Long Story Short: Weathering the Storm in Investment Grade

A dizzyingly expensive bond market, record levels of inflation and hawkish central bank policy shifts. Taken together, investment grade investors could not have asked for a more tumultuous start to the year following one of the worst years on record for total returns. After years of bond purchases at seemingly any price, how can investors navigate this new dynamic?

In the debut episode of Long Story Short, portfolio manager Jonathan Golan joins the podcast to discuss the outlook for investment grade fixed income, the search for yield and the key risks investors should watch out for.

Long Story Short is the podcast for investment professionals seeking thoughtful conversations about complex problems. From trading and technology to asset allocation and risk management, investors face a world of choices and challenges. Each month, Shanta Puchtler, President at Man Group, explores a specific topic in detail alongside expert guests. Find Long Story Short on Apple Podcasts, Spotify, and other podcast platforms.

Recording date: February 2022

Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.

Shanta Puchtler:

Welcome to Long Story Short. My name is Shanta Puchtler, I'm President, Man Group, and I'll be hosting a podcast series for investment professionals. Every year, we're asked by our clients, investors globally, all kinds of questions from data science, to monetary policy, the effective inflation, how to trade or better risk manage portfolios. It's the goal of this podcast to have wide-ranging and deep conversations on some of the most difficult topics that we face today. For our first episode of this podcast, I want to start by focusing on a wide-ranging and I think very timely question, and that's fixed income investing. In this environment of low yields, record inflation and rising rates, how is one to invest effectively in the investment grade and the high-yield world? To help shed light on this domain, I'm delighted to be joined by Jonathan Golan, a veteran in the IG space and a discretionary portfolio manager here at Man GLG. Welcome Jonathan.

Jonathan Golan:

Thanks, Shanta. Great to be here.

Shanta Puchtler:

Jonathan, investment great assets have just experienced some of their worst returns in 2021 and 2022 is not shaping up to look a lot better. Let's start today's podcast by asking you to provide some colour on what's been driving these difficult returns and what the prospect look like over the coming quarters.

Jonathan Golan:

Great. The main driver for negative returns in 2021 and early 2022 has really been the repricing of government bonds. So in some investment grade markets, we're experiencing the worst draw down since 2009. And the reason for this has really been a toxic combination of very unattractive valuations going into 2021, coupled with what I define as an unfavorable environment for bonds, where we had both very strong economic growth, but more importantly, accelerating inflation. So more than a growth story really has been an inflation story.

Jonathan Golan:

If we wind the clock back 12 months ago, the paradigm was that we're facing transitory inflation. And now as we look into the future, it seems that the risk of inflation becoming more entrenched is perceived to be much higher and central banks are called into action.

Jonathan Golan:

When we look at corporate bonds, corporate bonds spreads, or the difference in yields between government bonds and corporate bonds has come off a 10-year low, but is still relatively compressed over a long time period. So most of the pain that investors felt in the corporate bonds space has actually been again, linked to government bonds rather than corporate bonds.

Jonathan Golan:

If we look over to the next few quarters and I sort of peer into my crystal ball, I see a much more constructive environment for high-grade bonds. So when I assess investments, I always look at both valuations and fundamentals or risk. And in terms of valuations, the number of rate hikes that we're seeing priced in the market in early 2022 greatly exceeds what was actually achieved in the previous cycle in 2017 and 2018. So certainly you can argue that we've got much more of evaluation support over the next few quarters. And in terms of the fundamental backdrop, we also think that inflation and growth are likely to peak in the spring and start to fall as we enter the second half of the year. So both elements, valuations and fundamentals, paint a more construct picture for bonds over the next 12 to 18 months or so.

Shanta Puchtler:

That's great, Jonathan. I guess the thing that jumps out from what you just said to me is your view on inflation, which is potentially controversial. I'd be curious to hear how you think about inflation going forward.

Jonathan Golan:

I guess the difficult piece of the puzzle is to understand what has been driving inflation and how inflation is likely to behave over 2022 and beyond. When I look at what has been driving inflation, the first impact is relating to coronavirus and how that has constrained production of certain elements that feed into the supply of goods. So things like semiconductors that are absolutely essential in the production for anything from mobile phones to autos. So we think that is very likely to ease over the coming quarters. And we're seeing that through what companies that will lend money to are guiding us. They're saying that these supply chains are likely to ease and therefore that should help. There's also some base effects to do with oil, that the price of oil was very [inaudible 00:04:47] in the first quarter of 2021 and these sort of base effects are likely to ease.

Jonathan Golan:

And also, as we look forward, our expectation is that investments in these commodity sectors are likely to increase, alleviating some of the high prices that we're seeing now. The bigger question is what will happen with demand side inflation, which is to me, linked to central bank actions. So our view is that central banks will follow through with what they've promised in terms of increasing rates fairly quickly during 2022, and that would hold the inflationary demon at bay. This is the biggest risk that we're seeing to markets in the medium terms. So if they do not do that, we may be entering into a paradigm shift where the public, instead of having disinflationary paradigm and behaviour, shifts into a more inflationary paradigm and behaviour. And I'm happy to elaborate on that as well, if that's of interest.

Shanta Puchtler:

Well, maybe let's shift gears a little. I think about investment grade and high yield and sort of the classic equity bond blend 60/40, blend as a starting point for many investors. But with bonds at relatively low yields and feeling a bit expensive, what is a 60/40 asset allocator to do? Should they remain underweight? Or do you see this as an opportunity to start closing those underweights?

Jonathan Golan:

My view, which is probably somewhat out of consensus, is that it is a good time to reengage in the bond market, even if you don't believe that bonds are attractive in the absolute sense. The repricing of interest rate hikes certainly implies that bonds have a diversification benefit in any investor's portfolio. So if in 2021 we said that bonds are fairly toxic, we think now bonds are, again, a very important or a key asset class investors should put in their portfolio for the diversification benefit.

Jonathan Golan:

I talked earlier about the valuation of bonds and how the corporate bond market and the government bond markets imply a substantial rate hiking cycle. And in some investment grade markets, even a hundred basis points more than what we achieved in the previous cycle of 2017 and 2018.

Shanta Puchtler:

Right.

Jonathan Golan:

So certainly there's a lot of cushion baked in compared to what we've experienced in the last cycle, and also what we've experienced over the last 10 years coming out of the GFC. And the risk to covering the underweights that we've discussed at quite length earlier, that we do enter these paradigms, central banks behind the curves, and then inflation becoming what we call runaway inflation rather than transitory or temporary inflation.

Shanta Puchtler:

I mean, I guess I'm thinking on the backs of a couple decades of bond tail wins from a yield perspective, we're not looking forward to a declining rates lifts all boats environment over the next several years, or at least many people believe we're not. What happens in the investment grade market without some of those aggressive buyers of bonds? Does that fundamentally change how these bonds are trading or pricing, you think?

Jonathan Golan:

My view is that it's not only going to change how these bonds are pricing, but how the economy behaves more broadly. And I think you really hit the nail on the head with this question. It's an excellent question because the removal of central banks from the corporate bond market will have far-reaching consequences that are certainly not constrained only to the investment grade market. They're going to impact other asset classes and they're going to impact the economy more broadly.

Jonathan Golan:

My view is that over the last 10 years, capitalism has been on hold. We've had the long hiatus where the invisible hand that prices credit risks adequately according to the cash flows that companies generate was just not allowed to operate. What that meant over the last decade is that we've had on average, very low credit spreads across the market, but even more importantly, a low level of dispersion.

Jonathan Golan:

So good companies and bad companies were able to borrow at roughly the same rates. And that is the key element that's going to change. And that's going to have, again, far-reaching consequences. It means that companies will once again, be allowed to default. What does that mean for the economy? It means that we're pruning out all the zombie companies and we may get better productivity. What does it mean for investors' portfolios? It means that if you've had lazy loans and you own these passive bond funds, you might find yourself in a bit of trouble where some of these investment grade-rated companies, they are not actually investment grade. Quality might get into trouble and you also get some opportunities. So it's not only just risk, it also opportunity that this increased dispersion in market provides scope for active fund managers to generate returns because the central banks are not intervening so aggressively anymore.

Shanta Puchtler:

Sure. I mean, without dispersion and without fundamental underpinnings to pricing, it's hard to do your job, I'm guessing.

Jonathan Golan:

Absolutely. We've always said that the hardest periods for us is when central banks are most aggressive and the best periods for us is when they step away and we get a lot of volatility. So in a way, we relish volatility in a way that some investors do not.

Shanta Puchtler:

It's interesting. I mean, there is a parallel there to the equity markets, where we've seen a lot of dispersion. As we've come through sort of the recent value growth cycles, equity markets have also become very concentrated. Is that true in your world as well?

Jonathan Golan:

We've certainly seen an increase in dominance of exchange traded funds, ETFs. I'm not sure that it is as pronounced as in the equity market, but it certainly over the last 10 years that I've been active in the market, I've seen these grow from having a negligible impact to being very material. And particularly in periods of volatility, of increased flows, where investors are trying to sort of get in or out. My perspective on these ETF exchange traded funds is the same view that Benjamin Graham takes in the intelligent investor on Mr market. So I view the ETFs as capricious market players. They sort of buy and sell almost indiscriminately.

Shanta Puchtler:

Right, by definition.

Jonathan Golan:

Yeah. Whether there's more buyers or sellers. And our job as active investors, and as we like to perceive ourselves as the intelligent investor, is to take advantage of this capriciousness and really try to buy low and sell high. And what I find is that typically the ETFs tend to be very momentum oriented. So when the market is very cheap and people are very pessimistic, there tends to be a lot of selling. And then that's when you should step in as an intelligent investor. And vice versa when there's euphoria and the ATFs are very active in buying, you should really sell into that. That is what we're always trying to do, harness the volatility to our own advantage.

Shanta Puchtler:

One of the questions I have is, in an environment of relatively low rates, it would seem appealing to generate returns in the bond market, simply by taking on more risk. How do you think about that in your process and how should our allocators be thinking about that?

Jonathan Golan:

From my perspective, this is almost like the tragedy of the commons that basically everyone is sort of piling in at exactly the wrong time. And what do low yields actually mean? Let's take a step back. Low yields mean low expected returns. This is the worst time that you want to actually lever these returns. You want to lever returns when expected returns are high, but typically investors have a very cyclical investment mentality. So when the economic picture is rosy and yields are low and everything looks great, then they think, "Oh gosh, the good times are going to last forever," and they add risk. Whereas my view is that you should actually behave in the opposite way.

Jonathan Golan:

I believe investors should have a constant underwriting standards throughout the cycle, which naturally leads to counter cyclical investment style, because you will have many bonds that meet your underwriting criteria when the market is cheap, but very few bonds when the market is expensive. So if you want to generate additional yield from the market, really this would not be our preferred method. Our preferred method would be to harness the huge breads of the corporate bond market to your advantage. When I look at the global investment grade universe, you've got 17,000 securities. And to generate better yields, an intelligent and active investor should really seek to find the best possible bonds out of these 17,000 securities, rather than just levering or going down the credit spectrum.

Shanta Puchtler:

So just following up on that, from those 17,000 securities, and obviously we won't talk about individual securities here, but I'm curious of where you see the opportunities either in terms of sectors or types of investments. What do you see as a prospective opportunities there?

Jonathan Golan:

One point that is very important for me to highlight is that when investors lend money to corporates, they will be well advised not to think just how these companies might perform over the next six or nine months, but take a more strategic view of whether these companies can pay the coupon and repay the principle if an investor is forced to own that bond till maturity. So taking the Warren Buffett approach of saying, if the market is closed for the next five years, we're still getting repaid and we're comfortable with these bonds under various scenarios. Now that does not mean that investors should not be tactical at all.

Jonathan Golan:

I guess we talked about inflation and we talked about my view, which is probably somewhat out of consensus of also slowing growth. So our view is that investors should build a portfolio that can also withstand the stagflationary environment. And therefore we would recommend avoiding consumer cyclicals, industrial cyclical companies, and focusing more on companies that have inflation-linked revenues. So that would be on the commodity space, but also just companies that by the definition of their contracts, enjoy inflation-linked revenues.

Jonathan Golan:

We also think it is prudent to look at companies that benefit from higher interest rates. So certain sectors such as European life insurance benefit when interest rates go up. So that is where we think investors would be wise to tilt their portfolio tactically, but also keeping the strategic point in mind that they want to ensure that every single bond that they buy has adequate margin of safety and they can own it through to the maturity of that bond.

Shanta Puchtler:

How would you answer the question if we shifted it to high yield? Are the high-yield markets behaving in a substantively different way? And what do you see the opportunity there?

Jonathan Golan:

Broadly speaking, the high-yield market is very diverse in a similar way to the investment grade market. So there are always opportunities for active investors to find individual bonds that have promising risk return characteristics. That being said, given our view that the economy is likely to slow and inflation is likely to pressure corporate fundamentals. We prefer investment grade to the high-yield market. So high-yield companies than to be smaller companies, their balance sheets are much weaker. They tend to have less pricing power, and therefore they will suffer disproportionately. And this comes on top of the valuation cycle that saw investment grade bonds underperforming high-yield bonds materially. And from that perspective, we actually think that for the first time in a long while, investment grade bonds look more attractive than high-yield bonds.

Shanta Puchtler:

So just to close out our discussion, I think it'd be interesting to end with a more open-ended question around sort of what keeps you up at night as you are investing in this space? What are your worry points?

Jonathan Golan:

The biggest risk that I see at the minute, which is front of mind but doesn't mean is not a big risk, is this idea of getting into runaway inflation. And that would completely change the paradigm in the bond markets. So if you look over the last 10 years, people have been deeply imbued with disinflationary behaviour. If central banks fail to act now as the market predict that they will act, then we can certainly see the behaviour of people changing into more of an inflationary mentality. So people demanding higher wages, people negotiating contracts with inflation protection, and lastly, people selling out of nominal assets. So bonds into real assets. And if that avalanche hits, that can be very, very painful in a way that it has been painful in the 1970s.

Jonathan Golan:

I do want to caveat this risk in saying that this is not our core view, because we think central banks are committed to bringing down inflation, but that is something that investors should pay very close attention to. If investors have a sense that central banks are wavering and failing and humming and owing, then this is a point where they should be very careful with nominal assets in general.

Shanta Puchtler:

Jonathan. That's great. Let's close it out here. You've left us with a lot to think about, in particular this inflation stance and your perspective on it. Thank you so much for joining us today, Jonathan.

Jonathan Golan:

My pleasure.

Shanta Puchtler:

And thank you for listening to Long Story Short. You can find this podcast on Apple Podcasts, Spotify, and podcast platforms as well. For Long Story Short, I'm Shanta Puchtler. And until next time, take care investing out there.