Janelle Woodward, Global Head of Fixed Income, joined BrightTalk at IMPACT® 2018 for an exclusive interview on the current state of fixed income markets and what it means for advisors and investors in 2019 and beyond.
Topics discussed include:
- Entering a bond bear market
- What’s going on with interest rates?
- Using alternatives in a portfolio
- A discussion on inflation
- Is a crisis looming with credit and student loans?
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Ben Jones: I’m Ben Jones, Managing Director at BMO Global Asset Management and co-host of BMO’s Better conversations. Better outcomes. podcast. I’m joined here by Janelle Woodward, and we just wrapped up the BrightTalk fixed income panel. And we wanted to take a minute here, we’re having a lot of fun at Schwab talking a lot of fixed income, and wanted to spend some time with Janelle talking a little bit more in depth about some of the ways that they’re taking advantage of the current market conditions. Welcome to the show, Janelle.
Janelle Woodward: Thank you so much.
Ben Jones: So Janelle, I know that everybody who talks to you probably asks you, the first question they want to talk about is the Fed, but the first question I want to talk about is something we’ve been having a lot of fun with, which is, fixed income has kind of become your life’s work. How did that happen and why is that important to you?
Janelle Woodward: I think if I’m honest, I was not lying awake as a child, dreaming about doing fixed income for the rest of my life. I was lying awake dreaming about math problems and spreadsheets, and so I’m not sure if I found fixed income or it found me, but it’s been a really great fit and very rewarding. I think what I love about it is, it’s in everybody’s portfolio, directly or indirectly, everybody has exposure to fixed income markets. And then, really, it’s about the themes that get captured, everything from what’s going on at the government level, to corporate levels, so it intersects with equity markets, to the consumer level in terms of consumer finance, and it’s constantly changing and evolving. So we often get told we’re very boring, but I think it’s a really interesting aspect and area of the world.
Ben Jones: Now fixed income is at a different period of time. We’ve just gone through a very extended bond bull market, and now we find ourselves in a situation where a lot of people are saying we might be in a bond bear market going forward. Tell me a little bit about you and your team’s thoughts about the current market conditions.
Janelle Woodward: Sure, and we have gotten asked this a lot. I think it’s an important question. And I think there is two components to that bear market. One is looking at the direction of rates. Since the eighties, we’ve gone from about 15.8 percent to where yields are at currently today, and so it’s, one, about that, but then it’s also about this concept of total return. And so I think it’s important – we think about it as coming from a bull market doesn’t necessarily mean we’re going to transition right into a bear market, because we have to break down that composition of total return. And the beauty of fixed income is, really, total return comes from two different pieces. Yes, the price return, which is going to be impacted by what happens to rates, but also about the income, or the coupon return. And as rates go up, that coupon piece becomes more meaningful, both in terms of an annual return, but then longer term total returns. And so we look back and we think about the composition during that bull market, it was really coupon returns that drove the bulk of returns. That’s an important thing to remember.
Ben Jones: And you and your team have written a lot about this concept that the coupons are just as important to overall returns as, kind of, the total return aspect of the portfolio. Tell me a little bit about where you and the team are finding opportunities in the fixed income space today.
Janelle Woodward: Yeah, I think one of the things, when we step back, we think generically about five percent being a number that a lot of people have held on to in terms of what the expectation is from a return standpoint within their fixed income part of their portfolio. We don’t have to go back that long, a few decades, and we can see that we can get to that five percent, really, by being in purely “risk-free” assets. And then as we’ve gone forward, as rates have come lower, we’ve seen investors move out the risk spectrum. And so as rates go higher, we actually think one of the opportunities is for investors to step back, to de-risk their portfolio, to go into the more traditional fixed income sectors to pick up liquidity, diversification, capital preservation and income, and still achieve that target. So one of the things that we’ve been very opportunistic about is thinking about the investment-grade world, as vanilla as it is, as really the breadth, depth, liquid part of the market that can still meet some of those return assumptions.
Ben Jones: And what do you think about some of the compression that we’ve seen in spreads in the plus categories?
Janelle Woodward: Yeah, I think this is in part the behavior that you would expect given where we are in a monetary policy cycle. And so we’ve seen, as investors have looked for that yield, we’ve seen investors move out the risk spectrum. And we’ve seen a compression, emerging markets debt high yield, and I think it’s important to step back and realize there is a credit risk component of that, that, one demonstrates a higher level of correlation to equities, but also can go wider. We’ve seen that in emerging market debt on a year-to-date basis. So we do think there are select opportunities in the plus sector where it makes sense, doing our bottom-up research and analysis, where it can attract a relative value in a portfolio context. We don’t think that allocations, just from a top-down sector perspective in isolation, are the prudent ways to manage the risks that are really inherent in those buckets.
Ben Jones: Now in the TCH Core Plus [Bond] Fund, you guys use a team-based approach, and one of the things that I think is really unique is you have a really diverse team that is allowed to weigh in on the ideas that you put into the portfolio. Could you just walk us through how that all gets implemented?
Janelle Woodward: Yeah, I think that there’s an important point and something that we’re very proud of; the integration of thought, of people, the diversity of thought that comes to the table. When you look at the fixed income markets, being so dynamic and changing so significantly, to think that there’s one investment theme or one investment decision maker or one investment idea, we’d miss a lot of opportunities. And so we are about singles instead of home runs, a lot of ideas that can get put into the portfolio. We sit in an open architecture space; there’s constant interaction between the team. And in truth, idea generation can come from any discipline across our investment team, from the traders, we need to be a source of liquidity, here’s an opportunity to buy a bond at an attractive price, from research, the market is missing this fundamental theme and there’s attractive relative value, or from the portfolio management team, from a top-down standpoint, we want to tilt this way as far as a sector exposure or regional exposure. And it’s really bringing those together, top-down, bottom-up disciplines that we think yields a portfolio construction that’s in the best interests of our clients.
Ben Jones: Now I think the audience would be really upset if I didn’t ask you about interest rates. We are, as you mentioned, a little further along in the interest rate cycle. Tell me a little bit about what you see out into the future and into 2019 from your team’s perspective.
Janelle Woodward: Yeah, I think definitely this year as we look for, and have potentially, four increases in Fed funds this year, is that it is very timely and very topical. But if we step back, we do have to appreciate that December will mark the third year anniversary of a tightening cycle, and that in many ways, the markets and asset classes have matured ahead of that. When we look at the structure and the dynamics of the market, we don’t anticipate that there is a mean reversion argument to be made. We look at the longer-term neutral rates of about three percent, and when we look at Fed funds, two to two and a quarter, we’re not that far away. And in fact, some participants actually think that the neutral rate is lower. So we think we’re actually well along into the cycle. We think a lot of the asset classes have matured from a spread perspective ahead of that. And we think, coming back to the concept of income, total returns, and coupons, that it’s an attractive time to get involved in fixed income and use it as a diversifier within your portfolio.
Ben Jones: That makes a lot of sense. Now, given that interest rates have come so far, there are alternatives that people can use for “risk-free” assets. In addition, as interest rates go up, it doesn’t just affect the fixed income side of a portfolio. Tell me a little bit about how you talk to advisors about some of the alternatives relative to the fixed income side of a portfolio, like CDs, savings, treasuries, and then also, how you think about positioning as interest rates rise in the future?
Janelle Woodward: I think if we step back and say “what is the catalyst, what’s been the catalyst for a tighter monetary policy” it’s been a macro backdrop that’s been very constructive. Economic data has been very strong. And so, in parallel, this has supported a lot of the risk assets – equity markets, credit markets, corporate bond markets. And so this has created some attractive opportunities. We’re about halfway through third quarter earnings. We’ve seen twenty percent growth again in EPS. We see that resilience in corporations. And so we think, even with some of these things priced in, it does make sense to step out away from CDs, where you are treading water at best at neutral to slightly negative real returns, out the curve to pick up some of the steepness that’s left in the curve, but certainly the steepness that’s left in credit assets as well, and we think that this can be attractive in a risk-balanced way, again, within the context of an overall portfolio.
Ben Jones: And when you think about the current inflation environment, I think people have been surprised that inflation hasn’t, kind of, roared back faster than they expected. That plays heavily on asset prices and risk pricing. Tell me a little bit about your team’s thoughts on inflation going forward.
Janelle Woodward: I think we think that, we believe there’s a lot of structural elements at play that make this different. There’s been a lot written and talked about of flatter Phillips curves. Really, the structural elements of an aging population, savings rates, technology, the role of productivity, in terms of what inflation looks like. At this point, we don’t see evidence that inflation will break out to the upside, I think that is one thing that would change our outlook, in terms of where we are in the monetary policy cycle, but right now we don’t really see the structural evidence to support that. We think we will trade around this two percent target and that the Fed will continue its course, but in the short term we don’t expect and surprises.
Ben Jones: You know, and there’s been a lot of talk about credit, because I think we’re at a point now where there’s a lot more corporate credit out in the marketplace and people keep talking about the potential credit bubble. I know you and I have had a lot of conversations about student loans being a potential impact as well. Tell me a little bit about how your team thinks about a potential credit crisis as well as maybe the student loan issue.
Janelle Woodward: So there’s a lot of different elements of that; you can take it from the structure of the market or the structure of the consumer. I think the one thing is, we do have to appreciate as we go through the tightening cycle, while the market has the ability to be somewhat forward-looking in terms of where we’re going, the consumer feels it on a real-time basis. So prime adjusts as the Fed tightens policy. So there’s a little bit of a lag effect into the real consumer. Now having said that, we see that the dynamics in the amount of floating rate exposure, we think about mortgages in particular versus where we were, it is less. And then at the same time, we do appreciate the growth that we’ve seen in consumer. So, definitely, it’s been a little bit mixed in terms of what the flow-through has been to the real economy.
Ben Jones: Now the last decade has been a fairly interesting decade to be a part of the fixed income marketplace. The next decade probably has the opportunity to be just as interesting. What do you think is required from a fixed income team to be successful for their investors in the next decade?
Janelle Woodward: I think it’s, and it goes back to the point I made earlier, it’s not just about one investment theme or getting one thing right, it’s really about being flexible, about being nimble, about being able to source a lot of different opportunities. One of the things that’s defined our investment process, and we’ve had it for multiple decades, is really looking at these multiple drivers of alpha sources, so looking at not an outright call to duration but how are we constructing duration in anticipation of the shape of the curve, how do we approach sector and quality, and then, ultimately, utilizing security selection in a real way across our portfolios. Ninety percent of funds have more than 750 line items. We like to keep our credit exposures between 100 and 150. It gives us the upside of selection, but allows us to be appropriately diversified. And I think that nimbleness, the ability to move between regions, sectors, sub-sectors of the market to find value, is very critical as we go through these evolving markets.
Ben Jones: So you got to be nimble to adjust to the next decade or so. With respect to how you think people should be positioning their fixed income portfolios, for advisors that are watching this, how do you think that the portfolios should be constructed based upon your team’s views?
Janelle Woodward: Yeah, I think a couple of different things. One, I think you can’t lose sight of having those components: diversification, capital preservation, and liquidity in the context of overall fixed income. We think an allocation in overweight to corporates continues to be warranted, I mentioned the health of corporate earnings, but we’ve been a little bit more thoughtful about curve positioning, looking at opportunities on the front-end versus necessarily extending out with the curve, but then utilizing other sectors, ABS, CMBS, as opportunities present themselves, both from a top-down, a relative value trade, as well as from a bottom-up perspective, to find some of those opportunities.
Ben Jones: Now you mentioned the concentration of your credit names inside of your portfolio construction, and this is something that’s really a differentiator for you relative to many of the other fixed income managers in the marketplace. You also execute in the cash markets instead of derivatives. How does that benefit your investors?
Janelle Woodward: I think it’s important. One, it gives us a lot more structural flexibility. So we are not held to a certain five year CDS contract. We have the flexibility, term-structure flexibility, capital-structure flexibility, and as we move into this different world of liquidity, we can see bonds within the same complex trade differently due to liquidity reasons, size of issuance, seasoning of issuance, and that allows us to thoughtfully navigate that and not say “I like this issuer,” but really select the specific issue that offers the most value for our clients.
Ben Jones: Wonderful. Well I appreciate you taking some time out of your busy schedule here at Schwab IMPACT to join me and I hope all of you will tune into more thoughts from Janelle Woodward. You can visit her team and her thoughts at bmogam.com/viewpoints.
Janelle Woodward: Thank you, Ben.
The views expressed here are those of the participants and are not necessarily those of BMO Global Asset Management, its affiliates, or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements, as actual results could vary.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. Diversification does not ensure a profit or guarantee against loss.
Alpha: is the incremental return of a manager when the market is stationary. In other words, it is the extra return due to nonmarket factors. This risk-adjusted factor takes into account both the performance of the market as a whole and the volatility of the manager.
De-Risk: Refers to the activities or series of activities which help to mitigate risk.