Lower Returns, Higher Volatility
July 10, 2019
Remy Blaire: Welcome to Asset TV. This is your Fixed Income Master Class. Fixed Income is an investment security that pays investors fixed interest payments until its maturity date. At maturity, investors are repaid the principal amount they invested. Government and corporate bonds are the most common types of fixed income products.
Remy Blaire: There are also fixed income [ETFs 00:00:25] and mutual funds. I am joined by Maria Giraldo, managing director at Guggenheim Partners, and Douglas J. Peebles, CIA or Fixed Income at AllianceBernstein.
Remy Blaire: Thank you so much for joining me today. Well, this is a masterclass about fixed income investments, and usually when it comes to fixed income products, they are always recommended as a conservative option. So first and foremost, let's start by talking about the fixed income landscape.
Remy Blaire: Maria, starting out with you, what is your assessment of the current environment?
Maria Giraldo: So, when I'm looking at the landscape. I'm thinking about two different factors, two different drivers that are driving my views. One of them is going to be short term, the other is going to be long term.
Maria Giraldo: In the short term, we actually just got pretty positive data, very positive economic data in the first quarter, and we're also coming off of strong economic growth in the US from 2018. Growth was stronger than potential. It was stronger than trend growth over the previous two years.
Maria Giraldo: So generally, we do have a lot of good data that is baked into where interest rates are, for example, right now.
Maria Giraldo: On the credit side, you also have stronger earnings growth from 2018. That seems to be slowing in 2019, but you still have that as a tailwind. And as a result, you have very benign credit environment, if you look at the high-yield default rate, it's near historical lows.
Maria Giraldo: So that's all sort of baked into where the 10-year treasury yield is trading right now, which is, let's say, about 2%. There's something holding it up, and that's positive data.
Maria Giraldo: The longer term, not quite as positive. I think what's baked into the data is a lot of uncertainty, especially uncertainty that's just been injected into the business community, related to the trade war and tariffs. Businesses aren't sure if they have to factor in higher prices for the goods that they produce.
Maria Giraldo: They're also struggling with a labor market that is very tight, so that's starting to flow into the wage figures. It's very hard to find quality workers, so companies now are facing ... They're not sure about what their costs are going to look like in the future, they're not sure about how much they're going to have to compensate their employees.
Maria Giraldo: A lot of uncertainty, and so what we're seeing is business investment is starting to fall a little bit. Sentiment and optimism is starting to fall a bit, and inflation expectations have also fallen quite a bit. So, all of that then has brought 10-year treasury yields actually down from where they were last year, above 3%, to where they are now, around 2.25%.
Maria Giraldo: So for me, when I'm looking at the landscape, I'm seeing risks that are unfortunately skewed to the downside going forward. And that also is feeding into, I guess, an inflation expectation, where you're looking at inflation.
Maria Giraldo: Inflation really tends to be a lagging indicator of growth from last year, but I think that right now because of so much uncertainty, those inflation expectations have come down. So that's what I'm seeing on the inflation front.
Maria Giraldo: So again, just putting it all together, it's more uncertainty that's been baked into the data, and the risks skewed to the downside.
Remy Blaire: Well Doug, moving on to you, I do want to ask you about your take on the Central Bank, the U.S. Central Bank to be specific.
Remy Blaire: Now, do you think the Fed is kicking the can down the road? Powell did say in March 2018 that's there's no thought that changes in trade policy should have any effect on the current outlook. But what's your take?
Douglas Peebles: First of all, by the time we got to the end of 2018, Chair Powell was vociferous in his notion that rates needed to rise. They raised them four times last year, and he made it very clear that the expectation should be set that they're going to rise again in 2019, and the markets hated that.
Douglas Peebles: It wasn't that long after that commentary in December, in January, he basically turned his comments 180 degrees and said that they were patiently on hold, and they were going to examine the data. The dot plots all fell in terms of the expectations from the various different FOMC members.
Douglas Peebles: And then by the time we got to March, they started talking about inflation expectations and this whole notion about whether missing their 2% inflation target from a cumulative standpoint is weighing down on the economy.
Douglas Peebles: So a huge turn in just one quarter from the Federal Reserve. So, I think that the markets have now extrapolated that out into expecting rate cuts. We think that that's a little bit premature, to expect rate cuts, but I think that during the course of 2019, we've gone from a market that was almost exclusively centered on what the Fed action was going to be, and has clearly changed pace to caring even more at the moment about what's happening with trade policy.
Douglas Peebles: So I do think the Federal Reserve and other central banks remain extremely important for markets. In fact, in my humble opinion, I think it's unhealthy how focused the market is on what the Fed or the other central banks are going to do, as opposed to being focused on what's happening with the real economy. And then I think the market got caught off-sides, expecting a trade deal to be worked out by the time we were already at this stage.
Douglas Peebles: I think that we're now very far away from that, and so what we've seen is a greater degree of volatility in risk assets, and on the flip side of that, not surprising, we've seen risk-mitigating assets, like treasuries, doing very, very well.
Douglas Peebles: I think that you raised a good point, Maria, in looking at ... because the original question was the fixed income markets, and I think you did a very good job of breaking the fixed income markets into two types of markets. Because I think most investors out there, unfortunately, look at all bonds are the same, and really, there are things like treasuries that are risk-mitigating, that usually do well when the stock market or other return-seeking assets do poorly. I would put a good deal of the credit markets, high-yield bank loans, emerging markets, into that category that's return-seeking fixed income.
Douglas Peebles: I think people get into trouble mainly over two things: Number one, they're too concerned about rising interest rates, when rising interest rates, if you have an investment time horizon that's anything longer than a couple of months, rising interest rates actually aren't that painful for five or six-year duration fixed income portfolios. The other thing is when they just look at the yield available in the credit markets, I think they underestimate the risk, not only of defaults, as you mentioned earlier, but also of their liquidity. When the bid goes away, the prices can drop a lot more than they would on pure defaults in expectations increasing alone.
Douglas Peebles: So I think there's a lot of moving parts in the fixed income market, and this time period, as we both characterized it, is a prime example of that.
Remy Blaire: Well Doug and Maria, do you want to take a step back now and take a closer look at bonds? As you mentioned, Maria did a great job of talking about different types of fixed income products and how we get that difference in those products, but if we're having an advisor advise a novice who doesn't understand the basics of how bonds work, how would you begin this conversation?
Maria Giraldo: Doug made some great points about the way that investors are looking at fixed income where you have certain assets that are meant to be more principal preservation, so they carry little to no default risk. For example, treasury bonds or agency securities that have government backing, but they'll carry other forms of risk.
Maria Giraldo: Those securities will carry duration risk, for example, if rates do go up. And then you have returning assets, so when investors are looking for returns that are above government-backed securities, then you're going to look at the credit space, you're going to look at the investment grade corporate bond space, or the high-yield space. And each of those are going to carry a different risk too.
Maria Giraldo: In the investment grade corporate bond market, you mainly want to be concerned about the potential for downgrade risk and we can probably get into that at some point in this segment, but increasingly, the investment-grade corporate bond market carries a higher and higher degree of downgrade risk because the credit migration has been pretty negative in this cycle.
Maria Giraldo: And in the high-yield space, you do have quite a bit of default risk there, where historically on average, you would expect that a high-yield portfolio will default at a rate of about maybe 2.5 to 3% in a non-recession scenario. Once you get into a recession, you're looking at default rates that can be over 9 or 10% of your portfolio that can default.
Maria Giraldo: So varied levels of risks. All of these different areas of fixed income are then going to offer different compensation, so they'll pay a higher spread if you have higher default risk, higher spread over treasuries.
Remy Blaire: And Doug, you have decades of experience in the fixed income market, so how would you approach this?
Douglas Peebles: I think very much the same way. The advice that I would give to advisors if you have a client who's sort of structural portfolio is 60% equities and 40% bonds, don't kid yourself if you own 50% in the NASDAQ stocks and MSCI ACWI and large-cap growth stocks and then the 40% if you put in emerging markets and high-yield.
Douglas Peebles: Technically those are bonds, but they don't act the way that a 60/40, that the 40% in bonds should act, if you have 60% in equity portfolios. So, if you look at the high-yield market, excess returns in high-yield are much more highly correlated with the returns on the S & P than they are with the ten-year treasury.
Douglas Peebles: And the point of having that 60/40 asset allocation is because those return profiles are negatively correlated. I think it's really important for advisors to understand that not all bonds are the same, and if we run into a tough time period ... I mean, 2008 was the prime example of that.
Douglas Peebles: You had a situation where the equity market did extremely poorly. High yield did almost equally as poorly, and so if you have a portfolio that's 60% stocks and 40% high-yield bonds, then you have no negative correlation in your asset allocation.
Douglas Peebles: And the beauty of the asset allocation and the negative correlation is when one market does well you can sell that and buy the market that has done poorly, and that rebalancing is a very important part of the advisor's job. I would say other than keeping their clients in the markets when they're afraid, the asset allocation is probably the most important job for the advisor.
Douglas Peebles: And so, don't just categorize all your bond holdings in one bucket. I think that you need to look at that from a situation, is it providing you what you intended for it to provide you, as opposed to, Well the yield on the 10 year is 2.2%. I don't want to own any of that in my 40%. I'm just going to fill it up with triple-C rated high-yield bonds.
Douglas Peebles: Well you've just taken out all of the diversification benefits of your asset allocation.
Remy Blaire: And I think that's very helpful advice for advisors out there. Now that we've covered those two sections, I do want to take a closer look at the macroeconomic picture.
Remy Blaire: We've touched upon some points related to the greater macro picture, but we are in a late cycle economy, and that means that some of the valuations that we're seeing in the broader market are not necessarily a reflection of fundamentals.
Remy Blaire: So Maria, let's take a deeper dive into the macro picture for the U.S., as well as the Euro-zone and China. How appropriate do you think that a stimulus in those respective economies has been so far?
Maria Giraldo: I think very appropriate. Let's take the Euro-zone first. If you look at the PMI data, the Euro-zone continues to struggle on the manufacturing front. So, the PMI data has shown that it's been in contraction for quite some time. If you look Germany, they have been in a contractionary environment for the past, I believe it's five consecutive months now.
Maria Giraldo: So we've seen sentiment also fall in Europe, and we've seen in certain areas, in certain sales, like auto sales for example, have been weaker. Trade has taken a little bit of a hit. Euro-zone exports to certain areas, including the UK, Turkey, those have fallen. And they've weighed on Euro-zone GDP.
Maria Giraldo: So the ECB doesn't have a lot of room, if they were to go into a recession, it doesn't have a lot of fire power to combat that recession. So, they were originally on that this path to raise interest rates in 2019. They had to acknowledge earlier this year that what's weighing on Euro-zone growth looks like it's more persistent factors than they originally thought.
Maria Giraldo: And so now they've pushed off this plan to increase rates out to at least 2020. I would suspect that it's probably going to be even longer than that.
Maria Giraldo: So the best thing that the ECB, the European Central Bank, can do, I think, is to try to avoid a recession rather than finding themselves in the middle of one and having to fight it. And then of course not to mention too that there's a potential for auto-tariffs coming down the pipeline from the US, but now we've delayed that decision about whether we want to impose tariffs on Euro-zone auto exports to the US. But that's coming, and that's a looming risk as well. So, I think it's been appropriate in the Euro-zone.
Maria Giraldo: China has ... the central bank has more fire power there, less than they did during the financial crisis, but more than the Fed and more than the ECB, and they've been using it to try to combat some of the anticipated impact of tariffs, and some of the impact that we've already seen too. And also, the economy just in general has been slowing for several years now, as they have been trying to de-lever some of the economy.
Maria Giraldo: But now that the trajectory is a little bit too negative with the outlook for tariffs, just weighing on China. The Central Bank has been trying to fight that with different forms of stimulus. So, we estimate that something about 700 billion yuan totals worth has been injected into the Chinese community in order to try to stimulate through different things the reduction and the triple Rs, the required reserve for their banks.
Maria Giraldo: They've also extended different forms of loans that they target to their community. And then the other thing about China is that they also have fire power on the fiscal side, so reducing taxes for example, has been another way to stimulate activity.
Maria Giraldo: So again, it hasn't been appropriate, I would say. So, has it been effective? I think it's probably too early to tell.
Remy Blaire: Well, Maria, you gave us a great overview of what you think of stimulus out from the major essential banks. We'll continue to keep an eye on what happens in terms of the global group, the outlook going forward.
Remy Blaire: But it is a very interesting environment right now. We have a monetary policy, speak to monitor as well as ongoing tariff and trade war commentary coming out from the respective countries.
Remy Blaire: So if you're an advisor, what would you do when it comes to strategy in the current environment, and how do you get a handle of what's happening in terms of the greater geo-political picture?
Douglas Peebles: Well, look, trying to forecast where economies are going to go is very difficult. Trying to forecast what politicians are going to say and do is perhaps even harder than that. So, I think diversification is your friend, asset allocation is your friend. I think rebalancing is your friend, but those are all sort of standard answers.
Douglas Peebles: I think the advisors really need to take a look at, as I mentioned before the market's unhealthy reliance on central banks and what their expectations are going to be for monetary policy. Because I would have answered the question a little bit different. I would have said that if you look at the Euro-zone, Draghi has been in charge of the central bank for coming up on eight years now, and he's never raised interest rates once.
Douglas Peebles: In fact, interest rates have been negative in the overnight, right? As they are today, for about 90% of his time in office. We've had a mini-economic cycle in Europe, and interest rates have been negative the entire cycle.
Douglas Peebles: So I think that we've basically seen the biggest impact that central banks can have on economies through monetary policy. Do we really think that risk takers, whether they're companies or individuals, whatever they are, do we really think that they're holding back on making investments because interest rates are too high, when Germany has negative ten basis points in the ten-year space?
Douglas Peebles: I just think that the markets have an unhealthy reliance on central banks to just go fix that with the policy response, when I really think that it's up to the private sector to actually drive real economy production.
Douglas Peebles: Look, everybody wants to say that Japan is a situation that will not be repeated in other high income, wealthy countries. I don't know. It looks pretty much the same, that once you get to a shrinking working age population, which by the way, many countries in the Euro-zone have, China has, it's really hard to stimulate the economy through monetary policy.
Douglas Peebles: And so I think fiscal policy is one way to do it, but we're just shifting the burden of responsibility for the economy from one government entity, central banks, to another government entity, which is politicians.
Douglas Peebles: And I just think that we have to reset our expectations, first of all, of what nominal growth is going to be, and I think that the level of nominal growth, along with productivity, which drives profits, we have to ratchet that down for the next 25 years, relative to what it's been for the last 25 years.
Douglas Peebles: So if you take a look at what returns in the S & P have been, from let's skip the 2008, 2009, 2010, because we went way down, and then we came quite a bit back up. But from 2011 to about 2017, the return on the S & P averaged about 14 - 15% a year, and meanwhile the nominal growth rate of the economy in the United States was only about 3.5%.
Douglas Peebles: So this policy reliance has really front-ended, in my opinion, the return profile on financial assets over the last ten years. And that doesn't mean that they have to come crashing down, but I think that we have to reset return expectations from these wild numbers, much, much higher than nominal GDP growth, to a more realistic level.
Douglas Peebles: And so that means that we're probably going to get some pretty flattish returns for a while. I mean, if you look at the past almost two years now, in the S & P, it's almost flat as a pancake. Now, we've had a big increase, a big downturn, and a big increase again, so the volatility has gone up a lot, but the returns have been very, very dissatisfying for many investors.
Douglas Peebles: And I think that that's going to be the case for I don't know how long, but if I look out over the next 25 years, our economics team thinks that potential growth rate of the developed world plus China is less than half a percent per year.
Douglas Peebles: And that's a very, very hard environment to expect 8, 10, 12% returns in return-seeking assets.
Remy Blaire: Well, Doug, it's great to get your perspective as well as what you think a healthy relationship would be, versus relying on political talk or all monetary policy. And it's also hard to believe that Draghi's already been in office for eight years, but now that we've talked about some of the risks, I do want to talk about some of the benefits.
Remy Blaire: And moving back to you Maria, it appears as though the market has been monitoring the leverage credit development since the end of last year. So how can investors be prepared for the possibility of different outcomes in the fixed income space?
Maria Giraldo: Sure, yeah. First, to your point about investors really are tuned into the leverage credit market, I think that's actually an interesting development. I think on and off throughout different cycles, investors are often tuned in to leverage credit. They want to see where spreads are. They want to see what default activity is, but last year, I think many more eyes were on the market, because there was this sort of just a slew of warnings from different regulators about risks that were building in the leverage long market.
Maria Giraldo: So we saw it from the European central bank, the IMF, the Bank of England. We also saw individuals, Senator Elizabeth Warren, former Chairwoman Janet Yellen. All within July and December 2018, are warning about the leverage long market.
Maria Giraldo: And unfortunately, that was during a time when leverage long spreads were also widening, so I think that that made investors, credit investors in particular, very worried about what it all means. Part of that had to do with some liquidity issues. Part of it was just the market resetting expectations, because they were pricing in the Fed to be able to raise interest rates two more times, at least this year, and now there's a higher probably that the Fed would cut rates that's baked into the market, based on market implied rates.
Maria Giraldo: And so, it's really interesting. They've been very attuned to what's going on. When spreads were widening, the other thing that happened too was that the Fed senior loan officer surveyed, so they do this quarterly survey. They ask banks what are the trends that you're seeing in the loan market? Are you tightening lending standards? Are you seeing higher or lower demand for loans?
Maria Giraldo: And so that also showed in the first quarter and a little bit in the most recent survey that the banks were tightening lending’s standards. That typically follows a period of spread widening, but then also it tends to be a leading indicator for future default activity.
Maria Giraldo: So I think there's a lot of data right now that has investors worried about where the market exactly is going to go, because if you look at that data, it would tell you that defaults are going to be higher in the future.
Maria Giraldo: But then we got one of the best returns in high yield first quarter returns on record. Spreads tightened significantly, so now that's telling you the opposite. So, I think investors are looking at everything, and they're thinking, "Oh I have to prepare for many different outcomes."
Maria Giraldo: For us at Guggenheim, we have a view that we really are very close to a potential recession. We think that it could start even as early as the middle of next year. Maybe the Fed pause delays that a little bit, but for us, credit spreads at less than 500 basis points isn't enough to compensate us for the risk that there could be a high default activity any time really within the next 2-3 years.
Maria Giraldo: Because again, you have default rates that could be 9% or more. You have recovery rates that could come in even more than historical. So, for us, it's that excess return that you would get from buying a bond right now at 500 basis points is just not enough, especially for then you factor in their liquidity risk and all the uncertainty and volatility.
Maria Giraldo: So what we've been doing, as we want to participate in different types of environments that could unfold over the next few years, is that we keep some skin in the game. We still have some exposure to credit, but we look as much as we can for staying up in quality. If we're looking at the high yield market, we're shifting more towards defensive sectors rather than cyclical sectors.
Maria Giraldo: If you're looking at a broader portfolio outside of leverage credit, we are looking in structured credit, where we can get AAA, AA-rated securities. We still will have credit risk. They're a little bit less liquid, but we think that the spreads are compensating you for that, especially since they are higher in quality. I think that that can weather a more adverse environment a lot better than going down into single B or triple C rated credit.
Remy Blaire: And none of us have a crystal ball, so it's very helpful to be able to dissect the market in that way.
Remy Blaire: Now, moving on to you, Doug, at Alliance Bernstein, I know that you focus on strategic client relationships, so your approach to the global multi-sector high-income investing, it's seen various market cycles, obviously, but there are reasons to be cautious.
Remy Blaire: So tell me what you're seeing in U.S. investment grade credit spreads and what catalysts you're watching out for?
Douglas Peebles: Well, I think again, we saw, just as I mentioned earlier, that the equity market was very volatile, did very poorly in the fourth quarter and then did very well in the first quarter. The credit markets did the same thing, both investment grade and non-investment grade.
Douglas Peebles: There's a lot of talk in the market place over the last couple of years or so about the decrease in overall credit quality within the investment grade space. And so, the comment that gets thrown around all the time is that we now have 50-plus % of the entire investment grade market is BBB.
Douglas Peebles: When I talk to fixed income investors relative to non-fixed income investors, I find that the non-fixed income investors tend to be much more nervous about that than the fixed income investors. Not every single shop or every single person, but when you talk to a strategist or an equity person, that really sets them back.
Douglas Peebles: It's not like all of these companies have had such problems with profits or their expenses have gone up so much that they did this on purpose. They issued cheap debt, quote, unquote, "cheap debt", and bought back their stock. I mean, they did it on purpose. The CFOs and CEOs decided to optimize their balance sheet at a much, much lower credit quality than we've seen in the past.
Douglas Peebles: Why did they do that? Well, because rates were very, very low, and spreads were quite tight, because everybody's looking for extra yield. So, all they did was match the supply with the demand that was out there.
Douglas Peebles: What makes me really nervous about that is what happens when we move into an economic cycle that's much more difficult? And I think, look again, I don't think when we move into an economic cycle and we want to see some credit creation in order to help get us out of that economic cycle, I think we front-loaded the credit creation, both on the government side and on the corporate side. I mean, we're going to be relying on the consumer again, just one economic cycle after the housing crisis in the United States.
Douglas Peebles: So I just think that it's a good thing that the economy is on fairly stable footing at the moment, because I guess we can do another five trillion dollars’ worth of QE, but at some point, in time, the market's going to push back on that and say, "You can't just print money and expect everything to be wonderful."
Douglas Peebles: I mean, Venezuela, Argentina, and Nigeria would be the best returning countries in the world if that was a solid policy. So again, I just think that we have to be cautious, but you can't be overly cautious after you have a big sell-off, because I think that's really where ... the volatility is where the value-added is going to come in in these cycles.
Douglas Peebles: I agree that 5% spreads in high yield is sort of the Mendoza Line, so to speak, for credit investing. But if you take a look at today's yield, whatever time period you're looking at, and you look forward three to five years, that starting yield and high yield is essentially the return that you get over those three to five years per annum.
Douglas Peebles: In the beginning of the year, that number after the fourth quarter sell-off had gotten up to about 7.5%, and I think that for my money anyway, if I'm looking at return-seeking assets, 7.5% over the next 3-5 years, that looks pretty darn good to me. And I think it happens with lower volatility than equity market returns. So, I do believe that high yield investing and credit investing in general belongs in the return-seeking bucket, and I often look at where spreads are relative to expected returns over an investment cycle, not to try to trade it per se, but to say, look, if I had to hold this portfolio for the next three years, would I be happy with returns of 7.5% on that portfolio.
Douglas Peebles: Certainly, in January, we felt that way. Now, so did others, because it's done very, very well, and the prices have adjusted for that. I don't quite feel as confident in looking for 7.5% returns over the next three years, because the markets have adjusted to that.
Douglas Peebles: So I think that the final thing I'll say about the credit markets is, historically, the credit markets have moved before the equity markets, in terms of when you get some height and volatility in the credit markets, you just wait three or six months, and it turns itself into the equity market as well.
Douglas Peebles: Those two things are happening contemporaneously now. For the last little while, we haven't seen that sort of leading edge to the credit markets from the equity markets, and I think that maybe that the beauty of that leading indicator has gone away for the time being.
Maria Giraldo: We've done a lot of work on that too, in terms of the increasing risk with 50% being BBB. I agree very much that there's been a lot of just pulling forward and the debt issuance that we could have had in a future cycle to get us out of a recession, we've pulled that forward into the current cycle, and that's going to hurt us in the future.
Maria Giraldo: Definitely the U.S. corporates have done that because they are meeting the demand that's out there, but I think the real concern too in seeing that trend is that the rating agencies haven't really adjusted to that. I think that they've been a little bit lenient in keeping some of these profiles at the BBB rated level, when those leverage metrics probably put them already within the high yield category.
Maria Giraldo: So we actually took a look at the investment grade universe, and just for every public company, which is going to be the majority of them, we downloaded all of the leverage metrics, interest coverage, and just compared it against the rating agency's own score cards. So, they publish, in order to be an airline that wants a BBB rating, you have to maintain leverage within this range and interest coverage within this range.
Maria Giraldo: And then of course they have many other variables, both quantitative and qualitative. The rating agencies do have a very integrative process with their committees to assign those ratings. But am concerned that what we found is that least 25% of the investment grade universe already have leverage multiples that put them well within the high yield category.
Maria Giraldo: This isn't just the cusp of investment grade high yield. They should already be high yield to us. So, some of that is priced into the market, and some of those BBBs are trading wider, so really, as an investor, it is up to the investor to assess is this potential downgrade risk already priced in, and is it compensating me then for the risk anyway.
Maria Giraldo: Or is there potential that spreads could widen out even further because there is less liquidity in this environment than there has been historically. So, I think that there are more risks that the negative credit migration in investment grade, there's more risk that that poses to the average investor who needs to now assess all sorts of different levels of risk that might come from a more adverse economic scenario and then its downgrade cycle. That could happen.
Douglas Peebles: I think there's also this notion of comfort, I think it's a phony comfort that I don't want to be in that BBB space. I'd rather be in barbell to A and BBs. And I think those people are sort of fooling themselves that if we get a big fallen angel's population that go from BBB to BB, the current BBs are not going to be sitting at the same prices that they are right now.
Douglas Peebles: And I totally agree on the liquidity front. I mean, all of the debt issuance that has taken place, it's not like there's a lot of places for that to go if the retail investor turns into a net seller of credit. It just has to back up to a level that brings cross-over buyers and insurance companies and pension plans in, and by the way, the importance of that BBB rating for insurance companies and pension plans is hugely important.
Douglas Peebles: So again, what I think that advisors should be ready for is lower returns and higher volatility. And that's not a very fun thing to be looking forward to, but I think it's a reality, and I think we've already started to witness that. So, it doesn't mean that advisors can't make money for their clients, but I think that they're going to have to be more disciplined in what they do, and they're going to have to have a greater understanding of the underlying supply, demand dynamics as it relates to a lot of these things.
Douglas Peebles: I think it seems like the bank loan space has been, from 2010 until the good part of 2017 into 2018, it was like the perfect investment. A lot of demand came into that space, which was met by supply, some of which wasn't so good. These are loans, right? And that means that you shouldn't expect them to have the security of IBM stock. They're not going to have that liquidity, so don't pretend that they're going to have that liquidity.
Douglas Peebles: Make the investment as if you're going to own this thing for a long period of time. And if we get a dislocation in the market, particularly ones that are not driven by an increase in expectations of default, then I think that they offer great opportunities to take advantage of that dislocation.
Douglas Peebles: What worries me ultimately is when you get the dislocation that is commensurate with expectations of default, because then the liquidity's going to be gone, and you're going to have crappy credit on your hands as well. I don't think that we should expect, as we discussed earlier, that credit growth is going to bail us out.
Douglas Peebles: And I would also say that the U.S. government is running a trillion-dollar budget deficit with a 3.6% unemployment rate. So, I don't think that we can expect a lot of government stimulus in order to bail out a weak economy either.
Douglas Peebles: So just put all this into context, and don't just say, "Wow! The equity market returns 13% a year, so that's what we should expect for our returns going forward." I don't think it's going to work that way.
Remy Blaire: Well, I think both of you have done a great job of highlighting the many risks that surround the fixed income investment market, but I think this will be a good time to talk about your respective due diligence policies as well as philosophies at Alliance Bernstein as well as Guggenheim.
Remy Blaire: So can you let the viewers know what goes on at your respective firms?
Maria Giraldo: Sure. So, I'm in the macroeconomic and investment research team. We're really a research armed for the chief investment officer, Scott Miner, and in that role, we set these top-down views of the firm, where we are in the cycle, whether we think we could enter a potential default environment in the next couple of years. Where are the big risks that exist within the fixed income market? And these top down views get disseminated then to our portfolio managers, to our sector teams, and to our portfolio construction group that is then looking at asset allocation for different portfolios, depending on what kind of client you are.
Maria Giraldo: So really, we have a various or top down macro process, and then that of course helps guide the bottom up. So, we have several different, I believe we have over 60 different credit analysts, that are looking at individual companies, whether it's investment grade or high yield. We also have teams that look at structured credit in particular, so they're evaluating the different securities within collateralized loan obligations, asset backed securities.
Maria Giraldo: So we have sort of top down, and then looking at the bottom up and all of that is influenced by our views right now, which is really to try to migrate up in credit quality, be a little bit more defensive. That's the general theme that we've had over the past, at least the past year.
Remy Blaire: And what about at Alliance Bernstein? Can you tell me about your due diligence process as well as some of the -?
Douglas Peebles: Sure, sure. So, the investment process at AB is driven by research. We have two different philosophies behind research that we believe in both quantitative approach to research, as well as a fundamental approach. But we find that the combination of those two, sort of like a liberal arts education, where you have arts and science, is superior to either quant alone or fundamental alone.
Douglas Peebles: We think that each of those two disciplines have their own strength. The beauty of quant is that it can look at a very wide breadth of securities and come up with factors that are common to the return profile of all of those securities, and then you can maximize your factor-based exposure to those factors that generally coincide with strong returns.
Douglas Peebles: The problem with quant is that it doesn't understand tail events. It looks at markets as if they're normally distributed, and markets aren't normally distributed. And so, we think that the fundamental area can do a much deeper dive than the very wide but somewhat shallow work of quantitative research.
Douglas Peebles: And when both of those disciplines are aligned with each other, we tend to take more risk in those areas that are being recommended, just as obviously if they're both suggesting that returns are going to be poor, we stay away from them.
Douglas Peebles: The bulk of the discussions and the arguments, and I think any healthy investment process has tension in it, and it's up to the leaders to make sure that it's a healthy tension not an unhealthy tension, but the tension comes when we have different views from the quant side and the fundamental side.
Douglas Peebles: And that, by looking at the expected returns from both of those lenses has made us better investors over the years. That's really the key to what we're doing.
Douglas Peebles: What I would say ... and we've been doing that for a long time, many decades. What I would say is a little bit newer over the last five years, is two things: number one, something that we call efficiency alpha, so bringing technology to play, to help us make better decisions both in the fundamental and the quantitative sphere. So, things like machine learning and artificial intelligence are types of things that we look at to make us more efficient in the alpha driving.
Douglas Peebles: I think the other thing is trading. As the markets have become less liquid and the growth of the credit markets has been enormous, the amount of capital that the sell side allocates to those markets has not grown commensurate with the size of the markets, and that makes ... If Guggenheim, generally speaking, likes a name, I think that more often than not, our analysts are going to be looking at the same data, and we're not going to like the name either, and so we're not going to be looking to sell the name at the same time.
Douglas Peebles: That's what causes this disjunction in the price, and because prop desks and hedge funds really aren't the same as they were, nobody's coming in to take the other side of that trade. So, for us to be able to become a little bit smarter, a little bit faster in understanding the overall liquidity designs within the market place, I think that's another factor, that if I was talking to you 15 or 20 years ago, we wouldn't even be talking about this.
Douglas Peebles: So I think it's important to constantly be on the lookout for innovation in ways that makes you better at what you're doing tomorrow than what you're doing today.
Remy Blaire: Well Doug, I think that's very helpful to the viewers out there that are watching this masterclass right now. So, as we head into the end of today's masterclass, I do want to highlight some market trends.
Remy Blaire: Now we have been touching upon trends we're seeing interesting he marketplace, but Maria, I want to know about some of the industry trends that you're seeing across various sectors. I know you've been paying attention to energy, healthcare, as well as tech. So, what are you seeing?
Maria Giraldo: So we did this study, just looking at where has leverage gone, right? Because we're living in a very indebted U.S. corporate America environment. For whatever the reason it is, they've taken on a lot of leverage, they have them.
Maria Giraldo: So where did it go? When you look at bank loan debt, add it with high yield corporate bond, and add it with investment corporate bond debt, and exclude financials so that it's just the nonfinancial space, energy, technology, and healthcare are the top three, by far. If you look at just a chart going back to 1997, the amount of debt that they've taken on looks a lot like the telecom and tech bubble of the late '90s and looks a lot like the debt that was going into the real estate market in the mid-2000s.
Maria Giraldo: So it looks concerning, just looking at those numbers. Whether it is more concerning, does it pose more of a macros risk? I think it can. There are some macro overhangs within each of those sectors, so if you look at energy, for example, which is the number one in terms of nonfinancial debt, we just lived through an environment of what can happen when oil prices fall by 45% and then stay there for a few years.
Maria Giraldo: We had a bit of a slowdown in the U.S. economy. We saw default rates in the energy space, in the high yield energy space. We saw downgrades in the investment grade energy sector, and for a while there the Fed had to stay on hold. This was back in 2015 and 2016, so the Fed had to remain on hold. We saw a lot of volatility in the equity market and in corporate bond spreads.
Maria Giraldo: So could we get another 45% decline in oil? We just had another one in the fourth quarter of 2018, and the impact was a little bit more muted and oil prices have recovered a bit, but we are seeing an impact on earnings in the first quarter.
Maria Giraldo: I think that having the corporate bond sector very sensitive to oil prices I think is a macro to risk for the broader space, corporate bond space.
Maria Giraldo: So then if you turn to technology, for example, it's been experiencing a bit of volatility as a result of its exposure to the negotiations on the tariff and the agreement with China and the U.S., so that's one big macro risk that's there, and then the investment grade space in technology. Of course, you have dollar vulnerability, so a stronger dollar means you take a hit on sales that might be occurring outside of the U.S.
Maria Giraldo: And in the technology space, especially in investment grade, that exposure is bigger than in other industries. So, turning really quickly then to the healthcare space, a lot of that is going to be pharmaceutical, so there you have more regulatory risk.
Maria Giraldo: Especially as we go into a presidential election cycle, you might have regulators more focused on this hot button issue that pharmaceutical drugs are very expensive for the average person that needs it. Most surveys that you ask an individual, "Can you afford your pharmaceutical drugs?" One in every four will tell you that they can't afford it, or they have to borrow in order to pay for it. So more of a regulatory risk from that front.
Maria Giraldo: So each of those sectors are going to have very different risks. So, I think the fact that they've taken on quite a bit of debt, you have to assess it against what your views are for those risks. What are your views about the potential that we could have another oil bear market? What's the potential that these ongoing negotiations with China on technology that they start to hurt the technology sector? And in healthcare, what are your views on the risk that we could go into this very heated political environment that then focuses its attention on the healthcare space?
Maria Giraldo: Those are some of the views that we have.
Remy Blaire: Okay Maria, well thanks for your observations as well as insights, and last but not least, Doug, I do want to get your take on what you're seeing in the junk bond market? And for you as well, are there any other market trends that you're closely monitoring?
Douglas Peebles: Well, I think we sort of beat the junk bond horse pretty well, so why don't I just touch on the muni market, for maybe two things. I'll just quickly throw in there an area that we think is opportune at the moment, which is the commercial mortgage backed market.
Douglas Peebles: Another industry or corporate space that has gotten hit very hard has been retail, and this is the whole notion of Amazon taking over the world in retail. And that has fed its way into the commercial mortgage market because of malls and the expectation that basically every mall in America is going to go out of business because of Amazon. And we just think that the pricing has overshot the expectations that A and B level malls are going to be around for a long, long time. And we think that there's an opportunity there.
Douglas Peebles: The second thing that I'll touch on is the muni market. We were talking about that a bit earlier. I think that that's a very strong market. I think that tax changes that have occurred have made the need for tax free income to reach a wider audience than maybe it has in the past. And then I think that there's this very important regulatory rule in the bulk, not all, but the bulk of the muni market is that from an accounting perspective, state and local governments are not allowed to run budget deficits.
Douglas Peebles: And I think that over time, that's really a wonderful thing for municipal bond investors. Now, the market is extremely fragmented. Thousands and thousands of issuers, hundreds of thousands of [Q cepts 00:52:58], and so I think that it's really important that they have some strict rules prohibiting the leverage that some of the corporations, or even the U.S. government has issued.
Douglas Peebles: I also think that the muni market has gotten ... Still has a fair share of concern, because of two key events that happened over the past couple of years, the first one being Detroit. And so, Detroit did go through a bankruptcy. And the second one is Puerto Rico, one of the huge issuers.
Douglas Peebles: And I think ... Look, I'm probably the muni analyst in the world, and I think I could have figured out that Detroit was going to actually go bankrupt, and as far as Puerto Rico is concerned, I think it's important to realize that Puerto Rico is not a state or a local government, and they were allowed to run budget deficits, and so the debt level relative to the GDP in Puerto Rico had escalated to emerging market levels.
Douglas Peebles: And I think that the fact that it sat in the muni market where the typical analysis spends less time on aggregate debt than they do on income and expenses enabled Puerto Rico to find its way in more portfolios than it needed to find its way into.
Douglas Peebles: And I think many muni investors got burnt from that, and so I think that there's still a premium in the muni market that investors can take advantage of.
Remy Blaire: Well Doug, I'm glad you mentioned muni bonds. Since it is a segment of the fixed income investment space, but I also want to get your take on fixed income ETFs before we wrap up this segment. There was a report that came out recently saying $34.5 billion were funneled into that space in the first quarter of this year, and by the end of this year, that we could see one trillion. What is your take on the fixed income ETF space, and do you really expect to see that by the end of this year?
Douglas Peebles: I don't know how big the ETF market is going to be. I think that there's very positive elements to the development of the ETF market. I think it helps liquidity in markets for sure, but I think that there is, as is typical in our world, many of the things that happen in the equity market, investors just think, "Well let's just do the same thing in the fixed income market." And I don't think it's that simple.
Douglas Peebles: So the first thing I think users of ETFs have to understand is do you really understand the transaction costs involved in that? Number two, are you using the word ETF and passive investing interchangeably? Because I think if you look at in the equity space where the ETF growth has just been off the charts, most of that is really passive investing. And along with those passive investing’s come passive fees, and when you look at fixed income, if you look at many of the products in the ETF space, there's lots of products that are not index products. And some of those that are trying to be index products, like some of the high yield ETFs, their benchmark is not the standard active management benchmark of a Merrill Lynch or a Bloomberg Barkley's index.
Douglas Peebles: It's a different index that's valid for those securities, but are your investors who are going out and buying a high yield ETF portfolio, are they using it the way that we use ETFs in managing overall risk and liquidity in portfolios, or are they substituting it for an investment? And I think that if they don't know the answer to that question, they probably should.
Douglas Peebles: The last thing I would say is that if you look at some of those products, whether it's a bank loan ETF or a high yield ETF, when you get deep into the credit quality, it's really almost impossible to mimic a benchmark in those, because you just can't get access to the number of bonds that are in the index.
Douglas Peebles: So the job of actually managing a credit ETF is fairly difficult. You're not necessarily making the 60 credit analysts making the bottom up credit decisions, but managing the portfolio is actually rather challenging. And so, the fees that are associated with that look a lot closer to the active fees than an active equity fund and a passive ETF.
Douglas Peebles: So I just think that everybody needs to say, "Let's not just look at what happened in the equity space from active management to passive management and interchangeably use ETFs and say let's just do the same thing in fixed income." I think that they're very different animals.
Remy Blaire: Well, Doug, I think you made a lot of important distinctions there when it comes to ETF investing. So, Maria, do you have anything to add to that?
Maria Giraldo: I would only add that to the extent that an advisor is using an ETF, particularly in credit, to have all of their exposure within that space, you do have some of the risks that Doug pointed out, and then you're not actively managing the portfolio for what your views are about where we are in the potential credit cycle, where we are in a business cycle. So, I think that in that scenario where you have a portfolio, you want 10% of the to be high yield, so you just put it all into the high yield ETF, I think that's probably not the appropriate way to use it.
Maria Giraldo: One appropriate way would be to use for liquidity reasons if you want to go in or out of the market and there's just a very small change in the overall portfolio. But even there, I think that there are some downsides, because not every sector can ... The ETF is not as efficient in every sector, so for example, in the equity space where you have plenty of liquidity in domestic markets, the ETF will trade very close in terms of price to [NAV 00:59:24]. It'll be very little premium to discount, if any.
Maria Giraldo: But in the bank loan space when you have a lot of selling pressure, the bank loan ETFs have been known to trade at a 1% discount, because they're just not pricing in real time and maybe there's more selling pressure in the ETFs than the underlying, then you can get out of the bank loan space because there's no liquidity in that market.
Maria Giraldo: So you have to use it in the appropriate sector and then again think about how you're using these ETFs in an overall portfolio.
Douglas Peebles: When you look at a government bond ETF, they're very efficient, right? And that hugs very close to ... but that's not the type of credit investing that we're talking about here. Again, I have nothing against ETFs. I own some ETFs myself, but I just think that ... Just do your homework and understand the benefits and some of the drawbacks associated with ETF investing.
Remy Blaire: Well Doug, Maria, thank you so much for joining me today. I think we were able to cover a lot of ground in the fixed income space. So, thank you so much for joining me for the discussion.
Douglas Peebles: Thank you.
Maria Giraldo: Thank you.
Remy Blaire: And thank you for watching. This has been your Fixed Income Masterclass. I was joined by Maria Giraldo, managing director at Guggenheim partners, and Douglas J. Peebles, CIO of Fixed Income at AllianceBernstein. From our studios in New York City, I'm Remy Blaire for Asset TV.