Gillian Kemmerer:

Welcome to Asset TV. I'm Gillian Kemmerer. In this masterclass, we will focus on fixed income, how it will fare in the tug of war between interest rates and growth, the pockets of opportunity available now, and how investors should think about duration. Joining us today, we have Kent White, head of fixed income mutual funds at Thrivent Asset Management. Adam Grotzinger, senior fixed income portfolio manager and managing director at Neuberger Berman. And Bill Zox, portfolio manager at Brandywine Global.

Everyone, thank you so much for joining us. And Adam, I'm going to start with you. How do we see the fixed income macro landscape evolving over the next 12 to 18 months?

Adam Grotzinger:

Yeah, thanks Gillian. Great question and good to be here. A few things are really guiding our view of the macro landscape over the next 12 to 24 months forward. And starting with the major thing is inflation. What is the trajectory of inflation? Have we slayed the inflation dragon? And our answer to that is yes, we think inflation is headed in the right trajectory, which is less inflation versus a re-acceleration of inflation. But I think important context in that statement is that inflation equally is not getting back to the central bank targets in the short term. So by the end of this year, we're not going to be at 2% core inflation. It's not really until the end of 2024 that we start getting even closer to the central bank targets. So that's going to take some time.

The implications of that I think in terms of monetary policy are important, which is the Fed gets to restrictive territory, which is where they're at now. And they likely hold, but they're not incentivized to cut. They don't want to cut because that's going to risk their credibility as an institution. And it's also going to risk kind of the concerns around, is this a repeat of the 1970s? So inflation's going the right way. Central banks are largely done with cutting, but we should equally expect central banks to keep a restrictive policy stance given that inflation's taking some more time to work its way out of the system.

And then in terms of market implications of those two kind of themes, first would be with regards to volatility. We think interest rate volatility as a function of more behaved inflation and central banks done largely with hiking, i.e. reaching terminal policy rates, means that there's more interest rate stability versus the volatility we've seen over the last year, year and a half. And that's going to be a positive tailwind for investors when they think about fixed interest allocations and particularly interest rate sensitive sectors of the market.

And then lastly, on credit markets, given this backdrop of restrictive policy rates and stabilizing, but more medium term slowing growth to the overall economy, I think the message would be investors just need to be more sensitive and aware of the idiosyncratic and tail risks emerging in credit when they're thinking about constructing credit portfolios.

Gillian Kemmerer:

And Bill, what's your outlook for the end of 2023 and moving into 2024?

Bill Zox:

Sure, I'm a bottom up high-yield portfolio manager, but I will start with a couple macro thoughts. First would be don't confuse a long lag with a soft landing. And that this monetary policy is taking much longer than I think most investors anticipated to really impact the economy but that doesn't mean it's not going to happen. So that would be the first thing.

The second thing is I'm somewhat skeptical that the Fed is even going to try for the soft landing. When it really comes down to it, they don't want to make two inflationary policy errors in a row. They would never say this, but I think when it comes down to it, is the Fed really going to try for a soft landing? I'm skeptical. So the timing of that though is very uncertain. So in the next six months, is the narrative going to shift from soft landing and a long policy hold to a hard landing and rate cuts?

I don't have a firm view on that, but regardless, I think there is plenty of opportunity in the high yield market. I agree with Adam that you have to be careful at this point in the cycle, but there are plenty of opportunities in the high yield market. In the leverage loan and private credit markets, I think it becomes more difficult over the next six months. And that's because those are floating rate markets and the higher interest expense will have completely flowed through by the beginning of next year. So that trailing 12 months interest expense will reflect the vast majority of the rate cuts, or rate hikes I should say, that we've seen this year. That has not been the case yet because we still have two quarters of relatively low interest rates in the trail in 12 months.

So I think that you will see more stress in leverage loans and private credit, it takes much longer to flow through to high yield and there's still plenty of opportunity in credit.

Gillian Kemmerer:

To Bill's point about the skepticism around a soft landing, Kent, how should investors be positioned in the fixed income market in the event that the much talked about economic slowdown or recession finally occurs?

Kent White:

Yeah, so if we do get to a point where there is, whether it's a slowdown or a soft landing recession, whatever we end up seeing, you're definitely going to want to be overweight, fixed income, it's always worked in virtually every recession. It provides valuable protection against what we typically see in recessionary environments where we see equities and other risk assets, their prices decline and even more so now where yields are a lot higher than they've been in a very long time. The 10-year Treasury is now roughly 4.3%. And we haven't seen yields like that in, I think yesterday we did a high end since 2007. So there's actually some income in fixed income again. So that provides a nice buffer against the asset declines that we typically see in a recession from other risk assets.

And you also tend to, not tend but almost every recession, the Fed is cutting rates and that provides very nice tailwind in terms of asset prices because as rates decline, bond prices increase. So you're going to go a nice capital appreciation effect from bond [inaudible 00:06:52] increases and some of those can be pretty significant times, double budget type returns from fixed income just from the rates decline. So definitely more favorable outlook for fixed income and the most recessionary environment parts, especially parts of a higher quality fixed income market.

And that's where you'd want to be positioned more. Up in quality, treasuries, mortgage backed securities look attractive at this point. Other securitized assets are higher quality and don't have as much volatility in prices in terms of credit spread widening. And within my focus is generally the investment grade credit market and even within the investment grade credit market, you want to be up in quality, higher rated companies with more stable cash flows. So that's generally how you want to be positioned going into soft economy or recession.

Gillian Kemmerer:

So in light of this comment about the income being back in fixed income, Adam, why should investors consider fixed income in this environment? Do you share that view?

Adam Grotzinger:

Yeah, I'd echo that view and we'll share that kind of same thoughts. I think important, again, so it's been a real long time since you've actually had a real coupon in much of the high grade fixed income markets. And I think a lot of us that are newer to fixed income perhaps and coming back in or haven't used fixed income as meaningfully in portfolios are now reassessing it and reminding ourselves that for the forward-looking environment interest rates going higher versus lower, we would argue this symmetry skewed to lower. So that's positive for bond investors and remember that now with the fatter coupon in markets that even if interest rates go a little bit higher, you're better buffered against that because your coupon's there.

So let's just take, if interest rates went higher by a hundred basis points and you have a five-year bond, you're going to lose 5% on price, but your coupon's 5%, so that's a wash. That's very different from the starting point back in 2021 where the coupon's way less than 5% and so you're wiped out completely.

So just remember, I think to the point just made that you're better buffered against the short-term risk of interest rates bouncing around may be going a bit higher, but the more medium term kind of opportunity is that you're going to get better price appreciation from interest rates rallying. So the way to think about it or how we're talking about this is ballast fixed income, high grade assets, treasuries, mortgages, IG credit, not only provide income again, but also as mentioned, can do well in a risk off environment and historically have done that. And with inflation declining the correlation of those assets to risk assets should also come back to what investors should expect.

And then moving to the risk side of the equation, there's almost something for everybody in fixed income. That's the ballast end, but if you're looking at higher beta credit, high yield markets, loan markets, the take would be there's still opportunities there because the income levels are really high. And so it's kind of like what are you trying to solve for and how can these different parts of fixed income fit that portfolio high beta credit would kind of fit from the point of view it's competing with growth assets, it's competing with equities in our view and maybe should be taking share from equities as you're getting a similar return with greater confidence around actually receiving it.

Gillian Kemmerer:

Bill, coming back to your point about the potential for a recession or maybe the skepticism around a soft landing recessions typically indicate a risk-off environment. So can you explain your thoughts on the high yield asset class in relation to recessions?

Bill Zox:

Sure. And Adam set me up well there so I appreciate that. Whenever you're talking about high yield and recession, you have to say high yield compared to what? And if you're comparing it to equities, in the three recessions before the COVID recession, high yield massively outperformed equities going into the recession. And then we did an analysis for the 18 months after the recession.

So in the early nineties, high yield outperformed the S&P 500 by nine percentage points annually during the recession for 18 months thereafter. In the early 2000s and the late 2000s, the Global Financial Crisis, that was 13 percentage points annualized out-performance high yield versus the S&P 500. Now COVID was different, high yield did fine, but the S&P 500 really did extraordinarily well during that recession and coming out that was very unique, but I think that it makes it even more likely that high yield will outperform during the next recession because the S&P 500 is starting from a much higher level relative to high yield.

And then you can compare high yield to high grade fixed income or core fixed income. And there the issue is when does the recession come? Because we would've had the same discussion in the middle of last year and we would've had the same discussion at the beginning of this year. At the beginning of this year, high yield has outperformed core fixed income as measured by the Bloomberg Aggregate Index by 700 basis points. High yields outperformed this quarter by 300 basis points. So the problem with an inflationary environment while you are waiting for the recession is that can be a difficult environment for core fixed income.

Gillian Kemmerer:

Adam, coming back to you for a moment, what would you say is either misunderstood or mis-priced in fixed income in this environment right now?

Adam Grotzinger:

Yeah, I think there's a lot of... So everything's cheapened in fixed income, but we've also had some pretty incredible moves on a year to date basis in some sectors of the market. Our take on it are things like corporate credit, be it high grade corporate credit or high yield corporate credit, are fair to slightly cheap in their valuations. It depends on how kind of your expectations are regarding defaults and the degree of slowdown or degradation in the economy. But kind of the opening point is there's more left tail risks. So how much compensation should you have for that?

The general direction of travel has been if you're investing in a high quality portfolio, you don't need to stretch yourself like you did in the years past by going into those markets, you can achieve a comparable and compelling total return outlook from higher quality fixed income.

And we think in particular some parts of the high quality fixed income market that are not treasuries per se, which are kind of reaching the cheap ends of our fair valuation band in terms of yields, but things priced off at treasuries like agency mortgages look pretty cheap and there's kind of like two parts to that market. I'd say there's the unloved low coupons that are now low dollar priced positive price convexity opportunities. So like Fannie, Freddie two, two and a half, 3% coupon bonds priced in the mid-eighties on the dollar. It's rare to see that low of a dollar price on an agency mortgage security and that's just a function of how aggressive and fast interest rates rose.

But also some of the more recent production mortgages have been trading cheap on a valuation basis if you look at their spreads, their option adjusted spreads versus duration equivalent treasuries. And that has to do in our minds with a little bit of short-term dynamics in the market, which has been the Fed unwinding their balance sheet and on a big mortgage buyer, the banks temporarily stepping back given all the things that happened with the regional banks here this year and a new buyer emerging, which are private investors like ourselves that are a little bit more price demanding.

So I think something like agency mortgage-backed securities is a great example of kind of an area of the market that's quite cheap and a high quality asset and going through some price discovery phases as we transition buyers in a short period of time.

Gillian Kemmerer:

To Adam's point about some of the big moves we've seen this year, Kent, how do you manage and minimize volatility in the fixed income space right now?

Kent White:

Yeah, just real quick on Adam's point about mortgage backed securities, that's also an area that we find attractive right now. Especially relative to some of the higher quality portions in the investment grade credit market. They haven't seen dollar [inaudible 00:15:26] of stock in them, quite a long time. So it's also an area that we're allocating some of our money to.

In terms of volatility, volatility is generally something that fixed income investors don't want to see in their portfolios. It's been hard to avoid in the past year or two as the Fed has been raising rates and there's just been a lot of uncertainty about the Fed path. But some of the ways that we will try to dampen volatility in our portfolios, one, the most important way it's diversification. It's always whether it's an equity portfolio or fixed income portfolio, diversification will serve to minimize volatility. We also will use CDX credit burden swaps to dampen volatility. If we see valuations get to a certain point where we don't find them attractive, we'll try to hedge some of that risk out and we'll lose some volatility that way. And we'll also use interest rate features to dampen some more [inaudible 00:16:31] volatility.

Gillian Kemmerer:

So to summarize this global macro picture that we've painted Bill, recent global monetary policy has supported higher interest rates and central banks remain generally hawkish. So how will high yield issuers survive this higher rate environment?

Bill Zox:

Sure. For most of the post Global Financial Crisis period, the focus has been on leverage metrics, so debt to EBIDTA, debt to equity, debt to enterprise value. But now that focus needs to shift to interest coverage. And the bottom line is if your interest costs are increasing materially, your leverage has to come down to have the same interest coverage ratio that you had with your old leverage targets. So it's very important do the management teams of borrowers understand that concept or are they burying their heads in the sand and continuing to operate their business with the same leverage targets that they had in a much lower interest rate environment. So that's one very important thing.

The other thing that management teams can do is get creative. They have had and continue to have pretty good access to capital for the most part over the last 20 months or so. So all but the most stressed high yield borrowers have had good access to capital. So one thing that you can do is borrow in the convertible bond market now. So that's one way to continue with the same interest costs that you would've had in the low interest rate environment, but you have to give up some of the equity upside. And with the strength of the equity markets, that's a pretty good option for an increasing number of leveraged borrowers.

Then the final point I would make is, as I just said, maybe right now 10% of borrowers are really struggling with the, and I'm talking about in the high yield market now, maybe 10% of the borrowers, they're generally rated CCC, they are struggling with the higher interest rate environment. Depending on how high rates go and how long they stay there, that 10% might become 20%, 25%, I don't think it will, I think it'll stay closer to 10%. But the important point is that there's still 75% of the market that can handle this higher interest rate environment with no problem. And that's really where a good active manager should focus their attention is on that 75% of the market that is going to be able to handle any environment.

Gillian Kemmerer:

I think the question of duration is an important one. So I'd like to stay here for a bit and Adam, I'll start with you. Why shouldn't investors stay in cash and or short duration and how should they get off the sidelines?

Adam Grotzinger:

Yeah, that's a great question and really like a conundrum in the markets right now with an inverted yield curve, in essence cash or rolling T-bills is a very high yield alternative to pushing out the curve and getting more invested in a fixed income outcome. And there's been inertia I think that we've seen from clients and saying, "Well, why should I leave cash? It gives me certainty, the yield's pretty high and that's what I want right now." And so I think the answer to that on why extend duration, how much duration to add to a portfolio, you can look at history and look at the yield curve sheep and what past inverted yield curves have presented to investors as the most attractive kind of look forward-looking opportunities from point of inversion.

So if you go back to the 1980s, there's been four other periods of an inverted yield curve defined by the three month, 10 year slope on the Treasury. We're in the fifth inverted yield curve environment today over that time span. This inverted yield curve environment is pretty long in the tooth. We're month 11, going on month 12 since the curve has inverted. Other previous examples like the late eighties had been pretty short. COVID was pretty short, on average six months. Pre-GFC was a long 13-month inversion. So this one may be one of the longer ones.

But looking into what happens and transpires in an inverted yield curve environment and recognizing that we are in that window of opportunity right now can kind of provide guidance on what could you do with an asset allocation. And in fixed income, the results, perhaps not surprisingly, but good to remind ourselves on are pretty clear, which is in terms of duration, you don't need to go super long. History would show you in those four other inverted environments, getting out to intermediate duration is sensible.

And for the 36 months post those periods of inversion, historically five year treasuries and five year plus or minus points of the curve have been really the best performer. And that makes sense. So kind of gradual extension is a good idea from a point of view of maximizing total return, but it's also sensible from a simplistic point of view of locking in the income in markets today because you have to ask yourself the question of how many more three month or six month T-bills can I roll before the Fed cuts? And when the Fed starts cutting your T-bill rate and your cash rates are going to fall in line with wherever they take policy rates down to. So today is a good point to kind of just extend from the point of locking yield, but history would also show you that it can maximize your total return as well by being kind of intermediate duration in nature.

It's not only true for Treasuries, I would just say history also shows you that it's true for other high quality intermediate duration assets. So agency mortgages, high grade corporate credit, if you wanted to look at the Agg as an index, that represents all of those. That's also done well in these post inversion periods of opportunities for fixed income investors.

Things like high yield have held the line in the first two years post inversion, and that makes sense. There's a lot of income, it buffers you from the potential price fluctuations, which could be negative if growth slows more materially, but you have income to offset that. And at some point in time further out after high yield cheapens, that becomes even more attractive for investors. But again, I go back to my point when you think about a high yield, it's not only about your fixed interest portfolio, but how are you also thinking about that as a growth asset.

Gillian Kemmerer:

And Kent, what are you watching before you extend duration further in your portfolios?

Kent White:

There's a number of things that we're really keeping a close eye on right now. Obviously the path of inflation is most important if we continue to see some softening in inflation numbers. But we're really mostly focused on what the labor markets are doing right now and just how much... There's a lot of imbalance in the labor market still where labor has a lot of leverage and you can see it in some of the union negotiations lately, but even before that, just a lot of the service industries have a lot of bargaining power with their wages. So we're really looking for the labor markets to some signs of that's going to come back into balance and it's really, it's difficult to see without the Fed forcing a little bit more pain on the economy for those labor markets to come back into balance. Even job claims, they look a little bit weaker, but they're still at an absolutely strong level, especially when adjusted for workforce. It's not historically strong levels.

So that's the primary thing we're looking for. A little bit more, we're watching wages, see if that begins to loosen up a little bit. We're keeping a close eye on the consumer as well. We're starting to see them as things like some of the prior stimulus has begun to wear off, keeping an eye on that. Student loan payment are [inaudible 00:25:00] restarted. So that part of the economy is the first part that's going to see some weakness and I'm [inaudible 00:25:06] watching that as well.

Gillian Kemmerer:

So in practice, Adam, when should investors start to add duration and how much duration exposure do they need?

Adam Grotzinger:

Yeah, so that's the tricky part. We talked about what investors have or could learn from past periods of yield curve inversion and every period is different, the drivers of why rates have been high, how long they can hold there, how sensitive the economy is to the effects, how lagged it is, et cetera. Again, on average inverted yield curves and the opportunity to do something with your asset allocation and fixed income in that environment is the window of opportunity. On average they last six months, this one's month 11.

So there's no exact right answer. Fixed interest is a hard market to time. I like to say that in bonds it's about time and market versus timing the market because it's really an income generative asset where the longer you forego that income, the harder it is to kind of catch up on the price basis. Coupons a big driver, the outcome for bond investors in [inaudible 00:26:10] in markets now.

So we think it's sensible to take a balanced approach, start extending duration, particularly if you're heavy in cash, look at the intermediate parts of curves, look at high quality opportunities if you're thinking about the playbook for what can maximize your output, protect your overall portfolio in an inverted yield curve environment and give yourself more optionality of protection now. You get great income by extending out the curve. You get a little bit less in the front end, but you get the free optionality of price upside when things start slowing down and rolling over and insulating yourself from too much kind of credit risk particularly or equity risk that you may have in a portfolio.

Gillian Kemmerer:

Bill, before I ask you the question that's coming up on the outline, I just wanted to know since we were going back and forth a little bit about duration, if you had anything that you wanted to add there.

Bill Zox:

From a credit standpoint, we want to take our credit risk with little duration and we want to take our duration with little credit risk. So I think that the front end of the high yield market is usually fairly dangerous. It's adverse selection where there's a good reason why these high yield bonds have not been refinanced. But it's different this time because there's a lot of very high quality high yield bonds that the issuers are just in no hurry to refinance in this interest rate environment. So there's a ton of opportunity in high yield at the front end.

But when you want to add some duration to a high yield portfolio, which the duration is relatively low, 3.6 in the high yield index, but if you want to add some duration to those front end high yield positions, I think it's actually better to do that with investment grade corporate bonds. So even in our high yield portfolios when we are bringing our duration back up to the mid-threes, we're doing that with investment grade bonds where we think the credit spreads are attractive, but they have much less downside risk than the credit spreads on a generic high-yield bond.

Gillian Kemmerer:

So staying on these comments about high-yield, actually wait, before I do that, Ken, I saw you nodding, so I just wanted to know if you wanted to add anything there.

Kent White:

Yeah, I was going to say same thing in the investment grade credit market. Look we're seeing, we're positioned in the front end of credit, back the 30-year parts of the investment grade corporate credit market are really because there's been such a huge demand for duration credit spreads in the 30-year part of the market look pretty rich to us at this point.

So we'd rather take our credit risk at the front end and if we're trying to add duration, we will go high quality corporates in the thirty-year part of the market. The front end is really quite a bit more attractive just from the higher yield curve. And if we do get an environment where we'll see spreads widen, the break even spreads on the front end of the yield curve are much better than the ten to thirty year part of the curve.

Gillian Kemmerer:

Now Bill, coming back to the points about high yield, what should investors be considering when allocating to high yield and has the quality of high yield changed over the years? Meaningfully

Bill Zox:

Right. At this point in the cycle and with where the high yield market is priced, avoiding defaults is really important right now and it does help that the high yield market is much higher quality than it has been in prior cycles. And one reason for that is that the explosive growth over the last 10 years in credit has been first in the leverage loan market and then in the private credit market. So the size of the high yield market has actually been fairly stagnant over the last decade and the more aggressive financings have been done in those much faster growing parts of leveraged finance, private credit, and leveraged loans. So that's helpful.

High yield is now much more of a BB market than a B market. It's much more of a secured market than an unsecured market. And the issuers are more publicly traded companies, they're larger than they used to be and they're just generally higher quality businesses, but you still have to avoid the defaults. That's where active management comes in. This is a second important point about the high yield market is active management dominates the investible passive alternatives in high yield for a longer term investor.

And that's one reason why it dominates is that a good active manager can avoid the defaults or avoid a high percentage of the defaults. It's important that that active manager is capacity constrained, relatively benchmark agnostic and does good fundamental bottom up credit analysis. But if they're able to do that, then they're probably going to be pretty good at avoiding the defaults.

Gillian Kemmerer:

Kent, as we move around the opportunity set here, how do credit fundamentals look in the investment grade corporate space right now?

Kent White:

Yeah, investment grade corporates, they're still pretty strong. We're beginning to see some deterioration though, which begin to see revenues kind of flat line a little bit and costs increase. So that's had an impact on margins and a lot of that it's not just the goods inflation that's been up, but we're seeing wage inflation like [inaudible 00:31:51] referred to earlier really begin to spike a little bit and impact margins. So the companies aren't able to raise their top line as quickly as costs have been increasing. So margins are beginning to deteriorate a little bit in the investment grade credit market. Absolute debt levels are higher and leverage ratios are increasing as well.

So we're probably at a point, especially if the economy begins to weaken or get into recession where they're not going to get a lot better going forward. So part of the reason that we're not as constructive on investment grade credit or parts in the investment grade credit market is fundamentals are probably going to begin to roll over. And valuations seem a little bit stretched given some of the tail risks that you've all been talking about.

Gillian Kemmerer:

Adam, I saw you nodding. Was there something you wanted to add?

Adam Grotzinger:

Yeah, I was just going to say I think we have similar sentiment here at Neuberger, which is this kind of opening statement on macro I made about more left tail risk and that kind of sums up this discussion. The fundamentals are not bad, they're actually starting whether it's high yield or investment grade from a pretty strong position of strength on things like interest coverage. But if the thesis is stable to over time slowing growth and nominal growth as a result of that starts contracting a bit more. Things have been buoyed by nominal growth like real growth here or there, but nominal growth has been great for cash flows in these businesses. It's not to say they go from a great business to a defaulting one that's pretty [inaudible 00:33:23] but there's just some slight deterioration in the credit metrics for corporate borrowers at large. And so that's the way we're thinking about it.

And then you take that thesis and say, "Okay, well then what's the valuation?" And kind of see how corporate credit's performed really strong this year, both investment grade and high yield, and kind of ask yourself, "Is there a better time to think about adding back to these markets on a more tactical basis?" And that's kind why we've been taking down exposure to corporate credit and accounts where we can that have flexibility and putting more into things that don't exhibit that left tail credit risk like mortgages or a little bit more intermediate duration. So it's sensible to have some, know what you own, but I think it fits into that opening macro thesis that we are discussing as well.

Gillian Kemmerer:

Kent, was there something you wanted to add there?

Kent White:

No, I was just nodding in agreement.

Gillian Kemmerer:

Bill, coming back to high yield, we've discussed what investors should be considering, but now let's put a finer point on it. What role do you think high yield can play in an institutional investor's portfolio?

Bill Zox:

Yeah, I think there's a very strong case or a strategic allocation to high yield, and I think more and more allocators are coming to that same conclusion. And the high yield asset class, you're starting with a very attractive yield, especially today with the market yielding over 8.6%. The duration is less than four, so it comes with a reasonable amount of interest rate risk. I think that you have the contractual coupons and the contractual maturity dates, so it's a very resilient asset class.

Under periods of stress, if the stress is related to rising interest rates like the last 21 months, high yield tends to do much better than core fixed income in that environment. If the stress is due to recessionary conditions, high yield tends to do much better than equities in that kind of an environment. But over a long period of time, the returns in high yield relative to the drawdowns are very attractive.

And I'll just give you one example is the lost decade for equities, which was actually 11 years. If you remember from the end of 1999, and you're far too young to remember this, but from the end of 1999, for the next 11 years, the S&P 500 was up less than a half a percent per year. And over that 11 year period of time, the high yield index generated over a 7% return per year. So that was a major valuation problem coming into that environment that resulted in a lost 11-year period of time for equities but high yield did fine because you had those high coupons and maturity payments and then the reinvestment at very attractive yields along the way.

So that kind of valuation risk, I think we have some of that today. I'm not suggesting it's going to be anything like that 11-year period of time, but if it turns out that this starting valuation is very problematic for equities for a long period of time, I think high yield should do much better in that environment than equities.

Gillian Kemmerer:

Adam, circling back to you, where are you seeing the best opportunities right now and why?

Adam Grotzinger:

Yeah, I think a few parts of the market that we've liked, we've really shifted in some of our flexible mandates from really aggressive and bullish on credit back in 2021, particularly high yield, really attractive back then to trimming down that exposure, maintaining some, but pretty significantly reducing it. Again, not due to an imminent fundamental credit concern, but just kind of valuations and relative value driven arguments behind that rotation. And where we've been shifting it again, is to kind of more intermediate duration, cheap assets, and particularly agency mortgages. So a combination of some low coupon positive price convexity, low dollar priced mortgages, agency mortgages, combined with some more recent high coupon agency mortgages.

And again, these are AA assets, highly liquid, giving you a running income of circa 5% let's call it, with additional potential upside if we get some reduction in interest rate volatility going forward. So I think that intermediate duration opportunity set in high quality assets has certainly been resonating for us. If we screen the fixed income universe globally reducing corporate credit, but still maintaining some in more defensive areas of that market, higher quality parts of that market, businesses and companies that are resilient to kind of this slower growth outlook.

And then here and there, I think there's still opportunities in the front end of the curve. So balancing more intermediate duration with still some pretty lucrative just high net running yield opportunities on the front end of curves, be it in credit markets or rate space.

Gillian Kemmerer:

Kent, what has been driving demand for intermediate and longer maturity corporate bonds?

Kent White:

Boy, really its just been an increase in rates. It's all in a year, 2022, where the market saw a lot of outflows because we had extended periods of negative returns, flows follow returns, and we saw a lot of money flowing out of which every fixed income asset class. Different story, 2023, Fed began raising rates and yields are significantly higher now. So we've seen a lot more money flow into our funds and just you can see it in the market in general as well.

Just yields are significantly more attractive, whether it's to retail investors but also insurance companies and pension funds. It's been a long time since they've been able to invest in this and get these type of yields. So I know insurance companies for a while there, they're lucky to get anything with a 4% yield and now we're looking at high five, close to 6% across a lot of the investment period credit market. And even in the Treasury market where we're seen yields in the 10-year space above that we used to be able to get in corporate space. So it's really been yield driven intermediate, some longer duration funds where we've seen the money come in.

Another big thing too, a little bit over a year ago, there's stories being run all the time about how 60/40 is dead and fixed income, did it even belong in your portfolio? And that's really a reverse now. And a year and a half, no, there was no yield, there's very limited upside price appreciation potential. So now we have that back and I think asset managers and advisors are really kind of believe that 60/40 does and should be a part of investors' portfolio. So I think that's still some demand margin too.

Gillian Kemmerer:

Adam, I saw you nodding. Was there something that you wanted to add there?

Adam Grotzinger:

No, nothing else to add there. Just kind of agreeing with some of those comments and sentiment.

Gillian Kemmerer:

Perfect. Bill, coming back to high yield, what do you see as the biggest downside risk to the high-yield market right now and how would you be positioned to combat it?

Bill Zox:

Yep. I'm actually going to give you two, but we've talked about defaults quite a bit and that is the primary risk. And an easy thing you can do there is avoid CCCs. Historically most of the defaults come from that part of the market, and I think that that's likely to be the case in the next cycle. And you should either avoid CCCs or be very, very careful with any exposure that you have to that part of the market. That's roughly 12% of the high yield market.

But the second major risk is overvaluation risk. The problem is when everyone in high yield wants to high grade and they're constrained to investing only in high yield, they end up overpaying for the highest credit quality businesses in the high yield market. So the BBs can become overvalued. So it's very important to not fall into that trap. Owning an overvalued BB is not going to protect you in any environment. That valuation risk is important.

So that's why we actually like to look to the low part of the investment grade market, the BBB part of the market, which benefits from the same dynamic in that the dedicated investment grade managers who want to high grade, shy away from the BBBs. So in this kind of environment you can find BBBs that are more attractively valued than BBs. And I think that makes a lot of sense.

Gillian Kemmerer:

Kent, as we wrap up our discussion on the opportunity set, where do you see value in the investment grade credit market right now?

Kent White:

Yeah, I think both Adam and I talked about this a little bit and Bill as well on the high yield market. We really do like the front end of the corporate credit market. Three year part of the curves is a great place to put some money to work with [inaudible 00:43:04] curve. You've got this yield part of that, the break evens that should spreads begin to widen, you're going to be covered by a nice coupon. And then as the cycle progresses, we can then further extend as credit spreads widen out in the 10 to 30 year part of the curve, we will likely extend duration from there but right now that's kind of our sweet spot.

Gillian Kemmerer:

So we've painted a picture of the macroeconomic environment, we've decided to dive a little deeper into certain aspects of the market that look attractive right now to each one of you. So I'd love to give you an opportunity to share some final thoughts, some things that advisors, investors should take away as they're considering allocating in fixed income right now. And Adam, I'll start with you.

Adam Grotzinger:

Yeah, I'd just reiterate maybe some opening comments again and summarizing some of this, which is full stop fixed income is offering something for everybody. It's what are you trying to solve for and how does that fit into your portfolio? There's once again, the ability to rebuild ballast and fixed income and high quality parts of fixed income that not only give you a good running yield or income of circa 56%, but that additional ability to help protect and more risk off environments in a slower growth environment going forward through a potential duration working in your favor.

And then in lower quality parts of the market and high yield, et cetera, think about those as part of your growth portfolio and what they can solve for there and the running yield on high yield, maybe matching what your equity return expectations are over the next three, five years out.

And last point I'd say is while cash can look really attractive right now, don't be overly fooled by the illusion of how the temporary nature of cash yields are. They may be with us for a little bit longer here, depending on the course of the Fed, but at some point in time they will ease and they will come down. So be sensible and thinking about getting invested into fixed income markets and out of cash to lock, per se, that yield in markets that's on offer today.

Gillian Kemmerer:

Bill, any final thoughts from you?

Adam Grotzinger:

Sure. In the high yield market, you're starting with an 8.6%+ yield, which is really attractive. The dollar price is below 90 cents on the dollar. That's really attractive. We have had very limited time both post Global Financial Crisis and pre Global Financial Crisis where we have had a yield in that 8.6% range or higher and the dollar price below 90 cents on the dollar. It's very unusual. Now, the spread is a little bit below 400 basis points right now. That's where a lot of people get caught up when they're looking at the value of the high yield market right now. But we would adjust that 400 basis point for prior cycles and think of that more like 600 basis points spread in prior cycles. So 400 today is equivalent to 600 basis points in prior cycles.

And one important reason that I'll leave you with is that the management teams of these borrowers have had both time now, at least 15 months, and access to capital to prepare for higher interest rates and potential recession. So this is not something that's going to catch them by surprise. They've learned a lot of important lessons coming out of the early 2000s, coming out of the Global Financial Crisis, coming out of COVID. And policymakers have learned important lessons in those prior episodes. So that's just one reason why I don't think that old spread rules of thumb will apply in this cycle.

Gillian Kemmerer:

And lastly, Kent, how would you summarize and what are the key takeaways from this conversation for you?

Kent White:

Yeah, I think really the key takeaway is that fixed income is probably more attractive right now than it has been, and not in my entire career, but for a very long time.

I think Adam had said something about lock it in. I think that's what investors should be doing right now, locking in these yields. We might see a little bit more upside to where rates and yields go from here, but I think we're pretty close to the peak in yields and it's a good time to get invested in fixed income.

Spreads may not look overly attractive from a valuation perspective, but all in yields certainly do. And if we can find ourselves in an environment where we're heading into a recession or soft patch, those yields are going to come down and they're probably going to offset much of the spread weighing that we might see. So I think it's just a great time to be involved with fixed income. And if you're really bearish, it's an even better time because equities and other riskier assets are going to underperform. And we should see some really positive returns from the fixed income space.

Gillian Kemmerer:

As we said at the start of this panel and really throughout it's such an interesting time to be talking about fixed income. So I really appreciate Adam, Bill and Kent, your time in helping all of our viewers understand what the opportunity set looks like, the risks and the macro environment moving forward.

Kent White:

Thank you.

Adam Grotzinger:

Thank you.

Bill Zox:

Thanks.

Gillian Kemmerer:

And thank you for tuning in From our studios in New York, I'm Gillian Kemmerer, and you just watched the fixed income Masterclass.