John Nicely: Welcome to the Center of Investment Excellence, a production of JP Morgan Asset Management.  The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and Investment themes.

Today’s episode on Global Fixed Income, Currency, and Commodity, Core Bond Strategy has been recorded for institutional and professional investors.

I’m John Nicely, Senior Fixed Income Investment Specialist and host of the Center of Investment Excellence.  With me today is Steve Lear, U.S. Chief Investment Officer for Global Fixed Income, Currency, and Commodity, as well as Rick Figuly, Senior Portfolio Manager and Head of our Core Bond Team.

Welcome to the Center for Investment Excellence.

Rick Figuly: Happy to be here.

Steve Lear: Thanks for having us John.

John Nicely: So let’s go ahead and jump right in.  JP Morgan Global Fixed Income Platform has had a solid year in terms of performance and AUM growth.  While the year has had many twists and turns, I thought the best approach for our conversation is a speed around of questions covering a variety of topics from market themes to specific thoughts on fixed income sectors.

So Steve, let’s start with you.  First question, are U.S. treasury bonds still a reasonable hedging instrument?

Australia’s near-term economic prospects continue to improve. Sentiment among consumers and businesses is on the rise, the unemployment rate is falling and fourth quarter inflation was stronger than expected. However, this won’t be enough to move the RBA when they meet this week. While the economy is getting back on its feet faster than forecast just a few months ago, the medium-term prospects haven’t changed and this is what the RBA is focused on. The unemployment rate is likely to remain some way from the RBA’s full employment target even as survey based measures improve (see chart). Meanwhile, inflation may get a lift in the coming quarters from the low base effects from 2020 but probably won’t be considered a sustainable move higher by the RBA. There is a lot of good in the outlook for the Australian economy but not yet enough to really unwind the dovish view of the central bank and their long held belief of an ‘unpredictable and uneven’ recovery in 2021. Thanks John.  Sure.  The answer is yes.  But let me start with a story.  You know, one of my favorite bonds in 2017 the Government of Austria issued 100-year bond with a 2.1% coupon.  By March of last year the yield on that had fallen to 1.6% right where our government bond is today.

So the Austrian bond since then has fallen to half a percent and its price is up 80 points since it fell from 1.6%.  So the bond math is what the bond math is.  If our 30-year bond does the same, goes down to half a percent in yield it’s going up 30 points in price.

Now I guess the question you’re asking may be not do bonds hedge risk but is it worth the price.

Let me take a second and talk about real yields and inflation premium because the 1.6% yield we can decompose into an inflation premium of about 1-7/8 percent and a real yield of about minus 3/10 of a percent.

So it seems crazy to lend money to the U.S. Government for 30 years and to get an automatic return of minus .3% for the entire time.  I think of it as a wealth tax.

And I guess I’d ask our listeners to ask themselves do they think the possibility of higher wealth taxes is possible over the next 30 years which would drive those real yields lower.

The other piece of the equation is the inflation premium, a little bit below 2%.  The things that we were thinking about secular stagnation, last year and the year before, they haven’t gone away.  Inflation breakevens for 30-year bonds were 3/10 of a percent or more, lower in 2016, in 2019, and as recently as June.

So yes, I do think there is the potential certainly in a risk off.  Bonds will go up in price and will hedge the rest of the portfolio.

And getting back to the question you didn’t ask, is it worth the price to buy that 30-year bond, it’s certainly a steep price to pay.

But I would remind all our listeners that the Fed is on hold for the foreseeable future.  And even if bond yields do rise and prices fall, there’s a limit to how far they’re going.

The yields of 3% and 4% on 30-year bonds are not coming back anytime soon.  So perhaps the cost of that hedge isn’t as great as people might fear.  I guess that’s my answer.

John Nicely: Steve, that’s an excellent answer to a question that’s kind of open-ended.  So let’s go a little deeper.

And Rick, next question is for you.  Considering where we’re at in yields and as Steve said we are in for a lower for longer type environment, does Core Bond Strategy lose its appeal given such low yields?

Rick Figuly: No John, I don’t think so.  Core Bond is not the 10-year treasury, which is currently yielding just below 90 basis points.

Core Bond yield’s right around 1.70% right now.  And that yield is probably understated.  Take TBA Mortgages for an example.  The current coupon on TBA Mortgage has a yield of about 1.15%.

But because of a positive technical and the dollar rule market you can earn 7 to 8 Tics per month and if you analyze that you get closer to 2-3/4% yield.

Another example would be auto ABS.  Due to the de-leveraging structure of these securities you actually get what we call positive credit migration over time.

So as an example, take a single A 2-year tranche issued at a spread of swaps plus 75.  And just over about a 6-month period of time that structure would generally be eligible for an upgrade to a AA.  And 

AA’s are currently pricing a little tighter than 25 basis points versus single As.

John Nicely: Excellent.  Steve, can you elaborate on that response at all?

Steve Lear: No. I mean it’s a good answer.  The aggregate is not the 10-year treasury.  It’s got a yield in the low 1s.  We can manage portfolios to beat that yield.  We’ve demonstrated that over a long track record.

And therefore you do get income and an investment which goes up in price during a risk-off period.

John Nicely: Excellent.

So let’s change paths here and go to the next question.  And again going back to Steve, clients are always trying to strike a balance between yield and liquidity.  Has 2020 changed how we view that tradeoff, one versus the other?

Steve Lear: Changed, no.  It’s reinforced views that we had previously.  We started talking about real yields and negative real yields have had an impact on all asset prices by design.

So they’ve allowed price earnings multiples to expand, supporting stock prices.  They’ve allowed real estate cap rates to fall, which has supported real estate prices.  And by very definition, they’ve increased bond prices.

But what real yields have done is they pulled those returns from the future into the recent past.  And anybody who doesn’t appreciate that hasn’t noticed that the S&P is up 60% off the bottom.

So people want high returns in the future.  How do they get them?

There’s three ways.  One is to throw up your hands and say we can’t and accept the lower return, spend less or save more.

The second is to live with higher risk so sell some cash and buy bonds or sell some bonds and buy equities.

I think the third and best way is just to ensure that you earn a liquidity premium appropriately in your portfolio.  Look at what percent of your portfolio you traded during the crisis and ask yourself, “Did I need all of that liquid?”  And if not, you can reduce the liquidity of your investments, earn that liquidity premium without taking interest rate risk, without taking further credit risk.

To me that’s a smart way of generating incremental return.

John Nicely: Rick, how do you assess this tradeoff of yield and liquidity within the securitized sector?

Rick Figuly: You know, I think what happened in 2020 really doesn’t change anything for us.

So when I think about the risks of higher yield or reaching for yield versus liquidity the way that we have always approached things really worked for us through 2020.  And so our approach doesn’t change.

You know we’re always going to have an allocation in Core Bond to highly liquid sectors such as agency mortgages along with yield enhancers, which would be in securitized credit.  You know, obviously allocations to more liquid sectors are going to be significantly larger than what they are going to be in securitized credit.

And so when we do get into periods like we did in March and if we have to meet client redemptions we have the liquidity and we always have the liquidity to be able to achieve that and still be able to hang onto or hold onto our yield enhancers.

John Nicely: Excellent.  So taking a twist here to the other side of the investment grade market, while the election is behind us, has the outcome of that election changed our view in corporate industries, for instance healthcare, energy, or banking?

Rick Figuly: So if we would’ve had a blue wave, a Democratic Presidency and Congress, we would’ve been more concerned due to the possibility of higher corporate rates.

But it doesn’t look like that’s going to happen.  You know with the Biden Presidency and what we think is going to be, you know, like Congress, not really going to be official until January.  But we’re definitely less worried in this environment.

And if we’re talking about banks, they’ve been heavily regulated ever since the Great Financial Crisis and they have high capital requirements.  So we’re really not worried about those.

We think energy though could come under some pressure especially midstream.  With increased regulation, there could be some slowdown or even a stopping of the build-out in some of the new pipelines.

Technology is another sector that could come under pressure with increased antitrust legislation.

And then healthcare, the possibility of increased healthcare reform, single payer system, drug price pressure -- there’s always going to be that concern there.

John Nicely: Great. So as we round out here, last question I have actually for both of you.  What are your highest conviction ideas as well as the biggest risks you see in 2021?

Steve Lear: So I’ll jump in here.  Being a bond guy, which is to say a cynic, let me start with risks.  I think the biggest risk in 2021 actually comes from a continuation of the rise of populism.  We’ve seen masses in the streets on the capitals of Europe and Asia, South America and certainly here in the streets of America.  So far it hasn’t done much to impact global growth.

But if that trend were to worsen it would certainly have impacts on global growth and the global economy.  And perhaps more concerning is populist leaders have a way of taking actions, which can add to geopolitical risk.

And there’s a lot of talk about risks between the two current global powers, the U.S. and China.  And I really think in terms of the big picture these are the kinds of the biggest risks that we’re facing.  Although it’s hard to imagine on a day-to-day basis what the implications might be.  Taking a step back there certainly is concern given how frothy risk prices are.

Before turning over to Rick, I’ll talk about highest conviction.

I think that the Federal Reserve and the U.S. Government are going to cap borrowing rates for high quality lenders for the foreseeable future.  The economy still has a lot of slack in it.  And we’ve taken on leverage in order to get through the pandemic.  And there’s no desire to see financial conditions tighten and corporate borrowing rates rise any time soon.

So what that tells me is intermediate bonds whether it’s single A and BBB corporate credit or structured mortgages in that 5 to 7-year sector offer a lot of roll and carry on top of the stated yield.  And relatively little risk of sharply lower prices.  So I think that’s a good risk reward tradeoff in my mind in the current market.

What about you, Rick?  What are you thinking?

Rick Figuly: I couldn’t agree more.  I think maybe more specifically I would say with the red-hot housing market that is not going to change in the short-term and even in our view the long-term.  I would say any credit related to the residential housing market.

And whether or not that be some type of corporate credit or a specific securitized credit such as single-family rentals, nonperforming loans or re-preforming loans, I think those are all going to do extremely well for an extended period of time.

As far as biggest risks, I agree with Steve and populism is what I would consider a long-term risk.  It’s not something that is going to go away anytime soon.  So it’s going to be there for an extended period of time.

I think I’m looking at this a little bit in more of a short-term.  And so the way I view this at least going through end of 2020, I think the biggest risk is really the vaccine.  We see now that equity prices are at all-time highs.  We’ve had big risk on in bond markets.  This tells me that markets are pricing in the absolute best-case scenario.

And there are a lot of potential hurdles in front of us.  And any one of these could just throw us off course.  Manufacturing, can enough doses be manufactured fast enough to meet demand and more importantly, safely.  I guess when I think about this it would only take a small number of adverse reactions to damage consumer confidence about the vaccines and what the potential effects are as far as people wanting to get them.

And not to mention logistics, I’m an old Army guy -- and I have to throw that in there -- but in the military the one thing that is a constant is that no matter how well you prepare and practice for an operation something always goes wrong.  And it doesn’t matter if it’s at a platoon level, which is very small, or even at a brigade or division level, there are always going to be things that you have to overcome.

So now when we think about the logistics of the virus not only do you have to distribute a vaccine across the U.S. but you also have to track doses and timelines for everyone that actually has to take that.

Accomplishing that task is going to be unprecedented.  And there’s going to be hurdles that are associated with that.

I just think that maybe we need to temper our expectations a little bit.

John Nicely: Steve, Rick, I want to say thank you.  This has been very informative and insightful and I appreciate your time today.

Thank you for joining us on the Center for Investment Excellence.

Rick Figuly: Thanks, John.

Steve Lear: Thanks for having us.

John Nicely: Thank you for joining us today on JP Morgan’s Center for Investment Excellence.

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