenspan was raising rates from 1 to 5¼ from 04 to 06.
Fran Rodilosso: I think we have a lot of discussions internally and with clients about what's the difference between expensive or high valuations and a bubble? And I tend to agree with your statement. A bubble is where asset prices are kept up by a high degree of leverage. Now, there's a lot of leverage in government debt, at least in the developed market side. But less leverage in markets in some ways that we saw in 08 or some previous very violent unwinds of people going out the risk curve. So where if there is a rate shock, an inflation or rate shock in developed markets you could see a backup, but maybe not the level of sort of disaster that everyone is determined to predict since 2008, since most of the world did not predict it at that point in time. Just mention also, you know, it is important to have a global view, and sure this is getting back to, you know, my favorite theme which is emerging markets. But the world is not one central bank, certainly US and ECB and Japan are sort of setting the stage for demand for global assets. Most, you know a certain percent of emerging market central banks are still hiking rates, some still have plenty of room to ease the average policy rate. And emerging markets is near 6%, inflation rates are all over the map. So some countries are still fighting inflation, some, you know, Central Asia and Europe are certainly finding deflationary forces at the same time. So there is an ability for investors to diversify even that sort of central bank risk, get more into that when we talk about emerging markets specifically. But I think it's important to remember that there's not just one place to go.
Courtney: Absolutely.
Stephen M. Liberatore: We sometimes like to talk to our clients and consultants we deal with using other terms and social sciences other than the dismal science of economics. And one of the ones we refer to occasionally is in sociology there's these concepts of recency and primacy. And the concept of recency and primacy is that our behaviors or our judgments or what we expect going forward are often impacted by our first experience and our most recent experience. And the reason recency, your most recent experience becomes of interest is we all think back to our last recession, and looking at the great hair at the table, we've all been through more than one recession. But we're all paranoid about reliving the 08/09 recession. Now, the likelihood that we're going to go through some sort of major meltdown of the financial system as we did in ‘08 or ‘09, given the capital that’s been put in place, I think is very low. And it doesn't mean we can't have a recession, it doesn't mean we can't have rise in rates, it doesn't mean we can't have a rise in inflation, it doesn't mean defaults can't increase from now, from here where we are at the moment. But in terms of the relative impact, it's not going to be nearly as significant as it was in 08 or 09. The type of experiences we're likely to see going forward are more likely to be the repeat of like an 02/03 recession than they are in 08 or 09 recession.
Courtney: Because we don't have the leverage issue that I think Jeff was just pointing out, right then?
Stephen M. Liberatore: I think that's correct too.
David A. Daigle: Well, you don't have a leverage issue in the banking system. But you do have it in the global economies. So this theme that has been hit on about kind of this urge to believe that we're going to go back to the rate structure that we had pre the financial crisis, I'm not sure any of us believe that we're going back to the rate structure that we had pre financial crisis any time soon. So the level of low rates in fixed income markets is in part a function of central bank policy. But it's also a function of these other things we've talked about. So accumulated debt stock, that is larger now than what it was pre financial crisis. So the banks are in much healthier shape, but the economies are not necessarily in a healthier shape, if you look at the aggregate debt stock. You also have the demographic issues that we referred to. And when you look at the labor markets, even though we've had significant recovery, they're not improved to the point where we're seeing any kind of real meaningful wage inflation. In fact we have the most recent numbers that came out, spoke to the opposite, where wage inflation was pretty tepid. In that world we may be living with, this is going to make people very uncomfortable, but we may be living with an ultra low set of yields for an extended period of time. It's not unprecedented in history, there are periods in time, if you go back to like the 1950s in the US we had very low rates for an extended period of time. We are in a period like that where we may have to be comfortable living with a 1¼% 10 year for some period of time. And so people need to recalibrate. I agree that it doesn't create great value. I would not argue that there are great values in today's market. But I think they’re good and valid reasons why the rate structure is where it is. And I think the notion that The Fed can go up by 200 or 300 basis points is fanciful.
Courtney: And on that point we actually have a viewer question from Lee Baker, he's the CFP and the President of AARP Georgia, he's also the President of Apex Financial.
Lee Baker: Hi, I'm Lee Baker, certified financial planner with Apex Financial Services and President of AARP here in the state of Georgia. Like most advisors, my clients are looking for yield. And in order to get it, we've got to farther and farther out on the risk curve. And here in the United States we're finally starting to see some wage pressure, which typically means inflation isn't too far behind. So my question is, do you think we're likely to see inflation any time soon, and with that more of a beginnings of a return to normalcy from the fixed income market?
Courtney: Thanks so much, Lee. Alright, well, let’s dive into that.
Kenneth Monaghan: Well, it's a good question to ask because certainly as fixed income investors you would think that we're paranoid about inflation and it's certainly a major consideration. I don't think given the dialog that took place in the panel today that any of us are particularly concerned that we're going to get a dramatic increase in inflation in the near term. And inflation might tick up; as a matter of fact I think some of us might argue that that would be a good thing to have a rise in rates because we've been in an environment where savers are really being penalized because of rates being as low as they are. But if we look at it from an investment perspective, and recognize that the duration has been mentioned on this panel several times, that the average duration of most of the credit instruments that we're invested in is actually pretty short. And as David had pointed out earlier, a few high yield bonds ever actually mature, they end up coming out much earlier than the maturity date, either through a redemption or usually, hopefully not some other event like default. But redemption most frequently means that they never actually stay outstanding for the 8-10 years to their final maturity. So their risk exposure in terms of duration exposure, or interest rate risk associated with high yield bonds is much less than we might otherwise think.
Stephen M Liberatore: Yeah, the terminal rate of, you know, when you read all the recent Fed work that's been released, the concept of the terminal or squared rate getting back to 3% seems, as realistic as their original forecast at the beginning of this year, they were raising four times. The ability for you to do that, and it's interesting when you think about the concept of The Fed being able to claim that they've raised the flag, and the mission accomplished banner, it's interesting when their own measure of inflation, the core PCE measure is at 1.6%. And that the interesting thing I think there is, in order for them to hit their actual target, and I didn't know that once you’ve hit the target you were done, and you raise rates and that was it. If we've run below their target for 10 years at this point, you would think they would want some overshoot, just to get to their target level, inflation has to go up another 20% in the core PCE metric. Think about that, it isn't 1.6 to 2, it's that 20% rise. And where will that come from, which again I think, again leads you to a feeling at least that the complacency that we have in the market is concerning when you get these periods of time. They're always very low, and that's what leads you into the next period where all of a sudden you look at what has been the best performer this year at least in the aggregate, it's been Triple B commodity producers. Those are the same producers, the same people, the same issuers that were the worst performers last year.
And I'm not, you know, [inaudible] supposed to be a 20, but, you know, whether it's supposed to be at 50, especially again today, you know, yesterday, oil rally because Russia and Saudi Arabia were going to agree on a freeze. And basically they had a cup of coffee together. And of course now oil's back down. So it's interesting to see where we are as far as what the potential drivers of that are driving inflation higher.
Jeff Moore: Right, it's interesting, if you think, Chair Yellen, she was speaking in New York probably four months ago. And I thought it was a really interesting speech in the sense that one of the things that she was really clear is, I don't think she's a hawk to raise rates. I think people like to say hawk, dove. I think what she would say is it's a tool and if we have more yield, we can cut later. But so it would be nice to have the tool and if we can ever sneak a couple rate hikes in to have it in the quicker, great. But that's not what we're calling for. And so she's actually a part of this group, whether it's, you know, the G20 we had way back, the finance mission’s been, you know, back in March in China, you know, with where the Bank of England is, that looked like they're trying to orchestrate a fairly low vol environment. But one of the things that has changed is even though there's a low vol environment, this is kind of where you are, is industrial companies aren't out there doing a lot of CapEx. They’re doing short cycle, quick payback, high RR stuff. But there's nobody who's sort of looked at this period and decided, oh, I'm going to really lever up today. So they may have too much debt, and this is your point, I think is a good one, is it's the behavioral response of CEOs, it's been huge, 15, 2015 we had volatility event. You know, whether it was China, whether it was oil prices collapse and then China rumbled on us all, that led the stock market to go down, it went almost 20% sort of in that little bit of time.
There's a behavioral response with CEOs too and they, first they cut CapEx, which probably keeps us in this soup a little bit longer because there's no sort of organic growth. So when I look through the whole, you know, sort of where we're at today, I feel like we're this low vol benign growth, positive growth, thank goodness, and we're not really going anywhere. And I don't think there's any ability to go anywhere because CEOs aren't going to take us there, the banks can't take us there. And I don't think there's any sort of really big fiscal stimulus coming from government.
Courtney: So how does that color the way that you invest in fixed income, Jeff? I mean we've all kind of, you know, laid out that these other dynamics, I think you talked about almost a recalibration of expectations it sounds like, right, David? You know, how do you invest around that? Or do you invest the same ish, and it's more of a recalibration of how investors should digest this information?
David A. Daigle: So it's a great question. One of the things at Capital that we've done over the last year or two is to hold more liquidity, because well, I’m of the view that yields and general asset price levels are not stretched per se, they're not great value. And although we believe you can generate, for example, on a high yield portfolio, returns in the mid single digits at current starting yields. There are going to be bouts of weakness precipitated by things that we can't foresee today and we want to maintain enough liquidity so that we are able to take advantage of those bouts of weakness as they come. So for example, we were underweight energy coming into 2014, that was great, we probably starting buying too early in 2015 as the markets traded off. But that was a opportunity for us to recycle and go from a significant underweight position to more market weight, or even overweight position because commodity prices collapsed, right. So there are plenty of things at these yield levels that can induce weak periods in environments where you get a negative return for three months or six months, or even 12 months, we saw that in high yield last year. But if we have enough liquidity to capitalize on those events, then the longer term total returns should be very good coming out of that. So that's one of the things that we're doing.
Courtney: And Fran to that point, you know, the bottoming of commodity prices, that's a boom to emerging markets and local currencies, right?
Fran Rodilosso: Correct. It definitely has been, it may or may not continue to be. But the response of CEOs, the lack of CapEx, the commodity story, the bulk of a collapse was based on the supply side of the equation, an excess of supply in fairly week global demand environment. But demand for oil, for instance, has continued to grow actually at a fairly healthy pace throughout the last five years. What you're seeing in oil, in metals, some metals more than others are now the supply side of the equation getting more constrained. And that more than global growth is what may be supportive for commodity prices for the rest of 2016, into 2017. So that's been sort of a good favorable normal market response, low prices engender high prices, but by the fact that you will produce less. And that's certainly happening in commodity markets. Now, we've seen a response in EM local currencies this year because a lot of emerging markets are commodity producers. Interestingly that hasn't been the driver of EM local debt returns completely. I mean for a country like Brazil the currency move's been outstanding, but it's actually been rate moves that have had a larger contribution for an investor in EM local debt in general. Interest moves have had a slightly larger contribution than the currency moves. And most of the currencies haven't come close to recovering what they've lost in the several years leading up to 2016.
Courtney: And before we move on, Stephen I just want to get your take on how you address the challenge of investing with low yields.
Stephen M. Liberatore: Yeah, I think when you have this environment I think it is a recalibration of expectations and what you can look at going forward. I would agree that I think we're in this lower cycle for an extended period of time. And because of that, I think what it requires is the ability to be flexible to across asset classes or across sectors. You may in certain instances, want to go up in liquidity to provide you that opportunity if there is backup to add. But also I think if you have the expertise to do it, look at some different types of structured securities, maybe look at things like taxable municipal securities, maybe sell a little bit of liquidity if you feel as though you're being compensated for that extra illiquid and premium and risk that you take on. So it's a matter of being flexible and maintaining a true relative value framework where you are able to maybe do both of those things simultaneously, maybe add liquidity in one sector, and maybe sell some in another. And just make sure that you're looking across sectors so you can continue to find that best relative value.
Courtney: Overall would you say liquidity is pretty challenged at this point and that's why you have to look around across the yield curve?
Stephen M. Liberatore: I think that for the most part liquidity is certainly more constrained that it has been historically. But I think that also really is part of the, I think, the evolution of the market, you know, within investment grade fixed, every security but treasuries are a derivative, because they're priced off of treasuries. So, you know, when there is a liquidity event of a credit concern or a spike, to the point about having [inaudible] protection with treasuries, the only thing you really know you're going to be able to trade immediately and within decent bid ask spread is going to be your treasury position. So if you're someone like us who is focused on spread sectors, and we’re a credit shop, you know, we own things that I feel are cheap, and if we had some kind of backup, I'd like to be able to add to that name more so than sell it. So you want to maintain, you know, a portion of your portfolio, at least in a true aggregate type portfolio, you want to maintain securities that have liquidity treasuries, ATMBS, [inaudible], so that in the event, there is backup, you can add some of these higher risk, more illiquid type securities.
Kenneth Monaghan: I think you have to remember that liquidity is one side of a two sided coin, because on the other side is opportunity. And as long as you have enough dry powder, and as long as you're getting paid for the liquidity risk you're taking, these liquidity events can actually be wonderful opportunities, to whether it's to add to positions or to buy positions you've been waiting for, that they get cheap enough or all of a sudden there's an opportunity to add it to your portfolio. So I think we also, as my colleagues on the panel have mentioned, and Stephen had commented just a moment ago, really try to maintain some portion of the portfolio which we recognize has a higher level of liquidity, specifically because we want to be able to take advantage of those opportunities when we find them.
Courtney: That's a really good point.
Fran Rodilosso: Liquidity hurts you when you have to sell, and one of the great risk management tools that has never and will never go away is diversification. And there are a lot of different ways to get yield or additional yield in your portfolio right now. And if you avoid undue concentrations in any particular area, you're more likely not to be forced to have to sell a large portion of your portfolio at a given point in time.
Stephen M. Liberatore: And I think you need to be more nimble now more than ever. I think that what you want to do is you want to be in a position to sell when you can, not when you have to. And that's the difference, I think, that maybe what we've had over the last five or 10 years. Now it just requires a lot more flexibility, a lot more skill on your trading desk, a lot more skill from your analyst to make sure they're able to identify situations that maybe more apt for you to move out of a security now versus what you did historically.
Courtney: And that goes back to having that dry powder so you can move opportunistically if you need to. I want to pivot into the subsectors, we're going to cover high yield investment grade, ESG and emerging markets on this panel and a few others perhaps. But let’s start off with high yield. What's your take there, how are you evaluating how it's doing in the current environment?
David A. Daigle: Well this year is the opposite of last year, right. This year high yield's doing great and it was a train wreck last year. And it's largely a function of the same thing, it was a commodity related sector that’s getting hit very hard. If you look at returns within high yield year to date 2016, the market's up something like 13 or 14% depending on which index you're looking at. But every major industry sector has underperformed the market, except basic materials, so that’s energy and chemicals and commodities, metals and mining and chemicals, and energy. Those three sectors have primarily driven the returns this year. So you've had a lot of bonds that were beaten up last year. As Jeff said earlier, what's happened within those commodity spaces within high yield year to date is you've had a number of issuers go into default. So they've been removed from the index and the opportunity set. And then you've had a number of fallen angels come from the investment grade market, coming down, being downgraded below investment grade. So they've entered the high yield index, and the index itself has actually become higher quality. If you look at the issuer composition within high yield it's become higher quality because of that shift.
In addition you've had the commodity increase, commodity prices going in some cases, up a 100% year to date. And that's had a profound impact on their earnings power and their ability to survive. And many of these companies that have healthier balance sheets and have market capitalizations have used the opportunity to raise equity, and they've begun to de-lever inorganically by proactively taking down their debt levels. All of that's been super helpful, but it's probably largely over. I mean I think that current levels are reflective of a lot of the good news in commodity prices, that doesn't mean if oil goes to 80 there won't be more gains to be had, but I think we've captured most of those gains. Away from that kind of area of volatility, it's been a pretty subdued market environment with default rates outside of the commodity sector sub 2%. And general levels of spreads right around long term historical averages. So at 6% on the yield, on the index yield, I think there are still plenty of places to invest, but 6% is not high from an historical level. When you look historically at the high yield market, I think the average yield is in excessive of 8% over a long period of time, 20 plus years, we're now at 6. Now, relative to 1½% 10 year, 6 still sounds pretty attractive, but it is an environment where we want to be a little bit more cautious as I mentioned earlier. We are maintaining and have been for the last two years, more liquidity than we had historically. And one other point I'd make on liquidity, we haven't talked about ETFs yet, and I'm sure we'll get there. But one of the things that ETFs in the high yield market have enabled us to do is use those ETF bid and ask list to create liquidity for our funds, so we can get to them when we talk about ETFs.
Courtney: That's very interesting, because as an active manager, that it's actually the passive vehicles have been a boon to you. But we will get to that, it's a very interesting point. I want to keep on high yield because it's a big question mark. Jeff, what's your thought there on high yields, similar sentiments as David?
Jeff Moore: Yes, similar sentiments to David. The way I look at, everything's valuation oriented. And so when you get to lower valuations you have to diversify, add liquidity, not fall and go into rabbit holes, whatever you do, this is not the time to sort of chase that great 9 or 10% opportunity, in fact it's just the opposite. Having said that, we're in the camp that Double Bs look really good relative to the risk, especially if you're in the 5-7 years part of the curve, even Triple B minuses, Triple Bs, that looks fairly decent as well. And if you look at sort of sectors who still like bank bonds, maybe go a little bit deeper in [inaudible] that bank stack to get some more yield.- But even when you buy industrials, I would actually look in a [inaudible] portfolio. And these were the companies between 2010 and 2014 who did nothing but add leverage. Ad so that would be the energy group, almost the whole commodity space, the pipeline entities. That whole group in 15 learned a lesson and in 16 now they want redemption, and so they're buying back their debt, they're doing a lot of good sort of things in the marketplace that give you good liquidity. So we're thinking that you want to have a portfolio that has the yield, and you need to stretch for that yield a little bit. We think you should be able to put together a portfolio that's very diversified that gets you 3½/4% and has a fairly low volatility, lower drawdown risk, but if you try to go to 6% then you're into full high yield, you can't have your whole sort of net worth in high yield, so you somehow you have to say you want high yield in there, but it has to be sized for the opportunity set. And so we're constructive, but recognize valuations where they are today.
Courtney: Yeah, I want to just hone in on one point you made about like bank bonds. As we saw with the chart we have the 10 year yields are low, 1½%, they should have, you know, low net interest margin, or is that just offset at this point by their capitalization being so robust at this point?
Jeff Moore: Yeah, at this stage I would say that, you know, [inaudible] is an issue down the line, but the capitalization's so huge. And if you watched Brexit, what was the first thing that Bank of England did? They actually released the actual capital surplus, which is nirvana for banks. And you can give a bank ½% on its assets, it can take losses, it can do a lot of things. So if we run into trouble, it won't take much for the Federal Reserve, or the bank regulator to release the sort of countercyclical capital, and, you know, banks will fly.
Stephen M. Liberatore: One thing I would say is, while we continue at kind of a low rate environment, one area that may offer some attractiveness, again name dependent is in leverage loans on the high yield side. I think that they have, you know, a little bit higher up in the capital structure you also have the ability that, you know, in the event that we're wrong and rates do go up, you have the ability to capture some floating rate on the base of the loan itself as well, so there is some potential there, somewhat of a little bit of a hedge going forward.
Kenneth Monaghan: I would agree with Stephen, I think that his point is a good one, that there are opportunities in the leverage loan market that may not have looked quite so attractive six months ago when high yield was screaming as a buy at 900 over. We're not in that kind of environment at the moment, and with, you know, LIBOR plus 400 or so for an average leveraged loan at the moment, those are pretty attractive yields.
Stephen M. Liberatore: With floors at 75 or 100 basis points.
Kenneth Monaghan: And with LIBOR looking like it's rising a little bit despite what's going on in terms of treasury yields. So that gives you a little bit of a tailwind at the same time.
Fran Rodilosso: And there's a different industry mix than the broad high yield bond market, so lower [inaudible].
Jeff Moore: And you do have the risk retention rules come in at Christmas time, so December 31st 16. And that means that anyone sort of issuing a CLO has to retain risk through the capital structure. It should mean less supply and prior higher quality as well as some of us that, you know, retain seven years of risk on the balance sheet, that's a long time if you're an originator to keep it. And so you actually wonder what is the future structure product, whether it's a CMBS market, the leverage loan market, that risk retention is a real headwind for people who want or people, entities like, you know, the Wall Street that wants to sell the product, is because it has to sit the balance sheet somehow. We'll get more clarity on that in the next, you know, quarter or two, but it's an issue.
Fran Rodilosso: One other point on the fallen angel side. I think there's still potential for more volumes in terms of new entrants into the high yield space, pipeline and within the commodity space I think it's more pipeline oriented issuers now than say the equipment and services, which have been much larger than ... they were in a lot of ... it wasn't a high volume of Triple B E&P companies that became fallen angels, was more led by equipment services and pipelines, but it’s still a good volume there. And that has tended to be a very good technical point to buy those assets when those bonds are ultimately downgraded, and so there could be additional opportunity there.
Courtney: Ken, what's your outlook for cooperate defaults?
Kenneth: Well, it's certainly an interesting year for defaults. And I think for some investors that it may look a little frightening because defaults can certainly hit a 6% number by the end of the year. And if you think about a 6% number, that sounds like an awful large number. But if you start peeling away that from that 6% number and you recognize that about 4 percentage points of it really relates to energy, metals and mining. Then you get down to a 2% or even a little bit less than a 2% default rate for other industries. And that's not quite so scary all of a sudden. So as a high yield portfolio manager, when I look at the 6% default number, I have to kind of peel the onion away and figure out what's beneath it. And I'm not particularly concerned about the state of defaults at the moment relative to what's going on in the economy.
Stephen M. Liberatore: And that's really been helped ... that's been one … that’s the flipside really to low rate is that companies have been able to add net debt to their balance sheet, but improve their coverage metrics, because they continue to refinance it at over lower rates all in.
David A. Daigle: And that will be a danger point for the credit markets at some point if you do get a rise in rates. And we've had a wave of companies in the high yield market that have been able to refinance 10% coupons with 6% coupons, that's been very helpful and additive to free cash flow. Maybe at some point in the future you'll have to refinance 6% coupons with 10% coupons, that's not any time soon. But hopefully most of our bonds will mature before you get to that point. That's one of the good things about high yield market is that very short duration asset class, so you tend to get a lot of refinancing activity. I haven't seen studies in this, but my guess would be the average high yield bond doesn't live more than four years. So you tend to get your money back relatively quickly compared to most other asset classes.
Jeff Moore: I would say that liquidity wall, you know, a lot of high yield companies have escaped this year. And what it means is they've been able to reissue. So the liquidity wall is in the future, so there's nothing to default to now. So I'm actually agreeing that defaults are probably less than people expect. But it’s interesting that the liquidity wall in general has been changed materially. If you look at money market funds, so I think it's October 15th they go to floating [inaudible]. And so on that day, and I'm sure a lot of our clients will be thinking about that, on that day there won't be as much in the money market space as what I would say in terms of dollars, sort of in the old days 2002, we've a lot of grey hair here, we had a lot of large companies who would make a living issuing short commercial paper. I don't think that's a big story anymore, there's still some of that, but it's not the same size. So in almost every way, maturity profiles have been pushed out, whether it's to high quality companies, high yield companies. And so one of the reasons again I feel like, yeah, we may have a little bit of a default hit, we may have some volatility. But we may not get the cascading that we saw in 08, and so there's been a number of changes in the marketplace since then.
Kenneth Monaghan: And if you think about all of those things we were frightened of coming out of the recession last time, we were all talking about the maturity wall, we were all talking about the state of defaults, we were all talking about liquidity and volatility. I'm not saying that those things have completely disappeared, but they’re certainly a much lesser concern that they were several years ago.
Courtney: And just to take it back a little bit, what do you think the main, when people look back on 2016 what will the main narrative be, low rates or central banks divergence?
Kenneth Monaghan: David pointed out that last year was not an easy year for high yield. And I think if you look at it, it was the only year other than 1994 where we had repeated increases in rates, where we had at least some of the high yield indices showing a negative return for the year. Other than years where we've had a recession, where we've had negative returns, which you might expect because default tend to rise. So to have a negative return year in 2015 for high yield with no recession and no significant increase in rates, that was a bit of a surprise for investors. And I think that's one of the reasons why people were not expecting such a large return for 2016. And I think really what happened is the return for 15 got kind of sucked out of the year, and ended up being deposited as an opportunity in 2016. And you needed to take advantage of that fairly quickly in the first several months of the year in order to be able to generate the significant double digit returns that high yields has shown this year.
Fran Rodilosso: I think the year should be remembered maybe by one date, around February 11th or so.
Courtney: That’s it.
Fran Rodilosso: Where we … it did not start out a great year, right. And I think high yield was down up till that point, same amount it was down all of 2015, between 5 and 6%. And certainly rate policies haven’t done what central banks wanted them to do. But pumping in of liquidity in terms of its impact on asset prices has had a positive effect.
David A. Daigle: But I think the broad narrative will be central bank intervention and the effect on financial prices, the narrow one for high yield will be a rebound in commodities and basically the bottoming of the commodity cycle. Because if you look, all commodity booms have a period of massive investment culminating with high commodity prices, high commodity prices induce investment. So you get investment in their long lifecycle projects. So if you want to build a new copper facility, production facility it’s going to be a five or six year project. So you make the investment decision at a time when commodity prices are high, everyone does the same thing. And then you get some demand shock and all of a sudden you have too many projects online, you get commodity prices collapsing. The next step in the cycle is you get a massive withdrawal or contraction in investment in the sector. And we’ve seen that. We have seen, if you look at the rig counts for example in E&P in the United States, they have plummeted. If you look at the amount of new money that’s going into copper projects today, that’s plummeted. So that eventually forms a bottom and creates a bottom in commodity prices and ultimately a rise in commodity prices, and commodity producers do better. I mean a year ago, Glencore was the [inaudible] child for everything going wrong in the commodity space. And today they’re in the market issuing a bond at 200 over. So that was a company that everybody thought was going to be downgraded to high yield. And you know, some people were actually talking about the company defaulting, losing its access to its bank lines. And now they’re in the market issuing 200 over. So this year in 2016 will be remembered in credit markets for this massive rebound in bottoming of commodity prices.
Jeff Moore: Do you think though that maybe one of the triggers in February for this whole event was, we just came through 15 where part of the issue was the Federal Reserve had this high terminal rate, the dots. The dots were high for The Fed. And so China starts to rumble because China’s got a peg to the dollar. And they go, “We can’t handle this peg.” And if you’re going to raise rates the dollar’s going to surge and it’s going to hurt us more. And so the market started enjoying some volatility. And even The Fed would raise rates, get the rate hike done. And then in February we’d reverse course and say, “Oh, well, actually the dots are coming down. And we actually do think this is going to persist longer.” And one of the things I think, it’s really useful in the market today is most central bankers, whether it’s the Bank of Japan, the ECB, Bank of England, United States, every one of those central banks feels very confident with the tools in place. They may wish they had higher rates, they can have that lever too. But they feel very confident with QE. They’re going further afield. And so in 08 it was a great experiment, it’s not an experiment anymore, it’s here. They feel that this works, it has limited side-effects, it certainly buoys asset prices.
And so you kind of look at what happened February is the Central Bank realized that, we could induce volatility all by ourselves with our own rate forecast, that could lead to deflation if China had to rumble. And so we’ve walked back from that and we’ve had this amazing asset burst through this period. And so the question now is, well, in the next 12 months are the central banks around the world going to reverse course? I think the lesson for them is, yeah, there’s no inflation, yeah, unemployment’s kind of high. So we can be patient. And so I think the dots might just stay here, and might even come down a little bit.
Kenneth Monaghan: I think a bigger picture view for 2016, I think is really more about the efficacy and credibility of central banks, at the end of the day, that they have a desire, you know, we mentioned earlier that they came into the year believing that they were going to hike four times. And it’s almost been a realization that in some ways there’s always been this belief that they know more than we do, they have better tools, better data. And I think a lot of that has kind of been worn away by this continual overestimation of inflation over estimation of their ability to raise rates. And I think people have become much more cynical regarding exactly what central banks can do and what data they’re actually using and are looking much more at markets in general as more of a lead for where the economic environment really is and what to expect going forward.
Courtney: Because they become market dependent versus data dependent, although they say they’re data dependent.
Stephen Liberatore: Correct, because what was just described really was the debates of definition that The Fed realized they could screw up the market so they decided not to do anything. And that’s really, again that … I don’t think Paul Volcker cared what the markets reacted to when he was chair. And I’m not really sure Greenspan did either, or either Bernanke. But I think we’ve gotten to a place where you have such low levels of growth globally and the US economy is really the only one expanding, only the larger developed markets expanding in any material way. And I think that they are concerned about the impact that they’re monetary policy on what could occur to the rest of the global economy.
Courtney: Fran, you’re focused on emerging markets, do you see growth there though in the emerging markets?
Fran Rodilosso: Emerging markets are still growing below trend and still not, you know, we’ve seen a growth acceleration that you would, you know, the title of emerging markets should come with. But another interesting turn in 2016 and in part this is has to do with, not wholly, in part it has to do with the rebound in commodity prices. Also in some countries though, you know, actually, you know, better numbers are on the final demand side or other industrial parts of the economy. But EM growth relative to developed market growth has started to turn back the other way, where there’s a convergence over a two to three year period now, EM growth relative to developed market growth is starting to widen again. And that spread should widen even more based on current predictions in 2017. So that’s one very significant improvement in relative fundamentals. I mean growth is really the best way to pay debt. So when you talk about emerging markets ability to pay debt, growth is one great way to do that. So that’s one very important improving fundamental. Another relative fundamental is debt levels. And EM debt levels on the sovereign side are much lower than developed markets, rightfully so, where you’ve heard a lot of concern in 2016, is about private sector credit in emerging markets. And what problems that may cause down the road, I mean look at emerging market corporate debt though.
Again the fall rates that actually ticked higher in the high yield component than developed market rates, but not hugely higher, number one, number two. It’s still mostly in investment grade asset class for good reasons. There are pockets of excess private sector credit in emerging markets. A lot of it is in certain countries such as China, it’s not a monolith. It’s not one single market where, oh my God, private sector credit’s too high, stay away from EM corporates. So there are improving fundamentals in a variety of ways in EM. But that growth differential is a very important place to start.
Courtney: So not that monolithic trade that it once was. We actually have another viewer question from Lee Baker. Lee, welcome back and what’s your question?
Lee Baker: Hi, I’m Lee Baker, certified financial planner with Apex Financial Services and President of AARP here in the state of Georgia. We’re starting to see some signs of a good link to inflation and also the developed world. But what are some of the things we’re seeing in emerging markets? And is that a safe place to get some yield for clients in a fixed income environment, it doesn’t need to go in too far out on the risk curve?
Fran Rodilosso: Well, Lee, emerging markets have a variety of risk qualities that you could go after. So there’s the local currency space, it’s actually largest, deepest and in many ways the most liquid part of emerging markets. So it’s lower on the liquidity risk scale, but it’s got foreign exchange risk. You’re owning bonds and local currencies, you’re getting 6% yields. You’re in central banks in all sorts of different parts of the interest rate cycle. So your interest rate risk can almost be mitigated through diversification, through broad exposure there. But you’re taking on effects risk and by extension, most likely, commodity risk. It’s a dollar hedge, where in some ways a bet against the dollar. But emerging markets is also hard currency debt issued by sovereigns and issued by corporates. And in both of those spaces there’s investment grade debt and there’s high yield debt. So you can choose sort of your risk just as you can in other markets. In the investment grade space and EM sovereigns and EM corporates is actually, you know, proven over time to be a fairly safe place to be with a yield pickup over investment grade credit in developed markets.
Courtney: And I want to look at ESG factors, how do you evaluate them when you’re looking to allocate with a bond portfolio?
Stephen Liberatore: I think it’s interesting, you know, I think historically most ESG work or social work have been done on the equity side. So it’s much more nascent in the fixed income markets. But for us, I think that it’s actually … if you’re running an investment grade aggregate bond core fund like we are on a total return basis, it’s actually a competitive advantage, when you think about how you’re going to generate excess return on a core bond fund over time, it isn’t by picking winners, it’s by avoiding losers. And what utilizing the ESG criteria really speaks to is identifying those entities that are best operators and best managed firms. You know, if you are an investor who’s very focused on the asymmetric nature of an investment grade bond return, you know, do you want to be invested in a firm that has a poor governance track record? Usually that’s going to involve, you know, poor accounting issues or poor corporate governance, and utilizing that criteria helps you to avoid Enron, [inaudible], Volkswagen. On the environmental side, you know, do you want to invest in any part of the capital structure for a firm that has material financial exposure to the environment, but isn’t a good steward of the environment? And by focusing and identifying those issuers that helps you to avoid BP for example, and no pun intended. But you know, avoiding those issuers that blow up over time in an investment grade core fund is really the critical factor in how you outperform over time.
Courtney: That’s interesting. And I just want to come back quickly to high yield, Ken. How do you evaluate when you’re looking at a high yield portfolio globally versus in the US? That’s an important distinction.
Kenneth Monaghan: At Amundi Smith Breeden we are focused on global high yield. So that means we’re focused on the three components, it’s US high yield, it’s European high yield and then it’s emerging market corporate credit rather than sovereign credit and it’s in hard currencies. So if we look at those three markets, the interesting thing about them are the three subcomponents of the global high yield market. The interesting thing about them is no one of them is consistently outperforms. As a matter of fact of the three, the one that’s outperformed the fewest times, if you go back to 08 or 09, is US high yield. And lo and behold who is outperforming this year is US high yield. And it’s really outperformed European high yield by a factor of almost two to one. European high yield’s actually been much more consistent as has emerging market corporate credit. So we like to be able to look across those three subcomponents of high yield is we like to say to people or to clients is that it, you know, gives us more tools in the toolbox to play with and places to be from a risk perspective, while reducing risk if we want to be in Europe right now with a very supportive ECB. The problem is, is making sure that you know how to use the tools in your toolbox. And you know, we’re fortunate to be in the position where we’ve got resources globally and our boots on the ground where we’ve got research staff, you know, across continents to enable us to get access to corporate credit information.
Courtney: Interesting. And I want to pivot a little bit to asset allocation, it’s an important topic. Jeff, when you’re looking at asset allocation and you’re moving into and out of investment grade, how do you think about that while you’re forming that process?
Jeff Moore: Well, I’ll give you one concrete example. One of the reasons is, you know, even when we decided here that inflation’s nascent and not coming back, I think you should own inflation protected bonds say. And what’s the point of that? Well, one of the big issues we have is we’ve seen the unemployment rate plunge in the US. And a lot of that could be secular, could be demographic, we could just had too many white haired guys retiring, right, who just you can’t get them back to the workforce, even though they’re at that age where they could possibly work if they want to be retrained or what have you. And so one of the issues you have is could there be a big surge in demand for the millennials and then so their wages start to really accelerate here. So even though for here and now we don’t see any sign of inflation, no wage pressure for sure. One of the fears we have is that we are at low rates, we need a little asset allocation in the portfolio, a contrary, if you want to look at it like that. And because in the day that things change, at this level of interest rates, it means the Federal Reserve will learn about this the same day the stock market does and the markets. And that could lead to a significant asset move. And so you want to have a little hedge in the portfolio and a hedge in TIPS where you’re paid to wait, that’s not a bad little hedge.
Courtney: Interesting. So TIPS for your inflation hedge as the name says. David, what about your process, particularly wi