Fixed Income: “Take What the Market Gives You”
The CFA Institute Fixed-Income Management Conference is an annual event focused on global debt markets, fixed-income sectors, security selection, and portfolio construction. The Fixed-Income Management 2019 Conference will bring together researchers, analysts, portfolio managers, and top strategists in Boston, Massachusetts, on 17–18 October.
Gregory Peters, managing director at PGIM Fixed Income, describes the bond analyst’s dilemma quite simply.
“The thing about fixed income is avoiding the downside. We get penalized for losses and get very little for getting things right,” he explained at the CFA Institute Fixed-Income Management Conference 2018. “Investing in fixed income is about avoiding the fat tail.”
And that truism is something that fixed-income investors should keep in mind today.
“Growth is moderating, inflation is moderating, and the Fed is continuing to hike,” Peters observed. “That’s why I have a more negative economic outlook than many others.”
So what’s his advice?
“Take what the market gives you.”
To understand just what’s available, Peters outlined a three-step process for building and managing fixed-income portfolios.
“To me, investing is all about process,” he said. “It allows for repeatability and consistency. So I think process matters more than the manager.”
Assess the Global Market Environment
Peters is skeptical that the economy has much more room to run. Moreover, the rebound since the Great Recession while strong, hasn’t been that strong.
“Growth has peaked in my view,” he said. “So don’t look back. Look ahead.”
Peters believes that in 2020 the fiscal stimulus generated by US tax cuts will begin to work in reverse. And that deepening hangover will be further compounded by monetary and demographic headwinds.
On the monetary side, there is a fundamental dissonance between what the US Federal Reserve is signaling and what the markets are doing, according to Peters.
“The markets continue to dismiss the Fed’s repeated call to hike,” he said. “What the market is pricing vs. what the Fed is telling you will be a continued source of volatility.”
And don’t expect the Fed to get it right.
“The Fed, as they always do, will hike into a recession,” Peters said. “They will overtighten and throw the economy into more of a slowdown.”
The rate environment will be driven by a misplaced sense of where interest rates should be. Historically, US Treasury rates have hovered in the low to mid single digits. Yet, central bankers and investors tend to view the period between roughly the 1960s and the early 1990s, when rates were much higher, as the norm.
“Most of us in this new era are attached or quasi attached to that regime,” Peters said. “When you look at US rates in the longer context, they’re dislocated in that period of the ’70s, ’80s, and early ’90s.”
That regime was fueled by vast growth in labor as the baby boom came of age and women entered the workforce in greater numbers.
“So this anomalous rate is accompanied by anomalous GDP and thus interest rates driven by labor,” Peters said.
The labor situation is different today. A graying population and a smaller workforce is unlikely to spur a return to 1970s era interest rates.
And this demographic drag is not a new phenomenon nor is it a temporary one.
“The world is aging,” Peters commented. “The Japan story is pretty well-known. The US is the same story.”
Constructing a Portfolio and Overseeing Risk Positions
So having painted that less-than-optimistic vision of future growth, Peters turned to actual portfolio construction. Given the outlook, how should fixed-income portfolios be built?
Peters recommends allocating to the highest Sharpe ratio sectors. “It’s not an exactly enlightening comment,” he admitted. “The idea is build a portfolio with the highest Sharpe ratios of value.”
Obviously that means avoiding the downside. Per that, Peters recommends staying away from long A corporates. They are, in his words, “a very dangerous place to play.”
“Long single A corporates actually have through this time period a negative excess return,” he said. “That is an area you want to avoid. You particularly want to avoid it later in the cycle.”
BB corporates, on the other hand, may be worth a look.
“One of the best risk-adjusted trades in fixed income is double B corporates,” he said. “In good markets, investment grade folks dip down to double Bs to pick up the returns. In bad markets, they go up in quality and hide out in double Bs.”
High yield is similar to investment grade in this regard, Peters said. “Just the stakes are a little higher.”
Where we are in the credit cycle is another important consideration in portfolio construction. The current cycle is a long one. “The reason this cycle has been so extended is because it has been so dispersed,” he said.
The credit cycle variation by sector is also something to keep in mind, though Peters sees the credit cycle accelerating and becoming more synchronized.
“You want to avoid sectors that have late-cycle attributes, and prefer sectors that are mid to earlier cycles,” he said.
Overall though, Peters recommends embracing multi-sector strategies both as a means of diversification and selecting among the most attractive sectors.
In terms of the risks and managing them, Peters singled out corporate leverage as something to be concerned about.
“Corporate America has feasted on debt,” he said. “If you look at leverage today, it’s the highest it’s been without a recession.”
Which is good reminder for analysts to take their risk profiles seriously.
As Peters said, “We think of our risk profiles like Spinal Tap. We turn it up to 11.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of Paul McCaffrey