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Landmann: Risk-Taking Not Rewarded in Bonds Today

Jeremy Glaser

Note: This video is part of's November 2014 Risk Management Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Laird Landmann. He is the co-director of fixed income at TCW. We are talking about why he doesn't think investors are getting paid to take risks in the fixed-income market today.

Laird, thanks for joining me.

Laird Landmann: Thank you, Jeremy.

Glaser: Where do you think investors are getting paid to take risks today? What parts of the market look relatively more attractive?

Landmann: There are not a lot of attractive parts to the fixed-income market, in our opinion, right now. We would like to plug our asset class whenever we can, but I think investors prefer that over the whole cycle, we just tell it to them straight.

Right now fixed-income is certainly challenged. There are some pockets of value in non-agency mortgage-backed securities where we still think you're getting much better risk/returns than, say, high-yield, with an asset class that has similar volatility and probably less downside at this point because of the statistical changes that have occurred in the underlying pools over the last six years.

There are some areas in the government guaranteed market that we like. Some of the CMBS government agency-backed securities, we think, have interesting profiles versus the more heightened risk in the agency residential mortgage-backed market.

I think there are areas in the ABS market that are, again, government guaranteed, like the FFELP [Federal Family Education Loan Program] student loans, where you are getting very good compensation for the liquidity that's out there.

Those are some areas that we like, and they're consistent with our theme right now that we want to run a more conservative portfolio. A lot of things we're emphasizing are relatively safe or low-volatility types of securities, where we're getting paid for liquidity.

Glaser: If there are not a lot of attractive parts to the fixed-income market right now, are there areas that just seem like they're very overvalued that you really are actively avoiding?

Landmann: We've been concerned since the beginning of the year--and we would highlight that we've been contrarian here, and for the short term we have been incorrect--but we're very concerned about emerging markets as being perhaps the most likely place where exogenous shocks are likely to occur in the marketplace.

What's going on with oil recently has vindicated our concerns about that somewhat, and we've actually taken to running oil as a risk factor through our portfolios. We do think that energy prices for some of these non-U.S. particular investments, and some of the high-yield market, have critical effects on valuation.

Likewise, we're concerned about high-yield. High yield defaults are very low. All the backward-looking measures of leverage look reasonably benign, but we're watching company behavior and we're seeing companies behave a lot more aggressively, and we're seeing that the compensation you receive for that risk in high-yield is very low. I think that the liquidity of the high-yield market is going to be very challenged going forward. The Volcker Rule, the Basel III requirements for banks and brokerages to increase their capital requirements, all of those things are going to weigh on that market, and we saw a little preview of that in October. We saw markets that got hit by nothing, really. They got hit by rumors, scares about Ebola, scares about Fed statements, and markets reacted incredibly negatively and re-priced very quickly. That's indicative of the fact that while the overall investor base is fairly complacent right now, the fast money in high-yield is very skittish at this moment and very concerned.

Glaser: Do you think there is too much complacency, then? Are people taking on a lot more risk than maybe they're aware of, or should be?

Landmann: I think the logical conclusion is there is too much complacency, and you reach that conclusion by thinking about how we got where we got--and we got where we got because the Federal Reserve took short-term interest rates, cash, to zero and has held it there for about six years. And I think the way they've been pushing … I'll call them risk tourists. They have been creating a class of investors I will describe as risk tourism, where they can't get the return that they want. They've psychologically framed that as their correct return in the markets they typically invest in. So, they have been pouring into some of the other markets like high-yield, like loans. We are certainly concerned when we see a category like loan funds go from basically nothing in 2007 to $150 billion today, where the market is offering a product that is fundamentally mismatched with the liquidity of the underlying securities. When you look at what retail [investors have] been promised by these securities, they've been promised that they'll get low interest rate sensitivity, which may or may not be true based on the floors in the loans, and very low credit exposure, which certainly wasn't the case in the 2008 market.

So we're concerned that there is a lot of complacency out there in the investor base, and that people keep talking and focusing on finding a certain targeted level of return, rather than expressing that they're concerned about risk.

Glaser: What do you think is the biggest risk that is being underestimated? Is it that interest rates may not stay low forever, and that they are going to rise eventually?

Landmann: I think that's a good starting point, because it frames out the rest of the argument. If the Fed does come off the sidelines--and I think oil price shocks to the market certainly are going to be beneficial for U.S. growth--that probably gets us closer to the notion of the Fed tightening.

Then, obviously, investors will re-price risk from there, and the yield curve most likely flattens. Those risk tourists that I mentioned will begin to move back to some of the safer asset classes. And then you compound that with the liquidity issues that I mentioned--that the fixed-income market just has a very, very illiquid framework right now--and if you've got big flows from any one asset class, it will be very difficult for the current infrastructure for transacting to deal with that without major price adjustments.

Glaser: In your view, this is very much a time to be conservative in the fixed-income market?

Landmann: We do. It's not necessarily an opinion that's in vogue. I think a lot of investors keep asking, where can I get paid and where I can find money? But we are not believers in alchemy at the end of the day. And risk management should never be focused on alchemy; it should be focused on finding out where the next problem is going to be in the markets. I believe that there is a lot of potential for both endogenous shocks--that is, the leverage in the market just overwhelming valuations--or exogenous shocks, something coming from China or the oil shocks continuing, and you get something from the emerging markets.

So we are concerned, and we think this is the time to be a little more conservative in your approach to fixed income, and this is a time when you should vary your risk budgets. You should tighten your risk budgets now, when you're not being paid to take risks, and save the volatility that you're going to submit investors to in order to get alpha, save that for a time when pricing is more attractive.

Glaser: Laird, I appreciate your thoughts on risk today.

Landmann: I very much appreciate joining you, Jeremy. Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.