MASTERCLASS: Fixed Income - February 2021

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  • 55 mins 55 secs
Given all the expansionary monetary policy from the Fed, bond investors are being forced to get creative to find yield in this low interest rate environment. This panel explores corporate fundamentals, value opportunities across different credit sectors, and various investment risks, including inflation.

  • Brian Resnick, CFA®, Director, Senior Investment Strategist, AllianceBernstein
  • Maria Giraldo, Managing Director of Macroeconomic and Investment Research, Guggenheim Partners

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MASTERCLASS

Jenna Dagenhart: Hello, and welcome to Asset TV's Fixed Income Masterclass. We'll cover corporate fundamentals, where to find yield in this low interest rate environment, inflation and much more. Joining us now to share their outlooks, we have Maria Giraldo, Managing Director of Macroeconomic and Investment Research at Guggenheim Partners, and Brian Resnick, Director and Senior Investment Strategist at AllianceBernstein. Brian, starting with you, and setting the scene here, how would you summarize the current fixed income landscape?

Brian Resnick: Great, thank you. Thank you for having me today. And thank you for that question. We think it's a very difficult environment for all investors, but specifically for fixed income investors. And that's because the initial conditions are really challenging, we have very tight spreads and low rates. So, you have to be very careful to get both the macro and the fundamental correct in this environment.

From our perspective, we expect that the economy will be sluggish over the next five months or so. But in the back half of this year and into next year, as economies reopen, as we get wide dissemination of the vaccine, we expect there to be very strong growth. And that's predicated, of course on very strong fiscal and monetary tailwinds and just a general buildup of demand.

And so, as demand is released in the second half of this year, again, we expect really strong growth, especially in the US where we're about to get another large fiscal package. What does this mean for fixed income investors? Well, it means a couple of things. First of all, we expect that yield curves will begin to steep in. Most central banks are pretty anchored on the front end.

But we do expect upward pressure on rates. Now, that's going to be more so in the US than elsewhere, because we don't have explicit yield curve controls, and we're probably going to get stronger growth. Nonetheless, we do still want to own US duration in the context of fixed income portfolios. Because at the end of the day, we own duration, we own high quality bonds.

In case a risk off scenario should arise, and we get the rest of our portfolio selling off, your likelihood is that you're going to get more countercyclical benefit from owning US duration as opposed to non-US duration. But we would say that porting some of your US high quality bonds over to other areas like Europe does make sense because there, they do have explicit yield curve controls.

And you're likely to get less in the way of curve steepening. However, you also get less in the way of yield, and less in the way of downside protection. One of the things you can do to mitigate that is to hedge the currency back to the US dollar. We do think the US dollar is going to be strong to some degree relative to other developed market currencies.

And so, by hedging back, you take advantage of that currency view, but you also add carry to those bonds. So, we'd be underweight for the duration, porting some of it outside of the US because we do expect a rising rate environment. Because we do expect reflation, because we do expect growth, we would be leaning more heavily into credit sectors, and that is on the margin.

The reason I say that is because we have high conviction that we're going to have growth, but valuations are very stretched. So, you have to be very careful about how you approach credit markets. And you have to look for areas that still have value. At AB, we still find value in a few specific areas, some of the more diversified areas of credit, namely emerging market debt, and hard currency debt specifically.

We think that a reopening of the global economy will be a tailwind for fundamentals in emerging markets. And we actually think that while the dollar strengthens versus developed economy currencies, emerging market currencies should appreciate relative to the dollar, making servicing dollar debt easier. So, EM dollar debt is a high conviction area for us.

We also like securitization, we still think there's some interesting areas that are leveraged to the consumer and to housing, specifically CRTs. And then, within more traditional credit, we would emphasize that there's more value to be had, in some of the cyclical names and some of the areas that have been harder hit by COVID. And so, you do have to be, again, mindful of fundamentals.

But we think a lot of these areas do quite well as economies reopen. And we think there's still value there. And then, finally, we think a very interesting play is in higher quality, high yield right now. We see ratings migration already beginning to happen. And we think that continues. And so, there's a lot of opportunities there as well.

But the big picture is that it's going to be very difficult for investors to navigate, given the starting point. You have to be very mindful not to lean too far into credit, even though we do believe in a pro-cyclical environment. So, you have to be very, very careful about how you allocate your credit, and how you balance that against duration.

Jenna Dagenhart: Well, thank you for that overview, and we'll be sure to dive into some of those topics more throughout the panel. Maria, tell us about some of your top-down views that could have a big impact on bond investors.

Maria Giraldo: Sure. Yeah. I would definitely agree and echo a lot of the comments that Brian gave. My team is expecting about 6% real GDP growth for the United States this year in 2021. That would be the strongest growth that we have had on a year-over-year basis since the 1980s, since about 1984, to be exact. And that's largely predicated on the amount of stimulus that we have received.

I'm sure fixed income investors, I'm sure investors in general are maybe a little bit tired of the word stimulus. But that's really the theme for 2020 and 2021, aside from the pandemic. And if you think about, if you contextualize how much stimulus we've gotten, in the year surrounding the financial crisis from 2008, all the way until 2012, let's say, until the economy reached that escape velocity, we got about three 2.5%, 3% of stimulus when you measure that as a share of GDP.

In 2020 to 2021, already, we've had about 8% of aid, when you measure that relative to growth, and there's more coming. So, that is, the reason why that's such a central theme, just the amount of assistance that we've gotten from policymakers, not just on the fiscal side, really is driving a lot of the growth that we're expecting for this year.

And that's not just we haven't just gotten into fiscal aid, of course, we've had a very accommodative Federal Reserve last year, who not only cut interest rates in 2020 down to zero again, but also relaunched quantitative easing. So, they're steadily buying assets, treasuries, and agency mortgage-backed securities, effectively removing duration from the market so that investors have to go somewhere else to find yield.

And on top of that, in 2020, for the first time ever, they announced several facilities to buy things like corporate bonds and munis. And so, this has also significantly added to a lot of liquidity that is currently in the system. And it's not just, of course, liquidity driven, we also now have, as we have vaccinations starting to roll out, we have a lot of the benefits from the path of the virus improving.

And that moving out of the way, hopefully, by the end of 2021, that's permanently out of the picture, at least, with regards to the extremes of the pandemic. And so, we're seeing a better trajectory for the prospects of businesses reopening, and just being able to earn revenues. I think the challenge for fixed income investors, of course, is that there's two dynamics at play here.

One is that a reflation or a reacceleration of the economy should have rates going higher. And we have seen some of that. So, if you look at 10-year Treasury yields, for example, they have risen steadily since about September of 2020. But there's a reason why there's still a bit of downward pressure and 10-year Treasury yields don't seem to want to rise significantly higher.

And I think part of that has to do with the amount of liquidity that's circulating in the system. There's just so much cash looking for a place to park in order to earn investors, whether you're an insurance company, or a pension, or retail investors, to earn the returns that they need over the long run to achieve their objectives. So, that's also putting downward pressure on rates everywhere, especially when you're looking at credit. So, I think that's a very difficult dynamic for fixed income investors to navigate. And it's an essential theme for this year as well.

Jenna Dagenhart: Going back to your point on growth, too, we could really use a strong year after the worst year for the economy since World War II. Brian, once we get past everything with the Coronavirus crisis, what does growth look like on the other side? What does the world look like long term?

Brian Resnick: That's a great question. And that's something that we've been spending quite a bit of time on. Because like Maria, we agree that there's a ton of fiscal stimulus, it's going to create a lot of growth. But once that wears off, what is the state of the world? And what we've seen for a couple of years, really few years coming are some very strong secular headwinds, namely demographics, deglobalization, and rising debt.

And Coronavirus has actually, in the crisis that we just went through, has exacerbated two of those. So, let me just unpack that for you a little bit. Demographics have been a major tailwind for economic growth for about 30 or 40 years, because the working age population has grown. And economic growth over the long run is predicted to a large degree on the growth of your labor force and the growth in the productivity of that labor force.

And now for the first time in decades, what we're seeing is a tapering off of that labor force, and productivity growth has been somewhat dismal for the last several years. Recent productivity numbers actually look interesting. And that's largely because we've lost low productive jobs in this crisis. But generally speaking, we've had a fairly flat or modest productivity growth.

And so, all else being equal, as you get a decline in the working age population, it becomes a supply side shock. And so, you ultimately have slower growth and headwinds to growth. And we think about globalization, really, the same can be said for that. It's been a massive tailwind for growth, and reflation over the past several decades. And over the past several years, we've really seen that flattened out for a variety of reasons.

Part of it has to do with rising labor costs in places like China. Part of it has to do with trade wars and populist politics, which we think are actually exacerbated to some degree by the Coronavirus crisis. And part of it has to do with an assessment of risk around Coronavirus, meaning that your supply chains are really being reconsidered in terms of the risk of shutting them down if you get another pandemic like this.

So, for those reasons, we see globalization potentially even declining. And global trade is right now 60% of GDP. So, it's hard not to see that as a headwind for growth. And then, finally, debt has exploded. After the financial crisis, we all remember Reinhart-Rogoff, and all of the conversation about what it means to get above 100% debt to GDP from a sovereign perspective.

And now, we're approaching 140%. So, that too, servicing that debt will certainly slow down growth. It's also going to hinder the ability of policymakers to really affect economic outcomes. Because we think with this very high level of debt, you have monetary policy tied at the hip with fiscal policy, meaning that rates are going to stay lower for longer.

So, what that means for investors practically, in a low-growth environment, with starting valuations being rather high across the board, is that we're going to get less out of asset classes. It's going to be a very inefficient market, in which we think over the next decade, returns are much less than they've been historically, and their risk of a large drawdown is higher than it's been historically.

And in the context of an income or fixed income investor, that can be catastrophic. Because we all know that most fixed income investors cannot handle a large drawdown because they'll never really have the time or money to fully recover. So, we have to be really careful in this environment, not to stretch too much for yield, because it may be taking up too much risk for income investors. But we do think it's going to be slow growth, it's going to be challenging, and that continues for quite some time.

Maria Giraldo: I would definitely agree with everything that Brian said there. I do think that there's going to be some permanent damage once we get past the Coronavirus crisis. If you think about just what we have to adjust to, we still don't know fully whether certain companies, for example, airlines are going to have to space permanently. And what does that mean?

That means that they may never get back to the type of capacity that they had in 2019. We still don't know whether things like concerts, if we're going to be able to fill it up 100%, or if people are going to be comfortable, even if that's allowed to be sitting in restaurants that are absolutely packed. There are other effects that we're still waiting to see fully play out.

For example, in the commercial real estate market, in the office space, in particular, in New York, are businesses going to go back to Midtown? Or have they found the effects of working from home to be very permanently beneficial from a cost standpoint? Are we going to have business travel come back? These are a lot of things, I think, that we're still waiting to see what it's really going to look like, what areas of the economy are going to experience some permanent damage.

And I think that that's also an important part of evaluating the fixed income, the investments that you're looking at. Because right now, those are the areas where you're getting the best yields, and the best potential for total return. But the risk is that as a fixed income investor, you go into an area that will never go back to what it was like in 2019.

And you risk a permanent loss of your capital if that company is not able to pay back the debt that you're lending to them today. So, those are some of the things that we're looking at in terms of what does the world look like after the pandemic. We're looking very carefully to see where there might be some permanent structural damage for us to navigate that part more carefully.

Jenna Dagenhart: Given some of these risks that you mentioned, Maria, where are you seeing value across different credit sectors, including securitized credit?

Maria Giraldo: Yeah. So, we are seeing value in high-yield corporate bonds, we are seeing some value in investment grade corporates, particularly in the triple B space. We can find value really anywhere you look, and part of that is because we don't want to be swimming right now against the tide of liquidity that's coming at us. Because I think that that would work against us in an environment where policymakers in general, the Fed, and in the fiscal side, the new administration, they are trying to inject a lot of liquidity into the system in order to prevent business failures.

So, to take the counter view there, I think would not work for a fixed income portfolio in this kind of environment. But we're seeing even better value, I would definitely say it's going to be in the structured credit areas. Because there, you can have a separate vehicle, a cash flowing vehicle that is secured by assets that you and I might be very, very familiar with.

Aircraft, for example, or cell towers, or containers that are used for training. And if the business itself gets into trouble, generally, those vehicles are bankruptcy remote, or loss remote. So, they're secured for you, and they often give you your own cash flows that will help the returns that you were hoping to earn. So, in that space, in the securitized credit space, generally, you can have access to a theme or a business.

Let's say you want exposure to airlines coming back after the pandemic. And in one area that you want exposure to that is in through the aircraft that they operate. So, you can have that exposure in a vehicle that is secured by the aircraft, and it's giving you some cash flows. Recently, we actually did, if we're looking at some aircraft securitizations, we're looking at yields of 6%, 6.5% in some cases.

Because there's less liquidity in that space compared to the corporate bond space. But if you look at unsecured airline debt in the high yield space, that's yielding you about 5.5%. So, you get a better quality, the deals that we typically look at, the fixed income investments that we're looking  in that space will have a rating of A minus, triple B plus. So, you're getting an investment grade level of ratings.

So, you have better quality, better yields in some cases, and better security in case the airline gets in trouble. So, those are the type of places where we're seeing a lot of opportunities.

Jenna Dagenhart: Broadly speaking, how have bonds performed during the coronavirus pandemic, Brian?

Brian Resnick: Yeah. I think they have performed as you would have expected them to. In the sell off, we had credit was down, low double digits that typically what you have in a recession or a crisis environment, and we had a duration rally. Now, granted treasury is rallied by about called 7% or 8% typically, it's a couple 100 basis points higher than that. But nonetheless, it was almost like an entire cycle crammed into a very short period of time.

Because typically, the drawdown or recovery lasts 24 months, but even though it's a compressed time frame, I feel like fixed income acted as you would have expected. And then, of course, as Maria noted, the Fed came in with so much liquidity that we saw bonds and spreads recover, as you would have expected on the credit side.

So, from our perspective, very much as expected, which is why it's so important to have the right strategic or structural portfolio from a risk perspective. So, when you go through one of these environments, you have the ability to navigate them from just structure alone.

Jenna Dagenhart: Yeah. And I'm glad that you brought up the Fed because we are getting so much liquidity injected into the system. And the Fed slashed interest rates close to zero in 2020, as Maria mentioned. And during its first meeting of 2021, Chair Powell signaled that the Fed would keep buying $120 billion of bonds each month. We know rates can't stay this low forever, and the Fed will eventually have to tighten its monetary policy. But the key question is when. Maria, I understand you take a bit of a contrarian view here.

Maria Giraldo: Yeah. Where I take a contrarian view is in the fact that I'm already starting to see investors in markets and headlines talking about the Fed withdrawing that liquidity. And I've seen estimates as soon as the end of 2021, which I think is especially aggressive. But even in 2022, I think it's too premature.

If you think about what's going to drive the Fed to withdraw that liquidity, especially given that they've changed their inflation targeting framework to allow for inflation to be above their 2% target for some period of time for them to feel comfortable that it's sustainable. And it's going to be there for some time.

After the global financial crisis, we have had several years of the Fed unable to meet that inflation target. Even in the best of times, let's say before the oil market essentially collapsed, entered a bear market there. There were at least a few years where the Fed could have achieved that 2% target. And still, we have just these structural issues existing in the economy that won't allow inflation to rise to above the level that they are looking for.

So, I think that they're going to struggle to reach that inflation objective probably four years after the Coronavirus crisis is over. I think about, let's say if they do reach that inflation target, let's put it at 2023, for example, or even late 2022. Now, what the Fed is going to want to do is give some early indication, very early indication that they're going to start withdrawing liquidity.

And they are not going to start with raising interest rates. They're going to start with quantitative tightening. They're going to start with tapering the purchases of assets that they're currently conducting now. And they're going to give, I don't know how long of a lead time, but let's say they want to give at least six months of lead time telling the markets, "Hey, we are thinking about beginning tapering those asset purchases."

And over a course of a year is what we're expecting, they're going to gradually bring down those purchases, wait some time, in order to see how quantitative tightening is affecting the market, have it take its effect. Then, they're going to want to indicate, "Hey, we think the economy is doing well, we've brought our asset purchases down to zero. And we are still seeing growth.

We're still seeing inflation headed in the direction that we want it to head. Now, we're thinking about raising interest rates." And they'll give some lead time before they start raising those interest rates. Once you start introducing those communication lags, which the Fed is already saying they want to do. They want to make sure that they don't disrupt sustained growth.

We're looking at a timeline well beyond 2025, before they start raising interest rates. So, that's, I think, where we take a contrarian view, because I do agree with the market. The biggest concern is when all this liquidity is gone, and when it's taken out of the system. But to start worrying about that now, I think it's very premature.

Jenna Dagenhart: To your point, Maria, the Fed does not want to spook the market. It tends to signal its intentions far down the road miles and miles ahead of its actual destination.

Maria Giraldo: Unfortunately, Fed chairs, going back to Bernanke, Janet Yellen, and of course, Jay Powell now, they've learned the hard way, multiple times, when we get to a press conference, and they get asked a question during that conference about withdrawing liquidity or timing around withdrawing liquidity. And if they give any indication that's too early, that they might be thinking about withdrawing liquidity, the market reaction is often very negative if the market isn't expecting it during that press conference. We'll see equity prices decline.

We'll see corporate bond spreads widen. And we'll see the Treasury market rally. And that has the effect of tightening financial conditions, which is something that the Fed currently does not want. And so, we get responses from Jay Powell like, we're not even thinking about thinking of tightening monetary policy or withdrawing liquidity. And that's because of many lessons that have been learned, and they're in a very difficult position. I don't envy the Fed chairperson, because they have to navigate that very, very carefully.

Jenna Dagenhart: I don't envy them either. And Brian, over to you, you mentioned lower for longer earlier, where do you think we stand with rates?

Brian Resnick: Yeah. We think the Fed stays the course for 2021. I think to Maria's point, they certainly don't want to spook the market, not even in terms of communication. We do think they begin to signal tapering towards the end of the year, and they do begin to taper sometime in 2022. But rates really don't even begin to get on the table in terms of rates rising on the front end, until the second half of 2023.

So, largely staying the course. And if you think about the fact that the Fed's mandate is changed a little bit in terms of inflation targeting, they're not targeting an average, which means that they actually want inflation to rise above 2%. And that's clearly going to happen in the back half of this year. But the question is, and I think this to Maria's point, can they keep it at that level?

Can they keep that average level around 2%? And it is going to be difficult for them. So, we don't expect the Feds to move anytime soon. But we do expect them again to begin tapering into next year as the economy picks up some strength.

Maria Giraldo: So, I do agree that inflation is going to rise at the end of the year. Again, to Brian's point, can they keep it at that level? I think that's the key. And especially, can they keep core inflation at that level, which is your target? And not just headlines, where we might be seeing things like a commodity cycle come back, and oil prices come back. They're really looking at core inflation.

The other aspect, I think, that some people miss about the Fed and their objectives, of course, is the labor market, which we think that the labor market is good to continue to improve, the unemployment rate is going to continue to decline. But the difference now, I think, with what the Fed is targeting on the labor market is not just full employment, which there's various estimates about what full employment is for the United States.

Is it at 3.5%? Is it at 4%? We just don't know. At minimum, I think the Fed wants to get back to where we were prior to the pandemic. But I think there's also other signs of full employment that they're now looking at, especially because of the effects of the pandemic. And that is continuing to narrow the wealth gap, rather than the pandemic did a lot to exacerbate that division between the wealthiest, and the least wealthy, and the employment among different races, Hispanics, and Blacks.

And I think that they're looking to... and women and men, and I think that they're looking to narrow all of those gaps, and they're looking to narrow the gap too, between those that make the most, and those that are employed at minimum wage. There's a lot of things that I think the Fed is targeting, not just to go back to pre-pandemic levels, but to also close some of those gaps. And that could also take a long time.

Brian Resnick: Yeah. And actually, I'd like to make a quick comment. I agree with Maria, in terms of the fact that the wealth gap, Gini coefficient, however you want to measure it, has certainly widened. And one of the issues with that from an economic perspective, I talked about deglobalization and populist politics.

And this feeds right back into that, which can be very problematic for long-term growth. So, there are a lot of structural issues that we have to deal with. And that Gini coefficient, that division in terms of wealth, is definitely one of them, and has a very real impact on long-term economic growth.

Jenna Dagenhart: Do you think that a higher $15 minimum wage could have a meaningful impact on the Fed's employment mandate?

Maria Giraldo: I think a $15 minimum wage, it's a little bit hard to predict how exactly it's going to impact employment. On the one hand, I think it helps those who are employed at a minimum wage. It helps them get out of living potentially paycheck to paycheck, having to have two to three jobs.

And it helps the affordability for them from a living expense perspective. On the other hand, I think there's been research that shows that it might actually cost jobs, as companies who employ at the minimum wage have to reduce the labor. And so, I think there would be an adjustment period for the economy as a whole, for businesses as a whole to incorporate a minimum wage.

And that would take some time, which maybe gets us to full employment a little later, rather than getting us to full employment in 2022. Let's say, maybe we're looking at 2023 when the economy has adjusted to the minimum wage.

Jenna Dagenhart: And Treasury Secretary Janet Yellen, former Fed chair as well, has mentioned that fiscal stimulus could help get the economy back to that full employment, hopefully sooner rather than later. Do you have any thoughts on that as well?

Brian Resnick: I think that it is important to have a lot of fiscal stimulus. The key thing here is to get people who've been unemployed back to work. So, we lost about 20 million jobs last year, about half of those we've regained. And as we saw in the last cycle, the longer people stay unemployed, the longer they stay out of the workforce, more difficult it is for them to become reemployed.

So, absolutely, more fiscal stimulus getting the economy reopened, which is really the key here is getting the economy reopened, and getting on the other side of the pandemic ultimately will lead to job creation. And if that doesn't happen quickly enough, then it just exacerbates the problem. So, we would tend to agree with that.

Jenna Dagenhart: And going back to inflation, Maria, speaking of timing, how long is that lag from growth to inflation?

Maria Giraldo: Yeah. Historically, there's about an 18-month lag on growth to inflation. So, that's to say that wherever growth is today, it's going to affect the inflation levels that we see 18 months from now. Unfortunately, that's part of the reason why recessions, no matter how long they last, they still have this disinflationary impact even after the recession is called to be over.

So, for example, during the global financial crisis in 2008 and 2009, we still had this disinflationary impact going into 2009 and 2010. And if you look at in particular, core inflation, relative to the Fed's 2% inflation target, we were well below their target for years. I believe, until about 2012 or 2013, when we started to see a bit more inflation pressures.

So, I think those lags, and if you think about why those lags happen, partly because some of the inflation measures, they take into account things like housing costs, and rents, for example, is a big one. If you look at some of the metropolitan areas, what has happened? Rents have come down significantly. Here in New York, rents have come down. I've seen rents down 20%, 30%.

And that's a huge disinflationary impact that is going to continue to work through this system, especially, and then, once you think about things like migration rates, and people leaving New York, and people leaving other bigger metro areas. So, those are the lags I think that takes a long time to adjust to, and are part of the reason why we tend to see a bit of a delay of growth moving through to inflation.

Jenna Dagenhart: Yeah. Those are all great points. And Maria, what other risks in addition to inflation are top of mind for bond investors? And how are you managing risk in fixed income portfolios?

Maria Giraldo: I think a key risk right now that Brian also alluded to earlier is a big fundamental issue with corporations in particular. If you're a credit investor, you're looking at yields continuing to come down, high-yield corporate bond yields setting new record lows, and similarly, investment-grade corporate bond yields setting record lows. And you're looking for places to find value, you're looking for places for better total return prospects.

But then when you look at the fundamentals, this is typically the place in the cycle where fundamentals are the absolute worst. Because now, we're seeing the fourth quarter earnings, for example, being reported, and we get the full picture of what 2020's impact, what the pandemic impact had on corporate fundamentals. What do we see? We see 12 months of revenues that are depressed relative to 2019.

We see earnings that are very depressed. We see leverage ratios that are at historic levels. And I think, right now, investors are looking at that. And they're saying, "Well, but there's a lot of liquidity. And there's a lot of cash that's chasing these yields. So, yields are going to continue to go down." But we know, I think we all feel that that's just not sustainable.

And eventually, the fundamentals catch up. Now, I think the hope is that all the stimulus that we've gotten from the Fed and from fiscal policy is just merely a handoff from the effect of the pandemic into better times. And we hope that that handoff is smooth, and the transition is smooth. But we fear that it's not, and we fear that eventually, the fundamentals is going to catch up to us.

And it's going to lead to higher default volumes, and lower recovery rates. And that Triple C corporate bond that an investor bought at 6% or 7%, yield all of a sudden, even if you earned that coupon for two or three years, if that bond defaults, and that you only recover 20% to 30% of par value, you wiped out the coupon income, in addition to your principal. So, I think that's a huge concern.

And that's top of mind, maybe not immediate, because of the amount of liquidity that's out there. But it's something that investors, especially fixed income investors, who are counting on this income steadily over the next several years, it's something that they have to continue to bear in mind. So, how do we navigate that risk, especially in this kind of environment?

I think you have to still incorporate, of course, fundamental analysis into your work and do very, very deep bottom-up credit-by-credit reviews. In a worst-case scenario, can a credit survive if the pandemic takes the wrong turn? I think, to some extent, liquidity still has to be factored in. Maybe it's less attractive for some investors now, because liquidity can drag on returns.

But I think there still has to be some level of liquidity that a company that you're looking to lend to that they have. And of course, you have to look at businesses that have the higher potential for growth, and are in growth areas. So, really, really looking at very deep, again, credit-by-credit analysis that I think right now, that's for us, our armor.

Jenna Dagenhart: Brian, what's your armor look like? You mentioned earlier, you see emerging market currencies, potentially appreciating against the dollar. How are you using currency, and private debt, and other tools to help diversify?

Brian Resnick: That's a great question. So, I think diversification is really important, and retouch on some of the things we've been thinking about quite a bit, which is this idea that you can be procyclical. You can even own the credits you won, but if you get a turn in the economy that's unexpected. Let's face it, none of us predicted Coronavirus, you can really lose a lot of principle in credit.

And so, one of the things that we've been talking about for some time now is structuring portfolios to be efficient. So, we all recognize that you have a lot of credit in fixed income portfolios. And it used to be that fixed income and income investors broadly relied heavily on core bonds for decades, because they provided a high level of income and downside mitigation.

But now, we've seen so much credit make its way into portfolios. And one of the issues by the way, is that the safe money has gone to low duration and cash, areas that won't get hit as hard by rising rates. The problem with that is that if you take all your duration, and put into cash, and low duration strategies, you don't get that countercyclical benefit that you need.

And so, from our perspective, before we even drill into sectors, the most important thing is setting up portfolios to be structurally efficient. And the way you do that in fixed income, is to first of all, recognize that you have procyclical assets with credit, countercyclical assets with duration or high-quality bonds. And then, you pair them in a risk-weighted way.

That's our starting point for most portfolios that we delivered to individuals is a risk-weighted barbell, as it were, so that you get the same amount of volatility from two uncorrelated or negatively correlated asset classes. And you can actually end up with a pretty stable NAV, and get a coupon from that. And then, once you have a stable portfolio like that, you can then do things like apply modest leverage to it, so that you can get back up to high yield like returns with about half the risk.

So, a credit barbell we think is important. You still have to want a heavy amount of duration next to credit. But then, of course, as you mentioned, within that, you want to be nuanced in terms of your views. And so, our views right now, in terms of the procyclical side, are certainly to be invested in more diversified areas like emerging markets, as you mentioned.

We do think emerging market currencies do quite well. Ironically, we're not attracted to local debt. And that's just because emerging markets have done their own version of QE, and brought local debt down. So, it's not attractive to us as much as dollar debt is. But absolutely looking at those currencies as a tailwind for emerging market debt is important.

Now, you mentioned private credit, if we're thinking about the secular time horizon, and we're looking for opportunities to invest in, the liquid markets are just not offering us that much, which is why we talk about being as efficient as possible, and things like a barbell structure to accomplish that. But private markets are really a secular trend that probably continues for quite a while.

Maybe the rest of our careers, as you see so much of the markets going from public to private about the equity and the debt side. And there, it is a very inefficient market, there's a tremendous amount of idiosyncrasies. In our private credit portfolios, were able to get almost twice the yield you can get from a traditional liquid high-yield bond or floating rate bond bank loan.

And you get that with traditionally half the risk in terms of defaults and recoveries. So, your loss rate is quite a bit less. Again, it's very idiosyncratic. It's a very difficult type of investment to make because it takes a lot of resources to do it. You're almost acting as the bank, really. But we think that that's an area of emphasis. And that's an area that clients can really benefit from if they have the ability to take that liquidity risk.

And if they have the size and sophistication to be able to do it appropriately. Again, a lot of idiosyncratic risk. It's not just a beta trade. But by structuring your liquid portfolios efficiently, and tapping into illiquid markets through private credit, we think you can really set yourself up for success over the secular time horizon.

Maria Giraldo: I just want to say that I agree with Brian, particularly on the comments of private credit. And I think that's part of the reason why we're seeing trends like [SPAX 00:38:36], for example, that have just emerged with such strong vigor, really, in 2020 and 2021. Part of the reason is because investing in smaller private companies do yield better returns.

And what we see in a private debt space, similar to Brian's, you get better yields, you get to sit at the table with the borrower, you get to negotiate with them directly. If they get into trouble, you have a lead time, and work with them. And if ultimately, if they go bankrupt, you're sitting at the table with them trying to recover your value, versus in more broadly, syndicated deals where everybody is after the same asset.

So, there's a lot of benefits, you have, obviously, a bit less liquidity. But again, as Brian mentioned, you can barbell some of that. You can have a sleeve of your portfolio that's a bit less liquid and turning you more. And then, you can have a sleeve of your portfolio that has more liquidity in case you need it. And I think in this environment, especially when you have leveraged loans, for example, which we do also invest in leveraged loans.

But when you have in that space, recovery rates trending around 40% to 50% for companies that get in trouble and go bankrupt over default, you get 40% to 50% recovery rate in the bank loan market, whereas historically, you might have gotten about 70%. And then, the unsecured corporate debt space, in 2020, the average recovery rate was about 25%.

So, looking for opportunities to get a better yield, potentially get a better recovery rate, in case things go south. And also, to some extent, staying a bit up in quality where you can because some of these private debt opportunities aren't rated. But when we look at the fundamentals, and we have our internal rating approach, where we look at what's a typical triple B, what's a typical double B, leverage ratio, revenues, et cetera.

And we'll look at a private deal and say, "This looks a lot like a triple B right now, but it's yielding us what we can get in the single big corporate bond space in the secondary market." That's an opportunity similar to the structured credit space to get higher quality, maybe a bit less liquidity that you can manage by barbelling, and better total return opportunity. So, I agree, I think that this is a trend that's going to stay with us in our careers.

Jenna Dagenhart: And to your point, you never know when there's going to be one of those left tail risks, Black swan events, as we learned firsthand with the Coronavirus crisis. Brian, what are some of the benefits of taking an active approach to fixed income?

Brian Resnick: Yeah. Well, I think fixed income is the one space where you really can't use ETFs too much. And that's because these are illiquid markets, you really can't replicate the index very well. And especially when you get to credit, managing liquidity is so important in the credit space that ETFs just can't do that. So, managing liquidity is really the first part.

I think the second part is if you look at where value is, and Maria and I both talked about this, it's in some of the more nuanced areas, securitized, emerging market debts. Areas that aren't as well represented by passive investments. And you have to really take a very wide opportunity set, and be able to move between those in terms of specific securities, and find the best value across that.

Which is why we actually think that being multi sector and global in terms of your starting point for credit is so important. It tends to outperform over time. It tends to be a more efficient way to invest. You mentioned diversification earlier, diversification 101, you're going to spread out your bets across different markets. But it also gives you about five times the alpha opportunity.

So, in an environment like this, where valuations are so stretched, you want to have the opportunity to look everywhere you can to find value, to find opportunity. So, it's absolutely critical right now.

Jenna Dagenhart: And even the Fed is buying fixed income ETFs. And we've seen tremendous growth in fixed income ETFs, including active fixed income ETFs. What other trends do you expect to continue? What else could we expect on the horizon?

Brian Resnick: Sure. And we've talked about this before. We expect it to be lower for longer. The Fed is going to have to accommodate this massive amount of debt. In fact, all central banks are likely going to be joined at the hip with fiscal policy for a prolonged period of time. So, the lower for longer environment continues, I think one of the trends that we are going to continue to see, as I said a moment ago, is private credit.

And then, ESG. ESG continues to become an important topic, not just in terms of servicing consumers, and servicing investors, and what they're looking for from a value perspective, in terms of their values, but also becoming a legitimate investment thesis. And so, those are really the three things that we're looking at that are lower for longer, the rise of private debt, and the continuation of ESG is becoming a more important factor in investing.

Jenna Dagenhart: Maria, if you had to pick three things, what would you say?

Maria Giraldo: Oh, I'll start off by saying, I definitely agree with the ESG perspective. In the ESG, I think the way that investors used to think about it, including institutional investors, they would think we'll have an ESG specific strategy. We'll have a sleeve that is ESG related. We'll have a sleeve that is focused on environmental sustainability in particular.

And they forget the social and governance aspect of it, too. That's changing. You really have to think about ESG as just part of the due diligence process for any credit from the get go. We just went through one of the biggest health crises we've had in decades.

And if you had exposure to a company that, let's say, did not respect the social restrictions that were put in place, the business restrictions that were put in place, didn't respect the recommendations from the CDC to keep your workers at home if possible, and change to work from home environment, that business would have put the entire business at risk from a regulatory standpoint, from a legal standpoint, from a health standpoint for the employees that you as an investor, you're lending them money in order to trust that they're going to make business decisions that are in long-term viable for the company and for your returns.

So, if you were a business that didn't focus on that, that hurt your performance, and that hurt your return. And from an investor's perspective, we wouldn't want exposure to a business like that. So, that has to be just the beginning part of the due diligence processes, as any analyst would look at, what's the growth prospects? What's the historical revenue growth?

You have to also look at what the business is doing from an environmental standpoint. And from a social standpoint, are they hiring diverse boards and diverse employees? And then, from a governance standpoint, as well. And then, I agree too, I think that investors are going to rethink the premiums on liquidity. And do you want to take more liquidity risk?

Do you want to take less liquidity risk? The investors will understand generally that you don't need 100% of your portfolio to be liquid at any given time. And the more illiquid areas of the market are going to yield you better opportunities going into areas that are beyond the benchmark. I know a lot of investors, institutional investors are still benchmarked to something like the Bloomberg Barclays aggregate index.

But that benchmark isn't yielding enough. It's not delivering enough returns. And so, more and more investors are looking at other opportunities outside the benchmark. What are the more creative solutions that the market has come up to deliver the returns that you need in the long run, without stretching for risk, or without stretching in risk, without going too far down in quality? And so those are for me, the trends are definitely here to stay.

Jenna Dagenhart: Yeah. You raised some important points there, and it is called a fixed income, yet the income part can be difficult to find. Brian, building off of some of Maria's points there about the coronavirus pandemic, how has COVID changed the way that bond investors think about ESG?

Brian Resnick: Yeah. That's a good question. As I said earlier, I think that with everything that's happening socially, I think within environmental concerns really coming to the forefront. And obviously, that this global pandemic is really focusing more on outcomes that are affected by ESG. And so, we too also think that analyzing from an investment thesis perspective, the ESG quality, or the ESG score of a security, whether it's a municipal, a credit, or an equities is becoming important.

Since 2011, we've been focusing on this as an investment thesis. And it certainly has paid dividends to Maria's earlier point. Those companies that haven't focused on ESG have suffered from a business perspective. And so, we think it's becoming more and more important from an investor perspective, as well as from an asset manager perspective, in terms of a legit investment thesis.

But absolutely, with everything that transpired in the last year or so, we definitely think investors are becoming more keen. And also, you see the demographic base shift younger, whereas millennials gain more wealth. It's becoming more important to them, as well. So, from a value proposition in terms of their values, it's becoming much more important. So, it's definitely here to stay. And it's something that has to be taken seriously, again, not just from a marketing perspective, but from a legitimate investment thesis.

Jenna Dagenhart: What do you think institutional investors need to keep in mind moving forward, and let's just noise?

Brian Resnick: Sure. I think one of the things that institutional investors need to keep in mind is that we're going to see some really strong returns this year, because of the growth in the economy. But we have to be really mindful again, that on the other side of this, it's going to be a very low-return environment. And the key is really not to stretch too much for risk.

And to and to recognize that some of these returns are predicated on policy that will run its course. And so, as institutional investors structure portfolios, as they come up with capital market assumptions, it's going to become really important to take into consideration some of the secular headwinds that I mentioned earlier, because they are going to create a very low-return high-drawdown environment.

So, whatever the risk profile is for an institutional investor, whatever their liquidity needs are, they need to take that into consideration because it is going to be a very tough environment moving forward. And it is going to take a really well-structured portfolio, and an understanding, again, that it's going to be a lower-return environment in order to have appropriately risked portfolios.

Maria Giraldo: I would agree with Brian. I think one of the key things that institutional investors maybe, we're really evaluating this internally, if they are prepared for this lower for longer for a long period of time, especially, when again, you're looking at investment-grade corporate bond yields very yielding new very, very low, and also foreign investors, to some extent coming here too, looking for safety, looking for exposure in the US.

Because also, our investments look more attractive to them than their investments do at home, in Europe, where sovereign bonds are yielding, or in Japan, where JGBs are yielding, our treasuries, even on a hedge basis, look more attractive to them. In addition to having a lot of liquidity within the United States, we do have some interest from global investors, foreign investors. And we've seen that internally.

So, I think that's something that institutional investors have to keep in mind that we are in this lower for longer. I don't think that they are fully prepared for that. It's part of the reason why we have discussions about when the Fed is going to withdraw liquidity. Because we're thinking that rates are going to start rising naturally. But I think we're seeing a lot of pressure for rates to stay low for a long period of time, and for those return objectives to be very difficult to meet.

Jenna Dagenhart: As we wrap up this panel discussion, Brian, any lessons learned in 2020 you'll be carrying with you into 2021 and beyond?

Brian Resnick: Sure. I think from a market perspective, we learned that policymakers globally, certainly have the will to come in and intervene in markets in extraordinary ways. This was a unique situation in terms of a coordinated global shutdown, and then recovery. But nonetheless, if you compare this to, let's say, 2008, the last big crisis, we had very divergent responses. We didn't have a lot of fiscal stimulus or nearly enough. And we had central banks using austerity instead of a stimulus in the beginning.

Here, we have a very different story. Clearly, we've learned the lessons from the last crisis. And we recognize that policymakers need to go all in in this type of crisis. I think the concern moving forward, at least in the near term, or the intermediate term is now with Central Bank balance sheets so levered up, and with so much fiscal policy, and high deficits, what is the ability for policymakers moving forward to intervene?

So, certainly, we learned that the willingness is there. But again, our concern would be about the ability moving forward, given our balance sheets are, given where rates are, and given where deficits are at this point. I think personally, what I've learned is that I've really gotten up to speed, and so many of us in terms of interacting through technology, that I feel that I'm much more efficient now than I was a couple of years ago.

Meaning, I can do this interview now. And then, later on today, I'll be doing a conference on the other side of the country. I could not have done that two years ago because people weren't as comfortable utilizing technology to communicate. So, I think the efficiencies that we've gained from these technology platforms should bleed into where we are in a year from now.

Again, hopefully, we'll be in-person, we'll be able to do an interview like this in-person. We'll do conferences in-person, but clearly, there have been efficiencies that have been gained. And I don't think that goes away entirely.

Jenna Dagenhart: Yeah. A lot of those barriers have really come down. Maria, any final thoughts on your end?

Maria Giraldo: Yeah. I would echo Brian's thoughts there, particularly on the liquidity front. I think a key lesson that investors learned in 2020 was the value of that liquidity. Because otherwise, if the Fed, for example, had not stepped in with more quantitative easing, more asset purchases, bringing rates to zero, but also the corporate credit facilities, we don't know what volume of defaults we would have seen.

And further even worse, rating migration we might have seen. We don't know where we would be today. But we saw what liquidity did. But I think the key lesson too, is in this environment, of course, liquidity is driving a lot of the returns. But eventually, especially, again, to Brian's point, what more can policymakers do in the future if we get in trouble again, or if there's a downturn?

What more firepower do they have? And I think what the key lesson is going to be is that there is going to come a time when we need to switch back to looking at the fundamentals. Going back to the fundamentals. If you've done that in 2019, when we were already late cycle, and the Federal Reserve was neither too accommodative, nor too tight on policy, we were really letting the fundamentals drive.

At that time, at Guggenheim, we started taking a bit of risk off the table going more defensive, because we switched completely to the fundamentals, and saw that there were several late cycle indicators that told us that we were headed for a contraction sometime soon. And that switch, being able to switch from liquidity being a big driver to fundamentals being a big driver, I think is going to, for many fixed income investors, be the key in avoiding a big draw down at a time when in the future, cycles happen.

And when we have a contraction, and the policymakers don't have enough firepower anymore, that's going to be the key is being able to focus on those fundamentals, and switch to a more defensive stance at the right time. So, for me, that's a big lesson also learned in 2020.

Jenna Dagenhart: A lot of lessons learned and a lot of ground covered today. Maria, Brian, thank you so much for joining us.

Brian Resnick: Thank you for having me.

Maria Giraldo: Thank you.

Jenna Dagenhart: And thank you for watching this Fixed Income Masterclass. I was joined by Maria Giraldo, Managing Director of Macroeconomic and Investment Research at Guggenheim Partners, and Brian Resnick, a Director and Senior Investment Strategist at AllianceBernstein. And I'm Jenna Dagenhart with Asset TV.


 

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