The richest one percent of this country owns half our country's wealth, five trillion dollars. One third of that comes from hard work, two thirds comes from inheritance, interest on interest accumulating to widows and idiot sons and what I do, stock and real estate speculation. It's bullshit. You got ninety percent of the American public out there with little or no net worth. I create nothing. I own.
Sunday, December 09, 2012
Talking Macro, Fixed Income, and the Strategic Alpha Bond Fund with Loomis Sayles’ Matt Eagan
Loomis Sayles is undeniably one of the pre-eminent names in the world of bond funds. The flagship $22 billion Loomis Sayles Bond Fund has returned 10.07% annually over the last 10 years, beating the Barclays Capital U.S. Aggregate Bond Index by a remarkable 4.66% annually. While the big name at Loomis Sayles is the lead managerDan Fuss, CFA, co-manager Matt Eagan, CFA, plays a crucial role in managing the Loomis Sayles Bond Fund and other funds.
I recently had the chance to catch up with Matt to discuss the fixed-income universe, issues facing the global macro economy, and his multi-sector global opportunity Loomis Sayles Strategic Alpha Bond Fund. This fund is a go-anywhere multi-sector bond fund that is managed to relatively low volatility versus core funds. It’s a very interesting fund given the uncertainty in the bond markets from central banks and geopolitical risks (such as in the eurozone).
David Schawel: Tell me a little about your background and your time at Loomis Sayles.
Matt Eagan: I’ve been at Loomis Sayles for 15 years, managing portfolios for 12 years. My background is in the credit side. I previously worked for Liberty Mutual covering investment grade (IG) corporates, high yield (HY), and emerging market (EM) sovereigns. I came to Loomis as a research analyst in the early 1990s, and one of the first sectors they gave me was oil and gas. A lot of risks and opportunities existed in the oil and gas industry, with oil falling to $10 per barrel. They gave me some telecom credits, and I was also able to select corporate debt trading at attractive levels during the Asian crisis, such as Philippine Telecom.
David: In addition to being co-manager on the Loomis Sayles Bond Fund, you manage the Loomis Sayles Strategic Alpha Fund. Take us through the purpose, objectives, and strategy of this fund.
Matt: This multi-sector bond fund style is very eclectic. It’s a multi-sector, global opportunity set, allowing you to go anywhere in the fixed-income space. We don’t look like the benchmark. It’s a long–short fund, and at its heart, it is multi-sector. It has a lot of flexibility to go where there’s value. The objective is to generate LIBOR + 2–4% per year. When LIBOR is very low, like right now, we are looking to generate a return of at least 6% net annually for our clients over a three-year horizon. In this portfolio, we are going to provide investors with an explicit target of where we want to be in terms of standard deviation, which is 4–6% on average. We do this because when you give money to a multi-sector fund manager, you aren’t exactly sure what you’re getting in terms of volatility. We want investors to know what volatility they will be getting. Core fixed-income funds usually run about 4–5%, so it’s a bit of a step out from a core fund. But at the same time, it’s a long ways from long-only multi-sector global credit-oriented strategies, which run volatility of 6% or more, even up to 8%.
David: Can you go into some more detail with respect to your risk management practices?
Matt: We can go long and short. We could go 100% long or 100% short. We use interest rate, currency, and credit space derivatives to move the beta around. I spend a lot of time with risk management to disaggregate different risk factors. I’ve always looked at the three Cs (credit, curve, and currency) in this type of multi-sector portfolio. We can build the portfolio based on our top-down views and broad opportunities, or we can be purely alpha-focused and pick from a bottom-up perspective. When we put the portfolio together, we are measuring the market risk that is embedded in it. For every bond, we cut up the risks into term structure, credit, and currency risks. All of these risk factors can be separated and looked at independently, but they can also be rolled up so we can see how they covariate. For example, in HY and IG, where we see valuations on the stretched side or “fair at best,” we can dial down the beta by shorting some credit derivatives but maintain the long exposure. A long-only fund cannot reduce exposure without selling the bonds at the risk of never seeing them again.
David: How does this type of volatility targeting benefit the average investor, particularly in this low-interest-rate environment?
Matt: The challenge I see is that a lot of people are tied up in funds that are benchmarked to the Barclays Aggregate. Embedded into this is a high degree of interest rate risk because a large percentage of the aggregate index is in U.S. Treasuries (USTs), agency debt, and agency MBS (mortgage-backed securities). So naturally, this has a high degree of sensitivity to interest rates. The Barclays Aggregate correlation with interest rates is somewhere in the neighborhood of 90% or more. The Fed is forcing people to make a decision to move out into term structure or move into credit and take a different type of beta risk, such as high yield.
David: Speaking of that, let’s talk about the high-yield, leveraged loan, and CLO (collateralized loan obligation) space. The HY and loan markets have had a strong year, returning 13% and 9%, respectively, year to date. Issuance has exploded as investors seem to be chasing yield as they are pushed out of government securities, such as agency MBS and USTs, into riskier assets. Issuance of HY and loans of $580 billion through November has already exceeded the previous annual record set in 2007. Meanwhile, defaults in these markets have been below 2% for the past few years. How do you look at these asset classes?
Matt: I agree, and I think it’s very fair to view HY and leveraged loans together. It all starts out with the business cycle. Where are we in the default cycle? We think we are past the best part of the default cycle. Defaults troughed last year well below 3%. It doesn’t get much better than this. The capital appreciation has run its course in HY. If you were just looking at dollar prices, you would argue that yields are fully priced. With HY, you never really trade higher than par plus half your coupon. We’ll assume the typical coupon is roughly 8% right now. Because of the call option embedded in these HY credits, you cap out at about par plus half your coupon (104–105).
David: So you’re saying the bonds are negatively convex here?
Matt: Yes, they act negatively convex. You aren’t able to generate high capital gains as yields start to come down further because the companies will begin to refinance the debt out of 8, 9, 10% bonds into 5, 6, 7% bonds. We are at the point where the return profile is very negatively skewed. The upside is basically your yield; however, that’s not something to sneeze at. A lot of people say “spreads are still cheap at over 500 bps.”
David: I hear that a lot, too. I’d probably argue that, given how low UST yields are, the spreads are less meaningful here.
Matt: They are less meaningful to an extent. Compared with USTs, the data indicate that HY is a very good income generator. I don’t think the credit cycle will turn hard here though. We are at a point in the credit cycle that I’d call a “benign point,” where defaults just kind of bump along. Underwriting since 2008 has been relatively decent, and the use of corporate proceeds hasn’t been egregious. There’s been some silliness, but by and large, it’s been okay and it takes time for problems to surface.
David: We’ve started to see more and more PIK (payment in kind) deals surface, but at what point do you start to say things have gotten too frothy? The technicals in spread markets are very bullish here. Net supply for spread products in 2013 is projected to be negative, even before accounting for the impact of the Fed’s purchases continually pushing people out the risk spectrum. What stage of the game are we at here?
Matt: We’re at a stage where you want to be very picky about the credits you’re in. It’s become a bond pickers market here. There are plenty of one-off opportunities. From a complete top-down perspective, the most you’ll likely get in HY is your yield. With silly season in underwriting just starting, it takes time as the seeds are being sown. The minefield is being laid for the next credit cycle to get worse down the road. You don’t know what PIK deals will blow up on you, but they will come. The seasoning period takes 2–3 years before the defaults escalate. Getting back to your comment about the benchmark being broken, another way of looking at the spread is to compare the HY absolute yield with CPI. If you back out CPI and look at what your real yield is, you get a CPI-adjusted yield. This gives you a result of 300–400 over, which is well within the normal range in real terms.
David: Is there any specific names you’ve been long or short that you would elaborate on?
Matt: In the credit space, we have been playing the convergence trade in Europe. We started buying these credits late last year, focusing on IG corporates — large names like Telefonica, Finmeccanica, Telecom Italia S.p.A., and others (that is, IG names that are in the wrong zip code by being in peripheral countries). What appeals to us is that they have a lot of financial flexibility. Look at a name like Telefonica: It’s one of the largest telecom companies in the world, it has holdings in Latin America, and you have a 70 billion euro market cap below your debt as a cushion. Debt was trading at cents on the euro, with yields up to 8%, that is, trading as cheap as high yield. We kind of loaded up on those late last year and into this year. We had to take a longer term view that the eurozone would not fall apart. We ran a sensitivity analysis on each country, and projected that, even if they left the eurozone, these credits would go to non-IG. But guess what? They’re trading cheaper than non-IG.
David: So, are you guys looking at what these companies would look like if their respective countries exited the eurozone?
Matt: I’m old enough to remember the Brady bond crisis, and I’ve approached the eurozone crisis the same way. You have too much debt, so you’ll see some restructurings. I’m always thinking about what my margin of safety is. If I can at least have a roadmap in the worst case scenario of what it can trade down to, then I can make an intelligent decision about at what price it looks compelling. I don’t avoid situations. There’s always a price at which it makes sense. We took each country and put them into restructuring, and we said, what would it take to fix each country’s debt structure by knocking off a certain amount of debt? I’m always thinking, at what price?
David: The ECB (European Central Bank) has seemingly thrown the kitchen sink at the problems it has encountered. Do you think the “fat tail” risk has largely been taken off the table?
Matt: There were two key announcements in Europe that have taken the fat tail risk out of play. The first was the LTRO (Long Term Refinancing Operation), which took the systemic banking crisis off the table. The second was the ECB saying that it would not tolerate too high of a convertibility premium in the peripheral. It didn’t want the monetary transmission to be blocked to the peripherals. That’s how the ECB came up with the OMT (Outright Monetary Transactions). It has removed, to a certain degree, the risk of convertibility, such as Portugal and others leaving. Now, you look at Portugal-type names, and let’s say maybe the embedded convertibility risk gets taken out and they start trading more in terms of a spread to core names—then Spain, Italy, and Portugal start to look attractive, and that’s what has happened from where we were in July. Spreads have ratcheted in enormously. We’ve been long Spain and Portugal plus the IG corporates. So, we captured all of that, and I think there’s more to come. The next thing that could come is a triggering of the OMT, but our underlying premise is that the eurozone will stick together. It’s more of a range trade. We think the convergence trade theme will continue with peripheral yields coming down and the core names selling off as the flight to quality bid fades.
David: Michael Pettis’ commentaries are among my favorite to read. He recently remarked that, “For now, Spain has implicitly chosen the option of unemployment, in the hopes that it will be able to adjust in one or two years and eventually resume normalcy. No country, after all, can bear the pain that Spain is bearing today without a serious deterioration in the social and political fabric. If Spain wants to continue along its current path, it must be prepared to suffer at least another five years of extraordinarily high unemployment, an erosion of the productive capabilities of its economy, and rising political chaos. Or it can leave the euro. Given how rapidly the political environment is deteriorating, I have little doubt it will leave the euro. Unfortunately we will have to wait a few more years for Madrid to drive the economy into the ground and to rip apart the country’s social fabric before they choose to devalue. But I fully expect they eventually will.” Do you agree with his assessment of the options?
Matt: I agree with what he’s saying. The policy decision of austerity is the wrong one for Spain, or anyone else in the periphery for that matter. Spain is facing a balance sheet crisis, and the last thing you need when the private sector is deleveraging is for the public sector to deleverage too. That is a policy mistake, and I think that’s becoming more well-understood now. The complexity comes from the political situation where the core doesn’t want to throw good money at bad. Germany has kept the pressure on these countries, not austerity for austerity’s sake but, rather, to make big structural changes and fiscal reform, moving toward fiscal centralization. They are trying to get countries to give up their sovereignty over their fiscal policy, which is a big leap for them to make, and also broad labor market reforms. That’s what Germany is really after; they are keeping pressure on these countries so they are forced to make the hard decisions.
David: It feels like some progress is being made, but in my opinion, it will get worse politically and socially before it gets better.
Matt: Slowly but surely these policies are being enacted. They are playing a delicate game, and they need to be careful what they say politically. Pettis is right that it’s a dangerous game to play, as there’s a certain amount of hubris to say you can do this without causing a crisis, but the lynchpin is the ECB. The ECB, through its OMT, can keep the threat over the market from getting too unhinged from the downside that you’d fall into a crisis. The funny thing about the OMT program is that it has worked well. Looking at Spain’s yields, they’ve come down without ever having to trigger it, and it has reduced borrowing costs. It has allowed Spain to not ask for the OMT. It’s a bizarre situation, but if push comes to shove, Spain will come back to the ECB and agree to the core government requirements. There may be some tests along the way, and it’ll go on for years, but eventually, the north will have some control over the budgets of the south.
David: Eventually, the current account deficit situation will need to be repaired for true healing to occur.
Matt: We are already starting to see big changes in current account deficits. I think Portugal is in a positive current account surplus at this point. That’s not because it is becoming competitive on the exports, like Ireland is, which is the poster child for positive reform. Portugal has a current account surplus, a knowledgeable workforce, and low tax rates. The other countries don’t have that; the way its surplus happened is a collapse in the imports, and that’s not necessarily a good thing. But that does build the adjustment in. It will be painful, and the risk is that it can lead to social unrest.
David: You’ve said that your base case is for the eurozone to stick together, but how, if at all, should they go about hedging tail risk?
Matt: A lot of it is trying to figure out how much of these macro risks are priced into the market. You don’t want to be hedged paying for insurance when the risk is already out there in the market. This time last year, the risks seemed high, but you were already being paid for it. We are in a transition market right now. The global economies are deleveraging. The private sector debt has ended up on the balance sheets of the public sector. The public sector’s fiscal budgets are tapped out and are being forced in the best case to be non-stimulative and in the worst case to undergo some austerity. A weak private sector and a public sector with handcuffs on it mean that the underpinning impulse of the economy is very disinflationary. In Europe, you have the possibility of deflation in some places. The only reflation game in town is through the central banks, and they are doing their best to keep it going. We think the way out is through reflation and debt monetization. Historically, they get solved through inflation down the road, as debt as a percentage of nominal GDP gets eroded or monetized away.
David: I’m glad you bring up the central banks. As a portfolio manager myself, I have seen first hand how much the Fed has impacted asset prices through its QE (quantitative easing) programs.
Matt: We are in the late stages of a “risk on” rally, and you really want to fade it, as we know the underlying picture really hasn’t changed. There’s been a shelf life for central bank activity. They’ve flooded the economy with money, and as risky asset valuations have gone up, we have started to layer in hedges. We’ll go toward neutral in credit and take our beta down to zero. We won’t go short due to risks of getting hit by the Fed.
David: I’ll present a counterargument to that. Although many areas of the credit markets have rallied substantially, as measured by inflows, investors have not been pushed substantially into stocks yet, which is arguably one of Bernanke’s main goals through QE.
Matt: I think that’s a fair statement. I think the risk premium can come down in equities and multiples can go up. The thing that people may be misunderstanding is that QE-infinity does not have a shelf life with a date. I wouldn’t be surprised to see at the next Fed meeting, that the Fed would buy more U.S. Treasuries as Operation Twist ends. You’ll probably see $40 billion of USTs in addition to the $40 billion of MBS from QE3.
David: What’s interesting about another UST buying program is that it would be balance sheet expansion. Operation Twist was “sterilized,” as they were selling one maturity and buying another. They were adding duration, but it was still sterilized.
Matt: Exactly. It’s pure balance sheet expansion.
David: Real yields have continued to go lower, and I’m waiting for the 30-year real yield to turn negative as well. What is the catalyst for them to become less negative and eventually positive? And does the fact that they are negative here (except for the 30 year) imply that the Fed is working?
Matt: The Fed will move toward a targeting mechanism. They might currently use inflation and employment dual mandates, but really what they are targeting is nominal GDP. They are distorting the yield curve very successfully. The idea is that they will keep them low until they hit their targets — closing the trillion-dollar nominal GDP output gap, which we think could take a few years. The first impact would be that the yield curve will start to rise and steepen. It will steepen initially as the numbers get better. People won’t be looking for a certain date; they’ll be looking for economic forecasts. I think rates will rise on a secular basis from here. The first cycle will be relatively benign from an inflation basis. It will be more painful from a real rate basis as real rates move from negative to positive, and inflation will pick up more steadily after that.
David: In my view, there’s a large percentage of market participants who confuse base money supply and broad money supply. Bank loan demand has picked up, but it’s still extremely challenging here. Consumer and real estate loans are largely flat. C&I (Commercial and Industrial) has picked up.
Matt: This is a key point. The money multiplier is not working right now. The money that is pumped into the banking system from QE is being stuck as excess reserves at the fed and not lent out.
David: Lacy Hunt likes to say that the money multiplier is negative at the margin here. Would you agree?
Matt: Yes, I would. If they pump a trillion dollars into the monetary base, even if the money multiplier is negative, it will still expand nominal GDP at some level. Eventually, the deleveraging will turn around, and the private sector will start to borrow. You need to watch when lending starts to pick up again. That will be when those excess reserves start to leak out. The Fed is saying it will be able to rein that in through draining the reserves or raising IOER (interest on excess reserves).
David: I am not a big believer that IOER will be a very effective tool if things started to overheat. For instance, at the margin, I don’t believe lending decisions are being made over whether IOER is at 25 bps or 225 bps.
Matt: I think it’s some hubris that the Fed thinks it can do that. I agree; I think those reserves will leak into the economy at some point, although I can’t tell you when.
Conclusion Going forward, fixed-income investors should be cognizant of the risks they are taking in their bond funds. Coming off of the heels of substantial gains in both government and credit bonds, investors need to understand the risk/reward nature that various fixed-income classes have going forward. Investors who are willing to look at alternative bond funds should consider the Loomis Sayles Strategic Alpha Fund (LABAX). I like that in addition to having a great grasp of the macroeconomic issues, Mr. Eagan has a strong credit background, which shouldn’t be underestimated in a time when yields are at all-time lows and competition for spread assets is so high. While this type of fund is not for everyone, it could be a suitable part of a portfolio for a fixed-income investor seeking attractive absolute total returns with low volatility.