MASTERCLASS: Fixed Income - September 2019

The focus on fixed income has intensified investors attempted to grab yield and flocked to longer-dated bonds. Uncertainty over the trade war and the global economic outlook pushed borrowing costs deeper and deeper into negative territory. 

The capital markets are keeping a close eye on the 2-year and 10-year yield curve as it inverted. Individual bonds may be the best known type of fixed income security but the category also includes bond funds, ETFs, CDs, and money market funds. Fixed income may provide a buffer against stock market volatility - particularly when there are market drawdowns.

In this panel discussion, 4 experts discuss the investment landscape for fixed income in consideration of monetary policy and market trends :

  • Christian Pariseault, Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers, Fidelity Investments
  • Tony Tanner, SVP, Aquila Investment Management and Portfolio Manager of Aquila Tax-Free Trust of Arizona
  • Colleen Denzler, Investor, Smith Capital Investors
  • Nolan Anderson, Fixed Income Portfolio Manager, Weitz Investment Management

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  • 58 mins 48 secs

Remy Blaire: Welcome to Asset TV. This is your Fix Income Masterclass. The focus on fixed income intensified as demand for safe haven bond surge. The capital markets are keeping a close eye on the two year and 10-year yield curve following the inversions of the summer of 2019.

Remy Blaire: I'm joined by Christian Pariseault, Head of Fixed Income and Global Asset Allocation Institutional Portfolio Managers at Fidelity Investments; Tony Tanner, SVP at Aquila Investment Management and Portfolio Manager of Aquila Tax Free Trust of Arizona; Colleen Denzler, investor at Smith Capital Investors; and Nolan Anderson, Fixed Income Portfolio Manager at Weitz Investment Management.

Remy Blaire: Thank you so much for joining me today.

Remy Blaire: Well, first and foremost, we only have a handful of months until the rest of this year, and it's hard to believe, but we're in quite a different environment compared to the beginning of 2019. So first and foremost, I want to set the scene for this masterclass. Chris, starting out with you, let's start out by looking at the Federal Reserve. Now there are expectations for the Fed as we head into the final months of this year. So, can you tell me your expectations for the rest of 2019 as well as 2020?

Chris Pariseault: Sure, sure. It's been a pretty active 2019 thus far, and last week, Remy, as you know, there was a gathering at Jackson Hole. And certainly, a lot of views had been expressed last week. So, what is the market telling us? So, the yield curve is inverted. We've got the trade weighted dollar increasing. So, what the market is saying is basically that the Fed is insufficiently accommodative. So, the Fed has to, I think, stay in line with what expectations are.

Chris Pariseaul: If we go back to July and reading the July minutes, the Fed is ready to ease. They're looking at trade. They're looking at growth, and they're also looking to keep their options open as a hedge. And basically, what they want to be able to do is to have the monetary mechanism lead to sort of growth and broad economic expansion. Now that's going to come in the way of support for stocks and credit, which is a good thing. It would be a problem in our view if inflation were high and if valuations were stretched. But if you look at the long TIPS market, pretty much anchored between 2.3%, 2.5%, and if you look at valuations, forward looking valuations on the S&P 500, we're more in the camp of about 17 times forward earnings. So, valuations don't feel really full here. So, I think the Fed is really going to have to meet market expectations, and what those are today are 25 basis points in September and another 50 between October and February. So, we think that the Fed is likely to stay in line with that.

Remy Blaire: Well, we do live in interesting times. When we look at the central banks across the globe, we know that there are expectations going forward, especially for the Fed Reserve, and it's not just yields here in the U.S. that investors as well as financial professionals are paying attention to. So, we'll take a close look at the economic landscape as we move forward in this masterclass.

Remy Blaire: Now, Nolan, I do want to focus on risks. So, can you tell me how risks have increased as the U.S. government as well as corporate America has been able to issue longer term as well as lower quality debt?

Nolan Anderson: Sure. I think the punchline is, "It's been a wonderful environment to be a borrower." The recent rush of money into long term U.S. treasuries has pushed the 30-year treasury to a level of below 2%, which I believe is an all-time low. I think we're sitting about 1.9% today. So, I think it's no surprise that the U.S. Treasury actually has come out recently and talked about contemplating buying or selling 50 in 100-year debt, which would be the first time we've done that in the country. That's a great thing for the country. But there are serious risk implications for borrowers that would potentially buy such paper at potentially all-time low yields.

Nolan Anderson: In terms of corporate America, they've really ridden a wave of global search for yield. In terms of the corporate bond market, particularly investment grade, we've witnessed significantly more demand than supply, and what that's done is that's tipped the scales in terms of negotiating power to corporates. So, what we've seen is longer day issuance of maturities, we've seen weaker covenant protections, and we've seen very low, historically low coupon yields. So, while that's not necessarily an issue today, that dynamic could change dramatically if we were to experience... If the economy were to experience a bump in the night or if rates were to rise significantly from here.

Remy Blaire: And we'll be taking a closer look at other risks out there for this Fix Income Masterclass. Now I want to move on to you, Colleen. I know your organization recently released its mid-year market update. So, can you tell me about your expectations for the rest of this year, and some of the themes as well as the core thesis of this outlook?

Colleen Denzler: Absolutely. We actually wrote the paper for the first time at the end of last year, the beginning of this year. And I can summarize the paper in one word, volatility. And that's what we were most concerned about then, and it sure has played out. And I think what my esteemed colleagues have referenced is we've seen volatility in many, many different parts of the market, in the global economy, in the political arena, with interest rates. Although the volatility with respect to interest rates has been one way, down. We've just seen all of these factors come into play, and our thesis really was what could go right because if you remember at the beginning of the year, people were really worried that we were going into a different market in a different economy. And spreads were much wider, rates were much higher, and we felt at that time that we could see a rally. We could see spreads tighten. But, boy, have we gotten more than we, even we expected.

Colleen Denzler: And so for us, it's really now trying to understand what is the volatility going forward? And I think we're going to talk about it today, but the political environment, the China trade tariff issues, the yield curve inversion. There's just so many factors that are at play right now that are going to increase volatility. And that's important because volatility effects clients’ portfolios. So that's what we're focused on and what we're looking at for the rest of the year.

Remy Blaire: And I think volatility is such a keyword whether we're talking about the fixed income market or the broader market, and we'll be taking a closer look at that as we head into this masterclass. And now that we've set the stage, I do want to take a closer look at today's investing environment, in particular fixed income investing as a strategy. So, Tony, can you address the need to include general fixed income in investors overall asset allocation?

Tony Tanner: Certainly. It's a great segue from your discussion of volatility because fixed income as an asset class has very desirable attributes that are a really important part of any clients’ or advisors’ balanced asset allocation. First and foremost, the predominant source of return from fixed income comes from the income, and it's that predictability which lends a great deal of value to and stability to a client's portfolio.

Tony Tanner: The second is that bonds and fixed income have historically demonstrated significantly lower risk and volatility than the equity markets. In the case of munis in particular, the after-tax risk adjusted returns of munis are particularly compelling for investors. And so, I like to say especially within the municipal fixed income class, they're like the blue jeans of the asset allocation closet. They're never the height of fashion, but they're always in style.

Remy Blaire: Well, that's an interesting analogy, and one we might refer to later on in this segment.

Remy Blaire: Now, Chris, heading back over to you. I do want to talk a little bit about adding alpha in fixed income. So, what levers do you use over at Fidelity when it comes to fixed income?

Chris Pariseault: So we focus, if you take a step back and think about the levers we all have to pull, predominantly there are four. There is sector rotation, security selection, duration management, and yield curve. And if you're investing outside the United States, you can add FX and country selection to that. But sticking with the first four, at Fidelity, we really focused on generating returns from security selection and sector rotation. If we see a shape in the curve that shows us something that's really either flat or very steep, we'll try to take advantage of that position accordingly. And then duration management, we don't spend a lot of time on duration management, as we all can see. Nobody has a really good lens into what rates are likely to do in the near term.

Chris Pariseault: So I'll give you an example of how sector rotation really works nicely. So, in 2016 if you think about where markets were, we had just come off metals and mining and commodities price volatility. And in 2016, you had high yield that generated a return of about 17%, governments on the other end of that range at about 1%. And then in 2018, so you had a very wide range there. So about 16% in terms of returns, and the Ag was just up, the Bloomberg Barkley's Ag was up about 2.5%. And then if you go into 2018, returns were much harder to come by, right? So, the range of returns was much narrower, and short-term debt won the day. Then you had a whole host of sectors in negative territory given the volatility in Q4.

Chris Pariseault: So if you can rotate into sectors that are cheap and out of sectors that are expensive, you don't have to be right peak and trough, but it adds a lot to the portfolio if you get that sector rotation right. Sometimes you'll get fat pitches, and other times it's going to be harder to come by, which is when you rely on security selection. And there I think is where Fidelity spends a lot of time. We have an army of analysts both in fixed income and in equity and in global asset allocation to help us understand macro trends. We approach things from a fundamental perspective and a quantitative perspective, and we work very closely with our equity counterparts to understand trends that are going on in the broad market to really give us a 360-degree view of credits that we follow.

Colleen Denzler: Chris, can I ask a question?

Chris Pariseault: Yes.

Colleen Denzler: You talked about the different levers that we as fixed income portfolio managers have, and one that you touched on that's super important to us at Smith Capital is the yield curve. And so, we have been doing a lot of thinking and working and trading around the inverted yield curve, around the opportunities on the long end of the curve. And I agree with you, duration, the big number is super hard to call. But in our view, yield curve is one where you can do a deeper analysis and still add value. And I'm curious what your thoughts are on that.

Chris Pariseault: Yeah, absolutely. With the curve showing us a shape right now that's extremely flat, we're more in the camp of staying away from the long end of the curve at this point and time and kind of a little bit more bulleted in terms of where we can find return. So, we're kind of comfortable down in the curve, and then we're also looking closely at the credit curve and where the roll down is there. When the curve was extremely steep, it seems like a long time ago-

Colleen Denzler: December.

Chris Pariseault: The roll down was adequate. But we were still focused in that so call it seven to 10-year part of the curve when it comes to corporates and our allocations to treasuries as well.

Remy Blaire: Well, I think it's helpful to get that insight, especially for the viewing audience.

Remy Blaire: Now, Nolan, I do want to get your take on evolution when it comes to index passive fixed income investing. Can you give us insight into the evolution of the most widely followed fixed income indexes?

Nolan Anderson: Sure. So earlier we talked about how attractive the market has been for issuers. This is really been born out in the largest, most recognizable fixed income benchmarks the U.S. Ag and the U.S. Corporate Index. But investors need to understand that indexes are largely price takers. What does that mean? It means that the market determines what bonds go into the indexes. So, if you're investing in these passive indexes, you don't really have any control over the issuers, the maturities, the covenants or so forth. So, you're basically a price taker. So as the market has the duration of bonds has increased and the coupons have been lower, really the inherent risk have increased.

Nolan Anderson: So a good example of that would be we went back over the last 30 years and analyzed the U.S. Bloomberg Barkley's Corporate Index, and what we found was the option adjusted duration of that index going back to 1999 was about 4.5 years. Currently today, we're sitting at almost eight years. So that's an increase of almost 75%. However, at the same time, the yield on the index has declined from over 10% to a current level of below 3%, which is an all-time low. In addition, the credit quality of the index has declined. So, if you use broad ratings buckets as a proxy for equality, the triple B part of the market, which is the lowest quality of investment grade, has actually increased significantly from about 20% to 25% to about 45% currently. So, again, nothing potentially at risk today necessarily. But as active managers, we think over a long period of time, there could be significant opportunity.

Remy Blaire: I think that really gets us perspective on where we stand right now.

Remy Blaire: Now, Colleen, I do want to get your take on the current state of the credit market as well as treasuries. What are you seeing?

Colleen Denzler: Well, it's interesting to listen to Nolan talk about the Bloomberg Barkley's Ag because that's obviously something that... Well, you're muni, so you don't focus on that. But the rest of us, that's kind of our main world. And I agree with Nolan 100%. The index has gotten so much riskier. So, the issuances have changed, more risk in the index. What does that mean for us as investors? Well, on the credit markets, it means that you have companies who have been able to issue in this kind of free money, low interest rate environment, and it's changed the nature of their balance sheets. So, with that, you have people reaching for yield, which is also investors reaching for yield. So, we think credit has gotten kind of dicey and a bit scary.

Colleen Denzler: But going back to the yield curve conversation, that doesn't mean there's not opportunity. In our mind, that opportunity really is in the shorter duration, shorter maturity credits. We like high yield, although we're not significantly overweight high yield. But we do think there's some opportunity there.

Colleen Denzler: Now, treasuries, whole different story. In fact, the complete opposite. You have a situation where the 10 and 30-year treasury securities have rallied an immense amount, really historical levels. I haven't seen that kind of steep rally since 2008. So that does scare people, but in our opinion, you have to be participating in that market because you could've said a month ago that treasuries had rallied too much and the trade was gone. And you would've been really, really wrong. And so, part of our discipline is to make sure that we're keeping track of has the trade changed, has the market changed. So much of what has impacted treasuries has been global effects. Like I said before, the China-U.S. tariff situation, Brexit, which we are dealing with. We're right in the middle of it as we do this panel.

Colleen Denzler: So in our opinion, it pays for us to protect our investors and make sure that we're still invested in that 10 and 30-year part of the treasury market because they expect us to keep up in markets like this. But it hasn't been easy. It's required a lot of discipline, and so obviously the next thought is what changes it. What makes rates go up? We have some very interesting ideas about that, and I'll probably talk to you about that in one of the later questions.

Remy Blaire: And I know that there are financial professionals that are viewing this masterclass, and they are getting plenty of questions from their friends, their families, as well as their clients. So, given the current conditions and the investing landscape, when it comes to fixed income, what are some of your thoughts regarding what advisors should be telling their clients?

Colleen Denzler: I think advisors should be telling their clients that their fixed income portfolio needs to be something that will protect them if we see an environment where stocks go down. And that's something that traditionally, not to get too technical, but we call it the negative correlation. Meaning, when stocks go up, bonds go down, and vice versa. We haven't always seen that in the last 10 years. And so, you have a scenario where advisors have put risk in their portfolios on the stock side, but they've also put risk in their portfolios on the fixed income side. And they might not even know it.

Colleen Denzler: To Nolan's point, they might own the index, and then they have a ton of duration in interest rate risk and a ton of credit risk. So, the thing that we've been talking to our advisors about most is to make sure that your portfolio is built in a way that your fixed income product is your ballast and it will perform as you expect, not too much risk. So that you can take risk in other parts of the market where you're being compensated for that level of risk. So that's by far the most important thing in my mind is buy a fixed income product that's going to act like a fixed income product and protect you if stocks go down.

Remy Blaire: I think that's very obvious and key point, and that will help us a segue into our next section, which is about the benefits of fixed income. But when we were talking about the benefits, I do think it's very important to highlight what segment of the fixed income market that we're talking about. Now diversification from stock market risk might be one of the key points that people bring up when it comes to the broader fixed income market, but, Tony, can you highlight the ways that individuals can access the muni bond market?

Tony Tanner: Yeah, and it's an important topic because the municipal bond market is infinitely more complex than all of its taxable counterparts. To your point, Colleen, about indexes, that's one of the great things about the muni market is that complexity presents a great opportunity to add value in your portfolio construction. We're a $4 trillion market with $80,000 issuers compared to the corporate bond market that only has 7000 issuers. And more importantly, only about 2% of the municipal market ever trades on a daily basis. And so, it's what I consider to be a trade by appointment market. Whereas most of our taxable fixed income counterparts, whether it's corporate bonds, asset backed or treasuries, are much more similar to an exchange-traded market situation.

Tony Tanner: So because of that, it's important to have different ways to access the market. Individuals have three primary ways to do it. They can certainly own municipal bonds on an individual basis. But they can also access professionally managed portfolios through mutual funds and more recent development in exchange traded funds. And each of those vehicles brings a lot of advantages. Investors are certainly familiar with the idea of being able to hold an individual bond to maturity, and at the same time, professionally managed portfolios provide value because you're getting instant diversification. And that's genuine economic diversification, not just appearance diversification. You're able to collect a monthly check as opposed to waiting for a six-month coupon. And you get liquidity in being able to get the days NAV at the end of the day.

Tony Tanner: So that kind of complexity is really important in a fixed income asset class, which is traditionally been a challenging, do-it-yourself asset class. Because of that, it's really important to look at your individual opportunity set in comparing what you can do rather than a broad index because it's very hard to replicate a muni index on your own.

Remy Blaire: And, Chris, moving onto you. I do want to ask about what we're seeing in terms of the economic landscape around the world. What does the global slow down mean, and what bond markets do you find attractive?

Chris Pariseault: So the global slowdown has been very interesting, and if you think back to why global growth has been very difficult for central banks to engineer, it's because most global economies were laden with a significant amount of debt, and then what came after that were pretty significant austerity packages in many pockets of the world, which are not pro-growth and not pro-capital investment. So, what we have kind of leftover is you think about, you hear it in the news all the time, we have between $15 and $17 trillion dollars of debt globally that is in negative yield territory. Not so bad for some investors that think a negative 1% bond could go to a negative 150, and then you can have some capital appreciation there. But most people don't want to traffic in a bond that some of their principal is going to be given back if they hold it to maturity.

Chris Pariseault: I think the U.S. right now for a strategy that we manage that can pretty much go anywhere, we think that the U.S. is very attractive within that market. High yield is presenting us with some very attractive spreads relative to other opportunities. Fundamentals look pretty strong, same thing for leveraged loans where you're higher up in the capital structure.

Chris Pariseault: And then if you think about other parts of the market, U.S. corporates. Nolan talked a little bit about triple B, double D, you have to be careful where you traffic. I think in this part of the market, right now, we are not stepping out and taking a lot of risk. So, making sure you know what you own and being able to protect what you own and trade out of them if the opportunity arises. I think in other sectors of the market that haven't been so attractive, certainly TIPS are one of them. Break evens are narrow but they're not narrow enough to get excited about in our view. Inflation is really nowhere to be seen. So, there's no catalyst right now for us to get excited about. The securitized part of the world doesn't really offer very much in the way of spread. So, asset backs and CMBS in the U.S.

Chris Pariseault: Outside the U.S., we've been very, very picky about where we want to go. So, international credit has been a part of the market that we find is in certain spots is attractive from a spread perspective. We like national champion banks, of course. Hedging back to the U.S. dollar, you get a little bit more right now given where rates are and where the curve is from a U.S. investor standpoint. So those are the areas that we think are fairly attractive right now.

Remy Blaire: And I think each and every one of you have highlighted the reasons why we need to be cautious in this current environment, and you've also touched upon some of the risks that we're all paying attention to. Whether it's the rate outlook, inflation, liquidity, or credit. But, Colleen, I'd like to hear about some of the challenges going forward and the risks that you're watching.

Colleen Denzler: Well, I think we've touched on a bunch of them, but I think the biggest risk we have is that the market has moved so far so fast, and I would highlight this within the mortgage backed securitized part of the market. You have to bear with me, I'm going to bond geek out for a second. When we talk about a term that we use called negative convexity, and normally when you say those words, people shutter inside. But I'm going to take a second to explain what it means.

Colleen Denzler: When you think about the mortgage market, it's really a market of people's loans on their homes, especially the sort of Fanny May, Freddie Mac type of market. And so, when we have a scenario where rates are going down, people refinance their mortgages. Well, for us as investors, if we own mortgage backed securities, meaning we're on the other side of that trade, that means we get our money back, and we get it back exactly at the wrong time because rates are low. So, it's difficult to reinvest. And that phenomenon is called negative convexity meaning you get your money back when you don't want it.

Colleen Denzler: That's been playing a huge role in what's going on in the fixed income markets right now for a couple of reasons. Number one, the duration or the interest rate risk of the mortgage part of the market has just... Duration has cratered, meaning it's gone down too much, much lower than the overall market. So, people who are heavily invested in that part of the market are under performing. So here you are bonds are rallying and doing well, and some people look at their bond portfolios and are like, "Wait a minute, what happened?"

Colleen Denzler: One of the reasons could be this negative convexity issue. So that's something we're paying a lot of attention to. We also think that as people try to overcome that shorter duration because the market's going up, so that shorter duration is hurting them, that they're buying treasuries. So, one of the reasons why the treasury rally has been so powerful and so strong besides the flight to quality and the fear trade is that people who own mortgage backed securities at the institutional level have to buy duration. So, all of that has combined to increase the volatility and the magnitude of the rally that we're experiencing. So that's something we're focused on.

Colleen Denzler: And then the second piece I'd like to bring us is that we're very focused on what we don't own. We think it's just as important to have a zero wait in undesirable credits, in undesirable sectors, as it is to worry and to focus our analysis on what we are buying because, as Nolan pointed out earlier, so much of the index is not good for investors. It's too long. It's got too much credit risk, and so we're very focused on making sure that we avoid a lot of those credits that add volatility to our portfolio. Because our overarching goal is to provide our clients with risk adjusted returns and to preserve their capital. So, what we don't own is just as important as what we do own.

Remy Blaire: And I think it's very helpful to note what you're avoiding in the market right now, and, Nolan, I know that you'll be talking about this as well when it comes to risks. But what are you also finding opportunity as well as value in right now?

Nolan Anderson: Sure. So actually, somewhat counter to my friend over here, Christian. We actually are finding reasonable value in out of benchmark areas of the market like asset backed and mortgage backed securities. For us, we're not a super large manager. So, some of the issuers that tend to be a little bit smaller, where some of the very large managers really just can't get in and play from a liquidity standpoint. We can actually go in there and do the work and add some value. For us, primarily, these are higher quality, shorter duration investments. So, call it one to three years. We believe these areas provide strong investor protections with the way they're structured. They provide diversification benefits, and we do see some yield pick-up relative to higher quality corporates.

Nolan Anderson: In the corporate arena, it's not a super target rich environment, but out of favor sectors potentially like energy and retail could be somewhat interesting. Now before everyone kind of scatters a little, the fascinating part about fixed income is usually when the tide goes out, higher quality issuers get kind of put in there with lower quality issuers. So that can create opportunity. So, if you're a fundamental credit shop and you can go in and do issuer by issuer credit analysis, we think there actually could be some opportunity.

Nolan Anderson: Lastly, I think one of the fascinating parts about fixed income is you can actually tailor your investments to the amount of risk you like to take. So, we follow a lot of energy and retail companies that certainly could face secular pressures over the next call it five to 10 years, but you don't have to go out and lend for 10 years. You can go in and find individual names and bonds that maybe mature in a year or two that offer significant relative value, and these companies don't face the risk of potentially going out of business in the next few years.

Colleen Denzler: I love that you can Chris has differing opinions, but that's what makes a market. That's awesome. Somebody's got to be the bid, and someone's got to be the offer.

Remy Blaire: Indeed where there is a risk, there is opportunity. And although there's plenty of uncertainty in the market, when it comes to certainty, there are always taxes on the horizon. So, Tony, I want to hear about some of the tradeoffs when it comes to tax implications.

Tony Tanner: Well, the things that investors really need to take into consideration when they're looking at taxes is first of all taxes matter. One of the things that we haven't talked about is the importance of preserving purchasing power because at the end of the day what fixed income investments or primarily the desired focus of them is to provide a level of income after taxes that exceeds the rate of inflation. Because if you're not protecting purchasing power out the gate, you're not accomplishing the primarily objective that fixed income provides for an overall asset allocation.

Tony Tanner: We had the circumstance here in the municipal bond market where following the 2017 tax reform and the institution of the $10,000 state and local tax limit, a lot of investors work up to the value of the muni tax exemption, which is an attribute that it's always had. So that is boded well for investors and for the market alike. Here at Aquila, we focus on a number of individual single state municipal bond funds, and so when you take into account even the state tax implication, that really brings home the importance of looking at the overall taxable equivalent yield and the after tax total return. Prospects that you can get in a municipal bond investment.

Tony Tanner: To Nolan's point, with credit risk, one of the great things about looking at the muni market is the fact that municipal credit risk has been inherently more stable than corporate credit risk in fixed income. So that provides opportunity to generate that extra income because you don't have to necessarily own only the highest quality issues to manage credit risk.

Remy Blaire: And now that we've covered risks, Chris, I do want to ask you about some of the risks. But how are you navigating the risks that are out there?

Chris Pariseault: There's so many, right? I think we talked about a lot of different ones today. Inflation risk, certainly. Rate risk, credit risk. I'll talk about credit risk a little bit, and I think that a few folks have already hit on it here. But credit risk is something that was front and center for a long time in 2018, and Nolan talked a little bit about the ratings migration from triple B down to double D. And a lot of investors thinking that these bonds were likely to slide off a cliff. And as we're looking for securities that we're interested in, we engaged our research team to kind of go out and look at those segments in the market to see what they've uncovered. To Nolan's point, the market, the size of the market for credit, investment grade credit has grown from about 2.5 trillion to about 6.7 trillion over the past 10 years. Triple B's were 28% of the market in 1998, and they're about 50% of the market today. So, Nolan's debating sort of the size and the growth of the market.

Chris Pariseault: But when you uncover it, what's interesting is we think that approaching 2008, rating agencies sort of underrated credit risk. Today, we think they're over rating them a little bit. And when you look at the growth of the triple B market, it's really been a handful of issuers. Really, really large issuers with large amounts of debt that have actually chosen to be okay with the fact that they've been downgraded from single A to triple B to afford them more financial flexibility in terms of leverage. And in fact, a lot of those names are on their way up in terms of rating.

Chris Pariseault: So there were some really good opportunities to navigate credit risk. When we dug a little further into triple B's and double B's and their constituents, there's about 2500 or so issuers in the triple B market. 

Chris Pariseault: Having said all that, on a total portfolio basis right now, we're not very excited about picking up nickels in front of the steam roller, but it's something to look at. And you have very, very tight windows to take advantage of those opportunities.

Remy Blaire: Well, I think we've covered a lot of ground regarding risk as well as benefits in the fixed income market. So now we want to switch our focus on over to market trends, and, Colleen, I understand that you focus on the behavior of CEOs and CFOs. And in addition, you watch the behavior of management teams. So, can you tell me what you're seeing and why it's so important to keep such a close eye on these behaviors.

Colleen Denzler: It's incredibly important because CEOs and CFOs determine how cash flow is used, and for fixed income investors in the corporate market, that is really the holy grail. That's what we care most about. And it was very interesting, Chris, to hear you talking about this topic because we completely agree. It's really down to the individual bond level, and so what we're concerned about is at the individual company level what are the CEOs and CFOs doing with their cash flow. And they have a couple of choices.

Colleen Denzler: They can pay a dividend, which obviously is very popular right now given that people are concerned about stocks and feel like a dividend is a safe way to earn some money. They can do a share buyback, which is, again, very good for the equity investors. So far nothing I've said has been great for the bond investor. So, for us, we want them to use their free cash flow to pay down their debt, and particularly that pivot of the ratings triple B to double B. A management company whose intention is to de-lever the company, use that free cash flow to pay down debt. They're going to right size, in our opinion, their balance sheet. And for fixed income investors, that means they care about what's good for us. We have every reason to believe we're going to get paid back the loan that we gave them.

Colleen Denzler: So when I talk about not all credits being created equal, this is really where the rubber hits the road on that metric. So, the trend that we're seeing is that there's some companies who are kind of punch drunk on how cheap money is right now. Rates are super low, and Nolan mentioned it earlier saying that our own government is planning on extending duration out 50-100 years. That's because debt is cheap right now. So that's wonderful unless you're a fixed income investor who's asking them to make sure that they pay you back. So, we pay super close attention to what is the management team telling us, number one. Number two, do they do what they say they're going to do because we have experience where the equity analyst comes in and they say, "Oh, we're going to do a share buyback." And then the fixed income analyst comes in and they say, "Oh, we're going to pay down debt." We want management companies that tell us what they're really going to do and then follow through.

Colleen Denzler: So why is that important right now? It's important because management teams like that can represent opportunity even in a market where there's a ton of risk. So that's one of the ways that we try to add value in a risky market.

Remy Blaire: Well, it might not be so obvious to viewers out there, but I think indeed a very important one. Now, Nolan, I do want to ask you about some of the observations that you're seeing in the current rate environment. You've touched upon some of your observations. But what does this mean for fixed income returns in the future?

Nolan Anderson: Sure. So, I think one of the most powerful things, and Colleen hit on this, is just how far and how fast bond yields have declined, particularly for governments of all varieties. Just looking at Bloomberg, you sit there and you look at the world bond market's green and you see Italian 10 year bonds nearing 1%. You see based on market pricing Greece having the ability to potentially 10-year debt below 2%. I mean, these are incredibly low levels. German 10 year at significantly negative spread. So, we think to an extent, fixed income returns in the future face just... They have a math problem. With rates so low, to earn a reasonable return in some of these securities, you have to believe that rates are going lower or potentially going more negative to invest. So as risk adjusted return investors like ourselves, you can be certain that we're not going to play that game. We do own long term treasuries as a part of a barbell strategy in our intermediate strategies. But at the current time, we are increasingly mindful of duration risk.

Remy Blaire: And moving onto you, Chris. Fed watch does continue as we head into the following months of this year, and so given everything we're seeing regarding political pressure as well as monetary policy, what do you expect to see when it comes to the Fed? And what are the implications for fixed income?

Chris Pariseault: Yeah. I don't see much in the way of... So, political pressure has been brought up as one thing that Chair Powell has to contend with. I think as long as the Feds policy is supportive of this administrations objective of keeping things smooth, stock market stays supported, credit market stays supported, everything is fine. And so, I think in those terms, I think we're in pretty good shape. I think when the transition was made from Chair Yellen to Chair Powell, there was some reticence on whether or not Powell was going to just kind of listen to this administration. I think the Fed has done a good job of showing their independence. I think Powell and his staff have actually shown a very strong, stead hand. We did see last week that there have been some dissenting governors in terms of keeping rates where they are. But I don't see any significant change to the path that the Fed is on at this point.

Tony Tanner: The interesting thing about the Fed and its path, when you look at the course of what's happened with interest rates is that the Fed appears to be embarking on an easing campaign when the 30 year is already at 2% and the 10 year is below 2%. In my experience, what I've observed over the years is that often time the market does the heavy lifting for the Fed. And that's why whether you're in taxable or tax exempt fixed income, it's really important for advisors and investors to look at the direction of inflation, the level of income they're getting in relation to inflation. Because as a wise man once told me, there's a cost to opportunity cost, and so if you're looking at the value that the income that fixed income provides relative to these other metrics, that often has more of an impact on the success of fixed income investors than trying to guess what the Fed is going to do. Because the Fed can often only impact directly the overnight cost of borrowing.

Tony Tanner: If you look at what's happened to interest rates in the last eight months, we've basically had 100, 150 basis point drop in rates. And since last September, the Fed funds rate is unchanged. If you go back to the temper tantrum in 2013, the 10 year went from around 2% to almost 4% from May to September. And the Fed didn't touch the Fed funds rates. So, it's really important for advisors and investors to take into account more than what they're just hearing about what the Fed is doing.

Remy Blaire: And I'm sure as we head into an election year, we'll be hearing plenty of commentary from both policymakers as well as politicians. Now, Tony, before I move away from you, I do want to get more insight in the muni markets. So, what are you seeing in terms of regional market differences, and what does this mean for an investors approach?

Tony Tanner: Remy, that's a great question because oftentimes people look at the muni market as a national market. And the truth is there really isn't a national muni market. It's really a collection of small localized markets that oftentimes can vary greatly from region to region. As an example, issuance from year to date at about $200 billion is just a little bit ahead of last year. But in Arizona, where I live and manage, issuance has doubled from $2 billion to $4 billion, and I can tell you as a taxpayer, I like seeing our towns and governments making a wise decision to lock in low long term borrowing costs. From an investment standpoint, the credit and diversification implications are where that's really most important.

Tony Tanner: Perfect example for me is living in a state that's the second fastest growing state and in the fastest growing county, the repercussions for hospitals and healthcare issuers is different because we have a growing populace that needs and demands state of the art healthcare facilities. But if you compare that to other parts of the country that aren't as growing or losing population like the Northeast, looking at those hospitals requires a much more critical eye because the nature of the economy is fundamentally different there. So that's one of the great opportunities for municipal bond investors is that they can work with an advisor and make those discernments and really find some good values.

Tony Tanner: The second this is that even though the economy appears to be long in the tooth, municipal governments, municipal finances continue to be growing very strong with very stable, steadily growing revenues, and compared to... We've talked a lot about the double B corporate market. Any sort of hiccup in the economy is really not going to have a discernible impact on the health of municipal credits, and I think that's a really good positive for municipal investors.

Remy Blaire: Well, as we head into the final segment of this masterclass, I do want to take a look ahead. And as we all mentioned, we don't have a crystal ball. So, we don't know what will happen in the coming months. But, Nolan, the next 10 years maybe more difficult than the past 10 years, and as Tony mentioned, we are in a long bull market. And we just saw a branded 10 years. So that does mean that change is on the horizon. But what is your long-term outlook for fixed income returns?

Nolan Anderson: Sure. So, we actually think it's very important to look at history. We spend actually a lot of time thinking about the long-term history of the United States both from a financial and economic perspective. And what you'd find is if you study the U.S. over say the last 100 years kind of decade by decade, they actually look a lot different from decade to decade. This decade has been marked by very strong returns for both safe haven assets and risky assets. We've had a lot of tailwinds. We've had quantitative easing, low interest rates, in some parts of the world negative interest rates. We've had what's now the longest expansion on record. We've had low and stable inflation. We've had tax cuts. We've had fiscal spending, and now to top it off, we have rising deficit. So, there's been a lot of tailwinds for investors.

Nolan Anderson: So we're very mindful that investors tend to extrapolate what's going on currently into the future. That's the path of least resistance. But unfortunately, we think that even though we don't make strong or bold predictions about what future returns are going to be. We think future returns could be quite a bit lower than what we've experienced in the past just given where we are from a current interest rate standpoint. Also, something that we think about a lot from a risk standpoint is can you have over long periods of time negative interest rates around the world, near zero interest rates in the United States, virtually all-time low borrowing costs for consumers and businesses, and not have unintended consequences bubble up at some point. So, is there truly a free lunch by just having below interest rates?

Nolan Anderson: History would tell us that the answer to that is no. So, we think active managers that have the flexibility to adjust both interest rate risk and credit risk stand at potentially do well in the future based on an environment that could look very different than what we're seeing today.

Colleen Denzler: One of the things then, Nolan, is that as I managed money over the years and seen different cycles. Even when you have a one-way trade, like we basically had, as you said, for the last 10 years or longer, there's a lot of time periods where there's volatility in that one-way trade. And we found that you can add a lot of value, even in a scary, negative market by paying attention to when you can add returns, when you can take advantage of lighter spreads on credit. So, I guess I want to stress to the advisors in the audience and clients in the audience that even if we see a bond market that's going down, there is still opportunity.

Colleen Denzler: In particular, going back to your point about the index, the index isn't going to be trading those, and the index has long duration. So, if you own the index, you are basically saying rates are going to go down, and credit spreads are going to tighten. And we're not necessarily 100% behind both of those trends to that severity. We think the opportunities going to be very active in understanding how to trade in any environment to add value for the client. So even if we do have a scary market, it doesn't mean we can't still have some opportunity.

Tony Tanner: The best way I can summarize that is the search for value is never a predictive exercise. It's not about determining the direction of the price and whether you're going to make a profit or not. It's whether or not the asset class delivers attributes that are desirable and does so with good value.

Remy Blaire: I think that's a very important point. And, Colleen, before we head into the close, I do want to ask you about the trade war and uncertainties surrounding tariffs. When it comes to that topic, we all know there's plenty of volatility given the fact that it's so hard to know whether some of the headlines are true or not. So that adds complexity to the matter. But where do you see us going from here?

Colleen Denzler: Well, we watch this very closely. At Smith Capital Investors, we're in partnership with our partners SS&C and Alps. And SS&C is a global company. So, we're watching this not only from our own perspective, but seeing it as it plays out for our partners in the business. What we are seeing is that China's taking a long game. This is not going to be an issue that's resolved in a matter of months. We think it's going to be in a matter of years. And I think part of why the market's rallied so tremendously is that people didn't factor this into their sort of risk-reward trade off nine months ago. And now they're factoring it in, and so our number one call if you will is that it's going to take much longer to resolve than people expect. And that there's not going to be some grand agreement where everything gets worked out in the next month. We really don't believe that's a possibility.

Colleen Denzler: We do think though we can make progress, and that progress could come by a series of smaller agreements. And we've seen in the market, even when there's a small agreement between China and the U.S., the market's calm down. Everybody looks at the VIX, the volatility index. It's spiked recently. That's something that if you see some agreement, even a pathway towards agreement in the future, you'll start to see that volatility that we've been calling for coming down. But ultimately, it's worse for China than it is for us. We have been importing deflation from China for many, many years. And so that's been one of the things that's affected us from the perspective of our inflation rate. And I know that's come up a few times on this panel.

Colleen Denzler: 61% of our foreign trade is with China. We have other options, and that's what's being bandied about right now. We are the biggest consumer on the planet, we being the U.S. So, if you need a consumer to keep your economy going, there's not a lot of options outside of the U.S. Whereas we have options for trade with other countries.

Colleen Denzler: So overall, those are some of the themes that we're looking at. But one of the things I'd like to point out for the future is the risk of inflation. We think that with this potentially not importing as much deflation as we have in the past that over time this could be something that causes the inflation rate to go up. Maybe we're not importing quite as cheap products as we were when we were trading so much with China. So that's one aspect.

Colleen Denzler: But also just from a technical perspective, when you think about inflation, it comes out as a one year number. So, every month that it comes out, the one month, 12 months ago rolls off, and you get a new month on. So basically, there's a fundamental change that you can look at and predict. I gave you that really long and possibly not as clear as I wanted it to be explanation because we are predicting that we're going to see inflation rising over the next few months just from a technical perspective because the numbers that are rolling off are low. Even if we stay where we're at right now, plus or minus 2%, that's higher than the numbers rolling off.

Colleen Denzler: So I bring all these up because there's two indications that inflation might not be as tame as the markets are currently pricing in because the 10 and 30 years at very close to historic lows is not pricing in a lot of inflation. So, one of the things that we're looking for in the future from this trade in tariff uncertainty and from the basic economics is keep your eyes out for inflation.

Remy Blaire: And indeed. I'm sure financial professionals as well as investors are like, "We'll be watching for any progress," and that would be one optimistic sign if we see more progress heading into year end.

Colleen Denzler: Well, and it also impacts when and if bond yields ever start going up. So, for those that have banded about that term of the bond bubble. I'm not saying we're in one. Again, you could've said that a month ago and been wrong. But if you're looking for what could possibly make rates go up, this issue of future inflation at the back half of this year is definitely at the top of our list.

Remy Blaire: Well, we'll see how all of this plays out.

Remy Blaire: Last but not least, Chris, could you tell us how you're positioned to respond to changing market conditions?

Chris Pariseault: Yeah. I think about where we've come over the last several years and kind of where we landed. I think any portfolio manager will tell you they want to reserve the ability to have many ways to win. So, I think Tony and Colleen kind of hit on that. And in an environment like today, we have to be humble about what we think is going to happen tomorrow. So, building resiliency in your portfolio I think is very, very important. Think about what happened at the end of 2018, for example. We entered a period of significant volatility. We had a bad October, and we had a bad couple of weeks in December. But it was very, very painful for markets. And then the Fed entered the picture. Didn't know that was going to happen because we were on a steady Fed tightening campaign. And then all of a sudden it reverse course, and they were a very, very small window to take advantage of spreads narrowing. I mean, high yield spreads had widened out to over 500 basis points. We had investment grade spreads widen out.

Chris Pariseault: And as advisors think about counseling their clients and what to look for, the most important thing is invest according to what your goals and objectives are, have fixed income play a role, know what that role is. In many cases, investors might want fixed income to play the role of capital appreciation in this environment because they need it. Some want income. Some want the old-fashioned diversification from equities. But know the role that you want it to play and make sure that those that are managing your money have goals commensurate with that.

Chris Pariseault: And so I think in positioning portfolios, we always have to constantly think about what our clients are doing.

Tony Tanner: Chris, and just to kind of wrap that up too is the fact that we've talked a lot about income, and we've talked a lot about risks. And oftentimes investors and advisors look at those in isolation. One way to determine value is to always look at income and duration in context with each other. And so even though we might be in a period where rates are near historic lows, if you've got a good balance of income in duration, that's really one of the keys to being able to have a long horizon and to stay in a position. Sometimes a very short duration comes at an incredible sacrifice of yield. Whereas if in the case with the muni market, and that's one of the great things I like about being in muni land is our curve is always steeper than that of the taxable curve. There's opportunities to strike that balance of maybe going in an intermediate direction because the level of income you're picking up more than compensates for that.

Remy Blaire: Well, we have been able to cover a lot of ground, but before we wrap up this discussion on fixed income, I do want to ask about some of the misconceptions of myths surrounding fixed income. I'm sure with some of the experience that you have, the decades of experience put together on this table, what would you like to dispel when it comes to myths surrounding fixed income?

Tony Tanner: I guess I'd like to go back to what I said about the search for value being a predictive exercise. If you think about the equity markets, equity volatility is a function of the growth of the economy, which is a decidedly secular aspect. Bond prices are determined by interest rates, which are the cost of money, which is a commodity. And commodities tend to be cyclical, not secular. So, whether it's taxable or tax free fixed income, income always provides the lion's share of total return over the long run, and I think that's something that people often overlook about fixed income.

Chris Pariseault: I would say in general it shouldn't be a forgone conclusion that you index your fixed income allocation for all the reasons that we talked about here. And I think that trend has kind of gotten ahead of itself, and I think all of us will have the opinion that certain benchmarks are not always the benchmarks to follow. In the bond market, remember, the biggest constituents in the index are the ones with the largest amount of debt outstanding, not the highest market cap. So, they're in there for reasons that not necessarily are the best economic ones. So, I think we have to pay attention to that and know that, and I think that's definitely a myth to contend with.

Nolan Anderson: I would add that a lot of people think of bond investing as being sleepier and not as exciting and dynamic as equity investing. But I would say that bond investing is extremely fun and is very dynamic, and you can add a lot of value in that part of your portfolio.

Colleen Denzler: That's awesome. We're going to end on a controversy because I was going to say the exact opposite. But fixed income has been too sexy recently, too much return, too much volatility. We think bond investing should be boring. We think it should be the ballast of your portfolio, and that you own it and you know how it's going to perform. And it gives you the risk adjusted return and preserves your capital. And leave the sexy, exciting to equities. So, we got a little different of opinion. However, I do think bond investing is super fun. So, I agree with you on that.

Remy Blaire: Well, thank you so much for joining me for today's Fix Income Masterclass, and thank you so much for all of your insights.

Tony Tanner: Thank you.

Chris Pariseault: Thank you.

Nolan Anderson: Thank you.

Colleen Denzler: Thank you.

Remy Blaire: And thank you for watching. This has been your Fix Income Masterclass. I was joined by Christian Pariseault of Fidelity Investments; Tony Tanner of the Aquila Investment Management and Aquila Tax Free Trust of Arizona; Colleen Denzler, investor at Smith Capital Investors; and Nolan Anderson of Weitz Investment Management.

Remy Blaire: From our studio in New York City, I'm Remy Blaire for Asset TV.