Eigen: Running Out of Room to Make Money in Bonds

Holly Cook: I'm Holly Cook for Morningstar, and I'm joined here at the Morningstar Investment Conference in Chicago by Bill Eigen.

He is a Head of Absolute Return and Opportunistic Fixed Income Strategies at JPMorgan.

Thanks very much for joining me, Bill.

Bill Eigen: Thanks for having me, Holly.

Cook: So let me ask you first off, as your title suggests, does the absolute return element and the opportunistic element mean that the macro environment perhaps isn't as much of an onus as it might be in other areas.

Eigen: Well, yes, that's an absolutely true observation what you just pointed out. The first thing you need to know about absolute return investing is we try to avoid just relying on beta to earn a return. With traditional fixed-income investing including long-only fixed-income investing, which I did for many years, you constantly need two things working in your favor at all times... at least one of two things working in your favor at all times to earn a return.

Rates have to fall, and spreads or risk premiums amongst sectors of the market like mortgage-backed securities, corporates, etc., need to tighten. If either of those things don't work, you're either going to earn a suboptimal return or you're actually going to have a negative return. Now, very fortunately for fixed-income investors, rates, the single biggest determinant of returns, have been falling for 30 years. So it's been pretty easy to put your feet up and just watch the returns roll in.

The problem is, as you know, the math stops working at some point. Rates can only fall to zero. Risk premiums can only get to zero, and guess where we are in rates right now? We're at zero on the short end, and we have a "one handle" all the way out to seven years. Even out to 10 years, you have a "two handle" on the 10-year. So, you're just running out of room to make money, but far worse than that, is you have no coupon cushion anymore. You have no coupon income coming in, and here is the problem with that.

Even in the late '70s, which people described as worst bear market in fixed-income history, rates went from like 8% to 14%, so you got a 10-year Treasury of 14%. Boy, those were the days. I'll tell you something. That wasn't as bad as it seemed, because even when rates went from 8% to 14%, at least you had an 8% coupon coming in, right. So, you had a nice cushion.

So, actually, if you look at the indices throughout late '70s, they never had an average annual return that was negative, on a calendar-year basis at least, and that's interesting. That's something most people don't know. People view a bear market and like 1994 as by far the worst bear market I've ever seen. It's referred to as like the most chaotic fixed-income [bear market]. You were down like 1% to 2% on the indices. That was the worst return literally since 1973 in the fixed-income market.

So, getting back to absolute return: What absolute return tries to do is we try to use a combination of strategy, securities, and sectors to earn the best return we can opportunistically, and when I say opportunistically, here is what I mean. Our home base is cash. Cash is the only long-only asset class that doesn't lose money. Or doesn't have the capability to lose money. Rates go up, it's actually good for cash. Rates go down, you just don't earn anything, but you don't lose money.

So, we start with cash. We then utilize a combination of both traditional and hedge fund techniques-- long, short and relative value using both cash funds and synthetics--to opportunistically allocate when levels are such that it's worth doing. If it's not worth doing, we won't do anything.

So, for instance, 2008 is a good example, one of the hardest years I've ever had in my life, and I was up 2%. But here is why it was one of the hardest years of my life. To get that 2%, I had to sit on about 80% to 85% cash for almost the entire year in my offshore fund, and that was not very popular at the beginning of 2008. It became very popular towards the end of 2008. But the reason I did that was simple. The opportunity set was tiny. When I looked at all opportunities to be long, I couldn't find any. I couldn't find anything I liked where I was getting compensated enough to take on that risk.

There were short opportunities, and we took advantage of some of those. In retrospect I wish I took advantage of them more, but the key thing for that year was when markets started to sell off and risk premiums started to blow out, we were able to be a liquidity provider into that, which set us up to put up a 20% return the following year, because we bought high yield, we bought non-agency mortgages, which we hadn't owned before, because they were finally paying me enough where I thought I was being fairly compensated to take on that risk.

So, that's the big difference. It's pretty easy. What we do is not rocket science. Some might say, well, it's very complicated. We might use some complicated techniques, but the bottom line is this: when risk premiums are pretty tight, [volatility] is very low and everyone is felling really good, that's not a great opportunity set for me on the long side, right? That probably means risk premiums don't have much further to go in, fundamentals are probably perfect, technicals are probably perfect, money is piling into the fund of the day, and I understand that. But that's usually time when, to me, that might be a better short than a long.

And most importantly, I never let my portfolio become susceptible to just one or two factors. Like, if you own a traditional fixed-income fund, no matter what anyone says, you're susceptible to rates, right? Rates go up, you lose money. It's as easy as that. Fortunately, rates have really never gone up in 30 years, so I really do strongly feel that most people have forgotten what it's like to lose money in fixed income despite 2008 when you had a lot of so-called traditional fixed income funds go down double digits.

Cook: So, like you're saying, you had about 80% in cash back in 2008. Now, I know it's round about 45%. So what are some of the themes that you're spending the rest of the portfolio, and I think you're shorting emerging markets and are long U.S. corporate bond high yield, is that right?

Eigen: Yep. That's a good point. You know your stuff, don't you? The areas where we're long--and we're certainly not as long as we were--are areas where we feel we can at least earn a coupon-like return with a little bit of volatility. High yield is a good example of that where ... for us, every trading decision really comes down to looking at fundamentals, valuations, and technicals. It's those three things. If all three of those don't line up the way we want them, then we avoid. If they do line up to a large extent, then we'll get long. If they don't line up at all, we're going to be short.

Let me give you a good example. Emerging markets, that's actually good example. It's not that I dislike emerging markets. It's not that I think fundamentals are terrible; I don't. But again, fundamentals, valuations and technicals. And think about this when you're owning an asset class--you look at dollar-denominated emerging market debt, which we short using the CDX.EM index, which represents a basket of Latin American markets, basically. We look at that and we say okay, valuations--trading at the tightest levels ever in history, pretty much right now within 10 to 20 basis points. Okay, check.

Technicals, you got more money into emerging-markets debt funds last year than there were assets in emerging debt funds the year before. So when you look at the mountain chart for emerging market debt assets, it looks like this [gestures upward] over a 10-year period, okay--check two. So, you got technicals, you've got valuations, and now you've got fundamentals.

I don't disagree with anyone who tells me emerging-market fundamentals are wonderful. I agree, they are, and you know what? That's priced in.

So, fundamentals are perfect, technicals are perfect, valuations are among the tightest they've ever been. To me that's more of a short than a long. And it's not rocket science; it's just looking at those three things and saying, "That's not somewhere I want to be."

Now, you look at high yield in contrast--now high yield fundamentals, I would argue, are good; they're good. Leverage has come way down among your average issuer. SG&A has been cut to the bone. Maturities have been termed out; anyone who has needed to refi, has refi'd. So, your near-term default risk is very low, which is in direct contrast to '07. So there is fundamental.

Valuations, you are between 500 and 600 over on an option-adjusted spread basis, all-time tight is around 250, all time wide is the craziness of '08, which was 2,000. Before that, the all-time wides were 1,000 over the entire market. So valuations are not awful. They are not great. I don't love them, but I don't hate them, either. So okay, there.

Technicals: Technicals have been mixed, I would call them. High yield has been a flighty asset class. People ... hated it in '08. They really didn't get interested in '09 until you got to the back half of '09. And then 2010, last year, was a decent year for flows, and more recently, they have been kind of mixed off and on. So I'd say valuations are kind of in the middle.

To me that's an asset class that's worth owing but not in huge size. So when we really loved it, when things were at 2,000 over, we had about 40% to 50% of the fund in high yield. It's now down to the low 20%s and moving down. As spreads come in, we will move that allocation down even more.

The best opportunities I can find right now, and they literally are emerging right now, are within distressed names in the credit default swap universe, because what happens in CDS, CDS is the most inefficient market out there. I have been trading it for years, and it's extremely inefficient, which breeds good trades, good high IRR-type trades.

What I mean by that is, for instance, when you get bad news on housing, which just never seems to stop, but at some point it will--I am not a bull on housing by any means. In fact, I think it's going to get worse, but that doesn't mean if someone is willing to pay me 2,000 basis points a year plus a 5% coupon to own the top of the cap structure in a homebuilder for two years that has half a billion in cash and a lot of other things going for it where I know they are probably not going to file for the next two years, I will do that, because of the compensation that's associated with that.

So let's look at housing for a minute. So an average housing name, applying that same logic we talked about before: fundamentals: awful. Valuation: incredible. I am getting paid an incredible amount to take that type of risk. Technicals: terrible. Everyone hates these names, and no one is jumping into them. Those are the kind of trades that get interesting to me. Those are the types of allocations that I want to put in the portfolio. And when I can find them, I will, but if I can't, then I am either going to be more in cash and more tilted short than I am going to be tilted long. So that's kind of in a long-winded way, how we manage absolute return.

Cook: So given this kind of slightly thematic approach, how often do you actually address that? Is it day to day you are looking for opportunities or quarterly or…

Eigen: You know, it's interesting, because what we are looking for... we like to do what I call "attack volatility episodes." When there is a volatility episode, we have the liquidity to attack it, and say, "Wow! This is a level we have been waiting for; let's do it."

On any average day, we are watching 300 to 500 trades that we just tagged and were marked, single names, indices, tranches, default tranches, everything. And we are waiting for breakouts. I am not interested if something is just in a range. If it's breaking out of a range, that's when I'll start to get interested--either way, either as a short or as a long. So I've got a team of 10 people, and pretty much all we do all day is talk about the thematic approach that we are taking. Have our themes changed? What could we be missing here?

We model the portfolio; we model trades in the portfolio, and we watch--we watch a very, very large number of trades and just wait. And when a trade enters a range where we find it interesting, we reconcile, we try to reconcile it with the themes we have in the portfolio. If they seem to match, then it's a question of size and managing around that size and managing around the size of that position within the fund.

One of the things that is very important to us is correlation, which I think is taken for granted way too much. I am sure you would appreciate this. You can have someone who says, "Well, I am diversified. I own high-yield emerging market debt and preferreds." No, you basically own one thing because if high yield goes down, emerging market debt is going down, too, and so are preferreds. So that's the promise. I don't think people think enough about correlation. That's incredibly important to us at the trade, allocation, and sector level.

Cook: So my final question for you is that, I am curious about how you actually measure the risk. Given the use of swaps and trying to measure the fund's performance against a benchmark, given the credit environment, how does an investor who has an idea of what their risk profile is know whether your fund is going to fit their risk profile or not?

Eigen: I think that's a very important question. You can't just apply a single number like a VaR to that. I mean VaR has always bothered me as a metric of risk because it doesn't account for tails, and tails are really most of what we care about; especially running an absolute return fund, you have to care about that.

I mean the simplest thing to us, is every single day when we look at the portfolio, we know exactly how it's going to react to several factors, under different weather conditions, we'll call them. And that's what's most important to me, is making sure my risk factors within the fund are diversified.

For instance, if you run a long-only fund, like I did for many years, when you look at your risk factors, you say, "Okay, if rates move up or down, I am going to make or lose money." That's one risk factor that's going to dominate the return profile of that fund.

In our case, we're looking at 12 to 13 risk factors and seeing how we'd react. For instance, yield curve steepness, yield curve flatness, emerging-market debt spread changes, high-yield changes, investment-grade changes. And if we can't get comfortable with how the fund is reacting to each of those, what we call, DV01 changes, then we have to change the positioning of the fund, or we have to raise more cash. That's why one of the most controversial things in my fund that I constantly get questions about is my cash position, because it's been as low as 25% and as high as 85%. And in the fixed income world, people view cash as trash right now. I guarantee they won't years from now. I guarantee that, but right now I get it. Cash is a zero return, but in a zero-return environment, if someone is offering you a much higher yield than that, it does not come without risk. So again, when we look across the gamut of trades that are available to us, we're going to wait until we're getting paid what we feel is an adequate amount to put on that risk. I make no bones about this. We rent fixed-income asset classes. We don't buy them.

Cook: So it sounds like it's a very flexible approach, but within the constraints of that three-tier strategy that you've got there?

Eigen: That's exactly right. And what's really important to me is that we're able to ... it is an incredibly flexible strategy. We can be long. We can be short. We can put on relative value trades. No one gets on my case about having too much cash or adding short positions or whatever, and I think that's incredibly important. But to do that, you really have to ... to me, I don't know how I would do this if I hadn't run a hedge fund for a few years, because that's what got me heavily involved in the synthetic markets and understanding correlation, most importantly building those trading relationships, because trading is really very important in the synthetic market. ... It's very easy to get taken for a ride in those markets. You have to really know what you are doing. And it also creates incredible inefficiencies that you're able to take advantage of when you can read the tape and understand what technicals are impacting which trades and how to take advantage of those. I think ... if there is one edge we bring to the table, that might be it.

Cook: Well, Bill, thanks very much for joining me and talking me through the technicalities of your fund.

Eigen: No problem, Holly. Thank you.

Cook: For Morningstar, I'm Holly Cook. Thanks for watching.