By: Lara Reinhard, CFA, Seth Meyer, CFA, and Michael Keough
The tremendous pain felt in fixed income in 2022 could leave bonds positioned for potential gains in 2023, but certain sectors might be more appropriate given current markets risks and investor needs. In this webcast, Portfolio Construction Strategist Lara Reinhard and fixed income Portfolio Managers Seth Meyer and Michael Keough discuss the playbook for the year ahead.
- The prospect of moderating inflation in 2023 has created a better outlook for fixed income in the months ahead.
- Fixed income is ripe with yield opportunities that haven’t been seen in decades and, in our view, once again has the potential to deliver the diversification benefits investors have come to expect from the asset class.
- However, with the economic outlook uncertain and a hard landing still a possibility, investors should prepare portfolios for various outcomes, with careful consideration given to duration and sector allocation.
Operator: Hello, everyone. And thank you for joining us for today’s webcast, Bonds Are Back, hosted by Janus Henderson Investors. And now I’ll turn it over to Senior Portfolio Strategist, Lara Reinhard. Lara, you may begin.
Lara Reinhard: Thank you, Melissa. And thank you all for being with us today for what I think actually will be quite an exciting discussion on fixed income. “Exciting” and “bonds” are not really things we have associated with each other, at least over the last decade. But as the title of this webcast stated, bonds are back. I think maybe some, like, Backstreet Boys, “Backstreet’s Back,” would have commemorated this, amp the moment up a little bit. I also sincerely regret that’s the only comeback song that could come to my mind. And sorry for you if you know that song because it is the worst earworm that is now going to be stuck with you for the rest of the day.
But last year, we really have seen a pretty significant shift in the environment. And 2023 is shaping up to be a pretty exciting environment for fixed income investors. As a Senior Portfolio Strategist on our Portfolio Construction and Strategy team at Janus Henderson, my job is to review and consult on portfolios. And for as long as I’ve done it, it’s really been a conversation on the pain of owning bonds with some of the lowest yields that we’ve seen in fixed income in our careers. While we think that bonds have always maintained an important role in portfolios, it does seem to be that they are finally back in fashion to own them again. With that, I am pleased to be joined by two gentlemen who never went out of style.
Mike Keough, retired Air Force captain, portfolio manager on our Core Plus, Global Investment Grade, Short and Intermediate Duration strategies, and co-PM on our U.S. Corporate Credit, Long Duration strategies and Sustainable Corporate Bond ETF. And Seth Meyer – not a retired air force captain?
Seth Meyer: No.
Reinhard: But an equally talented portfolio manager, managing our U.S. and Global High-Yield, Multi-Sector strategies and Short-Term High Yield. And he’s the head of our Fixed Income strategy at Janus Henderson. Mike, Seth, thank you for joining.
Meyer: Of course.
Michael Keough: Thanks.
Reinhard: Before we turn it over to you to set the stage for where we’re at, talk about why fixed income is back, I do want to turn to the audience to get a sentiment from what you are all filling out there. If we can, let’s pull up the first polling question here. First polling question is, “What is your most probable outcome over the next 12 months?” It used to be soft landing, hard landing. Now, all of a sudden, in the last month or so, we’ve also got the “no landing” situation.
Let’s see what you all are filling out there. Backstreet Boys would have been great for this, as wait-time music.
Keough: Look, I think we can jump in. And this is something that we’ll hit on as we get through what we’re seeing in fixed income and how we think about how we’re performing, the difference in the areas.
Reinhard: I’m excited to see what the audience thinks.
Meyer: There we go.
Reinhard: There it is. Pretty … I think this is as we were expecting. Soft landing has the majority, but it is fairly even. There’s a good amount of us here thinking no landing, hard landing. Mike, let me turn it to you. Let’s just talk through the environment. Also, why is it just so hard to land this landing question?
Keough: For sure. First, we had a great turnout today. Thanks for taking an hour out of your day and spending some time with us. And I’ve been doing this since about 2006 here at the firm. Seth, a couple years before me. There hasn’t been many times where – yes, we’re fixed income portfolio managers – but that we’ve been out saying, “Hey, pay attention.” The opportunities that we’re seeing today are ones that we haven’t seen in many, many years.
And that’s what we’re going to try to walk you through. What happened in 2022? What’s changing about that in 2023? Maybe we can jump in with some of the slides. First, I just want to recap what happened in ‘22 and where we’re at today. Let me get some charts so I can see what we’re looking at here.
First, what you’re looking at is a chart. We have an orange line that shows the fed funds rate back to 1995. And the black line shows the core CPI or inflation. And you can see, inflation had been hanging around for almost 20 years at 2%-3%. And then what happened in 2021 and 2022, you see that black line accelerate up till 6%, 7%. We haven’t had that in 40 years. Inflation and bonds generally don’t get along very well.
And what do we have to do? Why was last year such a painful year for fixed income? You see what the Fed did. We had rates on the orange line starting at zero and we ended the year, you can see it going up to 4.5%. And I’ll tell you, at the beginning of the year, January 1, 2022, we can see market expectation to where fed funds will end. People thought fed funds would end at 1.5%. We thought inflation was somewhat transitory.
It came up and it would just come down on its own as supply chain worked out. But what happened, it wasn’t. And expectations had to reset massively. The Fed was very far behind the curve and they needed to catch up. You can see rates went from zero, ended the year at 4.5%. We didn’t know how high things had to go. Inflation kept surprising to the upside. Fed was way behind the curve, coming off zero.
They kept raising. And that’s what really set this terrible return environment for fixed income, when we had starting yields at roughly 1% and then rates had to go 200, 300, 400 basis points higher, depending on where you’re on the curve. That’s how we got there. But if you can see, at the tail-end of that chart, we have a bunch of dotted lines which tell you, based on different time periods, where the market sees the fed funds rate going in the next one and two years.
And you can see, we’re at the peak. Today, Fed has raised to 4.75. Market expects another three hikes. Probably gets us to 5.25, 5.5, somewhere in between there. But then they’re going to keep them there for some period of time and then you can see them come down in the years ahead. Last year, we were not talking at all about rates going lower. It was just about how high they could get. And I’ll dig into what’s giving us the opportunity or what’s allowing the markets to price in lower fed funds in the future.
But 2022, all about high inflation, how high you needed rates to go to get restrictive. As we sit here today, we’re pretty close to that level of where the Fed needs to stop at. And you can see some scenarios going forward where rates will end up lower. Moving on to the next chart, that was painful. Look on the right, you can see … excuse me, on the left. This is Agg returns since the Agg got created in the late ‘70s. You can see generally positive returns and very few negative returns. And last year, it was minus 13%. Inflation and bonds don’t get along. That’s what we ended up with, a 13% return on the Agg. Didn’t provide the diversification that we expected. But that comes with a bit of a silver lining. That pain takes us to where we are on the right-hand side. And this shows the yield of the U.S. Agg over the last decade.
I mentioned that I joined in 2006. We haven’t seen yields this high for 17 years. That is one of the reasons why that starting point, why we’re saying we’re excited. And rates, this chart, we got to a little over 5%. Rates came in a little bit. We’ve sold back off. And we’re still close to that 95th percentile in yields over the last 10 periods. There was inflation that caused a lot of pain. One of the worst returns on the Agg over the last 40 years. That gave us a better starting point. For income, it’s fixed income after all. Income is back into it. And then it can also provide some diversification. We’ll get to that in a slide or two here. I’m going to turn it over to Seth for the next slide. That just gives you some insight of the forward return potential as we think about it.
Meyer: Thanks, Mike. Obviously 2022, as Mike was revisiting the pain that it was, I think it is important to understand the starting point, as Mike was summing up at the end of his slide there. The best leading indicator for returns for an Agg-like product is really the yield-to-worst when you bought that portfolio. When you bought the portfolios five years ago, when you think about where our Core Plus bond fund was, yields were in the twos.
And we had two years, particularly 2019 and 2020, where you had high single-digit-type returns, with coupons of only two. What does that mean in general terms is the assets within your portfolio have to go up in order to actually make up that difference in income. Today, we’re in a much, much different spot. The vast majority of assets are actually under par. You have positive convexity to par. In other words, those bonds should actually gravitate back towards the par level and they’re starting below that level.
And then even more importantly, where we’re starting in yield terms. Mid-single-digit yields are really what most portfolios were built off of; that was what your traditional 60/40 was really hoping to achieve. And Lara sees this in her world with portfolio constructions. But this was the idea. And now we’re back at that level. And if you can look at the chart here, where you start is really, really important to where you’re going to end. And right now, starting in mid-single-digit yields, we feel right now, high-quality assets look very, very attractive relative to historic norms. Really setting itself up to the title of the presentation and why it was so nicely coined “Bonds Are Back.”
Keough: Thanks, Seth. The other thing I wanted to point out, on the next slide, is, what is different about ‘23 that sets it up better than 2022 for fixed income? I talked a little bit about the Fed; they had to raise from zero to 450 last year. Now we’re probably going to get another 1% and the market’s pricing that in. If you look at market expectations, they think the federal and the peak rate will be about 5.3%. The market’s priced for what the Fed is expected to do.
Let’s say… I’ll come back to this in a second. In inflation, this is an important chart. We talked about last year, it was just all about inflation kept surprising us to the upside. What’s changed in ‘23 that is setting up better fixed income returns? And have we seen that so far year to date? And what we did here is a chart of three-month annualized inflation. If you look at year-over-year inflation, that’s where we are today versus last year.
But it’s going to be very slow at catching turning points, how things are changing quickly. And what you see here is different time periods of core CPI. And you can see all those, the red- or yellow-shaded things, that was back in August and September, where you had core CPI plus 5.8%, plus 0.57%. That was 6 to 7% annualized inflation. And then look where we came and got month over month as we went into January and February, we started to see those annualized inflations get back to towards a 3% number. And that is a much different environment than we were facing last year. And we tried to show it over there on the right. But look, when you had annualized CPI, and this goes from the beginning of 2022 to January 23, look at what happened when the annualized CPI was really high. We had a negative 5.9% return in Q1, negative 4.7, and negative 4.8 in Q2 and Q3.
That was really problematic. What happened in Q4 of last year, we saw some of these annualized inflation prints coming down. We got a positive 2% return in Q4. And it’s plus 0.5% now. The inflation environment has changed. That’s creating a better outlook for fixed income. And I’ll also say we’re not calling the all-clear sign on inflation. It’s going to be sticky and it’s going to take some time for it to get down to the Fed’s target. But we’re not at 6 or 7%, wondering if we’re going to 8%. Now we are on our way down and we’ve seen some encouraging things. And how this will likely play out is, instead of the Fed having to keep taking rates higher and fixed income yields having to keep going higher, they’re going to get to their 5.5% peak fed funds and they’re going to hold it there for longer, and you’re not going to be battling the things we battled with in fixed income last year.
And that’s one of the… It’s just such a different backdrop. And this is probably one of the biggest things we think this year is more favorable than last. I think the other thing I wanted to ask Seth a question on is… and it goes back to that poll … Can you bring that poll up, the final numbers real quick? Look, I would say we had soft landing, 48%, hard landing, 33%, no landing, 29%. You’re a third, a third, a little bit, with a little bit more towards the soft-landing scenario.
I would agree that this is one of the more difficult times to accurately predict what’s coming over the next 12 or 18 months for the economy. You listen to some of the people I respect most across markets and fixed income saying, this is extremely difficult. We’re still trying to figure out how this economy performs coming out of a pandemic, supply chains, tight labor markets. And we are strong proponents of making sure your portfolio is prepared for these various outcomes.
Maybe we do get a soft landing. That’s going to be great. Maybe we get inflation to come down and we don’t have to lose a whole lot of jobs and employment. That doesn’t have to go. That’s going to be… I’ll let Seth walk through fixed income with the different returns or outlooks in those. But if we get a hard landing, which is still a pretty reasonable probability, and we’ll have to see what comes, you’ll probably want to have some fixed income to diversify that equity exposure.
Meyer: We should have actually put GDP ranges with the soft landing and hard landing numbers, just to get a sense. Because soft landing is now starting to become slightly negative GDP or maybe flat. And no landing is we continue to grow right through this. I think that the point that we’re trying to make with this is, depending on your outcome… and a lot of the questions that have been coming in are in regards to duration. Makes logical sense after what we’ve seen in the repricing of the Treasury curve and especially as inverted as it is. The point is, in almost any of your scenarios that you have up there, yields are so forgiving, the relative starting point that you’re starting with in fixed income. And the outcomes, you can paint a picture where positive total returns, and in some cases significantly positive total returns, are now available to you in fixed.
Back to the point of… Mike had a slide up there, it was talking [about] income and diversification. I think that’s going to be the bigger point here, is that regardless of your outcome, fixed income is providing you with a level of diversification that it just had a hard time doing when absolute yields, when the tenure was at 50 basis points or the tenure’s at 1%. Now, as you look forward, the diversification benefits of owning duration, coupled with your equity positioning, should offset the volatility that we’ve seen historically.
When you think about the 60/40 mix, only five times in something like 90 years have equity and bonds been negative, one of which was last year. Five times out of almost a 100-year track record, those two assets being negative, it would seem to me, given the massive repricing we’ve had over the past 12 months, as painful as it has been, is affording us an opportunity to get reengaged and provide those natural diversification benefits that we know between those two assets.
Reinhard: That both was really helpful in setting up the stage of why we’re here today and hopefully gets everyone else here excited about the opportunity in fixed income. As I mentioned, I’m a portfolio strategist. I consult on portfolios. I share insights in terms of what I see. And I also comment on asset allocations and maybe tweaks that I see could be made in certain fixed income portfolios. For purposes of today, I think it would be helpful to separate this, section it out into three parts.
First, starting with duration. You already got into your rate outlook, but it may come into that conversation a little bit more. Then we will go to the investment grade, non-investment grade debate. Talk about where your position there, what opportunities we see there. And then finally, we’ll wrap it up with specific sector outlook and implementation.
Leading off in duration, before we do that again, let’s pull up that second audience question, if you don’t mind, to get a sense of what you all are thinking out there in terms of duration. In your portfolios right now, given the sell-off last year, what you’re looking at today, what duration are you targeting in your portfolio? Are you still looking at short, under two years, in that two- to four-year range, more than four years, or we got some bold folks out there just going all in on TLT right now? I would imagine those are the hard landing folks if they’re going to sell all-in on TLT.
Keough: I would think so.
Reinhard: Mike Wilson is very into that. That’s what he’s been touting lately. And that makes sense, given he’s a little bit more of a bear.
Meyer: [Overtalking] slightly.
Reinhard: Just so slightly, yes. And this is good. I’m glad that you brought up the 60/40 too on the outlook. As we think about duration, even on fixed income, but maybe bringing in some of that equity, it’d be nice to weave that into some of the commentary as we get through this.
Let’s see, hopefully. Here we go. Again, relatively mixed. Not many on the TLT front. But we’ve got 4% there on TLT. This is resonating with me and my consultations, my team’s consultations, is oftentimes, we will have clients that are still on the short end. That looks like roughly a third. We do have some that are targeting more longer now; that’s also roughly a third. And then it looks like slight edge to that middle range, that two-to-four, at least in this poll. Seth?
Meyer: I think it jives with what we saw on the slide before. When you think about if soft landing or no landing is our base case, which is certainly what that slide before showed, I can understand the hesitancy of adding longer duration assets. Because you believe that growth is okay while the inflation picture gets better. Longer end of the curve should reset, etc.
Reinhard: And I think there’s still the pain from last year too, of that amount of pain in duration.
Meyer: Recency bias.
Meyer: There’s no doubt there’s some…
Reinhard: And there is this more hikes to come up. Maybe it’s priced in. But there’s a little bit of that.
Meyer: I’d agree with that. There’s some recency bias, I think, from wanting to go too far on the curve. Again, I probably would have expected a little more, maybe if you’d have thrown a tenure in there instead of TLT, maybe there would have been a little more diversification on it. But the front-end yield curves are attractive. I totally understand the argument of just staying short and clipping front-end yield. We haven’t been in a situation where you can get mid-single-digit type yields for two-year pieces of paper.
That hasn’t existed. And as a matter of fact, when you think back to 2019 or even early 2020, before COVID, we’re lending to high-yield companies at those levels. And now you can go out and buy a two-year Treasury yielding similar to that number. I totally understand the bias to the front end there. The thing I’d have to remove myself from and really think through, if Mike’s slides before showing us that three-month rolling CPI numbers are getting to the point where we’re run-rating 3%, think of the real rate if fed fund’s at 5.25, 5.5, really is providing. 200 basis points against the run-rate CPI number. Very, very restrictive. The idea that they will be able to hold that number for very long periods of time now, and they cut it down 50 basis points or cut it back to something more neutral, that would really be the argument for me. And when I think about the duration call, given what Mike was also saying about how broad the potential outcomes are and how painful some of those outcomes really would be.
In other words, the tails are relatively fat in this scenario. A hard landing scenario will be painful. Equities in that scenario are certainly, in many cases, not pricing that way. Corporate spreads have certainly not woken up to that reality either. When you think about that outcome, hard-landing type outcome, duration will be your best friend.
Think of where neutral is for the Fed right now. Maybe it’s three, maybe it’s 3.25. And we’re going to be pushing 5.25. If something does happen where they feel uncomfortable and need to cut, to get to neutral is 225 basis points of front-end cuts. As attractive as front-end yields are now, what do you do 12 months from now or 18 months from now? You’re supposed to be leaning in at mid-single-digit yields in longer duration assets. Because investment-grade assets at a mid-single-digit yield – whether it be agency MBS or even investment grade corporate, which we can argue is overvalued to some extent – is a forgiving valuation.
We have a recency bias because we go back and we say, we started the year at 50-basis point tenure and we’re ending where we’re ending. And that was painful. That’s right, that the path forward from here most likely doesn’t incorporate a move of what we just saw. With that, when I look at the evaluation of things on the curve… and I know front end is attractive. Because when the tails are fat, you want to be positioned for most outcomes, not just one, which is, let’s clip front-end yield, but protect just in case we are wrong. That’s more of the way I would be thinking about it right now, is when tenure’s hitting four, think about it. When the tenure is going wider than that, think about it and understand the purpose that you’re buying this for.
Reinhard: And Mike, you’re a manager, as I mentioned at the beginning, of both short and longer duration strategies. I know you won’t, but picking your favorite of the two, what’s your favorite child right now? Or is it a blend of what Seth was mentioning? You want both right now?
Keough: I think it very much depends on what you’re trying to achieve within your portfolio and what your asset allocation mix is. When you can get 5, 6% yields in two- to three-year high-quality fixed income, not just Treasuries, but some high-quality credit spread, we haven’t seen that. That’s amazing. And just to make it tangible, my parents are 75. They have 80% in fixed income. Probably 15, 20% in equities. They’re fine having a bunch of carry. They own so little equities, they don’t need as much of the diversification that you need if you have a 60, 70% allocation. Because we say, income and diversification, what if we go into a hard landing? Rates are going to go 200 basis points lower. You go 200 basis points on six years of duration, which is the Agg, that’s a 12% return. You started with 5% carry. You’re going to get mid-teens returns. That’s the diversification that we’re talking about. The Fed’s hiked aggressively. If you’re going to hard landing, they’re going to cut and they’re going to cut a lot. And in a diversified portfolio, you have to own some of the Agg longer duration stuff to give you some of that diversification.
Reinhard: And that’s the pushback that I get, it’s just that it didn’t do it last year. But that’s because last year is a very different situation. Now diversification might be back.
Keough: It’s inflation. We tried to set up how inflation was so bad. Inflation doesn’t work for fixed income. When the Fed has to hike that much, it’s going to give a concern around recession. Equities and earnings estimates are going to come down. But we’re saying that inflation, for the most part, has peaked and it’s coming down. As we continue to make progress on inflation, as the Fed gets to their terminal and holds it longer, it’ll slow things down. That’s what’s going to allow some of that diversification to come back. It didn’t work last year. We haven’t had inflation like that in 40 years.
Meyer: Actually, I think I’m going to make a T-shirt with your tagline you’re making, “inflation and bonds don’t get along.” That’s actually it. To put it as bluntly as you can, that scenario of the world trying to catch up with an inflationary picture that everyone, for the most part, underestimated, including our Fed, is not the same playbook in 2023. It’s just not. With that, “inflation and bonds don’t get along.” That’s not the case now. Declining inflation and bonds do get along. And now’s the time to be thinking about it. The fight was just different last year.
Keough: I’m going to make one other point. I said Fed expects terminal at – market and Fed – around 5.3%. Let’s say that goes 50 or 75 basis points higher. And rates have to move up collectively across the board. If rates go 70 higher on six years of duration, that’s a minus…
Meyer: 4.2, 5% return?
Keough: 5% return. And you started with 5%. That’s going to get you a 0% return. And I’ll tell you, if the fed does hike to that much and has to do more to get inflation down, that no landing scenario means the fed has to do more and hold that longer, that’s going to have implications on economic growth and direct [overtalking].
Meyer: That’ll be a forced landing scenario. That’ll be a forced landing.
Keough: It’s helpful for no landing now, but you’re going to end up catching up to…
Meyer: They would have to force.
Keough: That’s that starting point again. We get asked, is now the time to jump in? Has the bottom been put in? Has the peak in rates been put in? None of us can really tell you exactly. But I’ll tell you, where we’re at today is so much better than we’ve been in the last decade-plus, especially coming off last year.
Reinhard: To summarize, especially this is me talking to the clients that are on that under two, which I come across quite a bit. In hindsight, it’s like a congratulations. That was what you needed last year. But from what I’m hearing from both of you, the risk in that staying short is, maybe you can enjoy the yield curve coming down if it normalizes, but then what? You’re missing out on that true diversification potential fixed income can now once again provide on the long end.
There’s also just this balance that needs to be had because, like you’re saying, on the short end of the curve, you get the yields start to enjoy the income potential there, depending on your end goal. This one, it goes into it. But just to wrap up the duration, the question, to predict… and this goes to your return potential. What’s going to give you better return over five years? A five-year note held to maturity or a six-month rolling T-bill? I think that answers it. Right now, that T-bill’s looking very attractive.
Meyer: It is, but rolling, no, you won’t.
Reinhard: Over five years, you want to start thinking about duration when you’re getting yields.
Meyer: If you start thinking about… You would have to… A couple of scenarios. I would venture to guess we would have some economic slowdown or recession in the next five years. A five-year fixed rate note will pull forward some of that return. If you’re holding it till maturity and not selling it, to assume that rolling T-bills have an average of around 5% over the next five years is, to me, a really aggressive statement.
It seems unlikely, considering we will have inflation coming up, that they’re going to be able to hold short-term real rates at a two, if we’re at CPI of three and they’re at 5.25, for long periods of time without really slowing things down. More than they would want to be slowing things down. If we’re wrong and inflation reaccelerates, that would be where that’s the winning strategy.
Reinhard: That’s the risk with the duration?
Reinhard: Let’s transition. Thank you. The duration, it seems like we’ve got that cleared up. Let’s move over to this investment grade.
Reinhard: Cleared up. It’s all easy.
Meyer: Totally, [inaudible].
Reinhard: Investment grade, non-investment grade. If you don’t mind just walking through… You touched on it. But what’s changed, if anything, on your process this year versus what was like managing investment grade over the past 10 years?
Keough: You were coming out of a recession. You had a lot of accommodation. Things were accelerating and investment-grade yields were paltry. You had to push out to get some yield. Here we are today. And you can get safe yield. You can get that much. You can get 4.5% in front-end Treasuries. You had to take the most risk possible. You had to extend into private credit. You’re not having to do that anymore.
Meyer: And I think we’ve been talking a lot about interest rates and what that means with the ratio and what the fed is doing. I think it’s really important to also take a cue from what’s happening in the credit markets. Credit markets are showing very strong resilience, just powering through most numbers that are coming out, just ignoring it for the most part. We have spreads in the high-yield market in the high 400 range. If you believe historic averages are in the 400, which about they are, we’ve adjusted somewhat to a reality of a soft and/or a hard landing. But in no way are we pricing in a recession beyond something like a 20% or 25% outcome.
Credit markets have been very, very resilient, whether it be investment-grade corporates, high-yield corporates. Part of it is what happened in 2020, ‘21. Most corporations had the ability to access any financing at any time at very, very, very low rates. And they did that. The need to come and bring capital to the market today because of capital you need, it’s just not there. Because there are just fewer bonds, it results in the technical of things being tighter than they probably normally would have been.
Part of that is the same benefit of what’s happened in the corporate market, the great refi that we had in 2020, ‘21, is exactly what the consumer did. Everyone refinanced their mortgage at 3% sub-rates. You went out and bought washers and dryers and dishwashers. And then when Home Depot and Lowe’s ran out, you started deleveraging your balance sheet and paying back some of your fixed rate debt.
That recovering process has resulted in a pretty strong consumer. And I know we’re seeing signs of things cracking. That’s very clear. But for the most part, the consumer remains in pretty relatively good shape. Securitized assets, for the most part, are pricing in, in our view, a much higher likelihood of some soft and/or hard landing.
Reinhard: Are there any indicators that you will be looking for where you will shift focus? Maybe you indicated if we do go into recession or if credit spreads do start to come out, then that’s when you will look to go more into non-investment grade realm. Or what will you be looking out for?
Keough: Look, a lot of… Seth mentioned a little bit. I think we have a chart and that just shows the investment-grade and high-yield spreads. Seth said that you’re pricing in a pretty benign outlook for a macroeconomic environment. I think you could say that about credit spreads. I think you could say that about equities. That’s 18 times price-to-earnings right now. They’re pricing in more of a good landing, a soft landing or something like that. When you look at the spreads, they’re well below. That’s securitized…
Reinhard: This one?
Keough: No. Hop over to the… There we go. What you’re looking at there is, on top, investment grade spreads. And you can see that over long-term averages, that’s that line around 150 basis points. High yield shows the same thing, with a long-term average close to 550. We’re below long-term averages. We don’t necessarily think we’re in an average economic or central bank environment going forward. And that’s where we’re being a little bit more being patient in waiting for some of that opportunity. Or we’re taking it in securitised right now where you’re getting much more attractive spreads. You can go to that next one.
Meyer: Or even the one right before is even a little more telling for what’s priced into the market. This is an interesting slide. Just saying, hey, if we go back to peaks, how far away are we from those peaks? And corporate markets have yet to come to some reality that spreads are approaching peaks or getting there if we were to go in recession. And other assets have actually been significantly more forgiving.
Keough: And the other thing I’d add to that is when we think about where spreads can go, it’s like, if we go into a hard landing or that’s a recession, I think it’s also important to say, what do you mean by that? For the last 20 years, we’ve gone through a Global Financial Crisis in ‘08 and the pandemic in ‘20. Those were terrible environments. Our banking system broke and we dealt with the pandemic where we shut the economy down to zero.
If we go into recession, it’s not that. And you need to reframe to say, how wide can spreads go from here? And they can go wider. They’ll generate some negative excess returns or spreads widening. But on the same hand, we’re not going to wait till we hit 1,200 on high yield like we usually hit in some of those recessions. Or 250, 300 investment-grade. There’ll be value a little bit earlier than that. And that also goes to the point now to say, if people want to say I want to have some high-yield allocation right now, it’s the highest quality index you’ve had in…
Meyer: Two decades.
Keough: Two decades. And if you can hold that for the next few years and you just say, hey, I’m comfortable with the volatility, it’s probably going to give you some nice returns.
Reinhard: And then before we go to then more specific sectors… Although I can imagine we’re going to have some securitized focus. A question did come in. This is more for you, Seth. Just talk about the fallen angels universe. Are you liking them, staying away from them? Total returns.
Meyer: The fallen angel, the ability to exploit the alpha and the fallen angels has largely played out. We had, you think back to March of 2020, the largest amount of fallen angels in the history of really the high-yield index, double B’s went from a low 40 percentage of the index to over 50-something percent. And I think they peaked at around 55, 56, if you look at the Barclays high-yield index. That number has been trending down. We’re now closer to about 50%, 51%. And that’s because 5% of the benchmark has left, because they’re being crowned again investment grade and they’re moving back up. A lot of the alpha within these names have largely played out, like I said. When you think about the next iteration of upgrade candidates, spreads are pretty much trading where you would expect them to. There are still those one-off names where you’re looking for that credit improvement story that the market has yet to realize. But the obvious ones have already been making that leap.
Reinhard: Let’s move on then to this last section on specific sectors. We’ve framed up duration. We’ve talked about opportunities, really good ones in the investment grade space. But on the non-investment grade, you can potentially get some pretty good yields and withstand some spread widening potentially.
Let’s just wrap it up on sectors. But let’s go to an audience question just to see where your heads are at in terms of sector implementation of everything that we’ve been discussing already. Obviously, not an extensive list, but the main ones being cash, just government Treasuries, credit, or securitized? And I will just already go to you guys because in my consultations, we haven’t seen money markets at 4.5% in a very long time. That’s the number-one thing that I get, is just why do I want to own anything outside of money markets? I think that we’ve set that up quite well because of the opportunity.
But as you can see here, obviously, the answer coming in, cash is still pretty high in terms of one of the results, followed by government, actually, credit and security. Again, all over the place. But just, Seth, why shouldn’t clients just own cash, if we haven’t already answered that?
Meyer: I think it goes back to what we’ve been saying. The opportunity today really affords itself to extend out on the duration curve. I go back to the point of the correlation between your forward returns and your yield to worst, your starting yield to worst. If you’re okay with a model to give you around 500 or 5% in total return over the next five years annualized, that’s a pretty sweet spot to be, considering the volatility of an underlying flexible income-type portfolio.
And when you’re talking about the yield-to-worst starting point, again, really protecting, at least providing consistent income, in the event that things are a little rocker than we think, without taking significant amount of duration. I think that, as you can tell, we’re pretty excited about what we’re seeing in the fixed income markets. And you don’t have to go very far to find unique opportunities.
I’m using just agency MBS as an example. Agency MBS, triple A-rated mortgages, yielding in the fives. Mike was making this point, we were lending to triple C companies two years ago. Tighter than that. And now you can buy triple A assets yielding that same number. It seems like a really forgiving time to be dipping your toe in. And I know it sounds like a broken record to some extent, but it’s the continual theme of the starting point has gotten better, diversification benefits will be there, and income is back.
Keough: Can you pull up the slide, slide 12, which has securitizing relative to corporate credit? This is agency MBS, is what we’re looking at here. You can see… we got it… go to the…
Reinhard: Down … there.
Keough: There we go. What you’re looking at here is, the black line is investment grade corporate credit spreads and the orange line is agency MBS. Agency MBS, higher quality, no spread risk, given it’s backed by the government. But it does have a lot of interest rate risk. But look what happened. When I talked about investment grade being below the long-term averages, do you see at the black lines well below that, that average and well below some of those peaks that you hit, look at agency MBS.
That is, if you look at that long-term average, we’ve tightened a little bit, we’re close to the wides. What blew up agency MBS? Interest rates. When you have interest rates spike up a lot, those really struggle with interest rate and volatility. And while we said last year was all about higher rates, Fed repricing central banks, that was really painful for MBS. When you have rate vol getting lower and expected to be lower and rates coming down, that’s much more supportive for agency MBS. It was also … they had to deal with the Fed doing its QE last year or stopping and going to QT. The market had to reprice to lose the largest buyer of the asset. And it’s changed.
Reinhard: And it continues… Because that was the question that did come in. That’s one that you can continue to own for quite some time. We don’t anticipate… What are the signals you will look at to be, maybe I don’t favor this space as much anymore like I have? Will it be rates coming down? Prepayment risk comes back into play? And do you envision that happening anytime soon?
Keough: I think the assets are just misvalued. And with the outlook that we expect, that’ll balance itself out. But I think for us, it would have maybe been waiting to see some of those valuations of maybe this tightens a little bit based on our outlook. Some of the other sectors widen more towards where you think they would be priced in this environment. And then we can asset-allocate throughout there.
Reinhard: Of course, we have a team, a very specialized team, large one, on the securitized team at Janus Henderson, who all happen to be at a conference together today. They weren’t able to join us. But we are getting a lot of questions in on agency mortgage-backed securities.
Meyer: Active in the mortgage market is actually really important. Why? Because there’s a lot of inefficiencies that exist. There are a lot of non-natural buyers in that market that aren’t just money managers. Banks hold an awful lot of MBS on their balance sheet. In addition to that, there’s ways to exploit different coupon tenures. When you think about the vast majority of mortgages today, the vast majority are sitting at the very low end in coupon. And that’s because we all went through that refinancing wave that we all did in 2020, ‘21. The Fed owns the vast majority of those assets as well on the front end. But there’s ways to pick your spots on other areas of the curve of coupon stacks further out. Thinking about that, is an investor who has a 6% mortgage outstanding today less likely to refinance with mortgages at six? Yes, probably. But if he or she did not refinance when rate’s at three, certainly not refinancing when the rate’s at six.
If they drop another 100 basis points, are they going to refinance? Probably not. But there’s ways to exploit these inefficiencies in the market that if you are an active manager, you really can. Mike was talking about interest rate volatility, when you just think about it in the perspective of the refinance wave that we all went through, we need a 200-basis point reduction in today’s mortgage rate.
The prevailing rate’s 6.5 or whatever the number is. We need 200 basis points to have 10% of the market to even be able to refinance. When you think about consumers today, the greatest asset a consumer actually has isn’t the home. It’s their mortgage. They borrowed from a very large bank at a very, very low rate for a very, very long time. That is a phenomenal asset they have. They won’t let go of that unless there is divorce, death or they’re displaced.
You think about how strong that asset is, that’s why MBS looks really attractive to us. It will trade pure to its duration, unlike historic, where you do have it shortening. Because at the end of the day, the consumer has the right to prepay. And as an MBS owner, a great piece of paper can be called away from you tomorrow if the consumer decides to refinance that piece of paper. Right now, highly unlikely they may choose to refinance those.
Reinhard: Mike, and then last thing to you… And we’re getting lots of great questions, thank you. This could go on much longer. I’m going to have to pull up a disclosure slide here soon. But on your front, credit. Agency, we got the active lien. Just that’s something else that I come across and seeing in portfolios. It generally seems that active can outperform in fixed income. Do you want to comment on that in terms of your realm, why you think that typically is? Or maybe where you’re seeing opportunities over… What are the risks in passive at the moment in fixed income?
Keough: Look, we have a fundamental belief that fixed income indices in particular are set up really inefficiently. If you’re an equity index, the strongest companies that have succeeded the most are your largest allocation. Success breeds larger allocations. How you get to be a high allocation within the fixed income index is you borrow a lot. You’re the biggest borrower. We don’t like people who borrow or companies that go leverage themselves up. And whether it’s the construction of the indices or they have a pretty inefficient mix of a lot of interest rate risk. And then their spread risk is really concentrated in corporate credit. It doesn’t have the diversification, the wide range of tools that you can go to, to below investment grade, that you can go to different parts of CMBS or ABS, which are a little more esoteric. I see people, then there’s a low percentage of people having to securitize.
Look, that’s harder to understand. It’s trickier. And we do believe active matters. You often see the Agg going from first to worst in different environments when rates rally and spreads sell off. It goes to the first quartile. If rates do the opposite and spreads widen, it can throttle back and forth.
Reinhard: I have one final question for you, but let me just pull this up really quickly. Thank you for speaking with me. I think I always learnt a lot sticking with you. I hope everyone here did as well. If anyone here wants to learn more from my team on portfolio construction, engage with us, dive into your specific fixed income portfolio. Or if you want to learn and speak to these gentlemen here about any of the Janus Henderson fixed income capabilities, please do reach out to your director. Or, I think it was mentioned, you can click a meeting note, request meeting on this document. We really appreciate your time today. I do just want to follow with a fun one. Because I found out that we are all local. I’m saying local because you weren’t technically born here. But we all are local and that’s very rare at a company that is headquartered in Colorado. I don’t know that I know of very many. And all three of us happen to be. Let’s just round this out with, what’s the most Colorado thing about both of you? Let’s start with you, Mike.
Meyer: His beard.
Keough: I remember in kindergarten, in second grade, I came out here with my parents for ski trips. And I remember going off these little one-foot jumps that I thought were 10-foot jumps. I just got a passion for Colorado. Being outdoors, I feel really fortunate to be able to do this job in this industry and get to enjoy it out here. That drove me to go into the Air Force Academy down in Colorado Springs. I had an opportunity to do that in the late ‘90s. And I’ve been here most of the last 30 years and I have five kids that I’ve created, natives. We’re putting our roots [overtalking] Colorado [overtalking].
Reinhard: Love it. I think I also heard that you are quite a hockey player, though. I think you’re selling yourself short a little bit.
Keough: Colorado Avalanche.
Reinhard: Colorado is the hockey state now. There we go. Seth, what’s your…?
Meyer: What Laura failed to mention was the two other states that I lived in were California and Hawaii. Snowboarding is probably the thing that makes me most Coloradoan. My family and kids, of course, we love being outside and do outdoors. But the funny part about it is I have not let my kids even try it. They’re just really good skiers. But I’ve never allowed them to put a snowboard on, even though I’m going down the mountain that way. I’m like, no, you can’t be social and be a snowboarder. You got to be a skier. Anyway, snowboarding is probably [overtalking].
Reinhard: I would say for me, the most local thing about me is I don’t ski anymore. As a local, I know that’s bad. But just when you grow up and certainly, it was a breeze. And now I feel like most people that I spend time with, it takes so long to [overtalking].
Meyer: It does. It’s a commitment.
Reinhard: It’s a commitment. But anyways, thank you for the conversation. Thank you all for attending. I know we didn’t get to a lot of your questions. We will follow up with you on those. And with that, we will end this, and I’ll turn it back over to Melissa.
Operator: Thank you, Lara. That concludes today’s webcast. Thank you again for joining.
Originally Posted March 14, 2023 – Bonds are back: Finding an optimal allocation for ongoing Fed, inflation, and growth risks
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