Finding direction in fixed income
Tune in to hear Dr. David Kelly and Bill Eigen, Portfolio Manager, discuss opportunities and positioning within fixed income when the objective is maximizing absolute returns.
Welcome to Insights Now, a series of conversations designed to shine a light of clarity on the complex world of investing.
On today's episode, we're going to dive into positioning within fixed income. And for this conversation, I've invited my colleague, Bill Eigen, to join us. Bill is portfolio manager for an unconstrained fixed-income strategy here at J.P. Morgan Asset Management. His approach is unique as it uses an opportunistic go-anywhere strategy that aims at delivering positive returns no matter what's happening in fixed-income markets.
In today's particularly uncertain macro environment, it's a great time to bring on Bill for discussion on where he's seeing opportunities, what areas he's steering clear from, and his latest thoughts on the markets and the economy. So Bill, welcome to Insights Now.
Thanks for having me, David. Good to be here.
So let's start by talking about the big picture here. Mixed data on inflation growth and jobs so far this year has led to a fair amount of repricing in markets, to be honest. So what's your outlook now on inflation and the timing of a Fed pivot?
Yeah. Well, I think we've seen, what, in the past year, we've seen about five or six Fed pivot rallies. I think this is the sixth. I think there will be a seventh, possibly an eighth, because I don't think the Fed is that close to being done yet.
And part of the problem is the inflation that we've seen unleashed in the system the past 16, 17 months was a long time in the making. It's a result of a lot of things, including a very, very easy ZIRP policy for way too long. The fact that the Fed blew up their balance sheet to multiple trillions of dollars by buying everything from high-yield ETFs through treasuries, mortgages, et cetera, partially as a result of COVID.
And again, at the end of the day, like my dad used to say, "At some point, you've got to pay the price for the things you've done." And I think that's what we're seeing here. And I just don't think you transition out of this as fast as many would like to think.
And I say that partially as a result of being an owner of multiple small businesses and seeing the impact of not only this inflation but the fact that this economy seems pretty resilient. It's much more resilient than even I thought it would be. Certainly, within the small businesses that I own, I thought by now, with short rates around 5%, that that would put a damper on things. But so far, I haven't really seen it. But I have seen the inflation side of it.
And I've also seen the fact that... I've never seen a time where employees seem to have more pricing power, particularly in some of the service-oriented industries. I'd give you a ton of examples of that, but the bottom line is, if you're an auto mechanic, if you're a roofer, if you're a plumber, if you're an electrician, if you're a dishwasher, the amount of pricing power you have now, relative to any other prior time I can remember, is unlike anything I've seen.
I'll give you an example. We have a very large restaurant as part of an athletic facility that I own, and we just can't keep people employed there. And even when we entice them back with higher and higher wages and more benefits and more time off, we can't keep them employed. And it's resulting in a real problem. We've had to cut our hours, we've had to cut certain things off the menu, we've had to go with line cooks that aren't as experienced. And it's pretty frustrating. And you hear this from a lot of small businesses right now.
But the bottom line is, at the end of the day, inflation obviously hurts purchasing power, and obviously, the Fed's trying to put the kibosh on that by raising rates. And so far, they've done it a bunch of times, and I think they started to think they had it under control. And then, you look at the past six weeks, and you're starting to see it ramp right back up again. And I can confirm that because I'm seeing the same thing where I sit. So that's where I stand.
Okay. So given that, just to be a little bit specific here, how high do you think the Fed is going to get, and how long do you think they're going to stay there?
Well, it's funny, David, because I remember last year, about this time, Fed funds were still essentially zero. They were just starting to move up. And the mere thought of the Fed even going to 2% was like... You know, you got laughed out of a room when you suggested that. I know I did when I suggested that last year.
And about a month ago, I made the suggestion, in front of a very large group, that the Fed very well could go to 6, and I got laughed out of that room. So I'm getting used to getting laughed out of rooms.
So I'll say, to me, they've got a few more, maybe 150 left and a few more 25s. I'm not sure if they'll have the guts to do the 50. If the data keeps coming through the way it has been, I think they're going to be boxed into a corner at the next meeting. But even with a few more 25s, that get you upwards of high 5s, around 6%. And that's kind of where I think things ease off.
So let's turn to the economy itself. And we saw some really strong numbers out of January in the economic data. Do you think that this just delays an inevitable dip that we're going to see in the economy?
It's funny, too, because I'm with you on that. I keep thinking... Again, to go back to my small businesses, especially one of them that's very economically sensitive. I mean, auto repair and auto sales is one of them, and the other one is a very large multi-use athletic facility with restaurant, gym, all that stuff. And that's economically sensitive too. And it's in a interesting part of New England that's very kind of mixture of blue collar, white collar, low, middle income, and higher income. So you kind of see all facets of it.
And I'm not seeing any slowdown. For instance, in the auto service center, I'm not seeing people stretch their oil changes. We're not seeing people when we tell them they need brakes say, "No, I can't do it." We're seeing cars flying off the used car lot and at ridiculous prices. If you told me a year ago that I could sell a 2011 Ford Taurus with a hundred thousand miles on it for $11,000, I'd laugh you out of the room. But that's what we're seeing now.
The frustrating thing for me, David, is I can't readily explain it. It just seems like people just want to pay more for stuff, and maybe it's because they're paying more for stuff, so they just think they need to as well, then... Like I said, the service industry especially, all you have to do is call an electrician to know that, "Man, the same simple repairs that cost me 200 bucks last year now cost me 400 bucks." You talk to these guys, and they'll tell you, they go, "Oh yeah, we got pricing power. We're going to continue to use it."
So inevitably, I think this has to lead to some kind of economic contraction, but I'm just not seeing it. And I'm not seeing signs of it yet, which is interesting because I would think normally, by now, you would. And I know that's what the Fed wants. The Fed's basically trying to engineer a slowdown, and it's not working.
I'm sure Powell regrets last month talking so much about disinflation, and all this data comes out that's the exact opposite of what he was hoping was going to happen, and now he's kind of boxed himself into a corner along with the rest of the Fed. So it's kind of a tough spot we're in right now.
I would say it's not great for equities, just on the surface. I don't dislike equities because that's a long-term asset class. I mean, you should hold equities regardless. But it's not good for fixed income either, especially when you look at things like the fact that you can get 5% on your cash... And that's going to move higher not lower, in the near term. And the yield curve's completely inverted.
Basically, if you're buying out the yield curve, you're basically making the bet that short rates are way too high because the curve's so inverted, and the Fed's going to actively ease really in the near term. In the next year or so, a year to two, they're going to ease a lot.
And I'm not ready to make that bet, which is why I'd rather... Like they say, "Sometimes having nothing is a pretty good hand in poker." You look at cash yielding five plus percent, you're like, "You know what? Sometimes doing nothing is a pretty good hand." And sitting on cash is not a terrible thing to do if you're getting paid enough to do it because now the hurdle rate for everything else is, what, a minimum of 5%. It used to be zero for a long time, but now it's 5%.
And actually, that's a good point to which I think we can sort of pivot our focus here a little bit because, obviously, in this series of podcasts, we don't talk about individual securities or individual funds, but you manage fixed-income money in a particular way. You're managing it for absolute return. So can you talk a little bit about the overarching strategy that you have in managing for absolute return?
Yeah. I'm glad you asked that, David. It's very different, as you know. And you've known me for a long time, and you know how I manage money. And it is a little bit different. But in reality, to me, it's what fixed income is supposed to be about. When you invest with a fixed-income manager, you expect a couple of things. You expect to get your money back when you need it, and you expect some type of return on top of that.
And unfortunately, as we found out in a year like last year, where interest rates rise off ridiculously low levels, the average fixed income fund was down last year, I think, on the order of 12%, 13%. And that's not what people expect.
Absolute return management is very, very different. The neutral point for an absolute return investor is cash. In other words, if you can't find intelligent things to do with capital, if you're not getting paid enough to reach out the risk spectrum, then you should focus on capital preservation. When you are paid enough to reach out in the risk spectrum, then you do it because the math makes a lot more sense at that point, you can forecast your returns much better.
For instance, right now, buying credit, to me, is... I have no interest in it. Why? Because spreads are incredibly tight, which is partially a reflection of the economy. So you're getting paid barely anything over treasuries to own investment grade credit, even high yield credit, to be honest with you. So why would you do it? And second of all, you're also taking a tremendous amount of duration risk. As we found out last year, pretty much every fixed-income asset class was down the same. Didn't matter whether it was mortgages, agencies, treasuries, IG corporates, high yield, emerging market debt, international debt. They were all down 12% to 15%. So diversification doesn't work when the main factor that drives fixed income, i.e. the direction of interest rates, isn't moving your way.
And previous to last year, it had been moving everyone's way for about 40 years. So it has an impact on people. People are almost brainwashed to think that you can't lose money in fixed income because it's such a long bull market. But now things have turned. Now you have inflation in the system. You very well could be in a period here where you have several years where fixed income returns are poor or suboptimal, whether relative to zero or relative to cash, is the way I look at it.
So absolute return investing... Again, it's all about the neutral points. If you're running a long-only strategy that targets the fixed-income market, which is the Aggregate Index... That thing has a duration of six and a half years. It has an average coupon that's only around 4% now and in the low fours.
So you look at that, and you say, "Okay, if I'm neutral on duration, that means I'm still going to have a duration of six and a half years, which means if interest rates go up 1%, I'm going to lose six and a half percent." If I don't like where interest rates are, my neutral point is zero. My neutral point is zero. I don't want to hold any of it. I don't want to be forced to hold something that can lose money.
And that's the biggest difference between absolute return investing and relative return investing. They're very, very different. It doesn't mean one's better than the other or anything like that. It just means they're very different.
And, of course, last year was a particularly interesting year for fixed-income investing in general, as you pointed out. Very tough. But also for your approach in terms of absolute return investing. So we knew it went down, but what strategies helped you in investing last year?
Last year we were very focused on defense. Coming into 2022, I literally hated everything. And it was simply because of the math. You had rates at zero. So very little... The math just doesn't work. I mean, that's what it comes down to with fixed income. It comes down to math and opportunity. And opportunity is driven by things like risk premiums and term premiums.
Term premiums were effectively zero. You had a yield curve that barely went up at all from zero. In fact, at one point, you had 10-year treasuries at 50 basis points. And your risk premiums have really not widened at all over the past year and a half, despite equities. Despite equities having a very poor year last year, risk premiums in areas like high yield barely widened. They widened just a tiny bit. And so that just shows you... Why did high yield lose 12%, 13% last year? It was all duration. It was all because interest rates came up.
So what we focused on was really three things. One is we wanted to target very high credit quality areas with short durations that could benefit from rates rising. So we had about a 25% allocation to very short-dated investment grade floaters, which did very, very well as the year went on in particular. They were cheap at the beginning of the year. They were kind of neutral-ish by the end of the year. So those helped us.
On average, we kept between 60% and 70% of the fund in cash, which obviously, was just like holding a gigantic floating rate security. As rates continued to go up, we continued to reinvest that cash, and obviously, it reacted immediately. In fact, if you look at the yield on our fund last year, it basically goes straight up like a hockey stick during the year. Started very, very low, near zero, and then just ramped as the Fed ramped.
And the only other area we really focused on... Well, two other areas. One is some parts of the non-agency mortgage market got cheap during the year, and we focused on those, but there were kind of archaic pieces that really got hit more than they should have been, including areas like credit risk transfer.
And the only other thing we did was we had a number of short positions on that did very, very well because being an absolute return manager, we can go long, we can go short, we can put on relative value trades. And, essentially, we were short emerging market debt all year, which worked out really well.
In fact, it worked out too well to the point where, in October, we took the whole thing off because it was just getting punished too much. And we were just about to start actually adding some long positions in EM, but then it instantly richened with everything else and got out of our buy zone. But we continue to look at it. We have a very large shopping list of things that we're looking at right now that when they get cheap enough, we'll certainly bring them in.
And we remain short investment grade credit risk in the US end in Europe simply because it's such a cheap insurance policy. It literally is like buying incredibly cheap homeowner's insurance when you know a storm is coming. So we'll take advantage of that because the negative carry on, it's very, very low, and it adds another element of potential return to our portfolio, costing us very little in terms of negative carry drag.
Interesting. So just to summarize then briefly, are you comfortable yet with adding duration?
No. And keep in mind, my answer would be different if I were a long-only manager. If I were a long-only manager, and I said, "Well, duration's a lot more rewarding here than it was at zero..." Automatically, I'm going to say, "Okay, yeah, then I should probably own more." But I'm an absolute return manager. So I look at two things.
One is I think the Fed's going to keep going, number one. And that can't be good for duration eventually. If I think the Fed's going to 6%, do I really think the 10-year's going to stay at four, and you're going to have 200 bps of inversion as opposed to a hundred? Probably not. Probably not. Not unless we sink deep, deep into recession.
And that's the thing, the curve is incredibly inverted. I mean, as an economist, David, if you looked at this yield curve and nothing else, you'd say, "Oh my goodness, we must be entering into one of the worst recessions ever." And it's just not happening. And that shows you some indication of the yield curve as a prediction tool. I think its value is going down because of Fed intervention and a lot of other things.
So no. As an absolute return manager, duration is not interesting at all to me. But again, that just means I'm neutral. I'm not short duration either. It's not like I'm actively out there shorting. Dan Kim on my team, who runs our macro portfolio, he's got some short-oriented trades on the portfolio, and I think they're very good trades. They've been beneficial. I think they'll continue to work. But as a whole, we're not short duration. If you look at the duration of our fund, it's right around zero.
And then, I know that you're not enthused about credit in general, but if you had a dollar and you had to put it into either investment grade or high yield at this stage, which would you pick?
Well, if I had to, I'd probably go high yield. Mainly because the all-in yield there right now is pushing 9%, and that's a decent amount of cushion. The spread's not there. The spread is still only around 390 to 400 basis points, which is indicative. Usually, when spreads are at that level in high yield, that's indicative of an economy that's going to continue to do really, really well, and defaults are going to remain very, very low.
When I look at leverage ratios in the high yield market, and I look at some of the deteriorating metrics that I'm seeing along with the downgrades I'm seeing, you know these higher interest costs are going to impact some of these thinly capitalized issuers a lot at some point. It just hasn't been enough time. It always takes a year or two before the stuff flows through. And you're seeing signs of distress, particularly in kind of the triple C, single B area.
Because a lot of these guys... Let's face it. There's a lot of zombie companies out there that probably shouldn't exist. And the reason they do exist is because of ZIRP. Because of the incredibly easy policy we've had in place for so many years, they were able to get finance incredibly cheaply. But now, a lot of these loans are coming due.
And issuing a loan, for instance, at LIBOR plus 500 is one thing when LIBOR's at zero. When LIBOR's at five plus, and you have to pay another 500, 600 over that, and you're a thinly capitalized company, that becomes undoable at some point.
And again, I think we're going to see the impact of this over the next six to 12 months. But the reason I would pick high yield in that scenario is because of the cushion you have. Again, you're talking about a 9% yield. I'm not interested in high yield until spreads probably get to 600, 700 to start. And I think they will. And at that point, I'll be very interested.
Actually, now that I think about it, that's an unfair question to put to you because I said, "Well, if you have to pick," but, of course, as an absolute manager, you don't have to pick. You're not trying to hug a benchmark, you're just trying to provide absolute return.
Our goal is... When people ask me, "What's your return objective?" It's, "Make money." And when they insist on putting us in a box, I say, "Okay, what we're trying to get in an average year is anything from cash plus a hundred to cash plus 800." And over the 15-year history of this fund, the fund's been up as much as 20% a year, and the worst 12-month run that it ever had was down two in any 12-month period.
I know you hold a fair amount of cash right now. What would make you more excited about putting some of that cash to work in US fixed income at this point?
It's really easy. Something that offers me something significantly above the hurdle rate, which is five plus percent right now and moving higher. It's that easy. Honestly, when I look at a 10-year at 4%, and I'm looking at a hurdle rate of five plus percent, that means I have to think that that 4% 10-year treasury's going to be yielding something in the low threes over the next year to want to make me that interested. And I just don't think that.
So with high yield, the hurdle rate... Like I said, yeah, high yield's yielding 9%, but if spreads wide now just 100 to 200, that gets wiped, and it's vulnerable. So it really comes down to just math and risk premiums. That's all it comes down to.
And I haven't changed my strategy in 15 years. I mean, there's a lot of quant math behind it. When you look in our risk management process and how we view our shopping list, yeah, that gets pretty quantitative. But at the end of the day, we try to keep the process as simple as we can and as common sense as we can. And it's just different.
Like I said, even today, even having done this for 15 straight years, actually 17 years, managing nothing but absolute return... Like I said, when you're coming out of a 40-year bull market, some people just can't... They don't embrace the math, necessarily, and they want to think that the neutral policy for the Fed is zero forever. And it's just not, as we all know. It can't be.
And I think if you were to question the Fed under oath, they would probably voice a lot of regrets over some of the things they've done in the last few years and say, "Wish we could go back and do things a little differently in terms of expectations."
I think you're right. So how about outside of the United States? Are you active in international fixed income right now?
Yeah, we can be. You know what the biggest problem there, David, is? It's one of correlation. You know what I mean? I remember the good old days. When I started managing money in the '90s, you could buy things like sovereign debt and emerging market debt, and they'd have no correlation with US debt. US high yield would have no correlation with emerging market debt.
And now, if you go back the last 10 years... I mean, it's just crazy. If you buy high yield and emerging market debt together, you might as well be buying the same thing. They literally go up and down almost in sync. If you look at the five-year, 10-year correlations, they're in the high eighties, low nineties. So unfortunately, for me...
Now, EM last year did become disjointed a little bit and really started to get hit, and I started to get very interested in it. And like I said, we took off all our short positions, and we were just starting to get long, and then it instantly rallied into an area that I wasn't comfortable with. But I think I'll get my chance again there. So EM is one I have my eye on closely.
Now, the distinction there you have to make is, do you want to be dollar-denominated or non-dollar, right? With all this dollar strength we've had lately, that becomes an increasingly important decision. I don't really take currency views that often. But last year, I did say, "Given what the Fed's doing and continue to do, it seems to me that the dollar probably is going to be the currency of choice here for a while."
Not much has changed in that view. I mean, I know the ECB is pretty hawkish now, and they're playing catch up, but I don't think they'll go as far as the Fed will. And so, if you're a believer in interest rate differentials or interest rate parity, you're going to think that the dollar will probably maintain some degree of strength. I'm not saying the amount it has lately or certainly over the past year, but I also don't see any rationale for a dramatic drop in the currency either. So that makes me more or less neutral in the currency decision.
All right. And what we're talking about is fixed income. One other question I have to ask you is about the debt ceiling. Are you worried that we could actually see a default because of the failure to raise the debt ceiling or suspend the debt ceiling? And how would you manage a portfolio around that risk?
Yeah. Well, I certainly don't manage it around the odds of the debt ceiling being breached and us having a default because if I managed it around that... Yeah, you'd have big problems. I mean, if that were to happen, David, and I'm sure this is your nightmare scenario, you see money market funds breaking the buck, all kinds of horrible, horrible things would happen.
I think this debt ceiling argument will end like all the others with some last-minute deal where both sides save face. The debt ceiling is very political, and that's what I hate about it. It's used as a political tool on both sides. And at the end of the day, do we have way too much debt in this country? Of course we do. Do I think there's going to be a day of reckoning at some point? Yeah. But, you know, you could say that for the last 10 years. I have no idea what it's going to be.
The US government is an amazing organization. It's an amazing corporation because it has the unlimited ability to print money to pay bills and to take care of business. And ultimately, that's inflationary, right? Printing too much money. But again, I don't see what's going to stop it. So I, like you, probably, David, think there's going to be some last-minute face-saving two-way deal that's going to be reached. If it doesn't, then we have big, big problems. Big, big problems. So I have to imagine that's going to be the case.
No kidding. I'm believing and certainly hoping that we avoid doing something as catastrophic as allowing us to default. And, yeah, I believe we probably will. Okay. Finally, thank you so much, Bill, for your time here. To wrap up, what advice would you give to bond investors in navigating the markets this year?
I would just tell them... One thing I've noticed about a lot of bond investors, not all but many, is that they're just not diversified. You know what I mean? They spend all this time on their equity allocation, right? "Do I have enough small cap exposure? Do I have enough international?"
Then they get to fixed income, which can be as much as 30%, 40%, 50% of their portfolio, and they say, "Ah, just give me that whatever, that bond fund." Which ultimately is typically a traditional bond fund that has a high duration and has corporates diversified, et cetera, but has a lot of interest rate risk and some degree of spread risk.
And unfortunately, it takes a year like last year for many of them to realize that, "Wow, maybe interest rates don't fall forever. Maybe I should be a little more diversified." The best advice... And whether they do it with me or not is irrelevant. I wish fixed-income investors would pay more attention to that part of their portfolio and make sure that it's better optimized than, I would say, 70% to 80% of them are.
All right. Well, listen, thank you so much for joining us, Bill..
And thank you all for listening.
Please tune to our next episode, and until then, I invite you to read or listen to my notes in the Week Ahead podcast, where every Monday, I share commentary on the latest in markets and the economy to help you stay informed for the week ahead. For even more timely insights, you can also follow and subscribe to my content on LinkedIn.
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