PM Corner: In conversation with Rick Figuly
Rick Figuly, lead Portfolio Manager of the Core Bond Strategy, discusses core fixed income opportunities at a time of high inflation and rising interest rates.
Fixed income markets continue to be impacted by higher rates, inflation is at a 40-year high and more rate hikes are likely ahead. What’s your macro view?
Macroeconomic debate is part of the team’s daily discourse. But our process tries to keep, top-down macro decisions, like our strategy’s duration, range-bound to, Barclays U.S. Aggregate, our index. We do believe Federal Reserve (Fed) policymakers will continue to be hawkish until they bring inflation down to both their headline and core inflation targets. Unfortunately, reaching these goals may take longer than the market is currently pricing in. The employment market is very tight and will have to loosen before inflation comes down meaningfully.
A tight housing is another major component of inflation that has been persistent and needs to moderate. These are a few of the factors that led us to make recession our base-case scenario in the U.S. The recession is likely to occur in 2023; however, the market’s pricing of recession risk is likely to happen much sooner.
How do you balance the market’s focus on central bank policy with your team’s long-term focus on security selection?
Our Core Bond Strategy has always been focused primarily on relative value, regardless of market conditions. At times this can be frustrating, particularly when fiscal and monetary policies skew investment decisions away from fundamentals. It’s our belief that over the long term, fundamentals win out.
In the current environment, with the Fed aggressively raising the fed funds rate and engaging in quantitative tightening, we find the two best relative value decisions are first, to be underweight the shorter parts of the yield curve, because we believe short-term rates have more room to rise. And second, to add to shorter-maturity, amortizing securitized credit, for the attractive spreads and cash flows. We are also neutral, relative to the benchmark, the longer parts of the yield curve but will likely add there over time, as the economy likely gets closer to recession.
Mortgage rates are high, housing affordability is the worst in decades and the Fed isn’t purchasing agency mortgages. What’s your view on agency mortgage-backed securities (MBS)?
Our philosophy toward agency MBS has always been the same: Leave no stone unturned. The MBS index is 100% agency pass-throughs, skewed toward more recent mortgages—a lot of what we traditionally don’t want to own as long-term investors, since we have other options to choose from. But we’re certainly surveying the agency pass-through market for value. We also assess the multitrillion dollar universe of agency collateralized mortgage obligations (CMOs) and agency commercial mortgage-backed securities (CMBS) for best ideas.
I should say that we benefitted from the runup in mortgage prices. Over the last couple of years, the Fed aggressively bought current coupon mortgages, and since 30-year mortgage rates were generally between 2.5% and 3.5%, that has left its balance sheet skewed toward coupons of 3% or less. Due to those very low interest rates, issuance was large and the Fed ended up owning about 60% of the MBS index. During 2021 spreads on low coupon mortgages traded as tight as negative 40 option adjusted spread which we did not view as good relative value opportunities.
While we did benefit from the runup in prices, even then we continued to focus on long-term value because we thought in late 2022 the Fed was nearing the end of its mortgage purchase program. We concentrated on security selection, buying mortgages with greater convexity, for downside protection, that the Fed didn’t own.
While the MBS market has repriced this year, we still don’t believe it pays to own what the Fed owns, given that the Fed is no longer buying. The disappearance of Fed demand is obviously a negative technical factor. Banks were also a big source of demand over the last few years, and they have largely been absent this year. There’s also a possibility that the Fed will eventually sell mortgages to shrink its balance sheet, and that would be a catalyst for even wider spreads on lower-coupon mortgages.
How does the consumer factor into your search for relative value across spread sectors with elevated risks?
As with all sectors, risks across our market rise or fall in different environments. The consequences of COVID-19 have hit parts of the securitized sector differently. Most assets related to housing and consumer receivables continue to perform well, whereas office and retail assets are challenged. U.S. consumers generally came out of the pandemic with more savings due to fiscal packages, and servicing their debts was easier thanks to extremely low interest rates.
While some consumer stress is to be expected, the U.S. consumer has generally remained resilient, even with high inflation. The strong consumer makes asset-backed securities collateralized by auto and consumer loans attractive today, from a fundamental perspective. Spreads on these securities have widened significantly since the beginning of 2022, making shorter-duration, amortizing securitized credit one of our highest conviction ideas.