MASTERCLASS: Fixed Income - January 2020

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  • 01 hr 01 mins 48 secs
2019 was a strong year for the bond market. Fixed income funds experienced consecutive weekly inflows for most of the year and heading into year-end. The surge of new assets added to bond funds reflected the largest uninterrupted flows dating back to 2001. Amid global negative interest rates and new benchmarks the investment landscape presents headwinds and tailwinds.

4 panelists highlight risks and opportunities in the Fixed Income space heading into 2020:

  • Maria Giraldo, Managing Director of Macroeconomic and Investment Research at Guggenheim Partners
  • Laton Spahr, President at SS&C ALPS Advisors
  • Matthew Bartolini, Managing Director, Head of SPDR Americas Research at State Street Global Advisors
  • Matthew Salzillo, Managing Director and Portfolio Manager at Sun Life Capital Management



Remy Blaire: Welcome to Asset TV. This is your Fixed Income Masterclass. 2019 was a strong year for the bond market and fixed income funds experienced consecutive weekly inflows for most of the year. With the surge of new assets added bond funds, the gains reflect the largest uninterrupted flows on record heading back to 2001. Joining me to take a closer look at the fixed income space. Matthew Bartolini, Managing Director, Head of SPDR Americas Research at State Street Global Advisors, Maria Giraldo, Managing Director of Macroeconomic and Investment Research at Guggenheim Partners, Matthew Salzillo, Managing Director and Portfolio Manager at Sun Life Capital Management and Laton Spahr, President at ALPS Advisors. Thank you so much for joining me for the fixed income masterclass. We'll be taking a look at the investment landscape and Matt, starting out with you, 2019 has turned out to be quite a different year in comparison to last year. So, give me your perspective when it comes to market performance and fixed income this year.

Matthew Bartolini: I think this year was really driven by how far rates have just fallen. At the end of 2018 rates were above 3% and then we had the federal reserve come out extremely more dovish and we started to see rate cuts and basically, more accommodative monetary policy, issues around growth and inflation and that led to interest rates to decline throughout the entire year. That propelled bond returns to have some of the best returns in a decade, and that overall led towards investors also to seek out areas of yield. So not only did the core aggregate bonds have a strong year, but then also in this sort of hunt for yield, high yield fixed income areas of the marketplace also had double digit returns. So it has been a really strong return period for almost every single asset class within the fixed income space, whether it's short duration or long duration, but long duration had been rewarded throughout all of 2019 and our view is that heading 2020 maybe that might not be the same case, just given how far yields have already fallen.

Remy Blaire: And that indeed the Federal Reserve did cut rates three times this year. And the search for yield continues as we head into the new decade. Now, Maria, I'm moving on to you. What is your take on the macroeconomic environment? Tell me about the consequences of the current economic conditions that have played out.

Maria Giraldo: Yeah, so if you think about the easy answer of what happened in 2019 is that there was really a lot of uncertainty and when you want to dig into where did that uncertainty come from, you have to go back to 2018 when we had China growth slowing, global growth was slowing. On top of that, you had Chinese government focusing on this de-leveraging campaign and then we threw on top of that a US-China trade war. So, when I look at 2019 a lot of uncertainty did, we have a lot of that uncertainty resolved, not all of it.

We have had the Chinese government sort of change its focus away a little bit from the de-leveraging campaign, and we've had some progress with regards to the trade, the US-China trade agreement with this phase one agreement that's supposed to be signed in January, 2020, but a lot of uncertainty is still being carried over into 2020 and there's a lot more calendar event risks that lie in 2020. So, for me there's still a bit of a continuation of some of the risks that existed in 2019, I think it's being carried over into 2020.

Remy Blaire: And indeed when it comes to uncertainty, we all know that the US-China trade war was in the crosshairs and we did pay attention to all the headlines that came out this year. So, we'll continue to monitor any progress as we head into 2020. Now Matt turning to you, in the fixed income markets in general, they have had very healthy returns in 2019 but what are some of the data points that captured your attention?

Matthew Salzillo: Sure. So, I think what Matt said previously was that we noticed that the Bloomberg Barclay's Aggregate, which is a common benchmark used by asset management firms, has returned about eight and a half percent year to date. Now if we move further out the curve and talk about the long credit portion of the benchmark, we're talking about 24% return for the year to date. So, if you think back to just a couple of days ago before the trade war was maybe settled or pushed off, that's basically the same return the S and P 500 had for the whole year. So, as a bond investor, I find it to be pretty fascinating. So, I think a lot of plan sponsors will be very happy with the returns their bonds have generated. Obviously, it depends on asset allocation, but we've had a great year of returns in general.

Furthermore, excess returns on credit products have been very good. We've seen positive returns across the board in terms of excess. So, what does that look like in 2020? For us, we think 2020 might be a year where we have to give some of that back. I think 2020 is being much more of a bond picker's market where you're going to have to play from both sides. You can't just be overweight for the whole year in terms of credit risk and expect the rise tide to lift all boats. You'll be able to get excess return from both being underweight and overweight credit.

Remy Blaire: And that, I think you highlighted a lot of important points as well as statistics when it comes to the fixed income market. And moving on over to you, we have highlighted market performance, but what were the global macro drivers of growth? And tell me a little bit about the shift towards emerging markets.

Laton Spahr: Yeah, I mean I think the story at 2019 was how little there was of growth to be had. The US consumer really carried the weight for the whole planet and the story through the year was how easy monetary policy was becoming around the world. And I think that's within the context of at least 11 years of seeing very frustrating lack of effects of monetary policy. So, the lack of growth is really the story.

The US consumer is the stalwart for global growth. I think heading into next year, that's going to start to evolve into some of the benefits of that easy monetary policy where you start to see some emerging market growth re-accelerate. We're starting to see that in China, the early innings of that, if we get this trade deal, starting to thaw through the election cycle, I think that helps China and the rest of emerging markets really cue off of that. We're starting from a pretty tough global PMI standpoint, so if that just improves a little bit, I think it changes the story for 2020 versus 2019 pretty substantially, because we didn't really have any other growth stories to tell other than the US consumer.

Remy Blaire: And as we head into next year, we can't forget the fact that it is a US presidential election year as well. So, we are sure to continue to monitor headlines regarding not just monetary policy but also the US election as well. Now Matt, going back to you as we continue this discussion on fixed income, I know you specialize in ETF, so tell me about what we saw in terms of flows into fixed income ETFs.

Matthew Bartolini: Yeah, so fixed income ETFs overall for 2019 had record amount of inflows. Basically, where we are now it's roughly around 146 billion but that's likely to change over the next few days into the end of the year. But that's going to be a record overall throughout its history. And one of the areas that was a driver of that was also high yield bonds. So, as we just talked about earlier, there was a need for yield and investors tactically allocate into high yield ETFs, which took in about 17 billions of flows this year and raised high yield ETF AUM to an all-time record high. And I think part of the driver outside of market-based because there was sort of that demand for ballast to a portfolio given the uncertainty risks, so we saw investors seek to mitigate the equity risk in the portfolio, where we saw long duration do well and core Agri bonds do well, but there's also secular drivers that are going to continue to increase adoption within fixed income ETFs.

Whether that be costs, they'll just lower overall than mutual funds, both active and index-based ETFs, have a lower expense ratio on average than mutual funds. There's more choice. So, the ability to tactically allocate across emerging market debt, high yield bonds, active senior loan products, or even different parts of the treasury and corporate credit curve, but then also more comfort. We've seen identifiable periods where the operational structure of the fixed income ETF wrapper has been tested and been able to pass in terms of the ability to operate in a liquid fashion for investors to transfer risk in real time.

And then lastly, it's really about client type. So, client type, we continue to see a demographic shift where investors will need that sort of stable retirement income, but also insurance plans as a result of regulatory changes have gravitated towards the ETF structure because it increases their operational efficiency in terms of managing their balance sheets. So, there's market-based reasons in terms of looking for yield or portfolio ballast, but then there's going to be secular drivers where we are looking at basically at $1.1 trillion market, probably by the end of 2020 if a lot of these average flow figures continue to trend in the way that they have.

Remy Blaire: And that this is a fixed income masterclass. But because you up the ETF wrapper as well as touched upon some of the regulatory changes, how do you see some of these changes that took about a decade to pass now that they're coming to fruition, how do you see that affecting the space in the ETF industry?

Matthew Bartolini: So I think it's probably more about like the ACC rule in terms of using basketing processes. Typically if you did not have exemptive relief for this purpose and usually some of the original issuers had it where you could do more customized baskets with a smaller selection of bonds within the portfolio because that essentially creates more liquidity because you don't have to transact in all say 1200 line items, you can only do maybe a hundred and it'll still fairly well replicate your portfolio. So now issuers that are maybe newer to the market, they don't have to have a pro rata slice of their basket in terms of income creation, redemption.

They can do more customized and flexible basket arrangements like some of the older issuers that [inaudible 00:09:50] was, people might think that's not... We might look at that favorably because we had a competitive edge, but we think it's great because it actually makes the entire universe fairer and more balanced and I think there's only going to improve the usage of fixed income ETFs and the promotion of its liquidity benefits for all end users.

Remy Blaire: And indeed as we head into the new year as well as the new decade, we'll see how that plays out at the ETF industry. And Maria, moving on to you when it comes to the new decade, of course we'll continue to see what happens in terms of monetary policy as well as the macro outlook. When we look at the landscape, we see negative rates overseas, but here in the US we haven't gotten there quite yet. But what is your outlook going forward?

Maria Giraldo: Yeah. What's interesting also about recapping the asset class performance that we've seen in 2019 again, equities, double digit returns, long duration fixed income, whether you're looking at treasuries, you're looking at corporate bond, double digit returns, high yield has very strong returns, what that's telling me about the set of for 2020 is that somebody is going to be caught off sides, right? Somebody has to be wrong here. And so, I think that's going to be something big to monitor, who's going to be wrong in their call of how they're positioned for 2020. More specifically as it relates to sort of the macro outlook and monetary policy, a key risks that we are monitoring is the labor market. Because it's been alluded to already, is that the consumer right now is the strongest pillar of growth within the US economy.

And so, we need to ensure that, that strong consumer is standing on really solid ground. And how do we do that, is by ensuring that they can keep their jobs and they can keep making money and hope for wage gains and more spending. So, we really need to focus on the strength of the labor market, which goes back then to the strength of the corporate market. So that's something, the key that we're monitoring in terms of risk as it relates to the economic outlook and monetary policy. There's also a really big glaring risks that I think it's interesting to talk about as we head into the new decade, which is the amount of debt that China has accumulated, which has been a big theme over the past decade, but what I think we're starting to see now in 2019 is the beginning of the end of the credit cycle in China.

Because we're starting to see defaults and we're operating now in an environment where the government is having to step in and decide which companies, which vehicles are okay to default, and which aren't. And the more we see a rise in terms of volume of defaults, the less they can continue to control that. And so, I think that, that's something that we're starting to see and my concern is, where are the tie ins globally? And one of the ways that China has grown is by fostering business and financial relationships outside of China and that includes in the US, that includes in Europe. So, as more companies and vehicles default, how does that tie back into US and to Europe and globally in general. And that's something that I'm going to be monitoring really. I think it's going to be a very big focus over the next decade.

Remy Blaire: And Maria indeed, I know that your research does focus on this and later on we'll be getting more insight in terms of your take on corporate defaults, but when it comes to risks in China, where do you expect the economy to go? Where do you see the central bank going in China, as we head into the new year?

Maria Giraldo: I think that they're going to have to deliver more accommodation. And we've seen that already with the triple R cut that they just delivered. And I think the real question is whether more rate cuts, more accommodation from the central bank is going to be enough to stabilize the slowing that we continue to see. We're still seeing signs of slowing. And of course, again going back to the US-China trade agreement, whether that's going to help deliver stronger growth or a bit of a rebound in China. So, I think the outlook right now is that there seem to be signs, initial signs of some stabilization and we're just continuing to monitor the incoming data to see if that is sustainable or if that's just a short term blip.

Matthew Salzillo: So Maria, based off what you just said about China feeling some pain and worry about defaults, do you think that was a major reason why we saw the recent trade truce between both China and the US?

Maria Giraldo: I do. I think that there is clearly this urgency for a truce and that's part of the reason why we've seen this phase one agreement that there's not really a lot of clarity around, that we may get more details in January, but really it's what's contained inside that phase one agreement and what's going to come in phase two. Because I have a suspicion that phase two is going to really contain the meat of the actual agreement. And that could be delayed because there's still, this sort of wait and see about who is experiencing most of the negative impact from the trade war. And so, what we might see given that the US has presidential elections next year, is that China wants to wait and see if we feel more pain. And so that will continue to see a delay of the phase two agreement.

Matthew Salzillo: Right. So, for now we both have to claim a small victory, hope our economy stay strong and then see who has to bend the other person's will. Which is actually why in my previous comment, I mentioned that I think we'll have an opportunity to play both underweight and overweight unrest assets in 2020 in the fixed income class.

Maria Giraldo: I think it's a great point.

Remy Blaire: And Matt I would like to get your perspective on the implications of monetary policy for the US when it comes to the fixed income market. So, where do you stand?

Matthew Salzillo: Sure, so I don't think there's any doubt that we're in a low yielding environment. The Fed has eased off their hikes, as we all know. It doesn't look like we'll have much change for 2020 at this point in time. We all know data can change pretty rapidly and that goes back to how the trade war kind of plays out and other things out there. We've seen the US MCA get pushed forward even further, so that may be another positive, but I wouldn't be surprised if we stay in this lower range of yields right now. We've seen a little bit of a backup recently closer to the 2% range, but we really haven't peaked too much above the 200 quarter percent on a 10 year range recently. So, I would imagine that level will probably hold in the future.

Again, this is all data dependent, but there is obviously a very large desire for quantitative using across the globe. One thing that helps the US I think kind of keep a little bit of a ceiling on our rates is that across Europe we're still close to zero. So, if you want any yield, you're kind of coming to the US. We've also seen that when someone in the market stops buying bonds, the central bank will step in and buy bonds. So, it's really hard to kind of get away from that risk on and reach for yield, when you notice that the central banks are there to keep yields depressed over time.

Matthew Bartolini: And I think to that too around monetary policy that's going to be on hold, which for the foreseeable future in 2020 like we will be, is our base case view for the yield curve is that'll be in status. So, the Federal Reserve is unlikely to be pushing up or down on the two year rate and low growth, low inflation is going to keep term premiums negative. Term premium has been negative for quite some time and that's going to constrain the long end. And what we've witnessed is that with the exception of sort of the slight inversion in September, the ochre has basically been trading within this similar window for the last 15-18 months. And it's going to reside in that level, which sort of speaks to this low yield environment where if you had need to get a 4% coupon, you're going to have to take on some credit risk.

And as we saw, many people are trying to take on that credit risk but not dash for trash, because triple C's have not had a great return this year, it's the double B's. And well obviously we saw triple B's and the double B's, the spread between those converse to the tightest level basically since 1994, which is the longest stretch of data you have. So, I think that's the dichotomy between how do you stretch for yield in this environment but not overstretch and all of a sudden take on an uncompensated equity risk.

Remy Blaire: Well I think that's an important distinction there. And you did bring up a term that we've been hearing all year and that is the yield curve inversion. And there has been a lot of myths as well as misconceptions surrounding that term. But when it comes to seeing the inversion and how it relates to recession, where do you stand?

Matthew Bartolini: So it inverted, but it inverted for I think a matter of like 144 minutes. So, it's really not a really full throated inversion. So, I think you need to see that persistently. Right? It was more of a technically driven event. It had really. We are in a slowdown period, if you look at the LEI, it's year over year change has been moving lower for the past 18 months, basically since September of 2018 and that's just indicative of a slowdown. So that's where we think we're going to reside because the government’s fiscal and monetary policy, they want to keep the party going. I mean, Paolo just refilled that punchbowl with the accommodative policies we had in 2019 so the easy money's still sort of there and we're not going to have a recession.

I think the yield curve is one indicator. I think if it was going to be inverted for say three months, that'd be more of a forbearer of a recession to come, but a brief inversion, which then quickly was pulled out of it. It was more of a technical driven event and just emblematic of a slow growth environment that we've been in for quite some time and will likely continue to be because the secular drivers are not changing.

Remy Blaire: Well, I think that's a very helpful explanation. Some of the viewers in the audience are advisers as well as financial professionals and they may be getting that question from some of their clients. So, I think that's a detailed answer that they may not quite tell their clients but thank you so much for weighing in on that. And Laton moving on to you when it comes to the decade ahead, what's the consensus for you when it comes to inflation as well as lower rates, and where do you step in terms of global.

Laton Spahr: It's the consensus of one or I mean I think we are in a period of shocking stability and I think that's been the lesson of the last decade and I don't really see significant reasons to change that. That there are enormous demographic trends globally that are pushing that hunt for yield, we've 35% of Europe and Japan is over 60, it's over 25% here in the US and we're getting close to 20 in China. So, you look at the number of individuals over 60 it really, I think is one of the most important explanations for why growth is so slow, why interest rates stay so low, why monetary policy doesn't have the same effect that it had in prior cycles. I think it gets back to demographics and that's only going to continue on the path it's on now over the next decade, right?

It's the most thing we can probably look at. So, if I'm going to predict a decade out, I think the consensus has to start around demographics. I think that also ripples into something Matt was just talking about that, this fear around the inversion of the yield curve that we were, starting with in 2018 and was really a fear as we entered this year, we have to rethink what that means. I mean in the last financial crisis with the advent and QE, all the new policies and approaches that central banks are taking, the impact of international debt and what that means for currency flows, the size of leverage in China, all of those things I think are forcing the good old fashioned classical economists to rethink a lot of their rules of thumb. Right?

I mean in the fixed income markets we rely on a lot of rules of thumb that have just been broken over the last decade, and the one that I can still hang my hat on is demographics. And the simple observation is that as populations age over 60 they just need less stuff. And so they're less incented by lower interest rates to go out and spend and invest in all these things that create the classic cycles of the '70s, '80s and '90s, so all that boils down to a pretty low growth global environment, relatively little impact for monetary policy, and interest rates that are low for a very, very long time. So maybe that's a decade since we're talking about a decade, I'll put it there. I don't know if that's a consensus, but you know from the consensus of one it makes sense to me.

Remy Blaire: Well, those are some interesting observations when it comes to demographics and it's also good to get your take on a global growth as well as those, our data points going forward. So, I think this is a good way to segue into the global investment landscape when it comes to fixed income. Now you touched upon fixed income ETFs, Matt. So, tell me about some of the behaviors of investors when it comes to their portfolios right now.

Matthew Bartolini: With respect to fixed income ETFs, the structure is sort of like a Swiss army knife. There's a lot of different use cases. So, we see a lot of sort of credit hedge funds, maybe using high yield ETFs to go short credit or replicate some of their cash positions. But then you also have your strategic asset allocation, funding liabilities within pensions. I think what we're seeing from a tactical use case is that investors are trying to basically generate some income within their portfolio but not overextend. So, like I did say, we saw high yield inflows reach a record, I think juxtapose against sort of low equity inflows. You can see that investors were willing to express maybe equity risk through high yield bonds. And I guess that shows the sophisticated tactical nature of ETF investors, that's not really sort of just passive oriented autopilot type exposures, but we've also seen inflows into things like preferred stock that give you a higher yield, still largely investment grade, also areas like mortgages.

Mortgages, you basically had 10% yield more than the ag, but 40% in the less duration, and lower drawdowns historically. So, what we're just seeing is the multiple use cases from investors, whether it is tactical in terms of derivative usage or going short or just strategic asset allocation in terms of long-term views, but intermixed between that. Just tactically allocating to sort of navigate this landscape where returns are likely to be challenged in 2020. We had double digit returns in 2019 and if you look at the yield on the ag at a given point in time, so in the Bloomberg Barclay's aggregate bond index, sort of core benchmark, in the subsequent three year return, there's over a 90% correlation. So, we have a yield of about 2.3%. And if that correlation holds your annualized three year return over the next three years is likely to be that.

And that's going to be under what your capital market assumptions are for historical planning, right? So you're going to need to find that more yield and you can do that within the fixed income marketplace by expressing it with ETFs, because you can rotate into emerging markets or preferred, stocks or high yield bonds, but also leverage active management, which we started to see that industry grow basically about 80 billions of ETFs when the fixed income space are actively managed. And you've seen them actually pick up market share index based, I mean index is so much larger, but you've seen growth in that area and that expands that choice. What we're seeing from use cases.

Laton Spahr: So one thing I want to jump in there, so I mean when we look at the fixed income ETF market, one of the observations that I have is that it prices exposures, right? So, you're looking at regions, you're looking at durations, you're trying to position around something that's somewhat generalized and what I worry about. So as exemptive relief goes away and we have non-transparent ETFs, the amount of innovation in the ETF space is just accelerating from here. What happens in most ETFs that we see though, is that you price exposures and there aren't many exposures. There aren't parts of the credit curve that look particularly cheap or there aren't regions that look particularly cheap. I can say EEM kind of looks cheap and it's okay, but the market can go there so fast that from a fundamental standpoint to say that there's multiple years of excess return to be had by investing in emerging market credit. I don't know if I'd say that.

What it boils down to, to me is good old fashioned credit analysis and I do think that ETFs struggle to do that. That they are exposure vehicles and I think they are great at that, but they've been so good at it that most exposures are pretty expensive right now. Not cheap. And so, if you're going to try to earn some excess return and fixed income, I think individual credit analysis is back in style. I use the word style, which is an exposure. So, I don't know how to do that. But in ETFs, I mean, how would you think about expressing individual credit analysis? Are they broken down to the point you could get that granular?

Matthew Bartolini: So I think, obviously ETFs are largely doing for index based and my firm is largely known for passive investment management, but we always obviously believe active has a role, particularly in active fixed income. I think that's one of the best areas to express alpha generation. Just given the breadth of securities to employ your strategies over. But what we see is sort of two fold, wanting to have a very macro viewpoint and you can just rotate amongst sectors, whether it's looking at the yield curve slope or credit or what the credit spreads are doing and make those road value decisions between say short duration, long duration, sort of play those macro factors. But there's also, to your point like there's a strong case for credit analysis to drive alpha. And I think when we even look at sort of active strategies that we manage, part of the active decision making or active excess return potential it's from sector selection, and then the remaining is from security selection and basically 60, 40 sometimes.

So, I guess to answer your question, we see active management at a security level playing a role, but also the ability for the investors to tactically allocate across the curve and pick up some premium by using other macro based signals, technical indicators, is there. And I think ETFs allow you to do that in an efficient way because you have so many different array of options. And I don't think it's the ETF that is pushing prices to its expense evaluations, I think the market is. Right? I mean the Feds monetary policy. Because I think in the grand scheme of things, passive fixed income investing represents somewhere in the neighbourhood of like 4% of all global bond market capitalization, so extremely low and even when we dive into high yield bonds, it's still low.

High yield ETFs are in a record around 55 billion, but high market yield is much bigger than that, it's still dominated by active. Even core oriented funds, everyone sort of has a little bit of active high yield exposure to. So, I just think the ETF is a great use case vehicle in terms of expressing on those exposures, basically your macro viewpoints and that's a form of active management. One is just at the macro level versus security analysis, which I think also is a great place for active management.

Laton Spahr: Yeah.

Maria Giraldo: The other thing I would add is it's probably only a matter of time before the ETF market dives into more granular exposures. Do you want triple C energy exposure? Eventually the ETF market will figure out a way to give it to you. And this is coming from, I am a Guggenheim, which is primarily an active manager, but I think as an active manager we need to recognize, right? Where the industry is shifting so that we stay ahead of it.

Laton Spahr: Yeah, I absolutely agree. I mean I think the way we've advanced as an industry and we saw it in the equity market first and what that did to passive and active and we went into factor investing and then those factors became more factors, and that the more transparency there is, the better the technology is, the more we can segment these individual asset classes all the way down to smaller exposures, and maybe down to security analysis that's reflected through somewhat passive vehicles. Where that ends up, I think is really another story for the next decade of, will active ETFs start to bridge this gap? I don't know. Non-transparent, I don't know. But I do think the ETF landscape still sets the tone for active. It's not the other way around.

Remy Blaire: And as we look ahead, we know that the ETF marketplace is getting crowded when it comes to products, but indeed without a crystal ball, we won't be able to see quite that far into the future to see how this all plays out. Now when it comes to corporate defaults, Maria, I do you want to get back to you on that, what is your research telling you, especially given that we're in the longest bull market in history and we are pretty late in the economic cycle?

Maria Giraldo: I think right now the big question is the Feds delivered all of this monetary policy accommodation. We've seen a lot of liquidity injected into markets. Are we going to be successful in reflating the US economy next year? Or a lot of advisors have been asking me, are we going into a recession next year? Right now, the early indications are that the Fed's going to be successful. And there is another period that we can compare this to. I've heard this comparison drawn a lot, which is that in 1998 the Fed similarly delivered 75 basis points in easy, same as they did in 2019 and the next recession didn't come until 2001. So, the question with respect to corporate defaults is what happened then? Right? And what happened then is actually shocking to some, which is that the Fed was able to successfully extend the economic cycle, but not the credit cycle.

Spreads never returned to the 1997 tights. I think they're competing now to get there, and they might, but at the time in that cycle between 1998 and 2001 recession, spreads never returned to their tights. And we saw just this multi-year period of high defaults and it was very broad based weakness starting in the energy sector, and it spilled over into retail and to healthcare and to a lot of the areas that are actually experiencing weakness now. So, if we want to draw parallels to 1998 it does not necessarily bode very well for the credit cycle. So, I think now's the time to really stay selective. And if you look at what's happening with corporate fundamentals and company earnings, this is not necessarily a very strong year for corporate. So, it looks like markets are set up for a repeat of 1998 and what followed.

Remy Blaire: Well Maria, since you mentioned a sting selective, could you elaborate on that?

Maria Giraldo: Yeah, there's some areas if you dig down deep into, for example, where earnings have been this year, there are some sectors that have done okay and then there are sectors that have really struggled. The energy sector obviously is an area that has really struggled. The retail sector is an area that has continued to struggle. Healthcare has been pretty weak, and we've started to see defaults in there in that space. And if you follow the fundamentals, there are signs that you would have seen earlier on, interest coverage starts to fall, leverage really starts to go up, the rating agencies start to take action and they start to downgrade these companies, and so through active management you can avoid those areas where we're starting to see rising defaults, and stay in the areas that maybe have stronger fundamentals.

Remy Blaire: And speaking of fundamentals, I do want to move on to you Matt. What is your focus in terms of bonds and what are some of the market conditions you're paying attention to that are affecting the investment landscape?

Matthew Salzillo: Sure, so I think it echoes a lot of movements we've been talking about already today, we really feel that the market is pretty much priced to perfection. There's really not a lot of room to wiggle around here in case we get negative news. So, as Maria said it, while we're not back to the all-time tights, I think the investment index has just touched inside of a hundred basis points to treasury recently, which is pretty tight for the recent history. So, we really feel as though right now is not the time to be reaching for your lower quality bonds. Like I mentioned previously, it's really a time for us to be a bond picker to really identify companies that have strong balance sheets that will make it through a mild recession or even a much worse than that. So, I think focusing on up in quality is really going to be a big focus for us into the next year.

And that doesn't mean it's going to happen in the first quarter of 2020 maybe not even the first half of 2020. We've seen the Fed successfully pushed this cycle along, step-by-step here. But that's something that we have to keep our eyes on and really think about as we go along quarter by quarter and it really week by week. There will be other technical factors like new issue markets, which had been very healthy and very robust. And I think 2020 will probably be more of the same. So, it's really a combination of factors to keep our eyes on and really kind of see how that plays out throughout the first half of the year. So again, we're focusing on higher quality balance sheets and maybe some dislocations and some mispriced bonds, which is what we're all trying to do at the end of the day but being able to identify those opportunities first and in the right way is really important for us as we move into 2020.

Remy Blaire: And Matt you did allude to this, but could you highlight some of the negative news that you might be watching out for?

Matthew Salzillo: Sure. So, we're thinking about the trade war or trade truce, how that kind of works into the future. If we see negotiations breaking down, that would obviously be a sign for us to kind of pull back from risk and get even more into high quality. Spreads have really been on a one way train towards zero, I mean for all kinds of purposes when you have some long 30 year bonds trading at 65 basis off the treasurer, even inside of there, it really makes you kind of pause and reflect and think about technical of what's happening. Where we've come from, where we could be going and how much tighter historically, we've been. There really isn't a ton of room left in what we've seen to kind of go tighter.

But then again, this is really a market that no one's really experienced before, so it's hard to know where the limits will be. Again, one of the things we're looking at is new issue market. Sometimes as we turn the calendar into the new year, a delusion of new issues can really have a negative effect on people. Perhaps, we've seen great returns in 2019 and people start to take a little chips off the table and think about how 2020 will play out and that may just cause people to buy less new issues. So those are some of the early factors we're looking at. Of course, earnings will be a big part of that as well. 2019 wasn't the best year, you have pockets of positive earnings, but it's been okay at best probably.

We're at really high levels of leverage that we haven't seen historically for investment grade, I think credit agencies have allowed companies to kind of turn up their leverage little by little and really not said too much and kind of trust in their plan of de-leveraging or how they're going to use synergies and cashflows to bring them back into the range that's appropriate for each sector. Some companies have been successful and some really haven't. So, another thing to look at is how 2020 is in terms of radiant side. Do they start to really tighten the screws on companies and ask them to really bring their leverage back in line much faster than what they've done in the past?

Remy Blaire: Well, it sounds like there is a lot that we'll be looking forward to and looking out for as we head into 2020. Now Laton, moving on to you. Can you give me your assessment of the credit outlook and tell me about a potential ripple effect?

Laton Spahr: Yeah. So, I mean there's no evidence that we're on the cusp of a big credit cycle, right? I mean, I think the number one element of that is just how long this credit cycle has been. And this whole cycle is throwing these curve balls into people's models that say, well, at some point this is going to happen. We saw a glimpse of this in 2018, right? Everybody thought that was the beginning of it. When we're looking out another year or another decade one of the big themes, we're talking about today is it's very hard to know what is going to trigger the next credit cycle. What I'm looking at is really around currency movements. The last couple frothy environments that got off the boil, were often exposed by a devaluation in China or something like that.

Whether it was on purpose or whether it was technical, the world may never know like a [inaudible 00:38:15]. But when I think of ripple effects, if you look at big categories. So if you look at the triple B space, there's a lot of really big issuers that may be on that cusp. And if you lose a couple of those and they lose investment grade, which is always something we're looking at, that's a ripple effect. And I think that's something that when you look at the exposure and the consensus around, the aggregate bond index, what that would mean because of the consensus built around that is that credit analysis would really start to flow as the way to add value. So, I look at currency movements and I just look at what's going on those borderlines of investment grade and non-investment grade. And if either of those things were to go against a fairly tightly held consensus, I think the credit cycle starts to unfold.

Remy Blaire: And you bring up a lot of important points there. And that is important to consider the currency perspective as well. So, I think this is a good point to move on to sectors. Matt, I want to start with you. Can you tell me what you're observing in terms of the various sectors?

Matthew Bartolini: Yeah. So, our view is they should be actively balancing those risks, right? Whether through just strictly active management or outsourcing that capability and making those relative value decisions, but also security analysis. But we're also talking about the idea of being able to blend different exposures together to create maybe a version of the ag that can offer a higher yield with lower duration. So that speaks towards the sectors. So, we're taking this idea that you need to sort of thread the needle between these risks that are in the marketplace, whether it be excellent genius variables like geopolitical risk or just a growth and inflation risk. What happens if a trade deal results in a much higher plateau of growth where we get maybe 3% because the overhang has been reduced. So how do we actively balance these risks? Because you can't destroy risk, you can transform it.

So, we think about it from a duration perspective. And within duration, long duration bonds had a stellar year in 2019. It's highly unlikely they're going to repeat those gains because if they were, you'd have to have the yield on the long treasury fall by about 170 basis points, it'll be the lowest yield on record and that's unlikely to happen. So how do we structure a duration profile that is able to generate a yield but not overextend? So not take uncompensated duration risk. So, one of the sectors we like is the one to 10 year corporate bond market, investment grade corporate bond. You get a yield slightly higher than the ag, you cut your duration by about two years, you're only picking up about 10 basis points of spread risk. So, you're not overextended from that perspective.

And then within credit, obviously high yield, the carry that you're able to get with it has been attractive in 2019. If we look at where spreads are now, they're in the sort of 380 basis point range depending on the day you're looking at it and looking at a historical return path in that timeframe, your return is roughly over the next 12 months, about 5%. Take that with the fact that high yield bonds are the most negatively convex they've ever been, meaning that upside is lower than the downside that you do have and mostly your returns are going to come from the coupon.

So that's still attractive. I mean 5% return is basically more that you can get in sort of just large cap dividend and equities or even with treasuries. However, the spreads can only tighten so far they're basically 30% below their long-term averages. So, we think sort of two fold sort of siphoning off in your credit exposure, either senior loans which would take on less equity beta. So because HIO bonds are basically the most correlated to equities, they've ever been around 79% correlation in the last 52 weeks, so maybe moving up the capital structure in the senior loans, moving up more in high quality and the fact that the Fed is going to be on hold, that floating rate of senior loans is likely to be unaffected.

We also think in terms of credit, mortgages represent a credit exposure like I mean they do take credit risk. It's largely driven by the yield curve. We think within mortgages you do get 10% yield, but 40% less duration. They have had lower drawdowns as I said earlier. They're sort of modulating your credit risk and then just transforming it. So, you're looking for yield in this environment and moving a portion of your credit book or portfolio into say emerging market local debt. You now have transformed your risk profile because emerging market local debt risk is driven by currencies. And you're able to go into an area that gets about a four and a half, 5% coupon depending upon the credit, but also this largely investment grade, the local debt markets about 80% investment grade. So, we're thinking about how do you actively balance these risks in the marketplace, mitigating duration, not taking an uncompensated bet, but also transform that credit exposure, so you're not so equity sensitive, but you're able to still get a yield that you historically had.

Matthew Salzillo: Well, Matt, as you were speaking, I noticed that the other panelists were nodding during different portions of your answers. So, moving on to you, Maria. Where do you stand in terms of sector?

Maria Giraldo: Yeah, so I'll focus a little bit about on the high yield and the bank loan sectors because I'd imagine that for an advisor that's looking for which sector is going to offer me the best return next year, they're looking at equities, it's maybe a little bit too hot. They're looking at treasuries, a little too cold and maybe high yield is just like just right in termSs of the risk spectrum. In high yield, I think the issue with high yield is that spreads are just very, very tight. So, if you want to earn return or if you want a position within the sector for next year, you have to be expecting a strong growth environment or at least just generally moving sideways.

If you see any downside risks, there's a lot more risks to spreads widening in high yield than there is any more room for spreads to tighten. And then in particular, I think it was mentioned earlier, I think Matt mentioned earlier that triple C's have really gotten punished this year as investors try to avoid those with the highest default probability risk. And in some sectors, those that were the closest in terms of proximity to default, like the energy sector. And again, they offer some very decent spreads, they're very, very attractive yields. But you have to be very comfortable with the risks because if we do go into an environment where there's a lot of volatility, even just a pickup in volatility, we don't necessarily have to go into a recession. We see a pickup in volatility that tends to be correlated with spreads.

And the bank loan sector actually offers some interesting opportunity going into 2020 because this rarely happened in the long 30 year history of the markets, but loans right now look cheaper than high yield bonds do. And part of that has had to do with just the rotation out of floating rate this year and into fixed rate. And that's created this relative value opportunity in the loan market. Part of what's driving that opportunity is because credit quality overall in the bank loan market has deteriorated. Most of the bank loan market, now it's single berated, whereas the high yield corporate bond market, it's mostly double berated.

So, some of that is due to rating differences, but even when you control for that, in a lot of cases, double B loans actually offer better value than double B rated bonds. And even further, what we've found is that because of this relative value proposition and just because of differences in investors who focus on it, sometimes you can even find a loan trading more cheaply, meaning it's more attractive to you as an investor in the same capital structure. So, for the same issuer, you'll find a loan that offers you better value than the unsecured bond where that that type of relative value doesn't make any sense. And so, going into 2020 if you're looking for this sort of just right opportunity, I would look specifically for that where you can migrate a little bit up in quality, take a little bit of risk and find those relative value opportunities that definitely don't make sense.

Laton Spahr: So one point I wanted to make on that as well, so I'm not a fan of loans as a category, but there are really cheap loans out there. Right? So, if you get into the category, if you're buying exposure to the whole segment, I think it's a dangerous place to be, because of that deterioration in the average credit. But there are these individual opportunities that I think you can make some hay with. And I think that just speaks to the lack of really broad opportunities anywhere. I mean you have to segment things out into individual credits, individual regions, individual currencies, little parts of the duration curve that may be a little bit attractive. And you do have to be careful when you're talking about relative value. Two things right next to each other, one may be cheap, one may be expensive, but they both may be extraordinarily expensive relative to a lot of other opportunities.

And I mean I'll come back to this later, but I'm looking for ways to participate in growth and maybe a little bit steeper yield curve. You know RMBS is something that we haven't talked a lot about, and then emerging markets with local currency exposure, not us dollar denominated. But those are things that I think help diversify out of more conventional US treasury, corporate credit portfolio, but I'm a little probably more negative on the loan market than I think it sounded like you were, but I think you can find individual credits.

Matthew Bartolini: I would say in loans you have to be active.

Laton Spahr: Yeah.

Matthew Bartolini: That's you just have to. Like the mispricing you can exploit, and also just the size and liquidity in that space. Being an active management is the way to go for loans.

Laton Spahr: Yeah. I think they complement other categories really well, but to have a billion dollar, $10 billion portfolio of just loans, there's going to be some bad stuff in there.

Remy Blaire: And Laton since we're talking about mispricing, do you want to weigh in on some areas where you're seeing this?

Laton Spahr: I mean they're all modest and I do like emerging market credit, local currency. I think Latin America is actually a little bit interesting. It's always a scary region because you never know what's going to happen with currencies down there. But I think given the more recent negative attack from the US on Latin America trade, it opens up some opportunities to start looking as a contrarian there. And then, I also like the mortgage back market in the US. I think we're going to see the yield curve steep in a little bit, the yields are relatively good, so those are maybe a couple areas that I'd touch on that we haven't spent a lot of time on yet.

Remy Blaire: Well I think when we're talking about opportunities, it's important to highlight some of the risks as well.

Laton Spahr: Definitely.

Remy Blaire: And so Matt, I do want to get your take on some of the opportunities that you're keeping your eyes on in terms of sectors within the fixed income market.

Matthew Salzillo: Sure. So, I speak on these opportunities being very hopeful. They may not necessarily exist at this moment. Some of them do, some of them may not. On the corporate side, we're looking at healthcare, I think Maria spoke a little about this earlier, and energy, right? So healthcare, there would seem to be some political change in the future that has driven some uncertainty and maybe some mispricing there. So, I think in 2020 there may be an opportunity to look at some companies there. We've seen some companies merge that no one really thought would happen previously. So that's an area where there may be some opportunities. The energy, we all know that there's been some issues on the fringe in terms of the triple B names. We think there could be some opportunities there that we may see some of the weekend companies fall, maybe defaults, and there may be a chance for some synergies for a larger higher rated company come in at some leverage, healthy leverage and pick up some pieces and kind of make it work for them.

So just because energy is kind of the frown upon sector right now, it doesn't mean we can't find some opportunities going forward. Away from the corporate side, we do find some opportunities in the securitize side. So, one thing we haven't talked a lot about is maybe CLOs, right? So recently there's been some technical things happening with CLO market and I think where some large buyers overseas have stepped away, and there's been a little bit of a shift in terms of managers having to rejigger some of quality constraints and a lot of the higher quality loans got baby thrown off the bath water. So that started changing in the last week or so where some of the mispricing have started to kind of get tighter again, but we think there may be some opportunities there going forward. We also... And this may not be a super popular opinion, but we do like some of these subprime auto structures that are out there and some subprime consumer loans out there. We think the credit enhancement is very healthy in some of these structures.

It's not every structure, but that's part of the reason why as an active manager you pay us a fee to find these for you. And we've had some great success in that area in the past. And we think there's definitely going to be some in the future as well. And then a newer area that we've kind of looked at is there's a Freddy K Agency, CMBS Sector that's out there that's based upon multifamily homes. And we like the LTVs that they've all been improving and very healthy. These are some of the older issue ones and we like the market there. So those are just a couple of the areas where we think we might be able to find some opportunities in 2020.

Remy Blaire: And we've covered a lot of ground so far in this fixed income masterclass. So, I do want to move on to myths and misconceptions surrounding the fixed income marketplace. When we're talking about retail investors, some might believe that fixed income is just for retirement. But there are plenty of other myths out there. So Matt, starting with you, what is one that you'd like to dispel?

Matthew Bartolini: I mean I think we sort of hit upon a little bit earlier, but just sort of the size of the ETF market and the ability to sort of push prices around or that fixed income ETFs or some sort of weapon of mass financial destruction. They've been tested, we've had periods of volatility, the operational structure has been tested. If We look at the share of trading within say high yield ETFs, which some of them were liquid underlying securities, they basically represent roughly around 4% of the underlying cash bond volume. So definitely not a sizeable share that could lead to any sort of fear-driven concern.

So, I think just understanding the size and scale of the fixed income ETF market and that it is relatively small and also the way the operational structure works where basically the ETF is not buying or selling bonds it's a in kind creation redemption. Some of the myths we continued to dispel the ETFs, particularly fixed income ETFs will not blow up the financial markets. They're actually been additive to liquidity and we see that all the time, particularly within pension plans or even active managers using ETFs as a liquidity sleeve, because you can basically slice out a portion of your portfolio and do an income creation to the ETF. And now instead of managing a thousand line items, you manage one that has a secondary market, but also the ability to tap into the primary. So just we're leading more on education and the liquidity benefits, but also the size and scope of the fixed income ETF market in order to be relatively small to the broader available capital out there.

Remy Blaire: Maria, what is a myth or misconception you'd like to address?

Maria Giraldo: I would say the idea that a lack of liquidity is a fixed income investor's worst enemy. A lot of investors aren't comfortable with the lack of liquidity, but I actually think that you can find some good value within fixed income as long as you're willing to give up some liquidity and maybe manage your liquidity in another way. Maybe you barbell liquidity for example, take some... some portion of your portfolio can be in very safe havens, sort of treasuries or agency, backed securities that still pay you some spread over treasury, so a higher yield. And then on the other side you can stay up in quality. Matt mentioned CLOs triple aid, collateralized loan obligations, relatively less liquid but offer great value, great structure, high quality have been proven to survive the 2008 financial crisis. We also like a whole business securitizations, asset backed securities, private debt, there's middle market loans, there's a lot of unique ways with... As long as you're willing to give up a little bit of liquidity, you can have good yield and still stay up in quality.

Remy Blaire: Well, I think it's very educational to address some of these myths out there because you have to explain why these aren't true. Now, Matt, what about you? What is a one misconception or myth that you'd like to talk about?

Matthew Salzillo: So it may not be the most popular opinion on this desk here, but one of the things that I really think is important is having active manager versus a passive manager when it comes to fixed income. I can understand where there's uses for a passive ETF or passive in fixed income in general, but I really think that it's a much different ball game than in equities. So, for example, the Bloomberg Barclay's aggregate benchmark has maybe six, 7,000 securities in general, and ETF can't go out and buy those very easily, so ETFs, generally I’m not talking about everything. We'll try to replicate the same risk and characteristics on a portfolio level, which is good.

But the problem is you will find that ATNT might have 30 different bonds. Verizon might have 30 different bonds; you can't own every single one of those bonds. And so, in a way an ETF may actually be making an active decision to find what they think is the cheapest bond out there. So that's what we're doing. We're making active decisions to find the cheapest bonds in terms of maturity, risk profile sectors. We think that there is definitely a case to be made where active managers will definitely pay for themselves and justify higher fee. And we've seen it where we've grown an AUM base because we think the clients are looking for an active manager that can provide positive excess returns over longer periods of time, and really give them, justify our fee. So, while it may not be the most popular opinion, I still think that being an active fixed income manager right now outweighs being a passive fixed income manager.

Matthew Bartolini: I would just say like from the way we manage our index-based structures, they're actively. Right? We don't seek excess return doing credit selection or security selection. We're seeking returns that match the benchmark, but we're actively managing the portfolio based on different risk characteristics, whether it be yield duration, credit spreads, sector allocations, so our view like investing in is never passive. Like we're going to act of the construct the portfolio also for liquidity, making sure that if there's a bond that we need to buy to replicate the index, that it doesn't impair the overall tracking in terms of having to pay say 4 cents over the offer in order to access that bond. So how do we unfairly replicate that? Our goal is just to provide exposures to people to build portfolios, and I do think from a security selection perspective and we think, where does active work well from a return generation?

I think fixed income, it's been shown that active managers have that persistency because you're going to employ your skill over a large amount of breath. So, we just have that conversation about active management and that we do actively manage our index based vehicles, but it's not in terms of seeking excess return, it's in terms of seeking that benchmark return, which there's a lot of securities, right? So, we have to sort of optimize and structure and stratify sample. And it's one of those conversations that I think it's healthy to have. And will help a client about portfolio construction.

Remy Blaire: Yeah.

Matthew Salzillo: And I think there's definitely different parts of the yield curve or sectors that it may work even better for, than perhaps paying someone. If you're going to buy a one to three treasury ETF, you don't need to pay an active manager 30 basis points, 40 basis points for that. You can generally get an ETF much cheaper than that. And I think that makes some sense. I think when you're comparing to a core bond fund or a long credit fund where we've seen active managers sometime get an excess of a hundred basis points of excess return, I think that's where it starts to really be a conversation to have. Right? So, I'm agreeing with you, but while I'm still saying I think the act of management is a very important part of the fixed income market right now, and probably into the future too.

Remy Blaire: Well Laton, I know we have to get to you regarding that, some misconceptions, and I noticed that you're nodding. So, what is that one that you'd like to dispel regarding fixed income?

Laton Spahr: Well, there was a lot when we were talking about the benchmarks and active management and all that. I mean a lot of what I've had to say is around the value of active management. And I think just to dovetail on this conversation, the aggregate benchmark doesn't reflect the risk profile of your average investor, I think. It's much longer duration and it doesn't have the credit analysis, right? It's just built as an index of all the securities that represent those exposures. So, I think in the fixed income market, the benchmarks are less representative of individual risk tolerances than they are in the equity market. And I think that's a potential misconception that that fits into that conversation.

To more specific things, I think a misconception is that there's a problem with the repo market, right? So back in September we had this blow up, everybody freaked out about it, we're in year end, everybody's writing about it again. When I look at that, there are so many tools at the disposal of the Fed to fix those problems that if they continue to be problematic, they will get fixed. And we know how they're going to get fixed. And there's the slow fix, which I think is regulation where you have more prime dealers qualified to participate, or you have a standing repo facility from the Fed. Which is a little bit of the nuclear option. And maybe there's repo effects decades down the road where leverage increases even more. But the point is the repo market, which scared people in September, I don't think is a problem. So that's a little bit of a red herring.

And then the last misconception, and this gets back to active management, I mean we've got some really, really giant fixed income managers on this planet. And I don't think bigger is better when it comes to active management. Because a lot of times you can't buy the bonds where the mispricing really resides because you're too big. And so you end up taking that credit risk through swaps and you use leverage and you do things that have some unintended complexities to them, that when the next difficult environment arises, that leverage and that counterparty risk, don't work to the benefit of some of the biggest bond managers out there.

Remy Blaire: Well we are almost out of time. So, I would like to wrap up this discussion by thanking all of you for joining me. And we were indeed able to cover a lot of ground and although we weren't able to get to all sectors of the fixed income market, I think we're able to balance the risks as well as opportunities. So, thank you so much for joining me.

Laton Spahr: Thank you.

Matthew Salzillo: Thanks so much.

Matthew Bartolini: Thank you.

Maria Giraldo: Thank you.

Remy Blaire: And thank you for watching. I was joined by Matthew Bartolini, Managing Director, Head of SPDR Americas Research at State Street Global Advisors, Maria Giraldo, Managing Director of Macroeconomic and Investment Research at Guggenheim Partners and Matthew Salzillo Managing Director and Portfolio Manager at Sun Life Capital Management and Laton Spahr President at ALPS Advisors. From our studios in New York City, I'm Remy Blaire for Asset TV.