Jonathan Forsgren:
Hello and welcome to this Asset TV Fixed Income Masterclass. As markets come around to the idea that peak inflation is behind us and the Fed is likely nearing its terminal rate, investors are faced with a new economic landscape presenting new risks and opportunities.Joining me to discuss their outlook for this new landscape and the risks and opportunities in fixed income, are Dave Breazzano, Portfolio Manager and head of the High Yield Team at Polen Capital. Kevin Flanagan, head of Fixed Income Strategy at WisdomTree, and Maria Giraldo, Managing Director and Investment Strategist in the Macroeconomic and Investment Research group at Guggenheim Partners. Thank you all for joining.

Kevin Flanagan:
Thank you.

Maria Giraldo,:
Thanks for having us.

Jonathan Forsgren:
So Maria, seeing as you have it in your title, the first question's going to come to you. A lot of the macroeconomic conditions from 2022, a year marked by high interest, inflation, and volatility, are still persistent in 2023. In what ways has that hurt fixed income markets? And then, are there ways that fixed income markets have benefited?

Maria Giraldo,:
Sure, yeah. Thanks, Jonathan. I really appreciate the opportunity to set the stage on the discussion today. So far, for 2023, we're around the end of April, it's already been a round trip. We started off the year with a lot of optimism around the end of the rate hiking cycle seeming to be coming into view. And that comes from some of the economic activity that we were seeing in 2022. Housing activity was slowing, manufacturing activity was slowing, commodity prices looked like they had peaked. And we saw some inflation prints that were really encouraging. So that led to some stabilization in rates markets. That's really how it was flowing through, as a benefit to fixed income, with stabilization in rates markets, the market pricing in, the terminal fed funds rates stabilizing around 4.7, 4.8%. And credit spreads, for the most part, were tightening, through the beginning of the year.

Maria Giraldo,:
We get to around the January data and we start to see that, actually, a lot of themes from 2022 were still carrying on into the year. Namely, the labor market was still really hot. We got a very hot, non-[inaudible 00:02:30] payrolls report that was subsequently followed by inflation data that was not as encouraging anymore. Goods prices were holding up more than the market had expected. We expected, I think, a little more disinflation from the housing activity, a little more disinflation from categories like used vehicles. And so what we got, in a matter of a few weeks... This is all before the regional banking crisis... What we got is the market once again pricing in a rate hiking cycle. And in a matter of a few weeks we saw the terminal fed funds rate go from around 4.8% to 5.6%. That's the expectation that was priced into futures market.

Maria Giraldo,:
Once we get to March, and now there is a regional banking crisis that's seemingly unfolding as a result of the failures of Signature Bank and Silicon Valley Bank, all of which stem back to the rate tightening cycle and higher interest rates, now we get more volatility, particularly in risk assets. So credit spreads started to widen. But one of the benefits, and especially once the Fed stepped in to stem the volatility, one of the benefits was that we saw some stabilization.

Maria Giraldo,:
So I think to wrap up here, what we've seen at the beginning of the year, especially a continuation a little bit of the macro environment from 2022 that we thought we were moving past, we've seen periods of benefit, periods of hurt in risk assets. And as we look at the year ahead, we're sort of in this inflection point transition period to slower economic growth and a potential inflection in the Fed rate hiking cycle. I think we can probably expect a bit more of that ahead. I think that's probably a good place to pause.

Jonathan Forsgren:
Thank you for setting the scene. So going to move to you Kevin. What impact has the current market environment had on the performance and investor perception of fixed income funds?

Kevin Flanagan:
Well, I'll tell you, I think Maria really made an important point talking about the volatility quotient. There's no doubt that has been elevated, not just last year but into this year as well, even before the regional banking headlines hit back in March. It's fascinating to see it also occurring in treasuries where the move index which measures volatility within the treasury arena, really going back to levels we hadn't seen since about 2008. This follows through in fed fund's future. So with the Fed now in this highly data dependent mode, that puts the fixed income markets in a highly data dependent mode as well. So what's interesting is in the meantime, the perhaps worst year on record, or at least that we can remember in fixed income in 2022 has set the stage for perhaps a not so bad year for fixed income in 2023.

Kevin Flanagan:
If you look at yield levels across the board, you could make an argument that there's a generation of investors have not seen yields at these levels. You need to go back to 2007. We're talking now 15, 16 years ago. So it's fascinating to see fixed income coming back I think into its more traditional role in portfolio construction. And I think as we continue to move forward that will maintain, or I should say continue to be the case as well. I like to say income is back, fixed income. I think what you're hearing from advisors, from investors in general is that they're beginning to take note. And a great example of that was really one of the byproducts of what we saw in the regional banking headlines, that we've all seen bank deposits plummet over the last month or so as investors look towards, say, traditional avenues in treasuries for example, in order to get yield rather than bank deposits.

Kevin Flanagan:
So I think what it has done is to create an environment where investors now are going back and taking a whole new look at fixed income. But for somebody like myself, and I don't want to date Maria or Dave, for us who have been doing this probably for a while, it's nice to be back in fixed income.

Jonathan Forsgren:
Dave, can you discuss how you're viewing inflation within your universe?

Dave Breazzano,:
Certainly. And what Kevin said, it's great to be back as a credit person. But certainly, inflation and the expectations impact fed policy. But beyond that, in our universe, inflation impacts each company differently based on their business model. So we look at goods versus services as an example. Inflation in goods appears to be moderating, but labor costs are still a challenge. And labor costs, they lag and there's still a lot of upward pressure. For example, in the healthcare sector, certain companies are struggling because of the tight labor market in their space. And we, as credit investors have to analyze the impact of inflation and different credit dynamics and how it affects each of our companies before we include them in our portfolios. So certainly, inflation is something that's top and front of mind for us in how it impacts our credits.

Jonathan Forsgren:
So Kevin, I'm going to bring it back to you. You are the one that said, "We haven't seen yields like this since 2007," I believe you said. So I'm going to bring it back to that era. How do you compare the impact of the great financial recession in 2008 to what we're seeing in markets today as it relates to fixed income?

Kevin Flanagan:
Well, I don't want to say it's night and day, but there's definitely some differences. And I think one of them, Maria kind of alluded to earlier in her opening comments was, the fed's response to the regional banking turmoil. I don't if you all remember, it was that first weekend or second weekend in March. Here we are again on a Saturday and a Sunday going, "Oh no," waiting for the markets to open, waiting for some kind of an announcement from the Fed. And I think an important difference between then and now is the response from policy makers. Specifically, say, when you're looking at it from a Fed perspective, instead of doing things piecemeal, gradual as we saw... Remember the alphabet soup of facilities that the Fed put in place back then. This time around, I guess the expression is, they came with a bazooka, right? That's what people like to say.

Kevin Flanagan:
And the bank term funding program was actually very, very important to all of this, because it always comes down to the funding markets. You need to fund yourself. You saw that in '07 and '08, and that became a crux of the issue during the COVID lockdown, and just recently a few weeks ago. So this provided the wherewithal for banks to use the collateral, to use the treasury securities that were on their balance sheet at par value. They didn't have to mark to market, which was arguably part of the problem. And you could make the case, maybe if the bank term funding program had been in place, maybe we wouldn't have seen the headlines that we saw in early, mid and late March in the banking era. So things have definitely shifted in that regard, and I think how the market focuses as well. The market right now.

Kevin Flanagan:
Now I'm not saying, and hopefully that's not the case, there aren't a few negative headlines still looming ahead out there, but we seem to have turned the corner. Here we are moving into mid-April, late April into May, and the focus seems to have gotten back to what you were talking about earlier, talking about the Fed, talking about inflation, the fundamentals. Are we going to go into the perhaps most widely expected recession, at least in my career that I can remember the markets ever getting themselves geared up for? So I think those are some very important differences between how we should be looking at things versus the financial crisis in '07 versus where we are now.

Jonathan Forsgren:
And then I'm going to bring it back to you Dave. Could you dig in a little further? Are there any potential latent risks that are associated with the banking crisis or stress that we saw in March?

Dave Breazzano,:
Yeah. I mean there could be another shoe or two to drop before this thing kind of settles out, but fortunately for us, we generally do not invest in financial service companies. But where we've seen the impact is the tightening in the lending standards. It cost to freeze on new issues for a couple of weeks in the markets, and that constrained credit can be challenging for certain situations, but it does create opportunities. So for example, a number of bonds and loans were trading yield to call or yield to maturity. When the markets got nervous about the ability to refinance certain debts in the near term, some of these positions gap down like five to seven or eight points, because all of a sudden now, the perception was, "They're not going to get taken out at the next call or the maturity could be a bit of a struggle."

Dave Breazzano,:
So the opportunity for credit investors like us is, if we can acquire these positions and then go to the company and say, "We'll refinance. We'll guarantee that you can term out this situation for five years or so." It'll be expensive, but they have the option to either do that or find an alternative financing source. We can get taken out of that situation [inaudible] double-digit IRR. So it's like a bridge to a permanent solution for the company. And if they can refinance it away from us, that's fine too because we get taken out. But what this turmoil is doing is sort of helping grow the shadow banking market. We're seeing a lot of growth in private credit, a lot of interest in that area because traditional lenders and banks are reluctant to lend because they're worried about liquidity and a theoretical run in their deposit base. So yes, it's created some liquidity issues but also opportunities for those with more permanent capital to finance their lending activities.

Jonathan Forsgren:
And Maria, we're in the middle of earning season and we've seen the larger banks come in and have strong earnings for the first quarter of 2023, largely thanks to the stress in smaller and regional banks. So what is your outlook for regional banks and what are the implications to their credit spreads?

Maria Giraldo,:
Yeah. Well, the way that I see what's happened in March and all the turmoil unfolding for regional banks, there's sort of two channels, one of which Dave has talked about, and that is a tightening in lending. That's lending standards, lending volumes. We expect that to be pulled back from the regional banks, and it's going to impact certain sectors more than others. Commercial real estate will be impacted more. And then as the banks pull back lending in general, there could also be some other spillovers. And so you brought up a great point, Jonathan, about what we're seeing in profits. I think what we can expect ahead then for the regional banks is, if we're seeing pullback in lending activity, at the same time those banks are going to be increasing the provisions of credit losses that they take on in a quarterly basis. So that might mean for a very short period of time, lower profits. In the next several months, I expect that from now through possibly the middle of 2024, we're going to be seeing those increasing loan loss provisions, not just from the regional banks but also from the larger banks.

Maria Giraldo,:
The other channel through which I see this being impacted is through the regulatory channel. It's very rare to see a turmoil and crisis that would force the fed to step in to come to the rescue again without some sort of regulatory change. And I won't get into the weeds too much because we can get lost in acronyms relating to regulatory requirements on banks very quickly. But the one that I think will come into focus is going to be the liquidity coverage ratio. The liquidity coverage ratio was really put together to prevent what happened to Silicon Valley Bank [inaudible]. It measures the bank's holdings of high quality liquid assets to make sure that they have enough in case they experience cash outflows over a short period of time, which is again, exactly what happened to SVB.

Maria Giraldo,:
Now because of tailoring rules from back in 2018 that was put in place to help alleviate stringent regulatory requirements on certain banks, actually, SVB wasn't subject to the LCR. But there's analysis out there that suggests that even if they had been subject to that liquidity coverage ratio, they would've passed anyway. So what that means to me is twofold. One is that the regulators are going to be examining the extents to which not just the LCR but a slew of other regulation, including capital requirements, laws loss absorbing capacity, the extent to which that applies to regional banks and other smaller banks. That's going to come under examination. But then also, the application of the rules themselves. LCR, how do you measure deposit outflows? How do you measure high quality liquid assets? That's going to come under scrutiny.

Maria Giraldo,:
What it means to investors though as an investor and for credit spreads is that, for a short period of time, I think that that's going to mean wider credit spreads because it's going to raise the cost of capital for those banks. But over a longer period of time, I think what the implications would mean is that the regional banks will be safer. They'll be as safe, maybe a little less safe, if we want to say that, than the really large systemically significant banks. So over the long term we should see stabilization in those credit spreads, maybe even a little tighter than where they were pre SVB, but it could take some time before we see that normalization. So in the meantime, I would expect because of the increased cost of capital, the spreads are going to just be range bound a little wider than we've seen them in recent years.

Jonathan Forsgren:
And Kevin, following all this turmoil, how do you think savvy investors in the bank loan and private credit markets will adapt in this year, 2023, and beyond?

Kevin Flanagan:
Well, I mean we had been seeing some, I don't know if you want to say flashing yellow signs in some of the loan markets, the covenant-lite stories that we had heard before that, I think investors were beginning to look at, is there or are there any kind of alternatives maybe into Dave's area of expertise as well just in high yield in general? I think from our vantage point, I would look at high yield as still being an opportunity for fixed income investors. Going back to that, we haven't seen rates, this generation in a while. If you go back to where we were, I think it was in July of 2021, yields are up, I think over 400 basis points since then. So now you're hearing quotes in the eight to nine percent area where, in a sense, investors are looking to lock in that kind of return or clip that kind of coupon, and it provides cushion that there had been some concerns.

Kevin Flanagan:
Okay, we are going potentially into a recession. You could get higher default rates. But if you look at high yield spreads right now, everything I just mentioned is not new. I'm not making any earth-shattering, groundbreaking news here. The recession, some of the things that Maria was just mentioning before as well. And you look at the behavior of high yield spreads, it's been quite interesting. I actually did an interview during what was going on in the regional banking crisis and the question was posed to me, "what do you make of the orderly widening in spreads?" And I thought it was fascinating to see that kind of characterization of what was going on in credit spreads at the time that, yeah, they were widening out. High yield spreads moved out a hundred basis points or so. But we've come right back in, we've pretty much retraced about half of that. And you're looking at, "What kind of a cushion do I have now," versus say in the past?

Kevin Flanagan:
Jonathan, getting back to your question before, you were asking about fixed income and the great financial crisis and making comparisons to now, I think one of the big, big differences are the cushion effects from higher rates. If you look in the high yield market, if spreads were to widen out from here, you're not now talking about a starting point of four, four and a half percent in yield to worse, you're talking about eight and a half percent. Bonds are math. Us fixed income guys like to say, "Bonds are math." And if you look at the overall outlook, what if spreads move out a hundred basis points or so? High yield's still looking not too shabby. I think it's still looking pretty favorable in that environment. So from the bank loan space or something like that, I think traditional high yield, if you can get some quality screen into your high yield portfolio as well, in our opinion, it's a nice core plus way of playing the fixed income market.

Jonathan Forsgren:
Thank you. Maria, I'm going to keep on with credit spreads. Could you dig into or give us a little bit about where credit spreads are today relative to a year ago and what that means for investors?

Maria Giraldo,:
Sure, yeah. If we look at investment grade corporate bonds, for example, credit spreads are roughly about 130 basis points. So what that means is investment grade corporate bonds, you're yielding about 1.3% more than you would get for a treasury of comparable maturity. So where were they a year ago? They were actually around this time, April of 2022, about the same. And that's because in advance of the start of the rate hiking cycle investment grade credit spreads had already widened a bit. They're also around the same where they were at the end of 2022. But I think that these time comparisons undermine a bit or understate the range that we've had over the last year. So investment grade spreads have been between 115 basis points, I would say, at the [inaudible] to about 165 basis points.

Maria Giraldo,:
But to Kevin's point, a lot of that was sort of orderly on a spread basis. Actually, outside of crisis periods like the global financial crisis and COVID crisis in 2020, a 50 basis point range over a one-year period for investment grade is actually pretty normal. Where investors were feeling more of the volatility was on the rate side, was on treasury yields going higher, and that taking investment grade yields and high yield yields as well.

Maria Giraldo,:
Sticking to credit spreads and moving to high yield corporate bonds, compared to a year ago, credit spreads are about a hundred basis points wider than they were. They're trading around 440 basis points. So again, that's to say, you can get 4.4% more in yield than you would a comparable treasury of same maturity. And that what that's telling us is that you're getting paid more risk premium to take that risk, to take credit risk, to take liquidity risk in these markets than you were a year ago. And there's a reason for that. With time passage and given the fed rate hiking cycle, we are moving closer to a potential recession, and we have to price that into risk premiums.

Maria Giraldo,:
But as credit managers, we like that environment. I would say we prefer an environment where you have that additional credit risk premium, where you're getting paid to take the risk, compared to 2021 where credit spreads were actually very near all time types. That's an environment that makes it very difficult to take risks, and you really have very little cushion for being wrong. So you're getting paid more risk premium if you have the ability to roll up your sleeves and dig into the data, dig into the risk factors. Valuations are much more attractive than they were a year ago.

Kevin Flanagan:
So Jonathan, it's like we have a return to normalcy of some sorts in fixed income, is a way of looking at it I think.

Jonathan Forsgren:
Well, thank you. And so coming to you Dave next here. What about this environment makes it an attractive time to invest in leverage credit?

Dave Breazzano,:
Well, to expand on what was just said is, interest rates finally are at attractive levels after about 15 years. So you're getting paid to own and participate in the leverage credit market. Plus, when you peel the layers of the onion away, the credit quality profile of the market is pretty good. There's no near term maturity wall, and this reflects a combination of factors, unlike prior severe inflection points, like in '07 and '08, people were generally caught by surprise. This is a well telegraphed, anticipated, potential recession that nobody really knows how deep it'll be and when it will actually start. But what's certain is, less than 5% of the leverage credit market has a maturity before the end of 2024. So there's not a lot of catalysts out there. You hate to say there's anything good that came out of the COVID crisis, but it did flush out a lot of those challenged companies early on.

Dave Breazzano,:
And then those that survived, when the Fed just infused liquidity into the market, they were able to refinance, extend their maturities, lock in attractive coupons, and for the good or the bad of it, covenant-lite deals. And it's hard to default if you don't have any covenants. Now it doesn't mean it's a good or a bad thing, but it's just a fact. So now, we can construct, and we dip down into the lower tier of the credit markets, we can construct portfolios today to have a double-digit yield and we're comfortable with the overall credit quality of our portfolio. So fixed income now is an attractive asset class and not just a placeholder as it was for over a decade where investors just didn't want to have a hundred percent of their eggs in the equity basket or private equity and alternatives and needed some ballast. They were in fixed income but they were losing money on a real basis.

Dave Breazzano,:
That's not the case today. And because of the attractiveness in the real yields that do exist out there, we expect favorable investor flows over the near and midterm going forward. So those are favorable technicals. All this adds up to a fairly attractive time to be in the leverage credit market today.

Jonathan Forsgren:
And Kevin, I'm going to bring it back to you. What are some of the greatest risks or challenges that you see associated with fixed investing strategies right now?

Dave Breazzano,:
Well, I'll go back to the elevated volatility quotient. I don't think that's going away anytime soon. We've all kind of touched upon it, if not hit upon it directly where we're either at or close to the end of this rate hike cycle, and where do we go from here? So I cut my teeth on the trading floor and there were two old adages, don't fight the fed or don't fight the tape. One of those is going to have to win out as we move forward here. And so far as an investor, it's kind of been, don't fight the tape, right? I.

Dave Breazzano,:
It just feels like bonds wanted to rally and they got that opportunity with the regional banking headlines. But we've seen it even without that, that any little glimmer or any little sign that's like, "Here it is! That recession, it's finally coming." You get that rally in bonds. But is the market right now misinterpreting what the fed's goal is of what policy is going to be? That rate cuts are not going to come sooner rather than later, and they won't come perhaps in the same magnitude that had been priced in. Now you're beginning to see Fed fund's futures, I think take some more of that into consideration. But still, if you look at a treasury two year yield at roughly four and a quarter, which by the way, a week or so ago, or maybe two weeks ago was about 375, you had already factored in rate cuts, if you looked at just the yield of the two-year treasury, you didn't know any better. If you looked at a 375 2 year treasury yield, you would've said, "There's no way the top end of the fed funds rate is 5%."

Dave Breazzano,:
I mean, from what I can remember, I've never seen this kind of difference in spreads between a two-year treasury yield in the actual fed funds rate or where it may be going. So let's just say for argument's sake, the Fed does raise rates one more time at the May FOMC meeting and you get to a five and a five and a quarter kind of ban for the new target range, and then they go on hold, and they go on hold for an extended period of time. That in my opinion, is one of the challenges that, let's just call it the treasury market right now is facing. So I'm still in the position where I would rather be late than early to the duration party.

Dave Breazzano,:
Now after Powell spoke on March 8th, that's kind of like the line of demarcation here, if you think about it. That was his semi-annual monetary policy testimony. The two-year treasury yield was 507. You had, I think what Maria mentioned earlier, you were talking about fed fund's futures pricing in something in the area of 560 or 570 as a peak terminal rate. And you had a 10-year treasury yield back over 4% again. And look where yields are now. So it's kind of hard. It's kind of like, "Well geez, it looks like some of that duration rally has already occurred." But the volatility quotient, if you just see the ups and downs of the yield movements are just incredible of late.

Dave Breazzano,:
So in my opinion, when you're looking at, "Okay, how do I perhaps get around some of these difficulties or challenges or hurdles in the bond market?" One area, income without the volatility, I like to look at are treasury floating rate notes, where you're looking at treasuries, they're floating with the three-month T-bill weekly auction with a spread and you don't have that kind of volatility you're seeing in the fixed coupon part of the market. So that would be, I think for me, some of the challenges and how to address them.

Jonathan Forsgren:
Thank you. Maria, what are some of the key credit risk factors to be looking out for right now?

Maria Giraldo,:
Well, I think because of where we are in the economic cycle, where we are in the credit cycle where defaults are starting to trickle higher... In the first quarter of 2023, so far the default rate, just for the first quarter, is about 1%. That's according to S & P data that they track. Which means that if you annualize that figure, we are on track for the default rate to end of year at around 4%. That's assuming we continue to see similar volumes of defaults for the next several quarters. So if you're assessing credit risk and you're looking for key factors, some of the ones that we'll look at will tend to be around cash flow stability. What is the trend of cash flows in any particular issuer and what does that trend look like if we project it out over the next four or six quarters where maybe within that timeframe there may be a recession?

Maria Giraldo,:
What does free cash flow look like for any issuer? Are those cash flows secured by predictable things? Some operators have contracts where you can count on the stability of the cash flow, unless something happens with whoever's on the other side of that contract. We are also looking at balance sheet liquidity, how much cash to debt is on the balance sheet, what access to revolvers there are, what's the profile of current liabilities to long-term liabilities? One of which also Dave mentioned, which is a maturity wall. Are their upcoming maturities? A lot of that is going to impact balance sheet liquidity. To a lesser extent, we might be looking at industry cyclicality. And the reason why I say to a lesser extent is because you can actually find stable and more a-cyclical operators within a cyclical industry if you find things like cash flow stability or those contracted revenues.

Maria Giraldo,:
Whereas there may be more cyclicality in a company operating in a traditionally more defensive industry. I think it's really interesting that over the past four quarters, healthcare has actually led in default volumes when you compare it to other industries. So it's not so easy to just move into only cyclical industries and think that as an investor you're positioned for a recession. You really have to be looking at other sources of stability for a company. So those are key credit risk factors.

Maria Giraldo,:
Beyond that, I would also be looking at a position of a credit instrument. If you're looking to invest in any particular instrument, you want security right now. So in case something goes south because you can't really predict the severity of a recession in advance, there's still information coming out on which sectors will be affected more compared to others. So looking for that instrument security, a senior position secured by assets that can't be moved out from under you, debt subordination. These are very key factors that we look for, but there's obviously a whole process around credit analysis that sits with our teams.

Jonathan Forsgren:
Thank you. I'm going to bring it to you, Dave. How are you thinking about default risk today given your position and experience in the high yield space, especially after Maria was suggesting to go with more security in investing?

Dave Breazzano,:
Well, certainly, defaults are what we seek to avoid in our portfolio. So we focus a tremendous amount of our effort on due diligence, credit analysis. And perhaps we're a little bit different than many other traditional high yield managers in that we run relatively concentrated portfolios, and we're entirely bottoms up focus. So we look at each individual credit. And so with this well telegraphed recession that we're having, and with fairly well known risk factors such as inflation and its impact on the credit worthiness of borrowers, we can model that out. It's not a real mystery as to how these factors will impact the future performance of certain types of companies. So when you roll that all into our analysis, being bottom up, more targeted, more concentrated than a typical manager, we're not too concerned with defaults in the near term. They are trending up. But as I said earlier, with all the refinancings in 2020 and '21 and only 5% of the leverage credit market maturing inside of 2024, the near term, there's relatively few events to get companies into trouble.

Dave Breazzano,:
A 1% default rate, yes, that's trending up, closer to the long term average in the high yield markets. We've just been blessed with an abnormally low default rate over the last number of years, and we've always anticipated that it would trend back to the averages, which is about three to 4% annualized. We don't expect a spike into double digits as we saw in prior inflection points for the reasons that I've touched on. And so as the economy slows, it's our job to be vigilant in our due diligence. But I've survived many credit cycles over my 40 plus year career, and today's companies, generally going into this thing are fairly well positioned. It's often not the case as we go into credit inflections. This has kind of been telegraphed as we said, and companies do prepare for these things. It's when they get blindsided that you really have to worry.

Dave Breazzano,:
But right now there should be no one out there that doesn't expect the economy to slow down a bit. And if it doesn't, great, but our projection's heart's going to slow and companies are going to be more challenged and we have to look for the companies that have the wherewithal to survive a bit more challenging macroeconomic environment going forward. But they do exist. So a long-winded way of saying, in the near term we're not so concerned, but we're always vigilant. Our primary focus is to avoid defaults.

Jonathan Forsgren:
Kevin, we have two prominent discussions going on in the fixed income market. The first revolves around concerns around a recession induced increase and the default risk that we've been talking about, and the other revolves around the demand for treasury floating rate notes. Where do you see these products going given anticipated changes to the slowing economy?

Kevin Flanagan:
Well, Jonathan, we've always been here proponents of the expression, when you're asked the question, land the plane. So get to the point. So I appreciate where we are in this part of the presentation. So I can be pretty much pretty brief on this, because I think when you're looking at it from a high yield perspective, it's the coupon, it's the yield levels, where we're at, at the present time, that we spoke about before. Where are high yield spreads? There is an anticipation that default rate risk is going to go up, that default rates are going to go up. And to Dave's point, from one percent to four percent, that's not unusual at all, and not anticipating something in the double-digit category.

Kevin Flanagan:
So continuing to look at the area of high yield with a quality kind of screen, what Maria was mentioning, looking at the balance sheet is very important, cash flow. Where you go from here, and then treasury floating rate notes just get you back to that income without the volatility. And so for us, those are going to be I think two key, important areas that investors are going to continue to look at, and we continue to see a great deal of interest in, in our client conversations.

Jonathan Forsgren:
And Maria, we've talked a lot about what's been happening to credit spreads, but the question I'm going to pose to you is, are investors getting compensated enough for the risk?

Maria Giraldo,:
I think so, and I think the historical data over the long term does show that on average investors get compensated for the default risk in those credit spreads. And that's because there's an additional liquidity risk premium that investors require to invest in these bonds. But if you can hold these bonds to maturity, which most credit managers would prefer to do, we do all the due diligence and really try to assess the risk that a credit could default versus it getting downgraded, et cetera. We're happy to take the liquidity risk premium, that's a nice yield, that's a nice additional yield. So over a long period of time spreads for triple B's more than compensate for the associated credit risk, default risk.

Maria Giraldo,:
Think about it this way, over a 10-year period on average, a triple B will see a 4% default rate. That's cumulative, not annualized. So if you invest in a triple B portfolio today and hold it for 10 years, on average, you might have 4% of those default, not annually, just cumulatively. But you're earning that credit spread annually. And I find it to be the same for double B's. I find it to be the same for single B's. There's periods around recessions where you might need to be a little more selective in triple C's, but the history does show that those credit spreads tend to be very accretive to a portfolio of an investor looking for income.

Jonathan Forsgren:
Dave, can you talk about the role that risk ratings or agency ratings play into your investment strategy and how do you look at those ratings from a research perspective?

Dave Breazzano,:
Yeah. The rating agencies have a really difficult job. They need to fit multiple risk factors into just a few categories. So for example, virtually any company that has six times total debt to EBITDA or six times leverage, it will be rated triple C. Even if it has that same company has an enterprise value where it trades it say over 12 times EBITDA and has a loan to value less than 50% and it's owned by sophisticated private equity firm, it's going to be rated triple C, just like a secularly challenged company with six times leverage or even less will be rated triple C. So this creates opportunities. The triple C rating typically prohibits many investors from even owning it. So investor constraints create those opportunities. And we saw, we were the beneficiary of gifts during the COVID downgrades of so-called fallen angels that got downgraded from investment grade to just do the double B category.

Dave Breazzano,:
The price of those securities traded down 10, 20 points because there were massive volumes of this debt that the market could not absorb and investors were forced to sell them due to their internal requirements. So we as an organization, our rating's agnostic. And we try to take advantage of these types of opportunities where there are people that avoid certain rating categories for what I would consider non-economic reasons. They have constraints. They could be regulatory, reserve requirements or what have you. But for whatever the reason, they're prohibited from participating in certain sectors of the market, that creates an opportunity for us to get a little bit more yield per-unit of risk, and that's what we seek to do.

Jonathan Forsgren:
Maria, there's been a lot of talk about an earnings recession. What are your US corporate earnings expectations for high grade and high yield?

Maria Giraldo,:
I do think we're going to go into a corporate earnings recession. It's just consistent with the direction that the economy is headed for. Now in a recession, if we use the S & P 500 as a proxy, let's say for large cap, high quality names, although there are high yield names in the S & P 500. So let's take it for a proxy, earnings per share will typically fall by around five to ten percent on average during recessions. It can be worse. It depends on the severity of the recession. The global financial crisis saw about a 30% decline in earnings. I don't expect that. I don't expect that the recession is going to be as severe as the global financial crisis. So I think that earnings will fall by about five to ten percent, an average recession, but cutting off the tail risk.

Maria Giraldo,:
Right now, analyst expectations are for less than that. The expectation is for growth of 1% relative to 2022. So some of those expectations, they need to be adjusted. But again, it's somewhere to closer to an average recession. For high yield, more typically we'll measure it as earnings before interest, tax, depreciation, amortization, which we call EBITDA, that it's more of a closer proxy for cash flow. And I think it's more indicative of being able to pay back the debt. And there, you'll typically see about a 10 to 20% decline amongst high yield companies during recessions. I think it's going to be something closer to about a 10 to 15% decline. We'll know more as the recession's taking shape. But the expectation's, again, you need to adjust for that earnings recession. And I think we'll see that over the next several quarters.

Jonathan Forsgren:
And David, what would a softer corporate earning season mean for your investible universe?

Dave Breazzano,:
Well, right now the market is anticipating that, so we're kind of ahead of it in that sense. And these expectations have created what we call a risk-off mentality. We see this in relatively wide spreads between the rating categories. And for example, when we touched on this, Maria did earlier in the discussion, the option adjusted spread for double B's today is about 270 basis points. When you move down to single B, it's 470 basis points. So it's 200 basis points wider for that rating category jump. But when you get to triple C's, on average, they're over a thousand basis points spread. It gaps from 470 to over a thousand. So as always, we've got to conduct a thorough due diligence and factor in the eroding earnings into the fundamentals of the companies that we're targeting. But this isn't new for us, so we just build that into our models.

Dave Breazzano,:
And because we invest across the capital structure in bonds, loans, private credit, as well as public credit, in our private companies, we see financials in relatively real time and we can see what's happening in various sectors fairly quickly. And things are slowing down, but it's not material yet. It's coming. And there is margin compression, lower revenues, higher costs and so forth. But we just incorporate that into our analysis. So when you have parts of the market that are yielding over a thousand basis points, we can find a handful of pretty good opportunities in that large universe.

Jonathan Forsgren:
And Kevin, given everything we've been talking about, what is your approach to developing high yield funds right now and how do you see that changing over the next two and then five years?

Kevin Flanagan:
Well, in the ETF space that, traditionally, you're looking at market cap weighted approaches, which really is just a way of saying, the more debt you issue, the better, or the higher weighting you're going to get. And we've, for quite some time now, actually identified going to the balance sheet, things we've talked about before, and doing a quality screen and focusing on those kinds of issues with respect to high yield to see if we can mitigate default risk. I mean, it's probably almost impossible to eliminate entirely default rate risk, but if you can mitigate it especially in the environment that investors are expecting to go into with respect to the economy and default rates moving higher, I think those are the kind of strategies that you want to follow, that you want to use as solutions.

Kevin Flanagan:
And I don't see that changing in two years, the next five years, the next 10 years. I think it's really going to be a time tested approach when you're looking at investing in high yield. If you can use that balance sheet to your favor, identify problems before they arise, it goes a long way. "Be proactive," is what we would say.

Jonathan Forsgren:
Thank you. Maria, where are you seeing the best value in fixed income right now? And I know that earlier you had advised to go with a little bit more security. And then how do you see the value shifting in fixed income over the next five years?

Maria Giraldo,:
Yeah. I think fixed income is just a great place to be. I know Kevin and Dave have both touched upon the fact that there is income back in fixed income. We have yields that we can pick from. At Guggenheim, we have a view that we are going into a session, so that's why we'll tend to be a bit more defensive. But what that means for us is just looking for security, which we'll find in the high yield space as well, we'll find in the bank loan space. We like investment grade corporate credit. The yields there look very attractive. The yields are still in the 96 percentile of where they've been over the last 15 years.

Maria Giraldo,:
But in particular, going back to my liquidity point, a lot of times, in the credit spread you have embedded in there that liquidity risk. So if you do the credit analysis and you are very comfortable holding the position for the life of the bond, it could be five years, seven years, 10 years, that liquidity risk premium for us is very attractive. And where we find that we're seeing the best value in liquidity risk premiums will tend to be in structured credit. So we like certain areas of the asset backed security space. There's whole business asset backed securities that sometimes are unfamiliar to investors in terms of the companies that operate in there, and sometimes will be companies that you might interact with every day. We like collateralized loan obligations because there's also a little bit of an embedded hedge there in case the Fed continues to hike interest rates and the market's wrong on the fed pivot.

Maria Giraldo,:
So there are places to find value. We like structured credit for the additional liquidity risk premiums, and we also find the default histories to be very attractive. But over the next five years, broadly speaking, looking back, this is going to be such a great entry point across the board. Getting those yields in the portfolio and then writing a [inaudible] rates going down through the easing cycle. I think it's going to look like a great decision for a fixed income per investor.

Jonathan Forsgren:
And Dave, are you seeing any themes right now that are particularly interesting within fixed income? And how are you trying to capture them in the funds that you have?

Dave Breazzano,:
Yeah. One of the themes we're seeing right now, and I touched on it earlier, is, these shorter term bonds and loans that the market was anticipating were going to get refinanced fairly easily, then with the turmoil that we're seeing with the banking crisis, if you will, in the risk-off mentality, they kind of gap down. So the tactical trade that we're trying to take advantage of right now is to identify a number of these situations that... We're very comfortable with the loan to value. I mean, some of them have 30% debt to total enterprise value. There's a huge equity cushion below. And in the short term, there's double-digit IRRs to be had by buying these situations. And then we can go to the company itself and say, "We'll refinance it. We'll give you another five year loan to extend out." It could be expensive and you could use us to kind of stop out and refinance with somebody else, if you can find them. And if you can't, we'll do it. And if you can, take us out. It's a win-win situation.

Dave Breazzano,:
And so that's a nice, tactical opportunity that exists today. And the markets always present these types of opportunities. You just have to be very nimble and focused on where one sees value. And always be focused on downside protection. It's critical.

Jonathan Forsgren:
Kevin, as we wrap up here, what is the most important takeaway for a viewer to know about fixed income investing?

Kevin Flanagan:
Well, I guess I'll highlight something that we really didn't discuss was inverted yield curves. I mean, where at a point before, I said I'd rather be late than early to the duration party. You just have to look at the shape of the yield curves right now and see there's really no incentive, no urgency to move out along the maturity line. So my focus is continuing to be, if you're looking for a high conviction type of idea, are in the treasury floating rate note space. They are essentially the highest yielding treasury security, well over 5%, with just one week duration. Compare that to a 10-year treasury where you have a yield of about 3.6%. I think that's an environment where I mentioned before. Investors, volatility is here to stay. If you can get income without that volatility, it checks off a lot of boxes.

Jonathan Forsgren:
Dave, what are your top three takeaways for clients considering a high yield allocation?

Dave Breazzano,:
Well, one, absolute yields are attractive. Two, near term default losses aren't expected to be that severe for the reasons that we touched on earlier. And then three, we have this wonderful tactical opportunity that I just talked about to refinance those shorter term maturities. It's a win-win. Either we get to lock in a very attractive longer term solution for the company or we get taken out and we can lock in double-digit IRRs in the next one to two years. So three pretty important factors that make this space pretty attractive.

Jonathan Forsgren:
Maria, I had you kick us off, so I'm going to let you close. What would you like our viewers to come away with after watching this discussion?

Maria Giraldo,:
Sure. Yeah. I think if you believe the Fed is close to pausing or pivoting, you should be taking positions in credit now. The yields look very attractive. Risk premiums are more attractive than they were last year. I think you do need to do that in an actively managed way, given what we've talked about in the potential for default risk. But then the last few things I'll say is to reiterate what Kevin said, volatility is here to stay, try to mitigate that. And what Dave said, focus on downside protection.

Jonathan Forsgren:
Well, Dave, Kevin, Maria, thank you very much for joining us today and sharing your insights.

Kevin Flanagan:
Thanks for having us.

Dave Breazzano,:
Thank you.

Maria Giraldo,:
Thank you.

Jonathan Forsgren:
And to our viewers, thanks for watching. For Asset TV, I'm Jonathan Forsgren. We'll see you next time.