MASTERCLASS: Fixed Income - October 2018

As the Federal Reserve raises rates for the third time, despite criticism from President Donald Trump about higher rates, Bond Markets are finally seeing some drama in its after years of untouched interest rates. Doug, Mark, and Celso join together to discuss corporate bonds, loans and how to plan ahead.

  • Doug Peebles - Chief Investment Officer, Fixed Income at AllianceBernstein

  • Celso Munoz, CFA - Portfolio Manager at Fidelity Investments

  • Mark Redfearn, CFA- Senior Managing Director, US Investment Grade Portfolio Manager at PPM America, Inc.

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  • 53 mins 30 secs

Laura Keller: The bond market this year finally has some drama to it after years of untouched interest rates. This week, the Federal Reserve raised rates for the third time and will probably do so more times next year, despite criticism from President Donald Trump about higher rates.

We’ll start there in our panel, and we’ll dive deep into corporate bonds and loans as well.

I'm pleased to welcome two fixed income portfolio managers and a CIO to discuss all of that today. Welcome to the Asset TV Fixed Income Masterclass.

And thank you my three panellists who’ve joined us here today in New York. Appreciate your time.

Doug Peebles: Thanks for having us.

Laura Keller: Thank you. So, I’d like to maybe just start a little bit with what happened this week with the Fed going ahead and raising. Of course, we expected that, but just if you had some observations around some of the terms that were taken out of some of the commentary. And just where you see rates headed into the next year. Maybe we can start with you, Celso?

Celso Munoz: Sure, so, as you mentioned, the Fed came through and did raise rates yesterday, as was expected by about 25 basis points. And so, now we’ve got a hiking cycle that's got five hikes built into it. The market right now is at... Expecting three hikes through the cycle. So, there's a little bit of a gap there that needs to be filled, one way or the other.

Historically, we’ve seen that the Fed has overshot and the market... And has had to adjust, basically, to market levels. I think in this case, it might be a little bit different, where I think the market might need to reset a little bit upwards. But that said, we’re not talking about big upward moves in rates in general. I don't think there's a thesis out there that would support much higher interest rates from here and the Fed itself, within its... Within the dots isn't really projecting a very big increase.

And so, you alluded to the removal of the term accommodative from the press release, or from the statement. And, to me, it’s not terribly surprising, we’ve seen that Powell has been a little bit more conservative in the way that he approaches a lot of the dialogue around projections. And has said that there's a great deal of uncertainty. I think, for the most part, he probably just doesn’t want to designate, or make it clear, at what point he thinks we’ve reached the neutral level.

But, I think, given where rates are today and where the Fed... Given the action the Fed took already, we are in very accommodative territory right now.

Laura Keller: So, despite the removal of that word. Doug, do you agree with that?

Doug Peebles: Yes, I think that we’re still very much so in accommodative territory. I mean, they basically took the Fed funds rate to the inflation rate. So, we have 0% real Fed funds rate. And the yield cover is very, very flat. Credit spreads are tight. The Dollar is not in the middle of a trading range. So, when you put that all together, financial conditions are very stimulative for the US economy.

And that's happening at a time when fiscal policy is also given a goose to the economy. And so, I think that they can remove whatever words they want, but policy, at least on a monetary front, is still pretty darn accommodative for the US economy. But I think what’s actually happening is, the tighter policy that they're putting into place between the reduction of the balance sheet and the higher interest rates, is actually too tight for the rest of the world.

That's the crux of what the market has to come to terms with.

Laura Keller: Agree? Disagree?

Mark Redfearn: Yes, I think it’s a very interesting time. The economy is in very good shape, unemployment’s very constructive, under 4%.

I was a little surprised they removed the word accommodative, especially with what the dot plot say they want to do over time. But, the Fed’s been active since, I think, 2015, in terms of slowly raising rates, being data dependent. I think the market reads things dovishly on a continual basis. And so, I think there's a bit of transformation going on in global markets in terms of fixed income levels.

And I think we’ve got to be very attuned to what interest rate risks we have in our portfolios.

Laura Keller: Right. Well, that's really helpful just to better understand what happened this week. But I’d love to get, also, a broader perspective of where we might be.

One common question we always get is: Where are we in this bond bull market? I mean, you often see headlines saying, really proclaiming that we’re at the end, maybe, yes, no. Everyone seems to have a bit of a different opinion on that.

But for people who don't look at this every single day, what does a rising interest rate environment, of the one we’ve just talked about, mean for fixed income investors?

You want to start us, Doug?

Doug Peebles: Sure. I mean, look, at the end of the day, if you're not looking... Particularly for the people you've just referenced. If you're not doing what we do, which is we look at the NAV of our mutual funds and the price of our bonds every second. If you take a look over reasonable periods of time, let’s say three years, the return of most bond investments over a three-year timeframe is going to be the yield that thank you buy it at the first day over those three years.

Now, that's not for all bonds, but for intermediate bonds like aggregate-style duration, or most high-yield indices, that's what you're basically going to get.

So, I think that there's a big commotion about this rising interest rate environment and a bear market in bonds. The... So far this year, that aggregate style, in what has been a rising interest rate market and what can be considered a bear market for bonds, the aggregate index is down 1.5%. The Nasdaq was down 1.5% four hours ago.

So that, to me, puts it into context. What... And I think most investors today are extremely nervous about rising interest rates. If they own 30-year Zero Coupon Bonds, they probably shouldn't own those because they can lose a lot of money in that.

But if you own a five-year duration portfolio, you really should kind of relax about rising interest rates and be happy because the higher yield that you're going to be getting is going to increase your return over the next three years or so.

But the... What people don't talk much about and where I think people have most exposure in their bond portfolios is in credit. And, to me, when I get nervous about bear markets, it’s not because of rising interest rates, it’s because the credit cycle has turned, and people have lent too much money to poor credit quality borrowers at yields that are unattractive. And I think that that is the thing not... Maybe not tomorrow or the next day, but that's really what investors should be most concerned about in their fixed income portfolio.

Laura Keller: And we’ll talk more about that as we go on here today. But that's an interesting perspective that you're saying the interest rates rising themselves, that is something to be so concerned about. It’s the quality that you should be looking at.

Doug Peebles: Yes, I mean, look, 1994 was the worst bear market in bonds that we can remember, and the aggregate index was down 2.7%, and the next year was up 11. So, it’s that kind of... The framework that I think people need to understand. And, again, we haven't even talked to the additional benefits of bond portfolios, particularly in the interest rate space, which... Look, if we have a big correction in the equity marketing, not that we’re calling for that or anything... But if you have one, I think, now, you're back at levels on the, let’s say, the ten-year note, that I wouldn't be surprised if we saw a 50-basis point rally or drop in yields if we saw, for whatever reason, some even that caused the risky markets, or the risk return seeking markets go down for some reason.

Celso Munoz: Maybe Doug... I don't necessarily get fixated on the... On whether we’re in a bear market or a bull market for bonds. The way I think about bonds generally is that they should be a core component of everybody’s portfolio. They're a really powerful diversifier. They a great tool for capital preservation and a great tool for generating income.

And, to Doug’s point, if you look over time, negative returns have been really infrequent and tend not to persist in the bond market, and they tend to be followed by periods of really strong up performance. That pull to par, I think, is a really powerful force in bonds. And so, you end up seeing these types of periods followed by positive returns, and that's the environment that we’re in right now. And over the last 12 months, we’ve been in a negative return environment and I don't think that persists.

And the follow-on to that is that if you look at overall yield levels, what’s driven the negative return over the course of the last year is the move upward in rates. And if you look at yields since the crisis, we’re probably in about the 85th percentile or so, maybe even a little bit higher, in terms of yield levels. So, on an overall basis, this is generally a... It’s a nice level of an entry point for the bond... For bonds in general.

Now, the caveat, of course, like Doug mentioned, is that you've got... Take into consideration where spreads are right now, and that's a separate discussion, but for bonds in general, that starting point... Your starting point right now is a higher yield, which is a nice way to enter into the bond market.

Mark Redfearn: Yes, historically speaking, the vast majority of your total return in a fixed income portfolio is coming from coupon. So, if you aren't disciplined to be in the market long-term, and you're simply waiting, you're giving up a lot of upside with regards to total return capacity for your portfolio.

But, yes, I would agree with Doug as well in terms of... Quantitative easing was designed to push people into credit. And so, we know lots of investors went out of their comfort zone to invest along with Central Banks. And so, when you have $16 trillion of Central Bank balance sheet, that's pushed people down in quality, it’s pushed people down in CAP structure, it’s pushed people out-duration.

So, I think the market that we’re in and the concern, probably, the three of us share, is that there's a transitional period for risk taking amongst investors, and that rebalancing, independent of what economics are, where market valuations are. That's a risk. That's right.

Doug Peebles: So, we’re going to move into the fourth quarter now, the Fed’s going to start reducing the balance sheet at $50 billion a month clip. And by the end of the fourth quarter, the ECB is likely to be at a zero, in terms of their old quantitative ease, right?

So, if you take those two Central Banks, add in the Bank of Japan, that we actually are moving towards a quantitative tightening, an aggregate between those three.

Laura Keller: When we look globally?

Doug Peebles: When we look globally. And we’re going to have to see how that pans out.

But, interesting, the treasury is running this enormous budget deficit, right, at this weird part of cycle that they're doing this, so that we have this situation with the Central Bankers, but we also have this weird policy framework from the fiscal policy makers in the US. We have these huge budget deficits that we’re running in the US, combined with the Fed as a net seller, and the ECB is not longer buying, yet the yields really don't go up very much, I mean, the curve is flattening like crazy. So, the two’s ten spread today was around 23 or something like that.

I don't know, that sort of gives me the willies when I see a flattening of the yield curve, when I don't understand why in the world the yield curve is flattening.

Mark Redfearn: Yes, I think globally, as well, you look at treasuries to bonds, 260 basis points, that's materially higher than the average over time. And so, I think the principle loss potential out of Europe, where that's really hung up in that market, I think that's why we see lots of European investors still continue to come to the US.

Laura Keller: Right. And you, I believe, have some charts that you wanted to reference, talking about spreads. I know Celso had mentioned some of the spread, not confusion I guess, but concern over where those might be relative to historic levels. Did you want to talk about those?

Mark Redfearn: So, to summarize, what we’ve been talking about here in terms of concerns about what QE was. QE was an expansion of Central Bank balance sheets globally. It amassed in approximately 60 programmes, it’s become the norm.

And what we’ve seen over time is, as expansion has occurred in QE, spreads have rallied along with that QE expansion. So, the black line here... Excuse me, the blue line, is total Central Bank purchases on an annualised basis, on the left column. And you can see even though the Fed has been winding down its programme, actually, in reverse, the ECB and the BOJ have been active in the market the last few years.

So, when we take the black line is a lag 12-month change... Average 12-month change in spread, and it’s inverted. And you can see it’s a very tight relationship. So, for as much work as we do in fixed income, with regards to being traditionally trained to focus on leveraged, to focus on earnings, to have a conversation about growth, the concern here is that simply the removal of accommodation, this... To get our marketplace back to a normal market, where we can have those conversations. Independent of what growth is doing, as long as accommodation is rolling off, we think there's room for volatility to pick up and spreads to move wider.

Laura Keller: Oh, interesting, so we could see a picture where volatility is really going to be increasing, and maybe some, I don't know, interesting trades coming off of that?

Mark Redfearn: Yes, I think, really, 2018 personifies that. You've had, really, excellent earnings out of the US corporations, you've had growth around 3%. But why have excess returns been flat to negative for most of the year? I think investors continue to want to rebalance. When we look at flows, flows in Europe have been really poor this year for almost every asset class, because the ECB is on the precipice of getting back to a normal stance.

And so, I think you gained up [?] up with some binary outcomes, in terms of investors. Looking at what QE was, it was rational to invest along with Central Banks, but when Central Banks stepped back from markets, markets are likely to have less liquidity, more volatility, and that higher volatility puts spreads at risk.

Laura Keller: And when we think about... We’ve been talking about the ECB, we mentioned the BOJ in the US, I mean, are there places beyond the US that maybe are more interesting because of some of these things that are happening on the global sphere?

Doug Peebles: Well, I think if you start with where the most interest, that's what we call it when...

Laura Keller: Interest, okay.

Doug Peebles: When you get your face ripped off in the markets... Has been in emerging markets, right? And so, again, I think what happens when the Fed starts initiating a tighter policy, particularly after the one when it’s been so accommodative for so long... And because all of those Dollars were being thrown out into the system, a lot of them ended up offshore. And there was a lot of borrowing that took place in Dollars by issuers who don't have the same economic backdrop that the US has right now.

And so, we’re seeing quite a bit of spread widening. I mean, the dynamic in the US is very interesting because investment grade has not performed very well. High yield has been, really, a strong performer. And where you're seeing the biggest sell-off in the credit markets has been in emerging markets sovereigns. In emerging market, local currency in particular, with the EM currencies being quite weak against the Dollar.

And then, Dollar denominated Asian high yield. There's been a huge amount of debt issuance and aggregate in China, in particular. And I think that... That's something that we’re watching very, very closely.

Laura Keller: Okay. Well, we’ll dive more into that in a bit. But sticking with the US, I want to talk just more about the flattening yield curve and what that means for not only the portfolios that you manage, but just writ large for some of the investment interested in the fixed income space. Maybe break that down a little bit for some investors, again, who aren't looking on a daily basis and don't know exactly what that might mean for any one particular portfolio.

You want to start us off there, Mark?

Mark Redfearn: Well, I think a flattening in the yield curve, to me, is more an issue of some of the supply-demand dynamics that are in the marketplace. To me, it says... A flat yield curve to me means that there's more foreign buyers at the long end who need to match LDI. There's been in an insatiable amount of demand over the last ten years to put money into fixed income, to rotate into fixed income, and put that money at the backend of the curve. Whether they be life insurance companies, whether they be pension funds... We do have an ageing population both here and in other domestic markets.

And they simply have a need for that type of principle... That type of long-duration principle protection, fixed income security that would help match that.

Doug Peebles: Yes, I understand that flow. But, to me, that doesn’t square the circle completely. That... What we’re seeing is that a lot of those buyers are concerned about the currency, the Dollar. So, they're putting their money to work in the big liquid market with the higher yield, but they don't want to take the foreign exchange risk.

So, the hedging cost, the dynamic between the short-term interest rate differentials, has caused that extra carry they get from buying in the US, to actually be eroded over time.

And when we look at other foreign holder of US assets, like the Chinese Central Bank, and the Japanese Central Bank, they've actually curtailed their buying and their portfolios have shrunk somewhat. So, I think that we have seen, for sure, that's there's demand for long-dated risk-free assets. But the places where it’s coming from, again, I'm sort of confused about why I look at whole bunch of sellers... The mutual funds are clearly sellers, right, I mean, redemptions in bond funds, with the exception of really short-dated bond funds, has been pretty significant.

Laura Keller: So, forced them to be sellers, is what you're saying [?]?

Doug Peebles: Well, that's right. I mean, there's... When you see redemptions and you need to sell securities to meet the redemptions, that’s also a seller.

Now, insurance companies have been buying, right, and pension funds have been buying. Part of the pension fund buying is because the tax rules were favourable for expensing at the old level of corporate taxation. That ran out in the middle of September. So, again, it’s too hard to sit here and figure out all the supply and demand dynamics in a market like the US or global fixed income markets. But, I’ll admit that I'm a little confused at, given all the things that are going on, that the yield curve is still... Its still flat.

Laura Keller: Still the way it is.

Doug Peebles: Still the way it is. And I think that there's information value in that, at least historically. Now, it could be distorted because German fiver-year yields are still negative. So, does that mean that there's European buyers, yes, I guess it could easily mean that, but there's still a lot of information value in that flattening of the yield curve.

And it’s either predicting that the Fed doesn’t have to do much over a long period of time, or there should be no term premium for inflation expectations or anything like that.

But yes, I think it gives us pause, or at least pause for concern, to understand what is the information value that the yield curve is giving us through that flattening?

Celso Munoz: Well, I think that demographic trend that we talked about, I think that's a pretty powerful secular trend. And I think it is having an impact. But I think, really, the broader message, when we’re coming out of the curve, or the level of rates out at the long end, it’s telling you a little bit about what economic growth going forward is.

If you look over time, interest rates tend to correlate pretty well with the level of economic growth. And the reality is that we’ve got... We’ve had some fairly strong growth recently. And there have been some factors that have driven it a little higher. But in going forward, I think we’ll still have consistent growth but at a more modest level.

And the reason I say that is that if we look at the components of economic growth, what drives growth? It’s going to be driven by the size of your labour force and how quickly that's growing, and how productive that labour force is, and how quickly that productivity is growing. And when you look at the labour force, it’s not really... Given the demographics we talked about, given immigration policy, that's just not shifting in any dramatic way, so that's fairly stable where it is.

If you look at productivity growth, what we found is, if you look at investment and CAPEX, that tends to drive productivity growth. But the key is that it takes a long time for that productivity growth to kick in after you've done the CAPEX.

Our research has shown that it takes about seven years before you start to see that. And so, even if you're expecting a lot of investment in CAPEX today, which maybe we’re starting to see a little bit...

Laura Keller: From the tax changes.

Celso Munoz: Exactly, it wouldn't necessarily result in immediate impact on productivity growth. And so, is it unreasonable to think about 3.5% economic growth going forward? I think it’s fairly reasonable and lines up fairly well with where the curve is right now.

Laura Keller: Well... And maybe just sticking with one last question about the macro. You bring up a good point, just thinking about the underlying, how the US economy is really doing; what evidence there is that it’s strong. Because I think some people are still debating whether that's the case.

And then, to your point, going forward, what that might show. So, I'm just wondering what the panel thinks about where we are and how healthy is the economy?

Celso Munoz: Well, I mean... I think there's a few clear signals that you can look at, right? Unemployment is incredibly low, wage growth has been slow to come, but it’s bubbling there and it’s starting... You're starting to see some signals of it.

Profit margins, for a lot of the corporates, are at really high levels. And there really aren't a lot of signs of trouble out there. When you look at past... At least the most recent crisis and other crises over time, you could have looked at the banks, and you could have looked at their loan books and see how those are performing. Those are performing extraordinarily well. I think the US consumer is in really strong shape.

And then, if you look at the banking system itself, it’s got a lot more capital than it’s had in a really long time, or ever. It’s loan books are performing really well, like I just said. The funding mix of the banks has improved dramatically. There's been this big shift away from wholesale funding of the banks to more deposit funding. And they've also termed out a lot of their debts.

So, there's just not a lot of risk there. And even though people talk about the regulatory backdrop softening a little bit here, it’s softening, it’s... I would say more that it’s plateauing and it’s plateauing at a very high level. So, I don't think we’ll see a big retrenchment in terms of the... How credit friendly the policies are around the big banks right now.

Laura Keller: Well, then again, we...

Doug Peebles: I... Can I just say…?

Laura Keller: Yes.

Doug Peebles: I agree with all of that, with the exception, possibly, of the last point. Because I do think that if the midterm elections goes heavily favouring the Democrats, then not that we’ll have regulatory change, but the interpretation of the regulatory rules, given. Let’s just say, all of a sudden we come of this and Elizabeth Warren becomes the leading candidate to be the next president of the... At least in the polls in the... I think that the markets are going to say: Wow, that pendulum that's been softening since the Trump election victory, I think that we start to ease back a little bit on that.

Laura Keller: On the regulatory front?

Doug Peebles: On the regulatory... On the easing of the regulatory, particularly in the banking space. And so, if you look at the performance, for example, over the last little while, of the bank stocks, they haven't been performing particularly well. Even though we’ve seen the interest rate increase that everybody wanted, who loved the banks because once interest rates increase, their net interest margins will go up.

So, with just that one little piece at the end. But, I was thinking to myself: Wow, he’s going through all these things, and he’s accurate, these things are all true, why in the world do we have such an enormous tax cut on this economy? We just didn't need it.

Celso Munoz: No. Right. Yes.

Doug Peebles: I mean, it’s just that simple.

Mark Redfearn: In terms of procyclical, I mean, you've never really had a big push like this at this point in the economy, with everything going as favourably as it is. So, at some point, I mean, whether the treasury wants to issue a longer bond or not, I think that will be an interesting development over the next few years. They've said they won't, but we can see the pressure of what T-bills has done to the frontend.

Celso Munoz: Yes, sure.

Mark Redfearn: And so, yes, I think that those that argue right now that the economy is not in good shape, really are arguing how sustainable is the growth. So, yes, so today we got affirmation that 4.2% in the second quarter was the number. There's no one out there who says that's not strong. That's a great number. What would that have been without a tax change, that's really the debate.

And so, we know that the tax law change is frontloaded, and so I think it becomes more pertinent to have this discussion as time passes, as we get into ’19, and to see how sustainable the numbers are. Because the treasury and the Fed will tell you that 1.8% GDoug Peebles:  growth, right now, is the sustainable long-term growth rate. That's a... Really a surprising number for those of us who’ve been in the market for a long time. That was... Greenspan used to think 2.5 was the number. So, you've almost taken a full turn down to 1.8.

So that's, I think, the context in which people say is this... Is the data today sustainable over a five-year time horizon? And I would surmise it’s not.  

Laura Keller: There was something you wanted to point?

Celso Munoz: Yes, I just wanted to clarify. So, just one point on the banks. So, I completely agree with you with the equity take on the banks, right? You’d be very disappointed if you had to hold a lot of capital to run your business. And obviously, that's going to lower your return on equity. And you've been restricted from undertaking some of the riskier activities that, in the past, have produced more profitability.

I was more talking about it from a system perspective, in terms of the safety of the system, and in terms of how credit-friendly the polices are. So, it was more from a bond perspective as opposed to an equity perspective.

Doug Peebles: Yes, I totally agree. I totally agree. Yes, from a credit perspective, it’s not terribly worrying. From a return on equity. If we get – I mean, it’s a big if, right – that pendulum swinging back the other way, I just think that... There's been some excitement, and for bond people like us, we sort of like it when... From a credit perspective.

So, we buy the bonds of the financial institutions, we like them to be really, really boring, right?  

Laura Keller: Yes.

Doug Peebles: But also, we like them in the capital markets, to be really aggressive with their amount that they're willing to throw out and trade with us. So, again, I think bottom line is, it’s going to be a heck of a lot more interesting in this space probably over the next two or three years than it’s been over the last two or three years.

Laura Keller: In banking you mean?

Doug Peebles: Yes.

Laura Keller: Yes. Well, and as you say, if...

Doug Peebles: And in credit spreads, in general, right? I mean, we... Everybody loves it when spreads are tightening and you're making a lot of money. But the real opportunity comes when the volatility increases, number one, and you can buy some cheap assets. And for a little while, we have had the chance to do that.

Laura Keller: And so, I’d love to just segue back into our discussion on corporates. We kind of got into the policy side of things, we mentioned a couple of different sectors, financials being one.

But there's been something that, when we talked before panel, all of you and I, you really honed in on the credit quality starting to be degraded in a lot of the corporate bond markets. So, could you just explain a little bit about the impetus for that? Why is that happening? And maybe, particular spaces that you're seeing that in too? Celso?

Celso Munoz: Yes, well... So, one thing I want to be clear about though, in terms of the quality declining here. So, the composition of the index has changed. If you look at corporates, to your point, corporates have grown dramatically over the last decade. And they've gone from, roughly, 2 trillion to over 5 trillion. And if you look at the percentage of Triple B companies in the corporate index, it’s gone from a third of the market to, roughly, half the market.

And so, that's what a lot of folks in the market will point to and say: Well, that's a problem. The way that I think about it is, yes, it’s something that’s a concern; it’s something that we need to look at and analyse, and make sure to take it into account valuation ranges. What is... When we’re comparing spreads today versus historically, and if we’re simply looking at the index, we need to take that into account, the fact that the index composition has changed over time.

That said, fundamentals in general, I think, are very strong. And so, I'm not all that worried about a big fundamental shift among the companies.

Now, the other two factors that give me a little bit of comfort around the Triple B market and that dynamic of the growth is that if you look at the compositions of Triple Bs today, there are a lot more financials in the Triple  B space today. It... Just looking at it over that ten-year period, financials in the Triple B space have increased five-fold.

If you think about who’s in there, all of Citigroup’s bonds are still Triple B. And a lot of the bonds of higher rated banks that are lower in the capital structure, are also in that Triple B bucket, so they're adding a little bit that Triple B space.

Now, the dominant part of the Triple B space is still the non-financial, so the industrials, and that really is where the focus ought to be. But when you look at the growth over the last ten years of the non-financial Triple B space, it’s... A quarter of the growth has been... Can be explained by five names, ATDoug Peebles: T, Verizon, CVS, GM, and Ford.

And those first three, I think have made a lot of strategic decisions over time, to either defend or grow their business by acquiring other companies. Or have made strategic decisions to shift their capital allocation.

And so, those are very deliberate decisions that they've taken, fully understanding that they have room within the investment grade ratings. And so, they have the desire to stay investment grade and, I think, have an ability to stay investment grade.

Ford and GM are actually a little bit different. So, those were actually upgrades out of high yield into the Triple B space. And I think while there are a cyclical challenges, and some of the rating agencies will point out they're in a tougher spot today than they have been recently. I think they still have a lot of financial leverage, I don't think liquidity is an issue here for them, and so they still have a fair degree of flexibility.

So, these aren't companies that I worry about causing a major systemic shock in the bond market.

So that's how, in general, I get a little bit more comfortable with Triple Bs in general. But, when we look at valuations in the space, we do acknowledge that they’re at the tight end over what they've been historically. Mark showed us that in his chart.

And so, as a result, we have taken down our positions in corporates, we’ve paired back risk. Over the course of the last couple of years, we’ve reduced our investment grade corporate exposure by about ten points in our portfolio. Going down from, basically, about a third to a quarter.

And a big part of the reason is that valuation. We like to take the more conservative approach and that gradual contrarian approach of reducing our bets as we see valuations become richer.

Laura Keller: Okay.

Celso Munoz: We’ll do the opposite when they get... When they cheapen up, but that's been the approach. And then, within that, given how much more we like financials versus industrials, because there are some... Well, fundamentals, in general, are strong. I think balance sheets are in okay shape. Management teams are tending to do the right things. Corporate profit margins are at very high levels.

There is still a little bit more idiosyncratic risk in the non-financial space. So, we are overweight financials and underweight industrials.

Laura Keller: Okay. Well... And maybe just, with Mark and Doug too, I mean, it’s not just Triple Bs, these fallen angels that could get into that sort of territory, potentially, it’s a covernance and other things as well that might be a worry.

Mark Redfearn: Yes, I think the one thing I’d add to Celso’s commentary on Triple Bs is ten years ago, the Triple B space was twice as big as Double Bs. And we find ourselves, today, that that Triple B marketplace is now 4.3 times the size of the Double B market.

So, there's a real risk that, as managers, a downgrade of one of the large CAP structures really is not digestible in a high yield capacity. So, say, one of the firms doesn’t pull all, or enough, levers, is sent to Double B land and high yield, it quickly becomes a story of who’s next. And that's how reactionary markets get.

And so, our concern in terms of repositioning around Triple Bs really is a bit of a supply issue. It’s a bit of how much debt is outstanding. We think it will be hard to extract a tremendous amount of value with where spreads are.

And then, your question, Laura, with regards to covernance, this kind of down in quality play, I think, at this point in the cycle, really is a burden for long-term investors to extract good returns out of entities that have lighter and lighter covernance as time has gone on.

Laura Keller: And so, your point... Celso mentioned some of these firms, Ford, Verizon, that... Not worried about those, but if someone else is having trouble maybe you’d start to worry about them?

Mark Redfearn: Well, yes, the size is an issue. We know that certain names are going to counted [?] at certain insurance companies. We can see in the data today from some of the European purchase programmes that the ECB is doing, they're actually stepping away slowly from the Triple B market, as they have experienced loss in experienced loss in their portfolio as well.

So, I think the Triple B has become a bit more difficult to handle here.

Doug Peebles: Look, I agree with that as well. I'm worried about not necessarily Ford specific but let me just throw this out there. We’ve been running a strong economy, or a growing economy, for ten-plus years. The big trend in the marketplace, broadly speaking, has been issue debt because rates are really low...

Laura Keller: So, it’s means we’ll get the... Capture that. [?]

Doug Peebles: And by back your stock. I mean, that really has been the big trend, yes? And so, they're just, on average, more levered than they otherwise would be if that dynamic wasn’t happening. And Ford, Ford is struggling a little bit with its profitability.

Now, I think it’s not US dependent, I think that a lot of their problems are coming from offshore, as opposed to onshore. But onshore, I mean, we’ve had 17 million vehicles purchased... We sort of got to that level. And now it’s starting to trickle off. And so, I kind of do worry about some of these issuers that are as big as they are, when we move to the end of this credit cycle.

But my real worry on the credit side is in the bank loan space.

Laura Keller: The bank loans.

Doug Peebles: The bank loan space.

Laura Keller: You're very negative on that space right now.

Doug Peebles: Yes, I think that there's a couple of things going on. In the traditional high yield space, we haven't seen... At this stage in the cycle, we almost always get just a flood of Triple C issuance. That people are looking for yield and they’ll do anything to get the more yield. And the economy is strong, all that sort of stuff.

Laura Keller: And just to pars what you were saying, people, meaning the investors, will buy whatever is put in front of them no matter the quality of it, no matter the convernance?

Doug Peebles: Yes... I mean, that's a little bit...

Laura Keller:  Generally speaking.

Doug Peebles: Right, generally speaking. And that hasn't really taken place too much in the high yield space. In fact, net issuance after buy backs and coupon payments, in high yield, is actually negative. Which is really supporting the high yield market. And where the bulk of the new issuance of junk borrowers has taken place, is in the bank loan space.

Laura Keller: And leverage loans specifically?

Doug Peebles: Yes, that's right. And the demand for that product, is huge, both in the CLO space, and what I really get really nervous about is, in the retail space of investors who are buying that on the back of, basically, two things. Number one, its floating rate in nature. So, I go... We go back again to this fear of rising interest rates.

And the second one is this generic notion that it’s senior in the capital structure. Which, technically, is accurate, as long as you're looking at a single capital structure.

But if there's no high yield debt underneath you...

Laura Keller: You're not protected.

Doug Peebles: You're not protected with anything other than the equity. And that's really what I worry about is that... I think that there's maybe a misunderstanding by a lot of the buyers of those products. And so, when there's a misunderstanding of the buyer, in a market that is very liquid... And again, these are loans, they're not even securities. And so, that's the space that worries me.

Laura Keller: So, thinking about EM, have you seen more problems on the government side or has it also been in the corporate market?

Mark Redfearn: I think there's lots of examples of both. A lot of times in EM, you're going to get some type of government ownership of a guarantee of some sort. So, in Latin America, we see it a lot at the government level and some of the petrochemical companies... 

Laura Keller:  Petrogas, for example.

Mark Redfearn: Exactly, or Pemex in Mexico. So, there is a bleed through on the corporate side. And there's always a risk that the government can always print money. They've got a bit better call on preserving capital over time than the corporate entities and which they support.

Laura Keller: Anything on high yield commentary from you, Celso?

Celso Munoz: Well, so I guess just two follow-ups. I agree with the commentary around the bank loans, around the documentation on the leverage loans space really weakening. I think that is an issue. And to Doug’s point, you've seen a major shift in the types of issuers. So, there's, just as an example, I think halfway... Midway through the year, there have only been, I think, about $10 billion, or less, of LBO related issuance into the high yield market. Whereas, there have been at least five times that in the loan market. So that's a very big difference.

So, there is a bit of a different appetite, a different activity level going on there, and I think that is a concern. But I think it’s... But it’s a concern, really, when the cycle... I think when the cycle turns. Fortunately, for the time being, fundamentals are still reasonably strong. And leverage levels are actually not all that high within the high yield space. And coverage levels are still at pretty good levels.

But I agree that when the cycle turns, I think what will happen there is that you may see a protracted cycle where recoveries may end up being lower.

Now, given the way the cycle is shaping up, maybe the default rate won't be as high as we’ve seen in prior cycles, but that recover level, I think, is going to be something that we’ll have to consider.

Laura Keller: So, the pain might be fewer issuers, but longer-term.

Celso Munoz: Longer... Right. But to be clear, I just don't... I don't think it’s an imminent issue either.

Laura Keller: Well, maybe that makes sense to dive in on when... Where we think the cycle is right now. Whether it’s corporates or really on the government side. I mean, most people... I think I heard this commentary a little bit more earlier in the year, that we were at the top. I don't hear as many people talking about it as readily all the time now; maybe to this point where it seems like the getting there is prolonged, and maybe the pain will be prolonged too.

But, where... What do you guys think? Where do you think... Is it this year, is it next year?

Doug Peebles: Well, again, I don't think anybody really had exactly what the fiscal changes were going to be built in across the consensus views of the economy, right?

Laura Keller: Right.

Doug Peebles: Well, let’s put it this way, our economics team, which I obviously think is very good, we didn't have two quarters in the middle of 2018 with four handles on them. So... And yet, that's where we are.

So, I think that, clearly, the economic cycle, as we sit here today, looks to be better than where we and consensus had it at the beginning of the year. And so, if you think about... You're thinking about the cycles, there's no real reason to expect an end to this economic cycle. We might have to adjust because the first year you get a stimulus from the tax cut, you don't get quite the same stimulus from the tax cut the next year. But, low and behold, I mean, for all the things that were said earlier, the US economy is in pretty darn good shape.

I think what’s a little bit different this time is that I think that the economic cycle is actually behind the credit cycle. So, it seems like if we do the crazy baseball analogy, that we’re closer to the 8th inning or so, in the credit cycle. And we’re probably only at the 4th or 5th inning in the economic cycle.

And so, you have these more leveraged, on average, credit players in the credit cycle. Now, you don't worry about that because economic cycle is strong and mid-cycle. But as we go further and further into the economic cycle, and when we start to talk about a turn in the economic cycle, it’s usually when you get to the 7th, 8th inning of that. And, presumably, by that time, the Fed will have raised interest rates quite a bit more and some of that monetary policy will actually start to impact the economy.

And at that time, you're going to be late in the credit cycle. And I think that that's a unique situation that we haven't had to deal with, that worries us a little bit.

Typical bond person, now, I'm going to tell you why we’re not overly worried about it. Because, we’re starting to see this rolling sector cycles, right? We’ve already seen a really bad cycle for energy and for basics. I would argue that we’ve already seen a really bad cycle for retail.

Mark Redfearn: Yes.

Doug Peebles: And so, if we can manage this situation where we don't have a situation where all of the, right, industrials and the financials, broadly speaking, go into a downturn at the same time, we might actually just be able to roll our way through the cycle. And again, for active folks like us, that should be, number one, that the beta should be okay. And that, number two, that the alpha opportunities should be pretty robust.

Laura Keller: But on that thought process then, if we’ve gone through that cycle in 2015, with the energy sector, retail, I think, most people could argue it’s happened, but maybe still happening. What would be the other sectors that you folks are worried about for that happening in soon?

Doug Peebles: Well, I think we’re still in the midst of the retail space. I mean, again, who knows if it’s peaked or not, but the automobile industry, I mean, that space, at least at the moment, seems to be impacted by the higher interest rates. At least as it relates to auto sales.

Laura Keller: Trade wars, maybe, could be a catalyst for something like that?

Doug Peebles: Yes, I think that some of those areas, if... Particularly for the entities who can't pass along the price increases to the end consumer, we start to worry about that a little bit. Or, the... I just took a look at the trade numbers today, I mean, imports are just absolutely skyrocketing, and exports have nosedived. So, no, I think some of that is because China frontloaded some of their purchases of our grain and the like before the tariffs went into place.

But, look, I think there's just a lot of moving parts coming up over the next, probably, four to six quarters.

Laura Keller: Are there certain places, Mark, that you're looking at though?

Mark Redfearn: Yes, I think Doug and Celso, they highlight important facets with regards to... Look, it’s always going to be easier to be easier to be an economist. Economists predicted eight of the last three recessions. It’s going to harder to be an asset manager going forward, because...

Laura Keller: And know what to do with that information.

Mark Redfearn: Right, and to know what’s priced in. We’ve come a long way, we are in an adjustment phase. I think there's lots of segments in the market that look rich to me. I've chosen to move the portfolio up in quality. I just think the risk return, the tail events... I was asked recently about my... What would be the next crisis. Those are really difficult questions to ask, and it’s certainly rational for lots of investors to ask them.

But they’ll likely come out of left field and people won't necessarily see it coming. I think we’re still in an adjustment phase here in EM. EM currency, stocks, those things have difficult times against our own the Dollar [?]. I think, probably, the Dollar is as bullish as it’s been in quite a long time and that seems to be a high consensus conviction trade in the market. And if you were to see a reversal there, that might produce an event in markets.

Laura Keller: So, you look at it as a constellation of possible factors, possible catalysts, you don't really know which one, but at every point... I mean, when we’re talking North Korea, we talk trade wars, we’re talking in some of the retail aspects, where the consumer is, any one of those points, let alone some of the structures... I know we had talked about the CDO like instrument that you've been watching. It seems like there are many points where it could happen.

Mark Redfearn: Right, and if you look at the last ten years, it didn't take much to provide a dislocation in the market, whether that be Tantrum, whether that be some of the energy, whether that be Chinese equities. I mean, things come up... Turkish Lira. Things come up into markets that make people question what their risk posture is in the portfolio. And markets almost never grind wider, they always gap wider. And so, I think when we look at where we are... And liquidity is really a forefront issue for me in looking at how the market interprets what actual liquidity is.

Prior to the crisis, broker dealers had balance sheets to trade of almost $250 billion. Now the dialogue is what’s... Where have we... Have we gotten to zero? What are balance sheets on the street?

Laura Keller: Volcker could help the change there, maybe?

Mark Redfearn: It could help, but it... When the dialogue gets to be these very technical issues, who was in buying overnight? When you get these short-term commentaries that start to catch people’s attention and become the narrative, and move away from some of the fundamentals, I think that's when the market really is set up to fail.

Doug Peebles: When you talk about liquidity, there's a variety of different liquidities, right? There's how much liquidity is available for trading in the marketplace, there's the amount of liquidity that Central Banks are providing through their QE or...

Mark Redfearn: Or withdrawing.

Doug Peebles: Or withdrawing through QT. I think that in the past... And I think this is one of the reasons we’re in a transition period.

So, 2015, the Chinese come out and devalue their currency over the summer, right? And Chair Yellen gets nervous and instead of actually hiking rates like she said kind of said she was going to do in September, she doesn’t do it.

Mark Redfearn: Right.

Doug Peebles: And so, the market’s like: Okay, so, it was risk off because of that. There's going to be ample liquidity, so let’s go back risk on. And you know what, the inflation rate was still in a downward trend in America and elsewhere at that point in time, and so they sort of got away with it, and... Now, we’re at a different stage, right? I mean, inflationary trends around the world are not... I mean, they're not scary, but they're not at the... Scary increasing, but they're not at the level where the Central Banks are going to say: Okay, markets, we have your back. Take it easy. Don't sell off too much because we’re right here; we’re right here for you.

I think that that situation has changed. And that's a very different marketplace, going forward, than what we’ve seen, literally, for the past ten years.

Celso Munoz: I think what it would warrant is a little bit more of a cautious positioning at this point. And basically, being prepared for more... For higher bouts of volatility.

So, in general, I think the backdrop, particularly in the US, is a really strong one and I feel really comfortable with that. I feel very comfortable with the position of corporates in general. But, the reality is, the valuation levels are... Don't leave a lot of room for error here.

And so, again, like I said earlier, we’ve actually... We’ve reduced our position in corporates and in... And, basically, have increased the proportion of treasuries that we own, and we see that as dry powder for whenever that bout of volatility comes next.

Now, what’s going to cause it? That's hard to call. That's really hard to call at this point.

Doug Peebles: You're exactly right. And I'm thinking, when you said that, that back in 2015, when interest rates were still zero, right? And the ECB was just chugging along with their buy-backs of corporate bonds and everything else, the alternative investment, going into the US five-year note, people were like: Oh, forget it, I'm not doing that.

Mark Redfearn: Right.

Doug Peebles: And now you can get 3% on the five-year note. That's actually not so bad. I mean, everybody’s says rising interest rate environment, blah, blah, but you can get 3% on a five-year note. That's not so bad, right?

Mark Redfearn: Yes.

Doug Peebles: I mean, even... People are getting interested in CDs again, right, because you get positive real interest rates.

Mark Redfearn: Right, and for the longest time, the big equity, the big push into equities, was like: I couldn't get anything out of fixed income.

Doug Peebles: Right.  

Laura Keller: So, I may as well go there.

Doug Peebles: There is no alternative.

Mark Redfearn: There is no alternative. So, when you get T-bills, six-month T-bills at 230, and you look globally, European high yields at 260, that's an unsustainable kind of mandate captured environment for Europeans. So, the fact that they're going to look at US – and I agree, it’s the short end that's benefitted the most – that kind of rotation. Because in a marketplace where liquidity is drying up, it’s the dry powder, and it’s the ability to be able to move in markets that dislocate.

Doug Peebles: Yes, that's right.

Mark Redfearn: And again, I think if we run a multi asset class panel here… I always find it interesting that investors, they rake you over the coals when fixed income loses money, but they want to go with a gunslinger in equity that really makes money every two years and blows it all every third. So, I think, from a low beta perspective, a core commitment to fixed income, an ability to capture a 2.5 or 4% yield in a credit product, that, to me, is a really attractive environment... Where yields really haven't been this high in seven years.

So, it’s the alternative, it’s a risk-free asset on the front end. It’s a little bit of credit exposure into a portfolio to get you something around 4, a 30-year corporate at 5, 5.5%. Those are alternatives that equity markets haven't had to face globally for the last ten years.

Celso Munoz: And that... I would add that this type of environment, we’ve got a much bigger proportion of Triple-Bs. And you've got these questions around what’s going on with covernance in the loan space. And it’s an environment where, in general, the dispersion of returns is fairly narrow if you axed [or X’d out?] EM. So, looking at almost every asset classes, the dispersion of returns is fairly narrow.

I think that's a really good environment for an active manager. It’s the type of environment where fundamental research really pays off. And where you see security selection really adding a lot of value.

Laura Keller: So, you guys are arguing against passive, and you're arguing against some of the equity funds as well?

Mark Redfearn: I don't think we’re arguing against passive. I think we just need to realise how far passive has come. So, passive is probably a third of the marketplace. You put on the algo part of the markets, another third. Those markets haven't had to face dislocation of the size into another downturn. They are, and will be, price takers. You can't create liquidity by selling CDX or buying CDX. You’re going to have to transact in cash bonds.

And an ETF that's got a passive mandate, they're price takers, they're sellers at any price. And so, I think the passivity, or the value of active management, really hasn't shown itself because Central Banks have usurped that ability.