With interest rates hovering near zero, the Federal Reserve doing everything in its power to keep the economy afloat and money flowing through the economy, and the U.S. facing both a pandemic and a presidential election, what should fixed-income investors do? For answers, Pensions & Investments spoke with David Bees, managing director and portfolio manager at Manulife Investment Management; George Bory, managing director and head of fixed income strategy at Wells Fargo Asset Management; and David Zee, senior vice president and investment consultant in Callan’s global manager research group.
David Bees: The dash for cash definitely underscores the importance of fixed income. Within the securitized markets, having diversification across all the different subsectors really makes sense in terms of preserving the liquidity of a portfolio. In terms of government intervention, the Federal Reserve at this point has demonstrated that it only wants to provide support to the markets where the perceived probability of default or loss is low, so that's going to be triple-A-rated securities and investment-grade-rated corporate bonds, not equities.
George Bory: Fixed-income securities serve three primary functions in an investment portfolio: generating current income; allowing the portfolio manager to match the duration of liabilties; and providing a kind of crash insurance against equities. This last function featured pretty prominently during the height of the COVID crisis. Stock prices plunged and Treasury prices surged. Bonds did what they were supposed to do, which is to provide an offset or a buffer against equity risk.
David Zee: The COVID crisis hasn’t changed the perception of fixed income as an asset class; it’s still relevant in client portfolios. But it is being questioned because rates are at or near zero. It takes more fixed-income assets to offer the same diversification relative to riskier assets. You could say the option for liquidity got a bit more expensive.
P&I: Broadly speaking, are institutional investors rethinking their approach to fixed income in response? Are you seeing any major changes in allocations — inflows or outflows — or investor interest in specific types of products?
Bory: The aforementioned benefits of fixed income still exist today. However, as yields fall, the marginal benefit of bonds declines. And so the No. 1 focus right now is trying to generate diversified sources of income. Investors are really casting their nets wide and far to generate steady streams of income. Duration matching is viable today. It is expensive to do because of where yields are, but it’s achievable.
Zee: There is more interest in private credit. There has been quite a bit of fundraising activity from alternative credit managers, but also from long-only asset managers wanting to tap into pricing dislocations of companies perceived to have going concern.
P&I: What do you make of the breakdown in asset class correlations earlier this year? Are there tactical moves that institutional investors should be considering?
Bees: In March, the correlations largely converged to one, regardless of the asset class. There were very few sectors that remained unscathed from the full shutdown of the U.S. economy. The sectors that we’re allocating to within the securitized markets — residential, commercial or asset backed — have historically experienced lower correlations relative to other traditional fixed-income sectors. That really highlights the need for diversification across multiple asset classes within a fixed-income portfolio.
Bory: On a tactical basis, we continue to find value in spread product, vehicles that have a yield above and beyond what you can get in the Treasury or the sovereign bond markets. So corporate credit features in that strategy, but so do structured products.
The other component to our asset class selection right now is dollar versus non-dollar. Non-dollar bonds act as a nice hedge against U.S. dollar weakness, and so we have been actively putting non-dollar bonds in more traditional dollar portfolios, where permissible. We view this very much as a tactical trade, not as a structural trade.
Zee: That breakdown in correlation happens every time. There are tactical moves that investors should be considering, like opportunities in credit as companies struggle to deal with this severe disruption to their business model.
P&I: What happens when central banks exit their interventions, and do you see this happening any time soon?
Bory: What has Fed policy done? It has really forced the volatility genie back into the bottle. When the Fed starts to exit its intervention policy, then asset price volatility will increase. Our expectation is the Fed’s on hold here for a long period of time.
Bees: To put it into perspective, on net, you’re looking at about $2 trillion on the Federal Reserve’s balance sheet, or roughly just under 30% of all agency mortgages in the United States. In addition, they’re providing support to the asset-backed market through the TALF program. [The Federal Reserve established the Term Asset-Backed Securities Loan Facility — TALF — in March to support the flow of credit.] At this level of commitment, we really feel it’s going to be difficult for the Federal Reserve to unwind the stimulus, and we would expect their involvement in the market for years to come.
P&I: So how should institutional investors think about and factor into their portfolio strategies the potential for unlimited quantitative easing?
Zee: When I was a kid, my parents told me that too much of anything is a bad thing. So diversification is still important, though it’s harder to justify when the Fed now supports unlimited Treasury purchases, agency, residential and commercial mortgage purchases, all of these different types of lending facilities for asset-backed securities, corporate debt securities, and even going as far as potentially buying high-yield debt via ETFs.
You do have potential opportunities lower in the capital stack; there’s a large dislocation between spreads of triple-As versus lower tranches.
Bory: Unlimited QE is very important. It’s effectively in place right now. The repercussions for investors are twofold: Rates are going to stay very low for a very long period of time and interest rate volatility is going to stay very low.
We are seeing some suggestion that the curve would start to steepen, especially given that the Treasury needs to issue a tremendous amount of debt to finance our deficit going forward.
Bees: We expect interest rates to remain lower for longer, and that likely forces investors into riskier assets. Within securitized markets, we think institutional investors should focus on how to generate income outside of the traditional index-eligible asset classes, such as agency mortgage-backed securities [MBS]. Adding exposures to residential credit, asset-backed securities and select commercial real estate sectors creates diversification as well as the ability to potentially capture additional spread. This is already starting to occur as there really seems to be a grab for assets right now within these markets. New-issue deals are typically generating an order book multiple times larger than the available bonds for sale. However, we think opportunities remain and this is a solid approach for investors going forward.
P&I: What long-term risks are investors ignoring?
Bory: Inflation. The Fed’s stated goal is they want to generate inflation. They are doing everything in their power to generate inflation within the economy.
The other thing to keep a very close eye on is the currency. The strategies that the Fed is pursuing are really to try and debase the currency.
Bees: The market’s experienced significant technical rebounds, yet fundamentals still remain very challenged. There are many unknowns that exist. In securitized, we’re focusing more on sectors that we think will remain resilient, and underweighting those undergoing a more permanent structural change.
An example is brick and mortar retail. Prior to the pandemic this sector was struggling, but this year alone we’ve seen 29 retailers file for bankruptcy, leaving brick and mortar stores empty and causing issues in commercial real estate. This highlights the need to have a robust loan-level analysis to fully evaluate risks but also uncover value.
Zee: Complacency. Is the Fed always going to be there whenever there’s a market disruption? If after a while, you just assume that the Fed is always going to be there, there are risks with that assumption that we can’t anticipate.
P&I: Do you think negative nominal rates are a possibility
Bory: We are not expecting the Fed to take us down that path.
Zee: We don’t have a house view on that. The Fed has definitely come out to say that a negative rate policy isn’t something that they’re entertaining right now. But I do think that negative rates could be a real possibility.
P&I: What’s your view on the Fed implementing yield-curve control?
Bory: Our view is explicit yield-curve control could emerge later this year.
Zee: When we looked at the various types of purchase programs during the dislocation back in March and April, the Fed was buying across the curve. So would you consider that yield-curve control or would you consider that trying to provide additional liquidity? I think it’s semantics at that point. But the Fed has implemented purchases across the curve.
P&I: Is it too late to rebalance?
Bory: It’s never too late to rebalance. Fixed income plays a central role in any diversified portfolio. Finding diversified sources of income is very, very high on the agenda for just about every investor we talk to. All fixed-income investors are scrambling for yield, and we have strategies that get you there. But given where rates are, we’re just simply in a very low-yield environment, and that’s not going away any time soon.
Zee: There’s probably less discussion within fixed income and more regarding the overall balance between asset classes. Is this a good time to rebalance? When is a good time? We think it's never too late to rebalance.
But all of that thinking should be done beforehand, if possible, so that when it happens, you’re not frozen or trying to pick the lowest tick — you’re executing a predetermined plan methodically.
P&I: Given where rates are, how can investors still find income from fixed income? Where do you see the greatest opportunities?
Bees: That hunt for yield is going to occur in credit sectors. We find securitized is part of the solution. Typically these assets are shorter in duration relative to investment-grade corporate bonds but offer more spread, especially in maturities that are five years and shorter. Right now, we see opportunities in the residential market, which we think is a sector that remains resilient due to tight supply and additional demand for suburban housing, as well as conservative underwriting, given the stricter guidelines that were created after the 2009 recession. Nonretail exposure, such as warehouse and industrial properties within commercial real estate, will likely benefit from the growth in e-commerce that’s going to necessitate facilities for deliveries.
Bory: Expectations need to be recalibrated to the current environment. Yields here are very, very low. When you think about how you find income, you’ve got to think about the type of income, type of securities and ultimately what kind of currency risks you’re willing to take.
Curve-extension strategies still can work, and so do yield-enhancement strategies. We are actively putting credit risk in our portfolios, we are looking for structured products that meet the demands of clients, and we’re looking globally. Emerging market local bonds are a nice diversifier to the traditional U.S. dollar fixed-income portfolio, and they materially increase the yield potential.
Zee: That is a tough question. You could still clip coupons to generate current income, but maybe it’s better to look at fixed income from a total return perspective. Fallen angels, which are investment grades that that have been downgrade to below investment grade by rating agencies, might be an interesting opportunity right now.
P&I: Even as opportunities in fixed income arise, does it pay to be cautious and perhaps hold off?
Bory: Caution right now, in our opinion, is actually a very binary decision, and it really comes down to your view on the Fed. Do you believe that they’re able to keep rates in check and volatility under control? If you believe that — and we do — then yield-seeking strategies will continue to perform.
If you want to be cautious, chances are you’re going to be very worried about the Fed’s ability to keep control of things in the midst of both the pandemic and the upcoming presidential election.
Bees: As it relates to securitized, we do think the entry point make sense right now. Short-term rates are effectively at zero and expected to stay there for an extended period of time. Within the corporate bond market, you’ve seen spreads tighten dramatically. In parts of the securitized markets, spreads still remain significantly wide [compared with] prepandemic levels. A tactical entry point into the asset class makes sense.
Zee: The question sounds like, “Are you trying to time the market?” I would lean more toward saying that clients have to do their homework, look at these opportunities and see whether or not they actually fit into the overall master plan of what they’re trying to achieve.
P&I: Do you see a renewed interest in structured products? Does a strategic allocation to structured products make sense in institutional portfolios?
Bees: An allocation to structured products makes sense for several reasons, the first one being diversification away from the index. Looking at the Bloomberg Barclays U.S. Aggregate index [the AGG] and then focusing on the securitized portion of that index, over 90% of it is fixed-rate agency MBS. The bulk of your exposure is to interest rates. We really think you need to look to nonindexed sectors, and that’s the credit sectors within securitized. That’s really where you start to see more interesting opportunities.
What sometimes gets lost when we discuss securitized assets is the fact that we don’t have to sacrifice quality to gain this exposure. We can still maintain an investment-grade-rated portfolio and pick up spread relative to the index.
Another factor is the size of the securitized credit markets. While some of the subsectors within that market are on the smaller side, in aggregate, that market is close to $3 trillion in size. We think institutional investors that have minimal exposure may want to consider a more strategic allocation to the sector certainly beyond what they are getting through a traditional core or core plus allocation.
Bory: We would strongly advocate having structured products as a dedicated allocation to your portfolio. More tactically, the demand for structured product in aggregate held up pretty well throughout this year’s volatility. Generally speaking, the higher-rated components of the more vanilla-type securitized products performed well and actually provided a nice entry opportunity for those investors who wanted to increase their allocation to those parts of the market.
Now other parts of the market, and specifically CMBS [commercial mortgage-backed securities] and CLOs [collateral loan obligations], have been the laggards. That being said, the triple-A tranches have held up reasonably well. And I say reasonably because there is inherent credit risk in both of these securities. We have actively looked for opportunities in both those segments of the markets, specifically in the very high-rated parts of the market, those triple-B tranches.
Zee: We like structured products. We thought they were interesting long before the COVID situation. We believe complexity can reward experienced investors, but there’s a caveat: The increased appetite from asset owners is enticing the entrance of managers that had not previously offered structured products. For some asset owners, this is a resources consideration.
P&I: Institutional investors often assume that they’re getting adequate exposure to structured products through allocation to a so-called “AGG manager.” Is that something you feel investors need to perhaps change their thinking about?
Bees: When we talk to prospective clients we sometimes hear, “I get my securitized exposure through the AGG.” We always like to then ask, “Is that the exposure that you want right now?” Given where interest rates are and the amount of stimulus being pushed into the market, we really think you need to move outside of some of those index-eligible sectors.
There are opportunities to, as I said, maintain investment grade-rated securities but still pick up a meaningful spread. There’s a lot more to the market than just agency MBS but many AGG managers do not extend their exposure beyond agency MBS, which is the primary way securitized is represented in the AGG. Yes, there can be value in over or underweighting that exposure, but expanding into the wider securitized markets can be very beneficial, especially if the ability and expertise needed to really dig into underlying securities is there.
P&I: What do you think are the likeliest scenarios for an economic recovery, and what will the impact be on fixed income?
Zee: Yikes, that's a loaded question. We’ve had a lot of dialogue with investment managers and asked them a similar question. It’s very difficult to handicap exactly what scenario is going to occur. When the pandemic first hit, many managers thought, “This is going to be a short-term blip.”
As we know more and more about the coronavirus, there are a lot more questions. It’s difficult to handicap.
Bory: We call it a “dog-leg” recovery. If you think of the shape of a hind leg of a dog, it comes up sharply and then it quickly sort of plateaus. And that’s exactly what we’ve been saying since back in April and May when things were starting to peak from a crisis perspective.
But if you look at the trajectory of the recovery right now, we saw a sharp bounce earlier this summer, and now things are really starting to peter out. We do think we’ll recover, but at a much, much slower pace. That’s the dog-leg trajectory.
As it relates to fixed income, I think the simple message is, rates stay low for a long period of time, certainly through the end of the year, and we think volatility’s pretty well contained. We don’t think we’re going to see a big reversal of credit spreads at the end of the year.
Bees: The recovery is going to be uneven across the economy. This is really where you need to have a sector-by-sector view. Understanding the collateral behind the sectors that we’re looking at is key to evaluating risk exposure. For example, if we talk about the U.S. housing market, which I mentioned earlier, it’s a sector that we think was in good shape prior to the pandemic, with conservative underwriting and low mortgage rates. But you still need to go deeper than that. You really need to evaluate borrower characteristics [at the loan level], such as credit score, loan-to-value, debt-to-income ratios. This helps you better quantify the risk and screen out securities that could underperform, even within a sector that we think largely remains stable.
P&I: What are the short-term and long-term signals you’re watching?
Bees: Within the securitized markets, there is a heavy exposure to the U.S. consumer and to real estate. Initial jobless claims as well as continuing claims give us some insight into the pace at which the economy is beginning to recover. Also, early- and late-stage delinquencies indicate the amount of stress borrowers and businesses are under and their ability to stay current on mortgage payments and rent. Overall, the ability of the Fed to maintain stability in the fixed income markets will be important.
Bory: I am a big believer in the predictive value of the shape of the yield curve. Recently, the curve started to flatten a bit, but to the extent the curve stays at least positively sloped, it would be a good indication that some form of a recovery is under way.
It is important to keep a close eye on the dollar. We certainly are not thinking of the dollar being at risk as the reserve currency, but it’s definitely under a fair bit of pressure.
The election’s going to be a hotly contested point of focus for a lot of investors. Part of the dollar weakness is an interpretation of just how disruptive this particular election could ultimately be. Our recommendation is you stick with your fixed-income allocation. Yields are low, but they’re not at zero. The Fed is able to maintain an orderly fixed-income market. Corporate credit, despite those risks, is still a relatively attractive investment because there is aggregate demand, there’s a need for additional yield, and you have the extra support of the Fed heading into what’s likely to be a pretty volatile election cycle.
Zee: How many companies are filing for bankruptcy protection? Where are spreads trading? Those are all concerns.
In addition, there’s a real dispersion between Main Street and Wall Street, and that difference has never been greater. It’s tough to know what’s going on. The next support package from the government is a big question mark. You’ve got the election coming up, that’s another big question mark. ■