MASTERCLASS: Fixed Income

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  • 58 mins 13 secs
2022 kicked off with a lot of volatility. Now, with inflation continuing to tick higher and rate hikes on the horizon, fixed income investors share where they are finding the biggest challenges and opportunities. The panel also looks at different areas of the fixed income market and the role bonds play in a portfolio.
  • Janet Rilling, Senior Portfolio Manager and Head of Multi-Sector Plus and High Yield, Allspring Global Investments
  • Jason Callan, Senior Portfolio Manager, Head of Structured Assets, Head of Core and Core Plus, Columbia Threadneedle
  • Bryan Whalen, Co-CIO of Fixed Income, TCW
  • Chris Wilson, Senior Client Portfolio Manager, Fixed Income, Voya Investment Management
Channel: MASTERCLASS

Jenna Dagenhart: Hello and welcome to this Asset TV Fixed Income Masterclass. So far, 2022 has kicked off with its fair share of volatility. Now with inflation continuing to take higher and multiple rate hikes on the horizon, fixed income investors have much to think about moving forward.

Jenna Dagenhart: Joining us tonight to share where they see the biggest challenges and opportunities, we have Chris Wilson, senior client portfolio manager, fixed income at Voya Investment Management, Bryan Whalen, co-CIO of fixed income at TCW, Jason Callan, senior portfolio manager, head of structured Assets and head of Core and Core Plus at Columbia Threadneedle Investments, and Janet Rilling, senior portfolio manager and head of Multi-Sector Plus and High Yield at Allspring Global Investments.

Jenna Dagenhart: Well, everyone, thank you so much for joining us and being with us today. Janet, kicking off with you, could you give us a brief summary of where we are in the fixed income markets and how we got here?

Janet Rilling: Well, sure. I would characterize the current environment as being mid-cycle, but with some late cycle attributes. Starting from an economic standpoint, we've really seen a rapid and dramatic recovery from the COVID-induced recession. The recent growth figures have hit around 6% and unemployment has fallen to 4%, which is down from the peak of 14%.

Janet Rilling: This rapid recovery was really the result of three primary factors. There has been massive fiscal stimulus, exceptionally easy monetary policy, and we've been experiencing the release of pent-up demand that occurred due to the shutdowns related to COVID. So while those factors have been really helpful in restarting the economy, they've also led to what we're seeing as elevated and probably more importantly, worrying levels of inflation.

Janet Rilling: So that brings us to our current situation where the market, the Fed, the government and really almost every consumer is focused on the inflation levels. And that has led to a pretty rapid move up in rates and a flattening of the yield curve. Rates have responded and are pricing in inflation expectations and the Fed rate hikes that the market is expecting.

Janet Rilling: And then looking at the spread sectors, well, they still reflect a pretty strong economy. If you look on a historical basis, spreads are off their richest levels, but they're still on the more expensive side. So all in with these dynamics in place, I really think about this cycle as one that's likely to be more compressed with bigger moves and certainly we've already seen that. The expansion will likely be shorter as well than the one we experienced pre-COVID.

Jenna Dagenhart: Yeah, a lot to think about, and we'll have a lot to talk about today. Jason, 2022 has been anything but boring so far. How would you describe the current conditions?

Jason Callan: Yeah. As Janet mentioned, this cycle's all about compressed timelines, the exceptional levels of accommodation, both fiscal and monetary. The current environment is much more about repricing and starting to normalize policy. We're at an inflection point where starting the fall of last year, the Fed's been removing accommodation originally through the reduction of their balance sheet or reduction of quantitative easing, trying to tighten financial conditions.

Jason Callan: And you've seen a pretty rapid tightening of financial conditions, whether looking at nominal rates, real rates or credit spreads. And it's imperative to remind ourselves that monetary policy works with long and variable legs. That should both slow growth and inflation as we work our way through the rest of 2022.

Jason Callan: The million dollar question is just how aggressive does the Fed need to be to ultimately tame some of the inflationary impulses that the market's currently seeing? Expectations coming into the year were centered around two potential hikes. We've rapidly changed that backdrop to now the market, as of this morning, pricing in about six and a half hikes for this year alone with the expectation of introducing quantitative tightening where they reduce their balance sheet somewhere along the guidelines of potentially somewhere between $75 million and $90 billion per month.

Jason Callan: All that being said, we've had a pretty material level repricing and the markets in fixed income probably look much more fair and attractive as we go forward.

Jenna Dagenhart: And Bryan, rates are higher and the yield curve has been flattening. Is this typical? And what does that mean?

Bryan Whalen: Well, I wouldn't say a flat yield curve is typical, but it's also not unusual. I think what's really unusual about this period is how quickly the curve has flattened relative to when the Federal Reserve has started its hiking campaign.

Bryan Whalen: Typically, what you see is that wealth to about the halfway point of the hiking campaign or even near the end, you'll start to see the fives to 30 spread really start to flatten out. We're already down toward about 40, 45 basis points in terms of flattening.

Bryan Whalen:  Fed hasn't even started hiking yet. And so I think, what that's reflective of is a couple things. One, Janet and Jason both mentioned inflation, and it's just been inflation going from what had been subdued and quiet for literally decades to all of a sudden, exploding last year and well exceeding expectations.

Bryan Whalen: And basically, what the market's now pricing in is that the Fed is going to have to have a more aggressive manner, as Jason mentioned, going from two hikes to six hikes priced into the marketplace. But then what it's also implying is that once the Fed hits those brakes pretty hard, it'll tap down inflation, real growth will come down toward historical... recent historical averages, 1.5-2%.

Bryan Whalen: And the Fed won't have to do much more hiking beyond that. So that's what's different about this flattening credit yield curve.

Jenna Dagenhart: And Chris, I know I'm asking you to look into your crystal ball a little bit here, but how do you think the 10-year will finish 2022?

Chris Wilson: Yeah. So we're thinking that directionally, still a little bit higher in here. But we think that you'll begin to see more demand as you creep above that two and a quarter level in the second half of 2022. A couple of things in play here, with the Fed in action, hopefully, they'll be successful in taming inflation.

Chris Wilson: But you can already see the markets discounting the expectation for this shortened cycle as our panels have already acknowledged, and so the risk of maybe an easing in economic growth. A couple other kind of, I guess, technical factors in play that we think will draw in investors is first, an incredibly well-funded pension environment right now.

Chris Wilson: We're seeing a lot of corporate DB plans saying, "You know what? I don't care about valuations." They care about managing a liability. And so we're seeing that shift out of risk assets such as equity into fixed income to better align with that liability matching. And also amongst developed markets, the US, even though it's unpalatable to so many investors right now, we still boast the highest yields across most developed markets. And so we're seeing interest come in from overseas as treasury yields have marched higher.

Jenna Dagenhart: And default rates of corporate bonds have been very low recently. Bryan, how are those expected to change going forward?

Bryan Whalen: Well, I don't know if you always get panelists to agree on something, but I think they can all agree with this is that they're not going to go lower. It's pretty hard to get the default rates below zero, which is where they've been over the past 12 months. So we will all... I can guarantee we all agree that they're going to go higher.

Bryan Whalen: The question is just how much higher and what's the pace? And so what that comes down to is that we've got a fiscal withdrawal coming out of the economy. We have monetary policy tightening. And so the question is will the Fed in particular be able to create this kind of smooth landing from this high inflationary situation we're in right now?

Bryan Whalen: If they're able to do that, you'll probably see default rates trend back toward the 2-3% area, which is the historical norms. However, if the combination of the Fed going too aggressively, and also the economy maybe slowing down as that fiscal support is pulled out, you could see us enter, later this year, if not 2023, a recessionary environment. And that would cause default rates to spike up into the mid to upper single digits.

Jenna Dagenhart: Yeah. I have to say, Bryan, we haven't had any panels where everyone agrees on exactly everything, but I think we can all agree that rates are directionally going higher. Now, Janet, there were a variety of items and crosscurrents to navigate in 2021, inflation, as has been mentioned, the pandemic, supply chain, labor shortages, Fed actions, really, you name it. But how are these impacting fixed income markets in 2022?

Janet Rilling: Well, beginning with inflation, really the debate in 2021 was is it transitory or is it not? That certainly seems to be settled as of today. The market and the Fed view it as being more persistent. So the key question in 2022, as we see it, is can that inflation be contained?

Janet Rilling: We are of the view that it won't be a runaway inflation situation, but it does remain a continuing concern. The idea in our minds is that likely inflation will crust. And that will happen a little bit later this year. But we do expect it to remain elevated. We're not expecting to go below pre-COVID type levels of inflation.

Janet Rilling: I think we should all accept the fact that inflation's going to be higher than it was over the last decade. The next topic, the Fed, well, for its part in 2021, it was pretty happy to be behind the curve on tightening monetary policy, because it really didn't want to be responsible for choking off the recovery.

Janet Rilling: So in our view, they ignored some of the trouble signs of inflation during the year. Of course, in the fourth quarter and now here early in 2022, they've sharply adjusted their view. And this is what's been characterized as the hawkish pivot by the Fed.

Janet Rilling: They've started talking a more tough game and the actual act of removing some accommodation. What will be important is what true action still lies ahead of us, how much they're going to raise rates and then how will the market respond? And then lastly, in the pandemic and supply chain, we do expect continued dislocations.

Janet Rilling: But I always like to remind myself, the economy is not static and companies are pretty good at innovating and adjusting. Wherever possible, we'll see the substitution of technology for labor and we've already seen evidence of that, but all this takes time. So I think this is still something we'll be working through this year, but I think progress is being made.

Jenna Dagenhart: And certainly Chris, what do you think is the best way to navigate the current environment?

Chris Wilson: Yeah, well leapfrogging on Janet's comments, look, rate volatility, we would expect to remain elevated as well. And that being said, we think rate volatility will likely be more pronounced than credit volatility. And so we're still inclined to lean more into credit opportunities and steering a little more clear, playing more were defensively in some of the higher rated, more sensitive and, dare I say, the negatively complex contact sectors such as agency mortgages.

Chris Wilson: We think a good strategy in this type of environment... We all hear about the barbell and we immediately think yield curve. But a credit barbell, we think is quite sensible given this time going to the wings. So you're going to lean a little up in credit quality on one side, but then be willing to capture yield in some of these lower yielding segments, in part, supported by what we still think is a pretty good economic outlook for the US and for that matter, the global economy.

Jenna Dagenhart: Jason, turning to you, what's been your approach at Columbia?

Jason Callan: Yeah, similar to Chris's perspective. We think the inherent volatility in the market creates opportunity. It sounds cliché, but it's really about being flexible, both around interest rate risk management, as well as allocation to various kind of credit sectors in the market, not being tethered to a specific perspective, waiting until we get a greater degree of clarity around the tightening path from Fed policy, as well as some of the inflationary pressures and lean on areas that have really strong fundamentals.

Jason Callan: The corporate balance sheet's incredibly strong. As Bryan mentioned, the default rate environment is incredibly low. There's great opportunities in high quality, high yield that we see as catalyst-driven opportunities for upgrades, many fallen angels that have taken on too much debt pre-COVID and conversely, thinking about consumer based opportunities.

Jason Callan: The consumer's balance sheet is in an incredibly strong position. Most borrowers have been able to refinance their mortgage debt or debt in aggregate. And thinking about just the reasonable strength that we've had in the housing market over the last couple years, it's the two primary areas that we're focusing on.

Jenna Dagenhart:  Janet, back to you, given some of these recent crosscurrents that we've been discussing, what were the most important decisions that you made in portfolios last year to navigate these challenges?

Janet Rilling: I think there were really two key decisions. The first was duration. We took a short duration position as compared to our benchmark at the beginning of last year. And the premise here was we were in the midst of a pretty strong reopening. The economy and our expectations was going to be showing robust growth.

Janet Rilling: And then also, that inflation risk was underpriced. So given where we entered the year, where rates were, we just thought they were too low reflecting all of that. The second view we took was in the spread product area. We started the year with a sizable overweight to investment grade and high yield credit. And again, that was premised on the strength of the economy.

Janet Rilling:  But here, we weren't static in that position. Throughout the year, we were very sensitive to valuations. We saw credit spreads tighten as the year progressed. So that put us in a better place as we reduced throughout the first half of the year for when we did see some underperformance in the credit markets like investment grade credit that occurred over the last two quarters of the year.

Jenna Dagenhart: And Janet, you mentioned this at the beginning of the panel about employment is very strong right now. Bryan, the recent payroll numbers in the US were also very strong. What's the expectation for the labor market going forward? And what impact is that likely to have on inflation?

Bryan Whalen: Sure. Yeah. The labor market's incredibly strong and we expect it to continue like that at least for the first half of the year. The second half and 2023 will largely be determined by the factors we're talking about now, which is monetary tightening and fiscal withdrawal.

Bryan Whalen: I think when you talk about the labor market, you have to talk about the strength, the strength of labor. And I don't mean the unemployment rate. I mean the negotiating power. For such a long period of time, we had seen labor unions lose power relative to employers as they were able to expand margins.

Bryan Whalen: But we've entered a period now, whether you want to look at jobs to applicants, or whether you want to look at something like the quits rate, clearly and also labor participation is down. And what that's reflecting is that labor has the power. They have the negotiating power and you're seeing that come through in the wage data.

Bryan Whalen: And then I think you tie the labor conversation back to the inflation conversation and specifically inflation expectations. And that's the really hard thing for investors and all of us really to try to handicap and to quantify. It's just the psychology how is labor going to react? Are they going to demand cost of living adjustments in their contracts?

Bryan Whalen: And then that snowballs, and that's the hard thing for all of us including the Fed to try to really understand and quantify so they can properly apply the brakes on their policies.

Jenna Dagenhart: Yeah. And Jay Powell is very much aware of these very strong labor market numbers as well seeing that he brought it up in his last press conference. Now, let's talk about inflation. Chris, what's your outlook for inflation?

Chris Wilson: Before we go to the outlook, Jenna, I actually think it's appropriate for us for a candid reflection and perhaps the word transitory just needs to remain in the dustbin of 2021. Something that was far too excessively used, and as Janet mentioned earlier, just profoundly incorrect.

Chris Wilson: We are expecting to see evidence of a peak of inflation basically late the first half of 2022. There are certain contributions that are going to continue to lean upward to inflationary pressures. We've got the lagging effect of rents following home price appreciation, and that is going to continue to remain a source and a challenge for the Fed.

Chris Wilson: But we see other areas easing, so expecting a bit of a plateau and then a gentle slide back down. But again, as Jenna mentioned earlier, we think it will remain very much above the Fed's target for the calendar year 2022, and even in the first half of 2023.

Jenna Dagenhart: Yeah. Those are all great points. And perhaps that's a second thing we can all agree on, leaving the transitory line in the bin for 2021. Now, Jason, do you think that this 1980-style inflation will continue moving forward?

Jason Callan: Certainly not our expectation. We think there's a lot more exogenous and differentiated factors that are ultimately driving this. You can look at it through both the lens of the demand side and the supply side, as been previously mentioned. From the demand side, the shock of the response, about five trillion with fiscal stimulus.

Jason Callan: And then when you think about it through the wealth effects, we've had the equity market March towards all-time highs throughout the course of last year. And of equal, if not even more importance, is the level of home price appreciation that we've seen for homeowners in the market. Last year alone, properties appreciated by 20%.

Jason Callan: But if you looked at it relative to the start of COVID, you've had almost a 30% appreciation in home prices. That equates to about $7 trillion worth of additional wealth. That's ultimately impacted the US consumer and their willingness to spend. When we think about the supply side, clearly you had reopening shocks, airline fee prices, hotel prices, things of that nature.

Jason Callan: But the bigger story has been the movement from this transitory concern to just challenges around global supply chains and disjointed policies around COVID and various shutdowns throughout the world. Another perspective that we think is very thoughtful to think about is that this is an explicit outcome of the transition of monetary policy.

Jason Callan: They wanted to run the economy more hot, which is why they stayed as easy as long as they did both thinking about the policy around fate, so flexible, average and inflation targeting, as well as the concept of maximum employment, not full employment. Both lead you to a point where you run the economy hot, then inflation does remain a little bit more robust.

Jason Callan: As an offset to that, it means that you need to normalize policy a bit more aggressively. And that's what we're starting to see is priced into the markets. Another thing to consider from a Feds perspective is that they think about inflation expectations. And you can view that through two lenses. One is a market-based lens, looking at breakevens in the tips market.

Jason Callan: And if you looked at five-year forward, five-year breakevens, they're probably around 2%, 2.1% as of this morning. Pretty much in line with the Fed's expectations of where they should be over a longer-term period. Another is through the lens of the consumer. And earlier this week, we saw the New York Fed published their survey looking at consumer based expectations of both one-year forward and three-year forward inflation expectations.

Jason Callan: And what we saw is an actual March down. So for the first time probably in the last two years, we started to see some of those inflation expectations abate. One thing we have to keep in mind is inflation is about the rate of change. It's not necessarily about the level of prices and that the market is now starting to discount or starting to add in the fact that financial conditions are tightening, growth is going to slow. And some of these other issues should start to abate throughout the rest of 2022.

Jenna Dagenhart: And Bryan, turning to oil prices are at recent highs, do you have expectations for further increases in commodity prices which, of course, are a huge part of the inflation equation?

Bryan Whalen: Yeah. Look, in the short term, meaning days and weeks, the story about commodities is particularly about oil and that has everything to do with Ukraine and Russia and the situation going on there, the potentials to supply disruption we could see.

Bryan Whalen: I think over the shorter time or the one to three-month time horizon, the question on commodities comes back to inflation is particularly with regards to supply chains. What happens for you to be able to produce and harvest these materials and then shift them around the world?

Bryan Whalen: And over the long term, the question on commodities, it's this bigger question or it's tied directly to level of growth. Also, I think we should also recognize that it's somewhat self-monitoring in that at some point, this rise in commodity prices, particularly oil, eventually it acts as almost the tax on the consumer.

Bryan Whalen: And then that will effectively bring down consumer spending, which slows down the economy. And then finally too, weighing on that is how do the producers react when... And oil had spent the better part of the last year between $65 and $85. You saw OPEC, OPEC Plus act in a very disciplined way without turning on too much supply.

Bryan Whalen: But at $90 oil or higher, what we may start to see is the US to turn on the spigots again. You might see the Permian really start to increase production and that too should bring things down. So I think over the second half of the year, we would expect commodity prices to level out if not to slowly come back down.

Jenna Dagenhart: And Chris, what things are you keeping an eye on that could change your mind on inflation?

Chris Wilson:  A couple of things. First and foremost, there's been this just pronounced increase in goods consumption on behalf of the US consumer and services consumption has lagged, of course, as a result of COVID. We think that goods consumption remains at unsustainable levels. And so we're expecting that type of normalization.

Chris Wilson: Obviously, if that trend continues it just exacerbates some of those inflationary pressures that we've been witnessing and we're expecting to see abate. The second thing is we're looking for evidence of that handoff into CapEx and investment.

Chris Wilson:  We think actually, that one of the best resolutions is to see investment that can help address many of these price pressures, whether it be supply chain and supply-related or, for that matter, labor pressures that could possibly be offset with advances in worker-accompanied technologies.

Chris Wilson: So those are the things that we're really trying to figure and zero in on. The second... And then the last thing that we're keeping an eye on is how much excess savings is still left in that, in the pocketbooks of American consumers? Because obviously, the meaningful fiscal thrust that we saw helped maintain and even accelerate us in these consumption trends.

Chris Wilson: The fiscal stimulus is sunsetting. And so we are expecting, particularly amongst the lower quintiles of wage earners that we'll see that decline and, again, that moderation that we think can be supportive of that turn down in inflationary pressures.

Jenna Dagenhart: Janet, what do you think will be this year's biggest challenge? And do you expect any additional challenges?

Janet Rilling:  Well, I think listening to the panel today, it's pretty clear that the Fed is the big challenge and how they act with regard to inflation. So currently, the market is pricing in a pretty hawkish outlook, as already been reviewed here today. And so that's helpful that we have a lot already priced in.

Janet Rilling: But execution of tightening of monetary policy leaves us really in the situation that we could see a lot of uncertainty and increased volatility. And I think Chris mentioned that earlier as that part is a more difficult decision for investors. What to do about your duration, the volatility in the rates market is going to be elevated.

Janet Rilling:  I think looking for the second order effect, thinking about the implementation of Central Bank policies and its effect on the real economy is also a wild card that we all have to consider. Will we get a soft landing or will the economy slow too rapidly and the expansion gets choked off? So that's the question that impacts the credit markets more fully.

Janet Rilling:  In past cycles, it really wasn't rates per se that led to sell-off in the credit sectors, but rather when we had removal of accommodation. And then that triggered the slowdown in the economy. Well, credit investors took spreads wider to reflect the increase in top line pressures. So that's the second order effect that will likely come into more focus in the second part of this year.

Jenna Dagenhart:  Jason, I've seen you nodding your head some. Anything that you'd like to add about the challenges for fixed income investors in 2022?

Jason Callan: Yeah. It sounds like we share similar perspective. I think the big challenges at the moment, as Janet mentioned, uncertainty and volatility heavily induced by Fed policy. And we're just at a point where we don't have a great degree of clarity. The markets have repriced quite a bit. You have on one side of the spectrum, those like James Bullard that want to take a much more aggressive stance.

Jason Callan: You have many of the other Fed officials that want to be much more measured in their pace, not wanting to be too aggressive at a minimum from the rate side of things to completely flatten the curve in too aggressive of a manner. And the real challenge is just that monetary policy works with a lag.

Jason Callan: And so while we've seen financial conditions tighten quite a bit, it's going to take some time to want to see both inflation start to abate as well as growth start to slow, both of which we expect to happen. But again, we're just in this short-term period where it's going to take probably the next three to four months for us to get a greater degree clarity as to what the growth trajectory and inflation trajectory will be in the United States.

Jenna Dagenhart: And I know it's already come up several times, but let's really dive into Fed policy here. Bryan, with inflation running high, the Fed has changed its tune and clearly is on a path to higher rates. How is that process likely to go? And do you think that the Fed will have the courage to continue lifting rates due to high inflation? If equities are down, say, 30-plus%, what happens then?

Bryan Whalen:  Yeah. The question about the Fed, is in our opinion, where our conversation about investments has to start right now. I think what we're asking ourselves is, is this the Fed that we've all come to know and love over the past few decades? Meaning that they've had policy or they've had the luxury of managing monetary policy without having to worry about inflation because of the secular backdrop that's kept the lid on inflation.

Bryan Whalen: And so what they've been able to do is to target the economy through asset price appreciation, and that's benefited everybody who owns equities and owns... who owns stocks, who owns land. The question right now is that, is this the Fed that has to move inflation fighting up its priority chain? Meaning that historically, when financial conditions have tightened, at least over the last a couple decades, the Fed has been able to talk the market back down from its concerns.

Bryan Whalen: And it's been able to really manage financial conditions. But we may be entering a scenario here where the Fed may be okay with equities down 25% or 30%, or they may have to be okay with it because they're going to have to address inflation first and worry about asset prices second.

Chris Wilson: I think Bryan makes a great point about the situation of the Fed and the Fed's challenges today versus those of previous Fed regimes. And they're also leaning on policies that were born out of the financial crisis. And here I'm leaning more into the dot plot and other types of forward guidance, which is actually challenging them.

Chris Wilson: And so the Fed is no longer leading the market in our opinion, but rather responding to market expectations or even, dare I say, market demands. With each successive policy announcement that we've recently had with the Fed, they're simply coming up and meeting market expectations as opposed to blazing a new path.

Jenna Dagenhart: And Jason, given these likely scenarios for Fed rate hikes this year, what are some actions that investors should be taking?

Jason Callan: One is that given the market has repriced... To both Chris's comment as well as Bryan's, the market has led the way and repriced a significant amount of tightening. As mentioned prior, six and a half hikes are already priced into the markets. And so investors inherently should start to feel a little bit more comfortable with interest rate risk.

Jason Callan: We went from a period where we had excessively low negative real rates, as low as about 120 basis points on the tenure. We've seen about a 70 basis point repricing. That's very significant and it's happened in a very, very quick manner. It's led to quite a degree of tightening of financial conditions.

Jason Callan: And we've done a 180 from monetary policy from... And the irony, I guess, at the moment is that we're still actually buying or the Fed is still buying assets on their balance sheet both in terms of us treasuries and agency mortgages. And we're less than or we're about a month away from the expectation of starting the hiking cycle.

Jason Callan: It's something where we're just not going to have a great degree of clarity. The Fed has tried to communicate, and this is what makes this policy very different of the last 20-plus years versus maybe the Greenspan era, is trying to provide much greater degree of transparency around not wanting to be overly disruptive to markets.

Jason Callan: And we do think that that impetus will still be here, but it's centered around the willingness of inflation to start to abate. That ultimately will maybe dampen down some of the aggressive nature that's priced into monetary policy at the moment. But we're still at a point that it's a little bit too early to get overly comfortable with that expectation.

Jenna Dagenhart: Janet, how are you managing interest rate exposure?

Janet Rilling: Well, let me first start by looking backward a bit to put things in context for today. So throughout 2021, I mentioned earlier, we were positioned with a shorter duration posture relative to our benchmark. Think of that as more of a strategic decision, we had that positioning on throughout the year. There were certainly times that worked better than others.

Janet Rilling: But the general trend for the year made that a good position to be in. And again, really the factors there were the market, in our opinion, was not properly pricing in inflation risk or the strong growth that we were expecting out of the economy. The other position we took last year was owning a partial allocation in tips instead of nominal treasuries.

Janet Rilling: So now if you fast forward today, and you look around, inflation is certainly on every investor's mind. And Jason has pointed out that the markets have really reflected all of this current information. So to us, that means that the market view and our view are much more closely aligned. And so we think to be successful in 2022, we're just going to have to be more tactical.

Janet Rilling: So we started out the year with a more modest, short duration position, but have been moving it around more frequently rather than that strategic position that we had on in 2021. We also no longer own tips as we think they've gotten too expensive. They're really reflecting the market condition. So I guess in summary, we've actually moved to a more neutral position with the idea that we'll take tactical moves away from the neutral position rather than being more strategic due to all the uncertainty.

Jenna Dagenhart: We've seen a lot of attention shifting from QE to QT. Chris, what are your thoughts on QT or quantitative tightening?

Chris Wilson:  Yeah. So look, just with regard to the timeframe and the pace, our opinion is there is no reason to not take the Fed at its word for the direction and the pace that they're looking to share with the market. At the same time, we think history has a limited guide. We've only gone through a QE, QT wait once before.

Chris Wilson: And we think that the last time the Fed was trying to reduce the size of the balance sheet, it offers really limited clues. And in part, inflation was well below the Fed's targets and not an issue in their mind. And growth was also pretty darn tepid back in that previous regime. And so we think that it is necessary to go ahead and contain some of this liquidity draw from it.

Chris Wilson:  And historically, pulling liquidity from the market will always create, we think, some challenges across fixed income sectors. There's going to be some crowding-out effects and investors are going to be demanding more yield. At the same time, we think that this is where there's probably as much on the idiosyncratic or security selection side that can still be harvested across the market versus saying positioning in some of the sector allocations in the market today.

Bryan Whalen: Yeah. Agency MBS, it's the asset class everybody loves to hate right now, which means as a value investor, you'll probably start to... supposed to like it a little bit. And so warning, we're going to get a little nerdy here with the bond lingo.

Bryan Whalen: But basically, everyone loves to hate it right now because the Fed's slowing down their purchases and there's conversations going on about they might actually start to sell it. And so it's a supply concern. And that's one aspect and certainly, that would warrant a more cautious outlook.

Bryan Whalen: However, on the fundamental side, the other reason you might be concerned about agency mortgages is because their cash flows move around and that's based upon how borrowers decide to prepay or not prepay. Well, the good news is for agency mortgages right now, is that expectations or their cash flow is as long as they're going to get, meaning that prepay expectations are very down, so your cash flows have been pushed out.

Bryan Whalen: And so the possibility of going even further out the curve is minimal. And so from a fundamental perspective at the spreads, what you're being compensated right now in agency mortgages, they look quite attractive. And so the final thought would be they look attractive, but you should exercise a little bit of caution because if the Fed does get aggressive with the QT later this year, it will probably be agency mortgages they look to sell, which will cause some near-term pressure.

Bryan Whalen: But overall, from a long-term perspective, this is a point in time. You'll probably start to... You should start to step into the agency mortgage market.

Jenna Dagenhart: And Bryan, don't worry. I know the financial advisors out there watching love the nerdy bond lingo. So feel free to keep that going. Now, Janet, with rising rates, is now a time to move to a more passive approach to fixed income?

Janet Rilling: Well, I would definitely say no, really quite the opposite. Broadly speaking, I have to say though I'm a strong believer that active management and fixed income can really add value in any environment. But I think today, that's even more the case. If you look at the Bloomberg aggregate, for example, so that's the broad market index for the fixed income markets, it's extended to near its peak in duration terms.

Janet Rilling: And it's done that while providing the yield that's below the average of the last 20 years. So why would you as an investor want to just passively accept that change in the market construction? If you use an active approach, you can rotate out of the more rate-sensitive areas. And certainly with all the ground we've covered today, that seems like a better approach, can also, in an active approach, diversify your sources of yield.

Janet Rilling: So you can favor spread sectors, those things that maybe are out of benchmark like US high yield. You can also go outside of the US to add diversification and a bit of a different return stream. The other thing I'd say is when I look at where valuations are in many of the sector, they're still pretty full. We wouldn't consider them cheap. So we would like to be tactical in terms of our approach, rotate exposures, not just beholden to a pre-described weight.

Janet Rilling: That is what the benchmark effectively does. And then I think a last but pretty important point is active management means that you can also use security selection to do better than what the benchmark is doing. So for us, that's a lever we rely on pretty heavily. We have a strong research team that's really good at picking credits. They can look for ways to exploit mispricings, which do happen at times, or just plainly finding good value for the risk that we're taking in the portfolio.

Jenna Dagenhart: Jason, are there any areas that stand out to you in this rising rate environment?

Jason Callan: Yeah. To piggyback on some of the comments already, I mean, I do think that we are a bit more mid-cycle as the Fed tries to normalize policy. And we have had a lot of repricing both in terms of credit spreads, as well as just interest rates in general.

Jason Callan: And so there's been a lot of differentiation between those that are interest rate-sensitive on a year-to-date basis, areas like bank loans and CLOs have done incredibly well versus anything that carries a greater degree of interest rate sensitivity has really been... has really repriced.

Jason Callan: And you have negative absolute returns across the board. But when we think about where we are from an economic cycle, the areas that we find are most attractive is moving away from some of the benchmark-based assets, particularly agg-based assets that are higher quality and very interest rate-sensitive per se to other areas that offer a little bit more risk premium, high quality, high yield, looking at double Bs in particular.

Jason Callan: Spreads have repriced by about 55 to 60 bases points. We think that's quite meaningful, and many of these assets or many of these companies have done quite well, very strong earnings are de-leveraging their balance sheets. There's a lot of catalysts who believe in various sectors as to why they'll get upgraded.

Jason Callan: And as they get upgraded, those spreads will ultimately compress as they go back above that Mendoza Line back into a triple B type quality asset. And the other is thinking about opportunities and non-agency mortgages, so benefiting or investing on the backs of the US consumer. We've talked about just the strength of the balance sheet of the US consumer.

Jason Callan: Obviously, the income statements are in a strong position. As Bryan had mentioned earlier, there's a lot of pricing power in terms of the wage increases we've seen there. But when you think about borrowers progressively financing their debt load, the Fed produces a measure which is referred to as the financial obligations ratio.

Jason Callan: So how much of their income has to go to service their debt on a monthly basis? The Fed's been documenting this going back to like 1982, and it's effectively the lowest it's ever been. And why that is is just 70% of the consumer debt load is mortgage-related debt.

Jason Callan: And we've lived through this period where the available mortgage rate has been incredibly low, anywhere from 2.5% all the way up to 3% for a persistent period of time with very easy access to credit. And we think against that backdrop, the housing market, while home prices should continue to slow on a go forward basis, will still benefit from a lack of investment in the single family development side of the markets, really strong demographics as people flee urban centers into suburban centers.

Jason Callan: And while affordability is a little bit tighter in the current environment with the degree of home price appreciation, we do think over time that that starts to normalize and it still makes an environment where housing should continue to be quite attractive and see just a more modest level of appreciation in the home price market.

Jenna Dagenhart: Chris, where are you finding the best opportunities?

Chris Wilson: So we continue to prefer opportunities where you can get yield with some structure. And so there, we're going to be referencing things like investment grade CLOs, as well as across the asset-backed market, but not the asset backs that people typically spring to mind when you mention that part of the market.

Chris Wilson: So it's not necessarily autos and credit cards, but rather whole business franchise, solar opportunities and student loan, refinancing, not the government programs, but in the refin market. We continue to see plenty of opportunities there. Something that we're keeping an eye on, but a little gun-shy to wade into just yet is in the emerging market space.

Chris Wilson: So EM tends to struggle in these transitionary periods as global developed central banks move from accommodative to tightening in their overall stances. And so we want to see more of an equilibrium and stabilization in the US rate structure before seeking opportunities more broadly across the emerging market space.

Jenna Dagenhart: Bryan, this year with some recent volatility, is there any increased opportunity in the corporate and/or securitized sectors?

Bryan Whalen: It's starting to be. Chris used the word idiosyncratic before and it kind of... It made me think about 2021 opportunity set, which in the corporate bond market, there wasn't a lot. And meaning everything was fairly tight, spreads were tight.

Bryan Whalen: There wasn't a lot of dispersion, which was odd because even though we had a strong recovery, it was happening, a lot of volatility about where. Different sectors of the economy were performing very differently. Some were very strong, some were very weak. But when you looked at the bond market, everything was priced basically for the same scenario, which was not reflective of reality.

Bryan Whalen: And so we used to say that you think about the opportunity set as a tree, well, not a lot of fruit on the tree of corporate bond market, particularly investment grade. Securitized though, absolutely. I mean, I think it's the crosscurrents in the economy over the past two years combined with some very creative people in capital markets and wall street created some interesting things in the securitized market.

Bryan Whalen: The commercial mortgage-backed securities market, that used to be one where you just buy the conduit CMBS bonds, right? And it was 200, 300 loans, very granular. Well, due to the changes in the economy, what we've seen is investors want to take a single threaded approach on their commercial real estate research and get exposure to the specific properties that they like or dislike.

Bryan Whalen: And because some properties may be in industries or geographic locations that aren't doing well, it creates those opportunities. And so we've seen them in the commercial real estate market. We've seen, as we mentioned, the non-agency mortgage-backed securities market. Well, that used to be one where you just talk about the legacy market. All [inaudible 00:42:26] were created before the financial crisis.

Bryan Whalen: And they've just been a melting ice cube for the better part of a decade as they get smaller and smaller and smaller in size. Well, a few years ago, we start to see that plateau. Even though the legacy market's going down, what has been created now is this new issue market. And so we see things like good old jumbo bars, very large loans to pristine bars.

Bryan Whalen: We've seen the issuance of that pick up. We've seen Fannie Mae and Freddie Mac start to sell the credit risk in their portfolios with the CRT, the credit risk transfer bonds. That's created an opportunity set. And we've seen a securitization of non-performing and reperforming loans and in various types of packages.

Bryan Whalen: So if you think about the securitized tree, there's been more fruit on that tree over the past 12 months. And it's where we've tend to shifted our allocation. Although just in the last few weeks, due to the volatility cost by the rate markets, we've started to see some things pop up in the corporate bond markets, some opportunities that we hadn't seen in a while.

Jenna Dagenhart: To quickly follow up on that, Bryan, are there any particular sectors in the corporate investment grade market that look interesting? And what about high yield?

Bryan Whalen:  Yeah. Well, in the corporate bond market, what's interesting, first and foremost banks look the most interesting to us. They have lots of liquidity. They have de-levered balance sheets. And the reason they look interesting is they've had so much supply. And so that supply pressure has weighed on the spread. And so relative to other opportunities in the investment grade market, they look interesting. There's some very interesting opportunities in the telecom space on the companies that are producing a lot of cash flow and will be able to de-lever their balance sheet over time.

Bryan Whalen: Then maybe finally in investment grade corporates, aircraft lessors. It's an industry that just demonstrated that they can bend, but not break given everything they went through in the early stages of the pandemic, and their bonds trade relatively cheap. At high yield, you mentioned even though we've seen volatility, particularly in the rate space, and we've seen some winding and spreads, what we haven't seen yet is what we call decompression in the high yield market.

Bryan Whalen:  So we haven't seen the lower part... lower quality parts of the high yield market underperform. What we've seen is the higher quality parts, which you should know, to nobody's surprise, also has the most duration, that's been the part of the high yield market that's underperformed, and that's where we've been targeting our dollars now because it's high quality and it's also liquid, with the plan that if this volatility persists eventually, the lower quality parts of high yield like triple Cs will eventually start to decompress.

Bryan Whalen: Their spreads will really start to widen. And that's when you want to rotate down the capital structure into lower parts of the... lower quality parts of that market.

Jenna Dagenhart:  And Chris and Jason, I've seen some heads nodding here. Do either of you want to jump in?

Jason Callan: Oh, sorry, Chris. I'm going to share some more perspectives. Haven't seen that differentiation amongst the different ratings within the high yield space. And to Bryan's point, it tells a story that it's more investor concern around duration and exposure to interest rate risk management more than it is expectations of a increase in the default cycle, which is why triple Cs have done just as well as they have in the current environment.

Jason Callan: As well as the evolution of the securitized product market, it's really been something where all these different segments of the market have evolved post-financial crisis that create more unique one-off opportunities where, if you have the research capabilities, many of these assets offer really attractive risk premiums and probably have a lot of structure behind them in terms of just shorter, more stable cash flows that provided better risk-adjusted return to our investors.

Jenna Dagenhart: And Janet, in your opinion, how should asset allocators think about their bond allocation versus other asset classes?

Janet Rilling: Well, that's a very big and, I'd say, hotly debated topic these days. But I think if I put it simply, we really still believe in the usefulness of bonds and a broad portfolio. To us, fixed income still provides diversification for the investor.

Janet Rilling:  You think about times of extreme stress, it's comforting to have some exposure to rates. I know in the current environment, people haven't been real happy with their fixed income allocation. But we would expect if there is a big risk off, that we would again see a flight to safety.

Janet Rilling: And I think another point that sometimes gets glossed over is that the expectations around the Fed rates, inflation, those aren't just fixed income market impacts. Equity markets, the multiples there also have and will adjust to those dynamics. So I just come back to the goal is to structure a well-diversified fixed income allocation with additional sources of yield.

Janet Rilling:  With that type of structure, an individual investor's portfolio or even a corporate portfolio will benefit from having better risk-adjusted returns by having that diversified and broader allocation.

Jenna Dagenhart:  And Chris, how do you think advisors should be talking with their clients right now about adding fixed income to the portfolio or where it fits within the portfolio?

Chris Wilson: I mean, despite the challenges, that's not an excuse to abandon the asset class. And the idea of a momentum strategy, which has been clearly demonstrated as incredibly successful in the equity markets, not a winning strategy in fixed income.

Chris Wilson:  And so rather than abandoning, it comes back to just the basic question of would buy your fixed income portfolio today. And for most investors, the answer's no. The outlook has drastically changed, people's opinions about where the Fed might be going have changed.

Chris Wilson:  And so it requires some tweaks in the portfolio, but not a completely, "Well, let's just toss it out." Reflecting on Bryan's comments earlier in agency mortgages, we are defensive. So we're underweight versus the agg, but are we zero? No. There are always going to be opportunities across the agency mortgage market. But at the margin, we're finding some better opportunities elsewhere.

Chris Wilson: I think one of the frameworks that we've shared, particularly with financial advisors is think about creating a home base portfolio, and it can be creative indices for that matter. But all things being equal, what is home base? And candidly, it's not the agg. Having been in fixed income now for over three decades, I've yet to engage with a financial advisor.

Chris Wilson: Well, that's not true. Two financial advisors in 30 years have been overweight duration versus the agg. But instead, maybe aligning duration with your investment horizon, three to five years. Or for that matter, just reflecting on broad investments across the market.

Chris Wilson: We did this awesome study, looked at all the taxable fixed income investments, excluding money markets, and the duration was about four years. And so, by the way, that's aligned with that three to five-year target. I'm not telling you, "Oh, so that means Core Plus and Core bond strategies are out of favor." Hardly.

Chris Wilson: You're going to keep them, but compliment them with things that you also have in your portfolio, short-term bonds. As Janet mentioned, going internationally, seeking out some of those tactical opportunities, floating rate if you're truly that concerned about the Fed. But to completely run away, we think is at an inopportune moment.

Chris Wilson: And time and time again, throughout COVID, geopolitics and every other crisis, the US treasury market remains the world's preferred risk-free asset. You want some of that in your portfolio for diversification.

Jenna Dagenhart: Jason, why should investors consider off-benchmark, non-traditional approaches to fixed income?

Jason Callan: It all boils down to active management. And similar to what Chris had mentioned about the poor nature of some of the benchmarks, and just thinking about how poorly constructed many of the fixed income benchmarks are, they tend to be very concentrated in one specific risk.

Jason Callan: And focusing on nontraditional opportunities gives you the ability to manage that risk and not be tethered to a certain risk profile at all times. If we think about the agg as an example, if you decompose the risk 97% of its returns in a given calendar year, just simply going to be changes in treasury yields.

Jason Callan: It's such a high quality, long duration benchmark. It's broadly a third, a third, a third between US treasuries, agency mortgages and investment grade credit. And the investment grade credit profile has extended quite a bit over the last decade or so.

Jason Callan: Conversely, if you look at something like a high yield benchmark, it tends to have 90-plus% of its returns driven by changes in credit spreads, not driven by changes in treasury yields. And so having the ability to be much more flexible, dynamic, and ultimately balance out those risks based on where we are in a market environment, as well as how well we're being compensated for each of those two kind of risk factors we think will ultimately provide a much more beneficial, stable investment outcome.

Jenna Dagenhart: Tying everything together, Janet, as we think about 2022 with expectations of rising rates, what's a fixed income investor supposed to do? Is there a way to actively manage the risk?

Janet Rilling: Well, let's start with the good news. And that is that yields are beginning to rise. And while that creates pain in the short term, it does mean that savers can reinvest at higher yields. And for all of us who hope to retire someday, higher yields are a good thing.

Janet Rilling: But I would acknowledge still on a historical basis, yields are not particularly high and sourcing some of that additional yield can be a challenge. So going back to what many of us have talked about here today, the active approach where you can really choose from a wide range of fixed income sectors and not be so tethered to the agg, I think that's been a really common theme here today.

Janet Rilling: For us in the core part of our portfolio, we have been tilting allocation to sectors with more yield. So Bryan touched on structured product. We share some of those same views. So if you do your homework there, there's some good value tied to the consumer, which is really a strong part of economic story right now.

Janet Rilling: In the investment grade credit market, favoring triple BS with the yield pickup there I think is attractive. And then going more broadly, again, outside of the core sectors, things like US high yield, European high yield, and investment grade, those allocations, at times, can act differently than US. So you get some diversification.

Janet Rilling: And then lastly, emerging markets, we have some allocation in emerging markets. I would say it's pretty modest at this point. And Jason has made some comments that patience might be warranted for EM, and that's exactly been our approach. We're being patient. But we think there could be some opportunity there in the more intermediate term. And with EM, you get a lower, correlated yield profile. So to us, that all adds up to a better way to manage risk in a portfolio.

Jenna Dagenhart: Janet, to quickly follow up on that, you mentioned allocations to credit. Can you be a bit more specific about the benefits that credit adds to a portfolio and how your strategies use credit to capture those benefits?

Janet Rilling: So certainly, the first attribute is yield. Higher yield comes from credit than something like the rates or the high quality government sector. But then a point I made earlier, individual security selection is a place where you can get some value when you are picking securities in the credit space.

Janet Rilling: And then going down on equality, if you are able to do good research and pick the winners, adding high yield and finding some individual outperformers is a way that you can really benefit by that allocation. And thinking specifically about US high yield, we've been here also a bit patient. I know others have talked about adding with the recent backup.

Janet Rilling: Our expectations are spreads have some room to move wider. So we are holding steady here, but that's not to say we don't own any high yield. We just have a more modest allocation currently. We still like having some allocation because we are mid-cycle as I said at the outset.

Janet Rilling: And the strong credit fundamentals and pretty low default rates are reasons to support that position. But we'll watch, and with the volatility that we do expect, we think there'll be an opportunity to add to this part of the portfolio.

Jenna Dagenhart: And looking to the rest of 2022 and beyond, Bryan, do you expect consumer strength to continue or will there be some deterioration as fiscal stimulus fades? And what impact might that have on the economy and Fed actions down the road?

Bryan Whalen: Sure. Jason earlier talked about the financial obligations ratio, and that touches on how we're thinking about the consumer right now, and which is their ability to service the debt versus their willingness to spend. And so our view is if we think about the consumer almost as a company, what we would say is like, "We like the debt. We don't like the equity," meaning that they've had strong nominal wage growth.

Bryan Whalen: Chris mentioned savings earlier to question how much is there. But nonetheless, in the current situation, the consumer looks very strong. And so their ability to service their debt, the outright level, as well as the cost to service that, meaning the interest, is relatively low. So exposure to things like non-agency mortgages and parts of the asset market make sense to us.

Bryan Whalen: However, their willingness to spend, and we said nominal wage growth is stronger, real wage growth is actually negative. And the consumer, they're watching everything going on. The access to the information is stronger than it's ever been. And so as we move into this tightening phase of monetary policy, and as these trillions of dollars of fiscal stimulus comes out of the system, the fiscal impulse being negative now in 2022, what I think you'll probably see is the consumer to be a little more cautious than what we saw over 2021.

Jenna Dagenhart: Well, everyone, thank you so much for joining us. Great to have you with us.

Bryan Whalen: Thank you very much.

Jason Callan: Thank you, Jenna.

Chris Wilson: Thank you.

Janet Rilling: Thanks, Jenna, really enjoyed the conversation.

Jenna Dagenhart: Really enjoyed it as well. And thank you to everyone watching this Fixed Income Masterclass. Once again, I was joined by Chris Wilson, senior client portfolio manager, fixed income at Voya Investment Management, Bryan Whalen, co-CIO of fixed income at TCW, Jason Callan, senior portfolio manager, head of structured assets, head of Core and Core Plus at Columbia Threadneedle, and Janet Rilling, senior portfolio manager and head of Multi-Sector Plus and High Yield at Allspring Global Investments. I'm Jenna Dagenhart with Asset TV.

 

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