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Eigen: Fixed-Income Markets Are a Compressed Spring

Eric Jacobson

Eric Jacobson: Hi, I'm Eric Jacobson with Morningstar. We're here today at the Morningstar Conference with Bill Eigen of JPMorgan Strategic Income Opportunities. Bill, thanks so much for joining us today.

Bill Eigen: Oh, no problem at all, glad to be here.

Jacobson: You run, as I said, JPMorgan Strategic Income Opportunities. We classify it as a non-traditional-bond fund, but essentially it's an unconstrained and absolute-return strategy. You have a bias at this point in terms of valuations. Why don't you tell us what that's about and how it looks in your portfolio.

Eigen: As an absolute return manager. First and foremost you have to move with the opportunity set. So right now, we're at a point in the cycle where the tailwinds in traditional fixed income are now becoming headwinds. You've got the Federal Reserve exiting; you've got the economy actually growing above trend, which every fixed-income investor's worst nightmare. It's good for equities, bad for fixed income. And you do have some inflation pressure starting to show up in the system, and yet you look at rates, not only in the U.S. but globally, and they are still very, very close to the all-time lowest they've ever been.

Most importantly, other areas of the market that typically offer yield premiums are now converging. In other words you have risk premiums in areas of the market like high yield, mortgage-backed securities, investment-grade corporates, emerging-markets debt, very, very close to the all-time lowest they've ever been.

The problem that that creates as you can imagine is when spreads get tighter and tighter rates get lower and lower, correlations pick up, which means you need a very small backup in interest rates to create a lot of losses as people learned last May and June, when just an innocent remark from a Federal Reserve official caused yields at the 10-year point to double. It wasn’t even the economy or inflation then.

I kind of view the rate markets and increasingly other risk markets within fixed income more like a compressed spring: The longer it stays here the less it will take to cause valuations to just normalize and not to be at these very, very tight levels. And as a result, more recently just over the past few months I have gotten my portfolio much, much more defensive. I am leaning more on short positions and what we call alpha-oriented positions which is targeting mainly relative-value trades. And also targeting higher rates down the road from here and doing it very gradually as rates continue to fall. We continue to add to those types of positions while selling down our beta positions which have been very beneficial to us for the last few years.

We don’t want to overstay our welcome. And the time to sell things is when the markets are incredibly liquid because we know how fast that can turn when volatility hits.

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Jacobson: Those beta positions you are talking about were primarily high-yield to a large degree. Give us a little more color on what are inside those alpha or relative-value positions, as well.

Eigen: For instance right now, by default when long positions get very expensive, short positions get very cheap to put on. So what we try to do in our alpha sleeve is target a combination of things. One is idiosyncratic trades, I'd like to classify my portfolio as a little bit uncomfortably idiosyncratic right now because those are a lot of the trades we are targeting. But that’s what you have to do when systematically risk isn’t being priced correctly.

We're finding one-off trades, for instance individual credit default swaps that react in a nonlinear fashion to things like earnings reports and we can find a trade to do there. We have a number of relative-value trades targeting mispriced relationships within the credit default swap market which is a real specialty of ours, we tend to trade a lot of synthetics because when risk either goes on or comes off, it tends to manifest itself incorrectly in those markets as opposed to the cash-bond markets. The other thing we are doing is we are targeting trades that can really benefit from a Federal Reserve really just basically doing what they tell you they are going to do which is they are going to be completely done with quantitative easing by September. [The Fed has already tapered] down to $35 billion [worth of bonds purchased per month]; it's going to be zero by the time we get to September.

Also within six to nine months after that, [the Fed will start to] tighten assuming the economy continues on this very reasonable trajectory which it's on right now. So we are just taking the Fed at their word. If you believe that then, there are certain types of trades available in the marketplace including targeting Fed funds and things like euro dollars. They are not priced for that at all. So you can put on like for instance a Fed-funds flattener between two and five years. And if the Fed does indeed do what they say they are going to do, that trade can create quite a nice return for you.

Jacobson: So among the things that you are not holding much of right now or at all. But you imagine might look a lot better on the other side with some volatility. Are there specific sectors or areas that you really have your eye on that you think those are where you want to go.

Eigen: Yes, absolutely. And you are exactly right. When you say we are holding a lot of liquidity right now, I have the highest cash position I have had in the fund since 2008, when the fund was almost 80% cash. Now it's about 60%. I am finding a number of things to do which is why 40% of the fund is still invested and still making money. I mean the fund is doing fine it is doing what it's supposed to do.

I'm very excited for when volatility hits for a couple of reasons. When it hits like I said the first place we look--we basically have a playbook that we follow--the first place we look is in the synthetic markets because people inevitably you have very panicky hedge fund managers and arbitrage managers who instantly go into these markets and start to do lots of volume trading. And that creates inconsistencies; it creates irregularities much more so in that market than it does in the cash markets.

Eventually it makes its way to the cash markets. But every time volatility hits, we first go to the synthetic markets. Things like for instance default tranches which are just very, very simple ways to project the risk of default in a basket of securities over time, these things get completely mispriced. People start to build in outrageous default rates into these things when volatility hits our risk comes off. So that’s the first place we typically start.

We then look at individual credit default swaps and what we call correlation trades. Then we'll move into the cash markets if the risk keeps coming off, that’s when we'll start to build back up the positions that we took off at ideally much, much tighter spreads.

Jacobson: One last question. We've talked about this before to the fact that your style, and particularly especially when you are this much in cash, it's very much about not having interest-rate risk at this stage of the market. We had a lot of questions obviously about does that make sense within the context of a broader portfolio? Do you not have to worry about the fact that I don’t have rate sensitivity? And you have a particular outlook on that. As an absolute-return manager maybe you could tell us that.

Eigen: It's a completely different ball game when you are an absolute-return manager because you are not, you can't lose money for people, right. When I was a long only manager I wasn’t in charge of that decision, the market was, rates were. So if you are following a benchmark like the Barclays Aggregate Bond Index, you have very limited ability to control the outcome. If rates go up, you are going to lose money no matter what.

With an absolute-return fund you don’t have that crutch to lean on. So you have to do things that are consistent with capital preservation when the market's not offering you things to do. You don’t want to chase yield when yield's not worth chasing. I would say sometimes the best trading decisions you make as an absolute-return manager are the ones you don’t, like you chose not to go into things where the risk of loss is high.

So when I look around this environment right now and the reason my positioning is so defensive it really just comes down to again what's available in the opportunity set. I would argue that right now the opportunity set is about the most constrained I have ever seen in terms of beta. And frankly, if I weren’t doing the things I am doing right now, that would be inconsistent with absolute-return principles.

If I were sitting here telling you things like, "Eric, I do understand that high yield is at the tightest levels it's really ever been, but I am going to add to it, now because I think I could squeeze maybe 5 or 10 basis points out." That’s completely inconsistent with absolute-return investing. And that’s why we chose not to do those things. For instance, I don’t like interest rates right now. I will like them at some point, and this fund could very well look like a core or core-plus bond fund at some point. But it's not going to be until I am getting paid a sufficient amount to take that type of risk on behalf of my investors. Right now is not the time.

Jacobson: Thank you so much for being with us. We really appreciate it.

Eigen: Thank you. I appreciate it, Eric.