MASTERCLASS: Fixed Income - November 2018

Yields have been rising all this year, causing fluctuations in bond markets not seen in awhile. In addition, new drama poised to continue with the Federal Reserve is likely to keep raising interest rates and could deepen even more with potential raptures in a corporate bond market. Joined together are three fixed income portfolio managers to discuss the possible end to current credit circle, the questionable leverage corporate bond markets are dealing with and what to expect forth coming.

  • Garrett Tripp, CFA - Principal & Portfolio Manager of Braddock Financial LLC

  • Brian McDonnell, CFA® - Executive Director, Head of US Fixed Income of Delaware Funds® by Macquarie

  • JP Weaver - Senior Investment Portfolio Manager of Stewart Capital

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  • 58 mins 33 secs

Laura Keller: Yields have been rising all this year, causing fluctuations in bond markets that we haven't seen for some time, and the new drama is poised to continue with the Federal Reserve likely to keep raising interest rates over the objections of President Donald Trump. The drama could deepen even more with potential raptures in a corporate bond market dealing with questionable leverage. And, of course, a possible end to the current credit circle. Let's figure out where it will all shake out with three fixed income portfolio managers joining us here in our New York studio. Welcome to the Asset TV Fixed Income Masterclass.

Laura Keller: Thank you all for joining us here today. It is the day after elections, so we'll kind of move into that a little bit later into the discussion. But let's just start off thinking about the yield picture. Rates are rising. What kind of returns should investors be expecting in this area, Garrett?

Garrett Tripp: It's gonna be another tough year. Obviously, 2018 was a tough year. 2019, if the Fed does two, three, four more hikes traditional products, longer duration, fixed rate, it's just math but that that could hold the returns maybe toward a kind of flat year.

Laura Keller: Flat year. Is that what you're seeing, JP?

JP Weaver: Flat would be, I guess.

Laura Keller: That would be a positive outcome. Yes.

JP Weaver: Right? The only sector that I'm involved in that has indexes better than flat is short munis.

Laura Keller: Okay. Maybe not so much good things happening there this year.

JP Weaver: I think in a longer term perspective, coming out of a financial crisis, I think that engenders and breeds an era of low returns such as that we've just come out of.

Laura Keller: Right.

JP Weaver: I think it's important to get your clients to understand that As Garrett said, the simple math is rate's going up, performance is gonna be harder to come by.

Laura Keller: Right. And is that what you're seeing as well, Brian?

Brian McDonnell: Yeah, I would think we're gonna get, let's say, a coupon-like return next year.

Laura Keller: Coupon-like.

Brian McDonnell: I'm not necessarily in the camp that I think rates are going much higher, so that might be different than some ... certainly rates in the longer end. I think of the Fed rising rates in the short end will move up, but I'm not so convinced that the long end is gonna move materially higher.

Laura Keller: Can you explain a little bit more of that? You think the long end is not going where some people believe it might be.

Brian McDonnell: I think one of the reasons is just structural issues. The amount of debt that's been created since the financial crisis. To withstand that debt and to service that debt without having it impact on growth, I think, will be challenging. We've seen that a bit already as you've seen rates move higher. We've seen that influence or curtail some housing activity as mortgage rates get up to be about 5%. We've also seen that in some consumer behavior in terms of a lot of loans. As rates go higher, it's more difficult to see activity. And just overall, as rates move higher, it's gonna be difficult for both public and private and consumers to service that debt. I think it would be very difficult to see materially higher rates without having it somewhat bring about its own reversal.

Laura Keller: Mm-hmm.

Garrett Tripp: Yeah, I think we look at it and say, "The front end's gonna come up and you're gonna get some flattening." When you look at the strength of the economy, both GDP, leading economic indicators ... of course, low employment, strong retail sales, and actually some wage growth ... that gives you hope. We're in a good ... I try to put myself more in a equity mind frame than a fixed income mind frame. The world is good. But we can see that curve flattening. And then you say, "Okay, well, as QE runs off in Europe, if that's gonna be fall of 2019, then maybe we see some steepening of the curve."

Laura Keller: If you get that steepening ... because I think most people would like to see that ... where would you play it? Because this also feeds it into this idea of really having active managers really understanding, "Well, where can I hedge? Where can I think about things in the future?" How do you play that?

Garrett Tripp: Well, we've kept our duration very short. In our business, we talk a lot about interest rate duration being short, but we've also kept our credit spread duration short. Trying to limit the sensitivity of the negative effective of raising rates. When the curse steepens, we like to see the credit curve steepen and then we're getting paid to take more risk, and at that point, I think we would do that and link then out the duration of our fund.

JP Weaver: We pursued what I've termed a taste great, less filling strategy. Since the financial crisis and the ensuing recovery, short duration, higher yield fixed income has performed very well on the markets. When I talk about higher yield fixed income, I talk about low Triple B securities, crossover securities, securities that have maybe five Bs as we call it, two Bs, which is on one side of the investment grade high yield spectrum. But-

Laura Keller: Split rated.

JP Weaver: In the middle there.

Laura Keller: And so not necessarily high yields performing well, but other ... better rated securities?

JP Weaver: Crossovers, they term them. But these are issues that have provided more yield without taking significant duration risk and have sort of provided slightly above market returns. That's sort of what we've been pursuing for the last few years. Things may change now as the end of the cycle comes and we may have to readjust portfolios.

Laura Keller: Okay. That's what JP is doing. How about yourself, Brian and Garrett?

Brian McDonnell: In terms of how we've been positioned is, since we don't necessarily think rates are moving higher in the long end, we haven't been afraid to lose some duration out there. But I will say particularly as we look at shorter funds and shorter strategies that we manage, we've had what we call a barbell strategy on, where we'll own short floating rate assets. High quality assets. We're not necessarily looking for some spread compression, but those floating rate assets, particularly if they're floating off LIBOR, have worked very well for us and then owning some yield and some corporate bonds further out on the curve, where it can generate some significant income. And having that barbell approach outperforms, significantly, owning, say, the two-year part of the curve, which is really what you wanna own as the Fed's raising rates.

Brian McDonnell: That's weird for a couple reasons. A, because the curve is flattened, and ultimately we might see some steepening, as Garrett suggests, but for now, it still seems as though we're gonna continue to flatten. And with that, we've seen credit spreads compress. So, owning some credit further out the curve is done very well and we still like that positioning for where we are now.

Laura Keller: You mentioned LIBOR and being linked to LIBOR is really doing well for floating. Why is that? Why is that and versus what other kinds of benchmarks?

Brian McDonnell: Well, primarily, what we're involved in is asset-backed securities and top of capital structure, Triple As type structures, and those are benchmarked off LIBOR, either one or the three month both of them ... primarily one month. But to a certain extent, you can have Treasury bill floaters, but that's indexed off bills, so you haven't had that same benefit you have from-

Laura Keller: Yeah. That's what I was wondering. If there was something else other than working off of LIBOR. If there was some other alternative you would avoid?

Brian McDonnell: Not necessarily avoid. It just happens that the assets that we like happen to be benchmarked off of LIBOR. It's worked well for us. It's something we haven't had to look to find other areas that ... If I was to took a step back and I wanted to have a floating rate asset, I'd wanna be off LIBOR at this point in time.

Laura Keller: Okay. Same, Garrett?

Garrett Tripp: I mean, that's definitely the industry norm. The one in three month LIBOR. In our fund, we are ... I think of our floating rate securities, which are probably 75% of what we hold, 92% of that is indexed to one and three month LIBOR. We love because it basically moves ... highly correlated when the Fed raises the Fed funds rate and we see that move in LIBOR. It's really increased our interest income to our investors. Where we're a little bit different is most of what we're doing is kind of consumer ABS or residential-related markets, and we just see that whole sector as a little bit earlier in its credit cycle. You don't have quite as much leverage.

Garrett Tripp: But I still think I agree with Brian and JP that we could buy more fixed rate paper and we could extend that duration and we just haven't found a reason to do so yet.

Laura Keller: But like you said, you're going into some of those areas of credit where the cycle is a little earlier, so you can still get the better yields, still risk works out for you, not have these blowups that you might have in other parts of the market.

Garrett Tripp: Exactly. When you think of what's been a great performer this year, well, a lot of leveraged loan funds. A lot of retail investors moving to that sector so that they can have some positive numbers in their fixed income portfolio. Our fund performs very similarly and our return is very correlated to that right now. But those are still corporate debt. They're still corporate risk. A little higher recovery rates, because you've got some assets of the company to call on if a default does happen.

Garrett Tripp: We say, "Hey, we're comfortable with that now. We see the leveraged loan defaults actually probably falling this next year versus last year. We don't see that headwind yet, but we still prefer our space where we really don't see any credit headwinds probably until sometime in the 2020s."

Laura Keller: Hm. Well, we'll think about that more later on because I'm sure there are some other views. But I wanna get a little bit back to our macro chat earlier where we were talking about the Fed. Donald Trump obviously does not really enjoy the position that Chair Powell is pushing forward here. Do you think that will have any challenge coming up in the next year? Do you think that that butting of heads will happen, or is that really just a drama that is good for headlines? JP, you're laughing.

JP Weaver: It's Trump being Trump. I think he's not afraid to call out things he sees as not bettering his cause.

Laura Keller: He's advocating for himself on that front.

JP Weaver: I think and I sort of agree with Brian that I'm not sure that the market can stand a lot more rates much more higher than this, because of the factors he mentioned. There's a lot of leverage in the system. I mean, 100 basis points on the Treasury debt as they refinance their as the two years that are yielding 1% now come on at 2.5%, 3%. That's a lot of money. I think that maybe that's part of what President Trump's trying to do, but I think at the end of the day, we followed the dot plot very well last year because it made a lot of sense.

JP Weaver: The economy was growing. You had tax cuts creating easier fiscal policy with rates pretty low already. I think that there was a clear acknowledgment by everybody that rates were too low and needed to be normalized, moved up. Now, I think it gets a little more data-dependent than it was in 2018. Going forward, I don't know the number, but I think we're gonna have to see what the economy's doing. Right now, it's very strong. The points that Garrett mentioned, I would agree with. You can't not agree with him. The numbers are very strong that the putting out.

Laura Keller: It almost seems like because we don't have, like you said that there's a general bias towards rates need to raise, because now there is that flex, questions about the data, questions about how much can be supported in the marketing, then you'd almost when you have the president advocating for keeping rates where they're at, it almost seems like then maybe the Fed might be more interested in listening to him.

Brian McDonnell: I think the situation dictates whether they're gonna listen to him or not. And I think you're right, they're already butting heads. But I think the Fed always wants to remain independent. I'm sure Chairman Powell does, but he actually has the ammunition to do so now, right? Nothing's going wrong. As Garrett said, things are going very well. I mean, if you just were on the Space Station or spent the last five years playing Fortnite in your basement, if you came out and said, "All right, what's going on?" The economy's doing very well, unemployment's low, inflation's stabilized, consumer confidence is strong, small business surveys are strong. You'd say, "What's not to like in your environment?"

Brian McDonnell: The Fed's doing a very good job so far. I mean, despite what President Trump says and despite what some others have said, they've done a very good job of keeping the economy going without having it overheating. They've also done a very good job of ... people questioned a few years ago how they were gonna get out of the balance sheet that they had and they were gonna stop quantitative easing and what were they gonna do with the agency mortgage that they had on their balance sheet, and I think they did a very good job of reducing that without having a significant impact on the market. I think they did that ... that was much different than what they did in 2013 with the taper tantrum. They didn't surprise the market. They told the market what they were gonna do. They told them they were gonna do it in measured pace. All that worked out very well. Again, I think they did a good job with that and if you took a step back and you just looked at markets and the economy, you'd say they've done a very good job.

Garrett Tripp: Yeah, I look at it and say, "Most likely, the Fed stays right on its track." I just don't think they're gonna listen too much to the political pressure. Their goal is to avoid inflation. We've got a higher job quit rate than we've had in 18 years. There's more job openings than there are unemployed people, and we've seen a little bit of that wage growth. Over 3% last year. They're gonna try to stay in front of it, regardless of if its right or wrong. I think that's what they'll do, and then the question is if they see more slowdown, do they pause?

Garrett Tripp: As somebody who spends a lot of time in the residential sector, yes, housing is slowing down, but that's okay. We don't want the bubble like we had 10, 12 years ago. I mean, housing prices growing 6% a year. If they slow down and grow 2% or 3% a year that's just fine. That's your long-term rate kind of falling inflation that you wanna have. And as credit investors, I like that. I wanna avoid bubbles.

Laura Keller: But speaking on that point though, maybe not bubbles so much but blips, because a few weeks ago part of the reason that the stock market has gone down in the last few weeks is because people, suddenly, were worried about interest rates. As bond managers, how do you deal with those blips?

Brian McDonnell: Well, that's another reason I didn't mention earlier, but that's, again ... not only is the economy and consumers and companies have a difficult time withstanding high rates, but I think risk assets as worried about what will happen if rates move higher. And I think, to your point, I think that's what happened with the equity market in the last month.

Garrett Tripp: It's backwards this time because, historically, we all learned that high yield's gonna break and widen first and then equities are gonna follow-

Laura Keller: You look at that as a leading indicator.

Garrett Tripp: Yes, and yet twice this year, it's been the opposite way. It's been equities and then high yield following a little bit, and I do think that goes to the strong fundamentals, earnings growth that companies have had. I think this year, we might have been one of the first years in seven or eight years where we've had more earnings growth than debt growth. I think all of us have to admit that the world's a good place even if it's hard to forget what happened just 10 years ago.

Laura Keller: I think that's a really good point to make, Garrett, and kind of summarizing the thoughts that you've all three presented here. That there are so many good things that are happening, but everyone seems to be shaky and a little worried knowing that the 10-year financial crisis anniversary is upon us. It seems like people are just trying to pick through and figure out what that ... pricked the bubble might be. If it is a bubble.

JP Weaver: Stock market fundamentals are clearly good. Earnings are fantastic. But we also have corporate debt to GDP and government debt to GDP at levels that are typical of a recession. I think that will filter more into more and more conversations about where interest rates are gonna go. I would think the logical conclusion would be they would stay within a pretty close range or go down somewhat, but I think that that part of the valuation picture is starting to worry investors across the board.

Laura Keller: Yeah. Well, and then I guess thinking back to current day events, because I think we will come back to this idea of where we're at in the bubble, perhaps, but in terms of the elections. The Republicans were able to hold on to the Senate and now you have a divided Congress because the Democrats were able to take over the House. When you consider that, are there things on the policy front, whether they apply to certain sectors, whether they apply to certain pieces of the bond market, that you're really rapt to attention on at this point?

JP Weaver: I think it's early. I think it's early to say. Throughout my career, the thinking has sort of been gridlock is good.

Laura Keller: Hm, gridlock is good?

JP Weaver: Because then you get the counterbalances of the House against the Senate meaning that nothing gets done and the markets can not worry about them so much. I think ... as I look at it, I think the infrastructure point will be interesting. I can see the Republicans working with the Democrats in the House to do some infrastructure spending because that's on both of their agendas, and I think it's good for the country. I mean, capital stock of this country could certainly use a few dollars thrown its way. I think that will be good.

JP Weaver: When I think about sectors, again, I think it's early, but I think it probably helps healthcare a little bit in that now we're not gonna have any cuts to Medicare, Medicaid, probably, and maybe even some spending gains there.

Laura Keller: And certain states have authorized-

JP Weaver: Correct.

Laura Keller:... to push forward, expand Medicaid coverage, Medicare coverage.

JP Weaver: Correct. Yep. And so those kind of things in the current construct of politics I think will be beneficial to those two areas. But it's early.

Laura Keller: Brian? Garrett?

Brian McDonnell: I think I'd agree with those areas and infrastructure for sure. One of the things I look at is what's happened since Trump got elected and all the positive things that came with it and why there was gonna be this growth initiatives. If you look at three things, it was tax reform, it was deregulation, and it was infrastructure spending. If you look at after the election, right, infrastructure, fiscal spending ... as JP mentioned, both sides wanna do that. There's a good chance of that being pushed through at some point in time. I'm not sure what size its gonna be.

Brian McDonnell: Tax cuts. They've talked about tax cuts 2.0. Realistically, I don't think that was gonna happen either way, even if they kept the House, because I think there's enough fiscal hawks that would've stopped it, any additional tax cuts. And the last being ... or maybe the only one that might hurt it is regulation, right? There's been some deregulation. I don't think there's been enough ... if the Democrats took the Senate, then maybe there'd be an argument that they'd roll back some of that deregulation and have some re-regulation, if you will.

Laura Keller: Well, and then there are certain stocks and certain sectors that have benefited from the Trump bump. Financials, for example ... I've been looking at some of the sector performance since Donald Trump took office ... has not risen as much as it was at one point in term, and it's come down with the market. But in industries that were deregulated, such as financials to some degree, they have benefited from that.

Brian McDonnell: But they still have enough ... from a bond perspective, there's still enough regulation within that industry that makes them very attractive. I mean, if you look at individual sectors that we find attractive, it's regulated industries. Banking being one of the foremost and then the other would be, say, utilities.

Laura Keller: Utilities.

Garrett Tripp: I agree a lot with what Brian's saying. I think that infrastructure, I'm not quite sure I agree with you guys that that's gonna happen. I wonder if it just becomes a situation where the two sides dislike each other so much that they just choose to do nothing.

Laura Keller: That even that shared issue, they can't reach across the aisle?

Garrett Tripp: Well, yeah. And if the Democrats want to set up the next election by basically saying, "Anything that we work with him on signals that he's doing some sort of good job," maybe they don't wanna do that. I don't worry so much about a specific industry. I do worry a little bit about sentiment. When I think about small business, when Trump got elected, small business optimism goes way up.

JP Weaver: Good point.

Garrett Tripp: And you get it. I know ... my friends that own businesses they're like, "This is great." Well, now do they lose a little bit of enthusiasm? Does they not hire as much or expand their business? I don't think that's going to be a big deal, but it's something to watch.

Laura Keller: When do you think that we would know that? Is there a certain timeframe?

Garrett Tripp: I think they do the ... what, if they see their monthly or quarterly index. It shouldn't take long to get a read of how people feel. I know they also read, of course, the political parties. When Trump got elected, all the Republicans felt good and all the Democrats didn't feel good, and I expect that to switch as they do those future polls.

Laura Keller: Of course.

Brian McDonnell: I mean, that's where, I mean, they were

Laura Keller: Sure.

JP Weaver: I do worry a little bit about the financials. Congressman Waters being the ostensibly head of the Finance Committee in the House. You've already got a super regulated industry that has It's better from a credit perspective because they've built up capital levels, but they're not making as much money as they used to and they might be making less. I do worry about that a little bit because I think there are some pretty vocal Democratic voices about even regulating them more strictly.

Laura Keller: Sure.

JP Weaver: But I think that timing will be when the new Congress gets set and committee chairs are appointed and all that, which is, I guess, January.

Laura Keller: Yeah, it'll be a few months. What about sectors though? You brought up financials. We've talked a little bit on utilities. Are there certain sector bets that you, whether they have to do with the elections or not, that you're thinking about going into what really now is the end of the year?

Garrett Tripp: Nothing's really changing for us and we've talked about it some already. We're gonna prefer floating rate debt. We're gonna prefer to keep shorter on the duration curve, and we just look at the long-term fundamentals with the consumer, with housing, as very strong. A lot because of this banking regulation that we just talked about. I mean, you can't get a mortgage unless you really show you have the ability to repay that mortgage. There's a lot of laws now to just make sure that disclosures are adequate, that the amount of the fraud is down, and you look at the overall consumer and their debt level is still very low. We'll see how much that can expand or the fact that credit isn't really expanded. If that just kind of keeps the risk on that sector low.

Laura Keller: So, really not thinking about the sector, but as you said, more the sentiment, the consumer, and mortgage side of the house?

Garrett Tripp: Yeah. We look more at the valuation of all these different bonds and do I want a short bond? Or if I'm gonna go out on the credit curve, what type of product will I do for that? And does what's interesting about the ABS space that Brian and myself have experience in, is the structures are unique and they can have a certain type of when someone is callable or not callable. If it's floating rate or fixed, and those are things that we look at it and it helps us say, "Hey, what fits our portfolio today? What do we think from a relative value standpoint makes the most attractive pricing?" And then we move to that sector.

Laura Keller: Well, talk about some of the opportunities then in the ABS market. Are you looking more structural at that and saying, "Well, based on call options and things like that, I'm gonna protect myself by investing in one type," or are there other things that you're looking at in that market?

Brian McDonnell: See, for us, it's that anchor. We're looking for that floating rate aspect of it. We're not necessarily buying down or going down into structural looking for any spread tightening or spread narrowing. We're just looking for that floating rate asset that allows us to own some fixed rate assets a little further out the curve without taking an undue duration risk, particularly if you're looking at short duration portfolios. You can still keep a two-year duration, own some five, and even some ten-year higher yielding bonds. And also if you see some spread compression out there in corporate bonds, you'll get a much better benefit than you would if you only do two years.

Brian McDonnell: That's really not where we're gonna make our ... where we wanna invest in credit from the standpoint of spread tightening. It's just gonna be able to get that floating rate nature of it, and very high ... so, we're in the very top of the capital structure. Consumer receivables ... we're not really looking to take advantage of some of the things that Garrett might be in terms of credit.

Garrett Tripp: Yeah, we're more of a mezzanine buyer. That Triple B type of credit. Maybe a Double B, maybe a Single A, and what we find are the structures are very short. I love that I can buy loans that I feel are originated correctly today. It's a three year piece of paper. We roll down the credit curve, and often if I had bought a Double B or Triple B, I know in 18 months I can get that credit upgrade, get some capital appreciation to give my fund a little more return on top of its interest income.

JP Weaver: Is that in just the residential market, or are you involved in the commercial market as well?

Garrett Tripp: Primarily consumer ABS, so think auto-loans. Think of some unsecured consumer lending. One of the more interesting areas this year, which is very new and not a lot of origination, but is deals backed by solar leases. People want to save money on their utility. They want to feel green. They put the solar panels on their house but their not cheap. You gotta go out and get a loan for that. But they perform a lot like the RMBS sectors as far as how you underwrite and ultimately about the default percentage you can expect. But really that ABS is a short part of our fund and then when we're taking a little more risk and a looking for a little more yield, it's often in the RMBS sectors.

Laura Keller: I feel that the asset-backed sector is always coming up with new interesting products. I remember a few years ago when people ... the phone companies, Verizon, Sprint stopped allowing people to sort of buy the phone, just paying back on credit, but really moved to that monthly payment system and that became a new market for ABS.

Garrett Tripp: That's right. Absolutely.

Laura Keller: You kind of look at those things, I'm sure, as new trends emerge.

JP Weaver: It's an ingenious market. Remember the viatical settlements? No?

Laura Keller: No, I don't.

JP Weaver: It was just a way to get people ... get their estates from insurance companies pooled and make the payments from that.

Laura Keller: Interesting.

JP Weaver: That was a long time ago.

Garrett Tripp: I will say one of the benefits of the ABS, structure finance, RMBS, is their just low correlations to your traditional Barclays Aggregate Bond Index, low correlation to corporate bond, and equities overall. We always try to convince people that you should have a slice of this in your portfolio.

Laura Keller: Always. Yeah.

Garrett Tripp: Yeah.

Laura Keller: And then you kind of weight it as time goes on. Figure out which more or less depending on the risk, I assume.

Garrett Tripp: Exactly. I think it's easy for people to say, "Oh, it's complex. They're doing different things with these structures." But when you look at the actual volatility in the market, especially over the last four or five years, it's very low.

JP Weaver: The only thing that scares me about some of the new asset types is their very limited history on defaults in a recession.

Garrett Tripp: There's no doubt ... when I look at it and say, "What will somebody pay?" Well, I know they're gonna pay for their cellphone and then they're gonna pay for their car and then they're probably gonna pay their credit cards and then their mortgage and then one of these consumer loans. I think it's the first place you need to be careful. They're more structure driven. I think they'd be the first thing that ... One, they're a very small percentage of our fund, but I think you would stay away from that if the economy started to turn.

Garrett Tripp: Where mortgages, on the other hand ... mortgages today, they're the safest in our lifetime. The amount of underwriting that goes into getting a mortgage today from your credit score to your debt to income, how much cash reserves you have in the bank. All these things are extremely robust and I expect to see very low defaults in that probably until sometime between 2023 to 2025.

Brian McDonnell: So, within structure ... a little higher equality, right? We don't necessarily go down to equality, but like agency mortgages, and one of the reasons is, as Garrett mentioned, the diversification benefits you get from that. One of the things we do is we focus heavily on corporate credit. As a diversification, you're either gonna go into some high quality treasuries or a high quality agency mortgages. You're gonna get some additional spread from high quality mortgages and still have that benefit of having some diversification in case we do see some spread widening from what was very tight valuations from a historical perspective.

Laura Keller: And you like to stay on the agency side of things, not the non-agency because again, that whole risk picture?

Brian McDonnell: Right. But I agree. Underwriting centers are very good. The non-agency deals that are being issued now are much different credit quality than they were, and I think that was Garrett's point on the residential side, but that's ... we're looking for it just for a spread advantage over treasuries and also for that high quality nature of it for some diversification if there is a risk of scenario.

Laura Keller: Right.

JP Weaver: The mortgage base is the spread between mortgages and their expected average life has widened recently. I don't follow much of those closely, but I've noticed that. What's that about?

Brian McDonnell: I think it's ... from what you'll read is it's something to do with the Fed actually reducing the purchases. As I said earlier, I think the Fed has done a very good job and, in fact, once they announce what they're gonna do ... mortgage spreads are tightened and at some point, the flow effect was gonna come into play. I don't necessarily believe that that's the reason. I think it has more to do with just volatilities picks up. With the embedded optionality, any time you see a pick up in volatility, you're gonna see some sort of widening versus a bond like treasuries that doesn't have any volatility.

Laura Keller: Right. Well, what about going back to the corporate bond market? We kind of touched a little bit on this idea that some of the quality might be coming down. I think when we had all talked a little it before filming today, some of the things that you guys mentioned was these concerns about these Triple B rated companies and how robust those ratings might be. JP, you wanna start us off on that discussion?

JP Weaver: Yeah. Since I'm the most veteran in the group, I will ... I went back and actually a couple months ago, we had a client who only wanted to do Double A bonds, and I said, "Well, let me pull out some old files," that I had from the late 80s, even early 90s, "About why investors should consider using Triple B bonds." The market has changed considerably since then. There are still the same advantages in terms of yield, but the size of the Triple B cohort in the investment grade market is almost equal to all the other rating cohorts. It's just under, and I think maybe when Budweiser gets downgraded, it gets to 50/50 between Triple A to Single A and Triple Bs-

Laura Keller: Which also says that Budweiser has a lot of debt, but go ahead.

JP Weaver: Over a $100 billion worth. Yeah.

Laura Keller: Yes.

JP Weaver: You have a difference between bond indices and stock indices, and that bond indices are market-weighted by the debt. That's not necessarily a good thing if you're a debt investor. Just having more means if you're an indexer, you have to buy more because they have more. More debt.

Laura Keller: You have to buy the index in order to benchmark against it.

JP Weaver: Right, right. Equity indexes are market-weighted because people like the stock and it has some fundamentals behind it. I guess what I'm saying is if I was a corporate treasurer, I think that is the sweet spot. Sort of low Single A, high Triple B, is where I would wanna have the ratings so I could use some leverage to enhance my returns. But the fact that it becomes such a big part of the index and ... I mean, the conversations that I've had with our group has been, "Gee, is it really right that Campbell's Soup is a mid-Triple B at five times leverage?" That wouldn't have happened 10 or 15 years ago. You didn't see Triple B companies at five times leverage. There are many ... now, it's a big company and there's a clear size basis in my estimation of the rating agencies. But I think the rating agencies have sort of, with a wink and a nod, said, "Oh, you'll get that leverage down and if you ... again, if you hit a spot where you have to spend more for ..." They're gonna have to refinance a lot of their bonds. They'll be spending more money on that. They'll be spending more money on other capital management issues within the company. How fast can they get that down before they risk another downgrade?

JP Weaver: I think you're seeing more of that and I think that scares people, again, and then when you look at corporate debt as a percentage of GDP, it's a big number and if most of it is in that part that does have more default risk within the investment grade ... I think people talk about. Again, we try to keep our spread duration fairly low, but ... It really hasn't affected us a lot, but I think it's something that has been out there as credit investors need to worry about and so you have to worry about it a little bit.

Garrett Tripp: It's a changing time in the fact that rates are going up. I understand why companies borrowed so much coming out of the crisis because it was cheap.

JP Weaver: Sure.

Garrett Tripp: And the equity's expensive.

Laura Keller: Why not?

Garrett Tripp: But it is a little troubling now that this debt isn't as cheap and you think about the money they've been able to bring in from overseas, the tax changes, and we haven't really seen that money going to pay down this debt.

Brian McDonnell: Well, the debt that's-

Laura Keller: But ... but, yeah, to that point ... Go ahead, Brian, I'll ...

Brian McDonnell: Well, I was gonna say the debt that's been issued has been unproductive debt. Right. The debt has been used for shareholder-friendly activities. It's been dividends. It's been buybacks.

Laura Keller: It hasn't been to pay down-

Brian McDonnell: No, it hasn't, or to invest in infrastructure ... excuse me ... capex or things like that that can actually generate income going forward or increase their revenues going forward. It's been, again, a share-friendly activity. But I'd like to go back to something that JP just said in terms of your argument from Double As down to Triple Bs. I think that argument still holds when we look at single investors that want Single As down to Triple Bs. I'd agree that it's much bigger. I wouldn't wanna be an indexer, because you're lending money to your bank that anybody wants to come in the front door, you lend them money. That's how we look at being passive. It just doesn't make sense from an index standpoint.

Brian McDonnell: I think corporate treasurers ... when you're a Single A company, the cost of going down to Triple B is not very much. Going from Triple B down to Double B is very high, right? It's almost ... it's more than twice or three times as much. I think corporate treasurers are cognizant of that, and when you find good operators that are gonna maintain ... or are very concerned with that risk to that cost of capital, sometimes owning Triple Bs is safer and from a spread perspective than owning Single As.

Garrett Tripp: But to your point, that's why I worry more about all the Triple B rated debt is just because ... as you're saying, that price change from Triple B to Double B that's a significant price ... that's a spread widening that I think a lot of investors ... Maybe they feel safe because it's investment grade, but they don't realize the amount of price risks they're actually taking.

Laura Keller: Well, and I think that point ... JP sort of kicked us off here on this idea that the rating agencies are giving people a little bit of a pass. "You're gonna pay down your debt. We'll keep you at this rating. We're not gonna kick you that much further down." But if that whole ecosystem gets some kind of jolt from whatever perspective, then, to your point, you would see quite a substantial dropdown even if your rating stays the same.

JP Weaver: Look at GE these last couple weeks. You're gonna get in a position where what are you gonna do? Are you gonna not make a bond payment ... or are you gonna take more debt to make a dividend payment? Okay, I'm gonna cut the dividend. Which one's gonna go? That's created a heck of a lot of volatility in those bonds. It was pretty incredible to watch the last ... short GEs in the last couple weeks have gone from 60, 70 off to 140 or 150 at one point and now back to 90 or something.

Laura Keller: Well, maybe that's a little bit with the play between the equity and the bond markets, but-

JP Weaver: Yeah, but the money's gotta come from somewhere.

Laura Keller: Totally, but in the sense of that sentiment ... We talked about sentiment earlier, but if you've got that in the equity market, they can obviously play into the bond market too where you would normally wanna see the bonds maybe leading off the equities, but it hasn't happened that way.

Brian McDonnell: But I think that also points to where we are in this environment. A few years ago, if you bought bonds and spreads ... for the entire market, spreads were tightening, so you couldn't go wrong. You could own just about anything. The highest beta did well. But I think where we are now, it's definitely a bond-picker's market. If you're bottom up on selectors, this is an environment where you'll thrive because this ... you really have to avoid idiosyncratic risk. You have to avoid companies that you think might engage M&A activity. You might wanna avoid companies that are obviously gonna take on more leverage. It's really very important at this point in time to be able to do that bottom-up fundamental research.

Garrett Tripp: And I would encourage investors that are savings, more retail-oriented, when they're choosing their managers to understand the dynamics of how bonds trade, right? For us, we all know, "Okay, well, rates are going up. Bond prices are coming down." But certain entities ... I mean, if you're doing asset liability matching, they might not necessarily care today that ... If they can still buy at the same yield they could a month ago, they'll buy that bond there, even though their spread is tightened because rates have come up. That's the sort of thing where I think ... and ours as more active managers, we say, "Well, let's wait because we know credit spreads are gonna readjust to the new shape of the yield curve and then we can buy a bond without really instantly taking a certain amount of negative price risk."

Laura Keller: Well, that's interesting to me. Does that make an argument then for holding a little bit of cash at this point in time to make good on that whenever it does happen?

Garrett Tripp: I don't think anybody gets paid on knowing exactly when rates are gonna move. You don't really want to do that for a living. It's-

Laura Keller: Timing is hard.

Garrett Tripp:... hard to do. But there's no doubt when volatility goes up, you wanna have more cash and you need to know your investor base and have the amount of cash that really matches their needs or really the liquidity of how sticky your money is your fund.

Brian McDonnell: And rates are higher, so it's expensive to hold cash.

JP Weaver: Yeah.

Brian McDonnell: Right? It's expensive to also not have some duration, even if you do think rates are going up. I don't mean to be repetitive in saying rates are going up, but even if you do think rates are going up, at some point, if they're not going up next month, it's expensive to not be invested. You have to see a pretty significant increase in rates to actually ... your breakeven to holding cash versus holding some bonds and earning some interest. I don't think it necessary makes sense. Again, given where rates have ... like two years ago, it didn't really cost you anything to hold cash because you weren't earning any money on short-term rates. I think now it's-

Laura Keller: But now you are.

Brian McDonnell:... it's a little more expensive to. Yeah.

JP Weaver: Now, that there's some opportunity cost to ... or there was no opportunity cost to hold cash.

Brian McDonnell: Right. Right.

JP Weaver: Now there is.

Brian McDonnell: Right.

JP Weaver: The biggest conundrum was in the money market funds, who couldn't make enough on yield to offset their fees. So, they had to kick fees back, which is an issue at low rates for any investor. A typical trust department, which is one of our biggest clients, they're charging 70, 80, 90 basis points and when cash is earning 70, 80, 90 basis points, what could you do? It was hard to justify not holding cash ... to not hold something because you weren't even making the spread over the fee you're charging. Luckily, we're out of that.

Laura Keller: Right. It's a sort of new era there. But talk to me about that. Talk to me about the opportunities that are available because you mentioned cash is not something you wanna be having right now. You wanna be invested. But you also mentioned and to think to use some of the points that you had mentioned earlier, Garrett, that I said we'd save where we're at in the cycle here, there's some caution. People don't wanna be down in the capital structure. Don't wanna be on the low end of the risk pile. If you are there, what kind of opportunities can you find? Do you just have to accept a lower yield to be safe, or what can you do?

Brian McDonnell: I would say you don't have to necessarily be up in the capital structure. There is some areas out there ... and, again, it's a bond-picker's market. But if you can find sectors ... we like the financials, right? If we find a company that we really like from a credit standpoint, we don't mind going down the capital structure into their subordinated debt, and you can pick up some significant yield doing that and that's actually worked very well.

Brian McDonnell: But it has to be on an individual basis. You can't say, "Listen, I'm just gonna ... from a sector allocation, from a rating standpoint, I'm gonna go down in quality." It has to be on a bond by bond basis, and if you find bonds ... again, regulated industries, you can also do it in utilities, you can find it some industrials where you're really comfortable with the company ... you're really comfortable with them as an operator, with their credit metrics, then it does make some sense to sometimes move down in the capital structure within those companies, even if you wanted to move down into, say, bank loans, which Garrett was talking about earlier. I think that those are the opportunities that make sense and you don't necessarily ... You're not gonna reach for yield for the sake of reaching for yield, but take advantage of some of your best ideas.

JP Weaver: We've actually been thinking of the opposite strategy on a margin going up in capital structure. I think there's enough uncertainty related to coming out of 10 years of extremely low rates and unprecedented monetary policy moves, and there's enough risk in our minds that you may get a pop in inflation that we're considering making every other purchase something that's very close to the purchase ...

JP Weaver: We've been thinking about consumer ABS within the utility space. We're talking about first mortgage bonds. Owning the real ... being closer to the real asset, which if there is a non-trivial chance that inflation pops, which we think there is, that at least those assets are gonna appreciate somewhat and you'll have the same sort of security out there. Other areas that ... equipment trusts of railroads and airplanes, which ... that's a nice juicy yield. The enhanced equipment trusts. They're a really nice structures that have held up very well through a couple of cycles now. So, things like that-

Laura Keller: And that's getting closer to the asset, but you're saying also getting paid at the same time?

JP Weaver: Well, in utility land or in bank land, you're gonna get paid more if you like the company outright and you wanna get lower down the capital structure [inaudible 00:45:56] or bank loans. No, we're gonna give some yield to do that. In utility land, a 10-year first mortgage utility maybe 70 off versus 100 off for holding company debt. We're gonna give a little bit, but we just think at the margin ... I'm not talking about shifting all the seats on the deck. But at the margin, adding some layers of safety. Call it a ... it's a real thing strategy.

Garrett Tripp: I'm definitely more on the rosy side of where we are with the economy. But given what's happening in rates, I'm more with Brian. To me, it's about the bonds you pick. The whole industry is set up on, hey, every Triple B is supposed to be about the same sort of risk. Be it in RNBS or on a corporate. But we know that that's not necessarily true and so you going in and looking at that underlying asset, understanding it, understanding who buys and sells those assets, how they behave, can kind of help you find the spots where you are getting that extra relative value and hopefully creating some alpha for your clients.

Laura Keller: But, see, I think that's more of existential sort of question because when you argue those things ... the real fundamentals that you put into that, let's say taking a bank's subordinate, but would you buy a US, would you buy a European bank? Who would be buying it on the other side of you if you were to get out for some reason? All of those things really argue for so much analysis and that brings me to a fees question, and how you ... you have to pay people for those kinds of analyses.

Laura Keller: But then on the other side of things, we always have this pressure at this point from ... we touched on it before ... the passive side of things. Just benchmarking across that index. How are you able to work with your clients to make and help them understand that there is a real cost to those things, but it probably will protect you if there is some change, abrupt shift in the market?

Brian McDonnell: I completely agree that they will protect them by having active management and it is important to, again, do that bottom-up work and you should get paid for that. But on the other side, we're in a difficult world when it comes to that in terms of fee compression. As much as I believe in that argument, it's not always as easy to have investors believe that they shouldn't be looking at us to cut our fees because now's the time that they need active management more than ever in my opinion.

Garrett Tripp: Yeah, going to my point a second ago, when I think about collateralized loan obligations. It's a fairly complex asset class, backed by ... you've got 150, 300 loans backing a deal. But if you look at the historical performance of the rated debt from the Triple As down to Single B, even through the crisis, I think it's one or two single B bonds that actually took a dollar of it to their principle. The structure does work, but just because of its nature, the Triple A trades markedly wider than almost any other Triple A out there. To me, that's an example of how active management and looking at certain asset classes can pay off for you. How that relates back to fees? I don't know. We'll see what happens with ETFs, when we do go through a higher term of volatility, both in the equity markets and the bond markets, and if that's not as pretty as people like, then maybe it's easier for us on the active side to support our fees. We'll see.

Brian McDonnell: But that's also another argument for supporting fees, right? The asset classes you just talked about aren't in benchmarks.

Garrett Tripp: Mm-hmm (affirmative). Exactly.

Brian McDonnell: So, if you're gonna go passive or ... an ETF passive, you're not gonna have the ability to-

Laura Keller: To get that exposure.

Brian McDonnell:... to take advantage of those opportunities, which, I agree with Garrett, some really good opportunities there.

Laura Keller: Right. Yeah. There's been that kind of buffer that's existed between the ETFs and what markets they're able to actually pull into their funds. I wanna move on a little bit though to where we're at with the credit cycle. I think this is a good segue into that. You mentioned certain dates, certain timeframes, Garrett, of what you expect.

Garrett Tripp: Well, obviously, what I'm the expert in is, of course, housing and the consumer.

Laura Keller: Yes.

Garrett Tripp: And we look at those markets to say, "Well, we know we have a shortage of homes." That's partially why home prices have continued to go up above the rate of inflation. It's likely gonna take to 2022 to even match that supply and demand of housing. That's really a buffer on downward home prices. I like that when I'm buying assets that are backed by those mortgages. Then you think about the millennials. They're the largest demographic since the baby boomers. They all really move into home-buying age kind of when they're in their early to mid-30s. That's 2023 to 2025.

Laura Keller: So, that's how you get that triangulation.

Garrett Tripp: Exactly. Then you've got more demand after you've kind of solved the supply picture to, once again, be a buffer to downward prices. We like that ... it makes our fundamental long-term feel of residential mortgage backs, the residential market, we're very ... feel very good about it. That doesn't mean that a home builder's stocks gonna do great this year as rates rise and as cost of construction rise. We know it doesn't mean you can just go invest in anything in the residential market. But in our particular assets in RNBS, it's a very good and should be.

JP Weaver: I think we'd all sort of agree in a way from the assets in your market, Garrett, that we're towards the end of the credit cycle. I think that's ... I think we've had-

Laura Keller: Are we nodding our heads? I'm not sure. We generally think that?

JP Weaver: We've had a long run.

Brian McDonnell: Yeah.

Laura Keller: Yes. No, go ahead.

Brian McDonnell: Yeah, I think we can argue we're closer to the end than the beginning, right?

JP Weaver: Right.

Garrett Tripp: Yes.

Brian McDonnell: I think would've made that argument it's been extended clearly by something of the things that President Trump has done, and maybe will continue to be extended if we see some of these things if they ... not to get back to politics, but if they do come together and see some sort of fiscal stimulus, it might be extended even further. But you're right, JP, you can't argue we're not ... we're certainly closer to the end than we are the beginning. We're, I think, in the longest expansion we've had. We're 111 months now. Versus the average of 58 months.

JP Weaver: And our outlook is we're not gonna have any kind of equity bear market next year either. I mean, we're pretty sanguine about the economy at least through next year. I think it keeps going. I just think when you're at ... It's a little better now. But when you're at the level of absolute rates that we were, say, beginning of this year, it's very difficult to come back from a stumble because you're just ... 90% of your returns in fixed income come from the income. They don't come from capital gains and ... If you've got this very low income coupon level that your market's throwing off, it's difficult to get around that if you have a stumble or the prices fall because of interest rates.

JP Weaver: I mean, the best ... I was reading an article Bloomberg the other day. It said, "Oh, banks are doing so well in the bond market." They have about three years shorter duration as a sector than the industrials and like four years less than the utilities. So, yes, they're doing better. Interest rates are going up. That's an aside. But my point is when you don't have the level of couponing come ... Again, it's a little better now. I just think ... I'm more comfortable, and my clients are more comfortable, applying it a little closer to the vest in terms of not trying to get that ... What's the term? Pick up the last nickel in front of a steamroller.

Brian McDonnell: Steamroller. Right.

JP Weaver: Right?

Laura Keller: Yes. Yes, exactly. Which maybe ... who knows where we're at? Because ... I mean, I know we like to talk about it more from the innings perspective. What inning might we be in, rather than an actual date and timeframe. But I think it does bring us to that sort of precipice of what should we be looking for? And I know that's a hard question to answer as well. I wanna posit one idea to you. My former colleague ... you mentioned Bloomberg. Someone there, Matt Levine, is always writing about liquidity. People are still worried about liquidity. Is that one idea, or posit your own, on where we could really se the cycle really start to change?

Brian McDonnell: Well, I would say you definitely have to worry about liquidity. We're in a different environment than we were 10 years ago. Our counterparties, there's a lot less risk-takers out there willing to make markets on things. If you're gonna take something that has a little less liquidity, you gotta make sure you're paid for it in this environment. I think that has to be a concern into every investment decision you have to make. But whether that's gonna cause the next crisis ... you say the precipice ... I'm not sure if that's the case, but I think we're probably a lot more vulnerable to that than we would've been 10 years ago, say.

Laura Keller: And maybe if something else starts us off there. Maybe that liquidity really makes that even worse.

Brian McDonnell: Yes, certainly for some asset classes. Things like bank loans have done very well. But if there's a liquidity crisis and everybody's trying to get out the door at the same time that would be challenging. We don't necessarily believe that's gonna be the case any time soon, but that is one of the challenges or one of the risks of having liquidity if we do have an event.

JP Weaver: Clearly, you hit on the main reason why I think people talk about this, which is lower counterparty capital levels let them take a lot less risk. I keep getting told that everything's gonna be fine with ETFs and mutual funds, and I know ... and if you look at the numbers, it's a tiny factor. What's in the investment grade ETFs is a tiny factor of the overall market. But in my mind, when you have a same-day liquidity item that's backed by things that maybe you can't sell that day or next week, I worry about that.

JP Weaver: And I agree that to take liquidity risk, you really need to make sure you get paid for it, and that's liquidity risk and are you gonna be able to get a bid that day? It's also one of the elements that I find very hard about your world, Garrett, is pricing operational risk. How do you ... These things are weird. How's my back office gonna handle these and that's gotta be worth something to me? And understanding and being able to explain to the clients that's gonna be worth something to me too, and I don't know if that's liquidity or operational risk. But both those elements, I kind of agree with your friend from Bloomberg.

Garrett Tripp: I think there's a difference between looking at the dynamics of where further regulation got it. Okay, the underlying assets, hopefully, are safer, but now you have less market-makers on a daily basis. They have less VaR and therefore ... just on a given day, maybe you see more price volatility than you historically would've.

Laura Keller: Because they're not coming-

Garrett Tripp: I'm weighing those two. Like the better credit quality, at least in many of our sectors, versus maybe a little more volatility in the short term. I will say in our spaces, yeah, we always wanna know how many buyers are there in a certain segment and how many billions are being traded on a regular basis. Can we see a daily market? And you want all of that. There are definitely bonds in ... and likely in the high yield space as we saw with the high yield fund that blew up a couple years ago. You get in the stuff that's got enough credit risk, there's not gonna be many players, and ourselves as a mutual fund that's definitely something we avoid.