Pilar Gomez-Bravo, CFA, is the Director of Fixed Income for Europe at MFS Investment Management. Pilar also has fixed income portfolio management responsibilities, having joined the firm in 2013. Prior to this, she was Managing Director at Imperial Capital and Head of Research and Portfolio Manager at Negentropy Capital within Matrix Asset Management. This discussion took place in Sydney on 15 May 2018.
GH: What’s the first thing you check in the markets when you wake up each morning?
PGB: I manage global multi-sector portfolios, so there’s a lot to cover. I check what interest rates have done overnight, what equity markets or equity futures are doing, movements in credit indices and key asset class relationships, plus the top news headlines. We construct portfolios from the top down but driven by bottom up research. We concentrate exposures on our high convictions, and we have to size exposures appropriately. We are running large issuer exposures and I check any developments that could impact them.
GH: When 10-year US Treasuries yielded 1% or less, how did you manage that and what do you think now is the argument for 10-year US Treasuries at 3%? Even with this higher rate, is there an investment case?
PGB: We have become a little immune to Quantitative Easing after 10 years of central bank intervention, but this level of liquidity injection was quite a shocking thing to do. It was an experiment and maybe there are not enough people around to remember what it was like to have central bank policy that didn't use such extraordinary measures.
The reason we had 1% rates in the US was because there were fears of deflation after the extremes of the global financial crisis, and uncertainty about how the financial system would recover. Australian banks didn't have the same degree of failure as elsewhere, but there was a lot of soul searching in markets that led to severe deflation fears in Europe and the US.
The central bank manipulation encouraged consumers and companies to spend money to recover from the shock. And that worked and now we are in a different period where we are seeing signs of inflation instead, but still not sufficiently high to worry people too much. There’s a little bit of wages growth pressure in the US but nothing that indicates a sudden different paradigm of inflation.
Demographics, technology and debt will limit inflation rises
And in the back of investors’ minds is the large structural headwinds against yields going higher such as demographics, the deflationary nature of technology and the amount of debt in the world. If they raise rates quickly, will consumers and companies be able to manage that increased debt load? There’s also heightened sensitivity in the G20 about currency wars. So we should continue a gradual progress to higher global yields but at a pace that should be able to generate a long-term total return from fixed income.
GH: As in the US, in Australia we've seen a movement in what we call MySuper towards lifecycle (or target date) funds. What do you think of lifecycle funds and the merits of putting more into bonds as people get older?
PGB: Well, 20 years ago I took the CFA and back then we were already talking about the appropriate level of risk for different age cohorts. There’s economic theory that says as people age, they have different risk return profiles. And it also shifts as people become spenders and stop earning. People are living longer and so the nature of the products they need should shift. On top of that, shocks like the financial crisis linger in the mentality of investors for a long time. Investors are reluctant to potentially lose all of their savings and they look to own some lower risk assets to protect capital by holding fixed income.
There is an increased variety of assets to invest in today than there were 20 or 30 years ago, so that gives more richness to the allocation decision for investors. For example, more ways to invest in real estate, a more targeted approach for individuals by using ETFs, or even shorting the market to take a negative view. All of that is relatively new which gives more ways to discuss the risk return profile.
Equity managers argue they can deliver income
A major development when yields went so low was that generically equity managers could go to clients and say they would be the providers of income and investors could forget about bonds. On this basis, the discussions from equity managers with company management led to dividend increases, and that's distorted the behaviour of companies around the world towards higher dividends, share buybacks and less investment. So perversely, central bank policy has led to lower levels of investment worldwide as companies have chosen to do share buybacks and dividends to appease their new shareholders with a promise of income. Hopefully, we’ll see a gradual shift back to investing in the company as policy normalises and global growth stabilises.
Finally, now we can go back to saying that with bond rates rising, especially in the front end in the US, we have an asset that gives a yield and that is good for investors looking for safe assets.
GH: Can we discuss the move to passive investing in a bond context. Would you support the view that for non-government bonds, the case for passive investing is probably the weakest of any asset class? Is there evidence that retail investors understand why it's a weak argument?
PGB: There are a couple of reasons why it's more dangerous to follow passive investing in credit markets. One is that benchmarks are dominated by companies where the more debt they have, the bigger weighting in the index. Two, liquidity matters in credit and you may not be able to get out when you want to. That leads to another discussion around ETFs and derivatives. Credit markets become illiquid in periods of stress.
And three, in credit markets you have an asymmetry of risk and return. You have no upside and you have all the downside. So paying attention to potential blow-ups becomes increasingly important as the economy reaches the end of the cycle. A keen awareness of risk-adjusted returns is needed because you don't recover from a credit default.
The role of active management
People have forgotten about the value of active management. First, yields are low at the moment so any fees paid are painful. Second, with low volatility and low dispersion, it's difficult to generate alpha without adding leverage or taking concentrated risk, but with an asymmetric asset class and increases in volatility, the value of active becomes apparent. We tell clients when looking at active asset managers, ask them to show their excess performance in different periods of volatility. Obviously, you want to see performance through the cycle, but you should expect higher excess returns in periods of heightened volatility.
GH: With your own portfolios, how much of the extra returns you generate comes from off-market transactions? For example, where a company wants $500 million quickly and they ring you up and offer say 100bp over the market.
PGB: Our strategies have two characteristics for portfolio construction: liquidity and diversification. We don't hold a lot of illiquid positions and for those exposures we need to be paid more because you lock yourself in. In the hunt for yield, there are three main ways to add yield. One is duration, which nobody wants. Two is credit risk, so we've seen huge inflows into credit and emerging markets. And third is illiquidity. There may be better opportunities at times of stress to consider more of these off-the-run illiquid positions.
GH: What do you think about the big spread contraction in the high yield corporate sector? Is there adequate reward for risk there now?
PGB: At the individual level in some cases, yes, but at the lower quality parts of the high-yield market (rated CCC), you are not getting paid enough for the traditional experience of losses. Despite the stresses seen in equity markets, the CCCs have outperformed. They have lower rate sensitivity, when the fear in the fixed income markets has been that the Fed might make a policy mistake. There’s also a lot of energy companies in there that have been supported by rising oil prices. In general, we believe that high yield as an asset class is expensive.
GH: It’s difficult to make statements about correlations between asset classes in advance of a stress event. We saw during the GFC correlations rose so that when you thought there was protection in your portfolio, it didn't help much. Can you give guidance on what you think about future correlations? Is there anywhere safe to hide?
PGB: You are always looking for uncorrelated returns and good sources of alpha in multi-sector portfolios. The first choice is between duration and spread and the right combination, and that decision depends on what paradigm you think you are living in. For a long time back to the 90s, the paradigm was ‘risk on, risk off’. But since the GFC, the new paradigm is 'Goldilocks/QE' and 'taper tantrum', where yields and credit perform in the same direction. I think as monetary policy normalises, we will revert to the ‘risk on, risk off’ relationships. It provides more of a diversifier against risky assets or spread assets. The reality is that in periods of stress, bank correlations move to 1.0, even though fundamentals have significantly improved since the GFC. When fear strikes in the markets, all banks underperform.
How to create a multi-asset portfolio
GH: What’s your high level process for creating a portfolio?
PGB: We are really mindful of risk management at every step of the investment process. First, decide how much risk you want to take, your risk budget. Then you have to do your allocation correctly. How many uncorrelated sources of alpha can you put in. Then you need portfolio construction where you match risk allocation with idea generation. What bonds do you actually want to buy that get you to that risk allocation? Finally, monitor the risks so that under any scenario, you don't get surprised by unwanted sources of risk. So that's still the basics.
GH: You probably know we had our Federal Budget recently. Conditions are better than expected with a possibility of moving into surplus next year. Now there’s a debate on whether we should spend more, tax less or repay debt. What's your view on governments repaying debt to give more security for the good times, especially for the US where trillions in debt don't seem to matter?
PGB: At a basic view, whether you are a corporate or a government, you need to be countercyclical in your finances. You need to build cushions in the good times for when the bad times come, so you can then spend the money and keep growing.
There’s too much debt in the world. The IMF forecasts that most countries will significantly reduce their debt-to-GDP ratios between 2018 and 2023, but the US will continue to increase. All the efforts of countries like Germany and Australia will be completely offset by the US as it’s such a huge part of global GDP. The US has fiscal stimulus at a time of almost full employment when that extra stimulus is not necessary. So when times get rough, how much more can be borrowed?
Graham Hand is Managing Editor of Cuffelinks. Pilar Gomez-Bravo, CFA is the Director of Fixed Income for Europe and Fixed Income Portfolio Manager at MFS Investment Management, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any investor.