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What 3 Great Managers Expect From the Bond Market

We discuss value in the fixed-income markets and risks to be aware of during the Morningstar Investment Conference.

Sarah Bush: Hello. My name is Sarah Bush. I'm a director of fixed income manager research at Morningstar. Today I'm at the 2019 Morningstar Investment Conference. We had the opportunity to talk with three topnotch bond managers about where they're finding value in the fixed-income markets and also what risks are out there for investors to be aware of. Here's what they had to say.

Sonali Pier: You know, this is an environment where we don't want to rely heavily on a corporate credit overweight because betas have compressed. We're looking for flexibility and resiliency in our portfolio construction, such that we can step in to provide liquidity in a sell-off. We see financials as presenting some attractive opportunity, given the strong capital ratios and increased issuance to meet regulatory needs. Today, they trade wide to similarly rated nonfinancials, and there's virtually no M&A risk.

Additionally, at PIMCO we've seen nonagency mortgages as a high-conviction area. Our positive view on housing, which calls for 6% housing-price appreciation cumulatively for the next two years, as well as the fact that they are relatively insulated from some of the global risks effecting markets. Then we've seen improvement even in the underlying borrower quality from fewer defaults, fewer delinquencies, improved credit quality as reflected in their FICOs, and increased home equity.

Laird Landmann: Given the credit cycle is very, very old at this point, and I think we saw in December the strains of the credit cycle, and the credit cycles are very typical--you build up debt throughout the cycle. It's been 10 years of debt buildup, mainly in corporates and high yield and leveraged loans in the cycle. Then interest rates rise, and the debt becomes harder to sustain. Eventually, earnings turn down, and that's really the teeth of a credit contraction. We're sitting right on it today, in our opinion, and you'll want to be extremely careful. 

Bonds have two main features associated with them. One, they are bounded and mean-reverting. By that I mean when values get high, they're not like equities, they can't go to the moon. And so what you'll find is that the next move tends to be lower and you need to watch out for that at the end of credit cycles. 

The second feature is bonds that are good and money good tend to pull towards par over time. If you could find segments of the market that are pulling towards par, have shorter durations--whether they be short, high-quality corporates at this moment-juncture, stay low in your durations, or it be the legacy nonagency assets from the last cycle that are all pulling the par and deleveraging over time--those are going to be the safe places in this credit cycle.

Mike Collins: With regards to the credit cycle, there's actually mixed signals. The consensus narrative seems to be that we're late in the cycle. It's been a nine-year expansion. There's been a lot of relevering of corporate American, for sure, but there are actually a lot of good signs, a lot of more early, or midcycle signs out there, particularly with regards to, say, the big money center banks in the U.S., which haven't levered up at all. In fact, they've de-levered dramatically since the financial crisis. Consumers, on average, really haven't started relevering. Maybe just now they're just getting off the mat and starting to borrow a little more money.

Small businesses generally are in pretty good shape. All that bodes, I think, well for the longevity of the cycle. Our base case is that we're sitting here in two or three years from now and still probably not seeing a recession. All that being said, there are risks. It's really not coming from the sectors that blew us up in '08: housing, banks, structured credit, and derivatives. They've all been heavily regulated, and now they're essentially much safer. But it's the other areas.

It's really the private debt markets. It's the investment-grade corporate market where we're seeing a ton of issuance, a lot of M&A activity, a lot more highly levered companies. You've heard a lot about the BBB space. There's a lot of leverage, a lot of very indebted company in that space. Obviously, if you do get an economic slowdown, there is a chance for some fallen angel activity. That could reprice risk assets pretty significantly.

Pier: The risks we see in the credit markets today stem from: First, starting valuations are not cheap. Then, when we look at globally, the concerns that are out there--trade disputes, less accommodative central banks, peripheral Europe--there's reasons to be concerned here. Within credit, we're selective in certain segments. Given the robust capital markets we've seen, we've seen weaker lending standards. As a result, in bank loans, for example, we have a lot of loan-only issuance with no subordination below you, asset-light sectors that are coming to that market as well as covenant-light issuance, which could challenge recoveries in the next cycle.

One other risk I would highlight is more of a style bias, as investors try to time the beta. We looked at Morningstar data, which examined high-yield bank loans and EM. We looked at when investors were invested across these asset classes over a one-, three-, five-, and 10-year period and found that they give up roughly 1%-2% trying to time that beta. Earlier, I mentioned flexibility and liquidity, as these two factors in an active mandate can make quite an impact on alpha-generation when betas are compressed.

Landmann: The risks at the end of the credit cycle are very manifold. They start with the fact that you have high valuations. In a bounded market, as I commented earlier, that means they go down. That's the next move for high-risk assets out there. You don't have unlimited upside, like equities, and that's where you should take your risk. If you don't agree it's the end of the credit cycle--by all means, buy equities, don't buy fixed-income. 

But the risks you have to watch out for now are really ... The big risks are liquidity, and we saw that again in December. Liquidity just dried up. The risks are that we have a lot of ETF type of vehicles that haven't been tested at the end of a credit cycle. Really, it's psychological. Right now, companies, like ride-sharing companies, can get huge valuations in issue stock because everyone's optimistic. Everyone believes the world is changing for the better, and when that psychology changes, it's very hard to remember what people felt like in 2008, in 2002, in 1998. When that psychology comes back, valuations are going to change in a profound way. So, this is not the time to stick your neck out.

Collins: Interestingly, there are a lot of attractive opportunities in the global fixed-income market today. Again, the sectors that were more regulated after the great financial crisis are much safer, and they're actually, arguably, undervalued right now. We like the big global money center banks. Again, their leverage is really low. Their liquidity is really high. They trade a pretty attractive spread relative to government debt. One area we've been really adding to are a variety of very high-quality senior tranches of structured products, asset-backed securities, things like AAA rated collateralized loan obligations, commercial mortgage-backed securities, securitized nonagency mortgages, or consumer loans, where you have a tremendous amount of credit enhancement. These things are trading at really wide spreads relative to the underlying credit risk.