Credit’s place in the portfolio

Mark McCombe:  Thanks, Carly.  And hello, everyone.  Mark McCombe here.  Well, we’re now going to turn our attention to perhaps the most important part of this credit forum, which is really looking at credit’s role in a portfolio.  This is really going to be divided into two sessions.  To start with, I'm really pleased to have the opportunity to talk to four of our most important clients at the firm who are real experts on credit and the role credit plays in the portfolio.  Then, a little bit later on we’ll turn to some of BlackRock’s portfolio managers, just to get a bit of a perspective from them across public and private markets and how they’re navigating these unprecedented times.

So, I'm really pleased to be joined, as I say, by four incredible investors who come from a different range of backgrounds.  And I'd like to just introduce them now briefly.  First of all, we have Sandra Lao.  She’s executive vice president of fixed income at AIMCo.  We also have Tod Nasser, who’s senior vice president of investment management at Pacific Life.  We also have Mads Skaaning all the way from Denmark.  He’s the head of fixed income at PKA.  And then finally, we have Jim Wiviott, who’s senior managing director and head of asset management at Brighthouse Financial, Incorporated.

So, what I'd like to do is start with you, Sandra, and just first of all say thank you for joining us today.  We’re going to do this in quite a fast pace, because we’ve got a lot to cover and we’ve got some great panelists.  So, I want to kick you off with turning the clock back I guess seven months now to when the pandemic kicked off and, obviously, markets are very dislocated.  Could you just give us your perception of how you felt about credit going into this crisis?

Sandra Lao:  Yeah.  Thanks, Mark.  And thanks for having me.  And actually, I would say when we go into this pandemic and even before we going into 2020, the last couple years that we look at the credit market in general, public or credit, we have been pretty mindful when we going into the market, partly because of the late cycle we are in in the credit market.  So as such, when we going into 2020 with or without the COVID situation, we have been pretty defensive in our allocation of public and credit market. 

We have been pretty light and keep our dry powder in the private credit allocation.  When we are even allocating to private credit, we tend to move up in the capital structure, focus on short-term financing, stay away from cuff light situation.  And on the public side, it’s the same theme and we have been more focused on shorter maturity, high quality credit, prudent use of derivatives and to tail hedge our portfolio, and sometimes even maybe using some of the leverage to enhance yield.  So, I would say going in we positioned ourself pretty well, because we have been pretty defensive going in how we structured the portfolio.

Mark McCombe:  So, Jim, I'd like to hear how Brighthouse was positioned going into this crisis from a credit perspective and then how you’ve navigated the changing dynamic that we’ve seen over the past few months.

James Wiviott:  Yeah, great, Mark.  Thank you.  It’s good to be here.  Yeah.  I would start by just saying that, you know, our portfolio has generally been I would say probably have a little bit lower allocation to credit versus most of our industry peers.  And we’ve done that really because I think we don’t want to have too much exposure to corporate credit per se.  And we’ve, you know, invested across some other sectors to offset that.

You know, having said that, we really, I would say, became a little bit more nervous about credit during the second half of 2019 and what drove that was that we became more nervous about the US economy.  We obviously didn’t foresee a pandemic, but we did start seeing some cracks in the economy, which made us a little bit nervous.  And, on top of that, we really did not feel that we were getting paid for the risk across credit given how tight spreads were.

So, as a result of that, we actually did de-risk somewhat really across our credit portfolios.  We reduced some of our BBB risk, as well as some of our below investment grade risk to just better position the portfolio along our views on the economy.  I would say that, you know, our portfolio has performed pretty well so far and, you know, we’ve really been spending our time thinking about the risks that are in the market and really working with our managers to, you know, stress our portfolio and make sure that we really have a good feel, you know, for where the problems might be in our portfolio and make sure that we’re managing those risks appropriately.

Mark McCombe:  Well, Mads, I'd love to hear your perspective on that same point from a European perspective.

Mads Skaaning:  Yeah, sure.  Yes.  Thank you for having me here.  I would generally say that we came into the crisis sort of neutral.  PKA over the past years, we have had discussion about sort of some of the frothiness that may have been building up in particular in public markets.  I wouldn’t say that we foresaw what could happen with the pandemic. 

So, we came into the – to sort of that crisis period sort of neutrally weighted.  And I think it’s probably important to say that the way that we construct our portfolios is with a long-term view and our portfolios consists of both public and private markets.  And it’s clear that the private markets are clearly very difficult to trade in.  The public ones may be easier, at least in some areas of the market.  And I would comment that, you know, our portfolios, when I talk about public, I have to also include leveraged loans.  And I think that is, you know, an area where we have another – there was loans, but the public side an area where investment grade exposures has been zero on the public side for long actually. 

On the high yield side, we have these neutral allocations.  I will say that that is, you know, based on our approach that the yield that were available in those asset classes were decent.  You know, being a European investor where we have had sub-zero interest rates for a very long time, it has been hard to find areas where there was actually a yield to be had.  So, we had, you know, had some good exposures I would say going into the crisis. 

Mark McCombe:  Tod, if I can turn to you, just maybe a slight variance on that question.  There was a lot of questions around liquidity and yield and able to generate the returns and so forth.  So, similar question but just through the lens of an insurer.  How did you go into this crisis?

Tod Nasser:  Well, at Pacific Life we consider ourselves a credit shop.  We think BBB corporate credit is, you know, risk versus return versus capital versus expense is just the best relative deal in the market.  So, for the last 15-20 years that’s been our bet.  So, if you look at our portfolio, we don’t have a lot of treasuries, we don’t have a lot of high yield.  We’re sort of pushing toward that BBB segment and we always like to stress test ourselves and sort of see what kind of losses, downgrades, deterioration we could see, and I think we like the sectors we’re in.

And so, we’re – we were probably more aggressive going in.  As we got to the end of 2019, you know, Treasury rates were low, spreads were tight.  It was probably you could see a time that there was going to be a lot of pressure to move out on the credit curve, start looking at sketchier names.  But we never really got there.  So, by the time, you know, January hit we were probably where we wanted to be.  And then, you know, we all had to do a refresh come the middle of March.

Mark McCombe:  Well, Tod, let me stay with you.  Could you give us a little bit of perspective of like, you know, what have been your observations over the crisis and particularly maybe with a view to if you could talk a little bit about where you saw opportunity and then maybe based on the Fed stimulus and what started happening to spreads, like how you then sort of repositioned and repivoted as you thought about credit in the portfolio.

Tod Nasser:  Sure.  Well, like I said, coming into the year with a lot of cash, you know, insurance products were selling pretty strong first quarter.  When the market dislocated, call it the – toward the end of March, it was perfect, you know, best of all worlds for a BBB buyer.  You know, the market was seizing up a little bit.  A lot of issuers just learning from what they saw in 2008-2009 were coming to the market trying to grab liquidity.  And, again, that’s what an insurance company should be doing, giving solid credits liquidity when they need it and, you know, we saw very solid names come to the market at spreads and yield levels that we hadn't seen since 2009-2010.  So, it was a good time.

With the Fed coming in, they seemed like a competitor for us, right.  They wanted to make sure people had liquidity and we wanted to be that liquidity.  So, to the extent that they were convincing the market that no solvent company was going to sort of fall into hard times because of their inability to get liquidity, the game changed very rapidly.  Spreads started to come in.  We were very happy with everything we bought.  But then, we got back into the position we were late in the year in 2019, low treasuries, spreads tightening in, all-time low absolute rates, and just fighting for every basis point again.

Mark McCombe:  Jim, we’ve obviously heard from another US insurer.  Do you have any perspectives there that you’d like to add on that point?

James Wiviott:  You know, I think it’s probably saying the obvious that low interest rates are not generally good for life insurance companies and we certainly know we’re going to be and the Fed has said that we’re going to be in this low interest rate environment probably for a fairly long time.  You know, I would say, having said that, that overall low rates don’t really impact how we think about asset allocation.  We have a well-defined process in terms of how we think about allocating across different asset classes and the goal of that process is really to make sure that we are investing in sectors that we think offer us the best risk adjusted returns. 

And so, while yields are certainly coming down, you know, the goal for us is to really try to find the best places where we think value and risk line up well.  And I would say that, you know, we, we’ve been a big proponent of investing in private securities and that’s still, I think, an opportunity for us.  We think we get, because of, you know, structural enhancements there, we think private assets have a better risk adjusted return than public.  So that’s – that I would say has been a focus for us, especially as we move into what will probably be a prolonged low rate environment.

Mark McCombe:  So, Sandra, I could turn to you just picking up on Tod’s point.  As you think about, you know, your own asset allocation and how you think about the role credit’s played in that, take us a little bit through the journey you went on from sort of dislocation and opportunity through to where you are today.

Sandra Lao:  I would argue that the correction in the market, in the credit market itself with or without COVID is long overdue because of the late cycle of the credit market.  So, as the market turned in March and I would say as the silver lining for some of the investor is actually like Tod mentioned is it’s a lot of high quality of asset is trading at deep discount, deep intrinsic value that is – create a lot of good buying opportunity. 

So, with our position of ourself, it’s the very best timing to switch the gear from defensive into deployment.  This is exactly what we did during March.  And indeed, I would argue like the strategy is without looking too far.  It’s just go back to the basic, basic as the secondary public and private credit, senior secured high quality.  Just because of a deep trading and intrinsic value, this is a good value to pick up.

And over the long-term, it’s true that the public credit market particular has recover a lot since then.  But, I personally feel like there’s still a lot of lagging sector that the price hasn’t pick up yet, especially in the private credit market.  So, as the market continues to evolve and correct over a medium and long-term, I think there will be still a lot of interesting opportunity in the private credit market and we are now ready to deploy more into that strategy and going into more forward-looking.

Mark McCombe:  Sandra, I'd love to stay with you and push you a little bit on something you said, which is from defensive to deployment.  You’ve also, you know, really amplified for us this difference between the public markets and the private markets and where opportunity may lay.  So, let me put you a little bit on the spot here and say as you look forward and you think about that distinction and diversification between publics and privates, do you think that continues or actually do you think that we’ve got some more trouble ahead of us that may actually see public opportunities also emerging?

Sandra Lao:  Well, I think going forward given the price recovery which happened first in the public market, the opportunity, definitely it’s more happening going forward in the private credit market.  And especially in the private credit market, like we are nowhere like out of the woods yet.  I think there are still a lot of sectors, still a lot of company in different stage of stress.  There are also – we are – will be in a longer than normal default cycle because of the government, the central bank basically prolonged the cycle.

So, I think we will be in a longer default cycle and this – and given there are still some lagging price recovery in private credit market, I think there are still a lot of interesting opportunity, such as distressed opportunity, maybe a different type of underlying exposure or sectors exposure that private credit market will present a good value going longer-term.  But the bottom line is do the homework with discipline on the rating standard and that’s really the key going into this market.

Mark McCombe:  Excellent.  Thank you so much for that.  Mads, maybe turning to you, I'd love to hear some perspective from you on the private credit space. 

Mads Skaaning:  Yeah, sure.  I would say that to us, you know, private credits are a lot of different things.  So, we could touch upon, you know, a range of different things, you know.  So, the easiest comparable I guess to high yield and leveraged loans is historic lending or, you know, lending to mid-market companies.  I think that has been sort of an ongoing rotation in our portfolio out of sort of some of the more liquid parts of that area and into sort of private credit.  And I think that that is something that would, you know, continue.

And I would echo what we just heard that, you know, it’s about finding your best risk adjusted returns.  And I think we have had a preference for actually European direct lending up until now.  But we are also evaluating US opportunities.  But, it feels like the European market has been sort of later to the game than the US one, i.e. we have felt that the structures that we were looking at in Europe may have, you know, slightly better protections in – than what we could find on the US side.  That's also taking into account, you know, being, you know, a European investors or investor.

Then I would say to your question specifically on distressed, again, I would, you know, say previously that we didn’t see the pandemic coming.  That's for sure.  But we could see that there were changes going on, you know, in the way public credit was underwritten.  And I think for that reason we actually went to our board more than a year ago to ask for a risk limit to do these more distressed or special situations types opportunities. 

What we then spent a lot of time on last year was actually to establish relationships in that space to have the capital available when and if the opportunity would arise.  And that was what happened.  But what we also saw, which I think everybody’s aware of, that the market snapped back quite quickly. 

The way that we approached that and where I still believe that there may be, you know, opportunities down the line was that we were actually focused on the smaller end of the market.  So, we didn’t saw necessarily a very large opportunity around the leveraged loan markets per se, just due to the lack of covenants, for instance.  So, how do you actually get access to those risks? 

But, on the other hand, if you went for smaller companies, they may be, you know, more simple line companies and there may be, you know, covenants in their debt packages that could be tripped.  So, we positioned us actually to focus on that area and then we also focused on, you know, opportunities where there were more hard assets behind the companies.

Mark McCombe:  Tod, maybe I can turn to you.  I mean capital efficiency is kind of the name of the game when it comes to the insurance sector.  And yet, you’re obviously extremely sensitive to regulatory moves and downgrades and so forth.  Can you give us a little bit of a perspective from your seat at how you’ve navigated that over the past six months? 

Tod Nassers :  Yeah.  I think when I look at the credit markets in general, my thought was, you know, you go back to the conversation we had about the Fed.  The Fed is I think leaning more into making sure that people understand they’re supporting invest – the investment grade market and even more so the public companies.  So, where we think we see value today is where the Fed isn’t playing. 

So, you know, private markets, US private placements where there are companies that aren’t quite for one reason or another right in the Fed’s crosshairs, they need to come to the private markets, the insurance companies.  And again, within US privates we’re seeing more competition on outside the insurance industry, but we see really that’s been a change since the Fed has come back in the market.

So, early on public companies wanted money.  We were there shifting into the, you know, the public markets, large issuances, very easy to load up on opportunities.  The Fed comes in.  Those opportunities go away.  And now, we have to block and tackle in the private markets, which again getting bonds is work.  It’s just knowing where you want to be, getting into deals early, trying to do everything you can to stay relevant with the issuers and working with, you know, third parties, alternative sourcing modes. 

Again, BlackRock has been doing a great job at serving that – the insurance industry, knowing what our needs are, understanding the capital rules that we face.  And so, it’s been easy to work with somebody like BlackRock, who already speaks our language.  We know what we want to buy.  We buy what we can get and fill out the other opportunities with good third parties who understand what we’re trying to do and can help us get there.

Mark McCombe:  Well, Tod, thank you for that.  It’s – I don’t think we prompted you on that, but I really appreciate that shout out for the team.  Mads, if I could turn to you to talk a little bit about 2021.  Give us a bit of perspective on how you’re thinking about the world that we’re going to be living in next year and how that’s going to impact credit markets.

Mads Skaaning:  I would say sort of the biggest challenge I have personally at the moment is basically the big question are we sort of still, if you will, in the sort of on the late cycle of the credit market or have we actually gone to the other side and we start thinking about is that a sort of new period here, is that we’re going into sort of the early cycle of a new credit cycle.  And I think that is where, you know, the conclusion on that question is probably what’s unique to have right in terms of your positioning, because clearly if you are in the situation where we are in, you know, early cycle, you can probably be slightly more aggressive, you know, in your positioning as opposed to if you still believe that you are late cycle you may want to be more defensive or you want to be, you know, allocate more resources to your distressed allocations, for instance.

But one thing I think is a challenge to us and which came clear again during the pandemic was that most of our cash mandates were sort of there wasn’t the liquidity that we would like them to have.  So, I think another challenge that we are facing is going into a crisis, you know, how different is it to have, you know, public and private assets when it comes to it.  So, I think that is, you know, two big questions that we’re asking ourselves at the moment.

Mark McCombe:  Jim, turning to you, we’re obviously about to enter a very turbulent political period in the United States.  As you think about your long-term strategic asset allocation, how do you think about that from your broader insurance exposures and then particularly with an eye on credit?  Does it change your long-term view or it’s just something we have to get through?

James Wiviott:  Yeah.  I think it’s a great question.  I mean, I think, you know, elections can be tricky in terms of investing to elections.  I mean obviously there’s a lot of unknowns about who’s going to win and who’s going to control Congress.  But I think at a high level, you know, what we’ve really been trying to start thinking about is some longer-term trends that might impact markets and one of those is kind of politics and geopolitics. 

You know, we're thinking what’s going on in this country related to things like income inequality, various potential policy actions around things like climate change and how that might impact various industry sectors.  And so, this is something that we’re honestly thinking about as we speak.  We're working with our managers to understand how some of these things might impact markets going forward.  And, you know, we don’t specifically put that kind of into a strategic asset allocation.  But, you know, as we think about where we want to be taking risks, we’re trying to – you know, we’re calling these things disrupters and we’re looking at a number of them to really think through how those are going to impact credit overall and how we might want to be changing how we're investing our money.

And, you know, I would expect over, you know, the next several months we’re going to start formulating some views about how some of these things are going to impact.  And certainly, we’re going to know who wins the election and we’ll certainly think about how that might impact things like energy companies, healthcare, you know, I would say other sectors that are, you know, in the news around what politicians might be thinking and we'll start overlaying that into how we’re thinking about investing our assets.

Mark McCombe:  I guess, Sandra, I'd like to ask you just a final question.  What do you need going forward as you think about the – navigating the complexity of the credit markets? 

Sandra Lao:  I think as the market evolves and what I will – I would say is as a general theme at a higher level, out of every cycle, out of every crisis like what we’re experiencing right now, one thing that will consistently happen is more forming the shape of inefficiency in different market.  And I would say as we get out of this cycle of this COVID crisis there will be some inefficiency developing in some markets, such as the private credit market, due to supply and demand technicality difference, regulatory change, balance sheet constraint, and so on and so forth.  So, this time is no different. 

I strongly believe that there will be more new opportunity will evolve in service in private credit market.  So, what we need probably is having a strong partnership to be on top of the market and assist and help us to stay on top of the market, because quite frankly as the market getting more inefficient or efficiency over time, being first in the market, identify the first opportunity is the key to be success to identifies the first opportunity.  So, I think we are relying heavily on the experience and the team and the strong partnership to help us to identify this opportunity together alongside with us.

Mark McCombe:  This is such a fascinating topic and we could talk all day about the role credit plays in people’s portfolios.  And I just want to thank our four guests for taking the time to come and talk to us today.  Mads, Jim, Sandra, Tod, thank you for giving up the time.  I know it’s valuable.  But you really have provided some incredible insight into how you think about credit and just the shifting dynamic of this particular asset class.

I'm excited now to turn the attention to some of our portfolio managers and really looking forward to amplifying some of the insights that you’ve brought.  So, thank you again.

ALTSH0920U-1339066

Mark McCombe: Well, that was a great conversation.  So, thank you to all our guests for that.  We’re going to flip now to the second part of our conversation and bring in three of BlackRock’s experts in the credit space.  I'm really pleased to be joined by James Turner out of European Leveraged Finance, who obviously has investment strategies across European high yield, long/short credit, CLOs, and leveraged loans.  We also have Tom Parker with us, Chief Investment Officer of Systematic Fixed Income.  Tom’s responsible for all portfolio management and research, as well as portfolio construction across the systematic fixed income platform.  And finally, Carolyn Weinberg, who is the Global Head of Product for the iShares and Index Investment business at BlackRock.

Well, we’ve heard some incredible conversation from our clients and what I'd really like to do as we focus on this search for yield in traded credit is to start by talking about the universe.  Clearly, we’re in unprecedented times.  We’ve heard a lot about the focus on credit by our clients.  But clearly, relative to the last financial crisis, the universe is completely changed. 

So, maybe I could start with you, Tom, just to give us a little bit of your perspective.  And then, James, I’ll come to you after that.

Tom Parker: Yeah.  So, you know, the big thing ... on in credit is, you know, there’s very big cyclical reasons that we’re going to see a lot of dispersion.  You know, recession, recovery, early expansion are always periods of high dispersion and you tend to see a lot of winners versus losers in those environments, which we’re obviously in right now.

But there’s also going to be the secular reasons.  So, the technology disruption will continue and be accelerated by the COVID-19.  And COVID-19 itself is going to create winners and losers across companies, countries, and consumers.  So, if you add in changing global trade and a changing relationship with China, we’re going to see additional dispersion, even from those factors.

So, you know, what we’re looking at is a pretty high dispersion environment.  You know, the returns from beta will be low.  You know, the 60/40 portfolio will not be meeting a lot of client targets and we’re having a lot of discussion about that, about what you can do instead.

Mark McCombe: ... Tom.  James, similar question but maybe with a little bit of a lens put on through the leveraged finance world and particularly how you see the effects of sector dispersion and how you manage the risk/reward/return tradeoff on that basis.

JAMES TURNER:  Sure.  Thanks.  To an active investor, really dispersion equals opportunity and these sort of investment grade markets are not always very efficient and even less so in times like this.  So, really, we view this as a time to differentiate our performance and to have increased ability to generate alpha through this period.  And while we have ... with capital preservation and so we’re looking to avoid defaulting securities.  We’re also looking to unearth those hidden gems that are overlooked during the – due to out of favor status or just plainly misunderstood.

And then when, because when one looks across the rating categories, there’s an argument that there’s a set of the BB rated sector looks most attractive due to its low risk of default and we like many of these companies too as investments.  But that only makes up around 60% of the high yield market and significantly less of loans and the remaining 40% is not all going to default.  It’s this segment of risk where the alpha is typically generated by understanding the risk/reward is just wrong on some names and sectors.  And it’s differentiated at the moment and there’s a lot of dispersion around some sectors and there's some sectors that have really been in structural decline or faced severe challenges since pre-COVID, such as energy or retail, and they’re ... sectors but it doesn’t mean that every company within that sector is bad and it’s really unearthing those gems within that that is the key thing to generating alpha through this period.

And in a similar way, there’s sectors that are very affected by COVID, such as leisure sector.  But long-term, we think the future’s pretty bright for that segment.  It’s just really finding those companies that have the right balance sheets even through this difficult period.

So ultimately, it really all comes down to analyzing the companies properly, having a convicted view, and then sometimes a contrarian view, and then also importantly being prepared to act on it whilst making sure the risk overall is appropriate and diversified in the portfolios.

Mark McCombe: Well, I'm not sure people ever think they’re in finance when they hear terms like hidden gems and fallen angels.  But, I'm excited to talk about that a little bit later.  First, let’s come to Carolyn and talk about your perspective through the index lens.  How should clients be thinking about credit beta when you think about the environment that we’re operating in at the moment?

CAROLYN WEINBERG:  So, as you mentioned, the toolkit for fixed income investing has expanded and index or beta products are playing a larger role in the investment process with alpha generated from beta weights, security selection that we’ve already just talked about, and trading expertise.  So first, the investment process, the investment discussion.  What is the macro outlook and the relative betas?  And then second, the investment thesis.  So, what beta or combination of betas and securities are best to express this thesis?  And then lastly, the trade execution. 

And we’ve seen an iteration happening between the investment thesis and trade execution with ETFs, index derivatives, and portfolio trades playing a larger role.  Specifically, we’ve seen a surge in fixed income ETFs.  The adoption to efficiently and quickly express a credit sector view has really exploded.  Because the index is already part of the investment process, ETFs have become a tool for trading credit sectors. 

So, in such a low yielding environment, transaction costs, speed of execution, and certainty of execution is even more critical than before.  And to put that in perspective, the most liquid credit ETFs trade tens of thousands of times in a day and you can have that execution on exchange at pennies-wide execution.  So, getting your beta weight rates correct and at low transaction costs is key to alpha in this environment.

And index and portfolio trades as a tool to further dissect the credit portfolios has also accelerated.  So, for example, as a reminder, we strongly favor high yield and are neutral on investment grade.  But, within high yield we talked about fallen angels and BB as well and we’ve seen a substantial flow into the ETFs, index derivatives, and portfolio trades in these subsectors of fallen angels and BB.

Mark McCombe: Carolyn, I loved what you said that it is key to alpha in this environment.  Like I think that is music to most investors’ ears because the search for alpha continues to be ever more difficult.  I want to go deeper though and, James, maybe you can comment on this.  We’ve mentioned it a couple of times.  I have this kind of theory that, you know, we were full of promise on fallen angels at the beginning of the crisis.  But then, of course, we had the unprecedented stimulus from central banks and the like.  So, I guess, you know, as you speak to your clients and investors and you think through the lens of leveraged finance, are there opportunities still in the fallen angel space that you could perhaps talk about?

JAMES TURNER:  Yeah.  Fallen angels are a particularly interesting topic, I mean obviously front of mind to many people.  And there are a few questions that arise around them.  Firstly, we actually have had a lot of downgrade into the sub-investment grade market and it’s one of the highest percentages ever to fall into there.  And one of the questions people actually ask is are we going to be overwhelmed by them.  And I’ve been asked this question before in the financial crisis and asked it in euro sovereign crisis and the answer was no then and I believe it’s the same now.

These are actually very attractive opportunities still.  The companies that are downgraded are usually large and liquid and they often have the goal importantly of achieving an upgrade back to investment grade and at which point the spread tightening you get from that provides a very attractive total return and it generally materially outperforms the wider BB rated, BB rated cash grade.  And the ambition to return to investment grade is also in contrast to many other long-term BB issuers who have no stated goal to return to investment grade and actually often don’t have the means to.

And the reason that the fallen angels often have the means to become these rising stars is because, as I’ve said, they're usually the large public companies and they have a lot of levers to pull to return them to investment grade and to repair their balance sheets.  And that is not – this is not really available to most high yield companies and it includes things such as cutting their dividend payments, raising equity in the public market, selling off ... the non-core assets, all to reduce their leverage.  And then, their sheer scale enables them to be upgraded back to investment grade. 

And certainly, the one thing, and I think you alluded it to earlier, is often people overestimate there how many fallen angels will come down into this market.  And that's usually because, first of all, we’ve had the stimulus through the government, which has saved many from being downgraded.  But, it’s also actually because many companies actually take corrective action before they get downgraded as well and have opportunity to avoid the downgrade. 

But, despite the generally positive view on them, as ever there’s a note of caution, because some companies are downgraded may just – it may just be the first step on a series of further downgrades.  And when you consider what industries that have been downgraded, such as primarily they’ve come from automotive, energy, and travel industry.  And the first two industries, energy and automotive, are likely to be facing some long-term structural issues.  So, again, it comes down in leveraged finance, again, to credit selection being extremely important.

Mark McCombe: Well, James, thanks for that.  So, in two or three minutes you described $150 billion fallen angel market.  Now, we’re going to up the ante.  And Carolyn you're going to have two minutes to talk about a $13 trillion bond market, namely China.  So, I don’t quite know how you’re going to do that.  We could probably spend a whole panel discussing China.  But clearly, again, lots of promise, underrepresented in people’s portfolios.  We’ve seen within things like Bloomberg Barclays Agg, but now China’s being included.  Where are we in this journey and, you know, give us your forward view on how you think the Chinese bond market will evolve and then particularly obviously with a focus on credit.

CAROLYN WEINBERG:  Absolutely.  So, China bond is a very attractive option, both due to yield and diversification benefits, but also the flow momentum of the inclusion in the global bond indices that you just mentioned.  So, first, let’s talk about the attractive yield and diversification benefits. 

So, the Bloomberg Barclays China Treasury and Policy Bank Bond Index, that’s a lot to say, over – has an over 3% yield unhedged.  And on a hedged basis, that’s over 50 points above – 50 basis points above US treasuries.  And at a AA, at a, sorry an A+ S&P rating, there are very few other ... And further, China bonds support a supportive monetary policy, because the PBOC has not lowered the benchmark lending rate and doesn’t rely on capital inflows.  So, this is overall a good story.

Second, from a portfolio diversifier perspective, because of China’s more self-sufficient economy, China bonds have exhibited low correlation to other developed market government bonds and the US equity markets.  So, from a diversification and a yield perspective, this is quite attractive.  And from a flows and inclusion perspective, you mentioned $13 trillion bond market.  But actually, up until recently the bond market was not included in these global bond indices.  And as a result of recent market reforms and improved accessibility for global investors, benchmark inclusion has started. 

So, you mentioned the Barclays Global Agg that happened in April 2019 and the JP Morgan Emerging Markets also included China in February 2020 and FTSE-Russell is looking to include China bonds also in the WGBI.  So, we’ve seen $130 billion in inflows due to JP Morgan and Bloomberg inclusion and expect another $125 to $150 billion due to WGBI inclusion.  So overall, credit investors should really consider China as a result of yield diversification and potential benefits from the inclusion flows.

Mark McCombe: Excellent.  All right.  Tom, we’ve had $150 billion fallen angels, $13 trillion China bond market.  I'm not quite sure how we’re going to top that.  Maybe we need to talk about ... ambitions or something.  But, let’s go to something a little bit more ... world.  You use multiple levers in how you think about your systematic fixed income platform.  And I know that long/short strategies and ... are some of the areas that you’re focused on.  Tell us a little bit more about how you use those and how you think about them.

Tom Parker: Yeah.  You know, if we go back to the big problem that our customers are going to have, it’s this issue of, you know, where – how are you going to meet your bogies, how are you going to meet your targets in a very low fixed income return environment?  And the natural inclination is to go down in quality and down in liquidity.  And that’ll be one answer, but it shouldn’t be the only answer, because obviously what you’re doing is creating higher downside correlation with equities, both in illiquid bonds and in down in quality bonds which is not what you want to do, you know, for your fixed income portfolio.

So, the other uses of credit that you can do are things like long/short.  What long/short allows you to do is craft risk and return profiles so you can maximize the idiosyncratic risk and minimize ... risk.  Well, why do you want to do that?  It’s back to my first answer is this is going to be a high dispersion environment where it may be hard to make the market calls on factor timing, but there’s going to be a rich bounty of security selection alpha to capture.  And so, you really want to isolate that security alpha in that way.

And there's other things you can do with that.  It isn’t just about capturing income.  You know, you can create long/short portfolios that influence, you know, for example or long companies that have pricing power and short companies that don’t have pricing power, thus creating an inflation hedge, which is everybody’s wondering how do you create an inflation hedge in this environment. 

And, you know, the thing that’s really interesting is a lot of people’s answer is, well, let’s go private and capture the illiquidity premium.  But, the problem with that is the whole investment universe can’t go into illiquid assets.  It’s a contradiction in terms.  And so, the returns will fall dramatically and the correlations will increase.

But you want to do that in selected ways and infrastructure bonds are really interesting because while you may be going down in liquidity a bit, you’re often going up in quality.  So, you’re not making that complete tradeoff that you do.  You know, many of the illiquid assets are actually both, down in quality and down liquidity, which you definitely want to avoid, because the seeking of income is being counterbalanced by creating lots of negative, you know, correlation with equities at that time.  So, you know, we’re big advocates of using the whole toolkit to solve this problem. 

Mark McCombe: All right.  That was excellent.  So, we’re keeping an eye on time here.  So, normally this is a fingers on the buzzers round for our investors.  Although, we don’t actually have buzzers.  So, I’ll just have to go to each of you very quickly. 

But, you know, everyone on this call should be like a yield-focused investor and clearly navigating this unprecedented period in the credit space is uppermost on our mind.  So, with that in mind, I'd like you to give us a little bit of your sort of positive and negative developments.  Carolyn, I'm going to start with you.  A zero-rate world, efficiency where you say beta’s the right tool.  How do you see that evolving over the coming years?

CAROLYN WEINBERG:  So, we talked about fixed income ETFs as an efficient beta source for alpha and what can be even more impactful to performance is using ETFs as a liquidity tool for alpha and we call that liquid beta.  And we have seen an acceleration in the usage of ETFs as a critical tool to manage the liquidity sleeve of a portfolio.  And liquidity sleeves have become reimagined post-COVID with zero yielding cash and cash-like products, again potentially less liquid, that we see that – as we saw during the crisis than typically considered.

So, we saw the short end seize up during the crisis and yet ETFs continue to trade and provide liquidity.  So, we believe going forward liquidity sleeves should include a portion of liquid beta, which not only reduces cash drag, but can have a meaningful impact on performance due to liquid – diversification of liquidity sources.

Mark McCombe: Excellent.  Love the answer.  James, over to you on through the leveraged finance view.  Anything you’d like to talk about?  Particularly I think we haven’t spent a lot of time on convergence.  Maybe this is a good point to bring it in.

JAMES TURNER:  Sure.  I think it’s as the credits markets have expanded and what we’d want to ... now become more mainstream and I suspect with a certainty these markets will come, continue to grow in size.  And now, there are choices that investors have between public and private markets, choices between US, Europe, and Asia, and choices between loans, CLOs, and bonds. 

But we also have to recognize that just as investors have more choice, so do the issuers of this capital.  And whereas once their choice was limited, nowadays they can invest or choose to issue it all to the markets above and they can choose, you know, the way they’ll get the most favorable terms, the price covenants, call protection, and speed of execution. 

But if we have a broad platform and those with flexible capital, you can invest across that capital structure and just importantly, avoid the markets where it’s least advantageous to invest.  But this convergence provides real opportunities to invest capital in that way with lower volatility, similar yields, and ultimately better short ratios.

Mark McCombe: Excellent.  Tom, bring us home.  What’s your view on systematic fixed income going forward and why should people be thinking more about taking a systematic approach in constructing their portfolios?

Tom Parker: Yeah.  If you think about the next five years in fixed income, they’re very transform, you know, transformative, you know, very similar to what went on in equities as, you know, equities, you know, back a long time ago it was completely about security selection.  It was completely about fundamental.

What you’re going to see going forward is, like Carolyn said, you know, there’s lots of liquidity.  There’s lots of cheapness in beta now.  Over the next five years, there’ll be more factor portfolios that will allow you to kind of get factors cheaply, just like you did in equity, and they’re more liquid.  And then, there’s going to be alpha.  And we think in contrast probably to the last five years that this is going to be an alpha-rich environment going forward.

And so, to be able to systematically both mine that alpha but also make risk and return profiles that aren’t correlated with equities, aren’t correlated with inflation is one thing that systematic investors are going to do very well.  So, really, when you think about it there’s just going to be this diversity of tools to play, you know, liquids, illiquids, systematic, fundamental, you know, etcetera.  And so, it’s really exciting and I think fixed income is going to be very different five years from now than what we’ve seen today and you’ll see, you know, a huge share of liquid beta products, liquid factor products. 

But back again is people are going to want to, because of the low interest rates, low return environment, they’re going to need some alpha on top of that.  So, you know, that’s what we’re looking for.

Mark McCombe: Tom, thanks for that.  And this has been an incredible discussion.  I've got to tell you that in all the conversations during this terrible pandemic period that we’ve been experiencing, it’s so great to hear you guys talking about, you know, the different approaches you could take, diversification, seeking alpha, seeking yield.  You know, in a world where the herd mentality seems to be dominant at the moment, it’s really great to hear that there’s so many options available to our clients.  And as we heard earlier on, that’s exactly what they’re looking for.

So, a big thank you to all three of you.  I think that we managed to crack through at breakneck speed, which is exactly what our clients want to hear.  And so, thank you to all of you.  Look forward to seeing you in person soon and thank you, again, to all our clients for joining the session.

ALTSH0920U-1339066