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How to Position a Bond Portfolio Today

Given fundamentals and valuations, fixed-income investors should be tilting toward developed-markets credits, says Western Asset Management's Michael Buchanan.

Sumit Desai: Hi, I'm Sumit Desai, senior analyst with Morningstar's fixed-income manager research group. Joining me today is Michael Buchanan. Michael is deputy CIO and head of global credit for Western Asset Management. He is a lead on Western Asset High Yield (WAHYX) and also a part of the portfolio manager team that won Morningstar's 2014 Fixed-Income Fund Manager of the Year award.

Michael, thank you for joining me today.

Michael Buchanan: Thanks for having me.

Desai: Michael, one of the things we want to talk about today is that a few months ago you were promoted to deputy chief investment officer within Western. Can you talk a little bit about the scope of that position and what it means for your responsibilities?

Buchanan: Sure. It's really working more closely with Ken Leech, who is our chief investment officer, in terms of leading the portfolio management team globally. I'll still have oversight for our global credit team, but also I'm going to work more closely with our different regional offices or geographic offices as well as the heads of other sector asset classes.

Desai: So, it's more of a big-picture, thematic type of position?

Buchanan: Yeah, certainly focusing more on our overall positioning and strategy, but obviously, as Western always has, letting those who operate within those sectors--who really are the experts--letting those individuals really have the most influence in terms of our positioning.

Desai: Within your responsibilities as head of the high-yield portfolios that Western manages, one of the big positions that we've talked a lot of about lately is specifically within the energy sector. Western is a little bit of a contrarian in that space in that you have an overweight to the energy sector. Can you talk a little bit about that and your expectations?

Buchanan: Certainly. And you're right--we do have an overweight to energy. It's about maybe 17% versus 15%. It's really based, as all Western Asset portfolios are, on relative value. And when we look at energy right now, we see a sector that is trading very cheap relative to the rest of the high-yield market. That yield, in our view, reflects more negativity and a higher rate of default than what we actually think is going to transpire. We certainly recognize the stress in the sector, but we also think that balance sheets are relatively healthy. Companies have done a good job hedging. There's ample cash on the balance sheet, and that will ultimately let them get through this period of prolonged low oil prices and make it to the other side. In the process, we're getting paid a very healthy level of income or yield.

Desai: To what extent is that position a bet on oil prices versus company-specific?

Buchanan: It's more of the latter. It's more a bet on company-specific metrics. We don't know when oil is going to trend higher. Our view is that, ultimately, it will because of the reductions that we're seeing in capital expenditures; we're seeing the rig counts start to fall. But we certainly don't want to make a credit bet based on where we think oil is going. What we are doing is really looking at the balance sheet. We're looking at management teams, and we're trying to pick the survivors--the ones that have the best underlying assets.


Desai: Maybe you can talk a little bit specifically about where you are within the energy sector. I know some investors invest more toward the pipelines, whereas some go toward the [exploration and production] type of companies. Can you talk about that a little bit?

Buchanan: So, you broadly divide up energy between exploration and production, oil-field service, and midstream or pipelines. Our bias is right now to be overweight the pipelines. We love the fact that it really isn't dependent on the price of oil. It's really dependent on demand. It's a tolling arrangement. Those companies tend to be very stable historically with respect to cash flow. So, we have an overweight there, and we also have an overweight on the exploration-and-production side--again, looking for the companies that operate in specific basins that we find very attractive.

Desai: An area that's somewhat related to energy--but not quite--is emerging markets. There is some correlation there, but it's been similarly volatile over the past year. Can you talk about how Western is viewing the emerging-markets bond sector?

Buchanan: Selectively. We certainly recognize the valuation potential within that sector. You look broadly, and it's trading at very, very attractive yields. But I think you have to really do your work from a bottom-up perspective. You have to focus your efforts on where you want to be--where the macro fundamentals are more supportive. We are not as bullish on emerging markets right now as we are on developed-markets credit. But that being said, we're certainly seeing some pockets of opportunity--selectively.

Desai: Brazil is a place that we've talked a little bit about before. You mentioned that you're finding some opportunities there, but you're maybe not super bullish on the broad economy. Can you talk about that a little bit?

Buchanan: Looking at Brazilian credit, I think there are some really interesting opportunities. You want companies that sell in U.S. dollars--so their revenue is in U.S. dollars--yet their costs are in real, which as we all know has been falling dramatically. So, there are actually ways that you can get very good relative value by homing in on companies like that. One that we've talked about is a company called CBC Ammunition--which, as the name implies, makes ammunition for a broad array of purposes. Only about 25% of their revenue comes from Latin America, so 75% comes from outside of Latin America. They have very low leverage. They do benefit from selling outside of Brazil, yet their cost basis is mostly within Brazil. And that is a split single B/BB rated company that you could buy at around 8.5%. It's a good example of an opportunity.

Desai: Obviously, a topic that is very important to bond investors is interest rates--yield-curve positioning and duration. Western really benefited from its yield-curve positioning in 2014; it was one of the reasons they won Fixed-Income Fund Manager of the Year. Can you talk how you and the team think about yield-curve positioning, duration, and interest rates broadly speaking today?

Buchanan: I think we always think about our yield-curve positioning, our duration positioning in the context of a diversified portfolio. So, if we're going to have a lot of spread-product risk, it makes sense to have--

Desai: By spread products, you mean--

Buchanan: Spread products are high-yield credit, emerging-markets investment-grade credit--more of a yield bias. So, it makes sense to complement risk in other sectors with certain duration strategies, yield-curve strategies--and that's how we're positioned now. We do have a bias toward those, what I would call, spread sectors; but a nice complement there is to have duration that's longer than benchmark--maybe a curve-flattening trait. But it's good to have other sources of diversification within the portfolio that will offset some of that spread movement if, in fact, we are early on that trade and you start to see more weakness or deterioration. Usually, those duration and curve traits will kick in the other way and certainly salvage basis points for our investors.

Desai: Given where we are in the economy--at a fork in the road with rates and a little bit of volatility in [emerging markets] and high yield, specifically within energy--what does this really mean for investors? If I'm an investor with a fixed-income portfolio, how should I position that portfolio, and what do I expect going forward?

Buchanan: It's a great question. I think the first thing you do is you start with the macro view, and you recognize that we are in a world where growth is likely to be slower than what it's been historically and inflation is likely to be lower than what it's been historically. What that tells us is that rates shouldn't be a big threat to you going forward--just the big picture. If you take that as a backdrop and really start to home in on sectors where there is opportunity--again, I'll go back to credit--I think credit is a very interesting opportunity right now, both investment-grade and high yield. Given the supportive fundamental backdrop combined with compelling valuations, we think fixed-income investors want to have allocations tilted toward developed-markets credit.

Desai: Mike, thank you for joining me today.

Buchanan: Thank you. I appreciate it.