Credit Diversifiers for Long Duration Portfolios
Operator Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.
(Joe Staccato): Welcome everyone and thank you for making time to join us today. My name is (Joe Staccato) and I'm a client advisor and the corporate pension sector head in JPMorgan's North American institutional business.
Before beginning today's call, I just want to say that I hope that all of you and your families and colleagues are safe and keeping well in this new reality. It certainly has been a tough period of time for all of us and we truly are all in this together.
Moving on, for today's call, I'm pleased to introduce my colleagues, Steve Lear, U.S. chief investment officer of our Global Fixed Income Currency and Commodities Group, and Justin Rucker, portfolio manager on Steve's team.
Over the next hour or so, we'll have a discussion about the benefits of diversifying away from traditional corporate credit and liability-driven investment strategies, and into high-quality spread diversifiers like agency mortgage-backed securities.
Those of you that have been working with us know that this is not a new idea of JPMorgan. We've been talking about this for the better part of four, five years. However, considering that the (OBI) playbook has been developed over the past 15 years, we think that the current environment presents a challenge that might require a couple of new chapters to the playbook. One chapter should be about spread diversification.
Before getting deeply into today's topic, Steve, can you make some opening comments on the state of the economy and give us your market outlook?
Steve Lear: Sure. Thanks, Joe, and thank to you all for tuning in.
I guess we all appreciate that nowadays market outlooks and the state of the economy are more uncertain than we're used to. First and foremost, we're dealing with a public health crisis, and so, to understand where the economy is going, we have to make assumptions about the outcome of the COVID-19 pandemic.
I think we also have to appreciate that what has kept us, we hope, from a depression, has been a tremendous amount of fiscal and monetary support, as we calculate it, more than we saw through all of the global financial crisis, but instead of being spread over 2-1/2 years, we've achieved the support in about six weeks.
So, not only do we have to make assumptions about public health outcomes, we also have to have forecasts and thoughts about the sociopolitical response to the pandemic and whether and how we will see further support from fiscal and monetary policy to support the economy and markets.
We are not surprised to see that markets have rebounded strongly given response we've seen from Washington D.C. It's quite heartening to see all our politicians, for the better part, working together to respond to this pandemic.
For those of you I've spoken with two months ago in the worst of the crisis, we talked about three things that we needed to see before markets would be on firmer footing. The first, again, since it's a public issue, was some improvement in the battle in the U.S. against the pandemic, which we identified as the rate of new cases falling, which is not to say new cases falling but rather the growth in new cases falling. And we've seen that.
We needed support for the market from the Fed, and we got that. And we needed a fiscal response to replace the lost income from sheltering in place. And I think it's really important to spend a couple of minutes thinking about this concept of lost income from sheltering in place.
So as we think about it, we're going to see a giant hole, call a chasm, in the economy in the second and third quarters, and I want to give some context for this. Through all of the global financial crisis, the worst that incomes fell was a little short of 4%. We have an economy which is running at $20 trillion a year plus, so that's about $5 trillion worth of income that the United States generates every quarter.
We are forecasting not a 4% drop but a 10% absolute drop, not annualized, in the second quarter, with only a small rebound in the third quarter. So the way I think of that, the way we think of that, is of that $5 trillion in the second quarter, $500 billion worth of income is missing, is unavailable to service debt and to pay back lenders and bond holders such as us. And by us, I mean all of us on this call.
And then in the third quarter we'll need another 500 billion. And we won't actually see income get back up to where it was at the fourth quarter 2019 for about three years. And frankly, if our forecasts are right, we won't see the economy get back to the trend line it had been on before this terrible pandemic for the better part of a decade.
Contrasting that chasm, contrasting that valley, that lack of income, there has been fiscal response. And so, again, as we've calculated, between extended unemployment insurance and one-time checks, and other measures under the CARES Act, there's about $1.6 trillion, if we include in the PPP program and the money given directly to consumers, that covers, that more than covers two-quarters of the loss of income, which would allow most individuals and businesses to cover their expenses during this period of self-imposed quarantine.
What we don't know, and this is why it matters why we need to understand the political response, is, if we're still in some level of social distancing, so, significant portions of the economy, and we've all talked about what they are, whether it's leisure, hospitality, restaurants, the like, whether there will be further stimulus to -- not stimulus.
Sorry I'm going to take a side step here for a second. None of this is stimulus. It's replacing lost income. Stimulus is when you build something new. This is just relief for people who have lost income.
So we have to ask ourselves, how long does the shutdown or the quarantine last? And how rigorous is the federal government in terms of replacing the lost income?
Our review as lenders is that (unintelligible) will not be distributed equally. And you know, we can all think there, unfortunately, when we get through this, we don't believe we will be fully through it and back to the lifestyle and the economy that we're used to until there's an actual vaccine, an effective vaccine, and literally billions of doses are administered, or until there's an effective treatment.
We have ultimate scenarios for how long that might take and people understand that we may never get a vaccine. There are still viruses for which there are no vaccines. Or through the miracle of artificial intelligence and a world of scientists working cooperatively, we may actually have a vaccine in 2020. Both those scenarios for us are not the base case, they're outliers.
Based on the epidemiologists we had spoken with at JPMorgan Asset Management and the best research we can corral, we actually do believe that the consensus of the second half of 2021 is the best time to expect to have a vaccine developed, manufactured and administered.
And while this sounds somewhat depressing, it's the situation. You know, we can't invest money for clients on the basis of hopes. We have to base it on data. As the governor of New Jersey said, "Data determines (date)."
We see that there is a significant loss of income and it will be unevenly spread. So as lenders, we have to separate out not the winners from the losers but the survivors from the losers.
So in just one or two minutes more I'll say that companies and individuals are borrowing money to sustain their expenses during the period of social distancing, which will last for quarters. And many will make it through and there will be second (order) effects, we can't gauge. It may be as simple as your dentist.
You know, you don't think it is someone who is struggling for money, but while the office is closed or while they can only take a fraction of the prior patients, the expenses remain. The undocumented, people who, you know, if the government doesn't continue the unemployment insurance past July for minimum wage workers.
So these people will struggle to service their debts, and we as lenders of your money are spending all our attention understanding who will be able to serve their debts over this period of social distancing, and have a sustainable business model when we get to the other side.
So those are some thoughts on the economy and markets. I will just say in closing, we're concerned that there's too much happy talk and too much good news priced in to frankly equity prices given the expectation we have that we are living in some level of shutdown for the better part of another five quarters.
(Joe Staccato): Thanks, Steve. Look, I think there's no doubt, it's a tough message, and these are definitely tough markets. And you know, we work with a lot of CIOs of defined benefit plans, and I think that they kind of, on the back of 2019 with strong markets and not seeing any real material improvement in (funded) status, you know, they may be looking at this market and saying, you know, what do we do now?
Steve, given (accounted) profile, let's just say, plan sponsor maybe 80-ish percent funded, maybe a little less, a little more, perhaps carrying hedge ratio for the liabilities somewhere between 40%, 50%, duration of those liabilities maybe 10 to 12 years, what's your advice to that client given what you just spelled out and the prospects of rates and levels of rates, etcetera?
Steve Lear: Okay. Let me start with a very brief (unintelligible) of disclaimers that every plan is different and every sponsor is different.
Having said that, as the CIO for fixed income, I think this is the first time in 20 plus years I would say that it's not a good time to hedge interest rate risks in a pension plan. And I want to be clear, you know, within the last week or two we've spoken with Yellen, we've spoken with Bernanke, and we understand that the Fed funds rate is going to be zero for most of this decade.
If you think about the global financial crisis and the relatively small size of lost income we were speaking of, and the duration of that, and the Fed funds rate was at zero for seven years afterwards, we think that for most of this decade the funds rate will be zero. So that would tend to indicate that maybe there's not much risk and people should grab whatever income they can get from the bond market.
But I have to be honest, 1-1/4 on the 30-year, we don't see that breaking significant higher anytime soon. There's just so much demand from the insurance community, the pension community, the (Asia life) community, that we're not forecasting rates significantly higher.
But the bigger question is, do bonds provide the income you need? Do they provide the diversification benefit that an investor typically gets from owning bonds in a portfolio of bonds, real assets, cash (and such)? And I think the, you know, the conclusion we come to is no.
So I think that requires sponsors to make one of two choices, and this gets back to my first comment about what's the right thing for the generic plan to do. You'd have to choose a little bit of a higher level of volatility from your equities, because these equities can't be hedged, then the volatility will be higher. Or you have to live with the lower types of return by reducing your equity to maintain your volatility target.
And then there's questions which this call I hope will answer, about, how do you get further diversification benefits for lower volatility and how do you maintain a risk profile?
(Joe Staccato): Thank you very much for that, and that's exactly where we want to try to get to. May not be the case for increasing hedge ratios, but maybe it's a time to look at what's in those hedge portfolios and see what treatments can be made there. Next question for you, Steve, and then we'll take it over to Justin. What makes spread diversification so relevant now?
Steve Lear: Again, it's a stylized 60-40 portfolio, isn't diversified because the bonds can't really go up in price much. Our assumption is that we will not see negative rates on treasuries. That is an assumption. And you have to be creative about how you get diversification benefits.
So, typically, you know, our clients are looking at portfolios of equities and long corporate credit, and we've been talking for over five years, having conversations about how securitized should be part of the equation. And frankly, in response to clients who come to us and say, "I keep seeing that corporate America is getting more and more levered."
You know, taking a step back in time, when I got into the business in the early '80s, there were a plethora of AAA and AA issuers, but now we know. Everybody knows the statistics. Over 50% of the Barclays Aggregate Index is rated BBB. That is first of all risky. If they get downgraded to junk, plans are required to sell, or many plans are required to sell. And so that doesn't provide you the diversification.
The issuers or the biggest issuers in the credit index are the same issuers that are the largest issuers in your equity portfolios, so your bonds once again are not diversifying your equities, they're correlated there too.
And then finally, as we saw in March, you really needed something in your plans that was liquid that you could liquidate during periods of risk off in order to pay benefits, or use the opportunity to increase equity, since that was what was being done.
Long credit is not within the Fed's (virtuous) program. Short credit is, if you're a five-year, but there's relatively little of that in our pension plans.
On the other hand, the long securitized portfolios that we manage, old bonds, which are on the Fed's purchase program, Justin can talk more about that, so we see the opportunity to increase portfolio credit quality by going from BBB corporate credit at the agency credit, improve liquidity, and improve diversification benefits. So that's the result of conversations like this that we've been having with clients over a period of years.
(Joe Staccato): Great. Thank you very much, Steve.
Justin, going to turn to you now, as the PM specialist on all the long-securitized strategy. Before we get into some of the details that Steve had set us up with, why don't we level-set, what do we mean by long securitized?
Justin Rucker: Sure, thanks. I think most people on the call are probably familiar with securitized within the aggregate universe. So there's three major sectors. You have mortgage-backed securities, you have asset-backed securities, and then the commercial mortgage-backed securities.
The opportunity set for a long duration space is going to be much different than what you would typically find in the aggregate index. Let me explain that real quick.
So, typically the loans get back a securitized asset are going to be relatively short in nature when you refer to the asset-backed security market. The commercial mortgage-backed securities market are simply going to be made up by loans that are 10 years and shorter.
So that leaves us in the long space with an opportunity set that is primarily made up of agency-backed mortgage-backed securities and agency-backed commercial mortgage-backed securities. And these particular securities are structured in a way that they have underlying collateral, and that collateral is really going to be (back to) bonds, so the principal and interest of the mortgage-backed securities is going to be paid through the underlying collateral of the residential mortgage.
And then on the multi-family side, it's going to be the exact thing. The nice thing about the growth of both of these sectors over the last 10 years is that a lot of them, especially the agency CMBS market, they started to come out with longer maturing bonds. So the opportunity set in the long-duration space is primarily going to be agency-backed, which eliminates any sort of credit risk that you may have in your portfolios.
It provides an adequate amount of spread over the treasury curve. And they're structure in a way that protects you from prepayments, which most people know that is one of the biggest deterrents in buying a mortgage-backed (pass-through) security that you would find in the aggregate universe.
So, just to give you an example of the size, the agency (CMBO) market is roughly about 1.1 trillion and the agency CMBS market is roughly about 700 billion.
(Joe Staccato): Got it. Okay. That's very helpful, I appreciate that, because I know there's a lot of lingo that gets tossed around in this corner of the bond market, and, you know, getting a clear picture of what we're talking about is very helpful here.
Let's go back to the points that Steve was kind of transitioning to. So now that we have a better understanding what we mean by long securitized, let's talk about the composition of the corporate market and just what are some things that compare and contrast your market to the corporate market. I know that the headlines are issuance is off the charts, corporations are grabbing as much cash as possible. Give us some of the details there.
Justin Rucker: Sure. I think everybody is aware of the corporate credit market issuance that's occurred this year. And so, with the COVID crisis, you have a lot of corporate issuers that are out there tapping the corporate credit markets, trying to improve the liquidity of their balance sheets. Right now that's the most important thing to them. They're not concerned about how much leverage they're taking on. It's more about showing up liquidity.
So the actual amount of issuance in the corporate credit market this year has roughly been about 950 billion. At the same time last year, it was around 475 billion. So it's almost double what we've seen year over year.
We already came in to the COVID crisis with very elaborate balance sheets, so, with low interest rates over the last, let's call it, 10 years, the corporate credit market has taken advantage of low cost of funding. So, coming in to this COVID crisis, we knew that corporate credit balance sheet were already levered, rating agencies were giving them the benefit of the doubt to reduce leverage over time. And then lo and behold, we have this crisis that all of us are dealing with today.
So when we look at this market versus the market that we would be investing in on the long-securitized side, we look at the corporate credit side as a market that has an extreme amount of risk for downgrades. Just to give you a couple of examples, the long corporate credit A-or-better universe right now has almost 40% that has negative outlook or a negative watch assigned to it by one of the three big rating agencies. Fifteen-and-a-half percent of that is in A-minus. So you roughly have about 15% of the corporate A universe that is at risk of being downgraded out of that index.
And that's really the underlying issue that I think all of us need to think about right now. You have the Fed that's been supporting corporate credit ever since the beginning of April, at least talking about it. They created two facilities to purchase short corporate credit. And that's going to be roughly corporate credit five years and under.
So what we've seen is we've seen the corporate credit curve steepen where the short end has outperformed the long end. And in the long corporate space, that has not benefited nearly as much.
So as Steve mentioned, you really want to be doing, in looking at particular parts of the market where the Fed is supporting. So as I mentioned, the long agency CMBS bonds that we find as an opportunity, as a diversifier against long corporate credit, they actually have been purchased by the Fed.
So the Fed has been going out, they assigned Blackrock to purchase bonds, and about once or twice a week they will actually buy bonds from the market and that'll improve the liquidity of that market.
In addition to that, the Fed has been buying mortgage-backed (pass-through) securities, and that has really helped shore up the mortgage-backed securities market. The opportunity is, in the long space, is more going to be in the long CMO type of structures, that also has benefited simply from the Fed coming in and buying.
So, to sum all that up, you really see a lot of risks right now in the corporate credit market, especially in the long end, and now more than ever is a time where you want to start thinking about diversifiers, especially into the sector that still provides spread and is able to give you that long duration profile without having any sort of credit risk assigned to it.
(Joe Staccato): Thank you, sir. Listening to your comments here, I hear that long corporate market is in question, that there appears to be, relative to the long curve market, just technical support on the long-securitized part of the market. Talk to me a little bit about the fundamentals supporting the securitized market. What is there?
Justin Rucker: Yes. So as I mentioned before, the fundamentals of the long-securitized market that we find as the best and the largest opportunity set are going to be backed by Fannie Mae, Freddie Mac or Ginnie Mae. So they guarantee that you're going to receive back your principal at par (unintelligible) loans that back those deals default. So there's essentially no credit risk there.
Now, the underlying fundamentals are something that we keep a close eye on. So if you think about the multi-family complexes and you think about people losing their jobs, you start thinking about, okay, there are going to be missed rent payments, there's going to be people that are going to have to foreclose on their homes. So when we look at the underlying collateral of the opportunity set, we'd be buying in long securitized.
The nice thing about the agency CMBS market is that there are new requirements now. So, one of them is that, anytime a new agency CMBS or (DAS) security is issued, they must escrow at least 12 to 18 months of principal and interest. So, any new issue that we will be buying is a much safer issue than in the past.
Another thing is too that forbearance is something that is allowing people to defer their payments for 60 to 90 days, help them kind of bridge that gap until they get rehired or, if they are furloughed, come back to work, somewhat of a, you know, kind of a bridge loan, if you will, until the economy improves.
The underlying fundamentals of the long (unintelligible) market are probably better than they have been in a while, especially the protection that you're going to get. That's the complete opposite on the corporate credit side. And you know, there's two things I would point out. I already pointed out about how much issuance there's been, which is increasing the amount of debt on the balance sheets for corporate credit issuers.
The other piece of the leverage equation is your earnings. And when we look at projections of earnings over the course of the rest of the year, projections of earnings are down 20%. So if you have debt going up and you have earnings coming down, your leverage ratio is going to go up. And that is one of the primary things that rating agencies are going to look at.
So, fundamentally, the corporate credit market is deteriorating and we think that the long securitized space, especially the bonds that we will be buying, are going to be perfectly fine when it comes to a credit risk standpoint, but on top of that, they're putting in extra measures to really support that market.
(Joe Staccato): Thank you very much. Justin, the answer to the last question demonstrated some expertise in this area. Can you elaborate on JPMorgan's history in securitized market, maybe some of the resources that we have in this area?
Justin Rucker: Yes. So this is not something new to (unintelligible) within JPMorgan. We have been utilizing the securitized market as a diversifier and a sector that provides a lot of relative value for 30-plus years. So we've been utilizing this in corporate-only mandates, we've been utilizing it in multi-sector mandates for many, many years.
This is really something that's been ingrained in our DNA. So we have a really strong team of portfolio managers that have been taught the way to look at these markets, how to look at relative value. On top of that, we also have a very strong credit research team that is out there looking at the underlying collateral, looking at how these deals are structured.
So the moral of the story is that this is an opportunity we think is extremely ripe for this particular time in the market, but we have been using this particular part of the market for many other of the downturns within the corporate credit cycle. And it's always been an area that's provided a lot of diversification and lower volatility to the portfolios that we manage, not to mention tremendous relative value when you compare it to other sectors.
So we have a plethora of portfolio managers, credit research analysts, as well as support from our investment specialists, (CTMs), if you will, that all really know these sectors and are happy to jump on calls and talk to clients about them at any time.
(Joe Staccato): Great. Thank you. I'm going to ask one more market-related question at this moment here. We started your portion of the conversation, Justin, talking about level-setting around securitized. I think there has been a fair amount of market discussion around the broader securitized market.
Can you comment -- there's been a diversion in performance between the agency MBS and non-agency MBS, --can you comment on some of the drivers and maybe what your experience has been in those markets? And distinguish them, obviously, if we're trying to change them.
Justin Rucker: Sure, absolutely. So, you know, with the agency CMBS market, as I mentioned, there's no credit risk. You're backed by Fannie Mae, Freddie Mac or Ginnie Mae, depending on the program that you're investing in.
With the non-agency CMBS market, you obviously are subject to credit risks. And another thing is that this market predominantly is made up of conduit CMBS, which basically means that, when you look under the hood, it's like a collateral of these particular security are, it's a mixture of different exposures.
It could be hotels, it could be multi-family units, it could be strip malls, it could be big mega malls. So you're going to have a lot of diversification what the underlying collateral is, but it's very difficult to underwrite and predict how each of these sectors are going to perform.
So I think that, because we're in an environment right now where hospitality and retail and hotels are all under extreme pressure due to the lockdown, that people look under the hood, at what the collateral of these non-agency market is, and it's very difficult to assess the risks that you're exposed to. Whereas on the agency CMBS side, the majority of what we buy are single loans.
So we are able to go on to Fannie Mae's Web site, and typically what we're buying are multi-family properties, we can look on the Fannie Mae Web site, we can see exactly what the property is, we can see what the debt service coverage ratios are, the LTV, the occupancy. It's very transparent and very easy to underwrite, so you know exactly what you're getting.
So as volatility and uncertainty has increased over the last three months, that (unintelligible) dislocation between non-agency CMBS and agency CMBS. To just give you an indication on the levels. Typically the difference between the two on a spread basis is roughly about 30 to 40 basis points.
So right now you have non-agency CMBS in the 200 and you have agency CMBS, which has been supported by the Fed, trading roughly back down inside of 100. So that's probably one of the reasons why you're seeing the discrepancy that you have.
(Joe Staccato): Thank you for that. In closing, you know, for so many of you that have strong treasury and "the credit long duration portfolios," we encourage you to think about today's discussion and think about your existing portfolio construction. You know, prior to this crisis, there probably were concentration risks and credit risks that may have felt to be within bounds, but in the current environment, it may be time to review your hedge portfolios.
Our key message here is that there are tools in the market that can help identify those risks and there are asset types that can help mitigate those risks.
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