Jenna Dagenhart:

Welcome to this Asset TV 2023 Mid-year Outlook for Fixed Income Masterclass. Today, we'll cover opportunities in high yield, some of the top risks facing fixed-income investors managing through this season of monetary policy uncertainty, and some of the top themes to watch moving forward. Joining us now, it's an honor to introduce our panelists, Nolan Anderson, co-head of Fixed Income and portfolio manager at Weitz Investment Management, Maulik Bhansali, senior portfolio manager and co-head of the Core Fixed Income team at Allspringing Global Investments, and Ray Kennedy, portfolio manager at Hotchkis & Wiley Capital Management.

Well, everyone, it's a pleasure to have you with us. And, Maulik, kicking us off here, how would you characterize the current market environment for investors, and what's changed in recent months?

Maulik Bhansali:

Yeah, I'd characterize the current environment as one that's really very exciting for active fixed-income investors for a few reasons. Obviously, we are in a much higher yield environment for high-quality fixed income, as high as we've seen for any extended period since the financial crisis 15 years ago. So, the asset class itself is drawing a lot of interest, but there's more to be excited about than just the level of yields. The biggest shift in my mind is in market volatility, particularly interest rate volatility. We've come out of a period in which volatility was suppressed by policy actions, I'd argue since the aftermath of the financial crisis, and that's no longer the case.

For example, a widely watched gauge of interest rate volatility, the MOVE index is over 100 at the moment, and that's off the peaks we saw during the regional bank crisis, but it's still well above the levels we saw prior to the Fed's rate increases or before the pandemic when it measured closer to 60. So, in many ways, we believe we've entered a new paradigm, or at least one we haven't seen in many years. Volatility is back in fixed income markets and we think it's here to stay for the foreseeable future.

That's important because greater volatility provides more opportunities to find attractive relative value and create a rich opportunity set for bond-pickers that can exploit dislocations and dispersion. It may be a bit of a cliché, but we really are in a bond-pickers market now And more recently with the economy continuing to be resilient, the Fed remaining on a hiking path and so far the successful containment of emerging risks surrounding crises like what we saw with the regional banks, the market seems to have capitulated and accepted that rates may be higher for longer than most people thought they would.

Jenna Dagenhart:

Yeah. Volatility sometimes gets a bit of a negative connotation with it, but as you said, it can certainly be a positive, especially in these markets. Nolan, what stands out to you the most when you look back on the first half of 2023 and where we are today?

Nolan Anderson:

Yeah. Certainly, the scale of the regional bank failures was very surprising. Not only did it catch the markets off guard, it seemed to surprise regulators. No one knows for sure if we've seen the final episodes of the knock-on effects of what those bank failures really mean for the US economy, as well as the risk of increased regulation. I think increased regulation is something we need to be mindful of rolling out here over the next several months, quarters, in a couple years. There tends to be some knock-on effects to the credit markets and lending. I think second, from a big picture macro-perspective, I mean clearly, it's inflation and the resiliency of the US economy I think has surprised most people.

After the regional banking crisis, we saw the amount of Fed interest rate cuts accelerate to I think five or six cuts at one point, and those now have completely backed off due to the resiliency of both the economy and inflation. I think historically, given the speed and magnitude of the Federal Reserve's rate hiking cycle this far, I think the economy generally would've maybe slowed more than what it's occurred to date but it just simply hasn't. Take the housing market as a good example.

Despite mortgage rates more than doubling to 6% or 7%, and home affordability levels being the lowest in almost 40 years, there are now signs the housing market may be bottoming out. It's always, to be mindful of saying at this time is different, but certainly what does seem different here than what we've seen over the last 40 years is just the level of inflation and the lingering impact of that, as well as the significant percentage of the population that was able to lock in their debt service costs for their largest budget items, housing, mortgages, and car loans.

Those that were able to lock those rates in at such low levels as a result have less interest rate sensitivity in their budgets. And then, clearly the continued strength of the labor market, both wages remaining sticky in the 4% to 5% range, and just the sheer number of jobs we keep adding on a monthly basis. None of that really adds up to 2% inflation. So, I think the bank failures on the one hand early in Q1, and then just the resiliency that we've seen since both in inflation and the economy have been the biggest surprises in the first half of this year.

Jenna Dagenhart:

Now building off of your comments about the banking crisis, Nolan, with the collapse of Silicon Valley Bank, Signature Bank, and First Republic Bank, we witnessed three of the largest bank failures in US history so far this year. Ray, what are your thoughts about bank loans?

Ray Kennedy:

Well, first of all, I would add on to Nolan and Maulik's comments. One of the things that surprised me this year is that obviously, we've moved from a rate risk to credit risk, but the high-yield market has been incredibly stable given these dynamics. And I think a lot of that's just the technicals that are driving this. We basically have no new issues. At the same time, we haven't seen the outflows to the extent we would and that's been a surprise for me. I would've expected spreads wider and spreads are tighter, default should be spiking. They're not. So, it's a very unusual environment from that standpoint.

Bank loans itself, you have to give things from a historical perspective. Bank loans used to be the senior part of the high-yield market. For example, Charter unsecured bonds would be issued in the high-yield bond market, and you'd have Charter secured debt. And that Charter secured debt would go to a bank loan fund and go to a CLO. We've now evolved, we have these, what we call loan-only structures where we basically have issuers that only issue loans. And that's going to create some problems down the road.

And I think what's a little bit disconcerting, especially in high yield because these loan-only issuers tend to be more leveraged, they tend to be lower quality, but more importantly, they're held by CLOs. And CLOs are quantitative buyers. They're not necessarily credit buyers per se, not criticizing that investor class. It's a different animal. I ran CLOs at PIMCO for years. And your decision-making's very different in terms of what you put in the vehicle and what you don't put in the vehicle.

The reason I'm mentioning that is because we are all expecting a much higher default rate in bank loans, which is totally counterintuitive given that it's supposedly more senior in the capital structure. But because we have these capital structures that are all bank loans, we clearly are going to see some problems there. And that could bleed over into high yield, at a minimum, maybe repricing the asset class. Because on a relative value basis, loans might be more attractive.

So, it's going to be a very interesting dynamic over the next 12 months as we go through this process in the loan asset class and see what it does, whether we're overreacting or whether or not there's going to be a bleed into high yield and reprice that. A lot of things are going to be up in the air over the next 12 months, and we'll see how this plays out.

Jenna Dagenhart:

Maulik, what would you say are the key risks facing fixed income investors right now?

Maulik Bhansali:

Yeah, I think most people are aware of the big macroeconomic risks out there. Commercial real estate, especially office has been flagged as a potential source of risk. People may be concerned about pressures on the consumer as excess savings get depleted. And we do have the student loan payment moratorium ending shortly, and squeezed corporate margins are always a possibility if earnings don't come to fruition as expected. I'd say one of the key risks we are acutely aware of though is liquidity risk. You have the withdrawal of a tremendous amount of monetary accommodation. Quantitative tightening is in place, not just in the US but globally.

And there have been significant changes in market structure that impact bank's willingness to... and their ability really to warehouse risk. We're seeing ongoing shifts and challenges in fixed-income liquidity, even in places like the US treasury market. We've always had a focus on having a high-quality liquid portfolio that allows us to be nimble and change our views efficiently, but it's even more important now to pay attention to that risk in times of heightened volatility, changes in liquidity. The presence of forced sellers or sometimes even forced buyers can provide real opportunity for a bond-picker that's nimble enough to act.

At the risk of sounding glib, the other risk to consider is the one that no one anticipates. I think Ray spoke a bit about the resiliency of the high-yield market. And there may be a bit of complacency in markets today. We've had so many issues pop up in the last year and a half that weren't on most people's radar since the Fed started raising rates. You had Russia's invasion of Ukraine, the implosion of parts of the crypto world. You had an LDI crisis following the UK's budget proposal, and then finally, of course, the bank failures more recently.

The economy so far has managed to power through all of these, but it's hard to believe that there aren't other surprises lurking after an astonishingly quick 5% increase in interest rates.

Jenna Dagenhart:

And circling back to high yield, Ray, are you seeing any cracks emerge in high yield credit?

Ray Kennedy:

A little bit. You're seeing some names get dislocated maybe in the technology space, a little bit in the healthcare space, but really when you look at it from a big picture, it's been very benign. And so, we're all a bit surprised. As I said, I think we're going to see more of it in the bank loan market. If you look at the pricing that's occurred in some of the names down there, using a level of distress, let's say you pick 75 or 85 is your price point for distress in bank loans, there's a lot more in that space. And so, that's where I think we're going to see that stress.

We look at the healthcare sector because they were clearly over-earning during the pandemic. And so, that's starting to, as these hospitals get back to their normal admissions environment, what's going to happen there. And we've seen some names weaken in that space. And I mentioned technology. The only reason I mentioned technology is we had a credit discussion about one today, but one of the things that surprised me was when you look at where issuance has been in high yield, that's generally where your problem is. We call it the vintage problem sector. You look at energy and what happened in 2018, or 2019, 2020, that was largely because we had a significant amount of issuance in 2017, 2018.

And we had a ton of technology issuance in the 2020, 2021 period. And so, some of that's going to come home to roost, so that's the one area. And Maulik's right about liquidity. We had an expression at PIMCO, which is, liquidity is an ephemeral thing. It's there when you don't need it. And it's really true. Right now you look at liquidity and it looks okay, but trades take time. We do portfolio trading a lot to mitigate some of that, but it's not perfect. And I do hear about... I'm not active in the treasury market or the MBS market or CMBS market, where you are hearing about strains and liquidity there.

The Fed has just started issuing, the treasury has just started issuing the trillion that they need and they've been doing it largely on the frontend, but wait till they start going down the curve, going out the curve and start issuing, then we're going to really find out where the liquidity is in this market.

Jenna Dagenhart:

I want to dive more into the Fed, but before we do, Nolan, I saw you nodding your head a little bit while Ray was speaking. Anything that you would like to add about liquidity?

Nolan Anderson:

I actually was going to add on the high yield market, I think it's going to take time is a theme we've heard. I think part of the reason why it's going to take time is the debt maturity schedules of both the high-yield fixed market and the floating rate market, particularly the fixed rate side, the treasurers and CFOs did a really good job of extending debt maturities. And so, I think that market in particular, it's going to be... the defaults aren't going to be related to maturities per se. Whereas in the loan market, while the debt maturity profile looks good today, it has a weaker profile than the fixed rate market.

As we get into '24 and certainly into '25, there's a step function change, move up in the debt maturity profile, which will make refinancing much harder, particularly on the loan-only side like Ray said, when your base rate's gone from zero to five, that makes a really big debt on interest coverage and refinance ability.

Ray Kennedy:

Yeah, there's a great chart. I think it was JP Morgan was sharing with investors yesterday. One is that I think there's like 90 billion due in 2024, half of it's triple Cs. So, we're going to find out next year where we're going to use the, what is it, the Warren Buffet analogy, which is we're going to find out who's not wearing their bathing suits when the tide goes out. But the other thing is there's 350 billion due in 2025. Now, we're hoping that they start nibbling at this. We actually want the new issue market to come back. We need the new issue market to come back because, to me, that's current pricing in the market. That's what attracts investors.

We talk to investors and we tell them, "Oh yeah, we're 8.5% yield in the high yield market, average dollar price of 85 to 90." But the current yield is, it's still down there, low six handles. But when the new paper comes to the market at 8% and 9%, and those of us who have done this a long time, those are attractive levels. That's where the rubber hits the road. And we need them to come to the market, reprice the high yield market a bit, but more importantly, start really nibbling at that 350 billion.

We've been talking about the great maturity wall now for two years, but every year we're getting closer to the maturity wall, so we need to really start thinking about what happens in 2025. And I'm optimistic that we will nibble at it over the next few years because we've been so anemic in new issuance in the high-yield market. And again, you bring a deal at 8% and 9% that's maybe a week double B or a single B, you're going to get buyers.

Jenna Dagenhart:

And, of course, moving into '24, '25, we have all eyes on the Fed. The Fed left rates unchanged at the June FOMC meeting, but Chair Powell recently told congress that the move was more of a moderation in pace than a pause. Maulik, do you think that we'll see a few more hikes ahead as many are forecasting?

Maulik Bhansali:

Absolutely. I do think we will see at least one and probably two more hikes. We still aren't seeing the types of declines we need to in core inflation. And I think as Nolan mentioned, the housing market has really seemed to stabilize and that could be supportive to rents, which is a big component of core inflation going forward. And there's signs that the labor market is slowing or weakening, but it's still exceptionally strong. When you combine that with the regional bank crisis seeming to have been contained and bank lending doesn't seem to have been materially impacted so far, all of that points to additional hikes ahead.

At this point, if the Fed were actually to backtrack on its guidance to continue to raise rates while the economic data has continued to be resilient, they would risk a real loss of credibility. I think any concrete signal that we are at the end of the hiking cycle with cuts on the horizon would really allow markets to loosen financial conditions by supporting asset prices. And that would not be what the Fed wants. That would not be desirable from the Fed's point of view because we're still a long way from their 2% inflation target.

As it relates to more than two hikes, it's hard to see more than that at the moment because just from a timing perspective, that would put us towards the end of the year or maybe even early 2024. And hopefully, by that time, we've made a lot more progress on the inflation front.

Jenna Dagenhart:

And Powell's definitely going to be in the history books, but I think we know how he wants to be remembered in the battle against inflation. Ray, do you have any thoughts on Fed policy?

Ray Kennedy:

Yeah, you just said it perfectly, which is the history books. He clearly doesn't want to be the famous Arthur Burns. Without being too harsh on him, they've really been a disaster. They were too fast to cut. They held it down too long. They used that term transitory, which I'm sure Powell every night goes to sleep going, "Why did I ever say that? Why did I ever believe that?" And now I would argue that they're probably moving too fast, but one thing's for certain, they want to keep it higher for longer. They do not want to cut, if anything, Maulik's right, they want to raise. And I think the only question is now how much.

And just listening to all of them today with the interview on CNBC, boy, it's really clear that they are all joined together here in their mission to basically keep rates high and really bring inflation down. And they do not want to cut that inflation target. I think they're crazy trying to bring it back down to two. To me, two and a half is even better. But if they want to bring it down to two, there's only one thing they can do, higher, longer, and possibly even raise more.

Jenna Dagenhart:

And we're still a long way from two as you alluded to earlier. Nolan, what are your current views on Fed policy and interest rates and how are you managing through this season of monetary policy uncertainty?

Nolan Anderson:

Yeah, we get asked about interest rates and Fed policy all the time, and our answer always begins with, take it with a grain of salt and a heavy dose of humility. Because predictions are, even for the Fed, they've got an army of, 100s of econometric folks, data scientists, and they really don't know where inflation's going to go and where ultimately their policy is. I think what we try to be mindful of is the path of least resistance, tighter policy or loosening policy. And what environment does... what does that mean for fixed income and the economy? I think what we try to keep in mind is their goal is to slow the economy, and they haven't yet.

There are survey data that shows weakening, PMI data, but the actual facts on the ground, the anecdotes, going out and traveling and moving around the country and looking, and talking to people that still are having an incredibly hard time finding labor, qualified labor, it seems like the path of least resistance is more hikes and not only more hikes, but what also matters is the duration of how long they keep Fed policy higher. That will ultimately at some point have an impact on credit conditions and will have an impact on the labor market. So, really it's inflation.

Everyone's expecting and counting and seeming that inflation's going to come down toward 2% as Ray alluded to. If they really, really stay stuck on that 2% target, who knows how long rates might stay higher than expected? However, history shows that throughout hiking cycles, when the Fed does ultimately stop, fixed income performs well, particularly higher quality assets.

What we have done, particularly in our Core Plus strategy is as interest rates across the curve have moved up, which thankfully, after the regional banking prices they have, we've just continued to steadily increase the duration of our portfolio in the pockets where we think it makes the most sense from a risk-adjusted standpoint.

Ray Kennedy:

No, I think Nolan really said it well. I'd say that the one comment that Powell has used, which is he understands there's a social cost, which is polite way of saying, "I want to see the unemployment rate go up." And the only question is how much? If I were a man in Las Vegas betting, I'd say he'd love to see the unemployment rate get above 5% because, to him, that's the signal that he's starting to really fight this battle.

Jenna Dagenhart:

But we're still far from that, right?

Ray Kennedy:

Absolutely.

Jenna Dagenhart:

It's interesting too Nolan's saying that you said about travel. If you go to an airport these days or go out to eat or look at inflation or the labor market, it doesn't feel like we're on the brink of a recession even though we hear so much about one. How are you thinking about that?

Nolan Anderson:

Forecasting is the job of economists. COVID was obviously a very mild, odd recession if it was even that, but whenever we have a recession, this will be the first one that's happened in the era of social media and just real-time predictions and forecasts. And everyone has an opinion on every media platform. We just look at the facts and look at the data. So far we don't see that recession or that risk, that significant risk right now.

Jenna Dagenhart:

Maulik, how about you?

Maulik Bhansali:

Yeah, I would agree with everything Nolan just said. Certainly, I've probably been a bit wrong thinking about when a recession could occur. I agree that it is ultimately likely to happen given what the Fed has done. But in looking at the data that we see, even if you look at the data that's most recently been released, everything seems to be outpacing expectations. Corporate earnings have been stronger than expected. There's really very, very little sign of a significant amount of weakness in the US economy.

Jenna Dagenhart:

Ray, how are you factoring in recession risks into your strategies?

Ray Kennedy:

We're having a slowdown. I think the only question is depth and length. Yesterday, I think it was KPMG announced a bunch of layoffs. And one of the reasons they cited is just a slowdown in business. And you look at that report, you look at a retail sales report. You look at basically all of the earnings we've seen this year, they're down. They're not down as badly as we thought. It's happening. It's just now the pace and the depth at which it's going to occur. That's part of what we have to navigate through. And that's why it gets tough on the rate side because we're all trained to think when you get an economic weakness, your job, the Fed, is to start cutting rates, bring the economy back in line, but the Fed doesn't have that room this time.

There's a scenario that says this could be a very challenging recession. There's also a scenario that says this could be rolling. Who knows? I think one thing we can't ignore is that something's happening and most likely, it's going to be later this year, early next year. The one silver lining in all this is it's a political year and we know the White House is going to do everything in their power to try to avoid the word recession. It may be out of their control, but we do know that typically in those situations, we tend to have policies that basically keep the economy at least on life support for a period of time.

Jenna Dagenhart:

All great points. And, Nolan, considering recent volatility and current base rates, are you finding opportunities in asset classes that are not relative to benchmarks such as the Bloomberg aggregate bond index?

Nolan Anderson:

Yes, the answer is yes. We've been writing about the challenges for looking return prospects for benchmark US AG allocators before and after COVID. The great thing about fixed income is it's just simple math, a lot of it is. And as yields decline significantly after COVID, we were starting to write that there's just a math problem for looking returns. In first context at its low point in the summer of 2020, the US AG, which is a portfolio of US treasuries, investment grade corporate bonds, and agency mortgages, it had a yield to worst of 1%, which is the all-time low for the index going back to the 1970s.

And at the same time, average maturities were increasing during that period because the government smartly, corporations smartly, and homeowners took advantage of those all-time low-interest rates. You had the lowest rates in the history of modern finance coupled with rising maturities. The result of that is significantly increased duration in interest rate risk. Given the significant drawdowns, the broad fixed income benchmarks experienced last year along with equities, we've seen more and more investors looking for complementary bond strategies, particularly inactive. And that really has bode well with the way we've managed our portfolios.

We find value at times in the sectors of the AG, but over the last decade-plus, we've really worked really hard to build the circle of competence within securitized products outside of those areas. And I think still to this day, the broadly securitized products suffer from the stigma of the GFC in the subprime mortgage sector and just the vast pain and suffering that put on the global financial system. And the reason why the opportunities exist today in a broad array of securitized products, ABS, CMBS, CLOs, is because of the lessons learned from issuers, investors, credit rating agencies.

And so, we take a measured approach to off-benchmark sectors. It's not the majority of our portfolios, but over long periods of time, we think that having exposures to, like I said, asset-backed securities, mortgage credit, CLOs and CMBS, add both diversification benefits at the portfolio level and allow you to pick up additional yield. Having said that, as these gentlemen know, just as well as I, it takes a lot of work. It's not easy. It's taken us 12, 13 years to get to where we are today, developing a base level of understanding and developing relationships with issuers, sponsors, banks, broker-dealers.

It takes a long time, but we think we've added a lot of value in our portfolios as a result. And we're fortunate enough to have exposures to floating rate securities as an example last year, which helped us obviously avoid some of the drawdowns that we saw on fixed-rate assets.

Jenna Dagenhart:

Maulik, how were you thinking about duration relative to the benchmark?

Maulik Bhansali:

Yeah, we don't take interest rate risk relative to the benchmark in our portfolios. We prefer to focus exclusively on generating performance through security selection. But that said, we do have a view. I think in the last couple of months, we've given back most of the rally we saw after the failure of Silicon Valley Bank. So, market pricing is now a little bit more consistent with what the Fed has been telling us they're likely to do. We are now at levels where we would be comfortable legging into a modest amount of duration risk relative to the benchmark.

As it relates to the yield curve, though, we had been quite negative on the frontend of the curve when the two-year got to something like 4%. And the recent selloff has made us neutral on the frontend with the twos tens curve inverted by about 100 basis points. But I think the other points have alluded to, we're in a slightly different cycle here, and we do think that that type of significant curve inversion can last for a lot longer than it has in the past. We're not in any rush to put on a steepener trade here. There will come a time to do that, but I think we can afford to be patient there.

I would say even fives thirties is a little bit more interesting to us as a steepener trade rather than twos tens at the moment.

Jenna Dagenhart:

And, Nolan, you manage Weitz's ultra-short government fund and short-duration income fund. What are you seeing on the short end of the curve?

Nolan Anderson:

We're seeing the highest yields we've seen in the last 15 to 20 years. I got a printout of the UST screen, Bloomberg screen right now with the one-year treasury around 4.35, and as Maulik mentioned, the two-year got to what we thought was an unattractive level of four. Well, it's back up to almost 4.75. Short duration, obviously, it's the highest part of the yield curve from a yield perspective. But going back to the theme of non-benchmark sectors, we canvas the whole asset-backed market, all of structured products, and while there is a liquidity premium or there is increased liquidity risk there relative to treasuries and mortgages and investment grade corporates.

Given the short maturity of these securities, we're talking one to two-year assets that are mostly amortizing, fully amortizing, meaning that every single month you're getting a portion of your principal back. We believe that offsets some of that liquidity risk as you amortize your bond and the cash comes back. You're taking liquidity risk off the table as your position de levers. And while we understand the appeal and ease of 5% cash, that's the highest level of cash we've seen going back to the great financial crisis.

We think that buying one to two-year high-quality single A to triple A securitized products in the, again 6%, 7%, 8% range is very rare to get that opportunity set. These are contractual yields. These are fixed rate, contractual yields that in high quality, being able to lock that return in for one to two years we think is extremely attractive relative to cash.

Jenna Dagenhart:

Yeah, very rare. As you mentioned, you might want to hold onto those printouts and show people in, say, 30 years from now, "Hey, remember when... Now, Ray, let's talk a little bit more about high-yield credit selection. What's your approach to this process?

Ray Kennedy:

We're a little bit different than a lot of other shops. We're an equity firm. We've been in value equity for almost 40 years, so we are using the same research platform to cover both high yield and equity. Since we're a value shop, we tend to get involved in higher-risk situations, which complement the fallen angel strategy that you tend to see in high yield. And we're also a small and mid-cap value investor. We basically took that research platform and carried it over into high yield. And so, our legs of investing in high yield are fallen angels and SMID. So, it's a slightly different approach about how to invest in the market. It's not a large business.

We've always said that we cannot do this in the 10 to 15 billion size, versus a lot of competitors out there in high yield tend to be, what I characterize as buying just the go-go market. And that tends to be very large number of names in the portfolio, maybe less credit intensive, more sector intensive in terms of your decision-making. So, it's a different approach. We're a US-centric. Our sweet spot is a 500 million size issuer that tends to be a boring industrial that if you can get security on it, that's even better. So, if things go bad, you can basically minimize the downside.

High yield's got of a weird dynamic going on right now because we have a low carry, I'd say by historical standards, maybe 6%, maybe gets up to 6.5%, but a yield to worst of 8.5 to nine. And what's the difference? It's the dollar price. And that's one of the powers of right now buying high yield, which is basically when you buy high yield, you make the assumption that your names, or some are going to go bad. But when you are starting at the average of 0.85 on a bond price, you are starting from a risk profile that reduces the downside risk. And so, that's the appeal of high yield right now, and I think that's where you're seeing investors go in.

Nolan makes a really good point about the frontend because that's where we would love to be able to buy a little bit more of what the MBS, CMBS-type stuff, that's not our game. So, we do invest in cash while we're looking for ideas. If you contrast this from two to three years ago, we were forced to put money to work because you were earning nothing on your cash. Today earning 5% lets you be more selective. And the three of us are collectively part of the problem, so to speak, in credit because we have an alternative to buy short in risk from the Fed, 5% type area. And so, we can take our time putting money to work.

In essence, we're constraining credit, versus during the go-gos of '21 and a little bit of '22. But getting to the core of the question, high yield has its place in portfolios. We think it's still an attractive time, but you've got to be cautious because we can all see this weakening, this slowdown coming. And so, it's hard for us to pound on the table and say, "Put all your chips out into high yield or really anything that's in that risk space." I think you might be better having a good allocation to the quality space.

Jenna Dagenhart:

To follow up on that, Ray, where do you see opportunities in high-yield credit right now?

Ray Kennedy:

A lot of it's in the carry. Typical high-yield portfolio has a duration of three and a half versus typical triple B corporate name could be closer to six, seven. You're taking less interest rate risk from that standpoint. It's hard to find individual sectors that are super-cheap at this point. Really the story is to avoid losses at this point in the cycle. We want to see more dispersion and pricing to create opportunities. You can get someone saying, "Oh, this real estate stuff looks really attractive that's coming into high yield." It's probably too early to start investing in that.

Right now you can be a little bit defensive, can pick up the carry. Maybe that sector might include energy for example because there's clearly some tailwinds. But again, we can see what happens in 2020 with that sector. Home builders, for example, are having a good time, much better than we ever would've expected, but that could be temporary, that could be only for a year or two. So, the story for high yield is build your carry, stay out of trouble.

Jenna Dagenhart:

Nolan, turning to you, are you currently seeing opportunities in high-yield credit?

Nolan Anderson:

Yeah. Just for context, we don't run high-yield funds. We allocate to high yield within our opportunistic buckets. So, our short-duration strategy has a 15% high yield capability and our Core Plus fund can invest up to 25% yield. It's not a plug-and-play type of investment approach to us. We view the high-yield market currently, fixed-rate high-yield market as it's just not a target-rich environment. There is some dispersion, there are some opportunities, but with the double B spreads, I just checked them this morning, double B spreads are 280 basis points. Broadly, that's just not that attractive to some of the other opportunities that we can invest in across a wider range of sectors and asset types.

But I would point out that there could be some spread, some areas of the market where the spread compensation already is at recessionary levels in pockets of travel and leisure, banking and consumer finance. But as Ray alluded to using real estate as an analogy, high yield is a lot about timing, and you could definitely make the argument that in those areas they're trading at wider spread levels because of the increasing probability of recession. You don't want to step in front of a freight train some of the time.

There are some idiosyncratic opportunities, but I think our high-yield exposure in our Core Plus fund today is less than 5% in the context of a 25% exposure. So, I think our actions would speak toward just not being that we don't view it as that attractive.

Jenna Dagenhart:

Yeah, definitely don't want to step in front of a freight train. Maulik, where are you finding the greatest value in fixed income today?

Maulik Bhansali:

Yeah, we're focused on investment grade, and Nolan mentioned how unattractive some of that looked a year or two ago. I think that script has definitely flipped with rates being where they are. What I would say is that not only are interest rates attractive from a long-term perspective across pretty much the whole yield curve from my perspective, but there's certain securities that are offering even better value on top of that. And to us, the best part is that you don't really have to sacrifice a ton of quality or liquidity to find this value like you would've had to do a couple of years ago.

One of our favorite spots right now is in financials, which are a big chunk of the investment-grade credit market. Banks have significantly underperformed since early 2022 first because the market had difficulty digesting and absorbing the amount of debt they issued last year. And, of course, more recently because of the worries about the banking sector in the wake of the regional bank crisis and the failure of Credit Suisse. We believe that the fundamentals of the banking sector are actually quite robust, especially for a senior bond-holder.

And in the vast majority of large and mid-sized banks, we think those fundamentals should hold up very well despite some of them having exposures to commercial real estate that are pretty significant. Valuations right now are very attractive. If you look at where banks are trading, they're trading at levels relative to other corporates that we haven't seen in maybe 10 years or more. They certainly seem to be priced for a recession whereas many of the industrials in other parts of the corporate market are not.

Another sector we find very attractive that I think Nolan mentioned is high-quality asset-backed securities. Here we can find solidly triple-A-rated securities backed by fundamentally strong collateral like prime auto loans or high FICO credit card receivables. And these are protected by very time-tested, robust structural features that were enhanced after the financial crisis. These two are trading at close to the cheapest levels they have since the financial crisis. And really that's because of the volatility and dislocation that's been created by the hiking cycle more so than any real fundamental concerns.

The same applies to the agency mortgage-backed sector, which is a large part of what we do. With the Fed now reducing its portfolio through its QT program and the FDIC is, in addition, selling bonds it took on with the bank resolutions, the sector has underperformed quite a bit. We're not ready to sound the all-clear on the entire sector because rate volatility is a negative for valuations there. But if you pick the right securities there with stable cash flows, you can get some exceptional value right now.

Nolan Anderson:

We would echo Maulik's comments around agency MBS. One of the things we pride ourselves on is not really focusing on the AG's allocation. We don't think of investing as overweight, underweight treasuries, overweight, underweight agency mortgages. That's agency mortgages in particular is an area since we launched our Core Plus fund almost 10 years ago now that we just have not seen a lot of value in in the last few months as the banks have stepped back. And as we've seen selling and these big bid lists come out from bank, we've really stepped up to buy agency mortgages in a way that we have not in a very, very long period of time.

Jenna Dagenhart:

And, Ray, how do you differentiate yourself versus your competitors?

Ray Kennedy:

A lot of it's on the strategy side, but as I mentioned, we have a different research platform than our competitors or research process. You see more and more firms adopting what I call this collective industry research or company research and applying it to different asset classes, whether it be global value equities, value equities, SMID, or even high yield. Obviously, it doesn't translate too much to rates business per se, which is typically would you see anything that's AG based. The other characteristic is, in terms of the strategy, focusing on the SMID, and that's really our differentiating factor, which is this space that tends to be under-traded, under-researched.

The street has pulled back from research substantially over the years, and the larger shops just don't tend to have either the depth or resources or maybe even the quality to focus on that under-covered space. The tradeoff, of course, is that you have to manage that with liquidity, and you also need to manage that in terms of firm size, be an employee-owned the way we are. We control our own destiny and our own growth, so we can manage through that.

Picking up in the SMID's space, you'd pick up about 125 to 150 basis points of additional carry. And hopefully, your underwriting is good enough that you don't pick up additional risk along with that. The other leg is our fallen angels. Unfortunately, there's not that much to do right now. I was hoping with this mini-banking crisis that we had in March that we might see a little bit, didn't really happen. A few names came into high yield, but some of them just passed right onto bankruptcy or default.

The story's still out on that to see how many potentially could come in. We saw during the GFC, a lot of financials come into high yield, and it's both good and bad. It's good for us because we have research coverage in that space because that's a core part of any of our portfolios, especially on the equity side. But the other side of it is, it's not well covered in high yield, so it's always a learning process as these names come in.

March was a really interesting period. The Credit Suisse was a shocker. It was a shocker. And we just don't know how many more of those type of scenarios are out there. It was very GFCesque, so to speak, a little bit scary there for a little bit for a few days while we were going to see whether there's going to be secondary effects from it. I wandered there a bit, but in terms of differentiating factor, it's really the SMID strategy, fallen angel strategy, and going back to core credit, which is my vintage and my team's vintage.

Jenna Dagenhart:

And I know we've covered a lot of ground today, but, Nolan, what would you say are some of the top themes to watch moving forward for fixed-income investors?

Nolan Anderson:

Yeah, we've talked a lot internally about... away from the fundamentals and the bottom-up work. On the macro side, we continue, I think the evolution of inflation, monetary policy, and the consumer. You have to keep in mind that the consumer is really what's holding the economy up still. And consumer spending represents about 70% of the US economy, so that's critically important to pay attention to. We are also keeping a close eye on the leveraged loan in private credit markets. That's an area that I did work before but really, really ramped up our coverage and getting familiar with the landscape.

And we think there could be opportunities that present themselves with, as Ray alluded to, these loan-only structures, interest coverage ratios are coming down. And we think there's potential pickup in defaults later this year into '24, and we think that could represent an opportunity for us to take advantage of in the future.

Jenna Dagenhart:

Maulik, anything you'd add?

Maulik Bhansali:

Yeah. Certainly, the trajectory of the labor market is key going forward and related to that, as Nolan mentioned, is the US consumer. We've definitely started to see some cracks from certain retailers and consumer goods companies where price elasticity has increased considerably. So, that's definitely something to watch going forward. Commercial real estate, of course, is something to watch going forward, but that will likely take a long time to play out. A longer-term theme I'd watch for is just US debt and deficit dynamics.

The current trajectory is unsustainable and either the balance between revenues and expenditures has to shift, which would have obvious implications for the economy, or we're looking at a lot of deficit financing that has the potential to crowd out private investment going forward.

Jenna Dagenhart:

In light of everything that we've discussed, I want to go around and hear your positioning for the remainder of 2023. Ray, do you want to kick us off?

Ray Kennedy:

Sure. This is a bond market. For the first time in many years, we can say we've got carry, we've got yield where we're supposed to be. I think the only question now, especially for my part of the bond market, which tends to be the riskier side, is timing and how do you enter it. But I think we're going to be higher for longer both from in terms of credit spreads and credit yields as well as treasuries. Our market is back, so to speak, so it feels good. And you can tell investors are really starting to look hard. As Nolan was saying, do you buy a CMBS at 6% for two-year risk?

Do you buy high yield at 9%, 10%? Versus three years ago this is a screaming buy, or do you go buy equities in a world where basically regulations are picking up. You have the overhang of debt across governments. Our job now at this point is to basically keep carry and do no harm, so to speak. Raise your quality, keep your duration in line. If the 10-year hit were hit four, 4.25, 4.5, we'd probably be buyers of it at that level. And we'll, what I characterize as keep cash available to take advantage of opportunities, especially in my market.

Jenna Dagenhart:

Nolan, I saw you nodding your head a bit there. The income is certainly back in fixed income as Ray was talking about.

Nolan Anderson:

Yeah, I think it's the first time in a long time where all the different flavors of fixed income have value. There's a good case to be made to hold some cash at 5%. There's a good case to be made for treasuries across different parts of the current, particularly recently as we've phased out some of the Fed cuts that were expected this year into next year. We think there's a place for agency mortgages today. We think there's certainly a place for high yield in select spots. In the coupon incomes, we can get in, and ABS right now are in the 6%, 7%, 8% range we think are extremely attractive.

We also don't think that having some amount of floating rate exposure is an awful decision given that there is a risk that we might be in a higher for longer environment. And you get the barbell of having some... you can buy some longer treasuries today at 4% or higher on the 20-year part of the curve. So, I think to have a well-diversified portfolio, mostly high quality, there hasn't been a better time to get some carry and diversification that we've seen in the last 10, 15 years.

Jenna Dagenhart:

Maulik, any final thoughts you'd like to leave with our viewers?

Maulik Bhansali:

Yeah, I'd echo what Nolan and Ray said. This is one of the most exciting times that I can remember as a fixed-income investor in my career. I'd say in terms of positioning, we've had more recently a pretty nice rally across risk assets. The market seems to be getting more comfortable with a soft landing scenario and in my mind a little bit complacent. In our view, we still have some potential bouts of volatility ahead of us within a more range-bound market and as such we've kept our overall risk posture reasonably defensive with plenty of dry powder to play offense if and when things get a bit hairier.

So, right now we're really squarely focused on finding value through security selection in high-quality liquid instruments rather than having large sector exposure. And as I mentioned earlier, we're in an environment in which there's plenty of opportunities to do so.

Jenna Dagenhart:

Well, everyone, thank you so much for joining us.

Nolan Anderson:

Thank you, Jenna.

Maulik Bhansali:

Thank you.

Ray Kennedy:

Yeah, thank you.

Jenna Dagenhart:

And thank you for watching this midyear outlook masterclass. Once again, I was joined by Nolan Anderson, co-head of Fixed Income and portfolio manager at Weitz Investment Management, Maulik Bhansali, senior portfolio manager and co-head of the Core Fixed Income team at Allspringing Global Investments, and Ray Kennedy, portfolio manager at Hotchkis & Wiley Capital Management. And I'm Jenna Dagenhart with Asset TV.