MASTERCLASS: Fixed Income - January 2020
December 19, 2019
Remy Blaire: Welcome to Asset TV. This is your Fixed Income Masterclass. BNY Mellon investment management is one of the world's largest investment firms and one of the top U.S. wealth managers with $1.8 trillion in assets under management as of June 30th, 2019. BNY Mellon is the third largest fixed income manager in the world.
Remy Blaire: Through an investor first approach, the firm brings to clients’ specialist expertise from eight investment firms offering solutions across every major asset class backed by the global presence of BNY Mellon.
Remy Blaire: Today, we have three of their fixed income experts coming from two of BNY Mellon's investment firms. I'm joined by Brendan Murphy, PM at Mellon who manages BNY Mellon’s Global Fixed Income Fund and BNY Mellon International Bond Fund, Dan Rabasco, Head of Municipal Bonds at Mellon, and Gautam Khanna, PM at insight investment, who manages the BNY Mellon Core+ fund.
Remy Blaire: Gentlemen, thank you so much for joining me today. First and foremost, can you start by introducing yourself?
Brendan Murphy: Sure. Hi, my name is Brendan Murphy. I'm the head of global and multi-sector fixed income at Mellon. I manage the BNY Mellon global fixed income fund, as well as the BNY Mellon international bond fund.
Gautam Khanna: My name is Gautam Khanna. I'm Lead PM for our Core, Core+ strategies and insight investment and I'm responsible for managing our BNY Mellon Core+ fund.
Dan Rabasco: Hello, I'm Dan Rabasco. I head municipal bonds at Mellon and I'm also a portfolio manager on several of those strategies.
Remy Blaire: First and foremost, I'd like to learn about your individual approaches. Brendan, starting out with you, can you give us an overview of your approach?
Brendan Murphy: Sure. I manage global and multi-sector fixed income at Mellon. What that means basically is we invest in a wide array of fixed income securities, essentially the entire world. Everything from developed markets and emerging markets, including both investment grade and below investment grade debt, as well as multiple sectors, so not just government bonds, but also corporate bonds, securitized bonds, mortgages. Essentially, just about any fixed income market you can think of encompasses the opportunity set with which we invest.
Brendan Murphy: The approach we use is very much fundamental in nature. It's one where we start with a top-down view in terms of the world, try to figure out the different geographies, the different sectors that we find attractive and decide on how we're going to allocate risk across those various sectors. That top-down approach is complimented by a bottom-up approach where we have an individual team of analysts across the sub sectors who identify the best securities, the best companies, the best countries to invest in. My job is really to marry that that top-down and bottom-up view to create an optimal portfolio in terms of risk-adjusted returns for clients.
Remy Blaire: Gautam, moving on over to you. Can you give us an overview of your approach?
Gautam Khanna: Firstly, I manage our broad market fixed income portfolios, of which Core+ is a flagship strategy. Our investment philosophy, quite simply, is precision and diversification. One of the benefits or one of the attributes of fixed income is that you can employ the power of mathematics and be very precise about the exposures you are taking. Not unlike what Brendan was saying, we have a fundamental approach as well, and it's identifying those parts of the market that we believe are attractive to achieve a particular objective.
Gautam Khanna: A lot of our assets tend to be very much outcomes oriented. There are very specific goals in mind for our investors. The diversification aspect is an acknowledgement that we live in a world of uncertainty and we want to use multiple tools and have multiple sources of return so we're not relying on any one area of the market for our outcomes.
Remy Blaire: Gautam, Brendan, now that we understand your approach, Dan, I would like to understand what you do in the muni bond world.
Dan Rabasco: Sure. In terms of the muni bond world, what we're striving to do of course is buy municipal bonds for our clients. Our approach looks to succeed in getting these clients a stream of tax-exempt income with the potential for price appreciation and spread tightening. Again, it's a fundamental approach, like my two counterparts have said. We focus on credit analysis, looking to identify sectors that we think are improving or at least stable. Additionally, we'll look for municipal securities to populate these sector commitments for our clients that have good relative value, that are cheap relative to being rich.
Dan Rabasco: Additionally, what we do, even though we don't emphasize it as much because we want to have stable excess returns, we don't emphasize duration and curve as much because those are volatile sources of returns. So, fundamental approach, credit drives that sector security selection with an eye towards duration curve but not the major emphasis. We also meld the fundamental approach with the top-down just like Brendan and Gautam were saying, too. That's what we're trying to do in the muni bond market these days.
Remy Blaire: Well gentlemen, now that I have a better understanding of your individual approach, one key word that was mentioned was fundamentals. When it comes to fixed income, it's important to understand fundamentals from of course, the fixed income perspective. Let's take a look at the landscape, Gautam. Can you give us insight into the macro perspective?
Gautam Khanna: Let me start by giving you a little bit of a recap of post financial crisis. So, 2009 through 2018 we averaged growth in the U.S. at about 1.9%. I call that trend growth. Then, 2018 was a breakout year. We actually grew at 2.9%. 2019, our expectation is that growth in the U.S. is going to be a little bit lower, actually quite a bit lower. We're expecting about 2.4%. We had a pretty strong first half of the year, but we're expecting a continued slowdown in the second half, perhaps to trend, maybe even a little bit below trend.
Gautam Khanna: The same thing is occurring overseas. If you look at Germany for instance, the most recent GDP was actually negative and there's reasons for that and a lot has been said about this. There's over $17 trillion of assets in the fixed income arena, whether it's sovereign debt, quasi sovereign, or even some corporates that are actually negative yielding. It begs the question as to why that is the case. It has a lot to do with demographics.
Gautam Khanna: Certaintly, in the developed world, particularly in Europe and in places like Japan where you have aging populations, there is very little inflation if any inflation. There is also a very significant entitlement system in those parts of the world which are driving down inflation and causing the negative yields. Central banks on a global basis have reacted with unprecedented monetary policy, not to mention policy from a central bank balance sheet perspective in terms of buying fixed income assets to help promote risk-taking in the market.
Gautam Khanna: Here we are in 2019. We think the economy is slowing. The U.S. is probably the best among the developed world, but there are risks. There's a lot of risks around geopolitics. There's Brexit, there's the central bank concerns around what are they likely to do or not likely to do? Do we have a central bank put, if you will? There's the ongoing trade war with China. These are some of the headwinds that we are facing and all of that is creating heightened amount of volatility.
Gautam Khanna: That's the overall landscape. What it demands is very much very careful security selection. As I was suggesting earlier in terms of our approach of being very precise about the areas of the fixed income market that we want to invest in, taking into account all of these macro drivers that are creating volatility.
Remy Blaire: Gautam, you've given us a great overview of what the macro and fundamental outlook is focused on. You mentioned central bank policy as well as geopolitics and we know how important that is going forward. But gentlemen, you all have your areas of expertise. When it comes to the broader benefits as well as advantages of the asset class, can you speak to that?
Dan Rabasco: The advantage to the muni asset classes, you're getting a steady stream of tax-exempt income that appeals to investors in certain tax brackets. I think additionally, our asset class is a high quality one. This preservation of capital is also, I think one of the positive factors to our sector.
Dan Rabasco: The last thing is diversification. We've seen unprecedented volatility and municipals are negatively correlated to certain risk assets such as the S&P 500, not a high correlation to taxable high yield bonds, for instance. It's a good diversifier. An investor, if they have an allocation to munis, not only does it give them that steady stream of income, high quality asset class, but also diversifies the volatility of other asset classes they may be in. I think that are some of the positive supporting factors for our asset class.
Gautam Khanna: The way I like to think about it is that why invest in fixed income? If it was returned maximization, then we know in the fullness of time you just invest in equities. But the reality is we don't live with unlimited time horizons. The reason we invest in fixed income is to have income stating the obvious, which is reliable, durable, and perhaps a little bit above what is commonly available. Then secondly, and very importantly is to provide that diversification benefit or what I refer to as ballast. All of us own some equities in our portfolios. We may own some real estate, you may own some real assets, et cetera, and there's a lot of risks building in the system. There's geopolitical risks and otherwise. You want to make sure you have some ballast in the portfolio and that's frankly, the number one benefit of owning fixed income.
Gautam Khanna: It's not akin to having insurance on your home. When it's sunny weather outside and everything is bright and cheery, you may beg the question of why am I buying insurance? Well, you're buying insurance because there's going to be periods of rainy days and volatility that you need to contend with. Income and ballast are the two primary drivers and certainly, capital preservation. That's such an important component of fixed income.
Brendan Murphy: You've heard it a couple of times, but I'd say diversification. It's relevant not just for global, but munis for U.S. fixed income. You want to diversify. As an asset class, fixed income should behave as something that has a very low correlation to equities, provide some income, and provides you diversification. I'd say within the fixed income universe, it's helpful to adopt as broad or as global of an approach as possible.
Brendan Murphy: If you think about everything we've seen, as Gautam mentioned earlier, in terms of from a policy perspective, the significant amount of intervention from different central banks, a lot of distortions quite frankly in terms of different yield curves in different fixed income markets, you want that flexibility to be able to do as much as possible, invest in as many different areas as possible, as many different sectors, as many different geographies.
Brendan Murphy: I'd also argue too, and this is, I think an appeal from a global perspective, is you don't necessarily want to be married to any one central bank, if you will. The ability to invest into different central banks can be helpful from a diversification standpoint.
Remy Blaire: I think all of you have highlighted the benefits of fixed income investing. When we talk about retail investors out there, some people might only attribute fixed income to retirement planning. Should they reconsider that?
Brendan Murphy: From my perspective, fixed income is an important part of everyone's portfolio. All the things that we've talked about, whether diversification and ballast, that's important not just for people approaching retirement but for people at younger ages as well. You can argue about how much, given your timeframe, how much of a fixed income allocation is warranted. But from my perspective, it should always be an important part of an investor's portfolio.
Gautam Khanna: I'll just use one analogy. If the only tool you have is a hammer, you treat everything like a nail. Having multiple types of assets in your portfolio is only adding to the efficiency of that portfolio. Frankly, owning fixed income allows you to perhaps be a little more free in employing your equity risks in your portfolio because you have that balance. Not to mention, everybody enjoys having that durable, predictable, reliable source of income.
Brendan Murphy: I'd say, just to interject for one second, I think this year is a great example where if you think about the beginning of the year we came in negative yields across many places of the globe, really low yields in the U.S. Look at the total returns for fixed income. It's pretty exceptional, right? 8%, 9% returns on average, with a range of, I don't know, 6% to 12% for most of the major markets. Not something that I predicted. I think not something most people in the fixed income markets would have predicted. So, you know, who knows, right? Who knows what you're going to get. But from my perspective, that highlights the attractiveness of fixed income.
Dan Rabasco: In terms of the municipal market, we've seen the retail investor unprecedented getting involved with municipal bonds. Tax reform eliminated the state and local tax deduction are limited to $10,000. You've seen this whole mindset where we're the last tax shelter and people are just diving into tax-exempt municipal bonds. Flows have been unprecedented. I agree with Brendan.
Dan Rabasco: If I had thought that returns are going to be 8%, 9% for munis, I thought it was like a fantasy, but in view of the asset class, the demand for it, and the yield differential with the rest of the world for U.S. fixed income and even municipals. We're seeing foreign investors getting involved in municipal bonds because again, high quality asset class, low default rates, yield and diversification. It's just been historic in terms of demand for munis and I think that just highlights the attractiveness of the asset class.
Gautam Khanna: Yeah, I would just also add that a lot has been said certainly in 2000 and the first part of 2018, back end of 2017, concern about duration. Well, I don't think anybody is complaining about duration in 2019, so it just goes to show that duration is your friend in periods of volatility. That's the primary beta in fixed income, is duration. If you are void of duration in your portfolio, you don't have the benefit of diversification. You don't have the ballast because there's nothing to rally.
Gautam Khanna: Just another point to note is that the number one flight to quality asset class is the 10-year treasury instrument. Whether you're an equity manager or a hedge fund manager and you think volatility is around, you're likely to buy some 10 year notes and so, not having any exposure to duration is perhaps not appropriate.
Remy Blaire: At the beginning of this year, as you mentioned, we couldn't have predicted what would happen in the fixed income market, but indeed we are living in very interesting times, especially when we're looking at the investment landscape.
Remy Blaire: Since you mentioned yield, I do want to talk about the inverted yield curve. We know that there has been a lot of focus on this and whether or not this predicts a recession or not. What is your take?
Brendan Murphy: I'd say in terms of the inverted yield curve, historically what we've observed is that when the yield curve has inverted that, I think it's on average around 20 or 22 months later that the U.S. experiences a recession.
Brendan Murphy: There, that the US experiences a recession, I wouldn't necessarily agree that the yield curve is a predictor of recessions, but it's ... certainly recessions have coincided with periods where the yield curve has inverted.
Brendan Murphy: I'd throw out a few reasons why I think things might be a little bit different this time and they're mainly around the technicals of the global fixed income market. We've talked a little bit earlier about negative yields. The fact that there's negative yields, you know, 17/18 trillion in negative yields, has really changed some of the dynamics, particularly in the long end of the yield curve and created a lot more demand from investors. So, part of the yield curve inversion or the demand for the long end could be a function of the negative yields that we're observing.
Brendan Murphy: The other thing that's a little bit different this time, is just a significant amount of central bank intervention in markets. The fact that central bank balance sheets are as large as they are, that they own so many bonds, create some distortions potentially in the long end of the US yield curve. So, it's not necessarily obvious to me that the current environment and one where looking to the bond market, you know, as a pricing mechanism for what may be happening in the real economy, is necessarily appropriate. Because potentially some of these bond prices are being distorted by some of these other factors.
Gautam Khanna: Yeah, I would just add, and I think I agree with all the points that have been made, is that let's say if the US yield curve was only made up of US investors, it perhaps would have bigger signaling power. But that signaling power is right now muted, because there's a lot of cross-currents as Brendan mentioned. So, there's ... The bond is at negative 70, at the 10-year point. So, there's a lot of demand from overseas European investors, Asian investors, that are buying the long end that's pushing down the long end of the curve. And then, the fed is ... so part of it is the ... at the shortest end of the yield curve, there is perhaps a little bit more of an accurate statement which is that, the fed is now starting and has already embarked on a rate cutting period. Whether you call it an adjustment or a rate cutting cycle, the market is suggesting that we're going to get multiple cuts and it's probably right. The market's probably going to force the issue.
Brendan Murphy: And I think, what might be just slightly different this time too, is if you think about past periods where the curve inverted, typically it's caused because the fed is tightening monetary policies. So, they're raising short term interest rates. And then typically, when they've raised those short-term interest rates, they've raised them to relatively high levels, that are considered restrictive. That slowed down the economy and that's, hence the yield curve is inverted. Remains to be seen, because I don't think anyone knows, you know, if 2% is a restrictive interest rate or not.
Brendan Murphy: But my sense is that what's happening this time in terms of the inversion, is more a function of the backend of the yield curve being drawn down, by all these different demands that we're talking about from globally, more so than in the past where it was actually the front end being pushed up by the fed. So again, it's who knows, right? And clearly, we could very well be in a recession, two years, one to two years from now, that's certainly a possibility I'd say. But I think looking just solely at the yield curve as an indicator, that may be a little bit misleading
Dan Rabasco: In terms of the municipal bond curve, excuse me, municipal bond curve. It's a bit different. It really, if ever inverts and not for a long period of time, if it does do that. And the reason for that is retail demand, you know, bids up the prices making yields come down for shorter to intermediate bonds, while longer out on the municipal curve, that's where you see your supply and they're trying to match capital programs and needs at the state and local level. So, our curve is typically steeper than the treasury curve. All be it though, our curve is very flat, relative to municipal history. But again, we really have ever invert for those reasons, the supply demand segmentation in our market.
Remy Blaire: And Gautam, did you want to weigh-in?
Gautam Khanna: So just one other point I wanted to make is, that in 2018 was the first time post the financial crisis, where fed funds actually had a positive real yield. And it lasted for a very short period because the market didn't like it, the economy didn't like it. And the reality is, we are a fairly indebted society. There's leverage at every level of government, whether it's federal, state, and local. There's leverage at the corporate level that has also gone up quite materially and of course, at the consumer level through housing. So, the point is that historically fed funds would have a positive real yield of, call it 2%, and the economy would be fine. But in this go around, that was clearly not the case in 2018, which is why we have that tantrum in the fourth quarter of 2018 and then the fed immediately reversed course.
Remy Blaire: And as we look at the federal reserve and their meetings coming up heading into 2020, which will be an election year, we know that the probability of rate cuts are indeed on the horizon. But when it comes to fixed income, as well as opportunities, Brendan I know that you've highlighted this, but why do you think it's so important to look beyond the US?
Brendan Murphy: You know, I come back to diversification. If you think about the global ... just the investment grade global fixed income universe, it's about 40% of that universe is in the US, so 60% of its outside of the US. So, from my perspective to not ... to ignore that 60% is selling yourself short from as a fixed income investor. There's benefits to invest both in terms of interest rates and in terms of credit, I'd argue, outside the US. Particularly when you look at global fixed income and the ability to hedge the asset class back into US dollars. So, for us we manage two different types of strategies, some are currency hedged, some are currency unhedged. And when you hedge non-US, even low yielding non-US fixed income instruments back into U S dollars, you actually pick up quite a bit of yield. And in many cases, get yields that are in excess of what you can get in the US. So, you don't necessarily have to ... if you're looking at global fixed income hedged, you don't necessarily have to give up yield, but you get that diversification benefit, which I think is so critical.
Brendan Murphy: We're in a period where the fed is cutting rates right now, but we're coming off a period, a number of years, where the fed was pretty much one of the only major central banks that was raising rates. And that ability to diversify your rate exposure into different markets, I think can be very helpful and very useful. It could be, who knows, we didn't know and anticipate 8/9% returns this year. It could be that, you know, the economy recovers and the fed rate cuts that are priced into the market evaporate and it could be that in 2020 we're starting to talk about the fed hiking rates again. That's not inconceivable. So, I think you always want to be diversified in terms of both in terms of rates and in terms of sectors.
Remy Blaire: And I think you highlight a lot of important points and the importance of risk management as we don't have a crystal ball going into the future. Now, since we're talking about your individual areas of expertise, Gautam, I do want to get a better understanding of core, core plus and what it is. Can you give us more insight and tell us why it's an important part of an investor's portfolio?
Gautam Khanna: So core and core plus our both broad fixed income strategies. And they're directed at achieving those goals that I suggested that fixed income investors have, steady source of income and ballast. Now, if you look at the aggregate bond index, which is the sort of the S&P 500 equivalent for fixed income investors here in the US, it's very concentrated. It's very concentrated in government and government-like securities. So very heavy on interest rate exposure, very light on credit exposure, structured credit, other types of credit investments or even EM, there's no below investment grade, et cetera. So, in both our core and core plus strategies, where we're trying to do is build an efficient portfolio. So, we want to have a portfolio that delivers on income and ballast, but do it in a way that you actually enjoy a nice total return. So that means investing in some credit instruments, where you're picking up added spread in yield, that hopefully in our assessment, and firstly, we have 40 plus analysts at Insight and many of those are corporate credit analysts.
Gautam Khanna: So we harness a lot of excess return from security selection. And that's part of what we are delivering in our core plus strategy. So, the total returns tend to be quite a bit higher than what you might expect, given where yields are. And that's because we're capturing spread compression, we've got rising stars. Those are things that are below investment grade perhaps that are getting upgraded because they're improving situations. So that's the approach. And you know, I'll keep going back to the point that you want to have a diversified portfolio. Structured product, that's an area where we are picking up a complexity premium. So, it's not simple corporate bonds, it's a little bit more esoteric, but area that we have invested very heavily in, where we pick up quite a bit of incremental yield for the same amount of risk.
Remy Blaire: And we know that the search for yield continues to be very important in this fixed income space. So, what do you expect to see as we head into the new year?
Gautam Khanna: So, I think it's fair to say that in the search for yield, people have perhaps invested in areas of the market that they may be either A, don't understand or B, don't quite comprehend the amount of risk in those areas. Whether it's deep emerging markets, take Argentina for instance recently or in areas of the high yield market, particularly in energy of late, where the volatility is very equity like and perhaps even worse than equities in many instances. That reach for yield is perhaps something that investors should be looking at very closely, to make sure that their fixed income is fixed income-like and not equity- like, because of that search field. Because if they don't do that then they're compromising ballast. And then they're not achieving that second objective, which is to provide that diversification against volatility.
Dan Rabasco: And that's one of the things we guard against is that reach for yield, because you can reach for yield and credit for instance. And then if there's a dislocation and spreads widen out, that yield advantage disappears. So, we've got a governor on our process, we look at volatility and spreads and it boils down to are you being compensated for that risk, you know, for that yield. So, when volatility is low and spreads are tight, we're shying away from reaching for yield. We wait for the opportunity when ball picks up in spreads widen, move out of quality bonds into the lower rated type bonds. And get the portfolios position for the long-term in terms of, again, that tax income that yield with the potential for appreciation down the road. So, you, I think you need to have a governor on that process of yield.
Gautam Khanna: I think that's a great point and it's worth reemphasizing, is that active management in fixed income is the only way. Whereas we've seen a significant growth in passive investing on the equity front. In the fixed income arena, there is significant amount of inefficiency. There's ... I'll use an example, there's one IBM stock ticker, but there's probably 50 or 60 IBM bonds at different points in the curve, different points in the capital structure. So, there's a lot of inefficiency that can be harnessed. So, active management, employing risk when margins of safety are higher and the expected return potential is greater, makes sense. But when spreads are tight, risks are high, lot of uncertainty in the horizon, you want to pull back.
Dan Rabasco: And I think that holds for the [muni 00:32:02] market, especially when you mentioned the word inefficiency. We're a retail-driven market. We have 50,000 issuers, a million Q-sips out there and against a retail driven market. So, it's a real fragmented inefficiency, and active management can really capitalize on those moments when volatility picks up, yields spike up, spreads widen, retail run for the exits. That's when the active manager comes in and buys those opportunities, puts them in a mutual fund, puts them in an SMA to set up the performance going forward for the clients. So, it's something that we try to do on a regular basis, when those opportunities present themselves.
Brendan Murphy: I would definitely echo those comments. I mean, there's all kinds of inefficiencies in global fixed income markets. So, if you extrapolate the IBM example out and then think about all the different currencies that IBM can issue in as well. There's a definite home bias and that can influence pricing. And so, the level of which any corporation issues debt in different currencies, is not necessarily the same. So, and there's different reasons why that exists. Some of it is the home investors familiarity with the company. Some of it is the amount of research analysts they have with securitized products, for example, structured products. And I'd agree, we find those very attractive as well. But it takes a lot of work. It takes a lot of ... you got to build a lot of research staff. You got to do a lot of work to get that insight, to feel comfortable buying those securities. And not everyone has done ... can do that or has done that.
Brendan Murphy: So those types of inefficiencies, they're how active managers like us are able to add value in a risk adjusted manner, right? So, if you think about the different ways you can add value. You can just go take a bunch of risk, take a bunch of beta in your portfolio, buy a lot of high yield or reach for yield as we've talked about before, and that's one way to do it. But that way, comes with a lot of risk. And so, I think all of us would agree, we're looking for the best risk adjusted way to add value. And a lot of these inefficiencies in the markets is a good way to do that.
Dan Rabasco: One other inefficiency in the muni market. You know, I mentioned it's a retail driven market. In retail, mom and pop, know they're general obligation issues, state local governments. The thing that we've been doing for decades has been focusing on revenue bonds. Retail doesn't understand them that much, because they don't have the analytical capabilities to talk about analysis that Brendan and government have been talking about. So, we focus on that because there's a yield premium and these credits are strong fundamentally, they have monopolistic service territories, they're not subject to the pension problems that the state and local GO issuers are. So that's an inefficiency in the market that we also capitalize on. You know, our sector, allocation, focusing on the revenue bonds. So again, active management and another reason why that's supportive.
Gautam Khanna: The other thing, the other point on active is that if you look at the indices, there are just a combination of issuance patterns has nothing to do with market efficiency. And the biggest debtors are the biggest components of those indices, they're not necessarily the best credits or the best investments. So just hugging the benchmark and just buying that is perhaps not the right approach.
Brendan Murphy: Can you tell we all believe in active management?
Remy Blaire: Well I think you've emphasized the importance of active management. And Dan, I do want to go back to you and take a closer look at the muni bond market. I also want to hear about some of the technical attributes of your capabilities, so can tell us a little bit about that?
Dan Rabasco: Sure. I mean, in terms of the muni bond market, and I think this holds true for Mellon, and if I digress, cut me off and do a retake. But you know, we look at fundamentals, we look at valuations, we look at technicals. I've been hammering the fund.
Dan Rabasco: We look at valuations, we look at technicals. I've been hammering the fundamental part over and over. We also look at the technical picture, which I alluded to. Flows, retail demand. You have to be able to capitalize on that. Be the liquidity provider when there is a dislocation, meaning if mutual funds are selling bonds because they're seeing redemptions, we want to be positioned for that. That goes back to my vol spread, maintaining sufficient liquidity. The technical picture, we follow that closely, supply, demand patterns. I mean, it's so key.
Dan Rabasco: One other thing related to supply and demand, supply has been somewhat constrained after tax reform, limiting the advance refunding capability of issuers, so it makes it that more key. You've got the analysts to be able to make recommendations on credit, but your strategy, your sector allocation can be the best in the world, if you can't execute on it, it means nothing, so you need trading. We have a centralized muni trading desk. We have about 100 broker-dealers covering us, know where the bonds are, so we capitalize on the marketplace inefficiencies with our centralized trading desk, but fundamentals, technicals, valuations.
Dan Rabasco: We follow the treasury market, but there's times when we're rich or cheap relative to treasuries. We have a proprietary model that tells us that, and when we're doing our sector allocation security selection, what part of the municipal yield curve looks attractive relative to the treasury curve? That's where we'll do our entry point.
Dan Rabasco: I mentioned earlier, duration has been your friend. We don't push the duration out there, but we're modestly long. Capturing that carry, albeit our curve is flat, you're still getting some carry. With this whole trend in rates, it's been additive. Hopefully, that answers your question as to what we're doing. Again, fundamentals, sector, vol, spreads, liquidity and centralized trading. Execute on all of it.
Remy Blaire: How can everyday investors take advantage of some of these muni strategies in their portfolios?
Dan Rabasco:Yeah. I mean, we offer a host of muni strategies. We offer a short strategy or ultra-short strategy for investors. You've got some, a little bit of yield in the front-end, but you've got the safety. We have a one to five strategy, also. An intermediate strategy, one to twelve years. A long strategy. What I'm trying to say there is whatever the client objective is, making sure they get tax M income and what their risk tolerance is, we have a product for it across the curve and also across the quality spectrum, including muni high yield, which has performed fantastically, and we envision that to continue.
Dan Rabasco: I think the key is, again, active management, having an institutional approach to source bonds. I mean, the individual investor, it's very difficult for them to buy bonds and also to attain diversification. A mutual fund provides diversification. A separately managed account that we would have for a client. The client sees a transparency with bonds that are in the portfolio, they control the cost basis, and we can customize a solution for them.
Dan Rabasco: Again, those are the strategies we present but, again, it's a client objective. Providing solutions, and we've got a host of solutions for clients.
Remy Blaire: Gentlemen, since we're honing in on your areas of expertise, Gautam, I want to move to you and get a better understanding of Insight and its strong heritage of LDI. How does that assist in managing a fund?
Gautam Khanna: Sure. LDI is the world's largest. Insight is the world's largest LDI manager. What that means is that Insight is instructing portfolios for a particular objective in mind, which in the case of pension funds, is to immunize that pension liability. It starts with understanding what the liability looks like as opposed to what the index has.
Gautam Khanna: You're starting with the liability and working your way back to what the portfolio needs to produce in order to immunize or achieve that liability steam. It's about increasing the likelihood of achieving your outcome.
Gautam Khanna: In the case of active fixed income, that discipline of being very mathematical, being very targeted about what risks are included or embedded in the portfolio, versus those that are avoided. What is the volatility of each of those underlying assets that are being included in the portfolio, and how they interact and work with each other, is all part of that precision that goes into the portfolio construction, which then results in us achieving our objectives.
Gautam Khanna: In the case of our Core Plus strategy, we're benched against the aggregate bond index, but we're targeting 150 basis points of excess return above that index, on an annual basis. We have achieved that over time, and we do that through that idea of implementing precision, and thinking about that outcome, and then sizing positions based on that outcome in mind.
Remy Blaire: In addition to emphasizing the importance of risk management as well as active management, I do want to take a look at some of the misconceptions that are out there surrounding fixed income.
Remy Blaire: Depending on what type of audience we're speaking to, we might get all kinds of misconceptions about what fixed income is, how safe it is, where the risks are. What are some of the misconceptions that you would like to highlight today?
Brendan Murphy: I think there's, one misconception is that the best way to access fixed income markets is through individual bonds as opposed to through funds. Unfortunately for me, because this is my profession, to invest in fixed income, it's a very asymmetric asset class.
Brendan Murphy: Meaning that on my best day, when I buy a bond that comes at par and has some kind of coupon associated with it, the entity that issued that bond will pay me back my par and they'll pay me some small amount of interest along the way.
Brendan Murphy: The worst case is that that entity actually won't pay me back. We see that with concerns in emerging markets, with Argentina. We've seen it in the corporate credit space. Unfortunately for me, that can make life difficult at some times.
Brendan Murphy: The good news is that we do have a deep and talented team of credit research analysts that try to identify those securities that are most attractive in terms of credit worthiness, and help us to avoid the ones that may default or may not pay us back.
Brendan Murphy: If I'm an individual retail investor, I don't necessarily have the luxury of having that deep credit research staff at my disposal to help tell me which bonds to buy or not. If I'm buying a fairly concentrated portfolio of my own individual corporate bonds, there's a potential there that you're underestimating the amount of credit risk that you may be taking in doing that.
Brendan Murphy: Owning a fund structure, whether it's in U.S. fixed income, in muni space, in global fixed income that is well diversified across sectors, across names, across geographies, that has the benefit of a deep credit research team that can help avoid, help managers avoid the pitfalls, is really the benefit, I would say, of looking at funds over individual bonds.
Gautam Khanna: Yeah. I totally agree with everything that's been said. I would also add that in terms of another myth, and we talked a little bit about this earlier, is this move that's afoot into passive investing. It just doesn't make sense for fixed income. I would argue again and again that ...
Gautam Khanna: Take the high yield market. There's probably a thousand plus issuers. About 15 to 18%, depending on which index you look at, are triple C rated. Half of those will default, on average, over five-year time horizons. There's some that will actually gravitate up to investment grade, and some that will muddle along, maybe get distressed, maybe come back, maybe not.
Gautam Khanna: Active is the only way you can actually cut through the clutter and actually construct a portfolio that is created for the investor. Unlike, perhaps, in the equity space where active managers have a hard time outperforming indices, in fixed income, suggesting that whether it's picking up that complexity premium, or harnessing that inefficiency that is available to us in the market, that we're able to successfully do that consistently, year-in and year-out. I think that myth that you should be investing in passive, I think for fixed income, is wrong.
Dan Rabasco: I think another myth is that municipal bonds are only suitable for the extremely wealthy. If you look at municipal yields relative to treasury yields, for instance, at this time, a 10-year triple A muni is yielding 85% of what a treasury is. I mean, if you're in a tax bracket of 20, 30%, in that range, that bond still makes sense. There's still a tax advantage.
Dan Rabasco: Also, municipal bonds, in terms of maybe another reason why there should be demand for munis is the fact that, besides it's not just for the wealthy, there's a public purpose for them, infrastructure, the public good. Which, in ESG, for instance, sensitivity to that, munis can appeal to that investor set, away from the extremely wealthy. That's the point I'm trying to make.
Dan Rabasco: One other myth is that munis are boring. Even though we have the low default rates, there's no risk. We've been talking about risk budgeting, risk management. In terms of active management, trying to protect the downside, trying to provide alpha, you have to know what your risks are. You can't be overly concentrated in certain credits, Brendan was talking about that. Certain sections of the yield curve. You want to be diversified and know where your risks are, relative to your market outlook. I think there is a misconception that muni, you just clip the coupon. You could have some valuation risk in the meantime, too.
Gautam Khanna: I would add, and I think Brendan brought this up about the asymmetric payoff. If you just buy it, buy a bond, you just don't hold it to maturity. You want to be actively thinking about it, managing it, and seeing the relative value of that particular instrument, relative to other options that are available in the market at any point in time. That's another thing that, you don't just buy a fixed income instrument and just hold it for its entire duration.
Remy Blaire: What about the relationship of rising interest rates when it comes to holding bonds?
Gautam Khanna: Clearly, rising interest rates is a headwind for fixed income assets, but not all durations are created equal. If you think about a credit instrument, if you're getting paid a spread over the risk-free, that spread is compensating investors for three primary things, its default probabilities, its event risk, and a liquidity premium.
Gautam Khanna: If rates are going higher for the right reasons, as in the economy is stronger or inflation is picking up a touch, then the default probability of the right set of credits should actually be receding, so you should see the risk premia attached to default compressing. Also, if rates are rising and volatility is going down in the market, then that liquidity premium will also be shrinking. What you end up happening is that you get spread compression. Then, and the other point to make is that that's also the environment in which you're likely to unearth some rising stars, because the environment is improving, credits are getting better. They're getting upgraded, and that also helps offset, if you will, some of that drag from rising interest rates.
Dan Rabasco: That applies to muni high yield, for instance. What you just laid out there in terms of an economy that's doing better, while rates are going up. Credit quality, muni high yield, should be improving. Those valuations shouldn't be impacted as much, just by the increase in rates, but another thing. Muni high yield isn't all that liquid so the bonds aren't trading too. There's a governor on the rate increase too for muni high yield, so I think it applies to that also.
Dan Rabasco: I think in terms of munis, as they move in an upper, a rising rate environment, we don't move to the same clip as treasuries do. Why is that? I think the retail investor realizes they can shelter more income. Rates have gone up, "I have more tax M income I can shelter from taxes," so you see, actually, retail demand increase during gradual, rising rate environments.
Dan Rabasco: I mean, if it's a severe dislocation, that analogy I used earlier, people running for the exits. Whether it was Meredith Whitney or the tapering tantrum or the Trump trade. You saw dislocations, narrow windows though, but in a gradually rising rate environment, munis become attractive to the retail investor. That moderates our move in terms of the rate rise.
Gautam Khanna: Another point just to make is that rates across the yield curve rarely move in parallel shifts. Let's say if the front-end was to move up more materially, that will be disinflationary, so inflation expectations for longer periods of time will actually go down, so that will result in a flattening of the curve.
Gautam Khanna: That's where active approach, again, where we are thinking about, "What's happening with central bank policy? What's happening to front-end rates? What does that imply for long-end rates? Where is the optimal place to be on the term structure of interest rates?" is also something that you should be considering.
Brendan Murphy: Yeah. I think we've highlighted a bunch of important ways to sort of protect yourself in a rising rate environment. Obviously, sector diversification. Yield curve, where it would be, the one other that I'd highlight is just the geographic diversity. Just because interest rates are rising in one particular country doesn't mean that they're rising everywhere.
Brendan Murphy: Usually, there's a relatively high correlation between central banks globally, but even in this current environment where most central banks are easing or cutting rates, central bank in Norway has actually been raising rates. You can get these periods of divergence in terms of monetary policy, which can lead to different outcomes for different fixed income markets.
Remy Blaire: Well, I think we've been focusing on risk management when it comes to fixed income, but while we're on the topic of myths, as well as misconception, what if there is an investor out there whose risk tolerance is very aggressive, and they think that they don't need fixed income in their portfolio, how would you dispel that myth?
Gautam Khanna: Well, I think we talked quite a bit about it earlier, which is look at what's happened in 2019. Fixed income returns are quite high. I'll go back to my analogy, which is, "It's sunny outside. Why do I buy insurance?" Why do you have this balance in your, the totality of your portfolio? Having some fixed income allows you to be, perhaps, a little bit more aggressive on your equity portfolio, because you've got that balance.
Remy Blaire: Okay, gentlemen. Well, thank you so much for joining me today for the Masterclass, and thank you so much for your insights. Thank you for watching.
Remy Blaire: I was joined by Brendan Murphy, PM at Mellon, who manages BNY Mellon Fixed Income Fund and BNY Mellon International Bond Fund. Dan Rabasco, head of Municipal Bonds at Mellon, and Gautam Khanna, PM at Insight Investment, who manages the BNY Mellon Core Plus Fund. From our studios in New York City, I'm Remy Blaire for Asset TV.
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