Rob:

Welcome to another edition of the Strategist Corner Podcast. I’m Rob Almeida Global Investment Strategist and multi asset Portfolio Manager. In this episode I chat with Brad Rutan and Benoit Anne about opportunities in the fixed income market and some potential pitfalls investors may want to consider.

Disclosure Voice

The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as an offer of securities or investment advice. No forecast can be guaranteed. Past performance is no guarantee of future results.

Rob:

Brad and Benoit, welcome to the podcast.

Brad:

Good to be here.

Benoit:

Hello.

Rob:

Well, the income is back in fixed income after a tumultuous 2022. The two-year treasury is back to, I think its 2007 high. So we haven't seen these levels in a decade and a half. We know what the catalyst is, we know what's driving it. Obviously, inflation that was bigger than expected, stickier than expected. But from your perspective as two leading fixed income experts, what are the dynamics driving yields and what's your perspective on it and how should clients be thinking about it? Benoit, I'll go to you first.

Benoit:

Thanks. Well, it's a really great starting point for fixed income. Obviously, that happened with a bit of pain. Last year was horrendous. That's why-

Rob:

A lot of pain.

Benoit:

That's what I would call the great valuation reset, and it was indeed quite brutal in global markets. But going forward, there are a lot of reasons to be more constructive on fixed income. As you know, your starting yield is absolutely critical in shaping up your return expectations in fixed income, not only tactically but strategically. So there would have to be a lot of things going wrong going forward for fixed income not to do well at all. So that's a really good position to be in.

Rob:

All right. Well, we're going to get into some of those. So let me go to you Brad for-

Brad:

Yeah. I mean I think it's just the uncertainty around the Fed. I think for all the time and effort we put into trying to guess where Fed funds rate or 10 years-

Rob:

Yeah, the market, you mean?

Brad:

Right, the market, not just MFS, but just the broad market. When you look at Fed funds futures at the beginning of any year and see what they're pricing in for the Fed over the concurrent two years, I mean it's a chart like my eight-year-old drew it. There's no rhyme or reason to the path of Fed funds futures and the actual path of Fed funds. But the closer we get to terminal rate, everything converges, so we're near there. But I think the massive spike last year was uncertainty about the Fed. Obviously they were late to the game and then the massive spike in inflation. But to Benoit's point, the income's back in income.

Rob:

Right. And from my perspective, what I find fascinating having to look at both equity and fixed income. So it's not just that income is back in fixed income and yields are at great levels, to your point Benoit, but if you compare that to your earnings yield in the S&P, it's close to 100% on the short end of the curve, which is really remarkable, and from my perspective, rendering fixed income materially more attractive than equities through that lens. But let's-

Brad:

I mean, 60/40 was dead right? Nothing but a year ago, and now we're talking this.

Rob:

Right, right. So let's get into maybe some of the issues that could go wrong -before we get into the attributes and what parts of fixed income you guys are favoring and the department's favoring, et cetera. Let's talk a little bit about maybe some of the fears you're hearing from clients, the things that they're worried about. Maybe inflation's going to be greater than what the market thinks rather than what the Fed thinks. If you compare that to, you've got an inverted yield curve, maybe fears out there that we hear relative to the market is discounting or telling us two different things. So let's just start there.

Benoit:

So what is it that the fixed income investors don't like? Number one, aggressive central banks. So there's a risk still, all right. Maybe that risk is getting less and less as we get closer to the finishing line, but-

Rob:

To Brad's point, from five to 6% is a big difference than one to five.

Benoit:

That's right. Yeah. But still the jury is out. We're still hearing some central banks talking tough, including in Europe. The ECB is probably the most vocal central bank at this point. Fixed income investors don't like inflation. We thought we were lined up to have a nice disinflation process, but there've been some bumps on the road clearly and readily with data disappointing, so it looks a bit more sticky than we thought. So that also puts a little bit of a cloud in fixed income near term. I've got to mention the big R word - recession -, because of course if the recession turns out to be much more severe than anticipated, then you have a risk on spreads as well. Obviously, we've been talking about duration, but obviously credit risk is a big part of that story as well.

Rob:

Yeah, well sovereign yields would fall and bonds would rally. On the flip side, your corporates, your credits, et cetera, would be more susceptible to some pain.

Brad:

Right, because that all-in yield we've said is so attractive, whether it's 4.9 in a corporate or eight plus in a high yield. That has two parts to it. It has a rate and a spread. And the fear from a lot of clients is, well we believe that if the Fed stops hiking and is on pause before they cut, that there's a good case for rates to gravitate down in that scenario. But somewhere near the end of that is then you have rates, one part moving down and the spread part moving up, and you have that credit selloff and how steep is it going to be? High yield spreads, what should they be at, given that a lot of these companies are real low quality maybe should have been taken out in 2020, never were? So is it 400 basis points? Is it 300? Is it 500? And that's the worry. If it's 300, you can survive with a positive return still in high yield. If it's 500, now you're talking trouble.

Rob:

Which to me is the part that in particular the equity market is not thinking about. So from my perspective, the shock of 2022 was obviously inflation, higher rates and cash becoming a competitive asset and creating a devaluation amongst all risk assets and why correlations went to one. But it's still centered on that narrative, not just for fixed income, but I think for equities too and also for credit. So what maybe the market I think is not thinking about is, to Benoit's point about rates going from very low levels to now attractive levels, the transmission mechanism in fixed rate economies like the US, like big parts of Europe, it's a delay, it's 12 to 18 to 24 months. And the weighted average cost of capital for every company or every enterprise on the planet just went up by a lot.

Brad:

And consumers too.

Rob:

For everyone.

Brad:

For everyone.

Rob:

For everyone. And there's going to be enterprises, public, private, government, corporate that are going to struggle under a much higher, not just cost of capital regime but cost of labor, cost of goods, increased spend, all that.

Brad:

Right. I mean I think we're not fully wrapped up for earning season, but we're pretty close to it.

Rob:

Pretty close.

Brad:

And the numbers tell a story. Revenues are great. Revenues are up across the board. Earnings are down and obviously-

Rob:

High single digit revenue but with low single digit earnings.

Brad:

And you don't have to be an economist to figure out what that means. It's your cost of goods, your labor, your interest expense, and on top of that, tax rates for corporates are going up two to 3% this year as we retire some of those tax provisions. So, add that all up and the consumer's keeping that revenue number going up, but the company is having trouble with the other side, the cost of goods and you're seeing margins fall.

Benoit:

And that's why maybe fixed income looks much better positioned in a multi-asset portfolio environment, because we are talking about a lot of downside risk to equities right now and that argument about profit margins. So fixed income is back as an income provider. At least you have that defensive element and that cushion on the valuation front. I would always characterize fixed income as asymmetric, which is a good thing, whereas equities are probably a lot more symmetric. So now when you said 60/40, yeah, investors were way underweight fixed income, so the 60/40 is back with a lot more fixed income than they had, basically.

Rob:

So within that 40, so let's just think about a fixed income portfolio in 100% increments, and obviously without knowing an individual's asset liability mismatch and income needs and all that sorts of thing, but putting all that aside, when you think about the opportunity set within fixed income, I'm not going to ask you to rank per se, but let's just talk about attractive versus less attractive sector. So obviously high yield sounds like it might be a little bit more on the unattractive side just given the increasing default risk and probabilities. What do you think about on the maybe attractive?

Benoit:

Yeah. Rob, we spent some time in Europe together not so long ago and you heard it there yourself. Euro credit looks quite attractive and-

Rob:

Investment grade.

Benoit:

Yeah, investment grade, Euro IG.

Rob:

Walk me through why.

Benoit:

Well, so number one, the research and risks were heavily discounted in Europe through spreads. Spreads had corrected quite a bit. Now the actually outlook in Europe is, believe it or not improving. There was a lot of drama and I think fear about Europe going down and now we've seen a bounce back in micro fundamentals, which is quite positive. And well, the ECB is talking tough, but it's probably getting near the end in terms of market pricing anywhere, which I think is quite supportive for European duration. There's a lot priced in on that curve. So you put everything together, the valuation picture, the improvement in fundamentals and DCB cruising to the end of its journey, the stars are aligning for European IG credit the way we see it.

Rob:

I'm going to take a quick pivot to stay on central banks for a minute. Don't you think that the marketplace puts way too much emphasis on what central banks may do or even what they will do when ultimately what drives the shape of the curve, what drives long interest rates? It's economic growth, it's tax receipts. Maybe give me some color on that.

Benoit:

Yeah, so it depends on what time horizon you have I guess. The longer the time horizon, I think the less central banks should matter. In a near term, and sadly the way we observed it last year is the central banks were the only game in town. But everything works in cycles, including markets. So I would hope to see a new market cycle where central banks are taking the back seat and ideally we are going to talk less about central banks than we had over the past couple of years. So I think you're going to be right pretty soon. We're going to refocus on the long-term fundamentals, the strength of earnings, the growth dynamics and so on, and less about rates, inflation and central banks.

Rob:

Yeah, it's interesting interest to me, because 2022, you say that it was central banks were in charge, and I guess my pushback rebuttal to that would be volatility occurs when the market has to reprice for mistaken assumptions.

Brad:

Correct.

Rob:

And the mistaken assumption was inflation was transient. Oops. It turns out it was bigger and stickier. But you can think of a country, tell me if I'm wrong, because you're the economist, you can think of a country almost like a country. It has revenues, it has liabilities and interest rates not unlike maybe an equity price for a company, it's just a proxy for what that country's going to earn. Is that fair or unfair?

Benoit:

Yeah. So I said central banks were a big driver. I never said they were credible. In fact, you're absolutely right. The Fed surprised everybody, and Brad, you said that earlier, the Fed surprised itself. I mean, they woke up and realized they were totally way behind the curve I guess. So going forward, that should disappear.

Brad:

I think half the problem is the amount of narrative coming out of them that will then drive more assumptions, which then will be wrong, which will create more volatility. There used to be an era where the Fed didn't speak as much. You didn't get the notes, you didn't get the presser, and now there's so much coming out of them and the market tries to digest it all, it's going to get it wrong. And then when it is wrong, you get these just spikes of volatility.

Rob:

Yeah, I guess it's not like anything else that's contributing to short term noise and more and more people acting on that, and it just gets harder for them to discern between what's noise and what's material relevant information over the long term.

Benoit:

I want to give them credit because their job is not easy.

Benoit:

You need to find the right balance between surprising the market a little bit, because if everything is already fully integrated and fully discounted, actually monetary policy becomes ineffective, but you don't want to come across as not knowing what you're doing and have no credibility and make those big policy swings and also the other extremes. So finding the right tone and the right balance in the face of that macro volatility that we've observed, I mean it's pretty hard. So that's my one-minute credit to central banks, because it hasn't been easy for them.

Rob:

No, very fair, very fair. Let's shift back to the credit side, credit risk. Brad, I want to come to you. Spread. So whether it's investment ... Well, we talked a little bit about high yield. Let's maybe talk a little bit about investment grade. Benoit talked about that in Europe. Talk a little bit about that in the US. Are US investment grade corporates as attractive as European? It doesn't sound like they are, but maybe what's your perspective?

Brad:

I think they're attractive. So a US based investor, unfortunately they don't buy much from a global bond perspective. They're very US dollar, US bond. But on a relative basis, I agree that European investment grade is more attractive from a valuation perspective. But I mean the asset class has, call it a 5% starting yield. It's got-

Rob:

That's today's level?

Brad:

Today's level, yeah. Good duration if in fact rates fall, and the technicals are decent, fundamentals are good. So, I think it's an attractive asset class. Even high yield though, we're finding opportunities there. Sometimes secondary market even. So it's just the index, the universe of them, there's so many bonds with fake yield, there's so many bonds where we don't believe they'll achieve that yield that's on the bond. But I'd say less attractive than US investment grade for sure.

Benoit:

Brad is making a really good point. The higher the micro risk, the higher the credit risk, the more significant security selection becomes, because the cost of picking the wrong company becomes really high. So when you think high yield investing, it's hard to me to think index investing. Curbing your benchmarks doesn't work, because you've got to be very strong at security selection when it comes to high yield, especially right now with that micro vol.

Rob:

Yeah, I mean to me, my simple I guess angle on all of this is in 2022, we saw aggregate demand that was too high. So, central banks reacted, and it's still too high. So yes, you're not paying 8, 9% more for a salad downstairs, but you're paying 5 or 6% more. So aggregate demand is still too high and central banks' actions are working to reduce aggregate demand. And in order to do that, what has to happen is mal-investment in the real economy that accumulated over so many years has to be corrected. So to your point, particularly in deeper parts of the credit markets, you need to see that, if you want to call it natural destruction or natural selection and company failures, because I guess at a high level consumers, there's a high degree of consumption.

Some of that was savings from the pandemic stimulus. But a big part is because you've got a very healthy, robust labor market. To me, that's a function of there's not enough workers relative to the amount of companies seeking labor. So you need to have that natural destruction process work its way through, which introduces risk into corporate bond selection.

Brad:

And the Fed didn't allow that to happen.

Rob:

For years.

Brad:

For years. And as an active manager, while we're biased, I mean that to us, obviously we don't want people to be out of work. We don't want any random company to go bankrupt, but that's a natural part of capitalism. That's why we all get into this industry, and it excites us that that is coming back into play and that separation of the haves and have nots, both on the fixed income side and the equity side is in play this year and definitely next year.

Benoit:

I mean reflecting on what happened in 2020, with obviously the easy job benefit of hindsight, central banks overreacted, governments overreacted, because they were faced with a shock that was not easy to assess and it looked quite dramatic, but you ended up with perpetrating that zero cost of capital and liquidating, flushing all over the place. And that's how you end up with a really weird business cycle right now.

Rob: [19:51]

Which is what we have.

Benoit:

Look at unemployment and look at the strength of the labor market in the US, which doesn't budge at all. I've never seen this before.

Rob:

Which, back to my point is, incompatible with getting aggregate demand down to what central banks are looking for. That makes sense. I mean just think thinking back, the purpose of, to Brad's point, capitalism is to allocate society's scarce resources, and that was done incrementally less in the 2010s because of QE, and the purpose of a recession is just to rebalance imbalances that accrued over time. There is no free lunch. So we now know the cost of the stimulus package. It was 8, 9% inflation, but there's still some leftover on the bill that has to get paid, which is there's going to be some companies that can't outearn their new and higher cost of capital, and that's going to be material to risk markets.

Brad:

And a cost of capital that could rise higher as we enter, if a recession happens.

Rob:

Not just because of Fed funds you mean, but because of other factors, yeah.

Brad:

Not because of Fed funds. Because if we enter a recession and the market prices spreads higher, that company then, to reissue debt would be incrementally higher. And that's where it really gets fun for us because that's what we enjoy doing.

Rob:

And not just the cost of debt, but cost of equity too. Equities currency.

Brad:

Yeah, 100%.

Rob:

So you add those two. I mean in 2022, it's consistent with all the highest jump in rates in 40 years, but the weighted average cost of capital for companies in the S&P 500 jumped the most in four decades in 2022.

Brad:

Correct.

Rob:

That's a big adjustment that it's going to feed through over the next 12 to 18 months.

Brad:

I think you also have to wonder if we had all time high corporate bond issuance in the US, I think it was pretty high-

Rob:

Last year?

Brad:

2020.

Rob:

Okay, got it.

Brad:

Because the Fed basically-

Rob:

Yes, of course.

Brad:

And then that's come down about 35%, 2021, 2022. Fast-forward to this year. While we came out of the gate with a nice strong month of issuance, overall, the longer we get, I wouldn't expect issuance to be hitting any records this year, especially if the cost of capital is high and goes higher. I think that also gets at security selection, that if there aren't as many bonds issued out there, the ability to source trading through them, find them in the secondary market or primary market becomes advantageous for a firm like MFS.

Rob:

So I think what I'm hearing is fixed income's attractive on an absolute basis and on a relative basis to other asset classes, but caution or selection discretion is still warranted, particularly in the deeper parts of the credit markets. Two areas that we didn't cover that I want to touch on quickly, because Benoit, you talked a lot about it in our travels in Europe last month, was EMD, and Brad, you've talked about over the last couple years, is municipals. So maybe Benoit, you first. A couple points on emerging market debt.

Benoit:

Yeah. Why emerging markets? That's part of the same story of emerging markets being back after a horrendous time in markets last year. The dollar seems to be looking like hitting a wall maybe going forward, and that would be positive for emerging markets assets. Then also the narrative around China's reopening is also boosting overall investor sentiment towards the asset class. Global growth is actually-expectations are being revised upwards, not downward anymore. The fear of a global recession is disappearing, and that should ultimately benefit emerging markets.

Rob:

I guess maybe to add to that, we seem to be in a world that we have outgrown physically. So we're short on manufacturing capabilities, we're short on clean energy assets, we're short on materials that we need to build those sorts of things and net EM in aggregate or emerging market countries are exporters of those sorts of things. So Brad, talk a little bit about munis, maybe credit quality, how you're thinking about it, how you're talking about it with clients today.

Brad:

I mean when you look at the asset class and you look at the fundamentals, so they were beneficiaries of the COVID stimulus. Many munis are flush with cash. State revenues, you would've thought would've gone down in 2020. They went up versus '19. They went up again last year and the year prior. So, fundamentals look fairly good.

Rob:

So tax receipts?

Brad:

Tax receipts, yep. Except I did get some tax money back from the state this past month. I was confused by it.

Rob:

Don't worry, you're going to give it back next year.

Brad:

Probably.

Rob:

Yeah, don't worry. Don't worry.

Brad:

Valuations, yields are great. Yields and munis, high yield are great. Compare them to taxable, compare them to history. The only thing that's amiss is the technicals. We went through the biggest outflow cycle in munis last year. We had, I forget the number, it was $120 billion maybe, roughly around there.

Rob:

The asset class?

Brad:

The asset class, out of all funds and ETFs. You think of the Meredith Whitney cycle, where we had that massive outflow cycle. It was three times as big as that and it was the longest one. Just week after week, three, four, $5 billion came out of that asset class. So that technical, really headwind, because it's a retail dominated asset class. What we know is that will end. It'll probably end maybe around when the Fed pauses, and investors stop fearing that rate hikes, and you add good fundamentals to good yields and get maybe a technical tailwind, then I think it's a attractive asset class for sure.

Rob:

Yeah. It certainly doesn't have the profit margin risk, but it doesn't have the capital and labor risk of corporates.

Brad:

No. Right.

Benoit:

And the cyclicality. I mean, the sensitivity to the business cycle, which is what you want to have, I guess in the face of rising recession risks.

Rob:

You want the longer duration, high quality and tax free.

Brad:

Low default rates, high recovery rates and good fundamentals, valuations. We just need that outflow cycle to turn to inflow.

Rob:

What haven't I asked? What am I missing? What haven't we talked about?

Benoit:

I think dispersion in global fixed income. Also very interesting development. When we put our hat as global multi-sector fixed income managers, there is a lot of disparity, a lot of dislocation. Not only within an asset class, we talked about security selection, but I mean globally and originally. I think the US versus Europe trade is quite interesting. It looks like credit in the US has actually bounced back quite aggressively. Europe is a bit of a laggard, but that's actually a good thing maybe. There's valuation left in Europe, whereas in the US it probably looks a bit more stretched in my view.

Rob:

Okay. Brad, anything from you?

Brad:

I'd say correlation's right?

Rob:

Stock bond correlation you mean?

Brad:

Yeah, stock bond. I mean, that was death nail last year, was just that rise to one or 0.6 if you're at a two year or whatever. And I think you're right, partly caused by cash. I think also that if we think about correlation, if we think about equities and fixed income having opposite sign sensitivities to growth and unemployment. So, growth goes down, bad for equities generally, okay for bonds. And then same sign sensitivities to inflation and real Fed funds rate. Last year, what was the story? It was inflation, massive volatility and that same sign sensitivity sent them through the roof. But if 2023 turns into a growth story, a negative growth story, then that should help the correlation between fixed income and equity come down.

Rob:

Yeah. Because what I think people, at least in the equity market, are missing is when you have inflation bursts like we had last year, and you've seen this throughout the cycles, inflation is obviously what you're paying at the register, which is a function of price and the consumer's willingness to pay that price. So how does that pricing power flow through the P and L? So pricing power goes up, profit margins go up. It works the other way too. When inflation's rolling downhill, as it is now we, can argue magnitude, direction, level, et cetera, what that means is companies are then giving price, but the cost side doesn't roll as quickly, and that's when you start to see margins fall. And that's that negative sign that you're talking about.

Brad:

Exactly. And you've already seen them start to fall even with revenues up and maybe prices up, and now you switch to the next environment where those revenues come down and your costs are still sticky, then you get even further margin.

Rob:

Yeah. If you look at cost of goods sold on a growth rate and look at revenues on a growth rate, cogs are higher than revenues, which in the past has always led to lower, which is just intuitive. If your cost of doing business is higher than your money coming in the door, that's going to be a difficult-

Brad:

My nine-year-old understands that.

Rob:

Well guys, thank you so much. We're going to do this again in six to nine months whether you like it or not. We're going to review where you're right, where you're wrong.

Brad:

Love it.

Rob:

But no, seriously, thank you very much.

Brad:

Appreciate it, Rob.

Benoit:

Thank you.

Rob:
I think Brad and Benoit make a compelling case that bonds are for better risk-reward profile today then they have in more than a decade and probably deserve a larger share in many investors’ portfolios. Though, against an uncertain economic and market backdrop, selectivity should be pretty important.