Today’s podcast introduces the new fixed-income strategist at Wells Fargo Asset Management, George Bory. We’ll discuss the current macro environment and then drill down to the most important topics in the bond markets.


 

Laurie King: I’m Laurie King and you are listening to On the Trading Desk®. Today I’ll be talking with George Bory, Managing Director of Fixed Income Strategy and Product Specialists at Wells Fargo Asset Management. We’re excited to have him on today’s program because in his new role here as the fixed-income strategist, he will share his view of the bond markets and investment strategies with our listeners. Before we begin discussing negative rates, liquidity, and credit topics, welcome to the program, George.

George Bory: Thank you, Laurie. Happy to be here.

Laurie: You’re in a new role here at WFAM. Can you tell us more about it?

George: Yeah, sure. I joined Wells Fargo Asset Management middle of May, just a couple weeks ago, but I’ve been with the firm for just about 8 years. And in my new role in the asset management group, I have what I think is probably best defined as a hybrid role. It has two components to it. As you mentioned, my title has two aspects. The first is I’m going to be working as a fixed-income strategist. Prior to my time here on the asset management side of the business, I spent almost 20 years as a sell-side investment strategist, focusing on all sorts of aspects of fixed income—interest rates, credit, structured products—and bring those skills over and help work with our investment teams, but more importantly to be a conduit, to be a channel, to communicate our investment strategies to our internal partners in distribution, as well as our external clients.

Laurie: So as you talk to clients, do you find that they want to start talking about macro questions as you begin the conversation or dive right into asking about the bond markets? And if they do want to talk about the economy, what are their main concerns?

George: Most client discussions start with a picture of the macro backdrop. We always try to put things into context. What’s happening in today’s world from an economic standpoint, from a political standpoint, from a social standpoint? And then we try and transition to how is that impacting markets? How is that impacting securities? What is the investment opportunity set that’s created by that macro backdrop?

Once you set this framework for what’s happening in the broader world, you then transition to what is the client trying to achieve? What is their investment objective? What is their time horizon? What kind of liquidity needs are they going to have?

And then we try and put those two things together to figure out what is the most appropriate investment strategy for this client. In today’s world, there are very, very major policy forces impacting markets. It’s the Fed. It’s fiscal policy. We’ve got some social upheaval today. There are a lot of moving factors that are going to impact security prices, so it’s typically best to start there and then we get into the more granular part of the market.

Laurie: Well, that makes sense. Moving on to the bond markets then, what about negative interest rates? What are the most important considerations in your view?

George: Negative interest rates is a very hotly debated topic in the bond market these days. Historically, the Fed’s been able to cut interest rates to help stimulate credit creation and also help steepen the yield curve. Those two things are often a very significant buffer against a major contraction or dropping economic growth.

But what policymakers have realized or had to deal with as policy rates reached zero, it becomes increasingly difficult to execute this policy. If you look right now, the yield difference between the 2-year treasury and the 10-year treasury is a little more than 60 basis points, and it’s getting steeper. That’s actually a pretty good signal for the Fed. So with the curve positively sloped and getting steeper, at the moment there’s very little reason for the Fed to cut interest rates or to think about taking rates into negative territory.

However, if longer bond yields were to start to fall—maybe because of another big growth shock, perhaps the coronavirus starts to worsen again—and we start to experience another material shock to growth, it’s likely the yield curve would start to flatten, and then the Fed may have to consider breaching the zero interest rate bound on Fed funds to steepen the yield curve. And this is exactly what happened in Europe.

Just to be clear, this is not our central scenario. We don’t expect this to happen. And as a result, the probability of this happening is very low, but it’s important to keep in mind the probability of it is greater than zero and it could happen, but it really depends on what happens to the broader economy, how financial markets respond, and what the Fed is able to do to achieve those objectives.

Laurie: And what about liquidity? Are we past the worst in the markets and what does it look like now?

George: Liquidity is what I would call a very bond market-specific topic and I think it’s important to remember the bond market’s an over-the-counter market. It’s not an exchange traded market and as a result, buyers and sellers need to be matched up to execute a trade. And so when you think about liquidity, liquidity is defined as how easily those trades can be executed without creating a big move in the price of the security. And when conditions are normal, investors can buy and sell large volumes of bonds at whatever the quoted price is and you’re going to see relatively small price movements.

However, when a shock hits the market—either a big macro shock like we’ve recently seen in an emerging global pandemic or a smaller, more micro shock like the default of a company—then it can become quite difficult to execute a trade without triggering a very big move in price.

And then what market participants will call this is a one-sided market. When you have a one-sided market, there are way more buyers than there are sellers or way more sellers than there are buyers. And what we saw back in February and March, the global pandemic started to really gain momentum. Risk premiums started to increase as it got increasingly difficult to execute trades. And as prices started to fall, the moves got bigger and bigger as those trading volumes got smaller and smaller, and I think it’s best defined as just really a classic liquidity squeeze.

So much of what the Fed did with its policy response back in March was to specifically address these liquidity squeezes. By announcing that they plan to buy money market securities, corporate debt, high-yield ETF’s, and municipal bonds, they effectively helped to re-liquefy the market. And knowing that the Fed stood ready and willing to buy a wide range of bonds, that allowed investors to reengage. It allowed them to sell the bonds they no longer wanted. It allowed them to actually buy some of the bonds, perhaps, they did want. And then the market found a much more acceptable clearing level for buyers and sellers to exchange their securities.

So as we think about that while the economic consequences of the Fed’s action remained unclear, they can certainly declare victory with respect to clearing the illiquidity logjam that was really concentrated in markets and really helping the capital markets function more effectively. And perhaps the clearest evidence of this success is the $1.5 trillion of debt issued by corporations so far this year. These are record volumes of bond issuance in just five months of the year, and that’s typically a very high level of a full-year amount of bond issuance and companies have done that in just five months. But what they did is they provided much needed cash to help buffer these companies against the very stark and challenging economic slowdown, which is really a net positive from the Fed’s perspective.

Laurie: Well, with that, talking about companies, let’s turn to the topic of credit. Many companies have declared bankruptcy, including some well-known flagship companies. What is the Wells Fargo Asset Management credit team focused on now? Is it fallen angels, the companies that move from investment grade to high-yield, or is there something more going on in the investment-grade space or the high-yield space?

George: That’s a great question, Laurie. The upsurge of a volatility has led to know some meaningful challenges for companies. Companies have had to borrow a lot of money because they need the cash. They need the cash buffer. They need to be prepared for a much more volatile future. And so the rush to borrow money is more born out of necessity than anything else. Much of our fixed income investment process is based on what we would call bottoms up analysis. That means our research team’s doing deep credit analysis, and our portfolios are built around highly detailed company and security selection.

And in environments like today where investors face major economic uncertainty, violent swings in liquidity and volatility, and a rapidly changing political landscape, that deep fundamental analysis, it becomes the anchor of your portfolio, and it’s really how you build durability in your portfolio. And I think that word “durability” is absolutely critical in today’s world.

So to your question, when market disruptions occur and you start to see big upticks in defaults and fallen angels—so high-quality companies see their credit ratings downgraded to levels they’re probably not used to and their cost of borrowing goes up significantly—we’re in a very good position to do the amount of detailed analysis to make a highly informed decision. You need to know these companies.

And to take it one step further, if you look at some sectors—like airlines, hotels, retailers—they’ve been under tremendous pressure because of this big slowdown in growth. And we think that pressure’s going to persist for the foreseeable future, but there will be winners and losers and so we want to pick through that opportunity set to try and identify those companies. And we’re going to be very, very selective, but there can be opportunities for the right type of portfolio for the right type of account that can benefit from that kind of sudden change.

On the flipside, where you see maybe some what you’d call some safer opportunities in sectors like financials and even energy, which has seen a lot of volatility, there are a lot of companies within the financial complex, within the energy complex, that really should be able to adapt, that actually can weather the storm, that have that durable base of cash flow generation, that should do just fine over the coming months and quarters.

And so through a combination of those types of strategies, we take a medium-term look. We do the deep credit analysis. We take a bottoms up approach. And we really build portfolios that have a lot of cash flow durability over the medium-term.

Laurie: Hmm, so cash flow durability. That puts it in perspective. Can you maybe tell us a little bit more about some opportunities that may represent better relative value than others?

George: Yeah, sure. Relative value is just that. It’s all relative. And so when we look at securities, when we look at companies, we’ll look at the companies in absolute terms. Is this company improving or deteriorating? How are they trending from an earnings standpoint, from a balance sheet standpoint, from a cash flow standpoint? We can do the same in structured products where we see a securitized pool of assets that may have similar characteristics. And so what we’re trying to do is look, going back to that cash flow durability, at how sustainable is that cash flow.

But when we look at the price of those securities, now we’re looking at the market’s perception of those cash flows and we’re looking for the difference in the market’s perception. And so relative value right now is actually quite attractive. Risk premiums—the extra yield you get paid to lend to a company or to an entity—has gone up dramatically since the beginning of the year. Now they have been coming down. Those risk premiums have been coming down pretty significantly over the last few weeks.

However, credit spreads or spreads in general still remain at relatively wide yields. So we see attractive valuations still and I mentioned before sectors like energy, very broadly speaking, energy still looks relatively attractive. However, you can extend that into parts of the structured products market, and you can see that in areas like CLOs, collateral loan obligations, those securities have actually lagged the tightening or the improvement in risk premiums that we’ve seen across other parts of the structured products market. So we’ve been looking there.

The other is just simply points along the yield curve. As I mentioned before, the yield curve has steepened and so by selling short-dated bonds and buying longer-dated bonds, you’re picking up incremental yield. You’re also taking more duration risk or more price sensitivity to changes in yields. However, that incremental yield to us does look attractive at certain points along the curve.

So when volatility picks up, relative value tends to increase, because you have a lot of different opinions in the market. People are buying and selling for a whole host of reasons. Keeping your cool, focusing on that cash flow durability allows you to identify the oversold companies or credits and try and move away from the ones that perhaps are kind of outperforming for reasons that maybe are not sustainable.

Laurie: Well, thank you for that. A last question: What are you seeing as you look ahead to the rest of 2020?

George: 2020 has been extraordinary for several reasons, but perhaps the most extraordinary is the speed at which change has occurred. Simply put, the pandemic brought the economy to a screeching halt from about 2.5% growth to almost -20% in just three months. This kind of rate of change is simply mind blowing.

But even more impressive was the speed at which policymakers responded. Both monetary and fiscal policymakers were able to inject more than $6 trillion of stimulus into the system in about eight weeks. We’re pretty sure that that has never happened in the history of the United States.

And now we are witnessing signs of a faster-than-expected snapback in the economy. Just look at the most recent jobs report that showed that employers are already starting to add back jobs. So as we look going forward and into the summer, the hyper-speed rate of change for the pandemic, for policy response, and ultimately, the economy, will likely slow.

But just as those factors slow, our presidential election is heating up. This summer, the heat in Washington is likely to be hot as President Trump and Joe Biden square off against each other to battle for the presidency. It’s likely to be a very contentious road to the White House with meaningful implications for financial markets and investors.

So our message to our clients and to investors is keep your pencils sharp, do deep analysis, and make sure the companies and securities you invest in have strong durable cash flows to buffer against the volatility in the political and economic landscape.

Laurie: Well, thank you so much for joining us today, George. This has been a fun conversation.

George: Thanks for having me, Laurie.

Laurie: For our listeners, if you’d like to read more market insights and investment perspectives from the fixed-income teams at WFAM, you can find them at our AdvantageVoice® blog, as well as on our website at wfam.com. Until next time, I’m Laurie King; take care.

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