MASTERCLASS: Fixed Income - July 2017

The U.S. economy has reached full employment but continues to struggle with its 2% inflation target. As the Federal Reserve contemplates its next move, where do the opportunities in fixed income lie? Four experts joined Asset TV to offer their outlook on the progress toward the dual mandate, and the niche opportunities available to investors today.

  • Jeffrey N. Given, CFA - Senior Portfolio Manager at John Hancock Asset Management
  • Jim Robinson - CEO and CIO at Robinson Capital
  • Tad Rivelle - Chief Investment Officer for Fixed Income at TCW
  • Beau Coash - Institutional Portfolio Manager at Fidelity Investments


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  • 54 mins 16 secs
Gillian: Welcome to Asset TV, I’m Gillian Kemmerer. As the Federal Reserve [inaudible] its moves for the coming months of 2017, including potential rate hikes and trims to the balance sheet, where do the opportunities in fixed income lie? Today I am joined by a panel of experts who will dive into the macro factors driving markets and the sectors they like in today’s search for yield. Welcome to the Fixed Income Masterclass. Thank you all so much for joining us here today. So it’s actually great timing for this discussion because we recently had an up in rates from the Federal Reserve or now the Fed Funds Rate at the time of this taping, hovering between 1 and 1.25. So let’s talk a little bit about The Fed’s self-assessment, as much as we can understand it in terms of their progress toward the dual mandate. Obviously some self-numbers have been interesting lately, their inflation target not quite in line, but, Jeff, how do you think they’re assessing their own movements this year?

Jeffrey Given: You know, I think they are on target with what they really want to do. I think they started out, they really felt the need that they had to go three times this year and start unwinding the balance sheet. And especially after last two years where they have promised us two or three rate hikes and they have not been able to deliver. I think this year is really important for them to finally deliver. So I think they think they’re right on where they need to be. I may disagree a little bit but I think they think they’re doing a good job.

Gillian: But it’s interesting because for the next rate hike it looks like the market is less confident that they’re going to make the move. I think I saw 40%, is that about in line with what you’ve seen?

Jeffrey Given: It is. I think some of it has to do with The Fed possibly pushing up the timing of when they’re going to start reducing the balance sheet. And I do think that they’re more likely to do that in September and then skip a rate hike at that point in time, and go in December. I think a lot of that has to do with the shape of the yield curve and how flat it’s gotten. If they keep pushing short rates higher and flatten the yield curve out more, that’s a disaster. They want to be able to push the long end up a little bit and give themselves more room to maneuver later on.

Gillian: And we’re going to talk a little bit about some of the impact of that balance sheet trim in a moment. Jim, if you were Janet Yellen and grading yourself, what grade would you give you?

Jim Robinson: Probably a B. You know, I think there’s less round, The Fed speak was much more hawkish than we’ve heard. I agree with Jeff completely with regard to the balance sheet. They can’t afford to have this yield curve continue to flatten. You know, at the end of the day their oversight is of the banks. And the banks can’t make money on a flat yield curve. So I would expect that the balance sheet will be first and foremost on their minds at the September meeting.

Gillian: It’s interesting because [inaudible] have all spoken since that decision was made. And they seem to be a bit more benign at the actual decision. So it’s only, it’s up to them, we will see. Tad, what do you think?

Tad Rivelle: I think they’ve mostly failed. Years ago they laid out this idea that they would take these emergency steps, move to zero rates, do QE, take on a number of experimental policy measures. And the result was supposed to be ultimately a rate normalization. Eight or nine years later we’re still waiting for it. We’re still experiencing very subpar growth. Based upon the metrics that they laid out at the start of … when all of this started, they’ve completely missed their objectives. And they don’t seem to understand even what’s happening because they have their models. And their models are in part Philip’s curve derived. There’s supposed to be an uptake in wages and inflation, they’re not seeing it. They don’t understand it. They’re raising rates and flattening the curve. I think they’re actually completely lost in terms of where their policy is. And I don’t think that there’s any overarching guidance that is … that they’re able to live by that would essentially tell them or tell us where they’re going with their policy.

Gillian: So we’ve gotten a B, would you be more of an F?

Tad Rivelle: I think it’s completely failed. I mean I don’t think that there’s anything that was represented initially with respect to these policies that they’ve executed on. I mean they were able to get us out of the emergency conditions of 2008 and 2009. But we’ve never been able to exit it. So what good is an emergency measure if it essentially becomes an enduring feature of the economy? What it tells you is that they’ve acclimated capital markets in the economy to in effect an environment of subsidized rates. And now that we’ve lived with these subsidized rates they don’t know how to exit it in large measure because I don’t think that the policies were never properly conceived and properly designed. And they’re sort of arrogant policies. I mean who is supposed to know what policy rate or trajectory of policy rates is supposed to give you a given outcome of this unemployment, that inflation and by the way, also ensure financial stability, as if you could even measure what inflation is. I mean that’s a discussion perhaps for another day. But I think that you should be extremely skeptical that the numbers are meaningful in any way that matters. A tiny little prism into that is 25% of the CPI is captured by owners’ equivalent rent, which captures the carry of owning the house. But to any 25 or 30 year old starting out looking to buy their first home, it’s not the carry that’s the binding condition or the binding limitation, it’s coming up with the down payment, which doesn’t show up anywhere in the inflation numbers. So the notion that there is an adverse exchange rate between peoples’ savings and their wages and their capacity to buy homes is completely ignored by the numbers. So what do the numbers mean exactly?

Gillian: All interesting points, Beau, yourself, how would you grade them?

Beau Coash: They are great points. And we’d say it’s a little bit of best of both, in one world it was a job well done in that we got lower employment rates and rates have stayed low. So you didn’t damage housing, you’ve actually exited or gotten some movement from a beaten down economy and that you saved an economy hypothetically. But this QE exit is going to be the interesting part; I think will hold the final grade to how they navigate that. They’ll probably use a little bit of both the strategies, both you’re raising rates gently, slowly, but also doing the QE unwind. And that will be the biggest test and to see if that really impacts economy or the housing market or demand here in the US for any big items with the financing needed to keep rates low. So I think we’re a little bit more in the middle in terms of job, you know, two mandates, job well done on one side of the mandate with low unemployment. The other side of the mandate you had to be determined in terms of inflation and they’re exiting the QE space.

Gillian: One of The Fed speakers I think this week, and I forget exactly which one said that he hopes to see data that would suggest that the low inflation point is a temporary condition. But it’s interesting to hear a Fed speaker saying that when they’re already making decisions, you know, to move the curve. So, Jim, coming back to you, let’s talk a little bit about some of these potential moves, the balance sheet trimming is one that’s been mentioned a few times here. Let’s talk about what some of the risks or impact would be of that policy move, for example, I think they have 1.8 trillion in agency MBS, is that right? So what would a balance sheet trim look like?

Jim Robinson: Well, they’ve already kind of laid it out. And I think they’re trying to ease their way into … to doing this and prepare the markets for this. Interestingly, since 2013 and the Taper Tantrum they have been highly focused on communicating to the markets and making sure that we don’t have an adverse reaction. But there’s a natural adverse reaction when you put that kind of supply back into the marketplace. So it should put pressure on those asset classes that are being sold.

Gillian: Jeff, what about you, how do you think about it?

Jeffrey Given: Yeah. I mean we do worry about the exit. I think they really need to make sure it goes well because they’ll never be able to ever use this tool again if they don’t extricate themselves and have it fairly seamless. But the Federal Reserve’s been buying 30% of gross mortgage production over the last five or six years. Whenever you see a buyer that’s been 30% of the market disappear or significantly reduce their role, we don’t think that’s necessarily going to be the most orderly process in that just a 5 or 10 basis point backup and mortgage spreads is going to be enough to entice other buyers in. So you know, we have concerns with that and then the follow on effects of, okay, higher mortgage spreads, a little bit higher yields, higher home borrowing rates and what that does to the housing market is a big wild card. And if they have to stop their program after 3-6 months because the market’s taken it the wrong way, that would be, I think, an absolute disaster for the Federal Reserve?

Gillian: Beau, what do you think about it?

Beau Coash: Yeah. So that point is exactly right. So what level clears this big amount of mortgages coming back out? And it’s probably treasuries are going to be left alone. It’s going to be tweaking the mortgage space. And so how much demand is there from the banking system? So the banks have almost been forced to buy mortgages as well, given the cash, the capital required to kind of put up against mortgages relative to corporates. So capital charges for treasuries are 0%, mortgages 20%, capital charges for a corporate bond is about 80%. So the vehicle of choice for banks has been mortgages. So we’ll see if they step in, we’ll see if overseas steps in to take some of the supply. So it’s going to be interesting to see how this gets swallowed.

Gillian: And, Tad, you gave them an F in terms of their progress so far. How do you think they’d be able to handle a balance sheet trim?

Tad Rivelle: Well, I think, Beau, you made the point and others made the point as well that, you know, to a certain degree, you know, the question that we’re addressing is how is the plane ride before you’ve landed, right. And addressing the question of the balance sheet unwind is how is the plane going to land. So let me start with one or two disembodied comments, you made them earlier is The Fed has looked for every reason not to raise rates since the Taper Tantrum. Any shadow, if it was an inflation shadow, we’re scared we’re not raising rates. Asset prices, no, we can’t do it, doesn’t matter. There’s always a “good reason” for it. A year and a half ago, Stanley Fischer, the Vice Chair of The Fed said, you know, “You ninnies in the marketplace, you don’t get it. We’re going to raise rates four times on you; you’re just not listening to us.” And of course The Fed chickened out. The point is to contrast The Fed in 2016 with The Fed in 2017, so they miss on non-foreign payrolls, don’t worry about it. They raise rates and flatten the curve, no big deal. Inflation’s missing the target, we don’t care.

It suggests, I think that maybe it’s a bit cynical, but maybe there’s one of these rules of life that you can never be quite cynical enough usually, is that the difference may simply be that Janet Yellen knows her tenure is very likely up in a few months’ time. And even if it’s not up, do you really want the job of being reappointed to The Fed and landing the plane and risking a cash landing and having everybody in administration say, “There, that’s the person who cost you your job and destroyed your business right over there at The Fed.” It’s a good time to, so to speak, get out of dodge. And this is a long winded way of saying is, so what did these plans mean? These are plans that are being made by this management for a future management. The Fed this year does not have binding control over what The Fed might be next year. So I think we’re going to wait and see whether any of this talk about balance sheet reduction really turns out to be anything more than an exiting Fed Chair and exiting Fed management. You’re simply able to say, “Hey, it’s not my fault, I was normalizing rates when I left. I was making plans to exit the balance sheet when I left. And if the fools who followed me, didn’t execute, well, then go blame them.” But I think that there’s certainly a good chance that now that central banking, so to speak, has ceased to be an honest profession, where it used to be about being lender of last resort and that was your job basically, as opposed to sort of more of a micromanager of inflation and unemployment. It’s very possible that you don’t see a balance sheet unwind if there’s an adverse reaction in the market. So it’s almost a circular question. You know, will there be an adverse reaction? Well then if there is, it probably isn’t going to happen. That might be, as I say, a bit of a skeptic’s take on it all.

Gillian: Well, I’m going to borrow your plane analogy for a second and Jeff I’m going to come back to you. If the plane is landing let’s say five years from now, where is it landing? Do you have a sense of what the terminal rate would be and how long it’s going to take to get us there?

Jeffrey Given: We think the terminate rate’s a lot lower than what The Fed really thinks it is. We think the terminal rate’s somewhere 2-2½% zip code. And I think The Fed probably gets there and economies don’t die on their own, generally The Fed murders them. And I think the risk is The Fed murders the economy and takes, they think that terminal Fed Fund’s rate 3%, they take us there, that slows everything down. There’s little inflation, there’s not that much built up demand for things in the economy. So I think ultimately The Fed tries to get rates to 3%. And if they do, I think that’s a mistake.

Gillian: Okay, Beau, where do you think we land?

Beau Coash: We agree in terms of terminal rates somewhere between … well, a little bit higher, maybe at 2½n ish, plus/minus. But certainly not what we’re typically looking at in terms of terminal Fed Funds rates closer to 4 at end of cycles. You know, let’s just face it, we’re in a new cycle, this is .., we’ve only seen three economic cycles really since 1990, about six credit cycles. So this is new territory for a Fed with a brand new economy, with inflation fighters all over the place, new kind of companies who are destroying inflation, increasing productivity. And this is a, you know, we’ve got a Fed that’s really an academic Fed, and we’ll see what happens kind of going forward with replacements of maybe less academics, more practitioners. But we’ll see. But I think it’s going to be a challenging new time for figuring out how to do all this in this new world that we’re in, and a much more global world that we’ve been in ever before. So you know, but challenges, but we don’t think we’re going to get back to a 4% type Fed Funds rate, we don’t think. We think a 1994 event is off the table where The Fed moves seven times and kind of, you know, shutdown an economy that was coming out of a recession. So we think we’re more in the middling stage and we’ll see if The Fed can navigate it.

Gillian: And, Tad, where do we land?

Tad Rivelle: Consistent I think with what’s been discussed. The elaboration would be that the current New York Bank President, Dudley, I recall his coming into our offices when he was either Chief Economist or economist on the desk at Goldman 20 years ago. And I recall at the time, he putting forth sort of the Goldman thesis, that the two things that you can bank on as being the best determinants of a coming recession end of the cycle are downshifts in corporate profitability and slope of the yield curve. The yield curve will not allow The Fed essentially at this point any longer to normalize rates. But making sort of making a rhetorical point and maybe piling on a little bit is, and whose fault is that. When you falsified rates and you falsified asset prices and you caused poor resource allocation and you drove down GDP you weren’t stimulating anything, you weren’t solving anything, you’re just making it worse. It’s just sort of, I mean to make these grand abstract things very concrete is that if the theory for instance was that you drive up home prices and then it stimulates the economy through a wealth effect. Well, it doesn’t work so well if you’re on the other side of the knife. If you’re out of the housing market and you’re being crowded into an apartment unit, it’s not a wealth effect, it’s an impoverishment effect. But the deeper point is that by not allowing the capital markets and the economy at large to do what it has always done very well, which is allocate resources in an efficient decentralized way, but rather by trying to drive the process we haven’t been able to achieve the rates of growth that now allow anything like normal rates. And so the cycle will probably die and it will probably die at a very low level of rates, probably no matter what The Fed does.

Gillian: Okay. And, Jim, obviously anyone who thought this was the Janet Yellen fan club is now changing the channel. But if you just give us a sense of where you would land or where you see us landing.

Jim Robinson: Well, if you look at the dot plots, they say 3%, right. The market’s telling them an entirely different story and you’ve just had billions of dollars on this panel who invest those dollars say that it’s not going there. I can’t see them getting past 2%. I think when it comes time to raise rates in December the market conditions, economic conditions may not warrant it. And you know, as Tad mentioned, this is a Fed that has always looked for any excuse not to do something, Brexit, what have you. So I would be surprised if they get to 2%.

Gillian: Okay. So let’s move to a picture that I think we’ve already slightly alluded to, it’s going to flash up on the screen behind me. It has to do with the treasury’s journey along the rate hike. So 10 year US yields fell below their December 2015 level, which was the beginning of our four hike cycles. So let’s talk a little bit about what is driving this move in treasuries. And I remember a hedge fund had posted some kind of unprecedented bearish bet, it’s since completely reversed. It’s a very, very interesting market movement. So, Beau, I’m going to start with you, how do you think about treasuries, do you really consider them the “risk free” asset, which is the [inaudible] that they get all the time?

Beau Coash: Well, I guess it depends when you talk about them in a risk free way. So in 94 we talked about that before, it wasn’t risk free. Treasuries were not risk free; they were probably a dangerous place to be. Today I’d say in the modern history, we’ve seen them in VIX environments that spike, when volatility spikes up, they’ve been a great hedge for risk assets. So I’d say that generally speaking, they’ve acted as a risk free asset and a great ballast to portfolios in risk off times. So we saw that specifically through the 2015 and early 16 energy crisis where risk assets were being sold pretty dramatically. And we had regimes across the globe that had correlation to oil assets given their regimes needed oil proceeds to budget themselves. And they were selling risk assets, treasuries were one of the only treasuries … agency mortgages were one of the only places where you could get great returns and get good total returns. And that’s come off since. We’ve been talking about this QE exit strategy. But I think it’s, treasuries have a great place in any portfolio. It’s just there’s no bad bonds, just bad prices. And so we’ve actually been adding some to the portfolios. So I think they are, you know, it’s all relative value. So right now, we’ll get into that later in terms of the asset allocations. But, you know, we think treasuries are okay here, because we don’t see rates rising dramatically.

I think in line with the group here, we think there’s a tremendous amount of demands, but more of technicals, it’s a story of technicals across the globe where you’ve got tremendous demand coming from foreign countries, Far East specifically. Europe has got a huge demand for our markets, for liquidity and higher yields and they have, and they’ve got a hedging advantage now. It doesn’t wipe out the …, you actually have an arbitrage right now, we can make excess dollars over and above, the hedging doesn’t wipe out your extra yield. So it’s a very interesting place to be for those countries. And then we’ve got aging populations. So we’ve got asset allocators who have had a nice run in the equity markets, who are not coming back into fixed income, little bits and pieces. So we get decent support for the fixed income markets.

Gillian: Okay. Jim, how do you think about this picture of the US treasuries and their 10 year yield right now?

Jim Robinson: Well, I think the 10 year yield is telling you that if The Fed sticks to their dot plots, that in a year’s time we’re going to have Fed Funds equal to the 10 year treasury yield, which is a disaster for them. So that’s why I don’t think we’re going to see 2%. But the market is clearly telling … telling us that they don’t believe that The Fed should be raising rates as aggressively as their dot plots suggest they should be, because economic conditions don’t warrant it.

Gillian: And, Tad, how do you think about this?

Tad Rivelle: Well, there’s a global market of course for many types of debt instruments and most particularly treasuries. So there’s a myriad of factors that’s driving them. And so asking the question about why did we go from 1.6 to 2.6, I mean from the election to back where we were in February, 2.6% yield down to 2.1%? Almost anything that you want to offer is probably a valid enough reason for explaining the move. But I think as communicated, the more relevant issue is that whether the treasury market is the smartest guy in the room and has figured out that The Fed is unable to raise rates all that much further from where we are, which could very well be true. Even if you don’t want to accept that, the reality is, is that as you flatten the yield curve you start to compress net interest margins, you compress net interest margins and the treasury market doesn’t have to forecast a recession, it will cause it, simply by virtue of the fact that financial intermediaries are being incentivized to shrink their balance sheets. So if we’re asking the question of is 2.1% on a 10 year a long term proposition to invest? Obviously not, I mean there’s no way that you can build any wealth by doing that. Is it something that you might want to own tactically because it will de-correlate with risk assets into an end of cycle experience? Yeah, it probably will do that. And it might be a very appropriate asset to own so that you can access assets that have basically fallen more precipitously in value and it’ll be a way to finance those purchases?

Gillian: And finally, Jeff, do you think we’re close to the bottom?

Jeffrey Given: Yeah. I don’t see rates dropping a lot lower than they are right now. I mean we’ve referred to the treasury market as return free risk versus risk free return for a number of years now. Because we didn’t really see how the treasury market was going to be leading the fixed income asset class. I think what we’ve seen is actually fairly typical for a rate hike cycle, typically after the Federal Reserve does their first hiking move, the 10 year treasury peaks around 50-60 basis points higher than where it was when The Fed started raising rates. The Fed started raising rates when the treasury is at 2%, we went to 2.50/2.60, that peaked, it usually comes down. That’s happened in 94, it happened in 04, it happened in 99, and even going back to 1994 when it was a disaster for fixed income, the 10 year treasury peaked, I think it was around 125 basis points higher than where it was in the first cycle. So The Fed really doesn’t control the long end of the market. That being said, you know, now that you’re seeing real rates in 10 year treasuries at, you know, 25/50 basis points, however you want to measure inflation, it’s really hard to make any money unless you are trying to predict the crash of the equity market. And you need to be in treasuries for that drop from 2.10 to 1.30. Other than that it’s hard to see treasuries doing fantastic from here.

Gillian: I’m going to stay with you for a moment. We’ve alluded to it a bit but obviously there’s a lot of appetite for them at the moment. And when you look at the rest of the world, whether it’s the ECB continuing to maintain their dovish bias, Japan, we look like the treasure chest right now strangely enough. So how do you look at the global central banking outlook and how that really impacts the search for yield in the performance of securities here?

Jeffrey Given: You know, I think it has a very, very big impact. I mean we’re seeing that from demand from potential investors more on the longer end and more in corporate bonds. But you’re seeing continued demand in the US from overseas. I think the difference in this cycle is that traditionally The Fed starts raising rates, the rest of the central banks in the world follow along, it’s usually a year later, as everybody waits for the US to recover before tightening. That’s not happening, it’s not happening any time soon. So that continued demand from on the government’s side, it could be coming from overseas insurance companies that need the risk weighted asset for the treasuries. It could be from US banks that need that demand. And maybe that’s where it keeps rates in, is that the US banking system will need those securities for a lot of their tasks. So we don’t see that demand really changing any time soon. It would have to be by inflation and it just doesn’t seem like inflation is going to pick up substantially any time soon, either wage inflation or CPI type of inflation.

Gillian: And, Jim, what about you, how do you think about this influx of capital here and how we look compared to the rest of the world?

Jim Robinson: Well, if you look at our yields, they’re the most attractive on the planet, other than, you know, credit situations overseas. But amongst the developed world we have the highest yields out there. So in a Fed that seems hell bent on tightening, which should ultimately be good for the dollar, I would think that our market would be particularly attractive to foreign investors.

Gillian: And, Tad, last but not least, how do you think about the US in the context of global central banking policy, does it reduce Fed effectiveness the way the rest of the world is behaving?

Tad Rivelle: It does, I mean The Fed was first with the brilliant idea of doing what we did. But it was followed by the actions of many other central banks. It’s interesting that based on the data, if you look at the actual amount of balance sheet that’s been created globally by the central banks, the pace has actually accelerated over the course of the last 12 months. The acceleration in a sense is an indictment of itself. I mean if all of this stuff was supposed to work, why are you doing more of it? But it is also having the effect that was discussed, which is that by holding rates artificially low or negative overseas, it is, I don’t know, flooding maybe is kind of a histrionic term for it. But it is causing capital flight and we’re seeing it in the form of mandates from Japan and from Europe. I presume this has been done to help hold the exchange rates of these nations lower, with the hope that this is somehow stimulating something. And again I’m not really quite sure what the exit strategy or where you’re going with it. But it’s created arbitragable opportunities. The negative, the condition of capital flight coming out of Japan has allowed US investors, it was even written about, I think in the journal a couple of months ago. It allows US investors to buy JGBs at negative yields, hedge it out, and actually earn a positive rate of return hedged back into dollars that is in excess of US T Bills. So it’s created opportunities here. But I don’t think that it can be understood as an equilibrium condition to have negative rates in the Japanese T Bill market or 30 basis points of yield in the European corporate market. I think no self-respecting bond manager would tell you that there is enough compensation there to compensate you against the risk of credit loss or rate rises or liquidity or 100 other things I suppose that we could come up with.

Gillian: Now, I’m going to stay on the macro points for one last one and we’re going to give Miss Yellen a little bit of a break here. I want to talk a bit about the passive fixed income flows. I believe that the last statistic I saw was influenced through March to fixed income, ETFs was about 60 billion. Is this a trend that you are keeping track of, either as a potential risk or how do you think about it influences the way you look at liquidity right now on the market, Beau, I’ll start with you?

Beau Coash: So, yeah, there’s been a tremendous growth in passive. What that does, I think I just added up some of the larger strategies. I saw something like 450 billion from some of the larger managers that run passive strategies. Passive strategies or index strategies, index strategies are negative selection strategies of fixed income. So fixed income markets, the biggest issuers go in, in equities. The best performers go in and get bigger and bigger. So we think that’s a great opportunity for us to actually outperform as active managers by looking at what’s going on in the index, and we don’t need to buy every new issue. We don’t need to buy every bond. Many passive managers try to buy lots of bonds, others do selective sampling. But they do have to try to mimic the index. We try to buy the bonds that will have asymmetric risk to the upside. So we try to buy bonds that are good to bondholders, not great to equity holders. We try to buy bonds and every bond’s like a snowflake, it’s got its own holders, so we have to analyze every part of that bond. And so we think there’s advantages and better batting averages by looking at bonds individually and outperforming passive. But we also know that there’s a great place in the world for passive. So if you want cheap fixed income beta, it’s a great place to go for liquidity because as we know, 70% of it is triple A triple A and very liquid. So there’s a place in the world for both active and passive fixed income.

Gillian: And, Tad, how do you think about these inflows, are you worried about a run on some of these high yield fixed income ETFs for example?

Tad Rivelle: Well, as a bond manager I’ll disclose that I’m probably worried about everything all the time, so. And that’s certainly something that … to be considered. There is obviously a role for passive strategies as indicated. Strategies that are index oriented suffer from some benefits, or I should say they suffer from some drawbacks, but they do provide some benefits, right. So we talked about some of the benefits being cost. Two of the drawbacks would be that indexes can be gained in the sense that an issuer that isn’t necessarily qualified or would be qualified given a proper level of due diligence and scrutiny, can basically talk to the bankers and say, “Well, you know, if you issue it in this size and this maturity it’s going to go right into the index. And it’s going to get bought basically, the index funds will take it.” And that’ll be the end of it. It does suggest therefore that there may be arguably, less scrutiny about of certain borrowers in the marketplace. The second issue which is, you know, it’s reasonable, people can have different views and opinions, are just that, they’re bot facts. But the opinion I would offer is that an index generally speaking has a constant risk profile over the course of the cycle. And I think that part of the way we would offer that, you’re supposed to think about it is you’re supposed to be an enthusiastic risk taker in the early phases of the cycle, maybe a prudent risk cycle in the middle phases of the cycle. And you’re supposed to get out of dodge basically in the late stages of the cycle.

The index is just on autopilot, it doesn’t know from nothing. And I mean if that’s the kind of exposure that you need and want, there’s absolutely nothing to be said against it. But an active manager is supposed to be more consciously aware of some of the issues we’ve discussed and where you might be in the cycle, and should be doing something to actively adjust the risk budgets over the course of time. Proof is in the pudding, right, if you can produce the alpha over the course of a cycle, then active management for all of its stated notional benefits isn’t able to deliver the goodies, the tree by the fruit and all that sort of stuff. But you know, I do think that cycles are enduring. And you know, the ability to take advantage of the fact that markets always have a tendency to do what they’re not supposed to be doing, that investors in the early stages of the cycle, the kind of stylized conversation you have is, “What stocks, are you crazy?” High yield bonds you can lose your shirt. At the end of the cycle of course the conversation is quite different. My understanding is in the last 20 years, there’s been exactly 11 days where the VIX has closed under 10 and of those 11 observations, 6 have occurred in the last four or five weeks. So obviously nobody’s worried about volatility in the equity market. And that produces opportunity.

Gillian: That’s a great point that we’re going to touch back on later. Jim, obviously your strategy, which is a bit different, really benefits from some of the behavioral biases of retail investors. And we’re going to talk more about that. So when you think about these passive influencers, do you look at them as a risk?

Jim Robinson: Well, the rule of thumb with indexing is you index those markets that are most efficient. So, you know, I’ll say it another way. There’s probably very little large cap equity manager can tell you about Microsoft that the 100 analysts on Wall Street haven’t already figured out. So why do you need an active manager to pick that stock? Having run a large asset management firm and seen the sausage get made, I know that 80-90% of the holdings in large cap equity portfolios are there for beta replication, not for alpha. So why are you paying active management fees for a 100% of their portfolio when you’re really only getting 10 or 20% of active management? The fixed income markets are still not that efficient. When I started back in the business in the early 80s, Wells Fargo was trying to index the bond market. And that created golden years for those of us who were on the active management side, because they did things as Beau suggested, where they’re just filling buckets. They’re filling cells, they’re doing stratified sampling. They’re not actually evaluating the securities. And the challenge of indexing the fixed income markets, and the reason they’re less efficient than equity markets is that you have ever changing structures on securities, even to the mortgage market and it’s constantly changing. It’s a considerably less efficient market. And so it’s not the type of market that I would be indexing with my own money and I certainly wouldn’t be advising clients to be indexing inefficient markets.

Gillian: And, Jeff, lastly to you.

Jeffrey Given: I think actually passive creates an opportunity for us active managers, that it allows us a way to differentiate ourselves even more so from these type of strategies. I think it really comes down to fixed income too, the asymmetrical risks that we have. I mean we don’t have a lot of upside and lots of downside. I feel in an index strategy in holding companies that go into bankruptcy, and it can happen out of the blue, Lehman Brothers, WorldCom, Delphia and it’s very hard to earn that back. If you have a very good active manager that can get out of the way, that can save yourself a lot on the long run and it gets into risk budgeting as well. Avoiding areas in the marketplace where people are very complacent and moving into areas where maybe it’s not quite as loved and adding alpha from that standpoint as well. So I think from our standpoint, we don’t view it as a risk per se, and now as a risk to our cost of the strategies. And you have to be much more cost conscious on the products that you have offering. But I think it allows us to differentiate ourselves even more so over a longer period of time.

Beau Coash: And the additional point I’ve got on that is that if you consider the index eligible securities, well, there’s about as many not in the eligible securities in terms of dollar amount as there are index eligible. So you’ve got a pretty big pool to swim in and out of the index, and that can add a lot of value, as opposed to equities, which it’s basically a public market or a private market. It’s very hard to get access to the privates in equities. But in fixed income you can trade both the index eligibles or the non-index eligibles. And it’s all about size. So a non-index eligible of a billion dollar size is almost as liquid as an index eligible at a billion.

Gillian: This actually segways nicely. So you’ve painted a macro picture and, Tad, I’m going to start here with you. I don’t expect anyone to get up and be jumping up and down given how yields are looking right now. But on a relative basis, what do you like right now?

Tad Rivelle: Well, if one agrees with the thought process and one doesn’t have to, that you’re late cycle, you should begin by properly characterizing what the opportunity set looks like, whether you label it as such. And so what I’m getting at is that for the first two-thirds of the cycle, 80%, whatever, you should think risk on, risk off, that’s efficient. And then you can be looking at the risk on and say, “What do I like the most and how do I balance the two?” Late in the cycle you should recognize that that’s improperly nuanced, is that late in the cycle, what you have are breakable assets, assets that I’ll call bendable, and you have risk off assets. And breakable assets, I mean the name sort of implies in the last cycle, down the capital structure and subprime, Lehman Bonds, we had an example of a breakable asset in the last two weeks with the failure of the sixth largest bank in Spain, the Coco notes went from poor to zero over the course of a two week period of time. So you were alluding to it, I think, earlier, what was it, Benjamin Dodd, [inaudible], who many years ago, ostensibly the inspiration for Warren Buffett and so forth, described bond selection as a negative art, late in the cycle it’s a negative art. You must identify that which could be breakable, bricks and mortar retail, down the capital structure in CMBS. Some of the subordinated claims in the European banking system, maybe some names in the EM in the high yield area, commodity space etc.

So you begin there, is what could be breakable? I don’t want to look at it basically. I don’t even want to think about it. I want them out of the portfolio. And then that basically leaves you with balancing a portfolio, opportunity now becomes in a sense a bit relative. But the focus is on assets that I’ll describe as being bendable, meaning they’re going to suffer market to market volatility. But as distinct from breakable assets, not permanent impairment of principal and bendable assets in this case would include things like investment grade credit, top of the capital structure opportunities in CMBS, ABS, triple A CMBS, therefore triple A ABS. There’s a myriad of places to go. But what you’re playing for basically is to capture some, many people might call the safe spread and then you’ll own some risk off assets like treasuries, because you want to sell them into a deleveraging. But the opportunity set is not what it was in let’s say years one, two or three of the cycle, where it’s a story of how much high yield EM and subprime mortgages can you pile into your portfolio and stuff into it and live with the volatility. So it’s not that kind of … it’s not that kind of opportunity set anymore.

Gillian: So do you have a favorite among them all?

Tad Rivelle: So in the case of investment grade what we’ve seen is short maturity banks in January and February of this year, the money centers were issuing huge quantities. And a lot of stuff was coming out on swap. I mean you could buy one and two year bank paper at a 100-120, that looks great. It’s a little bit tighter right now. Some of the triple A CMBS, 75 or 80 over, some of the Phelps, US government guaranteed student loan stuff. I mean, okay, it’s not exciting, but it’s uncapped LIBOR based government guaranteed floaters at L + 75 or 80 or something like that. But all of these opportunities when you juxtapose them let’s say against high yield, and when people talk high yield, the problem is, is that the discussion oftentimes isn’t properly framed. You don’t look at the yield of a high yield bond and say, “Well, it’s more than that of an investment grade bond.” You loss adjust it. And if you layer in some very reasonable modest loss assumptions and default assumptions, what we’re finding is, is that the high yield opportunity set is almost equivalent to owning triple B securities. You need a very favorable go forward environment for defaults and expectations of same in order to justify it at this point. So there isn’t a lot of money to be made now, but if you prepare properly you will make plenty of money at the time of a deleveraging and in a period that follows, at least historically that’s kind of the way it works.

Gillian: Perfect. So, Jeff, give us a sense of what you like and just as Tad did, also tell us what you don’t like.

Jeffrey Given: I’ll start off what we don’t like and that is the asset classes that the Federal Reserve’s going to be unwinding and reducing. So we’ve been underweight treasuries, underweight agency mortgages for a while now. We remain committed to being underweight to those sectors for now. What we do like is spread product. I think it comes back to the most important thing in fixed income going forward as the income component because you’re not going to make a lot in capital gains. But you do have to be more defensive about it than you were two or three years ago. So we do like investment grade credit, whereas shortening your maturities are where you own investment grade credit, instead of owning a lot of 10 and 30 year credit, you own 5 and 3 year credit of higher quality issuers, or kind of just that you think you’re going to be upgraded. Or they have a reason to be committed to investment grade rating and let those roll down the curve. In high yield, we still have a decent allocation, it’s maybe half of what it was three or four years ago. And the high yield is also moving up in the capital structure in high yield. And going from not only less triple C’s and single B’s, and owning a lot more double B’s, upgrade candidates that we think that are going to move into an investment grade area in the next year or two. It could be subordinated debt or financial institutions, US banks that are rated double B that we are very confident in the bank’s structure and how they’re going to move forward. So those are the areas we like.

We think the income component’s important, and avoiding, you know, retail mall exposure, avoiding suburban office in the CMBS area. We tend to prefer single assets, single borrowers CMBS deals, which are basically loans to individual properties where we can do the due diligence, we’re on the capital structure, we’re comfortable even in a distressed scenario and own those assets. And it gets into the bend but don’t break scenario where even if we get into an 08 scenario, that bond’s going to be money good. You may have short term price volatility and approaching the market that way.

Gillian: Excellent. And, Beau, what do you like right now and what don’t you like?

Beau Coash: Yeah. So it’s the same types of themes. This is not the time in the marketplace to start putting … replacing your illiquid securities for … or your liquids for your illiquids, and reaching for yield. So we like to be … we’re actually doing some swaps out of the subordinated banks and going into more senior areas. We’re doing kind of upgrade trades as it’s been mentioned before on the panel. But we still do like credit. We have overweights to high grade credit across portfolios. And we also know that corporates are in pretty good shape. There’s a lot of excess to capital, EBITDA interest coverages, it’s still in pretty good shape. It’s probably double what it was in 06. Leverage is down, we’re not going to see systematic risk from banks this time round, at least we think that’s going to be the case given how much capital has been built up and regulatory rollback has not happened yet. So there’s still a good clampdown on banks. That’s tended to offer a lot of opportunities, when banks blow up, the tap goes to the shoulder and banks get rid of all their securities at very good prices. Well, it’s a new system now, now clients have to trade with clients through a bank. But the bank isn’t taking that risk and marking things up a point. And so it’s a little bit of better of a system for buyers and sellers in that we’re not getting that bid offer taken out.

That said, you know, there’s not a scramble in some blow up periods that have a wholesale selling of securities like we saw in 08 where everyone got tapped at the same time. It created a great opportunity. We see these gradual idiosyncratic events now with the energy meltdown. And that took over, if you noticed it was June 2014 all the way through to Feb 16, so this long drawn out kind of opportunity to put risk on, if you really liked it. And if you had to do the right kind of work where you kind of understand where the companies are coming from and they want to save themselves. There’s a kind of deep work that I think Tad was alluding to, where you get great opportunities to buy when things kind of blow up and you have an opportunity to step in and have liquidity. But we like high yield. We like loans. And so that’s where we stand on some of the opportunities.

Gillian: Jim, you don’t own the securities, you own the managers. So tell us a little bit about that.

Jim Robinson: Yeah. So we have a slightly different perspective on all of this. We arbitrage closed end funds. We have two different funds, one that focuses on tax exempt funds. The other focuses on taxable closed end funds. You know, the way I got into this trade was the heels of Lehman going down in 2008 and the carnage that remained. You know, at that time anyone could pick up a newspaper and see that the stock market was down 30%. Well, the average investor wasn’t reading his high yield bonds were down 35%, senior bank loans were down 38%, preferred stocks were down 40 something. That’s important because they all rank above stocks in the capital structure. So it’s not intuitive they’d be down as much, let alone, more. Over the last three years we’ve had a similar divergence that doesn’t get any focus because stocks are actually up. But for trailing three years you have the stock prices of the S&P up 25%. You have high yield bond prices are actually down 3%. In an environment as your graph showed where yields have been basically flat, that’s not intuitive nor do I believe it’s sustainable either the bond guys are wrong and they need to catch up a little with the equity market. Or the equity guys have gotten a little ahead of themselves and maybe that market needs to correct itself.

So when I look at things like high yield, it’s hard at 340 basis points for a five year CDS to get real excited about high yield. But high yield relative to the equity market, that looks interesting to me. So what we can do in our funds, that most advisors would be challenged to do on their own is we can hedge that out. So we actually have short positions on various equity indices to offset some of the credit risk of the high yield market.

The market that we find particularly interesting right now is munis. You know, one of the things I love about the muni market is that the credit situations get telegraphed years in advance, not days, weeks, months, but years in advance. So I’m based right outside of Detroit, pretty much the epicenter of what went wrong with the muni market in 2013. Had Detroit declared bankruptcy 10 years prior, no one there would have been surprised, the conditions had been there for quite a long time. I don’t think anyone was surprised by Puerto Rico, I don’t think anyone’s going to be surprised by Illinois and what’s happening in Chicago or Atlantic City, closer to here. These things have been out there for a long time. Whereas in the corporate bond market, another five point drop in the price of oil, you could see a number of marginal energy companies, poof, disappear. So the muni market looks reasonably attractive to us. Typically you would expect munis to trade somewhere around one minus the tax, marginal tax rate relative to comparable credit corporate bonds. A year ago munis were trading roughly 60% of the investment grade corporate bond market, which is what you would expect with a 39.6 marginal tax rate. After the election they got up to about 85%, as everyone got euphoric about tax reform. Now we’re back to about 70%. I would argue that they’re still undervalued, even if this administration should be able to get tax reform done. The last number I saw was 35%, so that would suggest munis should be trading roughly 65% of corporate bonds, not 70. So we think the muni market is reasonably attractive here.

Gillian: So one final question for all of you as we come to the end of our discussion, something that’s already been alluded to, Tad, you actually just alluded to it, so I’ll start with you. We’ve seen a surprising lack of volatility in the equities markets, so explain to us what the role of fixed income has become in a portfolio and where your products really fit in?

Tad Rivelle: Well, every investor of course has a different set of objectives and ideas about what the role of fixed income is supposed to be. I’m not going to, you know, speak for them. But I think in the current environment, the reasonable expectation for fixed income is it’s an opportunity, as mentioned earlier, to generate some marginal income. And if properly managed, to not provide anything like the potential drawdowns that are typical at the end of the cycle in more levered risk based assets further down the cap structure.

Gillian: Jeff, how do you think about where fixed income and your products specifically fit in.

Jeffrey Given: Yeah. I think fixed income is a very important part of somebody’s portfolio. I think it provides that anchor. I look at it as upside downside risks. So would see downside risk in a core, core plus manager, you know, negative 2, negative 3% if rates go a lot higher, upsize, not great, 4 or 5. But what’s your upside downside risk in equities? You’re upside, is it 15-20% from here or is it 4 or 5 and your downside is much bigger. So I think it’s a good way to diversify some of those risks away and provide a less volatile overall portfolio over in the next two to five years.

Gillian: Jim, what about you?

Jim Robinson: I think most investors still view fixed income as a higher yielding mattress in their money market fund. I mean I think they look for that level of security out of their bond portfolio. And many of them got shocked back in 2008, and many of them got shocked in 94, shocked again in 99. But I think by and large there’s huge demand for income, they just don’t want to risk the principal. And that’s becoming more and more challenging, unless as Tad mentioned, you improve your positioning in the capital structure.

Gillian: And lastly, Beau, how do you think about where fixed income overall fits into an investor’s portfolio?

Beau Coash: Yeah, I agree, it’s really a ballast with kind of yield targets or return targets of 7%. Many institutions are targeting that kind of return. We’re sitting here at 2.2% 10 year yields, the agg is, yielding anywhere, the target is between 2 and 4% annualized. So we’re not going to get anyone to 7%. You’re going to have opportunities once every few years to get those kinds of returns. But, you know, we are trying to really provide that ballast and be bond like for clients who want bond like product. We’re also trying to, for those who want a little bit more extra yield and a little extra performance, provide that alpha as well. So we’re pretty much ready to listen and hear what clients really need. And we’ve got products to get them almost anywhere they need to be. So really flexible with what clients need.

Gillian: Well, we’ve painted a macro picture. We’ve talked a little bit about what you like, what you don’t like and then of course how you fit into an overall portfolio. So thank you all so much for taking the time to educate us here today. And thank you for tuning in. From our studios in New York I’m Gillian Kemmerer, and this was the Fixed Income Masterclass.

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