Fundamental Fixed Income Call

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Fundamental Fixed Income Call

Thank you for joining today’s Janus Fundamental Fixed Income Webinar. I am Jessica Leoncini, Sr. Product Specialist at Janus Capital Group and I’ll be your host for today’s call. I am joined today by Darrell Waters, Head of U. S. Fundamental Fixed Income and Mayur Saigal, Global Head of Fixed Income Risk Management. Both Darrell and Mayur serve as portfolio managers on several of our fixed income strategies including our flexible bond or core plus strategy. Our intention today is to provide some insights into how we’re thinking about the fixed income markets including our views on rates and credit, as well as highlight what we believe are some of the key risks and opportunities that investors should be aware of. Lastly, we’ll review how we’re positioning portfolios in light of our views and the role we believe fixed income is designed to play in the current market environment. Perhaps it makes sense to begin by addressing one of the key topics that has arisen since the election last November, the fear of rising rates. Darrell, let’s hear your view on rates. Do we get the two to three rate hikes the market is expecting and if so, what are the implications for fixed income investors? Okay Jessica, yes, I think we will take the under on three hikes this year. I think we’re probably more dependent on the direction of the dollar than anything else as we have seen the dollar pick up strength over the past call it 10 months. We’ve certainly seen it give up a lot of that strength in the passing few weeks. We think that a lower dollar probably means marginally higher rates and marginally supportive to commodity prices, particularly oil. That does not bode well for continued pressure on inflation in an absence of a decent growth environment here in the US in general, but particularly abroad in Europe and some other larger economies around the globe. We think that the Fed will error on the underside of three hikes this year, so that means marginally higher pressure on 10-year rates, but not sustainably so. And certainly, something that a fixed income investor can live within the parameters of and pick up marginally higher yields on the other side of. Mayur, what about the threat of higher inflation? Do you expect inflation to play a significant role in 2017? Yes, Jessica. That’s a great question. Reinflation or reflation has been the overarching theme for the last seven months. In fact, since postBrexit, nominal 10-year rates here in the US are almost 100 basis points higher. A big part of that increase has come from changing expectations and inflation. In other words, if you look at the 10-year break-even numbers going back to July of last year, there was close to 140 basis points and now, that number is close to 205, 206. Clearly, that has been a big driver of changing inflation expectations. Now, the outcome of the election also amplified the expectations, but I would like to point out that even prior to the election, inflation expectations were changing here in the US and across the globe for three main reasons. One is data coming out of the UK post-Brexit was not as bad. The inflation and growth data coming out of Europe has been reasonable. Then, last but not least, I would say several banks led by BOJ last September, early October, acknowledged that QE is not working. All those three things were already driving inflation expectations slightly higher. There are a few of the things I’ll point out in terms of the jobs market. Here in the US, if you look at payrolls, they have been averaging close to 180,000 a month for the last 12 months. Unemployment is close to 4.8. The U6 number has trended in the right direction. Wage inflation is 2.5% to 2.6%. The last core CPI data was close to 2.3%. Now obviously, that’s backward looking, but I would like to point out that that 2.3% is the highest levels post financial crisis. If you look at the jobs data and combine it with where we are in terms of this administration and the fiscal policy that might be unleashed, I think there’s a possibility of higher sustained inflation here in the US. The only caveat there is the headwind to that would be a stronger dollar as Darrell pointed out. A stronger dollar is in essence, deflationary and that’s the only headwind that I see here for higher inflation. Let’s discuss the credit markets. For years, investors have been clamoring for a yield and while investment grade and high yield corporate credit spreads aren’t quite at their tightest levels this market cycle, they are through long-term averages. How does this factor into the team’s bottom-up fundamental credit work? What types of names are you looking to include in your portfolio? Well, we have continued to focus on US facing credit or issuers because the US economy is the strongest of the bunch around the globe. Obviously, we see better growth from a top line and margin expansion throughout the P&L statements. Here in US issuers, we’re looking for cash flow, growth of cash flow. Again, predominantly US focused. We don’t want to pollute it with a bunch of currency translation. Management intentions continue to be a key. Management intentions with the cash flow, we like to see companies that continue to pay down debt. There’s no shortage of fear out there from a corporate standpoint with good issuers who look at the balance sheet and don’t want to go anywhere near where they were back in 2007 to 2008. It’s safe to say there has been a lot of aggressive action out there, so it really is a bond picker’s market. Leverage is high across the high-grade index as well as the high-yield index. There is risk out there. There’s more risk than there’s been in the past three or four years, so we want to be very careful and selective about the credit that we get involved with, and that goes back to our core tenants of free cash flow and management intentions with that cash flow translating into better credit profiles.

Mayur, as the Global Head of Fixed Income Risk Management, can you provide us with some insight into the key risks that you’re watching for the remainder of the year? Are there any risk factors that you believe are currently under appreciated by the market? I think the elections in Europe this year are clearly being under appreciated in markets. I’m specifically talking about elections in France. If you look at French government yields, they’ve kind of trended 70 points higher over a 10-year Bunds. Obviously, those markets are pricing in some kind of uncertainty there with Le Pen coming into power and the goal there is for them to take France out of the Euro Project. That is some risk that’s being priced in, but I would say here in the US, there’s a lot of exuberance that you’re seeing in market evaluations. If you look at investment grade high-yield and even forward earnings multiples on the equity side are at all-time highs. You look at skew data on the options which is basically telling us how much drawdown risk investors are concerned around. That data is telling us that investors are extremely bullish in terms of historical trends. All those things really point out to the fact that markets are priced for perfection at this stage and if there is any outcome in the election that can surprise markets, I think there’s going to be a big change in sentiment there. I also think you know, I’m not an expert on opinion polls. Le Pen is not expected to win the election but the way I think about it is in the US and the UK, we’re way ahead of the rest of the world in this recovery in the last eight years and yet there were populist outcomes. I think in places in Europe, parts of Europe which did not recover at all, there’s a bigger chance of an outcome, a populist outcome. That’s one thing that I feel is not being priced completely. The other aspect is the five-year rate that I’m watching closely. Currently, there are five hikes being priced over the next five years. I think that’s a lot of complacency from a standpoint of Fed fund futures. Markets truly don’t believe that inflation is going to take hold and that the Fed is going to hike, so I’m not sure where, that’s definitely a tail risk, but it’s being underappreciated in the market because once the markets start pricing more hikes with higher inflation and with the Fed at play, there will be no place to hide in fixed income, particularly on the front end. Darrell, for those investors looking for a moderate amount of yield, we’ll still be mindful of downside risk. Where are you finding the best opportunities in the market today? Are there any sectors you find particularly attractive and in line with your goals of generating risk adjusted returns consistent with the preservation of capital? We’ve been looking in the energy sector in high-yield for opportunities over the past 12 months. It’s been obviously very fertile ground as those credits were thrown out last year when oil bottomed at $26 a barrel. There’s been a lot of recovery. There’s been a lot of value-add by focusing on that particular sector for the portfolios, for the strategies and so we continue to look at the oil sector. We continue to look at the mid-stream sector as an asset heavy, wider spread sector that is US-facing as well. We’ve been looking at some of the miners, some of the iron work producers that are here in North America. Some of those issues have presented a great deal of opportunity. And remember, the market remains open for a lot of these companies who need the market for balance sheet repair. Once they get that balance sheet repair done, they begin to trade more in line with the markets, i.e., with the indexes, i.e., tighter spreads, higher bond prices and lower yields. It offers a great deal of capital appreciation. It’s safe to say that trade is long in the tooth. We’ve realized a lot of what was out there offered, and again, it’s very much a bond picker’s market at this point. If you’re going to buy deeply discounted credits, you have to know what you’re getting involved with before you put you put the ticket on. What are your thoughts on the mortgage market? Mayur, how does an active Fed impact mortgages and what should investors be aware of? The Fed balance sheet currently is close to $4 trillion split evenly between treasuries and mortgages. Over time, this is mainly driven by QE policies which the Fed’s intention was to support housing, to drive down the premiums and credit risk premiums across the marketplace. I feel the Fed has been fairly successful in that area. Now, the Fed has continued to reinvest the proceeds from MBS and treasuries and rolling that back into its balance sheet. From a nominal level, the balance sheet is still impacted at $4 trillion although as a percentage of the GDP, that number continues to trend lower as a nominal GDP continues to grow at close to 3% or 3.5% over time. I do feel that the Fed is concerned from a tapering standpoint so it’s unlikely that the Fed is going to come and start tapering. In fact, in the last testimony earlier this month, in February, Yellen acknowledged that not reinvesting or tapering would actually, to move accommodation, so although the testimony was quite hawkish, the focus was on balance sheet and the focus was on keeping the reinvestment policy in place. Over time, maybe over the next 12 to 24 months, we think that the Fed is going to move away from reinvesting. I don’t think it will taper. The key thing here to consider also, is the communication and the language. I think the Fed learned its lesson in 2013 when they had been tapering, remember the taper tantrum and the outcome in the markets. I think that was a little bit unexpected for the Fed. I think the Fed has learned its lesson. Going forward, I don’t think it’s going to be as aggressive, so the language is key here and the choice of words is key. I do feel that once they start stepping away from reinvesting, it will widen mortgage spreads by 15 to 30 basis points. I think that’s easily absorbable within the marketplace. We are closely also watching changing leadership because that can change the outcome of the balance sheet. Also, we are focused on financial conditions. In other words, as the market changes, that’ll change the policy even if it’s 24 months from now.

With that backdrop, how are you positioning the flagship core plus flexible bond strategy and the fixed income sleeve of the balance strategy as a result? Well, we have stayed on the conservative side of duration, but not aggressively so. We’re modestly short duration versus our benchmark. We’ve certainly taken the allocation to credit higher but the risk within that allocation is very low compared to past allocations in history. Given that we have higher leverage, given that we have tighter spreads and less opportunity in any one issuer, so while we have a good deal of the portfolio overweight to credit, a lot of that’s on the frontend, it’s in higher-rated credits. A lower dependency on high-yield and certainly, a very conservative positioning in the MBS sector that is somewhat lower on a market-weighted basis than the benchmark. As well, some of the other more aggressive uses in the flex strategy would be governmental and non-US governmental or supranationals which we don’t use historically and probably won’t use in the near future because of some of the risks that Mayur cited overseas. We’re very cautious from a spread standpoint. We’re very cautious from a duration standpoint. It’s a good time to play defense in the fixed income markets until we get to the other side of this cycle. In your view, what are the goals of a fixed income allocation in a diversified portfolio? What value might an acting manager bring in this market? We believe that for client portfolios, fixed income has a dual role to play. One, provide income and then two, provide, be an anchor to the rest of the portfolio. If you look at the Barclays US Aggregate Index, I guess now, it’s the Bloomberg Aggregate Index, the duration on that index is now close to six years and that number is at an almost multi-year or multi-decade high. If you look at the yield on the index, it’s close to 2-1/2% which is at a multi-decade low. The traditional role of fixed income as a provider of income is definitely challenged with the lower yield, but it’s also the shock absorbing capability for the rest of the portfolio. Also, highly demonous given the duration is high, rate volatility is high. The reflation concerns are here and so buying passive means you’re buying duration with a lot of volatility and very little yields. That’s one thing I do want to point out. From a standpoint of fundamental fixed income, we are bottom up fundamental investors. We are credit focused investors and although we are credit focused investors, we are not all credit all the time. In other words, we are credit allocation for instance, in our strategy, it has a range between 25% to 75% of the allocation over the last seven to eight years. We are also mindful where we are in the credit cycle and Darrell touched upon this earlier. We feel we are in the late innings of a credit cycle. However, the election outcome has extended these innings a little bit. We feel there are pockets of opportunities in different segments of the marketplace. We continue to like banks. Banks for the last seven years were defensive play given their focus on balance sheet. And now, given the outcome of lower regulation, lower taxes and higher rates, that’s one place we are constructive on. We like bank loans, given that they’re senior in the cap structure and the coupon will reset with rising rates. Since our opinion is rates will continue to rise with the Fed changing or hiking rates in the next two to three years, I think that’s good. That will be a good place to be. We like the industrial sector and some commodity names. We like exposure to break-evens, given inflation break-evens will start getting repriced higher as the economy starts heading in the right direction, with growth and fiscal policy. Last but not least, we are very focused on security avoidance. We feel that security avoidance, at this time, the credit cycle is more important than security selection. Those are the things we continue to watch for our portfolio to diversify. If you were to leave our audience with one key takeaway today, what would it be? Mayur, I’ll go to your first. Our goal across our strategies is to maximize risk adjusted returns and preserve capital. We are laser-focused on delivering a client promise and we believe we can do that successfully through our integrated risk research process with the equity side through our bottom-up fundamental research process as well as our proprietary system, Quantum, global that we have here in fundamental fixed income. Darrell? I can’t really top that. I think really it’s a bond picker’s market and there’s a lot of hazard out there right now with just getting involved in bonds in general. As Mayur said, break evens or break evens on long credit and spreads on credit in general are extremely tight. If you get caught in a bad credit, you can destroy enough value in one trade that it wipes out the annual return for the entire strategy, so you have to be particularly careful on the credit work, keep the position sizes low and avoid those blowups. We’re positive. We’re looking forward to a year of positive but very difficult market environment and so we’ll see what happens from here. That concludes today’s presentation. Darrell and Mayur, thank you both for your comments today. Thanks to those on the line who had a chance to dial in today. We appreciate your trust in Janus Fundamental Fixed Income. Please reach out to your Janus contact if you have any follow-up questions or if there are any topics of interest that we didn’t cover today. Thank you and have a great rest of your day. (End of Recording)

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