MASTERCLASS: Fixed Income - December 2019
November 26, 2019
Susanna Lee: Welcome to Asset TV. I'm Susanna Lee. The ongoing hunt for yield has sparked renewed interest in bonds. More specifically, alternative approaches to investing in bonds as investors seek stronger returns but when venturing into fixed income, especially in this environment, what should investors carefully evaluate? Joining us now are experts in this world of fixed income, JP Weaver is senior portfolio manager at Stewart Capital, Matthew Bartolini is the head of SPDR Americas Research and Gerry Klingman, the president of Klingman & Associates.
Susanna Lee: Great to see all of you here. Thank you so much for joining us today. JP, let's start with you. Let's set the scene now for the fixed income world. What is your assessment of fixed income market dynamics?
JP Weaver: Well, I think there's a number of factors that are relevant. One is the flat yield curve and what that implies for Fed policy and for the economy. Two, we're clearly in the late stages of the economic cycle. I think the 10-year anniversary of the bull market is sometime in the next month or so.
Gerry Klingman: This past week.
JP Weaver: Oh, was it?
Gerry Klingman: 01:23 Yeah.
JP Weaver: Oh, somewhere around there. Clearly, we're in the late stages and you get a fit and you also have a sort of a synchronized global slowing. Slower growth from Asia and it's all the Fed's fault. The Fed as they started to tighten last year, I think that spilled into emerging markets as the cost to service, their debt went up, which spilled into China, which spilled into Europe. So, I think those three factors are making our lives interesting in fixed income.
Susanna Lee: Matt, do you agree that we're in the later stages of economic expansion and where do you currently see opportunities in fixed income?
Matt Bartolini: Yeah, so we definitely are in the later stages of an economic cycle. When we look at the leading economic indicators from the conference board, it already peaked. It has now moved a little bit lower. That's an identification of a slowdown. I think with respect to the Federal Reserve, I wouldn't say that's all the blame on them for the slowing of global growth. I think part of that is some of our trade related tensions but also just ongoing secular dynamics of just slower growth overall.
Matt Bartolini: I mean the estimates have gone down for pretty much the last two years. Where we are from a cycle perspective does have implications for fixed income. I think the short end of the curve as a result of the feds actions has created more opportunities to deliver higher risk-adjusted returns by focusing on areas that range from zero to three, zero to five year, particularly within either structured products. So CMBS but also within areas of the credit markets. But I think the biggest risk as you are at late stages of the cycle is watching how much risk you are expending.
Matt Bartolini: So [inaudible 00:03:12] your credit risk and your credit profile, not sort of going extremely into high yield but focusing on maybe sort of in the investment grade space, making sure that you have a decent amount of investment grade, not taking on too much credit risk because of a slowing economic cycle. That is where you want to sort of have more defensive quality type exposures.
Susanna Lee: Gerry, bonds have been known as safe haven, a place where investors can head for cover in the midst of uncertainty but safe haven assets may not have higher yields. So where are you finding places and spots of attractiveness in these stages of the late economic cycle?
Gerry Klingman: We talked about that too but I think it's important. The first part of your question is individual investors and we provide investment advice to high net-worth families, individual investors as they build their portfolios for the fixed income component are generally looking for safety. They're looking for capital preservation to some extent, yield. And I think where we are in the credit cycle, and I agree very much with JP and with Matt, is we're clearly far into the credit cycle, I kid, it's lots of discussion of exactly when the recession is gonna happen and what inning we're in and nobody knows. We won't know till after the fact but we're clearly late in the credit cycle, late in the economic cycle.
Gerry Klingman: So we think it's important for clients right now with their fixed income component to not be taking too much credit risk. They're taking risk in the equity components of their portfolio and then the additional twist right now is historically, when you've had a slowing economy, that might not be good for equities. Often time, long duration, high-quality fixed incomes as well as rates go down. And we think there's a tail risk that with the big deficits the government is running right now, that we could have an environment where long term rates are higher a year or two from now.
Gerry Klingman: So I think there's two risks that individual investors have to protect again where we are in the credit cycle and not taking too much credit risk but also not taking too much duration risk. So as Matt said, we're finding more opportunity on the shorter end of the intermediate end of the curve in higher quality credit.
Matt Bartolini: I mean one of the things that we commonly discuss is the fact that results of the Federal Reserve's actions, it's made essentially cash like products cool again, right? They became a return generating asset. We think about one to three months T-bill yields more than the entire SP 500 stocks. So, yield's about like 250, 240 right now. That's more than all the SP 500. Basically, you can use something like one to three months T-bills to earn a return or earn income higher than equities, take on literally no duration risk. So, you're taking on not any bond risk. Meanwhile, hedge, your equity portfolio because you have a negative correlation to equities.
Matt Bartolini: I think from a short end of the curve from a risk return perspective, that's where more opportunities have been found because if you extend on duration and yes, if there's a tail risk event and equities fall off, long term bonds definitely act as a better hedge but you look at the returns during negative equity return periods. However, there's this idea like a policy risk. If all of a sudden long-term interest rates go up, that could have a severe impact because you're extending yourself on duration. The short end of the curve gives you that sort of sweet spot to generate return and not overextend yourself on duration.
Gerry Klingman: And the risk on that is that, I totally agree on that, but that you could see the lower rates and then you're not gonna lock in the rate over a longer period of time. We don't see the Fed. They certainly have stopped but we don't see them lowering rates anytime in the near future. I agree with Matt. To catch all the sudden is a returning asset, which it wasn't for a long time.
Susanna Lee: JP, with the Fed now advocating a patient approach to interest rates, how do you think investors should weigh fixed income into their portfolio?
JP Weaver: Clearly, the events of the fourth quarter saw the Fed and as well as the ECB more recently pivot on their monetary policy. I guess I would kind of add on to the previous points and say, rates are very low in fixed income and I would also join the course of be safe and be defensive in terms of duration and credit quality. What we've seen, the manifestation of the curve do, again is the manifestation of dead policy into the curve has been to create up this flat curve where T-bills are the same as seven years practically. There's no real incentive except if the next move is potentially a Fed Funds rate cut, which is not out of the realm of possibility to our minds.
JP Weaver: If somebody asked me, "What's gonna happen to the Fed in the next 12 months?" I'd say I think they'll move once. I don't know if it's up or down.
Susanna Lee: Everyone's a Fed watcher now though, aren't they?
JP Weaver: Yes, and I think their focus on improvement communication is good. I think Chairman Powell's vowed move to really let the market or the economy dictate what the right rate moves are gonna be. Those are positive things but I just worry that typically, when the Fed does stop tightening that's not generally a good time for corporate bond spreads or investment-grade spreads. I think there's an element of risk to your question there. But you're just not getting ... Why would you take risk in an asset class that has asymmetric returns?
JP Weaver: You either get your money back in a few years or you lose a bunch of it. And if you're not getting bailed out by the coupon income, there's just no point.
Gerry Klingman: In terms of everybody watching the Fed as you said, so everybody is watching the Fed but they're not the front-page story like they were through December. I mean it was the Fed was tightening, the Fed was tightening and now with Powell's comments in January and so forth, I think now economic fundamentals is more taking the lead and the Fed is more following at this point.
Susanna Lee: Jerry can you ... Oh, go ahead Matt.
Matt Bartolini: I was gonna say, I don't think they're really dictating their policies based on what the economy is doing because GDP growth, we knew is gonna be slower. Inflation has been sanguine for quite some time. I mean basically we had a massive amount of fiscal stimulus. We basically threw all this money out of helicopter and it resulted in no inflation. So how are we gonna get meaningful inflation after doing all of this fiscal stimulus? So, the Fed knew that and I think what was really interesting is that in October, we were just below the neutral rate. I'm sorry, in November we were just below and in October, we were nowhere near and then December we're patient, so we continued to move.
Matt Bartolini: Now, what actually changed from October to December was the fact that the SP 500 fell out of bed. We almost had a 20% correction and that's what the Fed, I think, is really focused on those financial conditions. And there was a paper written by Lewis John Williams about how the Fed actually does have a ternary mandate. They have a third mandate about financial stability and that's why you have the Powell put or the Greenspan put or the Yellen put. So now, you have the market to rally and financial conditions are becoming looser.
Matt Bartolini: I think there is a risk that the Federal Reserve acts and actually hikes rates in this year then they could just be once but it's all gonna be dependent upon sort of the markets returns and the ability to interact in the slow growth period. Now, the reason why you have basically even probabilities of a hiker cut is that typically after the federal reserve pauses, they're more likely to cut than hike. The only time that they didn't do that was basically between 2015 and 2016, which is when we saw our earnings recession and massive amounts of geopolitical risk.
Matt Bartolini: Fast forward to 2019, it seems like the pretty much the same year. So, I would say wait for all of 2019 probably a Powell pause for all of 2019 but there is that-
Susanna Lee: All of 2019?
Matt Bartolini: Yeah, but there's that risk that they do hike as the market returns to sort of positive, you know, goes past the peak that they were before.
Susanna Lee: Can you give us a quick outlook again Matt? I know you touched upon this on the yield from a short-term bond portfolio now currently beating the rate of inflation. What is your outlook on that?
Matt Bartolini: I mean inflation is low. I think depending on which one you look at, 18, 19. So the short-term rates are above that. The result of the Federal Reserve pushing them higher and I think because of that low inflation, that's why you have term premiums that are vastly negative. Term premiums are the market's reflection of future growth and inflation and that's one of the reasons why the long end of the curve is gonna remain constrained. And it will likely now inversion, that could happen. It's unlikely it will happen without the Federal Reserve pushing up the short end but it's gonna remain a very flat yield curve.
Matt Bartolini: We're probably gonna be more in another stasis type period where nine basis points, 15 basis points wide and all that does is create more opportunities on the short end to generate income and not extend yourself on the other duration. And then pick your poison so to speak in credit. Do you want to be more on investment grade? Do you want to split it up between high-yield? Do you want to use something like bank loans? Or sort of that senior in the capital structure? So, it allows you to give you more opportunities to generate income as a result of a flat yield curve.
Gerry Klingman: One comment on the yield curve is everybody focuses, I guess rightly on the Treasury yield curve, which is very flat but most high net worth individuals are investing in investment grade municipal or investment grade corporates. We still have not a steep yield curve but a normal sloping yield curve. So, latter portfolios of short to intermediate term fixed income assets and those investment-grade asset classes are providing real rates of return for the first time, and with not a lot of credit risk and not a lot of duration risk.
Susanna Lee: So with the Treasury yield curve not in inverting but flattening, what's your thoughts on recession looming?
Gerry Klingman: The old joke is that they predicted 11 over the last 7% of recessions but correctly, we've never had a recession without an inverted yield curve. I do think the one that's different this time is the long end of the Treasury curve is affected I think in many ways by other factors besides just the U.S. domestic economy because obviously, it would appear to indicate that investors believe the long-term prospects with the U.S. economy is not great given the fact that long term rates are so low relative to short-term rates. But I think in this day and age of global markets, there's a lot of other pressures whether it's low global rates by other sovereign nations, whether it's the need to buy long duration assets for a variety of pension plans and insurance companies and so forth.
Gerry Klingman: So I think it's a little bit distorted. I think it's something we watch closely but if it inverts, it's not all of a sudden, a huge flag that goes up and we go into a recession a month later.
Susanna Lee: JP, the net yields on munis are much higher compared to Treasuries, some giving investors 80% or more. Is now a good time still to invest in muni bonds or has that boat sailed?
JP Weaver: As Gerry said, the long end is 80%, the front end of the yield curve is nowhere near that. I mean you're looking in say a three-year high-quality muni. I think the curve is somewhere around one and a half. So yeah, gross that up by a tax rate and you're looking at two and a half maybe at the highest tax rate. So that's barely competing with short-term Treasuries. munis only make sense for people in the highest tax bracket. We're actually have been more short corporates for clients that aren't in the tippy-top tax brackets.
Susanna Lee: That's interesting.
Gerry Klingman: I agree with JP. Just extending on that is we do have a lot of clients that are in the highest tax bracket and are in New York and California and with no longer being able to deduct that interest on their federal return with, that tax on their federal return. People in New York in the highest bracket New York City or California are in over 50% marginal bracket. So, if they can have an in-state ladder portfolio short to intermediate of 2.5%, that's a taxable equivalent yield of 4% to 5%. For someone in a high tax high state tax bracket, the munis are relatively attractive.
Susanna Lee: Matt, your thoughts on munis?
Matt Bartolini: Yeah, I mean we see a lot of investors use muni ETFs to sort of replace single [inaudible 00:16:22] muni bonds as a result of a cost profile, just because single-issue [inaudible 00:16:26] muni bonds can be somewhat expensive to trade from time to time. And we've seen them gravitating more towards the ETF structure from a cost profile. We've seen inflows as a result of investors trying to get more of a taxable income result from it. It's [inaudible 00:16:39] to be one of those sort of tools for asset allocation that the investors always gravitate towards.
JP Weaver: Munis proved their worth last year. There were extremely defensive investments. The real story in muni land is supply and demand though. You have a huge demand from people in the high tax states and because of the new tax law, they eliminated advanced refunding bonds, which probably would be starting to turn out some new bonds at this point. And the rate cycle with rates 50 basis points lower here but because you don't have that supply, I think April's supposed to be a good month and then net supply just goes way, way down over the summer. I don't see where ratios recover at all in muni land. It's kind of depressing.
Matt Bartolini: Well, outside munis we know we-
JP Weaver: have New York and California [crosstalk 00:17:41]. So that would help.
Matt Bartolini: Outside munis, US Treasuries as you mentioned just returned about 2% between the 2009 and 2018. So, do you think now is the time for fixed income investors to embrace the strategy of taking more risks, maybe looking at emerging markets?
JP Weaver: I don't think so. I mean I think as a group, we've all sort of urged caution here, which I think is appropriate where we are in the cycle. One of the relationships that I track is the average spread of BBB bonds versus BB bonds and that is as tight as I've ever seen it. This whole notion of wow, we have so many BBB securities out there. They're over half the index right now. We just went over in the last year and that's been a been a pretty steady discussion in fixed income. Is BBB the next blow up? We don't think so.
JP Weaver: If I'm a corporate treasurer and interest rates are low, I think I'm gonna try to lever up a little bit. If I think I can out earn my cost of debt capital, why not? So, I don't think I'm not as worried about BBB bonds as some are ... If you look at non-financial corporate debt over the last four or five years, it's been fairly steady in the five to five and a half trillion number. Yes, there's been a lot of issuance but then there's been a lot of terming out of short-term debt. So, new corporate supply is much less than some of these headlines would have you believe.
JP Weaver: And I also think there's new pockets of money in terms of distress funds and that are now gonna provide a shock absorber. As you have a company that goes from BBB to BB, there tends to be a lot of people are forced sellers and that tends to impact the prices pretty dramatically. Well, if you have more buyers of that, that's gonna cushion that somewhat and I think that you'll see that.
JP Weaver: We're still fairly comfortable but we very much are employing a credit barbell if you will where we have higher quality secured assets in many cases, airline enhanced equipment trust, railroad equipment trust, first mortgage utility bonds and real security where oftentimes AAA or AA rated we're using that in a combination again with a lot of shorter BBB corporates. And we think that's providing us a good mix. And if there are economic problems ahead, we think being in these higher quality assets will help even out the impact to the portfolio.
Matt Bartolini: Yeah, so I think with respect to emerging market debt, it sort of just goes back to, we do a lot with asset allocation and portfolio construction. Thinking about the entire gamut, the entire 60/40 portfolio. We think that emerging market debt is a strategic asset class. It should be included within the portfolio. So essentially like 2% strategic weight within your overall portfolio.
Matt Bartolini: From there to make a discretionary [inaudible 00:21:29] to go underweight or overweight, your strategic benchmark is based upon the market environment. And we've been talking a lot about expressing risk within the portfolio and how are you gonna do that. Is it taking on equity risk, combine equities? Or is it taking on equity like risk within fixed income like high-yield bonds? They have equity like return to the lower volatility? It's a way to participate in the rally but you're more senior in the capital structure and so on and so forth.
Matt Bartolini: The way we're thinking about emerging market debt right now is just going back to the basics of what that asset class is. It still is 80% investment grade. You get a yield north of 5%. Duration is a concern but it's not the driving factor of returns. It really comes down to currency risk. Particularly in the local debt space, currency volatility is basically as an r-squared of like 56% over the last 52 weeks. If you run that back, it's very reliant in a short term on currency movement.
Matt Bartolini: If you're in the camp that the Federal Reserve is going to remain patient, that it will be a benefit to emerging market debt because the tighter monetary policy in the U.S. has sort of butterfly effect to emerging market nations that are relying on our monetary policy and etc., etc. So we think there's actually a case for emerging market debt tactically to go modestly overweight your position because you can earn a 5% coupon with an 80% investment grade rate. The currency environment is relatively low from a volatility. So basically implied volatility on FX right now is in the lowest percentile in the past year.
Matt Bartolini: And there's a significant amount of fiscal policy and populism that's gripping the emerging market nations if we think about China and all the fiscal policy reforms they're enacting, Brazil, Mexico. Downstream, if that turns into higher deficits and you don't have the growth, that's gonna be bad but in the short term, all of this is creating the ability for those countries to maybe have higher trend growth rates and you have a more patient Fed and a docile dollar. So, you're able to clip that coupon in the short term but again, you always want to be mindful of the risk that you're taking your portfolio.
Matt Bartolini: So you've traded credit risk for sovereign risk. So as long as you understand that trade-off, I think there can be a case right now for emerging market debt and we actually have seen fund flows go into that space as investors have thought about the risk profile of their portfolio because late cycle dynamics, credit tends to be ... There's concerns about firms that are levering up, that might not be able to pay if cash flows are starting to become a problem.
Susanna Lee: Gerry?
Gerry Klingman: I agree with Matt. First of all, in building client portfolios, it's a strategic component to have both emerging market equities and emerging market debt. Is it diversifying the characteristics and building portfolios? And the tactical overlay to the extent that you want to under overweight whatever the strategic weighting is, I agree with Matt, is there's definitely tailwinds to emerging market fixed income right now. With the Feds stopping the dollar, we don't think you're going to be particularly as strong going forward as it had been the last couple of years, and where they are in the credits on these various emerging markets.
Gerry Klingman: We use active managers there because I think there's a lot of devil in detail in terms of what countries and whether your local currency versus dollar but I do think there's probably more interesting opportunities in that asset class than there is in high yield or leveraged loan.
Susanna Lee: 24:46 And what do you think about leveraged loans right now? Do you think they're overvalued?
Gerry Klingman: 24:47 Yes. Again, it's a very broad answer to a big asset class but you look back a year and a half ago, two years ago, leveraged loan looked like a great fixed income asset class to own. We were kind of in the middle of the credit cycle, so things were still looking good in credit. Fed was raising rates, so you don't have the duration risk on a floating rate product because most of these loans or all of these loans almost are floating rate and they were reasonably attractively priced. And we were even to slightly above weight.
Gerry Klingman: 25:18 Flash forward a year and a half, the Fed has stopped so we don't see rates going up from here in the near term. So, the floating rate feature isn't as attractive. There's been a lot of issuance in that market. There's not only a lot out there but a lot of what's been issued is a "covenant lite." So, we think the credit protections even though they're senior on the capital structure are not as strong as they've been in the past. When we saw this a little bit in the end of last year, the other thing that concerns us a little bit about the leverage loan market is it used to be an institutional driven market. It's very much a retail driven market now.
Gerry Klingman: So when you get flows out, the managers have to sell what they can sell. They end up selling in theory. They're the ones that are in higher-quality credit should do better but those they have to sell in order to meet liquidity. You put it all together as an investor with these loans getting back up closer to par from the discount they drop to in November, December is you're getting a 4.5% yield with, I think one of you said earlier, no upside on the principal and significant downside depending upon where we are in the credit cycle. And you're not getting paid much more than you are in a shorter immediate term investment grade credit. So certainly, there's pockets of opportunity but we're underway the leverage loans in this part of the cycle.
Matt Bartolini: Yeah, I'll take the other side.
Gerry Klingman: There we go. Finally, something to disagree on.
Matt Bartolini: I don't think loans are overpriced. We look at the average price within the broad S&P benchmark, the total leveraged loan benchmark, the average price is around 98. So, they're under 100. They're under par. With respect to the floating rate nature of it, yes, like they're much more beneficial in a rising rate period because you continue to step up your coupon as rates go higher. But you basically have an all-in rate now if you look at just broad senior loans around. I think it's around like five and a half. We've included the broadest measure.
Matt Bartolini: So there's ability to generate income and we talked about this earlier. My estimation is that the Fed doesn't cut. I think the cutting rate, so that you don't worry about that your sort of coupon going lower based on its floating rate nature. And I think if you're thinking about credit and you're willing to take credit risk in your portfolio, they're a more defensive area of the credit markets. They're senior in the capital structure. They have higher recovery rates. Of course, there's been more covenant lite issuance but with an active manager you can navigate those covenant lite issuance. And you can also then select deals that maybe if they are covenant lite, the quality nature of the firm is fine. You can look past it.
Matt Bartolini: So we also saw in Q4 during the master [inaudible 00:27:48] volatility, senior loans stood up well and so it's a result of their seniority in the capital structure. We've run the analysis and it goes all the way back to 1994 when credit spreads widen, senior loans outperform fixed-rate high yields. So, if you think we're in this late cycle environment and you're worried about spread risk but you need to have high income producing assets. I think senior loan to make a much more compelling case, the fixed-rate high-yield.
Gerry Klingman: They might outperform high yield net but how are they gonna perform versus investment grade there? My question is, are you really getting paid now for those loans trading at 98? Because even though they're senior on the capital structure, when you go into a recession, they all get marked down. So, in terms of mark-to-market, so in terms of what we see the next couple of years, we just don't think you're getting paid relative to investment grade. I agree with your analysis versus high-yield within an asset allocation of a portfolio.
Matt Bartolini: Yeah, I'm not making sort of the trade between IG in loans. I think there's an aspect we need to have IG in there for a margin of safety. I think if you're looking to generate higher risk-adjusted returns, loans have historically had higher Sharpe ratios. Definitely much more so recently because of the [inaudible 00:28:54] nature of them but I think the ability to sort of clip that coupon, so to speak. Even if you look at like a fixed-rate high-yield, I believe there's like a 71% correlation between the yield you're getting today and the subsequent five-year returns that you do have.
Matt Bartolini: So while there could be intermittent periods where you've different return paths, the ability to generate higher risk-adjusted returns as a result of that coupon is one of the big drivers. So, I do hear your point about investment grade. I think you should have a portion of investment grade. I don't think it should be 100% in loans. I think you should have a proper structure between that to balance your overall credit risk because again, if you're worried about BBBs in the investment grade space, if they go to BB, well where do the BB go to? Again, how do you properly modulate all your credit risk together?
Matt Bartolini: And if I'm looking at extend or express credit risk, or speculative grade and credit risk, I'd rather do it in senior loans but to your point around investment grade, it does give you some margin of safety.
Susanna Lee: JP, you want to weigh in on this?
JP Weaver: We're not involved in the market. Philosophically though, my view is this is not the time to be going down in capital structure. We've all been doing this long enough. We know that when that time comes, you will know and we are not anywhere close to that but the spread between senior sub financial paper is pretty tight. Same in the utility space between secured and unsecured. I just don't think ... I guess I'm gonna I'm gonna fall in with Matt on this one. We're not really that involved.
Matt Bartolini: It kind of goes back to speaking of like when you're gonna have an economic recession or a massive economic downturn that is protracted that last for a couple quarters. We go back to the financial crisis. Obviously, senior loan to the [inaudible 00:30:49] like 50%. It's not something you want in a period where you're trying to be more defensive. However, while we do think it is a good idea to be defensive, there's an understanding that corporate profits while slowing are still going to be positive. We've never had a recession while corporate profits are growing. We sort of have to balance all this out together.
Matt Bartolini: How do you target returns while still managing risk? You can't sort of control returns but you can definitely control risk. I think looking from the total portfolio construct, being all in senior loans not the greatest idea. I think mixing that in because they do have an equity sensitivity to them but in a low volatility manner. I think looking at the total portfolio construct, if you think that the rally is sustainable then we're probably gonna have 3% to 4% returns in 2019. And you think we're gonna have more volatility, instead of going into say a U.S. large-cap equities or small cap equities, go into something like high-yield or senior loans, knowing that you're trading equity risk for credit risk but do it in a manner where you still have interest rate risk within the portfolio particularly if there's volatility events.
Gerry Klingman: And we still own leveraged loans in our portfolios but within the fixed income category. We're getting with clients depending upon their time horizon. They're willing to take risk, have different percentages and allocations to equities but within fixed income portfolios where under weighted high-yield annuals with leveraged loan credit.
Susanna Lee: And Gerry, let's talk about the ballooning of budget deficit. What do you think the implications are there?
Gerry Klingman: They always talk about the Fed and they're supposed to pull away the punchbowl while the party is still going on. And this fiscal policy is the equivalent to showing up at a frat party with two kegs at 3:00 in the morning. I mean here we are nine years into an economic cycle and we just do a massive stimulus in terms of ... Now, we absolutely believe that the corporate tax had to be addressed. I mean it was just the companies have the ability in this day and age to be located where they want to be located and having amongst the highest marginal tax rates for corporations in this country made no sense.
Gerry Klingman: I don't think we have to go from 35 to 21. I think we probably could have been at 24, 25 and still being competitive. So that part aside, this was obviously a huge fiscal stimulus and when we got the benefits of it last year both in terms of the economy growing over 3% and corporate profits but we've never seen deficits run like this at this part of the economic cycle. And every economist that I talked to says it's gonna matter eventually. I guess the big question is when is eventually? Obviously, that's been floated around as long as we can print dollars and you know, this mumbo jumbo about it.
JP Weaver: You're not a fan of-
Gerry Klingman: No, no. [crosstalk 00:33:42] It kind of goes against what I've told my kids in terms of saving and spending. So, I think it really is that the Black Swan out there is what could ... I think the worst-case scenario is we very quickly have what we had in the '80s, the bond market vigilantes and people aren't willing to buy Treasuries and we see rates go dramatically higher. Now, I think that's probably less likely in the near term and it's more just a slow crowding out of other investment by the Treasury of just becoming a bigger and bigger and bigger part of the fixed income market in some time.
Gerry Klingman: Our children and grandchildren will pay for that in the future. I think that's probably more likely than this Black Swan event but you can't ignore it. We've never been in a cycle where we're gonna have this kind of debt run-up.
Susanna Lee: JP, what are your thoughts? Are we in a sugar high? Are we gonna come crashing?
JP Weaver: Yeah, I think deficits matter. I think inflation is a monetary phenomenon and to the extent that the Fed has dropped money out of the airplane and the growth and the deficit is kind of scary. Yeah, I think Black Swan is a reasonable way to look at that. The thing that ... As I thought about it and was reading some work on somebody and look at the Federal Reserve's flow of funds data and basically, the household is the residuals. You can count how many Treasuries the banks own and the foreign entities and hedge funds and what have you. And what's left over they attribute to the household and the household owns half the Treasuries. I don't own any. You guys own any Treasuries?
Matt Bartolini: No. I mean, not directly.
JP Weaver: I don't know, maybe savings bonds but I just don't know. I wonder where it's going and I think it is. I mean I just think it is scary that if we were to enter a recession, that tends to go up during a recession and we're already sort of on a debt to GDP basis where we are during the recession. So obviously, the factors Gerry touched on before, the global factors of why rates are low are working and what's the 10-year bond, where do you got a 10 basis points?
Gerry Klingman: On or around zero.
Matt Bartolini: Yeah, it's nine trillion worth of negative yielding debt right now.
Gerry Klingman: Yeah. So, I guess that's what keeping the bond vigilantes at bay but we've seen it. We've seen how they can wreak havoc on the market.
Matt Bartolini:Yeah, I think in respect to the deficits, it's just likely to create more overhang and slower growth, right? We continue to see an increase in deficits and it's what happens typically when you have what's going on from a geopolitics perspective. You have increase in populism, not only in the U.S. but outside the world and one of the things to do to appease populist basis is to do fiscal tax reforms or you see this within France, you see this within China.
Matt Bartolini: So the problem is if we don't have meaningful or sustainable growth and with the tax cuts, what that did is create a sugar high. It was not meaningful and sustainable growth to trim the deficit. I think that's one of the biggest concerns and that's why you've seen continued reduction in growth estimates because if you run your household with significant amount of debt, it's gonna be hard to have discretionary spending to pay for things and sort of increase your bottom line.
JP Weaver: And there's no inflation to move the overall level of income up.
Gerry Klingman: But to comment on the deficits, when we talk about the entitlement programs that we're all aware of, I've just never seen in my lifetime unwillingness to either party to really discuss it. It just doesn't seem like it. It seems like ever since George Bush talked about making some changes to Social Security 10 years ago, no one wants to touch it on either side. So, forgetting about whatever your orientation is and I just don't know at some point hopefully, it'll come back into the dialog again.
JP Weaver: Similar to the problem that a lot of the states are having with their pension plans. No one wants to address them.
Susanna Lee: Let's touch up on ETFs while you're here. Fixed income ETFs continue to garner assets. What areas are getting the most and how are you seeing investors implement it in their portfolios?
Matt Bartolini: So over the last 12 months prior to the market rally, we saw a massive influx into ultra-short government bond ETFs. And it's a result of, again, the Federal Reserve push up. The short end of the curve creating an instrument that now generates a return but also, the significant amount of volatility. Their asset base essentially doubled, more than doubled. They went from around 10 billion to around 40 billion in the last 12 months.
Matt Bartolini: 38:42 As the market rallied we saw money come out but for the main part where we are now in the market, we've seen investors again going back to what we've discussed all along. The way they're expressing risk in the portfolio is not through equities but through equity like bonds. So that we've seen inflows into bank loans. You see the inflows into emerging market debt. We've seen inflows in the high-yield. So, what that tells me is we've seen more asset allocation tools and that's what fixed income ETFs.
Matt Bartolini: One of the main benefits is the ability to allocate to emerging market bonds the same way you can allocate to U.S. Treasuries. So more sophisticated portfolio construction techniques are one of those generational themes that is gonna fuel the growth of fixed income ETFs. And the last thing about the market's positioning, the amount of inflows into mortgage bonds after a result of the Fed come in with a patient tone has been staggering. About four billion is coming to the market just this year alone, which is about 18% of the start of year assets. So, it's basically a significant shift.
Matt Bartolini: I think about mortgages, which we haven't talked touch upon at all, no credit risk and you basically are yielding much more than U.S. Treasuries. With the Fed and then a patient stance, extension or prepayment risk is sort of also patient and on hold. So, mortgages continue to be a valuable asset allocation that we see investors gravitate towards it.
Gerry Klingman: ETFs, one of the most intriguing things that we see. Potentially the long term for ETFs in fixed income and we've used ETFs in equities since their inception with SPY years ago and have used some fixed income the last number of years. For high net worth individuals, we have always believed in ladder portfolios of high-quality credit municipals or credit, that unlike owning funds, there's some benefit of building your own portfolio and have the bonds actually mature and rollover in managing that portfolio.
Gerry Klingman: That's really not practical for a smaller investor and a small investor, I mean even under a million dollars. You just can't get the credit diversification to buy individual securities and as Matt talked about the spreads, there are now ETFs that started being developed of actually pools of investment grade municipal or corporate and even high-yield bonds with set maturities. So, you buy the ETF and you buy a basket of fixed income securities. They're gonna mature at a certain date.
Gerry Klingman: I think that's actually a very interesting tool and as it continues to develop, that could allow smaller investors to get the benefits of credit diversification and actually owning bond portfolios that mature.
Susanna Lee: Matt, there have been claims that fixed income ETFs, particularly the high-yield ones, having distorted the overall bond market. What do you say about that?
Matt Bartolini: Yeah, it always comes up during market sell-offs. I honestly think it's one of the most lazy narratives you could possibly have. Just last year, 20% of high-yield assets in ETFs left. There's massive redemptions and there was no issues. There was no gating of redemptions. There's no sizable liquidity mismatches. ETFs particularly high-yield or any of them but high-yield [inaudible 00:41:41] folks on that, allow investors to efficiently transfer risk because of the secondary market.
Matt Bartolini: A lot of people point towards the fact that the secondary market has a significant amount of trading volume but that's between willing buyers and sellers, between participants on an exchange. So basically, the amount of capital that flows down to the primary market is actually quite low. It's basically five to one ratio. So basically every $5 that's traded on the secondary market, only $1 filters down to the primary.
Matt Bartolini: If we look at the amount of cash bonds that are traded in high-yield and the amount that actually is made up of ETF trading in that primary market, it's really low. It's basically around 2% on average of the last 10 years. So, for someone to say that high-yield ETFs are driving prices and pushing things around, it's not really true when you actually look at the route math of it. You only have 2% of trading being conducted within the high-yield cash bond market buy high yield ETFs.
JP Weaver: That argument convinced me. We started to look at muni ETFs and just the paucity of assets involved, I sort of said, "What's the worry?" The biggest one is only about five billion and that's just not a lot of mine.
Susanna Lee: Gerry?
Gerry Klingman: To go along with Matt about the high-yield ETFs is I absolutely believe that all this ... People would say that drives the market and so forth. No, I agree with everything Matt says related to that. They provide a function. They provide liquidity. There is a good use to them within portfolios. Having said that, I think individual investors and advisors have to think, when do you want to index and when do you want to use active management? and almost all the U.S. equity classes index high-yield is an example of an area where we don't necessarily want a market cap indexed to debt issuers.
Gerry Klingman: So although it's a good tool for many investors to have a high-yield ETF, some of the active managers that we work with, I know are happy to have an ETF in the marketplace because when they're getting in that redemption, they're selling. The active managers are actually taking advantage of that and buying some of the names they want to buy or vice versa. So, I do think as advisors, we have most of our clients and active managers in that particular asset clause.
Susanna Lee: When it comes to active versus passive though, there's been a significant growth in passive management. Why do you think that is?
Gerry Klingman: Probably because it's cheaper and the reality is people talk about active managers can outperform indexes. A lot of it is just because of the expense ratio. That's a huge head start that any index has. We absolutely believe ... and this is about fixed income, not equities but we absolutely believe most individual investors should be indexing most of their U.S. equity portfolio, not necessarily non-U.S. equities but in fixed income. And the perfect example is the Barclay AGG, what a great tool, AGG.
Gerry Klingman: It's a great tool to own fixed income instantaneously, very cheap, you own entire bond market but AGG is as everybody knows or most people know I think is primarily Treasuries and agencies. It's got a long duration for a relatively low coupon and if a client wants to have a 60/40 bond portfolio, I don't think that's a good 40 bond portfolio. That portfolio should look very different based on their risk, their tax bracket and so forth. So again, great tools but there are periods ... there are assets that you don't want to index.
Susanna Lee: I'm gonna ask a couple questions around the table. Matt, starting with you. How do you perform due diligence on your investments?
Matt Bartolini: So I mean from our side, so being the head of research for the firm with ETFs, we look at sort of product strategies. We will sort of invest but we'll do due diligence to make investors and clients aware of the unintended risks or the bets you're not sure you're taking or not aware. So, we like to do very thorough due diligence. Particularly in fixed income, we'll show different credit profiles. We do scenario analyses. There's shock different portions of the credit curve and then we talk a lot about just portfolio construction.
Matt Bartolini: So the active-passive dichotomy. We obviously have a sizable interest in index based investing, not only in equities but within fixed income but we're not dogmatic. We can understand that fixed income is actually an area where alpha generation has a high degree of potential. And we have active strategies. Also, ETFs, the active ETF market in my opinion is probably gonna be $100 billion market by the end of 2019 and that's because you have more track records that are formalized, three to five-year identifiable track records and it's gonna give investors more comfort in using that structure because it is cheaper than the mutual fund structure. You have daily transparency.
Matt Bartolini:So when we think about due diligence, we talk a lot about this to all of our different investors and clients to make sure they know what's in the portfolio and what role it can play. And I think that's one of the things that my team does a lot of.
Gerry Klingman: I'll jump up on that. I think that's gonna be an interesting development is how much active ETFs in fixed income continue to grow because I do think there's a place for active management in fixed income. But the ETF wrapper is a very powerful wrapper.
Susanna Lee: And how do you perform your due diligence?
Gerry Klingman: As we're advising high net worth clients, we focus on the drivers that are gonna make the biggest determinant of what their returns are gonna be, which is what their asset allocation is, what their tax bracket is, the tax location of their assets. So many clients not only don't have the right asset allocation but they have the wrong assets in the wrong places. If a high net worth individual is buying a floating rate loan fund at 4.5% and after taxes getting 2.5% there. It just doesn't make any sense.
Gerry Klingman: So a lot of it is focusing on the big picture issues that really are gonna be the biggest drivers. Beyond that, we spend time deciding where we want to spend time with active managers and spend money on the expenses of that versus our budgets related to having index managers.
Susanna Lee: JP?
JP Weaver: I would agree with that, both comments and I also agree very much that at the portfolio, construction level is where it's critical. Diversification is the number one risk management tool to my mind. We try to have some discipline about diversification, certain asset classes. We have our subsets of say, the muni market. We have a lot of clients in Pennsylvania. We buy a lot of smaller school district deals. We have a very rigorous criteria in terms of credit metrics but overall, our firm is value oriented firm that drives valuation from a measurement of free cash flow.
JP Weaver: And for bonds and stocks, I think it's important to monitor because a bond, they're gonna pay the bond off, they got to have the money to do so and consistent free cash flow is the way to not have refinancing risk.
Susanna Lee:And around the table really quickly, Matt starting with you, what's your top takeaway for investors to keep in mind when investing in fixed income?
Matt Bartolini: For right now and from a market's perspective, we would just focus on the opportunities that are afforded on the short end of the curve. Being mindful of the amount of credit risk you're taking. I think one of the more interesting sweet spots in terms of risk adjusted returns is that one to three-year corporate space. Basically, yield of around 3.1%, duration of 1.9, spread risks is about 20 basis points more than the AGG.
Matt Bartolini: So you're not taking a massive amount of spread risk and if we think about just that one to three versus one to five, that extension to the four to five-year space doesn't really add much. Add to 10 basis points of yield but a full year of duration, so just really trying to find that sweet spot. And I think the one to three-year corporate space, in my opinion, is an area where investors can sort of generate some really sufficient risk adjusted returns.
Gerry Klingman: Yeah, I'd like to say something much more interesting or much more different and there's times when I've done some things with Asset TV over the years where there was dislocation and I think there was real opportunity in high-yield or floating rate or to take some duration risk and particularly, in a period of time where there was virtually no return on cash. But now as we sit here, staying shorter duration, higher credit quality not just give a great example, you can get a real rate of return without taking that much risk. And it probably does not make sense from either a credit or a duration standpoint to take a lot of risk right now. Boring.
JP Weaver: Set your sights low. Following on their comments. Rates, you're not getting a lot of bang for your buck.
Susanna Lee: Interesting. Thank you, guys, so much for sharing your thoughts with us today and thank you for watching. Our experts today were JP Weaver, senior portfolio manager at Stewart Capital, Matthew Bartolini, the head of SPDR Americas Research and Jerry Klingman, he is the president of Klingman & Associates. From our studios in New York, I'm Susanna Lee. This has been Asset TV's Fixed Income Masterclass.