MASTERCLASS: Fixed Income - July 2021

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  • 54 mins 42 secs
With inflationary fears on the rise, this panel look more closely at monetary policy, interest rates, and the state of the economy. Three experts share how they are hedging against different risks and where they are finding opportunities in fixed income.

  • Ed Al-Hussainy, CFA®, Senior Interest Rate and Currency Analyst - Columbia Threadneedle Investments
  • Tom Carney, CFA®, Director of Fixed Income Research, Portfolio Manager - Weitz Investment Management
  • Julien A. Scholnick, CFA®, Portfolio Manager - Western Asset Management Company

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MASTERCLASS

Jenna Dagenhart:                                 Hello and welcome to this Asset TV fixed income master class. We'll cover inflationary fears, fed policy, where fixed income investors are finding opportunities, and much more. Joining us now, it's an honor to introduce Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle Investments, Tom Carney, director of fixed income research and portfolio manager at Weitz Investment Management, and Julien Scholnick, portfolio manager at Western Asset, an independent specialized investment manager of Franklin Templeton.

                                                            Everyone, great to have you with us and Ed, kicking us off here, what are the big catalysts driving fixed income returns in the current market?

Ed Al-Hussainy:                                     Yeah, absolutely. I was to categorize things in two buckets, broadly would be starting valuations here are relatively tight across, I think, a broad range of fixed income assets, and the second is policy. Within the policy space, broadly speaking, again, both monetary and fiscal policy are in the middle of significant transitions in terms of both the fed's posture and what the government will do with respect to infrastructure spending and other social safety net spending coming down the pike.

                                                            Both of those transition points are coming in the course of the fall, and so for us as fixed income investors, we're looking at both changes in the duration posture, as well as credit spreads in terms of how they can move through the rest of the year, and those are the two starting points.

Jenna Dagenhart:                                  Tom, it seems we cannot make it through a panel discussion in 2021 without inflation coming up. How are you monitoring inflation risks?

Tom Carney:                                         Well, maybe I'll start off by saying the one we're definitely not doing is trying to discern inflation trends by annualizing one month, three month or six-month data. For example, the annualized CPI inflation rate of 7% plus that was reported in the past six months is probably as misleading as the annualized six-month rate of minus .6% recorded a year ago.

                                                            As to the specific monitoring question, we're most likely doing many of the same things that my fellow investors are doing on this Asset TV panel are likely doing, and that's staying abreast of the macro level data that we all get to see on a day to day periodic basis, to the more micro level, which allows firms like all of ours, but to borrow from the extensive work that we do, for example, at Weitz, within our own portfolio companies, their competitors, their suppliers and customers, across not only what we do on fixed income but in an environment where we are fully integrated with our equity teammates gives us a pretty broad tapestry to draw information from, and to even the super micro where each of us have an ability to see in talking with friends and neighbors, what is happening to their own personal consumption basket.

                                                            While we probably have all experienced a summer like no other, it arguably is a spring break for adults in terms of how much people are willing to get back on the road and travel, and so we're certainly seeing those pressures, anyone who wants to rent a car, maybe fly a plane, but we have to realize that that may not be the same sort of inflation data that we might see a year from now. Ultimately, though, we're trying to make sure that we strive to see the proverbial forest for the trees. Namely, how the risk inflation might pose to future fixed income purchasing power returns, because at the end as fixed income investors, we have a contract that has a specific grade over a specific term and so that real return, the difference between the coupon that we receive and how much current or future inflation reduces that return matters a lot.

                                                            While I mention that we're not annualizing recent data to make investment decisions, the current trend is clearly not a friend of fixed income investors. For example, the current gap between the 10-year US Treasury yield of approximately one and a half percent and US CPI that's at least trailing north of 5 is the largest negative number that we've seen since 1980. In fact, it has only been more negative for 10 months in the last 70 years, all of which were in 1974, 1975, or 1980. Such a deeply negative, albeit crude measure for real yields is super good for financial conditions today, but we can't help but wonder if we're building up to another accident, which we always seem to have at some point in time, given the current mismatch between inflation or potential inflation in bond yields.

                                                            These are some of the things we're monitoring on a day-to-day basis.

Jenna Dagenhart:                                  Julien, do you think inflation will truly be transitory as the fed has said?

Julien Scholnick:                                    That's a good question. Obviously, pretty topical. Our thought is that the elevated levels of growth that you are seeing in the first half of 2021, part of that is coming from the reopening trade which is occurring as we all know. Part of that's occurring from much higher levels of fiscal spending which came much larger and much quicker than many were anticipating and part of that resulted from the change in politics and the change in control of the senate. We do think that, though, the path going forward as it relates to fiscal is not going to be as positive and as big a stimulus to the economy as it was in the first quarter and it's going to be in this quarter, as well. We think that's going to tail off somewhat going forward and the ease with which large fiscal packages get passed, we do think, again, that is going to be somewhat diminished going forward, and the elevated levels of growth that we're experiencing for 2021, we could end up in the range of 7 to 8% for GDP growth.

                                                            We do think that falls back down to the low single digits going forward into 2022, and if that's the case where you're in a period of sharply falling or relatively sharply falling GDP growth, it would be uncommon to expect to see inflation continuing to move higher. When you listen to Chair Powell speak at the June FOMC meeting, he did reiterate that while current levels of inflation are elevated, he does expect those to be transitory, and when you think about the factors that are causing some of these elevated levels of inflation like the reopening and bottlenecks related to the reopening and to supply disruptions that have occurred over the past year, the expectation is that those will resolve themselves as supply chains further open up and as the economy continues to reopen, so it would be our expectation that these elevated levels of inflation are transitory.

                                                            Could they persist for a bit longer? Sure. It does take time for some of these issues to be worked out, but we do try to keep in mind some of the longer term secular forces that are holding inflation down and were holding inflation down below trend even prior to the pandemic, things like aging demographics, higher debt burdens which have only been exacerbated throughout the crisis, the increased use of technology which, again, was pulled forward quite dramatically over the past year, all of these forces, again, are longer term, have secular impacts and impart a dis-inflationary catalyst, if you will, and so we think those remain with us.  It remains to be seen whether these elevated levels can be sustained.

Jenna Dagenhart:                                  In addition to inflation, what are the biggest market catalysts out there right now?

Julien Scholnick:                                    I was just going to say, I mentioned it briefly, but we do think that fiscal is very important and back in the first quarter of this year when you got the run-off election in the senate and that tipped the balance of power to the Democrats, you really saw the market begin to place a much more meaningful expectation of fiscal spending and clearly we got that with Biden's first plan, just under two trillion, which passed relatively easily. We do think, though, that fiscal going forward, and you've heard large numbers that are being thrown out there, multiple trillions, depending on the day and depending on where things are going to end up. Even though those numbers may be large, we do think they're going to be spread over many years and so the impact won't be as concentrated as the initial fiscal package was.  There will also be some offsets in terms of higher taxes, so that'll somewhat diminish the impact of fiscal, so we do think that's important. That has been a driver of market pricing recently and that's something to watch going forward.

Tom Carney:                                         I'll maybe just dovetail a little bit on what Julien said, and one of the data points we're certainly watching with respect to how easy conditions are is, for example, the Goldman Sachs Financial Conditions Index, which is at a multi-decade low, which, what that implies is that, and everybody who's tried to get a loan can see in the marketplace, as Ed pointed out with lower spreads, and just lower nominal yields period, that is a really powerfully good, strong sign for the economy. That is something that we're certainly watching in terms of maybe excesses building in the marketplace, but it certainly could be an early warning signal to the extent that tightens going forward.

Jenna Dagenhart:                                  I see you nodding your head, Ed. Anything you'd like to add?

Ed Al-Hussainy:                                     Yeah. Maybe I'll add, just, the global dimension of what's going on, I think, is quite interesting, as well. We're seeing, I think, a more pronounced disconnect, both in terms of fiscal and monetary policy between the US and Europe and Japan. If you take a step back, look at what the trajectory that we're on for the next several years, we will have liquidity withdrawn here in the US. We will have, again, sequentially fiscal support decline from relatively elevated levels, and in Europe, monetary support will remain in place, really, for the foreseeable future, and the same thing in Japan. I think it creates an interesting disconnect in terms of policy support across these major regions. There's two follow-throughs from that. One, from a risk asset perspective, risk assets in Europe will enjoy that policy support for longer. It remains to be seen whether that shows up in credit spread differentials with respect to the US, and second, to the extent that there's room for rates to rise here in the US. That room is much more limited in Europe, both in the core and in the periphery, so we'll see, I think, that divergence play through in the coming years.

Jenna Dagenhart:                                  Taking a closer look at monetary policy, earlier this year the fed called for no rate hikes until at least 2024, but then at its June meeting, the dot plot signal that we could see two rate hikes by the end of 2023. Obviously, markets didn't initially love this news, but Julien, what was your reaction to the June FOMC meeting?

Julien Scholnick:                                    Sure. I think there's a couple things going on which the committee had to discuss and analyze at their June meeting. One, they have to look at the incoming data and when they look at the recent unemployment data, that tells one picture. You've had two months in a row now of below expectation job prints. You had just under 300,000 job print in April, and then you had about 500,000 jobs in May, both well below the million plus jobs which was the expectation heading into those meetings, so that's been a disappointment, and then on the inflationary side, you've had two months of above trend inflation prints and you're now running at a very elevated year over year levels of inflation, so I think the feds had to balance both of those and it appears that coming out of the meeting, they did appear to shift some of their bias and give a bit more weight to the inflationary prints that we've realized, not the forward looking measures of inflation, because if you look at what the fed forecast in terms of their model in 2022, they really didn't move their core PCE number. Clearly, they moved up their number for 2021 to just over 3% from the low 2s, but really unchanged in '22 and unchanged in 2023, and given their new average inflation targeting framework, what they're basically then saying is by having the median dot now show two hikes in 2023, is they're putting more weight on the fact that they've now essentially met their threshold for average inflation target [inaudible 00:13:21], they've been able to achieve 2%, modestly above 2%, over the period since the recession that we experienced. Given that outcome, that's what the markets took as a relatively hawkish signal.  They did allude to the fact that there is continued progress that needs to be made on the unemployment picture and they did not do anything really to suggest that taper was going to happen any time soon. Chair Powell mentioned that they began talking about talking about it, so again, that's something that is still a long ways off. They need to see substantial further progress made before they can really have some more imminent timeline, and so it was a bit of a mixed picture, but we do think they weighted their analysis about more towards the realized inflation that we've seen away from any potential concern about future inflation and also, again, shaded their bias a bit towards inflation relative to the unemployment picture, so we think that was a modestly hawkish outcome for the meeting.

Jenna Dagenhart:                                  Spending a little bit more time on the fed, Tom, as a fixed income investor, is monetary policy keeping you up at night?

Tom Carney:                                         Short answer, no, but speaking to my sleep patterns, and I might speak for Julien and maybe even Ed, I might suffer from what might describe financial post traumatic stress disorder from the experiences we all went through in the early part of 2020 when the bond market in many places, for all intents and purposes, just seized up, but it did provide incredibly valuable lessons that reinforced ours, and I'm sure, fellow panelists' long held conviction about the importance of real liquidity and convicted credit underwriting. These experiences from a year ago, while we might have dreams about them now, will pay meaningful dividends when, not if, the next crisis occurs, but as to monetary policy, the feds' June meeting, and Julien covered this quite well, highlighted that they're not completely willing to let the inflation genie get out of the bottle. Clearly, the timeline for normalizing monetary policy is being accelerated because the US economy is making swift progress towards the expanding list of goals the fed is pursuing, namely inflation and inflation expectations, employment, and properly functioning financial markets which we didn't, certainly, have in certain parts of 2020, but what might be keeping investors up at night could be, is that should inflation make a comeback, and all 18 members of the FOMC at their June meeting said that there was a higher degree of uncertainty around their own inflation forecast, up from 16 in March.  All of them are really unsure what inflation's going to do, but if it does make a comeback, the government and central bank's role in the economy is now completely shifted from where we were 40 years ago when the inflation dragon was last slain. Back then, Paul Volcker was appointed due to his inflation fighting credentials and President Reagan had a mandate to reduce the role of government in the economy. Fast forward 40 years and President Biden has placed very big government at the heart of the economy, just as the fed has embraced this new acronym that Julien pointed out, AIT, average inflation targeting, and is now waiting for actual economic progress and not just forecasting.  If you combine the annual US fiscal deficit with the increase in the fed's balance sheet as a percent of GDP, the only time we see anything like this, history does matter, this level of stimulus, was briefly during World War II. The great financial crisis of '08, '09 and the 1930s depression don't even come close. It's this level, even if it is slowing, this coordination, especially in the US, that can mean that this time may truly be different with regards to inflation. Time will tell, but if this time is truly different regarding inflation, the fed and big governments' current policies could be the two headed version of Freddie Krueger as the potential inflation bad actors in the remake of Nightmare on Elm, or is it Wall Street? That could keep investors up at night.

Jenna Dagenhart:                                  Ed, are there any trends that concern you related to the possible end of QE and fiscal support as they relate to consumers and the bond market more broadly?

Ed Al-Hussainy:                                     Yeah. I think Tom and Julien put it really well. From my perspective, I'll say two things. In addition to the tail risks of inflation skewing to the upside, first is the labor market. The fed has, and it signaled so at the June meeting, a really high degree of confidence that the labor market will heal and that we will return to not just high levels of employment but to maximum employment which they define with a pretty broad bush in terms of both labor force participation, low unemployment rate, wage growth, equity across gender, race, geography and so on.

                                                            There's no guarantee, in my mind, that that will happen. In previous recessions, we've seen significant levels of scarring. I think the good news is, so far, I think fiscal support has short-circuited that process and we've actually seen significant progress in the labor market front, year to date, but I think it's healthy to retain a level of skepticism around how the labor market will evolve. There are significant structural changes happening underneath. There are significant psychological changes happening in how people are making employment decisions at the moment, and whether to come back into the labor force.

                                                            How that's going to play out over the next couple years, I think is still an open question, and it's possible that the some of the support is withdrawn prematurely, so that's one side of the risk. The other piece is, look, with respect to inflation, obviously, we're all looking at the up side risk of inflation, but I think it's also important to retain the possibility that we return to, sort of, a 2018, 2019 picture where inflation returns to below 2% and remains sticky at those levels, or in other words, the fed's new monetary framework would not have achieved inflation sustainably above 2$ which is their goal, and that brings us to, essentially, the core of the fed's problem, which is, they don't really have a process that identifies what drives inflation.

                                                            We're feeling around in the dark, both as policy makers and investors, and so the possibility that inflation, again, returns to sub 2% levels is a little bit disturbing because it again puts pressure on the fed to change things up.

Jenna Dagenhart:                                  Julien, now that the fed is talking about talking about it, are taper concerns justified and will taper this time around, if and when it happens, look like the last taper in 2014?

Julien Scholnick:                                    I think that the potential for a similar taper situation like we saw in '13 and '14, it's a little bit different. In 2013, the market was really surprised by the timing, the FOMC announced that they would be making some tapering decisions and starting that process sooner than market participants expected, and so that really wasn't well telegraphed, [inaudible 00:21:23], more surprise to the markets and that's really what precipitated the 100 plus basis point sell off you saw in tenure notes and 30 year bonds in a very short period in the spring of 2013, and continued throughout the summer, leading up to the September FOMC meeting in 2013.

                                                            At that meeting, though, the fed did not make any major adjustments, whether to their dots or to other portions of their program, and then you saw the market really re-price and you saw that really begin a very significant rally in treasury yields that continued throughout the course of 2014 which really reversed the whole sell off that you saw in that brief time period in the spring of 2013, so this time around, we think that that memory is obviously still fresh in the minds of many market participants, as well as the fed. We think they're going to be, obviously, very transparent. Want to do what they can to be as transparent as possible, and I think you're already starting to see that process in place just by the questions they're being asked, by Powell's response and the discussions happening.

                                                            He's indicated that the market will be well-advised in advance of the discussion, and then everyone's going to be pretty clear about when the timeline starts, and so if the discussion ultimately happens in August or September and the program's put into place in December and then actual taper begins in January, if you follow the timeline like that, I don't think anyone out there is going to be surprised by things. If they are, then they're clearly not paying attention to what's being said out there and what's being discussed. That's the first point, one, I don't think you would see the same market reaction.

                                                            Now, you see a bit in Q1 of the market getting ahead of the fed and really pulling forward the expectation of when the fed would first raise rates, and even today, falling the June FOMC meeting, where the fed did pull forward that the meeting forecast into 2023 for two rate hikes, the market's already gone above that, so the market's already pricing in rate hikes in 2022, a greater than 50% probability, and market's already got more than three rate hikes priced into 2023, and if things and inflation continue to proceed, then you could see them pull forward the thought that taper maybe would occur sooner than the fed would want it to, but we do think they're going to be very well telegraphed, and so it shouldn't be a surprise like last time around, but that being said, markets obviously can run ahead of the fed and market participants can push things in a direction that the fed's maybe not quite ready to go yet.

                                                            One other point there would just be the yield curve. Following the taper tantrum in 2013, not only did treasury rates rally, you saw a very significant flattening of the yield curve led by the long end. Obviously, in today's markets, you're starting from lower levels, so after the taper tantrum, you got to 3% tenure notes and 4% bond notes. Today you're 150 and 210 on 30 year notes, so you're starting from a different standpoint and the forward market also already has the curve flattening pretty significantly, so today if you look at the spread between [inaudible 00:24:43] and bonds, after the 15 basis point flattening we've had for the past two days, you're right around 120, and the forward rate in two years’ time when the fed would actually be thinking about raising rates is already 65 basis points, that spread between [inaudible 00:24:57] and bonds, so it's somewhat up in the air, I guess I'd say, in terms of how much the curve could flatten from here although that's been the initial knee jerk reaction, and what you would expect with a bit of a hawkish surprise.

Jenna Dagenhart:                                  Ed, what are some of the tools you can use to mitigate the impact of higher rates and the potential for higher inflation in fixed income portfolios?

Ed Al-Hussainy:                                     Yeah, I think, broadly speaking, three dials that we think about in our multi-asset and multi-sector credit funds. The first is active duration management, and that's kind of the most important thing to do, both versus our peers and versus our benchmarks, and so if we are walking into an environment where we see sustainable pressure for rates to rise, we will be lowering our duration. We were relatively low duration at the start of the year. We recovered some of that as rates rose, but again, if we have a new catalyst on the horizon, in my mind fiscal policy's a really good candidate, if that catalyst plays through in the second half of the year, we'll be looking to lower, lower duration.

                                                            The second is things like floating rate products and products where we see credit spread that can absorb some of that increase in nominal treasury yields. The tools that stand out, obviously is loan products as a proxy. You get a little bit of credit exposure, in addition to the floating rate component, and then mortgage-backed securities and CMBS, commercial mortgage-backed. Both of these, at the moment, from a valuation perspective, stand out as quite attractive, first because they give us exposure to the household balance sheet, and second, if you look at them relative to corporate credit spreads, there's a little bit more value there, so those things, I think, to us, look quite attractive. The final thing is the usual inflation hedges. In my experience, they tend to pay out during periods when inflation is not actually very high, and TIPS is a really great example of this. They've been exceptionally attractive, but they've paid out in the course of the past 12 months, and now we've ended up at a point where real rates, the long end of the TIPS curve, are relatively low. They have started to rise, and break evens are relatively high, so the inflation premium that's already priced into TIPS is elevated, so from my perspective, investing in TIPS at this point is quite unattractive, so the way we've positioned at the moment is to actually be short break evens with the view that some of that inflation premium starts to come out.

Jenna Dagenhart:                                  Tom, moving forward, how will you be protecting your portfolios and hedging for risks such as higher rates?

Tom Carney:                                         Yeah. This kind of question, and I was pondering it beforehand, if we were all to get it together, it would be, probably, in often cases, like a couple carpenters trying to hammer the same nail in the same way, so I'm coming in a little late, but I would echo a lot of what Ed just said, but while we always strive to adhere to our investment mandates, we see, like Ed, three key ways to hedge against the prospect of higher rates should they actually occur. One, again, similar to Ed, to be particularly tactical in managing lower overall portfolio duration when appropriate.

                                                            Two, similarly, is to increase exposure to floating rate instruments where appropriate, and for us, we've done that most recently and most meaningfully in the corporate collateralized loan obligation market, and three, slightly different though but similar, is to continue to invest as we always have. That is, one security at a time, where we think the risk/reward is in our favor. For example, using a corporate credit investment as an example, where we believe that there's a misprice between where it's trading in the marketplace and where we see value is, and that it could reward investors via spread compression even in, at least not rapidly, but even in a rising rate environment as the investment thesis plays out.

Jenna Dagenhart:                                  Tom, I want to get your take on CLOs in just a moment, but before we get there, Julien, how is Western monitoring different risks and how do you structure portfolios in a rising rate environment?

Julien Scholnick:                                    I think some of the options that the others mentioned, we would be on board with those and think that makes sense. I do think, though, sort of the time period that you're talking about is important, so is the rate rise occurring in a very brief time period? Is it spread out over a longer period of time? We talked about taper last time around 2013. That was a very challenging period, not only for treasuries but also for spread product because it occurred in a very short time period, a very rapid rise and so investors just wanted out of fixed income broadly, and so that negative correlation that typically exists between your risky assets, your corporate spread product and structured product and whatnot, and your risk-free product, your treasuries, that correlation is typically negative but can break down in a taper type of environment.

                                                            You saw a little bit of that in the first quarter of this year. Again, you had a very sharp rise in interest rates. Tenure treasury notes doubled, essentially, but only at the tail end of that rate rise did you see a bit of a wobble in credit spreads, and even then, it was mild, maybe 10 or 15 basis points wider in investment grade credit spread, so I think it sort of matters what the context is for rising rates. If it's in the context where the economic fundamentals are improving to such a large degree like we had earlier in the year when you had the reopening trade beginning and you had the rollout of the vaccine here in the US at least go much smoother than people expected and the efficacy of those vaccines was actually surprisingly high, all of that lent itself to an environment where economic growth was improving, commensurate levels of inflation were moving up, but that's an environment where spread product can do well.

                                                            Now, if it's just the case that it's a monetary phenomenon or the markets were surprised like they were back in 2013, and you didn't have a commensurate level of growth, that's a situation where a spread product can be challenged, but again, were economic and fundamentals are improving, just like the fourth quarter of 2020, you saw rates increase but you saw spread product do extremely well, so we think it's a bit of, what's the context where rates are rising, but again, if you're in an environment where rates are rising, then having floating rate product certainly makes sense. We added it to our bank loan exposure in the first quarter because economic fundamentals justified it and you are given some protection in that environment.

                                                            We also would agree that TIPS are relatively expensive after the significant appreciation that they've had, and so we've reduced our TIPS allocation quite significantly. We retained a little bit for tail risk exposure, and then some of the floating rate product, whether it's in commercial mortgages and non-agencies, we think that makes sense. Some of the less interest rate sensitive sectors like high yield relative to investment rate credit. Also, there's potential opportunities there, and so there are cases and places where you can do well even when rates are rising, but we really think the context, what's the economic fundamental backdrop that's underlying the rising rates.

Jenna Dagenhart:                                  Tom, you told Asset TV in another conversation that you find the middle market CLO space attractive. Are you still eyeing opportunities within that space of the market, and if so, where specifically?

Tom Carney:                                         Yeah. Short answer is yes, and primarily in the more senior portions of those securitizations, but first maybe it might be helpful to give a brief overview of CLOs broadly, these collateralized loan obligations and corporate CLOs in particular since many investors, for example, that might use index funds that track the Barclays Agg, for example, would have no exposure to this segment of the fixed income marketplace. CLOs, the collateralized loan obligations, are a subsegment of the very broad and large securitized or asset-backed segment of the fixed income market. CLOs represent a little more than half of the one and a half trillion of US ABS securities in the marketplace, year-end data. That's within the overall 51 trillion US fixed income marketplace.  Like other ABS securities, corporate CLOs are securities backed by, at least for this case, pool of senior secured loans to companies with low or no credit ratings, but through the process of securitization, investors have the opportunity to invest in securities rated as high as triple A to equity or non-rated. Historically, banks, both foreign and domestic, and insurance companies, were the largest investors in CLOs. That has changed a little in the last several years as more investors, mutual funds, investment advisors and more have identified value in this area.  The CLO market is broadly separated between two primary segments, BSL, which is broadly syndicated, and middle market. The BSL segment typically represents larger, oftentimes public companies, much larger companies overall, while the middle market segment, only about 14% of the total CLO marketplace, represents loans to smaller companies, those with annual cashflow typically of less than 100 million annualized. What we found intriguing about the middle market area is, it's an area we haven't really been able to access, historically, because it's small, but it is large. There's roughly 200,000 companies that represent about one third of US private GDP that would fall within the middle market area.  On its own, if it was an economy all its own, it would only rival the US and China in terms of its size, and nearly 48 million jobs in the US are represented here, so after many years of getting to know this industry and many of the sponsors in it, which are the companies that originate the loans that go into CLOs, we found the middle market CLOs to be an attractive area to invest, particularly as I mentioned earlier in the higher rated or more senior portions of the various securitizations, and that's still true today. A not all inclusive list of reasons why we found more value in middle market versus broadly syndicated CLOs, include strong sponsors who have more ability to be involved in the underlying company business, which gives them great level of control, certainly, versus the broadly syndicated CLOs, and this has historically allowed these sponsors to intervene faster to resolve and mitigate issues, all of which has led to historically lower default rates and recovery rates, higher recovery rates in the case of defaults. Partly in exchange for decreased liquidity in this area, the middle market CLOs have provided investors higher returns than broadly syndicated CLOs, and this is what particular drew us, invariably more return relative to other comparable rated securities like corporate bonds. And then two more reasons, floating rate. Besides the nominal return we were getting, the potential upside, should rates rise, is a nice hedge of sorts against rising rates and then, finally, diversification benefits. Unlike many companies inside broadly syndicated CLOs, middle market companies are unavailable in the public marketplace, so it's a real diversification benefit to the assets that we manage.

Jenna Dagenhart:                                  Ed, as you look forward, what areas within fixed income do you think present the greatest opportunity and why?

Ed Al-Hussainy:                                     Yeah. I'm going to echo a lot of the same, I think, themes that Tom just brought up. I think, particularly in the securitized space, anything that gives us exposure to the housing sector and household balance sheets is something we have preferred. Our MBS and CMBS in both of those spaces, I think, there are pockets of value at the moment. If we take a step back and we look at where we are in the business cycle, and this has been a business cycle that has been quite unusual, a lot of things have been quite accelerated, but we're coming out of this period with significantly higher corporate leverage and significantly lower household leverage.   The good news is, debt service costs across the stack, whether it's governments, corporates, or households, are close to record lows, but we think the household sector in particular has a much larger runway to leverage up in the course of this cycle and remain in a pretty healthy place. Anything that gives us access to that household balance sheet looks like a good long term investment. I think in a relative value perspective, we're looking at both high yield in emerging markets relative to a US investment grade. Again, as pockets of value, particularly in EM, on both the sovereign and the corporate side, there remain attractive spreads.  Ultimately, we're starting from a point where valuations across the board are quite stretched, so being quite active and nimble around things as valuations change into the end of this year and into the start of next year, that's really top of mind.

Jenna Dagenhart:                                  Julien, looking at the yield curve and given some of the themes we've discussed today, where should investors be looking for income in this kind of environment? Which sectors, subsectors, offer the greatest potential for return in the fixed income markets?

Julien Scholnick:                                    Right. I think the comment that valuations are stretched in many sectors is the right one. When you look at spread levels, whether it's in investment grade credit, high yield, you're back to, in many cases, you're obviously through where you started prior to the pandemic at the beginning of 2020, and in many cases you're back to pre-great financial crisis type levels, so by recent history, things look on the richer side. Now, that being said, if you go back over a longer period of time, there have been periods in past decades where corporate bond spreads have traded much tighter than they are today, so we do think there is scope for tightening. Again, that being said, you look at the overall index level, things don't stand out, and it's really more, we would say, at this point in the cycle, more of a bottom-up type of analysis that needs to be done. Which sectors do you think will do well going forward? Our approach at Western has been to reduce some of our exposure in those more on the run consumer generic type sectors that never experienced quite the draw down during the COVID crisis and really try to concentrate and keep on our exposure to those sectors or subsectors that are most sensitive to reopening type trades. Think about the high yield market in subsectors like airlines or cruises, gaming, things like that, that would stand to do well as the economy continues to reopen and people begin to travel again, so that would be one example. Within the IG sector, the market, the energy subsector still trades wide relative to the overall index. You're picking up about 50 basis points for a generic E&P energy name relative to where the index OAS is, and that we would also put in the category of a reopening trade as the economy continues to reopen, people begin to travel, back to work, vacations, then energy should continue to do well in that sort of environment, and then, probably one of the areas where we do see a lot of value is in the emerging market space, and so when you think about the EM, emerging markets, broadly, that's a sector of the market that's really highly levered to the health of the overall global economy, and so emerging markets do well when the global economy is doing well. Clearly, 2020 was a very difficult year for emerging markets from that standpoint, let alone from other issues that they experienced, and so as you begin to have this reopening that's clearly occurring here in the US, that's starting to occur in some of the European markets, eventually emerging markets will catch up to that, as well. They've been behind because of difficulties with the vaccine rollout and getting that distributed, logistical issues among other issues, but as that begins to happen, and the other side of that would be global trade tensions, as those reduce from elevated levels that we saw over the past several years, that should also be a positive for emerging markets, so anything that has the ability to enhance global trade, EM should stand to benefit by that, and so that is another area of the market where, clearly, from a valuation standpoint, things look attractive. Now, within EM, you can look at the local EM space where you're taking on local currency risk, local interest rate risk, and there's the hard currency, the dollar denominated sovereign and corporate space, we think that latter part of the market clearly offers value where you can pick up comparable rated names in the EM space, comparable rate to domestic corporates but at wider spread levels, and then on the local space, we think it's important as it always is to have a constructive view on individual countries. Every EM country has its own set of issues to deal with, but certainly that's where you're going to get a much larger pickup and yield relative to what you can get in US Treasury bonds, or certainly relative to what you can get in core European government bond markets, so picking your spots within the emerging markets space, we would also say there's the potential for value there, and then I think someone mentioned it, as well, just on the structured product space, again, domestic credit spreads are through their pre-COVID type levels, but on the structured product space, in many cases, depending on where you are in the capital structure, you're still getting a pretty good pickup and spreads have not compressed all the way back, and so we would think that would be another area of the market for opportunity over the balance of this year.

Jenna Dagenhart:                                  Tom, as we wrap up this panel discussion, what else do you see on the horizon for fixed income?

Tom Carney:                                         I was just agreeing with a lot of what Julien was saying, and so rather than repeat some of the same things, I can't help but thinking is we think about the horizon for fixed income, I was pondering the phrase red sky at night, sailors delight, red sky in the morning, sailors take warning. We've talked a lot on this, nearly an hour, about how the fixed income market is, as Ed commented, quite stretched in some areas, not all, but certainly how important it is to remain, again, as Ed said, active and nimble. We certainly want to strive to do that, but from today's overall low levels of credit spreads and all in nominal returns, and in many cases, historically so, it just seems prudent for fixed income investors to be steeled for lower returns on a go forward basis, and particularly prepare for the one constant in investing, and that's change, which often comes out of the proverbial blue sky.

                                                            I'll maybe close with just a couple quotes because I was pondering comments by John Kenneth Galbraith in terms of forecasting which is always difficult. "There are two kinds of forecasters in the world. Those who don't know, and those who don't know they don't know." We hope we are in the former, not the latter. We strive to be, and as this quote suggests, we're not much for making forecasts. We're trying to invest capital on behalf of investors one security, one sector, one industry at a time where we find value, many of which that Julien highlighted, but borrowing another quote from famed investor Howard Marks, "While we can't predict, we can prepare," and that seems like good marching orders for any investor, fixed income, equity investors, broadly, as we head off into an always uncertain future.

Jenna Dagenhart:                                  Julien, looking forward, what should fixed income investors be watching for?

Julien Scholnick:                                    I think we talked about a lot of the risk, certainly the up side risk to inflation which is something the markets clearly have caught onto, and that's a potential risk that's out there, and as I mentioned before, we do think there is the issue that you need to deal with that you have the shorter term cyclical big boost to growth that we've had in the first part of this year and a commensurate increase in inflation. That makes sense to us given the reopening and given the repressed state that the economy was in, but going forward, once you get through this reopening trade which is only going to occur one time, once the reopening trade's done and everyone's back, then, again, you don't get any sort of further boost from that, and the fiscal stimulus, which also occurred to a large degree in the first quarter was very front loaded, happened very quickly.  All those fiscal stimulus payments got to individuals, got to corporations. That money got put into the economy and that's why you're seeing these higher levels of growth rates, but going forward, not only will fiscal stimulus most likely be smaller, it'll be spread out potentially over the next decade. You will have offsets from tax increases, and some of the types of stimulus going forward, it's not just going to be direct checks to consumers and to borrowers, and to individuals. It may be in the form of infrastructure, and that, again, is not as an immediate impact to the economy as what we've seen in the first quarter, and so I do think there are reasons why it is not unreasonable to expect growth rates to fall, and then inflation to commensurately fall. Then, again, on a longer-term secular basis, if those trends that were in place prior to the financial crisis, or excuse me, prior to the COVID crisis of last year, those are still with us, things we talked about, increased use of technology, increased debt burdens, aging populations, all of those have deflationary or dis-inflationary impacts to them, and those are going to remain with us. We could be in a situation like we were in 2019 where unemployment rate was at an all-time low. Financial conditions were extremely accommodative and yet the fed cut rates three times in 2019 because they were missing, as they had been for the previous decade, on their inflation goals. Again, there's a lot of uncertainty but we can't rule out that possibility that you're going to have that situation either, in which case, spread product at these levels or treasury yields at these levels aren't necessarily terrible places to be. You may not have a lot of spread compression from here. Treasury yields may not be going back to the 50 to 100 basis point range that we saw in much of 2020, but maybe we settle into a slightly higher rate range here over the balance of this year and into 2022, but not necessarily on a trajectory where rates are ever moving up from these levels.

Jenna Dagenhart:                                  Ed, what's your outlook for the final half of 2021 and beyond?

Ed Al-Hussainy:                                     Yeah. I like how Julien ... The rates outlook remains quite uncertain. I think in the short term, it probably makes sense to look for higher real rates from where we are starting today, as the fed tightens policy on the margin and pulls a little liquidity out of the system. From a credit risk perspective, I think we're going to find out how smooth the hand off is going to be from liquidity support provided by the fed and global central banks to the underlying growth story, to the underlying fundamentals that have definitely improved versus where we were last year. So far, it's been exceptionally smooth sailing from a credit risk investors perspective. We really cannot, I think, bet on that continuing, and we should definitely, I think, be prepared for some volatility on that front.

                                                            The other thing to look for, again, is the policy mix. Beyond monetary policy, fiscal policy is, I think, in a really interesting place. We are going to see on the margin some pull back in terms of just the sequential amount of growth coming from fiscal policy next year, but the structural story, whether it's around infrastructure or social safety net spending, is changing. I think it has the potential to lay the groundwork for a very different economy for the next decade relative to where we've been in the past 10 years, and I think that's the exciting part longer term.

Jenna Dagenhart:                                  Obviously, this is everyone's first pandemic, first reopening trade, coming out of the global lock downs. Any final thoughts about this historic time, historic market action, you'd like to leave with investors watching this panel?

Julien Scholnick:                                    Sure. As you say, it's pretty unprecedented. I would say the enormity of the response by policy makers on a global basis, and that would include monetary policy makers, that would include the fiscal response by governments here in the US, and really, across the globe, as well as the input from the private community, from the medical community, to really combat a crisis like we've never seen before and ultimately get to a vaccine and to multiple vaccines that had very high efficacy rates within a 12 month period is pretty astounding and pretty impressive by all metrics, and so I think the fact that we were, as a global community, able to achieve that is positive and reason to be optimistic, and I think that on a forward looking basis, though, some of the damage that was done over the past year is another reason to think that that support in a variety of forms, whether it's monetary accommodation remaining with us, whether it's fiscal support remaining with us, that's going to be with us for some time as there's a lot of healing that needs to be done.We can see it, again, just in the labor market here, like we talked about, in the US, but that's true of across the globe, and that continuation of support and wanting economies to continue to heal, addressing the issues of inequality that have been exacerbated over the past year, those are reasons to remain optimistic on risk markets in general, on credit markets in general, and also reasons why we think that policy makers are going to want to take a relatively accommodative approach versus what they've done, maybe, in past periods when inflation and growth were up at these elevated levels. That's sort of the outlook that we would have going forward.

Tom Carney:                                         The only thing I Might add to that is that this past year has, as I mentioned early on, provided investors invaluable lessons, and right now we are seemingly on an pretty smooth waters, but not much more than a year ago we weren't, and it's really in those rough waters that you really test the mettle, not only of your own resolve, your firm's resolve, your manager's resolve, but it'll be those periods that can draw great experiences going forward and for investors in any of our particular core platforms, I think those are the things that you'll really learn the mettle of the people who are managing money on your behalf or whether you're doing it yourself.Clearly, it's in those tough times, when the proverbial bullets are flying, when they were a year ago, you not only learn a lot about yourself, but about your teammates, as well.

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

Tom Carney:                                         Thank you all.

Ed Al-Hussainy:                                     Thank you.

Julien Scholnick:                                    Thank you.

Jenna Dagenhart:                                  Thank you for watching this fixed income master class. I was joined by Ed Al-Hussainy, senior interest rate and currency analyst at Columbia Threadneedle Investments, Tom Carney, director of fixed income research and portfolio manager at Weitz Investment Management, and Julien Scholnick, portfolio manager at Western Asset, an independent, specialized investment manager of Franklin Templeton, and I'm Jenna Dagenhart with Asset TV.