PODCASTS

PARTICIPANTS

Guest Host
Lloyd Perruzza
VP National Accounts and Managed Assets Portfolio Manager

Jeremy Lucas
Vice President & Portfolio Manager

Voiceover: You're listening to On the Money with Dynamic Funds, the podcast series that delivers access, insights, and perspective from some of the industry's most respected active managers and thought leaders. From market commentaries and economic analysis to personal finance, investing and beyond, On the Money covers it all because when it comes to your money, we're on it.

Lloyd Perruzza: Welcome to another edition of On the Money. I'm your host, Lloyd Perruzza, VP National Accounts and Managed Assets for Dynamic Funds. Investors in bonds have seen the world of fixed income shift rapidly from a period of super-low interest rates, which was often referred to with the acronym TINA that stood for There Is No Alternative to now find themselves in 2023 residing in a world with numerous bond opportunities. However, with this change came a seismic shift in bond prices in 2022 and one of the most volatile years in bond market history.

With so much change in such a short time, bond investors are confronted with difficult decisions regarding the future path of inflation, interest rates, and credit risk, and how to adapt to this new and complicated environment. To help us unpack these questions and more, I'm thrilled to be joined by Jeremy Lucas, VP and Portfolio Manager at Dynamic Funds. Jeremy has over 22 years of experience in fixed income.

Further, he is a long-standing member of Dynamics' specialized credit team that oversees over $6 billion in bond mandates for K investors. Jeremy, many thanks for joining us. Let's start by giving our listeners some of your foundational thoughts on the bond market. Can you give us your views about the macroeconomic environment and how you are applying that in your current thinking around portfolio positioning?

Jeremy Lucas: Sure. Absolutely. Thanks for having me on and the opportunity to express our team's views on fixed income and credit generally. When we think about where we're at, I'll give you our big-picture view and then we'll drill down to our thoughts around portfolio positioning. The past year and a half has really been about central bankers and inflation and their war on inflation. What we've seen since the end of 2021 has been an absolutely violent increase in interest rates, and central bankers have been very aggressive with their rate-hiking cycle and their monetary tightening policies.

In our view, the consequences of this aggressive hiking cycle have really truly yet to have been felt through the economy. We've certainly seen some cracks, but we really haven't quite seen the full effect of these interest rates, and that's because there's a lagging effect. It takes time for it to work its way through. From a macroeconomic perspective, we have some concerns about how these interest rates are going to ultimately play through the economy.

There's some examples that the lagging effect has yet to take place. An example would be the leisure industries. Cruise lines are doing better and better despite the fact that perhaps their capital structures are a bit stressed. Airlines are showing strong earnings. We're seeing in the leisure and more consumer discretionary sectors some evidence of excess COVID-driven demand. It's still out there. It hasn't been mopped up fully yet.

Let's look at another important area of the economy. Obviously, the labor market and that's quite strong. It's still putting together good job growth post-COVID. There still is this broader recovery narrative that's out there. When we think about some of the other elements that are a little bit more sensitive to interest rates, one of the areas that we've seen start to crack first has been housing. New homeowners in the US has gone down, there's been bigger cancellation rates. Obviously, you've seen what's happening, you're hearing what's happening in the Canadian real estate markets.

The reality is housing is starting to crack first. Another area where we're starting to see some deterioration is profits. When you go through in a period where there's stagflation and there's costs that are creeping higher in the economy, those margins start to get constrained if you can't pass on those costs to consumers. We've seen some deterioration in certain sectors and in certain areas where profits have actually underwhelmed. How do you fix a profit problem? You fix it through your labor force.

If you can't right size your revenues, you're going to right size your margins through labor, and this will be the last domino to fall, in our view, where we could start to see some pressure on labor markets. Maybe that's later this year. Maybe that's something that happens in 2024. We look at our indicators and we drive into our portfolio positioning. Our view is that it's a time to start thinking defensively. From a credit perspective, one of the surveys we look at is the senior loan officer survey in the US, this is indicating that banks are constraining access to credit. That will further weaken the economy, frankly.

We look at other indicators like the yield curve, the bond market is signaling that a recession is on the horizon by inverting the yield curve. Actually, a fairly steep inversion relative to what we've seen all the way back to the early '80s. These indicators, which are typically very good indicators of recessionary pressures, suggest that it's time to start thinking defensively, and in our mind, it's a little bit too early to declare victory on inflation. January, we saw a strong rally in the first month of this year, and in our view, investors got a bit complacent, they started to price in a soft-landing scenario and we thought that was a bit early. We're more defensively positioned as we move into our portfolio construction.

Lloyd Perruzza: Given that, what impact has monetary policy had on fixed income and credit in particular?

Jeremy Lucas: The main word for the past year has been stagflation. When we think about what stagflation does to credit and risk assets, generally, well, it's not good. There are no real risk assets that perform during a stagflationary environment. You think about traditional portfolios, 60% equities, 40% credit, or 40% fixed income, in a stagflationary environment, your fixed income simply can't protect you, everything goes down.

The math is pretty simple, we started a year ago with yields, and I'm just going to approximate here, roughly 2%, with duration of seven to eight years. What that means is, if rates go higher by 100 basis points, the price of your security, a bond, a fixed-income instrument, goes down by 7% or 8%. If you only started with 2% yields from the get-go, you very quickly entered into a negative total return territory and that's what happened. Fixed income failed to protect capital in 2022 in a stagflationary environment, but this monetary policy chaos brings opportunity.

I think that's what investors need to take away from this conversation is, through these more violent moves that we're seeing in fixed income and in credit, that dislocation, that chaos costs up winners and costs up investment opportunities and capital deployment opportunities and that's what we've been focusing on our team. If you think about now, let's fast forward to where we are today, all-in yields are attractive and Lloyd, this goes back to your comment at the beginning of our conversation, you're on the TINA, There Is No Alternative to where we are now we call TARA, There Are Reasonable Alternatives.

All-in yields, we look at fixed income and credit, you can earn in credit without really having to do a lot of legwork, high-quality credit, shorter duration profiles, 5% or 6% yield as it stands today, and in our mind, this competes well against other asset classes. When we think about equities and dividend yields, all of a sudden, you've got your credit instrument which ranks senior to the equity now yielding roughly the same as some of their underlying dividends.

In our mind, you finally have a point where credit is competing against other asset classes, and as we look to the beginning of 2023, we just simply started with a much better starting point. All-in yields that were much healthier, investors finally getting paid for taking risks, but it took a bit of pain to get there.

Lloyd Perruzza: On that note, Jeremy, what are your thoughts about 2023, could this be a repeat of what we saw in 2022?

Jeremy Lucas: Furthering our comment about where we are right now, we're starting with relatively attractive all-in yields. In our view, it's tough to see a repeat of 2022. 2022 will stand out for many years in our mind as an extraordinarily bad year for risk-taking generally and for credit and fixed income generally. It is tough to see that happening again simply because our starting point in 2023 has so much more yield attached to it, but predicting the future, Lloyd, the way our team thinks about it, it's a real challenge.

I couldn't sit here and tell you that I think I know exactly how 2023 is going to play out. There are a variety of scenarios that could occur. We've got geopolitical risks; we still have a large central bank tightening regime that leaves open question marks. For us on our team, it's really all about evaluating risk reward. What risks are we getting paid for? Are we getting an appropriate level of return for the types of risks that we're taking? How much risk or credit risk, how further down the credit spectrum do we need to go to earn those yields?

In our mind, things have shifted a little bit more attractive in fixed income and in credit, high-quality credit in particular, but we have to be mindful, but I think as we look at how 2023 plays out, the role that central bankers are going to play is still going to be significant, and we'd like to talk about central bankers who are walking on this tightrope. On one hand, they're looking at tightening monetary policy to combat inflation, but if they do it too aggressively, they risk pushing the economy into a deep and dark recession.

Knowing that, they lean sometimes towards being dovish and going the other way and, perhaps, shifting their rhetoric that their hiking cycle was over. The problem with doing that is that if they do that too early, inflation could rear its ugly head again and cause even further problems down the line such as what we saw in the '70s. Central bankers are walking this tightrope between being hawkish and dovish after having just come through an extraordinarily hawkish regime over the past year and change.

We also like to say they're walking down this tightrope, unfortunately, by using a handheld mirror and looking at what's happening behind them. This presents risk for investors where they're looking at lagging indicators to dictate forward monetary policy. What does that mean if we boil this down to 2023 and what we think could play out? The reality is that you may want to buckle your seatbelt because we could see some volatility as markets lurch between pricing in different scenarios.

Obviously, a nice bullish dovish scenario would be, we've beat inflation, we're going to navigate this soft landing, we've done it, success, or a deeper and darker recession as we've hiked rates too far and we've pushed the economy over the edge. As we navigate and we shift between those two different scenarios and investors pricing in those two different scenarios, in our mind, our advice to investors is prepare for some volatility. Remember, though, volatility can bring opportunities.

Lloyd Perruzza: In that regard, how do you think about positioning further down the credit spectrum? At what point will it make sense to increase exposure to riskier assets within credit?

Jeremy Lucas: Right. Great question. I think you can see where we're coming from in that we are playing a bit of defense as it stands right now. We think valuations are not screaming cheap, but they're not screaming expensive either. When we overlay our concerns about the broader macroeconomic environment and the uncertainties that are still out there, in our view, it's prudent at current valuations to play a bit of defense.

Now, that doesn't mean to avoid investing altogether. There are lots of opportunities and lots of places where you can put capital to work and earn terrific returns. One of the key things that we look for as we migrate down the credit spectrum is stakeholder alignment. We're very much focused on our equity holders, are subordinated stakeholders in the capital structure aligned with the needs of bondholders? If you think about those two constituents, equity holders and bondholders are diametrically opposed in their needs.

An equity holder wants growth, they want torque, leverage, upside. Bondholders are about risk control. We're about de-levering. Make sure we get our coupons on time and make sure we get our capital back when the bond is due. Those two constituents can be at loggerheads, but where we see alignment is where we see great opportunities for capital deployment. Interestingly enough, one of the sectors where there's considerable alignment is within the energy market.

Equity holders and bondholders are still very focused on delivering, paying down debt, improving their balance sheets. For bondholders, that's music to our ears. We're seeing similar alignment as well in the metals and mining sector. Something to think about, though, as we migrate down the credit spectrum. In high yield, particularly, the credit spectrum is higher quality than it ever has been before. Historically, if we go back 15, 20 years, triple Cs, the riskiest component within credit, the lowest quality credits out there, they represented almost a third of the entire index. Today that's about 12%.

The quality of the overall market has improved. Furthermore, as we look at things today, we're dealing with a very strong technical environment. There's less primary issuance. The market itself is shrinking. When we marry a high-quality overall asset class and we marry that to a strong technical environment, it creates a bit of a bullish narrative for migrating down the credit spectrum. You might say you've got a macroeconomic picture that you're concerned about and valuations that aren't necessarily pricing in the most adverse outcomes, but you've got a strong technical outlook with an asset class that's highest quality it's ever been and shrinking, meaning that there's less bonds to go around.

These two forces are at play. Currently, as it stands for us, we are leaning towards being more defensive due to our outlook on the macroeconomic side of things, but we also want to act opportunistically. If we get some sort of a violent selloff, we want to push capital into the market to take advantage of those opportunities as they come. Of course, if the market starts pricing in wonderful outcomes and low-zero outcomes, of course, we're looking to reduce our capital and reduce our exposure to riskier asset classes, or riskier parts within credit.

Lloyd Perruzza: Jeremy, if the economic environment is less supportive of taking risk down the credit spectrum, are there any features or strategies within credit that investors can use to their advantage?

Jeremy Lucas: Right. This is one of my favorite things about credit, and it comes down to structure. A cash bond issued by a company is a contractual commitment to pay. If they don't pay, it's an event of default and the equity typically goes to zero. The bond ranks ahead of subordinated stakeholders like equity holders. Structurally, we are senior to the subordinated equity, and we have a structural component, a contractual commitment to pay that effectively locks in our return. Those structural tailwinds can be leveraged by a credit investor.

We can actually add a modicum of leverage to that profile and further enhance the return. The critical element when you're doing this is to make sure you're doing it to a high-quality exposure. We're doing it with high-quality credit and we're doing it with relatively shorter maturities so that that forcing function of the maturity itself is always in play, and something that the management team is thinking about when they're thinking about refinancing our bonds. We would not look to lever up default risk, that's a mistake, or lever up long-duration outcomes which really don't have a forcing function attached to them with their particular maturity.

Those structural advantages of a bond can be massaged in a way that really tilts the favor in the hands of investors, in the hands of bondholders. Another element structurally that has just emerged more recently over the past year has been the emergence of high-quality, low-dollar price or discounted-price bonds. We think this is a really attractive area and it's a generationally attractive area that hasn't existed for the past 30 years.

When you take a look at a bond with an extraordinarily low coupon that was issued five, six years ago when yields were less than 1%, and you attach a yield environment today that's in the 4%, 5% area, the only thing that happens with that bond is that the price has to trade at a very discounted level. For an investor, this is a wonderful opportunity. Now, your all-in yield, your return, involves a significant component of capital gains, which, of course, are taxed favorably.

Moreover, you have less capital at risk than a premium price peer. Your risk, you have less capital to put into the market to earn a similar return. In our mind, those tailwinds, those factors really, really shift the narrative in the favor of bondholders. Then finally, one final thing to say on structure that I think is worth mentioning here is the value towards shorting low-quality credits. If you think about shorting equities, you have an unlimited downside. Some famous investors in New York found out the hard way with GameStop a couple of years ago that equities can rally and they can keep going. That was a very painful experience.

The beautiful thing about shorting low-quality credits is that your downside is effectively capped at the yield that you put the short on. Eventually, the bond is going to mature at par. It can't run away forever, but you, in theory, have a near 100% upside because the bond could end up being a zero if the company defaults and there's a zero-recovery attached to the instrument. We think that's another way where you can take the structure of a bond and flip it on its head to your advantage as a bondholder. It's another wonderful strategy that we're pursuing in our hedge funds and in our liquid alts.

Lloyd Perruzza: Now, for investors listening to the podcast, given the current environment we discussed, what would you feel is the most prudent area of credit to lean into at this time, and what areas would you shy away from?

Jeremy Lucas: The main message I would leave here is we think it's a great time for a keep-it-simple approach. The valuations in the market as we migrate down the credit spectrum don't necessarily support taking a lot of risk. You don't have to necessarily push too hard to earn a very attractive level of yield. Keep it simple, keep it high quality. That type of approach makes a lot of sense. There will be moments to take advantage of more risk-off environments where you can be more opportunistic. You can add increased amounts of leverage, or you can push down the credit spectrum.

Right now, it makes sense from an overall perspective to keep things pretty simple and keep it focused on high quality. Specifically, I mentioned earlier the value of those low dollar price bonds, where in high-quality instruments where you're not taking necessarily a significant amount, if any, default risk, but you're earning a terrific yield that's tax-advantaged and has less capital at risk than its premium price peers. We think that makes a ton of sense today.

The other element is, I would argue, you need strategies that are flexible. Focus on strategies that can leverage the attractive features of high-quality bonds with contractual commitments to pay and locked in yields and enhance those returns using leverage prudently, but also be flexible in that take advantage of strategies that would short low-quality credit, where you're reducing overall market correlations and improving the diversification of your portfolio.

Those are two areas I think it's low hanging fruit, it's a keep-it-simple approach, and we're not stretching too far down the credit spectrum. Places to avoid, I would say would be riskier levered loans. This is an area where we've seen really poor underwriting standards, where we've seen significant amount of private equity levered deals to fund buyouts. The docs are extremely weak. The documents, that is, that are governing the covenants of the underlying loan.

Often these loans get packaged into rather ominous sounding instruments, such as a senior secured floating rate product, which in our mind sounds great, but it's important that you look under the hood at the individual holdings. If you're seeing a whole bunch of riskier loans that are weighted way down the credit spectrum, you need to be careful because these loans are floating-rate products, the issuers are exposed to higher interest rates because their cost of capital is climbing, and there's typically a lot of leverage attached to them. It's an area where we think investors should be very cautious.

Then I will add, avoid sectoral headwinds. Avoid swimming upstream, for example, with significant consumer discretionary exposures in our mind. Why do that when there's lower hanging fruit available within easier sectors that have less consumer discretionary exposure and avoid those sectors that are exposed to higher interest rates, such as housing, for example. Try to keep your exposures focused on positive earnings fundamentals and positive earnings growth rather than swimming upstream and fighting a consumer discretionary or fighting a consumer that might actually have less income as rising rate environment takes its bite out of their pocketbook.

Then I would also leave you with this comment, which is, I think it's really important as it stands today, as always is, but to stay active. As I've talked through this podcast, is the importance of being opportunistic, of letting valuations dictate how you take exposures, being aware of macroeconomic pressures, and deploying capital with a manager or on your own within a prudent risk-reward framework that makes sense and has been time tested over time.

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Lloyd Perruzza: That was fantastic, Jeremy. Our sincere thanks to you and to all of our listeners for their time. This has been another edition of On the Money. On behalf of all of us at Dynamic Funds, we wish you continued good health and safety. Thanks again for joining us.

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