Roger A. Early, CPA, CFA, is executive director and head of fixed income investments at Delaware Management. He is executive vice president and co-chief investment officer of Delaware’s total-return fixed income strategy.
Roger rejoined Delaware Investments in March 2007 as a member of the firm’s taxable fixed income portfolio management team, with primary responsibility for portfolio construction and strategic asset allocation. He became head of fixed income investments in February 2015. During his previous time at the firm, from 1994 to 2001, he was a senior portfolio manager in the same area, and he left Delaware Investments as head of its U.S. investment grade fixed income group.
I spoke with Roger on August 22.
You’ve written about the debt “supercycle,” which you’ve described as a buildup of government debt over the last 30 years that will drive lower growth in the U.S. and globally. What that means for fixed income investors and why is it about to unfold now?
The current-events version of this is the buildup in debt in recent years. McKinsey did a study recently citing the idea that indebtedness globally has increased by $50+ trillion since 2007. Its numbers were $142 trillion in 2007 and $199 trillion as recently as 2014. There are no signs that that trend has changed. The buildup, predominantly in government debt, continues up to this moment.
It’s important to stop and go backwards to better understand what we’re suggesting is at hand. The debt supercycle, in a broad sense, is not just current events. It refers to the process during most of the postwar period and certainly since the 1960s and 1970s, as opposed to prior to World War II, when economies were allowed to go through failures. Debt was allowed to fail and you went through a period where there was some washout. Then you started again – a renewal if you will. The debt supercycle is nothing more than a series of periods where the authorities -- governments and the central banks -- have reflated the economy every time we’ve seen either economic or financial problems. A couple of cycles ago corporate debt was the problem. We reflated the economy so that we didn’t have massive defaults on the corporate side and off we went.
The most recent example was the post-NASDAQ bubble. The Federal Reserve under Chairman Alan Greenspan reflated the economy in order to protect us from its follow-on. He directed the reflation into the housing-borrowing market; the debt market in housing was where we got a bubble. Since then we have reflated through the creation predominantly of government debt.
This is not something that started in 1999 or 2000. Go back to as far as the oil problems in the early 1980s, or the high-yield debt problems and the savings and loan problems in the late 1980s. Each time the process was, “Don’t allow the failures to carry on. Reflate the economy. Protect the economy. Protect the investor base.” It meant we pushed out another level of debt. We have lived under that process for many years.
You get to the point where the only parties who are borrowing in a bubble-like form right now are governments. It would appear as though we have to be near the end of this debt supercycle, because there is nobody to reflate that debt if the governments are the ones that are indebted. On top of that, at least when we were funding high-yield, oil and gas or houses, there was some argument for the productive use of borrowing. But the government debt that we have seen taken down, to the tune of tens of trillions of dollars since 2007, has very limited productivity behind it. We are building the bubble of debt to a never-seen-before level and we are doing it on the back of virtually no productive outcome to its use.
The debt is very large and a headwind to economic growth. If you can’t take on additional debt, at some point you’re going to have to live like anybody would, within your means for a period of time, which means a lower level standard of living, rather than borrowing to create a higher standard of living. That’s the guts of what this is about.
How does the debt supercycle affect investing globally and in the emerging markets in particular?
You have to move from macro to micro and understand the nature of borrowing within different parts of the world – different countries and economies.
The emerging markets went through of their moment of fear in the late 1990s. There was a lot of corrective action and some pretty good behavior from the emerging markets after the Asian crisis in the late 1990s. There was a period of time where they ran their business pretty effectively. They were careful about debt.
That all went out the window sometime in the mid-2000 area. From 2005 to 2007, and certainly in recent years, the buildup in debt in the emerging markets is part of this story. It’s part of the debt supercycle going to the next level.
Emerging markets have better potential growth than the developed economies. They’ve got a younger population and more potential for productive population growth. They don’t have quite the demographic challenges that Japan or the United States face. But that debt buildup has definitely occurred. When you match that up with the decline in commodity prices, even though we have had a bounce in oil, we are still substantially off the peaks of energy and other commodity prices from several years ago. I worry about their ability to service the debt. If I had to take a guess where you will see an inability to service debt, the emerging markets are the most likely place to look.
Is it fair to say that some of the paradigms that have traditionally existed in the fixed income markets no longer exist? What are some examples of that?
Having been in the fixed income business for 40 years, I am on a very short list of people who were working in the business when rates were rising in the 1970s.
The core of everything is income. The paradigm that has completely changed is that, for most of the post-war period, we lived in a world where if you were earning 8% to 10% coupons and sometimes higher, even in the worst of years, you were likely to return something positive because it was hard to lose 6%, 8% or 10% worth of your principal to more than offset that income that you were getting, especially in higher-quality assets.
Move forward to today where the Barclays Aggregate Index is yielding less than 2% and its duration is about 5.5 years. Forget worrying about corporate bonds, spreads or credit risks. Forget all that. Just a flat-out half-percent rise in rates eats up more in principal than you are making in income in the AGG.
That’s the new paradigm.
Bonds used to be the ultimate absolute return product. I was going to make some money in one way or another. I hoped to make all my coupon, but at least in volatile times I could at least make something – the coupon minus some principal impact. Now you clearly have a marketplace where you can end up with a negative return. People have had to change the way they’ve invested to find a balance and a little bit of protection from negative returns.
Because yields are so low, the paradigm now is a lot of people don’t use bonds for safety anymore. They are chasing any yield they can get and taking risks that they shouldn’t. But they’ve got to find some income. The fear is you get to the end of a credit cycle, which you clearly will do at some point, and people will have stretched as far as they can to find yield or income, and they will have far too much credit risk. The result will look like a small version of a downturn in stocks, because that’s what you end up with if you take too much risk on the credit side.
We’ve had a persistent low-rate environment for some time. How should investors adjust their expectations?
Our general theme has been that the 2% GDP growth that we have been experiencing since the financial crisis is likely to continue for the foreseeable future. If underlying real GDP growth is 2% instead of 3% to 4%, there is an adjustment to your expected total returns. That covers stocks as well as bonds.
If you then also assume that the global competitiveness that we face creates some deflationary pressure, there will be a continuation of a relatively low inflationary environment for the foreseeable future. We are not just talking real returns. Nominal returns will be considerably lower.
Think about where we were pre-crisis. Because the emerging markets were growing, their growth rate was literally double digits – 10% to 12%. That carried the global growth rate across all types of economies to a mid-single-digit growth. Now EM markets are growing closer to 4% – so we’ve gone from a global growth rate of at least 5% to 6% to a rate that is certainly sub-4% and probably sub-3%. Return expectations need to be reduced. You’re not going to make as much in fixed income. Frankly, you are not going to make as much in equities on average over time. Profitability won’t sustain it. Free cash flow won’t sustain it.
We are telling our clients to be realistic about what to expect: low- to mid-single digit returns in high-quality fixed income, and that’s if you do good credit work and differentiate between credits that are going to fail and those that are going to perform better than expected. You’ve got to find some of that active management value to even get to those low- to mid-single digit returns.
We are up 5.5% to 6% this year. But we are saying to clients, “Please don’t annualize these numbers because it fundamentally doesn’t add up.”
When you say you are up 5.5% to 6%, which products are you referencing?
I’m referring to the high-quality marketplace – investment-grade portfolios. If you look at the flagship markets, and include some high-yield and some non-U.S., and then the returns through the end of July in the institutional portfolios were up about 6.75%.
We are surprised that we are doing this well. We are surprised that rates have fallen as much as they have and corporate bonds have done as well as they have. We were positioned to deal with some of the challenges that we saw in the first six weeks of the new year after a tough 2015. The bounce in some parts of the market that we’ve seen doesn’t match up with the change in credit fundamentals. We are expecting some retracement of some of those gains, and only investing in things that are sustainable in terms of the risks that we are taking.
In this world of low yields, what are the big risks that you see fixed-income investors facing?
First, let me clear off a couple of items that I wouldn’t put at the top of the list that others might. We aren’t of a mind that we are going to have massively higher interest rates. In defense of that position, we weren’t of a mind that we were going to have massively high interest rates back in 2010 or 2011 either. The market has come around and is now believing that story, but it hasn’t been a common point of view. We’ve acknowledged rates could go up a little bit, back when rates were 2.5% or even approaching 3%. But our view even then was a modest rise in rates would bring about its own reversal, because the pressure put on key parts of the economy would bring rates back down.
Our view is the Fed doesn’t have a lot of room. They might move once or twice in the next year, but they are not going to move at the rate that they had once hoped that they would move.
Longer rates are already acting like this isn’t a brand-new economic expansion, where typically, as the Fed begins to raise the Fed Funds rate, intermediate and longer term rates rise to a similar degree. This feels like an economic expansion that’s already fragile or potentially late stage. In a late stage economic expansion, we would not expect to see long rates rise with short rates. Rather, the yield curve would flatten as short rates rise independent of longer maturity rates. In our opinion, intermediate rates are going to be low for a long time.
The second point is corporate spreads are a place where you can lose money. Obviously you have to be aware of risks related to individual companies. The big risks are focused on companies that might be subject to headwinds from volatility in commodity prices or the dollar. Export-oriented businesses have faced headwinds because of the strength that the dollar in recent years. We need to be focused on that credit issue. Companies are coming to market for all the wrong reasons, at least from a bondholder standpoint, with new issues where they can pay a special dividend to shareholders, or they can do some type of M&A transaction and basically leverage up their balance sheet in order to try to grow through acquisition. We need to do a very careful analysis as to whether those companies are doing the right thing for bondholders.
In many cases, our conclusion is they are not.
The headwinds are pressure on exporters and on commodity-oriented business with the volatility of energy prices, and pressure on any company that comes to market for “bad behavior,” as it is sometimes referred to.
Liquidity comes up frequently now. Liquidity wasn’t always a big risk. It was an afterthought. But in the post-crisis period and even marginally before that, Wall Street has chosen not to be in the business of putting its balance sheet at risk. It is not putting capital to work by holding bonds. It is serving as the conduit from the seller to the buyer. Liquidity can dry up rather quickly. That’s not based on fundamentals. That can be based on the fear trade. You can list 100 reasons why the market could feel some stress. Investors could develop some fear. There’s always going to be sellers, but when buyers take a short pause, liquidity is challenged. It’s a risk that can impact good-quality as well as marginal-quality corporate bonds. Even the Treasury market in the last year has had two or three days where you’d argue liquidity dried up.
So you talked about the U.S. economy growing at roughly 2%. Do you think that that will be strong enough to support another Federal Reserve rate hike this year? How does Fed policy more generally fit into your investment process?
It’s fixed income, so it’s rates. The Fed owns the rates market. They’ve got a major input. Fed policy is critical to our work. But you need to figure out how is Fed policy affecting the broad fixed income market and how is it affecting the economy.
Certainly during my entire career and even before that, during the entire post-war period, the economic cycle has been pretty easy to understand. The economy for some set of reasons got into a very strong growth period. Businesses took risk. Then the economy got to the point of beginning to overheat. The Fed raised short rates aggressively, enough that they were above long rates. We got an inverted yield curve, and that was absolutely the marker, every single time, that we were going to enter a recession.
We are in a different world today. The prism you look through to understand what’s behind the markets and what is driving things is almost reversed. This 2% growth rate means that any increase in the Fed funds rate now will not push intermediate rates higher, because the market will anticipate that we are not that far from the Fed having a negative impact on economic growth. We’re probably not going to go through an inverted yield curve in order to get to a recession. We are growing at such a slow rate that we could fall into a modest recession through any number of marginal impacts – the Fed increasing rates slightly and giving the dollar another boost in relative value is one example. Certainly the Brexit and its impact on Europe, or what is happening in China, could lead to the third-party pressure that could be put on a slow-growth economy.
The Fed is important to us, but we don’t follow the old prescription that has worked so well for so many cycles. Before the Fed existed, economies fell into recession often because of asset bubbles and deflation.. You need to at least admit to yourself that that kind of an outcome is likely as the Fed pushing rates dramatically higher and creating an inverted yield curve. We are trying to keep an open mind and monitor from that perspective.
How does your investment process work at Delaware, and what differentiates it from that of other asset managers?
We are bottom-up, research-driven investors. That works across the entire Delaware spectrum here in Philadelphia, where our equity teams would give you that same answer. Our first work is idea-generation from across a team of about 80+ individuals. I expect team members to make a difference, whether they are senior vice presidents or whether they are relatively junior members, because we want to encourage ideas to come from across the team.
What’s different about Delaware? We are big, but we are small. We are big in the sense that we run over $100 billion in fixed income. We are big enough in corporate bonds where we run close to $80 billion, and are a major client to Wall Street and to the new-issue market. We demand a certain presence on Wall Street. We get bonds. When we like an idea we can usually get an allocation. You’ve got to be big enough to have the resources and big enough to have a presence.
We are small in the sense that we do things the more traditional way, where we are making a difference one idea at a time. The mega-firms that we compete with, but who are definitely in a different category than us, are so large that it would be hard for them to make a difference in their portfolio outcome through one or two individual ideas. We can own an appropriate amount of bonds and one idea will move the needle for our clients’ return. Yet, we do not own so much that we can’t get liquidity in the market if we change our view on that bond. There is a subtle balance there that’s very important. Size makes a big difference.
We want diversified sources of excess return through fundamental analysis, but we also want to protect our clients’ assets and we want to provide reasonably liquid conditions within the portfolios. Among the 80+ people, for those with a research focus, that is their career. The traders, that’s their career. We broke the mold almost two decades ago, away from this portfolio-manager-centric idea to an idea that is based around every member of the team bringing value to a client’s portfolio. Great research people and great traders should be doing that for their entire career here at Delaware, rather than forcing them to become portfolio managers in order to become more relevant within the team.
I understand you have an initiative called the “Great Risk Rebalance.” What is that and how does that affect your investment process?
The Great Risk Rebalance is a series of papers addressing what we view as some of the most important risks facing fixed income investors today. You and I have already talked about the debt supercycle and the belief that we have that we have approached or are approaching the end of what has been a reflationary cycle over and over again for decades. If we are getting to the end of that, there is nobody left to reflate the next time around. If government debt literally faces some challenges in the near future, we are going to have to deal with it at a more fundamental basis.
Liquidity is an issue that we’ve addressed as well. We are preparing a third paper focused on the low level of yields. One of the key features of that conversation will be that low yields provide a reason for investors to chase yield irrespective of underlying principal risk, and take too much risk at the wrong moment in time, and potentially set themselves up for some pretty unattractive returns. Our argument is there may have been very few better times or more important times than now to do good fundamental credit work and research, and to have at least a piece of your focus centered around protecting principal.
We believe that protecting principal is critical, and in building portfolios where you can sustain the risk level that you’ve chosen through any kind of market volatility, and having portfolios where we can provide liquidity to the market when it gets stressed so we can take advantage of opportunities rather than be a panicked seller. These are the key features that help us manage some of these broad risks that we are talking about within the Great Risk Rebalance.
You touched on the risk of liquidity in the U.S. bond market. Is there anything specific that Delaware has found to be effective in addressing that risk?
There are two things. Everybody in the business does what I’m about to describe in some form or another. We have a risk management committee that reviews our risk exposures on a frequent basis. We meet weekly with a couple dozen of the senior members of our team to go through risk metrics and how we are positioned across all our different types of mandates and portfolios.
My point in bringing that up is years ago that was focused around three key ingredients: performance attribution, macro or top-down risk – duration, yield curve, spread risk – and relative value, all of which we reviewed and discussed on a monthly basis. The fourth component now is a trader-led meeting to discuss liquidity, looking for any marginal insights about liquidity being challenged in any particular market.
In the spring of 2011, we started to hear about cracks in liquidity in the commercial mortgage-backed securities market from our traders. We thought that that was important information, and at least kept an eye open for the idea that it could start to carry through to other markets. Sure enough, even before the government debt was downgraded late that summer, we began to see cracks in other markets like corporates. Just having a conversation is important.
The second piece is how you run the money. You build a portfolio where you are comfortable that you can sustain a level of risk through a period of serious stress and volatility in the market. The last thing, the critical ingredient in managing during less liquid moments in the market, is not being a panicked seller. Sustainable levels of risk are what you need. We focus on that and we hope that we have the discipline to be a source of liquidity to the market when everybody else is panicking. That is how active management can add value.
How else can active management offer opportunities in the current low-growth high-debt environment that perhaps passive management cannot?
I don’t think this is a fixed-income-only topic. It can apply to equities, too. What we see is that passive management– and this has happened before – becomes very popular during a period of a reasonably solid up-move in risk markets where typical active management investors are evaluating the markets and not getting on board and enjoying the ride. They tend to trail a little bit and passive becomes more and more popular. That usually ends badly for the passive investor because the passive investor doesn’t distinguish between good and lousy fundamentals; you just own everything. When the market is rising you are happy to own everything. But good credit work and the valuation of underlying fundamentals in the stock market provides better protection when the markets turn.
For us active management is differentiating between the literally 20% to 25% of the underlying corporate bond market that is in the benchmark that isn’t actually a very good credit. We are trying to differentiate between the lousy credits, those that don’t have good free cash flow, have overleveraged their balance sheets and are bringing deals for all that wrong reasons, from the better credits where all those things are reversed and we are very happy about what that company represents and their ability to deliver on their business model over a full business cycle. It really does come back to fundamental research and it does make a difference over a whole investment cycle.
Read more articles by Robert Huebscher