A Top Bond Manager Explains His Bottom-up Approach

Since the beginning of this year, rates have dropped across the yield curve. What does that signal for fixed income opportunities?

This means fewer opportunities. We generally want to take on risk when expected compensation increases. As you mentioned, year-to-date, risk-free rates have fallen dramatically for the U.S. Treasury market. But at the same time, credit spreads, or the compensation we get for taking risk, have declined as well, which means all-in yields and expected compensation are lower. That's despite the fact that risk in all of its different forms, whether it's a slowing global economy, a U.S.-China trade war or Brexit, has increased.

That doesn't mean there are no opportunities, but investors need to be willing and able to do the necessary analytical work to understand the risks they are taking. We're more hunting with a rifle than a shotgun these days.

Successful, long-term investing begins with knowing what you own, which is why we are a bottom-up, fundamental investor, which is just another fancy way of saying we do our homework. Because we execute our strategies very simply using cash bonds, our portfolios tend to be highly transparent and easy to understand. Advisors know what we own, can see what we're doing and understand what risks we are taking with their client's money, which makes it easier for them to explain to their clients exactly what we're doing.

I want to get your take on an incident that happened about a week ago, where the repo market lacked sufficient liquidity. The Fed stepped in and provided what some have called a “mini QE.” What happened and, more specifically, will this will have any longer term significance for bond investors?

The very short end, the overnight part of the market, basically had a mismatch in supply and demand. There seemed to be a confluence of events where there was a lot of U.S. Treasury collateral settling and a lot of companies who usually invest in money market funds. They had to pull their money away to make their tax payments. You had people wanting more money to finance that U.S. Treasury collateral and fewer people participating in that process, companies in particular. The Fed described it correctly, as did some other observers, as a “plumbing issue.”

It is part of the normal functioning of the Fed to make sure that that plumbing is working properly. They introduced additional liquidity into the marketplace. I was meant to be short term in nature, which is why I hesitate to call it a mini QE. The Fed has promised that they'll be in the market until October 10 with $75 billion of collateral on an overnight basis. Occasionally it will be in there for the 14-day repo market. That's just to ease the pain in a short period of time.

Longer term, the actual mechanism that they used doesn't have much significance. Banks have grown in terms of a desire to hold cash reserves and they're reticent to let it go. That can drive up short-term rates. The Federal Reserve let their balance sheet grow just from the natural growth of the economy. As the economy grows currency in circulation grows, and the Fed needs to support that by letting their balance sheet grow.

This was an easily solved problem. It doesn’t suggest any massive problems in the banking industry, like we saw in 2008. This is very short term in nature.

I want to talk about something that is a bigger concern from a longer term perspective – inflation. The PCE, the Fed's preferred measure of inflation, has been mostly below 2% since the financial crisis. But there's some signs that, for example, wage pressure might be building. How worried should bond investors be about inflation?

Obviously with a fixed rate of return, inflation is always going to be top-of-mind for investors. People should be thinking about wages and understand how inflation plays into how they position their portfolios.

Advisors can add some TIPS and have some exposure to some securities that will do well in a more inflationary environment. That said, I'm not particularly concerned in the near term about runaway inflation, given the general slowing nature of the global economy and the fits and starts we've seen in the U.S. Global inflationary pressures have been subdued. That will continue to have an impact in the U.S. Even though wages are rising, it's harder for companies to pass through those costs to consumers both here and abroad.

One of the outlier scenarios that we haven't experienced in a long time is stagflation – an economic environment where we don't see any growth, but we have inflation. That becomes very problematic for assets in general, especially fixed income. We should be thinking about how to manage that risk and what that might mean for our portfolio allocations. TIPS would be a part of that, but other broader solutions should be put in place as a contingency.

Let's come back to the point you raised earlier about the limited fixed income opportunity set. Where are you finding opportunities now? Do you own TIPS?

We haven't bought TIPS because of their very low real rates of return. We have some in our portfolios, which are well-diversified, and TIPS provides some insurance against some of the potential outcomes.

We are finding individual opportunities across the market, but I'll emphasize the word “individual.” We continue to find good value in the most senior or the most credit-enhanced tranches of the asset-backed and mortgage-backed sectors, both of which have cash flows that are backed by the U.S. government.

Among asset-backed securities, we own collateralized car loans, student loans, un-secured personal loans, and mortgage-backed securities that have first lien mortgages on people's primary homes. With a strong job market and a solid financial position, the U.S. consumer continues to be a standout in terms of fundamentals as compared to the U.S. and other governments and corporations, where their balance sheets are quite weak, and in some cases, particularly governments, are weakening further. Consumers have strong cash flows to pay their bills. Credit spreads in the asset-backed and the mortgage-backed markets remain wide relative to corporate bonds. That combination provides us with a real relative value proposition that is quite favorable.

You and I spoke about three years ago. I know that Thornburg employs a very collaborative structure and an un-siloed approach to its management. Going back to what you said earlier about the fact that you are a bottom-up investor, how does that fit in to your management style to give you an edge?

I'll let you in on our secret. More than any place that I've been or seen, Thornburg gives its investment professionals the freedom to exercise their creativity and entrepreneurial spirit as they pursue that bottom-up, fundamental process. Every team member is a global generalist and can go where the value is. Our approach allows our team to better assess risk-reward across asset classes, sectors and geographies.

Traditional, siloed structures may look for the best securities within a given, narrow silo. Take U.S. airline corporate bonds. Because that analyst rarely speaks to, say, the international airline corporate analyst, let alone the airline asset-backed analyst, decision-making about which security to own in the airline industry broadly defined won't be optimized.

We all sit on a trade desk in Santa Fe within 10 feet of one another and actively participate in every decision in real-time. It's a team effort. That process helps us avoid not looking across the entire spectrum. When advisors come to Santa Fe, they see our setup, our process and our culture in action. It makes a lasting impression, and we often hear them remark on how different our approach is.

I would ask how the traditional structure answers this question, "Should I buy a given airline investment-grade asset-backed bond or, say, a high-yield packaging company bond?" The traditional structure doesn't answer that question very well because the decision rests with the portfolio manager, who may see the difference in valuations but not understand the underlying fundamentals. He or she will have trouble assessing that relative value. Our process keeps those fundamentals and valuations paired throughout the analysis, which enables efficient and effective relative-value decision-making.

Going back to the macro outlook, we've seen that the correlation between equities and fixed income has been increasing. Does fixed income still offer the right level of portfolio diversification with respect to equities?

Over a long period of time, the correlation between fixed income and equities tends to average about zero. But that correlation is highly variable. Since the late 1990s, the correlation has been negative and notably so at times. But for the 40 years before that, it was positive. There were even some periods where correlations were positive, and yet fixed income returns were positive and equity returns were negative. It's just a quirky nuance to the period over which you're making that measurement.

Correlation ultimately suggests a direction. It doesn't define the market in total. In particular, it doesn't define the magnitude of annual returns. Certainly, it is more beneficial if fixed income returns are increasing as equities are falling. But even if they happen to fall together, the magnitude of the fixed income move will most likely be much smaller.

More importantly, when we say “fixed income,” we think of a monolithic entity. But it is a very large market, and there are many different pieces to it they're not created equally.

High-yield and lower quality investment grade will tend to be the most correlated with equities. They fall into the risky asset category. But risk-free assets, like U.S. Treasury bonds and some very high-quality fixed income assets, like corporate bonds, asset-backeds and mortgage-backeds have the lowest or even negative correlations with equities the majority of the time. Over the long term, there's a reason to own each piece of the fixed income market in a well-diversified portfolio. They'll be additive to the overall risk-adjusted outcome.

Each will perform well at different times, but that's the point. That timing is awfully difficult to predict, so remaining diversified across sectors serves investors well.

But when we see equities go into decline as markets go into extreme “risk-off” mode, U.S. Treasury securities will be the only asset that will be increasing in value. If you have a somewhat dour view on where we are in the cycle or what's going on in the marketplace – including the new risk of presidential impeachment – U.S. Treasury bonds should be a part of the portfolio from a diversification and risk management stance.

You've been managing bonds for about 20 years. What features of the market have benefited investors and what features have detracted over that time?

It's been an interesting ride. There has been a lot of innovation in the fixed income market, from the type of companies that can get financing to the way certain assets are financed, such as directly through securitization. Some folks have seen businesses go into the securitized market. You're seen things called “whole business securitization” as an alternative to a corporate bond. Companies like Wendy's, the fast food chain, did that. It makes the market a bit more efficient.

There are more opportunities for investors to diversify their portfolios. But at the same time, those increased opportunities come with an increased workload, and it increases the demand on our time and resources to be sure that we are actually understanding the risks that we are taking. Investors need to decide where they can be particularly successful on their own and add value, and where it makes sense to hire someone to do it for them, whether it's an individual hiring an advisor, or an advisor hiring an investment manager.

But innovation is good in the long run. It makes markets more efficient. It brings financing solutions to new sectors of the economy, creating a broader opportunity set for investors. But in the short run, that innovation and the economic rewards and incentives that follow can make people either sell products or take risks that they don't understand. Simply, greed overtakes the market. There are a lot of examples throughout history of this, but one of the things that comes to mind was the sub-prime mortgage debacle.

It started with a very good premise of allowing more people to own their own homes. But it ended with way too many loans being made to people who couldn't afford them, such that that the securitization apparatus designed to facilitate this brought the market, the financial system and the economy to its knees. Ultimately, the market and the economy survived, but history tells us this won't be the last time this happens. We should remain vigilant.

Given what's going on in the equity market, one thing that has surprised me is how little fixed income trading is done electronically. We use things like instant messaging that didn't exist 20 years ago. We call it “Instant Bloomberg,” based on the systems we use. We do fewer trades by talking to humans and more typing, but trades are still largely done human-to-human. Huge volumes of equities are traded in fractions of a second, and yet fixed income trades go through several people and can take minutes or tens of minutes or sometimes even hours to complete. It's because of the vast number of smaller deals.

That's why humans are still needed. The sales folks and the traders on the other end of the line or the other end of the instant messaging machine get paid to have that strong roster of clients and find that individual home for a given bond.

It sounds though like the market has become more efficient over time. Is that correct, or how has the level of efficiency in the bond market changed?

Markets tend to become more efficient over time. The fixed income market is no different, especially because of the aging population globally and the growing need for income. We have a lot more eyeballs than ever on this marketplace. That said, if we take the U.S. corporate bond market, it continues to expand and now has nearly 15,000 different issuers and over 40,000 individual issues.

That's not counting U.S. government or securitized debt issues. Increasing the complexity of the market tends to offset some of the natural increase in efficiency. But more importantly, at Thornburg we have long believed that the fixed income market is inefficient at evaluating the risk and reward I talked about earlier, due to the siloed nature of traditional fixed income analysis and because many investors start their allocation and decision-making process by focusing on a rules-based, market capitalization weighted benchmark.

Because it's so embedded, it's unlikely to change anytime soon. Attractive relative value opportunities across those silos should remain in place for our nimble, global generalist structure team to take advantage of and ultimately deliver value to our end clients and investors.

I'm going to put you on the spot. If we were to talk again a year from now, what will be the yield on the 10-year Treasury? To put that in perspective, the yield right now is about 1.69%.

My best guess would be we'd be somewhere in the low 1%s, something like 1.10% to 1.25%. That's largely for a couple reasons. We're slowing down. We have several risks on the horizon, any one of which could derail a pretty slow growing global and U.S. economy.

If there's one thing that you'd like our readers to take away when it comes to the bond market and Thornburg's approach to managing fixed income, what would that be?

When people think of Thornburg, they should think of a highly flexible, nimble manager who does the work on individual assets and builds highly diversified portfolios based on the underlying risk of the marketplace. Our differentiation is that focus on the relative value, which allows us to perform across different types of market and economic environments. It's in our nature, our DNA, and it's how we collaborate together that ultimately puts that relative value process into action and makes us successful.

We don't rely on any single individual, and that makes us a very robust. Our team is small but very skilled and very tenured. That allows us to be nimble and design a portfolio that is very responsive to changing market conditions.

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