Animal Spirits Podcast - Fixed Income Investing in a Low Rate World

Episode Date: July 31, 2020

On this edition of Talk Your Book we discuss the challenges of investing in a bond market will generationally low interest rates with Marvin Loh from State Street.   Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ridholt's wealth management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions, are subject to change based on market and other conditions and factors, and do not reflect the opinion of Ridholt's wealth management, state street global markets, and or state street corporations and its affiliates. This podcast is for informational purposes only and should not be relied upon for investment decisions.

Clients of Ridholt's wealth management may maintain positions in the securities discussed in this podcast. Today we're joined by Marvin Lowe, Global Macro Strategist for State Street Global Markets. State Treat has over $450 billion in fixed income assets under management and $10 trillion in fixed income assets under custody and administration. All right, Marvin. So the first half of the year was solid. certainly a wild one by any measure in terms of the market. And not just for stocks, but also certainly for rates and for bonds. So talk about, please, what transpired and where did investors put their dollars? There's really so much that happened in the spring. I think the rates market

really was the center of the initial storm, if you will. Government bonds are often thought of as the most liquid, widely traded security in the world. And that's true. What wound up happening in early March is that that bond market was not tradable. So you had bid offer spreads, which a lot of your folks and a lot of your listeners are certainly comfortable with. And the bond market, sometimes a five basis point, if not smaller type of market, it got to percentage points. And that's when the Fed first started to step in. When the treasury market can't price itself, all other risk assets can't price themselves either. And then you had the cascading effect of really spreads blowing out in the corporate bond market, moving to the commercial paper market. There really wasn't any

market that didn't get affected by this. And it really did take the aggressive actions from the Fed to kind of calm things down so we could start getting to pricing risk again. After we started pricing risk from the perspective of actually having a hedge that worked, and that was the Treasury market, then we really started to address what the fallout from the pandemic would be. And I think that that's when the second round of Fed programs started coming in, when they started zeroing in on various asset classes and saying that they would help backstop those markets. I think one of the craziest charts of the year, you look at corporate credit and you saw like a 20% downturn in March for corporate bonds and high quality in some cases. So Michael and I have been going back and forth on this. How much of what you think the Fed did was psychological and how much was it important to just keeping things moving?

Like, how important was that? Because obviously, again, people pay more attention to the stocks and bonds. But getting those credit markets freed up from the Fed really had a lot to do with what's happened since. Did we jokingly call the Fed a placebo? Marvin, what's your take on that? It certainly brought some calm to a market. When there's no one there to make a market, which is parts of the period that we were dealing with, if you will, looking for bids and no one there to step up, kind of having the Fed there certainly helped.

So the backstop was important to getting the markets unglued. We were able to go from there to a place where risk could wind up pricing itself. Issuance could, for the most part, occur again, which wasn't occurring in the new issue. market, particularly on the corporate side of things, and then their commitment wound up being more like the placebo. It wound up being more like the backstop. The market takes comfort that it's there. It might be needed again. We don't know what the economic outlook, how it's going to evolve. But certainly for the moment, the placebo comment is appropriate. I mean, obviously this is only speculation. The market would have healed eventually, but what would

have happened in the interim between how much more carnage could there have been if the Fed didn't step in and do something? There's so much going on when you think about. not only the markets, but economy shutting down, everyone trying to figure out if their work from home computers could actually deal with the volume. It was something where the financial system could potentially have gone into an area that would have taken a long time to repair. So I'm not necessarily a fan of completely administrative markets, which is the environment that we have here as well as really for the most part in the rest of the developed world. But needing to calm things down and have that backstop was important when we kind of think about.

that March, early April kind of period. How much has it surprised you that the Fed not only stepped in and is buying individual corporate bonds, but that they stepped in and said that they would buy these high yield ETFs or different ETFs? Does that shock you at all or just because of the nature of this beast? That's just sort of what the Fed decided they had to do. It's easy to second guess. It's certainly easy to play a weekend quarterback while all this is going on out there.

I think the problem that the investors had was that it was very difficult to get to a rational conclusion as to how to price cash flows. and how to get a sense of what companies were going to make it or not make it, because we effectively were shutting down all companies. The Fed went to the high-yield market because ultimately it felt that there were enough companies that were in that space that unless they provided a little bit of comfort that there was somebody that was going to help that out, we weren't going to be able to unglue the situation that we were in.

So the Fed's meeting this week. What do we expect to happen as a result of their meeting? Do you think that there's any risk that they'll try and pull back on the liquidity? which sounds crazy, but I guess we'll see, that they'll pull back on the liquidity, pull back on the stimulus based on the recovery that we've seen in the stock market. Is that possible? I don't think so. They've spent so much time, so much money to get us to this point.

Ultimately, I think that their messaging has been fairly consistent, that they are concerned with how the virus is going to continue to impact the economy, how difficult it is to really model and get a sense of how social interaction is going to happen. And picking winners and losers at this point seems like it's something that they're not willing to do. Now, the hard thing to think that ultimately all of us as investors try to get a handle on is what's expected from the Fed in terms of additional stimulus. And my thought is that this meeting is not the meeting where they're going to aggressively go back and announce additional programs. I think they want to get a sense of what these increased virus cases are going to look like in terms of economic activity. But they're going to try to convince us that they stand ready to do what's necessary with actually doing.

Not a whole lot this meeting. So Michael and I have been talking a lot about the fact that, obviously, the rescue packages from the fiscal stimulus have been huge. We're approaching these debt-to-GDP levels not seen since World War II. Are rising interest rates and inflation a big risk from this? And why haven't rates started to price some of this in yet? And they've continued to fall. I do think that there is a risk to it.

And I think the markets themselves, the rates markets have been pricing them to a certain degree, not necessarily from the overall inflation rate. If we're all looking at the 10-year, kind of, again, going back below 60 basis points. But when you kind of look at how break-evens are, which is that inflation protection, that's wildly negative at this point. Depending on what part of the curve you're looking at, it's the most negative that it's ever been. So there is a part of the investor world that saying, I want protection for that inflation. And to a certain degree, that negative yield is representing that. Now, why overall yields have an increase, one, there's in demand for safe haven still.

Like we were talking about the very beginning of this conversation, the treasury market is the largest, most liquid asset market in the world. And to get protection from that is quite easy by going into the treasury market. So there's a demand for that. But also the Fed is saying, we're not going to let rates go up, which from a longer term perspective makes that tips yield even more in demand, if you will, because if they're not going to take their foot off the pedal and they have a policy mistake, inflation is one of those policy mistakes that can come out there.

Demand at this point is one where we're certainly recovering. Inflation numbers are still sub 1% from a CPI perspective. So it's not as if there's a concern right now about it. But when you've got these really zero interest rates for the foreseeable future, Fed says they're not going to increase rates until 2022. They're all in agreement of that. The swaps markets are actually saying it's much longer than that. There is the potential that they have a policy mistake. And demand increases a bit better. The recovery is earlier than they think. And then all of a sudden, they've got an inflation problem. So let's stick with the size of the market. There was a station report recently, quote, the U.S. Treasury issued a record $2.7 trillion in net new debt during the second quarter,

bringing total outstanding debt in the U.S. to $26.5 trillion. I thought this part was interesting. Most of that issuance was initially focused on the short end with T-bills making up 88% of total new issuance, end quote. All right. So the question is, what sort of effect does all of this supply have on the market? And who is the biggest buyer of our debt? Fortunately for the U.S. Treasury, it hasn't had that much of an effect at this point yet. We've had a little bit of a steepening of the curve. Long yields have increased a little bit more than the short end. But really, demand for those bills has been pretty strong. As we see the fact that they issued this $2.7 trillion, which is just such a massive number to try to get

your head around. Money market funds are a big buyer of those bills in that market. We see the record issuance of debt from the corporate sector. A lot of companies, corporate America, if you will, they've been borrowing a lot of money and they've been putting it into these money market funds because they just want to have rainy day assets. So that's how they've cleared and that's why the Fed has focused on the short end of the curve because it's one where there's been a lot of demand for it. Now, longer term, that's not necessarily the best way for the Treasury to kind of manage its portfolio, if you will. They have to come back to market depending on the distribution within the bills every three months, every six months, every year,

year rates could rise. What they're going to try to do over the short and intermediate term is get more of those bills into the coupon space. So they'll slow down the bill issuance and they'll issue more bills. And that has the potential. That market winds up being a little less kind of short term in demand, if you will. So you can see longer term yields rise a bit. The Fed's going to watch how quickly it rises. They might need to or might decide that they want to buy more of those longer coupon bonds to kind of help treasury clear that issue. But at this point, kind of thinking about a potential steepening of the curve as a result of all this issue into something that we spend a lot of time on. You just spoke about the shape of the curve.

Any thoughts on the inversion and the recession? I mean, obviously the pandemic choked us and threw us into recession. Do you think that the inverted yield curve would have brought us into a recession regardless had COVID-19 not happened? You know, we wanted. We wanted to up being proven correct again, right? It winds up being one of those economic indicators. With an asterisk. An asterisk, right? Yeah, yeah, yeah. Honestly, I mean, I doubt the inverted curve can predict pandemics, but history is going to show that once again got it right. I wasn't in the camp that thought it was going to be a recession, to be honest with you. Again, certainly how quickly things change shows the market fragility that existed, and I think that's why that signal was out there. But we'll chalk up

that converted curve is once again being one of the best indicators to problems ahead. That World War II scenario has me fascinated because right after it happened and we had all this government spending, inflation did take off. And I think it got as high as 19% year or year in like 1946, 1947. But the crazy thing to me was interest rates essentially remained flat. Ten year treasury didn't move at all. So my question is, let's say we get out of this and inflation I think would actually be a good thing. Does the Fed have the ability to keep interest rates capped, if they want to, could they keep interest rates lower to keep those borrowing costs down, even if we have inflation? Is that possible? No, I mean, the Fed is kind of this

all-encompassing powerful organization out there. But if you have inflation that's being driven by demand, I guess it depends what type inflation it is. If it's like a supply shop because of oil and energy and something like that, they certainly can come in massage asset markets. You know, I hope that they don't go down that route per se. But if you have good inflation that's driven by demand, it's going to be hard for them to do anything other than really take a step back and think about what they're mandated and price stability is one of those mandates. And it winds up being an extreme case, if you will, when you think about kind of what we think inflation looks like for the next couple of years, but it's a possibility.

And it's something where rate hikes might be in the cards at some point earlier than the market expects. And I think that your positioning portfolios for that potentially, you need to really think about what that scenario looks like. So we've got rates at all-time lows. The 10-year start of the year at 1.92%. Now there are less than 60 basis points as of this recording. A broad index of bonds, obviously, are not going to generate income these days for investors. So what are some sensible alternatives? In other words, waste to generate yield without going all the way out on the risk spectrum, MLPs, junk bonds, etc. And before you answer that, my two cents on this has been, listen, unfortunately, this is the world we live in. We live in a world of very low rates. You can, can't manufacture income where it doesn't exist, what would you say? That's absolutely correct. I remember listening to one of your prior podcasts where you and Ben, we're kind of going back as to whether or not we're just observers in this and need to operate within what the Fed gives us.

And to a certain degree, we are. Yields are going to remain low for the foreseeable future. And even as we kind of see this recovery, if you will, this quote unquote recovery, where data has been better than expected, we've still got these 10-year yields that are now approaching the lows that we saw this past March. I think by definition, We're needing to relook what our comfort level is from a risk perspective. We are going to be pushed into additional risk if we want to generate income. There's ultimately no way around it. There's no such thing as a free lunch when it comes to that.

We do know the Fed is buying high yields. That's something that I think we need to consider as part of our investment thesis of incomes an important aspect of it. Like all kind of portfolio construction questions, it's like what's your end goal? There are ways to generate capital gains also from the fixed income market. When you kind of look at your risk-adjusted returns from the fixed income market, they've in a lot of ways beaten a lot of other asset classes that get a lot more attention. But emerging markets are another interesting way of going at it.

It's not an area that we normally think about, particularly for an average investor, if you will, but kind of having said that these are not average times, they are extraordinary times, and we need to kind of look at where those yield advantages exist around the world and across different asset classes. But off the top of my head, really, EM and high yield are two of the most. more broadly traded asset classes that do offer a little bit of incremental income, given that we're looking at a 10-year yield, like you said, below 60 basis points. So this was interesting that we found. So there's been more than 2,000 corporate bond downgrades this year.

A bunch of these companies have lost their investment grade status. So there was a study from Cass Business School that they said, on average, these fallen angels, they're called. Once they get that initial credit downgrade, they see some losses. But then that recovery period is like 23 days afterwards where they make it back. So what is the difference between this type of strategy where you're looking to catch these fallen angels, or I guess some people might say falling knives, versus just straight up sticking into high yield, something like that? I hadn't seen that study. It does make a bit of sense to me because there's just so much indexing moving around at this point in time.

And IG index can't hold that fallen angel, or particularly if it's downgraded by both agencies. And then once it gets into high yield, there are other people that can buy it outside of high yield, if you will, maybe some of the more multi-asset class crossover type buyers. So that makes sense to me to a certain degree. You still wind up in a lot of ways with income, if you will, if we kind of go back to the income discussion that that bond offers. If you're more total return and you're looking for that capital gain, there's certainly ways of doing that. A fallen angel, not necessarily always,

but a lot of fallen angels, they become the strongest within the high yield universe because they're downgraded from a triple B minus into this kind of double B category. From that perspective, if you want to and you feel comfortable picking those individual bonds, that's going to screen as one of the stronger high-yield bonds within kind of that rating category. The caveat is make sure you understand the story as to how it got there and whether or not this is an intermediate step to potentially further downgrades. Because once you get into the single B and double and triple C part of the high-yield curve,

it certainly becomes more of a serious credit consideration for you. Ben, are you still holding your WeWork bonds? Does that consider a fallen angel? I don't think they were adverse investment grade status. So yields have been relatively stable. I mean, obviously, they're incredibly low and going lower, but not all over the place. Tips, on the other hand, fall to all-time low pretty aggressively, depending on the maturity that you're looking at.

What, if anything, does this tell us about the economy and what investors are thinking about for the inflation outlook? And by the way, we're recording this on Monday where gold is up 2%, dollar is falling mightily. So what do you think about that? This is a multi-asset class world that we're all living in trying to figure out these correlations is always a challenge. Tips themselves are possibly one of the most interesting from an academic perspective, but one of the most confusing from market perspective because it is the real yield. It's the yield that we're demanding as an investor above and beyond kind of that break-even

yield. And the break-even yield represents current inflation. Now, we've got these tips yields that are negative. So we're willing to theoretically take a loss on that money in order to get that inflation protection. Can you just explain what that means, please? When we kind of look at Treasury yields, there are two components to it. One is what we call the nominee yields. That's going to be the percentage that everybody looks at. When we close the market today, if 10-year yields are below 60 basis points, that's what people are going to say, that 10-year yields were 58 basis points. There are actually two components to that. One is the inflation part of things. So that's considered the break-even. That's going to be the average inflation rate that the market

implies for the two, five, 10-year period, whatever type of bond you're looking at. And the difference between that break-even and that nominal yield is the tips yield. Break-evens are applied from tips. Tips are purchased as a way to either express the belief that inflation is going to be above and or below what that break-even number is. So when break-evens are falling as much as they are, there's this kind of implicit understanding that either yields are going to break out of the range because there's going to be a problem selling bonds that potentially could also be represented in that real yield. But more often, it's a view that inflation is going to exceed what that break-even yield is ultimately implying. And again, we're looking at a world where inflation's

not necessarily a concern, but the way a lot of us are readjusting the pandemic, a lot of things may change. Supply chains may change. Inflation certainly might not follow the path that we saw during the financial crisis. And not only are we having massive monetary stimulus, we're having massive fiscal stimulus. So certainly the biggest discussion in the market right now is the next round of potential fiscal stimulus. All that coming together creates an environment where the inflation outlook becomes a little bit cloudy.

So that real yield is either saying, to me at least, two of the main things is that potentially in the short term, the Fed's going to, and the fiscal authorities are going to need to keep their gas on the pedal. And that creates greater risk when it comes on the inflation side of the discussion longer term. Those are the two biggest words we hear from people. A lot of people say, well, inflation is surely coming. And the other one is, well, yields are so low. So the question we get from a lot of people is, why would I own bonds in the first place right now?

Why not just have my money parked in cash and wait for maybe a potentially higher yield? What do you say to people who just don't want to invest in bonds these days because they think they're too risky? I guess I would first question them as to what risk do they see. I think there's a risk in staying in an asset like cash potentially that earns you nothing. It certainly gives you dry powder if you want to ultimately go and deploy it into risk your assets because you feel more comfortable. You know, that's one of the reasons you're doing it. But if you do need income, a lot of us do.

Me kind of getting towards more of retirement age needs to kind of start thinking about it from that perspective. Earning something when I don't think that yields are going to rise, particularly in the intermediate term, at least gives me some of that income, if you will. And then there's a lot of the other alternatives that we kind of talked about, whether it's emerging market debt or high-yield debt that kind of offers you some incremental returns. And then if you're looking for total returns, the total return on fixed income from a risk-adjusted perspective has been one of the strongest performing over the last several years at least.

All right, Marvin, last question. So you spoke briefly at other parts of the world in terms of their bond markets. So what do bond markets in the rest of the world look like, both developed and emerging compared to ours? And I guess I should say with the caveat, Assuming a U.S. investors' perspective when you're hedging the currency back. It's a tough world for fixed income investors right now. Great. It's never easy. I guess that's why you get paid to kind of go through a lot of this analysis.

As meager as U.S. yields are within the developed world, the Germans, if you will, the France's, even Canada and the U.K., their yields are lower than where the U.S. investors looking at. German yields, I kind of looked before we started talking, are pretty much negative across the entire term structure for them. So you buy a 30-year German bond and you still have ultimately a negative yield. When we kind of go into the emerging markets, it's a bit better. But even there, all of the central banks in the world have been very aggressive in cutting rates.

So your, let's say, better positioned emerging market, one that has positive balance of payments type of environment, their yields are somewhere three to four percent, if you will. Incredible. Yeah. And then you need to, for those that are really risk tolerant, there are names like Mexico, which are. in the 5 to 6% range, certainly South Africa has a lot of well-publicized concerns. That gets you closer to the 9%. But again, like everything else in life, you get what you pay for. So there's a lot of risk associated with that.

Those are the local currency bonds. So they will fluctuate with the currency aspects of it. Hedging certainly takes some of that currency risk out, but there's a cost of that hedging also. So it's all part of that balance. The one thing that I would say is that expectations are not that yields are going to rise significantly any time soon. So really thinking about how you need to generate income over the intermediate to potentially longer term is something you need to do now.

Marvin, you've been in this business for a while. Did you ever think that, I think you said this, risky government bonds, something along those lines would be yielding 5 to 6 percent. Does that blow your mind? It really does. It's an unfortunate state of the world that we find ourselves in, but it is the state of the world that we find ourselves in. And we're required to just figure out how to navigate this and get through it. You got to play the field as it lies, like that guy says to shoot him at Gavin and happy Gilmar. Exactly. Love that movie.

All right, this is great. Marvin, thank you so much. Thank you to State Street, Animal Spiritspot at gmail.com, and we'll see you next time.