Talk Your Book: Strategic Income

0:00Today's Animal Spirits Talk Your Book is brought to you by Naveen. Go to Naveen.com to learn more about their fixed income products that we're going to talk about today. Again, that's Naveen.com.

0:35in the securities discussed in this podcast.

0:41Welcome to Animal Spirits with Michael and Ben. Michael, we've spent a lot of time in recent months talking about people moving money to cash because money market funds are good and CDs and short-term stuff is good. And we've been wondering, like, what's the impact of that on the stock market, potentially for flows, right? Like if the stock market takes off and short-term rates go down, will that money go back into the stock market? We've never really talked about it in terms of the bond market. So one of the reasons people gave for why the long-term end of the bond market came up is because, well, the government is issuing all this new debt and there's no supply to pick it up.

1:14And so we talked to Nick Travolino today from Nuveen, and he said one of the reasons that liquidity is so low is because of cash. Like people are moving fixed income into cash, not necessarily just stock market. Like we think about timing the market like going from stocks to cash. But cash is an alternative for the bond market as well. So how about this for a theory? What if rates were to fall for either a soft landing or because inflation fell or recession, whatever the reason is, rates fall and the bond market starts to rally. Could we actually see money come out of cash and going into bonds for like a flight to safety as opposed to the stock market?

1:52How's that? You don't think so? No. You don't think people will chase if yields start to fall and they start to lose their yield in the short-term money markets and such? Nope. I don't think that is very slow money. And I don't think people will chase a bond rally. I think money will come out of the stock market and chase bonds, or not chase bonds, run to the safety of bonds. But I don't think cash is going to come out. No, I reject that idea. I think if there's a recession, the flight to safety and quality of treasuries could be a thing. Out of money market funds? I think it's possible. If rates were to fall enough to get people to say, eh, this is not worth it anymore.

2:29I, you know, time will prove me right or wrong, but my working thesis or my working assumption is that the money that slowly made its way into money market funds will be trapped there for a long time. Okay. All right. I think, I think it's a, I think it'll be interesting because there's been so much money that has gone in there. I, and people have been known to chase yield when it gets higher. I'm curious. It also depends what the Fed does. Yes. Like if the Fed cuts from five to three, then yeah, that should spur some activity. But if it's a stair step, we'll see. We'll see. I do think that's like the, it could like help sway some sort of, through cash flows alone, some part of the market potentially.

3:11I think it'll be interesting. I agree with you. Like there could be some inertia there or people, it could be fast money chasing yields. I don't know. So I do think the bond market is interesting. We got into a bunch of different topics with Nick Travelino from Nuveen, who manages a strategic income fund there. And we hit on everything from the Fed and predicting rates and macro and all this stuff. So this was a good conversation, but it spurred me to think about that. Here's our conversation with Nick Travelino from Nuveen. We are joined today by Nick Travelino. Nick is the Managing Director and Portfolio Manager at Nuveen.

3:42Nick, welcome to the show. Hey, guys. How's it going? Super excited to be here. Bonds are typically the boring part of the financial markets, of portfolios. They have not been for the past couple of years. I would venture to say bond, the bonds have been more exciting. They've been gotten more attention than they usually do, than they normally do. What has it been like for you just managing money through this period of just an unprecedented fixed income market? Yeah, it's been really exciting for once, especially after the zero interest rate policy that we came out of in the COVID era and, And, you know, actually seeing yield and opportunity and changing dynamic markets that give spread opportunities and relative value opportunities for investing.

4:25I remember like the back in the day, when I say back in the day, I'm talking like 2019, where high yield bonds were yielding less than cash is now. Kind of an incredible situation. So Ben and I were talking, I think at the title for one of our podcasts, like, I don't know, three, four weeks ago at this point was higher for longer. and it seemed like that became consensus pretty quickly. I don't know, it seemed like it happened kind of overnight. And then as things in the market tend to do that aged incredibly poorly, here we are, I don't know, four weeks removed from that and the world has changed yet again.

5:02So how do you see the state of the yield market today? Yeah, that higher for longer mentality kind of went poof like really, really quickly. you know it's been a challenging year and an interesting year for bonds I think we entered the year looking for 2023 to be the year of the bond that's what a lot of people were saying in terms of the market and there was this expectation given the higher level of yields we were going to see investors come into the complex we were going to see you know a return in terms of price appreciation spread tightening and we then got kicked in the teeth right away with the banking crisis.

5:40And that kind of caused a flight to quality, a little bit more uncertainty. And we wanted to see how that was going to affect future Fed policy. And then all of a sudden, we hit the summer, the end of summer, and rates started back up again, really quickly. And saw spreads widen, especially thinking about like high yield bonds, spreads widen dramatically. The thing that always challenged me and what I didn't understand was that the information that we had at that time, moderating inflation, a Fed that had been saying that they were going to be on hold or potentially putting one more hike into the front end of the yield curve, and then maintaining a higher level of yields in the front end of the curve for some time, as well as additional treasury supply.

6:27Those were things that we knew back in May, June, July. And then all of a sudden, we woke up one day in August and we started seeing people selling bonds. It feels a lot more normal to me right now after we pulled back post-Fed, post-CPI in terms of the level of yield that we have in the marketplace and where spreads are. But the only thing I can really characterize the summer events and the most recent rise in yields and interest rates is that we saw a lot lower liquidity across the market, whether you're talking about treasury bonds, whether you're talking about corporate bonds, high yield instruments or other off the run securities.

7:09And I think it just takes sometimes one or two market participants to kind of push things the other way. And I think that's what we saw happen. And now we're seeing that pullback due to lower liquidity in the marketplace. I've been thinking on this low liquidity thing for a while. How much of that can you ascribe to the Fed? So the Fed came in during the pandemic and they made sure that the credit markets still functioned, as they slowly pull out of some of the markets, did that impact at all? Or do you think it is mostly just fixed income managers that are doing that? Yeah, I don't think it's actually relegated to just fixed income managers.

7:44When I'm out and I'm talking with our sales force and I'm talking with FAs elsewhere, what I'm hearing a lot of times is I would just rather sit in cash. and cash yields are great. And I see that I equate that to a lack of desire to add risk to portfolios. It doesn't matter if it's equity risk. It doesn't matter if it's, you know, interest rate risk, credit risk. People are hesitant to add risk to their portfolios at this point in time. Thinking about the Fed, you know, their involvement and their outsized force on the marketplace has been declining. We've known that it's been declining. I think that has a little bit to do with it.

8:26But I think that kind of retail marketplace that's sitting in cash, institutional marketplace being weary of the next move has really exacerbated these liquidity issues going forward and to this day. And I think that's why we've seen such a snapback rally here since November 1st. You mentioned cash. Here's an analogy. Are you a sports guy? I am. So Bonds are Chet Holmgren and Cash is Wembenyama. What I mean by that is Chet Holmgren is a 7 '3 rookie, outstanding player, that if the 7 '5 Frenchman was not in the league, Chet would be getting a lot more attention. But Wembenyama is sucking all the attention out of the NBA economy.

9:15Same thing is happening with Cash and Bonds, where bonds are super attractive, certainly relative to they happen for my entire career, but people are forsaking bonds because they see the headline rate on cash and they might be making a mistake. They might be sleeping on bonds the way that people are sleeping on Chet. What are your thoughts about that? Yeah. First off, I think Chet needs a really cool nickname and then maybe he gets a little bit more of that attention. That is true. Right. But, you know, if I think about the attractive yields in fixed income and cash and thinking about cash, great cash, I can earn five and a quarter.

9:51Well, what if I can get you cash plus 250, 300 basis points? And I think that's one of the common misconceptions of the bond market and one of the things that we try and do with our strategic income fund at Nuveen. And that is adapt to what the market gives you. Um, you know, I look at what we hold in this particular portfolio. We've got, uh, you know, 28 % of the portfolio is in floating rate securities. You know, another 22, 23 % of the portfolio is in, uh, what I'll call variable rate securities. So I think I should say, I should say for your, for your sake that we're recording this on Friday, November 17th, and that is apt to perhaps change.

10:32Yep. Um, and these are what I'm quoting. You are actually quarter end numbers. Oh, even better. Okay. Yeah. So we're protected there. But I think that's one of the misconceptions of the bond market is that you're going to go out and you're going to get the Bloomberg aggregate index. You're going to get a bunch of treasury bonds. You're going to get out. You're going to get a bunch of investment grid corporate bonds. You're going to get a bunch of agency mortgages. Those are fixed rate bonds. They're typically longer duration. You're going to have a lot of interest rate sensitivity, and you're going to be exposed to parts of the curve in the longer end where yields are still inverted or a little bit lower.

11:03but there's significant opportunity outside of those core sectors. And a fund tries to go out and take advantage of those opportunities. So thinking about floating rate securities, leverage loans, floating rate mortgage credit, things like that, where we can get cash plus. I wanted to get into the aggregate stuff, but where are you buying these floating rate securities from? Is this mostly issued by banks? Who's issuing these floating rate securities? Because they're obviously the ones that are having some pain right now if their costs are going up basically. Right. So thinking about the senior loan or leveraged loan market, those are typically instruments that are taken out by corporate issuers, arranged by banks and then syndicated out to investors.

11:42They're going to be three-month floaters essentially. So they're going to adjust to three-month term so far. And they're going to be typically below investment grade. The issuers that go out to the marketplace either can't access capital markets or wish to potentially finance LBO activity or some other type of activity on their end. And they're going to go out into an arrange or a bank and syndicate these loans. So they're going to be corporate issuers from that perspective. One of the biggest sectors in our number one call this year was in mortgage credit. We love mortgage credit. We think the status of the U.S.

12:19homeowners and very strong footing. And the two biggest issuers of mortgage-backed securities in the United States are Freddie Mac and Fannie Mac. And they actually take a portion of their credit risk of their books and issue that back out to the market in a credit-rated structure that offers a one-month floating rate coupon. When you combine those fundamentals of housing plus the floating rate nature of that security, we would think that is a really important place in portfolios. I want to get more into the credit stuff and talk about what you just mentioned. I just don't want to forget. You mentioned benchmarking.

12:58Talk about some of the differences between benchmarking in your world versus equity people who are unfortunately racing against the Apples and Googles and the standard benchmark there has been, for all intents and purposes, impossible to beat over the last decade. Talk about the differences between that benchmark versus the one that investors compare you with. Yeah. So maybe a little bit of background in terms of benchmarking and fixed income first and not specifically to the strategy that I run. But if you think about the passive world, it's just trying to replicate that index. So in passive fixed income investing, you are generally going to see fund managers try to replicate the Bloomberg Ag, which is a very heavyweight, like 93 % of those sectors that I'll call the big three, treasuries, IG corporates and agency mortgages.

13:56Then you have your active managers. Your active managers are typically trying to beat that index by a significant margin. But there's going to be limits in terms of how far outside of the index they can invest. And then you might have a more active kind of go anywhere strategy, such as our strategic income fund, which can deviate substantially from that index, has a significantly large amount of tracking error versus that index. And I would say it would then be more benchmark aware, so to speak. Like, I understand that the broader fixed income universe as defined by the Bloomberg Aggregate Index is like six and a quarter years duration.

14:36It has these fixed rate securities, it has these characteristics, it's investment grade. Now, where can I add value for investors? Where can I go out outside of the index and add these different sectors into the portfolio? You mentioned you're investing in mortgage credit. That's one space Michael and I have been paying attention to, just looking at mortgage rates. And of course, that's something that's not all the consumer mindset right now. People are borrowing. And if you look back historically, the spread between 30-year mortgages and 10-year treasuries is maybe not at an all-time high, but it's blown out about as wide as it gets, right?

15:12Can you explain how that sort of spread works and why the spread is so much wider now than it has been in years past? I think there's several very simple reasons in terms of why that mortgage spread is so much wider now than where it was two years ago, three years ago. The first thing is that people aren't selling their homes and there's fewer, there's lower demand for homes. So there's less of a need for mortgage originators to be on staff to close loan after loan after loan. They have pricing power. They're transferring that pricing power over to the potential homeowner. Number two, the demand for bank portfolios is limited for mortgage-backed securities as well as just whole-owned residential mortgage investing directly.

15:59We think back to March. SVB, Signature Bank, ran into problems where they had very large portfolios of mortgage-backed securities or mortgage loans that they accumulated during the financial crisis. A large number of banks still have significant mortgage exposure on their books and are not willing to add more at this point in time. And when you factor those things in, it's a seller's market if you're trying to originate a mortgage, and they're transferring that on to potential homeowners. What would cause that spread to narrow in the years ahead? Because that's obviously what consumers would want.

16:35They want their borrowing costs to go down. So what would it take for that to happen? Would it just be more housing activity? I think, yeah, you're going to start to see greater demand for housing. So it's going to be a challenge at this point, I think, with the large number of homeowners who refinance their mortgage during COVID, who are locked into a really favorable scenario to come out and create additional existing home supply that homeowners can buy or potential homeowners can buy. We're seeing demand start to pick up. It's increasing. I think mortgage applications last week or I'm sorry, this week were took a significant leg up.

17:13As rates came down, would-be borrowers kind of pulled forward that demand and started locking in mortgage rates again. Is it back to 2020, 2021 type activity? Absolutely not. But we're seeing just even small amounts, any decline in interest rates is spurring homeowners back into the marketplace. And we think that that would continue given a larger move, lower in rate. How surprised were you in 2022, which was a really difficult year for bonds that set up the really nice environment that we're in today for investors? How surprised were you that in an environment where stocks get killed, bonds get killed, that high yield outperformed treasuries?

17:52Well, I think thinking about the construct of the high yield market and where it is today versus what we think about the high yield market historically, the quality of the issuer is significantly greater. There's a bias more towards the double B sector of the market. There is this fundamental strength there. So to some degree, and with certain issuers, I do think that there was greater strength in that sector of the market than what we would have ordinarily forecast in terms of a changing economy, increased funding rates and challenges to business. Furthermore, we did see companies being able to transmit their higher costs to consumers to basically increase their prices.

18:38And I think that really helped them maintain a solid footing. And we saw generally strong earnings out of a lot of these below investment grade issuers. It was a little bit of a surprise. But then when you kind of break down those subsectors, you could go, oh, yeah, that kind of made sense. In your investment process, how much of your process requires you to pay attention to the macro and figure out what the Fed's doing and figure out where interest rates are going or growth or inflation or whatever? And how much of it is just looking at the risk-reward setup in fixed income? Because it's kind of like a top-down versus bottom-up thing for stock pickers.

19:12What's your relative weighting there? Oh, man, you totally gave me this layup here to hit on this one. Because I think regular people would probably think, Like, well, people who manage bonds are just guessing which way interest rates are going. And as we've seen in the last few years, that's nearly impossible. Yeah, I agree with that. You know, you might have a view. You might lean into that view. And that comes into your top-down perspective. You know, the way I like to think about how we invest and what I do in terms of the lead portfolio manager role on this fund is I invest the way that I would want to invest in my PA.

19:47I invest in the way that I think things are supposed to be done. and kind of chasing yields or putting on a yo or just going max risk doesn't make a lot of sense to me. I also think about that. I've listened to the pitches. I hear guys say, oh, we combine a top-down and a bottom-up process, and this is what we do. But I've never really heard anybody explain that. And I think what we do in our setup at Nuveen really helps us kind of implement those aspects. And from a top-down perspective, It's all about understanding global macro. It's understanding what the next move from central bank activity is going to be, what Fed interest rate policy is going to be like, what foreign central banks, what the Bank of Japan is going to be doing, because they're a large consumer of US treasuries.

20:32Putting all of these things together, thinking about what the growth trajectory for earnings is for investment grade issuers. What are the pitfalls for funding from a below investment grade issuer that might see their borrowing costs increase for their floating rate leverage loans as short-term rates increase and putting all these things together from a macro view. And then layering that in to where we see value across fixed income, whether it's investment grade corporates versus treasuries and agency mortgages to comparing below investment grade securities and high yield corporate bonds, leverage loans, as well as double B rated mortgage credit instruments, and then factoring in the global view from our emerging markets team and kind of synthesizing that stuff together.

21:17And I think we have a lot of tools that we use to put together that composite view from a macro basis. But then we have to combine that with what we can actually do at the security level. And that's where our focus on relative value comes into play. And one of my favorite examples and discussion points is when I set an asset allocation strategy for the fund. I'm looking at the opportunities on a large, broad level, like an index type level for, let's say, emerging markets. And I'm just going to make up some yields for reference and give you some scale. But let's say the potential yields in emerging market sovereigns are 9%.

22:00And we like that risk profile. We feel comfortable with gross scenarios across a number of issuers there. And then I interact with our sector manager for emerging markets. And he's like, that's great. I understand you're looking at the entire world, but that has Argentina. And Argentina is like 25 % yield. And we don't want to include that in our portfolios because it's too volatile. And they default every time that I change my socks. Forget about it. What you're really looking at is something more actionable, like an 8 % yield, but we feel really strongly in near-shoring trades, like putting a significant amount of investment into Mexico.

22:42So we kind of revise those assumptions. And those are the types of conversations that we're having on the desk. Nick, if you're looking at different areas of your universe, I guess let's start with corporates. Are you seeing any stress on the balance sheet that's being borne by higher interest rates? Like, how does cash flow look like coverage ratios? How does all that stuff look like? Yeah, I mean, what we're seeing is that the maturity wall got moved out a lot from investment-grade corporate issuers. They took advantage of the gift from the Fed in 2020, 2021, refinanced their debt, extended maturity.

23:20So we're really not seeing that come through. You know, that's on the investment-grade side. But we're expecting defaults to pick up either from lack of earnings or maybe a degradation in terms of sales from certain high yield issuers. But broadly speaking, the sector remains very strong. And the names that we're invested in were pretty selective. So it's going to be a little bit more challenging there. But I think the dire scenarios of seeing something in like a 5 % to 7 % default rate for high yield is a little bit overblown. In terms of areas that are under pressure, obviously, commercial real estate, specifically the office space, it's no secret to anybody that that's under pressure.

24:06I'm sure you've seen bonds that are trading at 20 cents on the dollar or worse. You see any sense that some of that might be overdone? Obviously, warranted the punishment, but any opportunity there or are you staying away from it? We are invested in CMBS in the portfolio. As of quarter end, we have about 12 % of the portfolio in select CMBS holdings. And I think unfairly, the entire sector has been, route would probably be too strong a word, but faced a significant amount of spread widening. And when I say it's a little bit overdone or broad based, it's because the office story is still unfolding, but very real.

24:47But when you're looking at CMBS issues that are backed by a large number of industrial properties that are not facing those same challenges in terms of return to office and overbuilt real estate that we see across the country, that's a different story. But it's being kind of dragged down by that office sector. Same thing with multifamily. There's not enough houses in this country. We were talking about from the resi side earlier. It's the same thing from apartments. And when you look at multifamily deals, we're seeing those that significantly wider spreads, higher yields, and those sectors have been drawn down as well.

25:25So we have a greater concentration in those sectors of the CMBS market. Another interesting feature that a lot of people don't realize about CMBS is that there's a certain subsector of the market called single asset, single borrower, or SASB. And that's a CMBS deal where you can buy an exposure to one particular building. So it might not be an office complex in, you know, middle America that has 15 % tenancy, but it's a recent building, brand new construction that has 99 % occupancy with 10 year leases locked in. That's a pretty good risk. And we really like that risk. So we've been able to tailor our portfolio and take advantage of some of those opportunities in the SASB space as well.