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Investing in a 'Beyond Difficult' Bond Environment

Jason Stipp

Gary Madich, CIO of JPMorgan Asset Management's global fixed-income group has called the current rate environment "beyond challenging" for bond investors. We sat down with Gary to learn about his take on the persistently low rates, the inflation environment today and why it might be a good time to buy inflation protection, as well as the risk-on/risk-off environment that investors are facing.

Jason Stipp: Gary, it still seems like we're living in a very much risk-on, risk-off environment. Just when Treasuries looked like the worst investment in the world, we see them rally again in the second quarter with 10%-plus returns on the long-term Treasuries.

In an environment like this, where we are seeing these flights to safety on macro concerns, how do you think about structuring, especially a fixed-income portfolio, when you can see very low-yield investments continue to gather assets as people are worried about the macro situation?

Gary Madich: Well, I think the first thing you need to do is, you really need to understand the thematic part of your process, i.e., you have to create some themes relative to the markets in which you are navigating.

Right now a lot of our themes, obviously, are built around trying to create portfolios in a low-return type environment. So, first of all that macro oversight process should act as a filtration system, really in any environment, but certainly most importantly right now--and then obviously drives your security selection.

When you're thinking about low returns in this environment, I think it would behoove people to, as we do, balance kind of a relative value return oriented mentality, which does focus on yield, with kind of a growth process, trend analyses and specific security analysis both intra- and inter-type sector. And when you do that, you tend to be less focused on the pure return, but on more the allocation process.

So, for example, a lot of people would suggest that, obviously, the safe-haven assets are truly, truly overvalued. We would agree with that. But that doesn't necessarily mean that we are significantly underweight Treasuries. We're underweight, but not significantly. We do see value in safe-haven assets like Treasuries from a standpoint of helping us at the total portfolio construction level with liquidity, managing our term structure, helping us hedge convexity, etc.

So, even in a low-yield environment where obviously we all thought rates were as low as they could go and then they went lower, we still have an appetite for Treasuries for the appropriate reasons.

Stipp: Gary, we heard recently from the Fed that they're going to continue to try to bring long-term rates down. We're also seeing easing, so-called quantitative easing, in other economies across the globe.

What is your strategy for managing a portfolio in an environment where we might see rates, because of policy measures, stay low for an extended period of time? How does that affect your interest rate outlook? And in the meantime, as rates are at these depressed levels, what do you do as an investor?

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Madich: Well, first of all, I think it's important to understand that in terms of our process, I wouldn't characterize ourselves as rate anticipators. So the duration decision, albeit in our process, isn't considered a key driver in terms of where we get alpha or excess return. So we don't depend on that so much.

What we try to do from a rate perspective is just get it secular correct, and obviously that's been a easy part of the trade. But having said that, I think that beta part of the trade is pretty much done. And so right now, from our perspective, and we have been for quite some time, we're focusing on the spread sectors, and we're doing that with an idea that we would be somewhat up in quality, whether that be in high-yield, investment-grade, mortgage credit, certainly even in things like asset-backeds and CMBS. So we are getting some spread; there is an income orientation there, try and maintain as much positive convexity to our portfolios as we can, given low rates, volatility. So it’s an income orientation right now.

From a duration standpoint, obviously the intermediate part of the curve right now is probably the best in a sense that you not only get some duration protection relative to the long run, but you're also getting pretty decent rolldown. So we're focused on the intermediate, but we will tactically move around the curve as we change opinions on our key rate duration positions.

Stipp: You mentioned some of the spread sectors there, and looking for opportunities. Obviously with rates so low, income so low, the Fed wants investors to go out and take on some risk, and you really need to get some kind of yield these days. In your opinion, though, in most areas of the market, are investors being adequately compensated for the extra risk they have to take on to get some yield? And in what areas might that be more the case and less the case?

Madich: I think they are. I think we are getting compensated as investors, and shareholders obviously in our products, to move out the curve a bit, kind of the short intermediate part of the curve. I think you're getting paid to take on some credit risk in areas like high-yield, where I think there's a mispricing of default risk in many cases. I think when you compare high yield to equities, a lot more has to go wrong for high-yield than equities for them to underperform. You are getting pretty decent valuations. Corporate health is very, very good right now. That translates also into the investment-grade valuations as well. Mortgage credit, in terms of non-agency mortgages, I think people getting compensated. But again, kind of staying up in quality, more the prime, up in cap structure, Alt-A type structures there. Asset backeds as well, a good surrogate for short agencies, short corporate. Again, playing a more high-quality bias, and even CMBS.

So I think they are, but you can't forget that a lot of those sectors are credit game, some are rate, and you have to be careful about how you view those risks relative to moving into those sectors.

Stipp: Let's talk about munis. Over the last couple of weeks we've had some headlines again about defaults in some municipalities, bankruptcies. When you are thinking about the credit risks in munis as well as what you are getting paid after the tax considerations for folks in those higher income brackets, are you seeing opportunities in munis right now? And also are there pitfalls that investors should consider?

Madich: Well, I think most certainly when you look at some of the recent problems that a Stockton, Calif., has had and some other names in California ... just recently, you've had Scranton, Pa., the mayor reducing everyone's pay to the least common denominator there, the lower wage.

That does tend to make an investor like ourselves to take pause and understand that there are some pitfalls out there from a credit perspective. But having said that, we've always approached the muni market as a credit market first and a rate market second. And so, when you look at our approach to munis, it's really been a credit bias, it's been mostly up in quality because this is "go to bed, sleep well" type money for most of our clients. So you don't want to create a credit situation. We've avoided a lot of the sector plays relative to high-yield.

But there are opportunities. If you do your credit homework, we would prefer revenue type situations and bonds over GOs. If you are going to look at GOs, we're going to go with larger names, a state GO relative to a Stockton. But there are definitely opportunities there, and if you look at our allocation, I would say we're overweight munis relative to a multi-asset class type structure, even at this point.

Stipp: Last question for you: A lot of investors in fixed income have to think about rates, obviously, but also inflation is another issue.

Inflation has cooled over the last few months. So is it a good time now--because inflation has cooled and maybe expectations about inflation have cooled a bit--to think about inflation protection in your portfolio, and what areas, what kinds of investments, might you consider to do that?

Madich: It's interesting to me. Our approach to inflation, which led to the creation of some of our inflation-managed bond products, is that people should look at inflation and inflation protection more from a strategic perspective as opposed to a very tactical, trading-oriented [perspective]. And so, if look at it from a strategic standpoint, now might be one of the best times to be looking at it, because break-evens have cheapened quite a bit, and you can put on some very cheap insurance so to speak through some inflation-oriented type products. I think you have to distinguish, though, between a couple that we use. Obviously most of our products err on the side of using CPI swaps as a mechanism to hedge inflation along with a cash-bond portfolio, and that’s kind of our foundation.

Stipp: So why CPI swaps instead of TIPS, for example, which are obviously a very direct way supposedly to hedge inflation?

Madich: Good question. From our perspective, if you look at year-over-year multi-year type correlations of CPI swaps [and] TIPS relative to inflation, you get a much higher correlation in a hedge with CPI swaps--so that’s the first reason.

The second reason, when you look at returns, and you can go back to last year. One of the highest yielding, if not the highest yielding and returning market in fixed income was TIPS. In a low inflation environment, what that said to me was, TIPS are very, very duration dominated. So to me, current market as an example, I would use CPI swaps right now as an inflation overlay, a pure hedge. Right now because break-evens are cheap, I may look at TIPS more from a valuation standpoint, a trade standpoint, but less so from an inflation-protection standpoint.

But I think, to answer your question, it should be a strategic allocation and you can make these moves like we just discussed tactically through TIPS and CPI swaps. You might throw real estate in there, commodities or whatever, but I think on the margin you should have some strategic protection to inflation right now because it’s cheap insurance right now.

Stipp: Gary, thanks so much for your insights on the fixed-income market and for being here with us today.

Madich: You are very welcome. I appreciate the time.