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Liquidity: The Greatest Risk Facing Bond Investors Today

Sumit Desai, CFA

Sumit Desai: Hi, I'm Sumit Desai, senior fixed-income analyst with Morningstar's Manager Research Group.

Joining me today is Gibson Smith, fixed-income chief investment officer for Janus. Gibson is the lead portfolio manager several fixed-income funds including the Silver-rated Janus Flexible Bond Fund and the Silver-rated Janus Balanced Fund.

Gibson, thank you for joining me today.

Gibson Smith: Thank you for having me.

Desai: We talk about your strategy a lot and how you approach the fixed-income market. We use the term, and I think you use the term a lot, of "sector rotation." Can you talk a little bit about that? What are the data points that you look at to decide when to shift toward a more defensive or aggressive stance within your portfolios, and what are those signs telling you today?

Smith: Our two core tenets are risk-adjusted returns and preservation of capital, and to achieve those tenets we feel there are times to take risk and times to not take risk.

When we're looking at markets, we're paying very close attention to valuations, where the opportunities are in the marketplace, and we're letting our bottom-up fundamental process guide us toward those areas where we can generate returns for investors.

That means there are times where we will be opportunistic in our investing approach and other times that we're defensive in our investing approach. Right now is a period of time where we're being much more defensive.

Desai: When you say defensive, what does that mean, and specifically, when you think about risk within the fixed-income markets, we think about interest rate risk and credit risk among other things. How do you think about defensive positioning considering both of those factors?

Smith: Excellent question. When we look at the market, the wonderful thing about fixed-income investing is that it's a mathematically based product. We can calculate expected returns and outcomes in the marketplace. Within that context, we can see where the best opportunities are in the marketplace.

Today valuations are stretched. Yields are low. Spreads are tight. So, there is not a lot of opportunity for return, but there is a lot of opportunity for downside. So, we believe that it's a time to be more defensive, more cautious in our investing. Let security selection still drive the returns in a portfolio but add insurance and be careful in the portfolio as we approach these volatile markets, and again, a stretched valuation environment.

Desai: One of the hot topics within fixed income is divergence of rates and central bank policy across the globe. Can you talk a little bit about how investors can navigate through a lot of this volatility that some of this confusion has caused?

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Smith: We've been in an environment of zero-bound policy for many years with the 37 or 38 primary central banks all cooperating, adding liquidity to the system. But we've now entered a period of time where we're having divergent central bank policies. The Bank of Japan, the European Central Bank, and the Bank of China continue to add liquidity to the system, while the Federal Reserve is starting the early stages of taking liquidity out of the system. These divergent central bank policies, based on divergent fundamentals in the economies around the globe, are going to create new opportunities for investors, but they are also going to create escalated volatility. That's another reason to be a little more defensive in this environment.

Desai: You have a big team of credit analysts that are really doing a lot of bottom-up analysis. Where do you think we are in the credit cycle today?

Smith: We've got a great team out there researching individual companies across various sectors, looking for those best total return opportunities. It's really a difficult environment as we've moved into a more shareholder-friendly environment, where companies are increasing dividends, buying back more stock, and we've seen a real escalation in M&A activity with management teams using leverage to do the deals.

That tells us we're late in the credit cycle. If we're using a ballgame analogy of nine innings, we're probably in the seventh inning of the ballgame, and probably seventh inning of the credit cycle. Again, another validating point that we have to be careful here with the tight spreads and the low yields available in the marketplace today.

Desai: How do you think about that specifically within the high-yield market? Energy is the hot topic within the high-yield market. Talk what your views within that subsector?

Smith: Energy is a big portion of the high-yield index that we're measured against, and we recognize that a lot of the growth in that segment of the market has been because of the growth of the energy segment within high-yield. So, companies are using the high-yield market to finance their growth. They borrow bonds to engage in drilling, to get the assets out of the ground, and then turn it into cash flow.

What's interesting, though, is that those companies that are highly levered are very dependent on the price of oil in particular. And if oil sits above $60, which is close to their cost to pull the oil out of the ground, they are OK. If it's above $60, they do well; if it's below $60, we have a problem.

So, I think all high-yield investors are watching this segment of the market very closely. They are modeling out different scenarios based on where oil will be going forward, and that will ultimately determine the fate of that segment of the high-yield market.

There are going to be some companies that are not going to make it in this environment, especially if oil reverses course and goes down again, and then other companies are going to thrive.

Desai: You have about a 17% position in mortgage-backed securities within the Janus Flexible Bond Fund. Can you talk a little bit about what's in that sleeve and how you view that going forward?

Smith: We're underweight the index in mortgages, and we have different characteristics of our portfolio than that of the index. In an environment where valuations are stretched and we're late in the credit cycle and volatility is increasing, volatility is not the friend of mortgages. It causes extension risk, where a bond that might have three years to maturity all of a sudden becomes a bond with seven years to maturity, and that's not unnecessarily good for fixed-income investors.

So, we've chosen to have a lower weighting and also to focus on securities that have high predictability of the cash flows, which means less variability in the duration based on moves in interest rates. In this environment of heightened volatility, heightened uncertainty, we're being very careful in the mortgage allocation in our portfolio, focusing on mortgages or securities that have more definitive duration, more definitive predictability of the cash flows, and it's worked quite well actually. I think that bottom-up security-selection focus is a very valuable component when investing in mortgages.

Desai: Another hot topic within the bond world is liquidity--or the lack of liquidity. Can you talk about how a bond manager should be positioning a portfolio to account for the liquidity risk in the market?

Smith: It draws in another discussion around asset allocation and having a committed portion of a portfolio to fixed income. In this environment, again, with heightened volatility and high risk and a lot of uncertainty, it's important to still have an allocation to fixed income, but to make sure that that allocation is appropriate in the context of valuation and liquidity.

Liquidity, in my opinion, is the greatest risk facing fixed-income investors today. We grew up in an environment of massive liquidity with large investment banks, large liquidity providers, and through the regulatory environment, through the changes in the system, we're now in an environment where liquidity is not as robust as it used to be, but yet the asset management industry has continued to grow. And that creates new issues for fixed-income investors.

I think it's something that everyone should be talking about. I think investors should understand the downside risks associated with illiquidity, and for investors, they have to remember that the spreads that they are earning over Treasuries represent a liquidity component, and that component is much bigger today than it has been over the last 20 years.

Desai: Gibson, thank you very much for joining us today.

Smith: Thank you for having me.