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Western Asset: Tremendous Opportunities in High Yield

Sumit Desai, CFA

Sumit Desai: Hi, I'm Sumit Desai, fixed-income analyst for Morningstar's manager research team. Joining me today are our 2014 Fixed-Income Fund Managers of the Year, Western Asset's Ken Leech and Carl Eichstaedt.

Gentlemen, thank you for joining me today.

Carl Eichstaedt: Thank you.

Ken Leech: Thank you.

Desai: First of all, congratulations on the award. It's quite an honor. Part of the reason that your team won this award was for your performance in 2014, which was largely driven by your views on interest rates and yield-curve positioning. Can you talk a little bit about what you saw at the beginning of the year that helped you position the portfolio as it was and helped the fund outperform?

Leech: Sure, Sumit. I would say that on behalf of our entire team--we have a very team-based culture at Western--we really appreciate the award and we appreciate the vote of confidence that Morningstar has shown.

I think from our perspective, in 2014, we felt that the inflation outlook in the United States was pretty subdued. More importantly, inflation around the world was actually very subdued, perhaps in a declining trend. So, our forecast for the U.S. economy was a little less robust than the Fed's. But that, in conjunction with the low inflation outlook, led us to believe that the pessimism, the number of rate hikes that the market was expecting, was unlikely to occur. And that allowed us to take a little longer duration position. I think even more importantly, when you look at the shape of the curve, we felt that it was the short-intermediate sector of the curve that had been the biggest beneficiary of [quantitative easing] and would be the biggest loser when QE was finished. So, that in fact meant that the curve would flatten. So, the flattening curve plus the longer interest-rate exposure proved very beneficial.

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Desai: Throughout the year, you've brought duration for the portfolios--both the Core (WACSX) and Core Plus (WAPSX)--a little bit closer to your benchmark, the [Barclays U.S. Aggregate Bond Index]. So, it's maybe a little bit less of a contrarian call than you started 2014 with, or maybe that's not how you view it. But maybe you can talk a little bit about your expectations for rates and the yield curve going forward.

Leech: You're exactly right. We have brought our duration back to neutral. When we look at the U.S. government bond market, it's quite a conundrum. When you look at it from a U.S. perspective, obviously, with 10-year notes under 2%, we see no real meaningful value there. We are a value investment firm. That's how we make our decisions. So, we don't see the value in the 10-year Treasury--and certainly from a U.S. perspective, you can argue that it's even overvalued.

When you look at it against the rest of the world, though, our interest rates are much higher than, let's say, Germany, Japan, most of Europe, most of the developed countries, and the dollar is strengthening. So, from that perspective, there is a case to be made for Treasuries. From our view, therefore, we have taken a neutral stance on the Treasury market. In fact, we are actually a little underweight Treasury duration, as we speak.

With respect to the Fed, going forward this year, we think they are very desirous to end the zero-interest-rate policy. We do think they want to move rates above zero, and we think that their goal is to do that in June; but we've actually changed our firm's forecast. We now think the inflation outlook in the United States will actually be declining by the middle of the year. And subsequently, we think that they may have to wait perhaps until the end of the year.

Desai: You mentioned an underweight Treasury duration. I view one of the hallmarks of your funds as a little bit more of a credit bias rather than an interest-rate focus. Can you talk about what opportunities you're seeing within the credit markets, both investment-grade and high-yield?

Eichstaedt: Sure. From an investment-grade standpoint, we think corporate America is in very good shape. Balance sheets are clean; earnings are good. Within the corporate space, we see better value in what we call the finance sector--bank and finance. Historically, like-rated finance companies trade at a tighter spread than industrials. Today, that's the opposite. So, we have an overweight to bank and finance. Industrials may concern us a little bit more from bondholder-unfriendly activity--releveraging the balance sheet, for example. Utilities are a little bit underweight because we think they have to go through a big [capital-expenditures] program.

High-yield, we think there are some tremendous opportunities. Particularly since June, spreads have widened substantially. The high-yield index yields over 7%. The spread over Treasuries is over 500 off, and there is definitely "a tale of two worlds" within the high-yield market. The biggest subsector within high-yield is the energy component. We all know what's happened with the price of oil. So, the energy component has really underperformed. I think there are some big opportunities in there. There are some survivors in there, and some companies that may not [survive]; but if you identify those that will survive, I think there is tremendous opportunity in energy high-yield.

Desai: So, obviously, energy is a hot topic for all investors. What role will energy prices play in your macro forecast?

Leech: I think we were surprised, obviously--like many--with just the severity and the speed at which oil declined. Having said that, forecasting oil in the short run is not something in which we believe we have a comparative advantage. But we do think as we look at the oil sector--and having brought together our senior leaders on this topic--as Carl said, we think there are pockets of opportunity in the credit space.

From a macro perspective, we think it may take time for the decline in oil to actually level out and then be arrested before it increases. That would be, I guess, our modest house view. But we do think it contributes meaningfully to a very subdued inflation backdrop. We think that allows central banks to stay lower for longer. But at the same time, we also think, ultimately, even if in the short run there is some pain to be felt by those countries and companies that are dependent upon oil, it will be a tailwind for global economic growth.

Desai: So, maybe expanding on that a little bit further, you mentioned countries that are dependent on oil. And clearly, that's been an issue within the emerging-markets space. Emerging markets have doubled within the portfolio to around 8% of assets, depending on which one you're looking at--whether the Core or Core Plus. Where are you investing within emerging markets?

Leech: I think, in the emerging-markets space, one of the things that we've liked is dollar-denominated sovereign issues. We think this challenge for emerging markets is not really the kind of crisis we saw in past times. For emerging markets now, it's not really a solvency crisis. Emerging markets issuing their own currencies are in much better shape, have much better reserves. And we think that when you look at the spreads of the sovereign emerging-markets governments--especially countries like Mexico and Brazil--we think that they are very well positioned relative to the tighter spreads we've seen in investment-grade corporate bonds.

Desai: Are there any risks to that part of the portfolio?

Leech: I think you don't get to buy bonds at good prices when the news is good. You're very much on point. Obviously, the challenges of a weakening global growth outlook and lower commodity prices have put a lot of fear into the market of emerging. That's why yields are much higher relative to the U.S. government's than they have been in any time since the crisis. But that's also why we think, if we do our homework correctly, that's where the opportunity is.

Desai: Another big driver of performance for your fund--and a big portion of your assets are invested there--is mortgage-backed securities. Can you talk a little bit about that? Specifically, are those investments both in the agency and non-agency space?

Eichstaedt: Sure. Let me answer that in two ways. One would be the traditional agency-backed mortgages--Fannie, Freddie, Ginnie. We, as a firm, find them relatively uninteresting. Spreads are very tight, historically. The technicals have flipped. When the Fed was doing the QE program, we were having negative net supply. Today, [we're having] positive net supply. And with a 10-year rate at 1.75%, we do believe there is some prepayment risk within the agency market.

Now, the other side would be the non-agency market. We see great opportunities there still. In the legacy non-agency market, we see single-digit after-loss yields. The commercial mortgage market is one that we've really been focusing on more recently. You've got a much more robust commercial mortgage market in the U.S. You have much more conservative underwriting standards and much higher subordination levels. You put all of that together and we see big opportunities in [commercial mortgage-backed securities].

Desai: Gentlemen, congratulations again, and thank you for joining me today.

Leech: Thank you very much.

Eichstaedt: Thank you.