Fund Spy

Fixed-Income Highlights From the 2018 Morningstar Investment Conference

Kenneth Oshodi

This year's Morningstar Investment Conference featured fixed-income panels that focused on the corporate-bond and municipal-bond markets, with a third panel that zeroed in on opportunities in emerging-markets debt and equities. The three panels shared multiple themes. All of the speakers identified pockets of opportunities in the market. But they also agreed that investors should practice caution, especially considering the possibility of a recession on the horizon in a few years.

It's Late in the Credit Cycle
This was the clear theme of the "Bond-Picker's Guide to Fixed-Income Strategies" panel. Western Asset's Ryan Brist pointed to his firm's current positioning, noting that it's the most conservative it has been since 2008's financial crisis. PIMCO's Mohit Mittal echoed the sentiment, referencing his decision to reduce risk in late 2017. Though he sees modest growth, he mentioned threats to the credit markets, including the end of accommodative monetary policy and trade conflicts. PIMCO argues that the probability of a recession increases a few years out, but that it could be a shallow dip owing to a lack of excessive capital investment. All of the panelists agreed that deteriorating lending standards, financial engineering on balance sheets, and a surge in BBB rated debt are all cause for concern.

However, the catalyst for the end of the current cycle isn't clear. In his comments on the "Smart Plays in Developing Markets" panel, Brandywine's Anujeet Sareen noted that "cycles don't end from old age." Meanwhile, in his closing remarks, Mittal noted that all three corporate-bond panelists shared a cautious view on credit, which could itself be a corrective for the excesses of the current cycle.

Opportunities Are Still Available for Picky Managers
Against that backdrop, the corporate-bond managers agreed that there were pockets of value in the market. Loomis Sayles' Elaine Stokes noted that  Loomis Sayles Bond (LSBDX) and other portfolios she manages have a fairly large allocation to high-yield bonds, although she tends to favor shorter-term secured names and is carrying a large stake in cash and U.S. Treasuries to offset the risks of this position. Mittal noted that PIMCO has found opportunities in bonds that stand to benefit from housing market growth, including nonagency mortgages. And Brist mentioned the attractiveness of certain crossover bonds, which sit at the intersection of the investment-grade and below-investment-grade markets. The Bond-Picker's panel also noted that companies in certain commodity-driven sectors that were hit hard in 2014 and into 2016 have repaired their balance sheets and don't look as risky today.

In the municipal-bond markets, the conversation focused on some of the market's more challenging names. MFS' Melissa Haskell and T. Rowe Price's Jim Murphy found value in Puerto Rico's debt, but in different areas. Haskell focused on insured bonds, a play on insurer strength. However, Murphy found opportunities in some of the island's unsecured debt that he bought at low-dollar prices. Opinions were mixed on Illinois general-obligation bonds because of uncertainty surrounding the state's politics and pension problems. The managers were also split on tobacco bonds, noting long-term declines in smoking rates and threats from competitor products.

Not All Markets Are in the Same Part of the Credit Cycle
Divergence in economic cycles was a theme on the emerging-markets panel, and the potential for growth in the world's developing economies made this the most optimistic of the three discussions. TCW's Penny Foley contrasted the United States, which has enjoyed a long economic expansion, with emerging markets, which have faced three notable drawdowns. WisdomTree's Jeremy Schwartz highlighted equity opportunities in China, a country that he believes has potential for significant growth owing to the strength of its leading private companies, namely Alibaba, Baidu, Ctrip, and Tencent. The speakers on the Bond-Picker's panel also noted opportunities in emerging-markets debt, especially in the wake of recent bond market turbulence.

Specific Challenges Remain
Although there were common themes across the panels, our contributors also touched on asset-class-specific challenges. In the emerging-markets discussion, Foley and Schwartz discussed the positives of dynamic hedging to help alleviate currency volatility, especially in the face of rising rates. However, Schwartz also noted that the costs associated with currency hedging can detract from the long-term performance of fully hedged strategies.

Meanwhile, the muni-bond panel included a lively discussion of the impact of tax reform on the tax-exempt market. Uncertainty surrounding the policy's long-term impact led to a lot of issuance being pulled forward into late 2017, with a corresponding decrease in volume in the first months of 2018. Indeed, Vanguard's Chris Alwine noted that changes to the treatment of advanced refunding bonds, which represent nearly one third of market issuance, have helped drive the contraction of supply. On the demand side of the equation, T. Rowe Price's Murphy highlighted the falloff in demand from bank and insurance companies, which have sold shorter-dated high-quality paper. Overall, however, constrained supply hasn't been enough to protect muni funds from losses this year as bond yields spiked.

Kenneth Oshodi does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

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