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Fed Will Be Aggressive in Raising Rates

Eric Jacobson

Eric Jacobson: Hi, this is Eric Jacobson from Morningstar. We're here today with our manager of the year award winners for Prudential Total Return Bond. We've got Mike Collins and Mike Lillard. 

Gentlemen, thank you so much for joining us today. We appreciate having you.

Collins: Thank you.

Lillard: Thanks for having us.

Jacobson:Let's talk a little bit about the macro environment that you've seen in 2017 and where it's leading you right now.

Lillard: The global economy's really strong, it continues to do really well. All the data comes in strong. Corporate earnings are really strong, so it really looks like a very strong global economic environment, very broad-based, strong strength everywhere around the globe. What that leads us to think, given the strength of this economy, is that the Fed is actually going to be pretty aggressive here in hiking rates. We've been thinking three to four times. I might be more on four times this year. Mike might be more on three times. But we think the Fed is going to continue to be pretty aggressive here in moving short-term rates up. 

That said, we don't think long-term rates are going to move up much at all. Right now, you've got the 10-year at 2.65. I would tell you by the end of the year I think it could be 2.25. So the Fed's going to raise up the front end. I don't think long-term rates go up all that much. Rates are so low in Japan, Germany, and elsewhere in the world, that the U.S. rates just stand out as being really cheap as you move further out the curve.

Jacobson: On the one hand we've got this situation where the global economy looks very good, the Fed responding, as you had said, expectations for some rate hikes and so forth. 

On the other hand, we've got this market with valuations grinding tighter and tighter. A little bit of indication that we might be at the start of weakening underwriting for corporate credit and things like that. I think it's fair to worry, maybe a little bit early, but fair to worry--what do those things mean in terms of the market and risk and so forth?

Lillard: Looking for those opportunities as you point out to decrease risk within the portfolios. Really, you don't see anything on the horizon at all in terms of recession. But on the other hand, valuations have done really well here as spreads have been coming in. Looking at upside, downside, thinking about the probability distribution of where spreads could go, so our base case is that spreads will just continue to grind tighter as people reach for yield and the economies continue to do really well and earnings continue to do well. 

It's not just about the base case. You have to think about the tails of the distribution, too. There's not that much more tightening to come. There's risks that spreads widen materially. We're looking selectively at those spots. How do you decrease risk? How do you get to more emphasizing high-quality core positions with respect to credit risks on a portfolio?

Jacobson: That's the perfect segue. Let's talk a little bit about what you have been buying or avoiding even, but what you really have been focusing on and why, maybe from valuation and fundamental perspective, that's giving you the confidence to get what you need, but also avoid taking on too much of that tail risk.

Collins: As a portfolio manger, you really want to do well or manage for that base case, but really holding well in those tail risks. Right now we're focused a lot on the tail risk because you're not getting paid a lot for the upside. We've developed more of these higher quality, what we call core, long-term positions, which should do well through the cycle. Some of these are the big U.S. money center banks, which have de-levered significantly and are really in great fundamental shape. The structured products, the AAA commercial mortgage-backed securities, AAA collateralized loan obligations, some other secured structured products that have tremendous credit enhancement, where the underwriting has actually been better than it was last cycle. Those are our long term high-quality defensive strategies.

But on the other side of that, we do have a little bit of a barbell. There are some opportunistic, attractive relative value opportunities around the world. Some of them are favorite names within the BBB space. Some are high-yield, and some are even in emerging markets or some of the European peripheral countries where we've opportunistically added positions.

Jacobson: Thank you guys so much for joining us. Congratulations on a great year, and good luck continuing with that success in 2018 and beyond.

Collins: Thank you, Eric.

Lillard: Thanks again, Eric.

Jacobson: From Morningstar, I'm Eric Jacobson.