Fixed income perspectives

Oct 1, 2018
By BlackRock

A CIO roundtable on markets in transition

The fixed income era now ending could be summed up this way: much lower rates, but much greater size and complexity. A flood of issuance in credit and emerging market debt has greatly expanded the market. New cross-currents created by historic injections of central bank liquidity—as well as by demographics, technology and regulation—have made it more complex.

Today a transition is underway, and as monetary policy normalizes and liquidity ebbs, bouts of volatility are roiling the market. The implications for all fixed income investors are significant—but not necessarily the same. Investors hold fixed income assets for a variety of reasons, from diversification to income generation, capital appreciation, liability matching and capital preservation, and they need to consider what market trends mean not just for the broad market, but for their own allocations. Getting multiple perspectives can help with this task.

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We gathered four leading BlackRock fixed income investors to review the trends from their varying vantage points:

  • Rick Rieder, Chief Investment Officer and Co-Head of Global Fixed Income
  • James Keenan, Chief Investment Officer and Global Co-Head of Credit
  • Tom Parker, Chief Investment Officer of Systematic Fixed Income
  • Peter Hayes, Chief Investment Officer and Head of the Municipal Bond Group within Global Fixed Income
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Rick Rieder

Understanding the changing liquidity regime probably matters more for investors than headline events such as how many rate hikes the Fed implements.

Rick Rieder
Cheif Investment Officer and Co-Head of Global Fixed Income

With the U.S. Fed in the lead, central banks have begun to normalize interest rates.  How are fixed income markets and investors adapting to a regime of diminishing liquidity? 

Rick Rieder: I think reduced liquidity is a major contributor to this year’s market stress points. Essentially, central banks are handing off liquidity provision to organic sources. The transition is likely to succeed, but it’s making for a more volatile market because any proactive reduction in the total global liquidity pool impacts a very broad set of economies and asset classes. When Italian bonds sold off last spring after the new populist government was formed, the spike in yields reflected reduced market liquidity as well as structural problems like Italy’s high sovereign debt load and budget difficulties. We’ve seen similar dynamics in bond selloffs in some emerging economies.

Understanding the changing liquidity regime probably matters more for investors than headline events such as how many rate hikes the Fed implements. Investors who underestimate the risks surrounding liquidity and who position too aggressively, or in too concentrated a manner, could run into trouble.

 


So how can fixed income investors make their portfolios more resilient?

RR: For building resiliency, I’ll cite the important contribution that shorter-end Treasuries can now make to a portfolio. They are offering greater cash flow per unit of risk than other fixed income assets.

While yields in the investment-grade and high-yield sectors are higher on an absolute basis, that is driven more by the rate component than by spreads. At the same time, on the Treasury curve, the 5-year/30-year spread is only at 25 bps. That means 5-year Treasuries are yielding 92% of what 30-year Treasuries are, according to Bloomberg data as of September 21, 2018. Moreover, the 5-year yield rarely exceeds the peak policy rate in a given interest-rate-hiking cycle. So if we are right in believing that policy rates will top out in the 2.75% to 3% range, then the 2.95% yield on the 5-year UST as of September 21, 2018 is reasonably attractive.

Shorter-end Treasuries aren’t the whole answer. In this evolving market environment we continue to think a barbelled portfolio makes sense, with less-risky front-end assets for carry, and some smaller notional contribution from riskier assets. That could mean selected credit or equity, and we also see value presenting itself in some parts of the emerging market debt world.

 


You said you see value emerging in some emerging market debt. What role can EMD play in a portfolio in the context of rising rates and a strengthening U.S. dollar?

RR: Emerging markets have shown considerable divergence in performance this year. This is because idiosyncratic, country-specific factors are converging with reduced levels of global liquidity, a tightening Fed, and U.S. dollar strength. So while Argentina and Turkey have seen their currency values tumble recently, the Mexican peso has been a notable outperformer, even with the headline risk surrounding trade disputes. These dynamics underscore the need for caution and detailed local knowledge when it comes to EMD investing, but opportunities can still be found.

In the long term, there are powerful demographic trends that will favor including emerging market assets in portfolios. In developed countries, aging populations probably mean lower future economic growth rates. Globally, real growth and inflation are at much lower levels today than in, say, 1995, and unlikely to return to past rates. So we think investors will need to go where the growth is to generate return. That means increasing exposures to emerging markets, where population growth is contributing to higher economic growth, as well as to businesses and products at the leading edge of technological innovation.

 


What impact will an aging population have on developed-market fixed income over time?

RR: It’s already increasing demand for bonds, and helping to prevent yields from rising more than they otherwise would. We have corporations de-risking their defined benefit plans and individuals de-risking their 401k plans and IRAs as they approach and enter retirement.

 


Technology is disrupting sectors and driving dispersion. What else is it doing? Do you see it as deflationary?

RR: I do. In fact, I think we’re in the midst of one of the greatest supply-side-driven cost revolutions of all time. We are watching cash flows shift at an extraordinary pace, with powerful deflationary forces at work on large swaths of the goods economy.

Call it the Amazon effect. In the 1990s Amazon exposed consumers to a universe of books that previously couldn’t reach a mass market, or sometimes any market at all. That redistributed market share and eroded the pricing power of bestsellers, deflating the price of all books in the process. Today premium brand value and pricing power are being eroded in virtually every consumer goods sector that has significant online penetration. And of course, the value and business models of traditional brick-and-mortar retail operations are also heavily impacted.

 


We’ve identified some themes that are likely to drive the market going forward. Greater dispersion is one theme. Is greater volatility another? What additional themes would you add to the list?  

RR: I’ll make it unanimous on the outlook for heightened volatility and I’ll come back to a theme that Peter touched on earlier, because I think it’s so significant.

This is the renewed importance of the income component of total return. In the QE era, low yields led investors to de-emphasize income and focus on the price-return component. Now the QE era is over, but many if not most investors have yet to reorient themselves. Over long periods of time, income can be extremely valuable to a portfolio, and given the higher volatility and diminished outlook for price returns in the QT world we now live in, investors should recognize this.

 


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Rick Rieder
Chief Investment Officer and Co-Head of Global Fixed Income
Rick Rieder is a member of BlackRock's Global Operating Committee and Chairman of the firm-wide BlackRock Investment Council.
James Keenan

When the U.S. eventually slows, I see mini cycles and sector-specific stress as more likely than a major 2008-style liquidity shock.

James Keenan
Chief Investment Officer and Global Co-Head of Credit

With the U.S. Fed in the lead, central banks have begun to normalize interest rates.  How are fixed income markets and investors adapting to a regime of diminishing liquidity? 

James Keenan: The shift from quantitative easing to quantitative tightening—from QE to QT—is clearly affecting different parts of the markets. I would add, however, that liquidity for the financial system as a whole remains good. Debt ownership shifted after the financial crisis from households, banks and corporations onto central bank and government balance sheets, and that lowered the risk of a systemic liquidity shock. So while some pockets of risk exist, the financial system is more balanced as the central banks begin draining liquidity from the markets.

 


The current global economic expansion is the longest on record.  Where do you think we are in the cycle, and how does a maturing cycle change the way investors should think about asset allocation? 

JK: I think global growth will continue in the near term. I don’t see the U.S. economy weakening into a possible recession until late 2019 or the beginning of 2020 at the earliest. The big question is how big a pullback we’ll experience when the U.S. eventually does slow. The eventual downturn may be relatively small and quick. I see minicycles and sector-specific stress as more likely than a major 2008-style liquidity shock, for the reasons I just noted.

Meanwhile, corporate earnings are strong. The first two quarters of this year were two of the best ever for below-investment- grade credits. Companies have strong earnings and good interest coverage, and have used easy financial conditions to push off debt maturity for several years. So while the cost of capital will fluctuate and likely rise in the year ahead, it’s hard to see a major credit default cycle in the short term.

 


So how can fixed income investors make their portfolios more resilient?

JK: We expect rising rates to cause tighter liquidity and increase dispersion, which will create opportunities to generate alpha. We recommend positioning for this shift by moving up in quality and reducing duration. This will help to mitigate against unintended, idiosyncratic risks, and interest rate uncertainty.

This positioning leads us to leveraged loans and CLOs, which offer the downside protections of floating rates and a senior position in the capital structure. We’re not the only ones interested in these assets, of course. Investor demand has been strong, spreads are tight and 2018 institutional-leveraged loan issuance—which totaled $357 billion as of September 25, according to S&P LCD—may surpass 2017’s record. But both high-yield bonds and leveraged loans have historically performed well in a climate of gradually rising rates, which we expect.

Finally, we think it’s important to pay attention to technical factors. We expect supply to be the biggest factor in second half performance. 

 


Technology is disrupting sectors and driving dispersion. What else is it doing? Do you see it as deflationary?

JK: Technology disruption is well documented by now, but we’re starting to see the second-order effect in some industries, such as Amazon opening brick and mortar stores in retail.  Companies that are in sectors with sustainable demand through the cycle, and use technology effectively, will likely be winners. And generally, one exciting part of the growth of the credit markets is the breadth of companies and subsectors you can invest in. So we can really dig deep into companies or subsectors and focus on those which are differentiating themselves. This is a chance for investors to find good alpha opportunities.

 


We’ve identified some themes that are likely to drive the market going forward. Greater dispersion is one theme. Is greater volatility another? What additional themes would you add to the list?  

JK: I think increased volatility will be a hallmark of this period of quantitative tightening. There are technical reasons—supply and demand within asset classes, liquidity—and, as Tom says, flare-ups of geopolitical risk will be a factor too. We also see investors becoming more attuned to company-specific information, and to idiosyncratic events.

Equity markets are likely to see the greatest volatility, and credit assets can still help mitigate that drawdown risk. Credit risk falls between the duration sensitivity of government bonds and the economic growth sensitivity of equities, so credit assets can potentially help investors generate income while reducing their exposure to equity drawdowns. As this late-cycle period progresses, that’s worth keeping in mind.

 


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James Keenan
Chief Investment Officer and Global Co-Head of Credit
James Keenan leads the strategy for Global Fundamental Credit and is responsible for providing oversight of the investment process and performance.
Tom Parker

Rather than abandoning spread exposures for low-yielding assets, we think investors may do better by taking advantage of late-cycle dispersion trends.

 

Tom Parker
Chief Investment Officer of Systematic Fixed Income

The current global economic expansion is the longest on record.  Where do you think we are in the cycle, and how does a maturing cycle change the way investors should think about asset allocation? 

Tom Parker:  For asset allocation, there’s no question that late-cycle investing presents challenges. The greatest mistake I have seen investors make is accepting too little return for taking on risk. The reach for yield, the power of FOMO—fear of missing out—as well as increasing adverse selection in debt underwriting and the need to put cash to work all push investors into taking on more risk as the cycle ages.

It is fascinating that the greatest levels of CCC rated bond issuance, the greatest high-yield inflows, the largest increases in corporate leverage and the highest acquisition multiples all occur late in the cycle, usually within two years prior to recession. So the irony is that fixed income investors buy bonds to get a negative correlation to equities in down markets, to diversify their portfolios, to lower their volatility and receive income. But late in the cycle, many investors focus on the income objective to the detriment of those other objectives.

At the other extreme, of course, are Treasuries, your most benign defensive instrument, with forward curves already pricing in rising rates risk. But because a recession does not appear imminent, it is too soon for investors to move into Treasuries and out of riskier investments. Investors don’t want to abandon spread exposures given that they own liabilities which aren’t diminished by a maturing cycle. So there’s the conundrum.

 


So how can fixed income investors make their portfolios more resilient?

TP: The problem is how not to be dependent on timing. To instead create a risk-return profile that pays you to wait as the expansion matures, and has a good upside profile when the cycle weakens and turns into recession.

A good way to do this is to use dispersion to your advantage, and to remember that as the cycle advances, dispersion tends to increase. At present two sources of dispersion can be especially helpful. One is record high levels of corporate leverage. It’s true that, as Jimmy says, interest coverage is generally good, but the leverage still makes companies more fragile, and helps separate winners and losers from a credit perspective. The other source of dispersion is the long-running trend of technology disruption, where you see tech-enabled disruptors increasing their productivity advantage over the laggards in sectors such as pharma, media, retail and energy.

Our systematic fixed income team uses quantitative tools to create predictive insights and devise strategies that benefit from rising levels of dispersion. We use proprietary default models in conjunction with long/short expertise, and apply risk models to separate alpha, beta and style factors. The goal is to create a defensive portfolio while minimizing unwanted exposures, such as equity beta.

 


Trade tensions continue despite progress in some areas, with disagreements between the U.S. and China the most severe. How is this impacting fixed income markets?

TP: There are two key variables I’ll be watching over the next 12 months or so: appreciation of the U.S. dollar, and the China credit impulse.

Because of the trade outlook—a combination of limited U.S. imports and rising U.S. exports—we expect a rising dollar. An overheating U.S. economy, record-low unemployment and Fed tightening could help push it higher as well. The trade risk premium has been a huge driver in equity markets, and can also be expected to cause sector rotations as well as rotations from EM into DM in fixed income if it expands.

As for China’s credit growth, it has been highly correlated with global growth in the past three years, especially within emerging market economies.  Recently, China has signaled it is restarting fiscal stimulus in response to trade tensions and slower growth. Beijing may see the need for further stimulus if the trade situation worsens, or if (in a longer timeframe) China’s aging working population begins to curb growth. But since they also want to deleverage their economy, they need to strike a delicate balance.

Interestingly, we currently see extremely risk-on positioning among quants and active managers because forward earnings in the U.S. are very high, financial conditions are loose relative to history and default rates are benign. But a stronger dollar, and the direction of credit stimulus in China, could begin to change this trajectory.

 


We’ve identified some themes that are likely to drive the market going forward. Greater dispersion is one theme. Is greater volatility another? What additional themes would you add to the list?  

TP: Yes on volatility—we do expect more of it, and investors should consider it to be inherent to late cycle dynamics. But the reasons lie more in tight valuations, crowded positioning, and geopolitical risks than in any immediate threats to macroeconomic growth. This phase of the cycle is likely to last longer than many investors expect. So rather than abandoning spread exposures for low-yielding assets, we think investors may do better by employing some of the defensive measures we’ve discussed, which take advantage of dispersion trends in late cycle environments.

 


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Tom Parker
Chief Investment Officer of Systematic Fixed Income
Tom Parker is responsible for all portfolio management and research ("alpha teams") as well as portfolio construction across the SFI platform.
Peter Hayes

Tom Parker is responsible for all portfolio management and research ("alpha teams") as well as portfolio construction across the SFI platform.

Peter Hayes
Chief Investment Officer and Head of the Municipal Bond Group within Global Fixed Income

With the U.S. Fed in the lead, central banks have begun to normalize interest rates.  How are fixed income markets and investors adapting to a regime of diminishing liquidity? 

Peter Hayes: In a climate like this it becomes even more important to understand the risks in your portfolio and how the assets you hold might react in different scenarios. Over the last decade many investors moved outside their comfort zone, taking more duration risk or credit risk than they would in a higher-yield environment. Now it’s time to consider how portfolios might behave as normalization proceeds, and what type of liquidity you require.

 


So how can fixed income investors make their portfolios more resilient?

PH:  In municipal bond portfolios, we recommend moving up in quality. We still see opportunities in lower rated credits, and lower rated IG and HY assets still have a role because income is an increasingly important part of the return equation.  But these lower-rated credits should be a smaller proportion of the portfolio, and investors need to be more selective. They should also be mindful that the price return has been harvested, and the returns will really be based on the coupon.

Hedging duration is another way to build in more resiliency. So is managing risk with a barbell curve strategy—emphasizing the short and the long end, as opposed to overweighting the belly of the curve, where negative term premium unwind will be the greatest as central banks continue to normalize monetary policy.

Investors should also be aware of one other major change. Whereas for years, market performance has been largely driven by greater demand than supply and other technical factors, underlying fundamentals will take center stage in the next downturn.  Knowing what you own is becoming essential, and understanding all of the risks associated with later-cycle issuance patterns is paramount from both a performance and liquidity standpoint.

 


What impact will an aging population have on developed-market fixed income over time?

PH: We have a particularly good window on this in U.S. municipals. Especially in high-tax states, we are seeing greater demand from individuals seeking more consistent returns. But as it turns out, the tax advantage is often just the initial draw. For older investors with less risk appetite, it is the lower volatility, consistent return profile, high credit quality and equity diversification benefits of munis that make them such a good fit in the portfolio.

 


Trade tensions continue despite progress in some areas, with disagreements between the U.S. and China the most severe. How is this impacting fixed income markets?

PH: We’re also keeping a close eye on trade policy, because it could have unintended negative impacts on local economies and certain sectors of the municipal bond market where we invest. Industries such as aircraft manufacturing could be impacted, which could be a negative drag on the economy of the State of Washington, depending on the level of tariffs imposed. Areas dependent on agriculture might see a detrimental effect as well. We are also watching certain revenue sectors like ports, particularly those on the West Coast of the U.S., which are the most reliant on trade with Asia. And regardless of where and how tariffs are directed, any negative effect on consumption could hit governments more broadly via declines in sales-tax revenues and, if the economy should slow, income taxes.

 


We’ve identified some themes that are likely to drive the market going forward. Greater dispersion is one theme. Is greater volatility another? What additional themes would you add to the list?  

PH: I don’t think there’s much question that we’ve entered a more volatile period, and I also think it’s pretty clear how investors should navigate it: remain liquid and flexible, in order to best take advantage of late-cycle market dislocations

 


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Peter Hayes
Chief Investment Officer and Head of the Municipal Bond Group within Global Fixed Income