Bond Market Bumps Ahead

The article was published in the February/March 2017 issue of Morningstar magazine.

On Dec. 20, we spoke with three of the best bond managers in the business: Dana Emery, CEO, president and director of fixed income at Dodge & Cox, Laird Landmann, co-director of fixed income at TCW, and Ken Leech, CIO of Western Asset. Among them, they oversee a number of Morningstar Medalists, including

In the first part of the series, Emery, Landmann, and Leech shared their outlooks for inflation, long-term interest rates, and Federal Reserve policy. In this second installment, the three tackle questions of risk in the fixed-income markets. Their conversation has been edited for clarity and length.

The U.S. Federal Reserve is moving in the opposite direction from central banks globally. As you look at the balance sheets of central banks, what is the risk there? Laird Landmann: Since 2010, the Japanese central bank has gone from having about 22% of their balance sheet as a percentage of GDP to now close to 90%. Where does this stop? Clearly the end game will be extremely inflationary if you take it to its logical conclusion. You have to have an end game before that if you want to avoid runaway inflation within your economy.

There is also a very distorting effect on asset prices. We’ve seen that throughout different central banks’ cycles just in the U.S. Generally, the ratio of the wealth economy to the income economy is about 5:1. Right now, it’s about 6.5:1, meaning that asset prices, whether of equities or high-yield debt, generally are at higher prices than they otherwise would be in the absence of central bank intervention on this scale. As it unwinds, logically you will see asset prices begin to decline. That usually shakes out that last turn of leverage that’s been placed on a capital structure, so it can add pressure to those areas.

We would agree that the fragility doesn’t seem to be quite as high in the U.S., but valuation in the investment-grade indices and in the high-yield indices is not particularly compelling now. Leverage is near an all-time high, depending on how you measure it. We don’t really see the upside in being very long credit, even in the U.S. at this point.

Ken pointed out the fragilities very clearly in China and how those could set off a downturn in the world. We addressed the idea of Trump as a positive to growth, but if he does move from a Twitter war to an actual trade war with someone like China, that will clearly not be good for growth. We might catch a bad cold from it, but China might catch pneumonia because they’re at a fragile point where they’re trying to transition their economy.

Emery: I would add that I think that the Fed is going to be very data dependent, as they say over and over, and I do feel that the unwinding of the balance sheet will be pushed off and delayed. They'll be very careful about unwinding and selling off their assets. They may move into just a roll-off of assets to try to keep it orderly. We've seen where they'll start to talk about tapering or start to talk about stopping quantitative easing, then markets react and they'll delay and do it a few quarters later. In terms of the Bank of Japan and other central banks, it's going to be very difficult, given the sheer size of their balance sheets at this point, to unwind them. My guess is that they keep large balance sheets for a much more extended time than they would have anticipated when they started this.

Leech: Laird brought up the uncertainty with respect to Trump. If you remember the first hour after his election, you had a massive risk-off trade. Some of the risk scenarios that had been put out by many of the Wall Street firms and political think tanks suggested that an anti-trade, anti-immigration, anti-globalization policy would be very much risk-off, as with what happened in the immediate aftermath of Brexit. That gave way, given a lot of conciliatory language by the Trump people and leaders around the world. People started to say, you're looking at a fiscal policy which is very pro-business and tends to be very pro-growth, with tax cuts, regulatory reform, and infrastructure build-out, all at the same time. But it would be a mistake to push aside all the possible missteps with respect to trade, immigration, and foreign policy, again particularly with respect to China, because those uncertainties could create very dynamic market dislocations.

Broken Covenants Turning to the credit cycle, what trends are you seeing today in underwriting standards and covenant packages? What does that tell you about where we are in the credit cycle? Landmann: Trying to make a hard-timed forecast of when the credit cycle is going to end is next to futile. We're eight years into the credit cycle. All the elements of leverage seem to be there. There are fragilities around the world, maybe a little less so in the U.S., but we have seen earnings disappoint for the last six quarters, with actual declines in five of the last six quarters. We've seen leverage continue to increase, and we continue to see money get plowed into buybacks. All of the late cycle dynamics are there.

Objectively, covenants are not favorable at this stage of the cycle for debtholders. So you have to be very careful in the type of credit risk exposures you take and highly selective in the individual credits that you’re buying. At these valuations, toward the end of the cycle, there won’t be a large margin for error.

The U.S. banking system has made significant changes. That’s why I think that as a debtholder, you can be pretty confident in buying some of those issues of the major banks and even some of the regional banks in the U.S. You just have to stay away from most of the European banks. We are a lot less positively inclined toward cyclicals at this stage of the cycle, though we do think there will be very good buying opportunities that are going to be caused by policy uncertainty. The illiquidity premium should be there in this market. I’m sure all the participants would agree that the resources on the market-making side in fixed income are much more impaired than they were 10 years ago. If we do get these bounces of crisis and panic in the markets, prices are going to move a lot more than they otherwise would.

We’re just trying to make sure, at this stage of the cycle, that our clients are getting a sufficient liquidity premium if we’re buying bonds for them now, and they’re certainly getting the best covenant package and credit that we can deliver at this time because this is not a time, based on valuation, liquidity, or where we are in the credit cycle, to really stick your neck out. There will be opportunities, but only when the credit cycle turns.

Emery: I think the biggest area of covenant weakness has been in the leveraged loan area. That's not an area that we invest in, so these guys probably know more about it than I do, but I would say that all the measures have deteriorated significantly since 2007.

You need to be selective, to try to put yourself in the shoes of the issuer: What’s going on in the industry, what are the competitive dynamics, and, given the company’s own fundamentals, what’s a likely path of leverage to achieve the corporate goal? In investment-grade bonds there are few covenants to protect you. Usually you get more protective covenants the lower in quality you go.

In the below BB area, the covenants have gotten significantly worse. There’s a lot of issuance of first lien debt that doesn’t have the junior lien protection that it had in the past cycle. There’s also a lot more ability for structural subordination. That always existed in investment-grade; it’s something you have to evaluate. But in the high-yield area, the loosening up of covenants to allow structural subordination is worrisome and could lead to much lower recoveries in the next default cycle.

Leech: We very much believe that the tailwind we've had from this enormous rally since February suggests that you need to be more cautious than you otherwise would be in the investment-grade space. Given where we are in the cycle, and with the renewal of animal spirits, and perhaps with tax cuts ahead, you need to be thoughtful. Company management is really trying to be equity-friendly and bond-unfriendly, so you have greater dividends and share buybacks and M&A threats. We've tried to concentrate on U.S. banks. They're really not in a position to releverage in any meaningful way. If they want to increase dividends or buy back stocks, they need to get 17 regulators to sign the dotted lines. That's our foremost overweight. But we also think metals and mining and energy have a lot of positives because they are actually deleveraging. Obviously, they were over their skis in a different part of the credit cycle, given the commodity bust. From that perspective, the deleveraging, those are the plays we think, as an industry, have a little bit less risk. Going forward, it's all about security selection.

Emery: A lot of higher leverage has been generated by investment-grade M&A. Many are companies that generate significant cash flow, like consumer products or communications companies with high numbers of subscribers. You need to analyze this issuer by issuer, but we can see a path forward with carefully selected issuers. We agree that certain commodity-related issuers should see balance sheet improvement over time. Paying attention to sources and uses of cash flow remains very important at this point in the cycle. A potential tailwind to the credit markets includes a reduction in corporate tax rates, which may encourage lower leverage and lower supply of debt issuance.

Managing Uncertainty Landmann: We will continue to focus on those companies where you have the protection of a regulator or a structural protection that's built in beyond covenants and will wait to accumulate positions in riskier situations at much better valuation levels. I am optimistic that this president's going to deliver that result for us!

Emery: We learned that we cannot underestimate Trump! We agree that a lot of the changes in bank regulation have been very bondholder-friendly, in terms of building up capital and liquidity and minimal low-quality lending. But one of the things on the table is the possibility of revoking parts of Dodd-Frank, and that's something we have to watch closely: What are the implications of that for the quality of the debt?

Landmann: Hopefully one of the implications is that we'll be able to trade bonds again, that there will be liquidity coming back to the market!

Any parting thoughts to highlight for investors looking at the bond market? Emery: Given where we are starting with yields, fixed-income returns will be modest at best. You can't create high returns from low starting yields. There's not a high likelihood of significant compression in credit spreads, so you don't have that as a tailwind. It's important to have an extended time horizon to give time for income and the reinvestment of income to work for our shareholders. We don't construct portfolios assuming one scenario; we utilize a variety of scenarios in our analysis. It's important to conduct deep, bottom-up research at both the security and portfolio level. In this environment, the case for active management in fixed income is very, very high.

Landmann: We have a new administration with major policy changes that could have unintended consequences. I think those unintended consequences, mirrored with illiquidity in the market, will create very good opportunities. We are kind of looking forward to this after a period of pretty low volatility based on the Fed pinning rates at basically zero and providing stimulation whenever there was a period of uncertainty in the marketplace.

One thing we didn’t touch on is there are good high-quality substitutes out there to get yield in the marketplace on the structured product side. We think that the highest-quality commercial mortgage-backed securities remain an attractive substitute for some of the more leveraged areas of the marketplace. The nonagency mortgage trade is entering its final phase of remediation where the underlying mortgages having seasoned 10 or 12 years are pulling to par. This is also a space where there are a lot of issue selection opportunities that we will be able to take advantage of.

Emery: We would concur with that. We think, especially in the short to intermediate part of the curve, that relative to taking credit risk, certain structured products are a compelling way to keep the yield of the portfolio elevated at an attractive level in a safe way.

Leech: The good news is there's been a lot of optimism, but the challenge is that the uncertainty premium around it is very high. We need to be thoughtful and reactive as conditions change with respect to an unprecedented policy environment that we may be going into. There's a possibility of a discontinuity in American policy from what we've seen before, whether it's trade or immigration or foreign policy. Our perspective: Make sure you build your portfolio so you have some meaningful diversification from a strategic perspective to protect yourself in a risk-off environment.