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Landmann: Opportunities in Today's Bond Market

TCW's Laird Landmann discusses why he likes nonagency mortgages, what others are missing in the emerging-markets debt story, and where he thinks interest rates are headed.

Karin Anderson: Hello, I'm Karin Anderson, associate director for Fixed Income Strategies at Morningstar. I'm here today with Laird Landmann, who is the managing director and co-director of Fixed Income at TCW. Hey Laird, how are you today?

Laird Landmann: Very well. Thanks for having me in today.

Anderson: Great, thank you for joining us. So tomorrow is another big day for the Fed. Do you think there's any chance we'll see a raise tomorrow? And if not, what are your thoughts for the rest of 2016?

Landmann: I think they say they're data-dependent and the data wasn't good, so I think there's really almost no chance that we'll see any activity out of the Fed tomorrow. I think if we can put together a few good months of data, they'd probably like to get rates higher to give themselves a little policy latitude. I think they're as aware as the rest of us are that things are cracking around the world, and that there's going to be problems, and the U.S. can't be immune from those problems, so it's very difficult to be the key policymaker and to enter the end of a credit cycle and not have any policy, real true policy latitude. We can talk about going to negative rates and crazy talk like that, but I think they would like to get rates a little bit higher before the end of the year. And I think there are some good theories out there that are suggesting that as we get rates down for as low and long as they have been, behavior begins to change. And it's possible that in fact the low rates might at some level lead to higher savings and less consumption as people plan for their retirement is something Morningstar is obviously very involved with. And so as behavior changes, it may be that low rates aren't as stimulative as we thought.

Anderson: OK. And given that you and your team are not too worried about any hikes anytime soon, you've been running the Total Return Fund with duration maybe not quite a year short of the benchmark, but around that.

Landmann: Closer to half a year short, yeah.

Anderson: Half a year. I guess why not be closer to the benchmark on duration given your views? 

Landmann: I think it's just a risk-return type of outlook that we have that really the bias is toward higher rates. We're the first to always say that we don't know exactly when rates will go higher, and the first also to then add that we don't think anyone really knows exactly when rates move or does a good job predicting interest rates in the short term. So we try to break it down to really, are you getting paid to take the risk? Is it good value? And when you think about U.S. inflation now headed toward above 2% and possibly toward 2.5% with the Fed targeting a 2% inflation rate, it seems like that data we talked about a moment ago will come together for them to raise rates and hence, it's probably not a good risk-return position to be in to be longer on the duration spectrum. At the same time, you're giving up a little bit of yield and so you have to be moderate in it and that's why we're closer to a half year short as we sit there today.

Anderson: OK, great. And on the credit side, you have a latitude of about 20% in high yield in the Total Return Fund I believe, you've been on the short end of that or the low end of that for quite awhile. What are you waiting for to build that up?

Landmann: I think it's really high yield has to fall into what we call breakable assets. These are assets that when the credit cycle ends really change in their pricing dramatically, it's not a linear function anymore. People stop thinking about them as a discounted stream of cash flows and think about it as what's the recovery if this bond defaults and I discount that at a very high rate, like 15% or 20%, what price do I come up with? That's our concern with high yield as it exists. And there are better asset classes right now to get yield in, particularly that nonagency, that legacy nonagency mortgage space, if you are willing to accept the below investment grade ratings in high yield, you certainly should be willing to accept them in that space and really the credit quality in that space is profoundly better, and you're de-leveraging in that space. Whereas in high yield and emerging markets, we're still leveraging, we're still in the phase of the cycle where leverage is increasing, risk is increasing, and yet you have these other investments in that legacy subprime space that are de-leveraging, credit is improving, and you're getting comparable types of return profiles.

Anderson: Great. And so a lot of people at the conference this week have been talking about emerging-markets bonds as being a great deal. You have that leeway to invest there as well, but for years you haven't touched it, I believe that's still the case. So what are you looking for there? 

Landmann: You're being very kind by saying years, I think decades would be more correct. It's never been a big emphasis of our strategy. We're fortunate now that TCW has a very capable team in that realm, so we have occasionally used them, our unconstrained fund has had as much as 22%, 23% in emerging markets. And I think our feeling is that people are looking at the wrong things right now. People are focusing on the fact that the governments of these countries have very low debt levels. But when you look at the countries themselves, the companies, the economies, they are more highly leveraged, and there are certainly potentially areas where reform is happening like in Lat-Am where it could be interesting going forward. But there are other areas like Asia where I think the overcapacity that's been created really on a secular basis in China, it's massive overcapacity in the industrial space, there's gonna have a profound effect on all those surrounding economies there, and I think we're worried that that is probably the tinder box for the next downturn in the credit cycle.

Anderson: OK, great. One last question for you. You mentioned nonagencies already, that's been a longtime favorite, but one area that you've kind of soured on more recently or taken down is Agency MBS. Do talk about the reason for that?

Landmann: It's very topical and the reasons for us is simply valuation there. I think that the dispute over what these securities are was settled in the 2008-2009 market volatility. These really are U.S. government-backed securities at the end of the day. And since then, we've seen them trade in a fairly tight range. When they get toward the expensive part of that range, yields are lower, prices are higher, we tend to de-emphasize them. We've actually been bringing that weighting back up a little bit as we've seen the yield spreads get a little bit wider there. We don't think it's an area that's gonna be particularly problematic in the marketplace. It's really just a valuation expression for us. And as we look forward, there was a proposal sort of floated today from the Clinton camp about restructuring Fanny and Freddie. We think all those things are off the table for a long time. And because of that, I think the mortgage market will function fairly well in the US.. for the next couple of years. So we don't have any particular bearish outlook on agency mortgages. It's really for us all about value.

KA: OK. Great. Thanks for clarifying and thanks for sharing your insights.

Landmann: Thanks for having me in today.