KEN LEECH
Western Asset Management
Chief Investment Officer
Growth And Inflation, Not Rates
Whether and when the Fed raises the funds rate is a major issue for fixed-income markets, but it is not the main event. The larger issue is the divergence of U.S. and global growth and even more importantly, inflation. The conditions for an interest rate increase that Fed Chair Janet Yellen has laid out—stabilization in the inflation rate and continuing improvement in the labor market—have been sufficiently met to justify an interest rate increase. We suspect the Fed may start the process of inching the funds rate off zero later this year. But whether the funds rate is zero or just near zero is less important than the path of growth and inflation going forward.
Just as we felt market optimism was too robust last quarter, now we feel market pessimism may be getting carried away. We feel strongly that this downshift in global growth will not lead to a recession. The global recovery theme is intact, even with the downshift in global growth and inflation expectations.
Moderate growth in the U.S. and improvement in Europe should continue. Monetary policy remains extra-odinarily accommodative. Chinese growth is manageable and both monetary and fiscal stimulus should increase. Lower for longer inflation rates mean a further extended period of low interest rates. Lower commodity prices, while a sign of weak global demand, are not without their benefits.
We continue to believe spread sectors should outperform government bonds. But respecting the challenges from today’s strong disinflationary climate, we have chosen to favor slightly elevated extra duration as well as continuing our aversion to hedging for lower-quality securities.
As the sector we tend to favor, we feel investment-grade bonds are where the risk/reward is the most advantageous. In our opinion, investment-grade credit will not do as well as lower-quality sectors in a sharp rebound. But valuations relative to fundamentals are so compelling that investment-grade should hold up well even in the event of a more challenged economic environment.
For more information, please visit www.westernassetfunds.com
JOHN PATTULLO
Henderson Global Investors
Co-Head of Retail Fixed Income
JENNA BERNARD, CFA
Henderson Global Investors
Co-Head of Retail Fixed Income
Interest Rate Phenomenon – Less Pronounced In Europe
The Federal Reserve’s desire to raise interest rates has attracted an inordinate amount of press and investor attention in 2015 but relatively little in the way of volatility for the US Treasury market. It is the under-discussed credit market that has proved a far bigger issue for bond investors in 2015 and where a rapid tightening in financial conditions has already begun.
Both the US investment grade and US high yield market have been in a bear market since June 2014 with spreads nearly doubling over that time frame and now at close to the widest levels they have traded outside of times of crisis. In the case of the investment grade market this is driven by aggressive equity friendly activity: acquisitions and share repurchases funded by debt. This phenomenon is much less pronounced in Europe where animal spirits are still in the process of recovery and as a result, the business cycle is stuck in a different gear. For high yield there is also a notable difference between Europe and the US with the former being relatively unaffected by the debt-funded commodities expansion that is currently hindering the US market. Nevertheless, both markets have suffered from a rising number of bonds trading at distressed levels as investors begin to ration funding for marginal companies.
With this in mind it may well be the case that credit markets along with the US dollar have already tightened financial conditions in the US and around the world to such an extent that the ever-anticipated Federal Reserve tightening cycle fails to get off the ground.
For more information, please visit henderson.com.
ANNE WALSH, CFA, JD
Guggenheim Investments
Senior Managing Director, Assistant CIO, Fixed Income
The Core Conundrum
Despite the end of quantitative easing by the U.S. Federal Reserve, global monetary policy continues to impact bond investors. Artificially depressed yields on government-related securities make traditional core fixed-income strategies less effective in achieving total-return objectives.
Compounding this issue is investor exposure to the Barclays U.S. Aggregate Bond Index, which is currently heavily concentrated in U.S. government and agency debt. As benchmark yields languish near historical lows, the chasm between investors’ return targets and current market realities deepens, creating a conundrum for core fixed-income investors.
Accommodative policies by global central banks simultaneously support a benign credit environment, while likely masking market-wide investment risks. Employing investment shortcuts, such as accepting lower credit quality or extending duration solely to generate yield, may jeopardize future performance.
In the current environment, we believe the surest path to underperformance is to remain anchored to conventional strategies. Investors must develop a new, sustainable, long-term investment strategy to generate attractive returns. Opportunities exist beyond the Barclays Agg, which only represents about half of the U.S. fixed income market. We look to the other half for idea generation. This is where robust credit work can uncover a world of attractive fixed-income securities with higher yields and lower durations than government and corporate bonds.
Accessing unique short-duration, high-quality investment-grade securities with considerable yield pickup relative to government and corporate bonds may be the investment blueprint needed to navigate the current low-rate environment and hedge against interest-rate risk.
In this environment, we recommend a barbell strategy to further mitigate potential risks. The barbell structures a portfolio with a higher concentration of both short- and long-duration securities. The short-duration securities, typically adjustable-rate, protect the investor from the risk of the short end of the curve moving higher. The long-duration securities protect the investor from the likelihood of U.S. long rates falling to match counterparts in Europe while generating higher income.
The implication for investors is greater rate volatility at the short-end of the curve compared to the long-end. A barbell strategy that complements an allocation to long-dated bonds with floating-rate assets dually benefits from greater price stability and rising income from its floating-rate investments.
For more information, please visit www.guggenheiminvestments.com or call us at 800.345.7999.
PETE WILEY
Investment Advisor
Whitebox Advisors, LLC
Why Bond-Picking Matters
Must corporate bond investors accept inferior company fundamentals in exchange for higher yield potential? And is a bond’s rating an ironclad indicator of its real risk?
We at Whitebox have long argued that investors can’t necessarily tell a bond by its rating or its yield. We’re convinced that when rule-based investors buy credit according to a broad category, such as rating or yield, without digging in to identify individual bonds that can potentially raise returns by lowering risk, they may end up owning risk they never intended to buy.
We take a different approach. In actively managing a credit-dominated portfolio, we seek securities that have fundamental characteristics similar to investment-grade securities, but which are priced more attractively from our perspective and may be lower-rated. How do we go about this?
We seek securities from companies with attractive free cash flow, strong balance sheets, and low levels of financial leverage. We favor companies that have demonstrated resilience to changing market conditions, or that are more likely to withstand a contraction in the economy, often through business models that exhibit more predictable revenue streams.
Crucially, when we identify what we believe is an interesting company, we scrutinize its entire capital structure to uncover what we see as the most favorably priced claim on the underlying assets. In effect, we seek a greater return than the market is currently paying compared to the actual risk of the security, as opposed to its generally perceived risk in terms of, e.g. credit rating.
We believe many bond investors do relatively little “bond-picking,” and as a result, actually help create inefficiencies (mispricings) for experienced bond-pickers to exploit. We believe that rather than accepting poor company fundamentals and higher risk in exchange for yield and return potential, investors should instead efficiently reduce risk.