CJ Doherty
Welcome to the Lending Lowdown.
I'm CJ Doherty, Director of Analysis at LSEG LPC. The topic for today's discussion is the US corporate bond market.
It's the first time we've covered this segment of the credit markets, and we thought it was a good time to touch on it given its size and importance and especially amid the recent volatility we've seen in the broader markets. Joining me to discuss this is Connor Fitzgerald who is a portfolio manager at Wellington Management.
Thanks for taking the time to join me today, Connor.
Connor Fitzgerald
Thanks for having me on.
I really appreciate it.
CJ Doherty
Great and as usual, we like to first get a little bit of an insight into our guests. So, to set the stage, Connor, can you tell us a bit about yourself and your role at Wellington?
Connor Fitzgerald
Sure. So, I'm a Fixed Income Portfolio Manager at Wellington.
I work on multi sector bond portfolios that would include things like corporate credit obviously, but also mortgages, treasuries, emerging markets and high yield debt as well.
My specific niche or area of expertise that I've focused on for a very long time would be, you know, investment grade corporate credit where I've been sort of in the investment grade arena really since I was a junior in college when I did an internship at Lehman Brothers so fast forward today, still doing the same thing, working on investment grade credit. That's what I love to do.
CJ Doherty
Okay. And let's drive right into market conditions. Then what are you currently seeing in the market given recent volatility and the impact of tariffs, etc?
Connor Fitzgerald
Sure. So, I think the Trump administration is in a challenging spot right now. I think a number of the policy objectives that they want to achieve, namely things like reducing spending at the government level to try to address long term concerns with the deficit, present a challenge because if you think about a lot of their policy objectives, whether it's cutting spending, rolling back immigration, tariffs to improve the revenue side of the equation, a lot of those policy pillars are are growth negative in our opinion.
And we think there's an issue whereby if they lean too hard on those slowly, the economy risk tipping us into recession, that there is in fact a risk that the revenue side of the equation in terms of the budget deficit starts to fall and then the deficit could potentially increase along that vein.
And then the second thing is as it relates to tariffs specifically and sort of like the international negotiations we're seeing today.
You know, while we, we tend to agree with some of the long term objectives that they're trying to achieve, we think the risk that the administration may be underappreciated a little bit is that if we get too aggressive with some of our trading partners by way of tariffs that their response will be to liquidate the capital account, meaning there's a risk that they sell equities that they've bought of US domiciled companies, pullback FDI and in a more extreme case you know start to reduce holdings of treasury.
So, I really think that the Trump administration has to sort of thread the needle on both those dimensions and obviously a very, very challenging to do and that we think is really why you've seen a lot of volatility in the past few weeks.
And then finally, I'd just say, if you just take a step back and try to block out all the noise to us, the single most important thing to focus on in the market is the trajectory of the deficit. The the math is really challenging any way you cut it without going into entitlements and that's that's obviously something that's not politically popular. So, we're really focused on sort of the moving parts of the deficit going forward and trying to block ourselves out from the day-to-day headlines and the day-to-day noise, if you will.
CJ Doherty
And in times of volatility, questions often arise around credit quality.
What are you seeing there?
You know, including a cross-rating categories, any concerns?
Connor Fitzgerald
So, I would say the volatility that we've seen and that we expect, I don't think the problem is in the investment grade corporate or the high yield corporate part of the public markets. And what I would say is the quick story I try to tell about the public markets and I think the story is actually really similar in high yield and in investment grade with the exception of the very low quality part of the high yield market. During the pandemic, we saw companies take out, effectively, insurance policies by issuing debt. They put that cash in their balance sheet because who knows what was going to happen?
We obviously had a recovery that came about much quicker than folks expected because of excessive fiscal and monetary policy working together, but also a vaccine that came a lot quicker than maybe most folks expected. 2021, we saw companies sort of pay down that debt and pay down those insurance policies and then in 2022, before we could get like a late cycle virtuous animal spirits type RE leveraging environment, the Fed, sort of jumped up, raised their hands and said, hey, we have too much inflation. We’ll just slow the economy in order to get inflation under control.
And why that's important is because companies reacted by behaving even more defensively with respect to their balance sheets. And then in 2023, we had the Silicon Valley banking issue and just concerns over regional banks holding of treasuries. People thought that was sort of like the the long and variable lag of Fed policy.
So really, we've had these like rolling issues where companies have been incentivized to behave very defensively very prudently with respect to their balance sheet.
So, the way I would try to share that in a data point is we track a data set of say like 3 or 400 investment grade industrial, non-financial companies.
We look at their free cash flow after CapEx, dividends, buybacks and really for the past couple of years it's been running positive by a couple percent, which means companies are effectively building cash on their balance sheet. Typically, what you would see when you're like late cycle and volatility is low, you would see that number go negative because companies don't get rewarded for building cash on their balance sheet.
But I think that's really just, a proxy for how uncertain the environment has been. So really, we've seen credit quality kind of improve over the last few years. So, if we are moving into a crisis and obviously there's a lot of reasons to be concerned today, we just think that the stance towards balance sheets will remain disciplined and prudent.
So that's sort of a backdoor positive of the volatility we're seeing on the macro landscape, if you will. What that means to me is the range that spreads can trade and even in sort of a downside scenario is probably a little bit lower and spread than maybe that would have been in the past where companies were more leveraged.
We think fundamentals are sort of back to where they were, in the early parts of the twenty tens before we had that that many re leveraging cycle there.
CJ Doherty
Okay great, relative value considerations are often a focus for investors.
Can you discuss relative value across asset classes and within bonds?
Connor Fitzgerald
Sure. So, I think using investment grade credit first, spreads are kind of at like the 25th percentile. So not exceedingly attractive versus history.
That sort of belies the fact that underneath the surface, longer maturity credit, say 10-to-30-year maturities are trading - 10th or 12th percentile versus history. So very tight. We don't see a lot of value there.
We would definitely avoid that part of the market, all else equal.
There is a little bit more value in say the one-to-10-year part of the market.
Some of that's because there's more value in the financial sector, which has a higher waiting in that part of the curve.
We would prefer to focus our investments on sort of the intermediate like say five-year maturity spectrum.
When I look at high yield versus investment grade, I do think the upper tier part of the high yield market is potentially better quality from a credit perspective than maybe folks appreciate.
So, I think there's a good reason that that part of the market can trade, maybe tight versus investing in grade peers.
So, we do like that part of the market and then I would say just in the past couple weeks we've seen I'd say a lot of value created in the more cyclical segments of the economy.
So, things like energy, chemicals, cruise liners, things that will be sensitive to recession. And I do think there's some value being created there.
So, I think that's definitely worth looking at where if we do get a little bit of a recovery and sentiment, I think that part of the market can perform well. And as I mentioned before, I think generally pretty, pretty good companies in that part of the market.
So, I think more recently we've been favoring like higher quality, high yield and still think intermediate investment grade is okay. But not exceedingly attractive versus history. So still, I think still save some dry powder if that makes sense.
CJ Doherty
Yeah, and indeed it does.
Let's talk a bit about duration now, Connor.
What's your outlook for long duration bonds versus short duration bonds?
Fitzgerald, Connor
So I think that's possibly a more important question than the relative value within the credit sectors, I think what my personal highest conviction view right now is that the treasury curve will continue to steepen.
We've retained that view for quite some time.
It's really started to move in the past couple of months, but I think when I look longer term at something like the fives 30s yield curve, it's not even at average levels versus history. And I think one of the most important themes in the market right now is like, who's going to buy all the bonds that are being issued by the US government and what we've seen in the past year or two when the Fed has really stepped back from buying bonds, it's been the US household sector that has picked up the baton and bought those treasuries.
Historically, the US household sector doesn't buy long duration bonds. They buy more like one-to-five-year maturities and occasionally a little bit longer, out to sevens or 10s.
So, we think that handoff of, like, a price insensitive Federal Reserve to a price sensitive household buyer base is very important. And frankly, cash is still pretty competitive versus a good bit of the treasury curve unless you want to go way out to 10s and 30s. So, we just don't.
We think over time, as deficits continue to grow, this is sort of classic crowding out, if you will.
Those deficits are going to need it to attract capital from other sources, whether it's cash, equities, etc. So we're not, we're not in the camp that say, you know, treasury auctions are going to fail.
It's just we think that yields will need to move higher on 5, 7, 10 year maturity securities to incentivize people to come out of cash to buy those bonds.
And we think that means a steeper curve, all else equal.
And then just from a fundamental perspective, I'm a huge believer in this idea of term premium, which I think at its simplest form just means you should get paid to lend to someone for a longer period of time than for a shorter period of time because there's a great deal of uncertainty around the path of the fed and the path of inflation over those longer timeframes.
So, acknowledging that the curve has, uninverted and now steepened a bit, we still think that's sort of a structural trend in bond markets.
So, we really like, again similar to credit, we like intermediate bonds like 3-4-5-year treasuries strike us as sort of the sweet spot.
We're still concerned that the structural trend for 10- and 30-year yields is higher.
And I think that I try to think of like the good and the bad outcome.
I think in the bad outcome, if we have a recession, the fed will cut aggressively.
I think shorter dated bond maturity yields can fall precipitously, but 10- and 30-year yields might not move that much.
Conversely, if the current administration can pull a rabbit out of their hat and sort of thread the needle and then get tax cuts through over the summer, I think the market will be concerned about deficits and the way they'll price that will be by pushing long dated treasury yields higher.
So in sort of the good and the bad outcome, I expect a steeper treasury curve.
CJ Doherty
Now a question that every investor wants to know, and I'm sure you get asked a lot. How to build a good, fixed income portfolio.
Connor Fitzgerald
Sure. So, I think it's an important question, especially today. I think the biggest challenge that fixed income investors have been facing really for the past couple of years, but also, maybe acutely so today is that the correlation between risk free rates and risk assets has been extremely volatile.
We lived through a period of time post the global financial crisis where treasuries were sort of this perfect positive carry hedge that every time you go to risk off, they rallied and sort of protected portfolios, but that was an environment where the Fed was doing quantitative easing, you know, they are more worried about deflation vis a vis inflation and we weren't running nearly as large a deficits as we are now.
And so I think the question is like, what is the role of treasury duration in a portfolio?
I think we still believe that, you know, in a in a true left tail economic downside type event that shorter dated treasury's in particular will protect a portfolio, so I would anchor portfolios with a good bit of liquidity and defense by way of short term treasuries and then on the credit side, I just think at the end of the day, when you take a step back and you look at where yields are today, they are they are pretty attractive vis a vis what we've experienced in the past 15 or 20 years, although not at the highest levels we've seen in the past few years and why that's important is I think you can build, you know a 5 or 6% portfolio without taking a ton of credit risk, whereas in, say 2021, you would have had to buy some low quality emerging markets, low quality high yield to get yields anywhere near those levels.
So, given the concerns about sort of rates drifting higher, you know volatility emanating from pretty dramatic like Titanic policy shifts from the US government, we think it makes sense to sort of keep your duration down, keep your credit risk down and sort of just earn, you know, 4-5-6 percent income, depending on your risk tolerance.
In what is pretty good quality, good stable credits, and I think that's sort of the way to build the portfolio right now and frankly something like a 6% portfolio, if you just look at long run returns of the stock market, it's it's 7 or 8%.
That's just not nearly as much of a give versus equities as it was 5 or 10 years ago, and sort of the low-rate era.
So that's kind of how we're that's sort of the mental model that we're using to build fixed income portfolios today.
CJ Doherty
Great. And so last question for you, Connor, we want to look ahead to the future.
Not always an easy thing to do, so best guess will do.
What's your outlook for the market broadly going forward?
You know, where are things headed for the rest of the year?
Connor Fitzgerald
I do think the uncertainty that is emanating from policy changes at in the US government will ultimately slow things in the economy.
So I do think there's a higher probability of recession than there has been in than the past three or four years for sure.
I would caveat that by saying again that credit quality I think can the credit quality in the markets that we traffic in, I think can certainly hand over recession and also that, you know, a shallow recession is not the end of the world. That might actually be like a positive clearing event in a way, we've sort of been like waiting for a recession for a couple years. And recessions are sort of natural things that happen from time to time in in capitalistic economies.
And really I think the reason the number one thing I would point to as to like why we think that's likely is just that even if we don't go down, the more extreme policy paths that have been floated from the administration.
Just the mere fact that like the excessive fiscal stimulus that we had in the US coming out of the pandemic is fading.
That was a major pillar of support for the US economy. If I had to point to one reason why we didn't have a recession in 2022, when the fed hiked 500 basis points, I think it's because there was so much fiscal support coming from the government running 7 to 8% budget deficits in a full capacity. Full employment economy is a very atypical thing to see.
So, I just think that that's fading. I think the cumulative effect of not just the rate of inflation, but like the level of inflation just stuffs a lot more expensive than it was a few years ago and it stayed there. And that's just eating into consumers savings and budgets.
So, I think we'll have a little bit of a slowdown in the back half of the year and maybe test 0% growth and maybe a minor recession. And so I think what that means is you want to stay higher quality in your orientation to credit, and I think, you know, again lean on those front end treasuries to provide some bump in price if the fed can actually engage in sort of a cutting cycle back to neutral. I think, you know, if neutral is the market seems to think neutral is like two and a half, three and a half.
And if you can earn 4% on a 5-year treasury and rates can come down 50 on a duration of four, you can get another 2% return there.
That's that's a pretty decent return.
So that, that's again, you know sort of dovetails with how we're positioned as well.
CJ Doherty
Great, thank you.
And with that, we will wrap up for today.
Connor, thank you very much for joining me and sharing your insights. Will certainly be monitoring how things play out in the bond market in the remainder of the year.
Connor Fitzgerald
Thanks again.
Really, I appreciate the opportunity to talk with you and share some perspective.
CJ Doherty
And thank you all for tuning in.
As always, I invite you to check out our loan and bond news data and analysis at loanconnector.com and also on Workspace. I'm CJ Doherty, subscribe to the Lending Lowdown on your favorite podcast platform.
