#31 - Dan Ivascyn: Fixed Income, Market Outlook

27:12So, today, when you look at a popular benchmark, Bloomberg Ag, you're getting close to a 5-ish percent return, give or take. If you hold that for three to five years, that's typically what you earn. And if you make a few thoughtful asset allocation shifts along the way, you generate a little bit of alpha, well, you can get some more incremental returns. So I think although we are in a new world today, after the selloff we've seen the last few years, we do think current pricing provides cushion in terms of real rates being higher, term premium being higher, inflation being higher. So more uncertainty over the short term, but pretty good value for investors that are looking out three years, five years in time and not relying on the type of positive price performance that we got used to during many years leading up to the COVID period.

28:03And as a fixed income investor, you're obviously very focused on default rates because that's how you can not get your yield that you're promised. So how do you think about the risk that default rates surprise to the upside, given the new regime of higher for longer? Because if you look backwards, anytime there's economic weakness, you get a cut in rates and it's easier to refinance and so on. But if rates stay higher for longer, what does that do to default rates? Yeah, the longer we stay at these higher real rates, the more pressure there is on the economy and particularly the rate-sensitive sectors.

28:36Plus, we live in a highly uncertain world where that growth shock can happen outside the financial space. COVID being a good example of that, there's plenty of geopolitical risks that could flare up that could create that type of dynamic as well. So, you know, bottom line is we haven't had a recession in a long time. When we had the mini-recession, policymakers didn't let it last for long. Massive fiscal and monetary response. We may not get that same response. It's harder to get that response given the inflationary period we've gone through and the fact that the politics aren't nearly as favorable towards a big policy response.

29:11Also with higher debt levels, just less fiscal flexibility to address any type of negative growth shocks. So we'll have a recession again. And when that occurs, there'll be higher credit losses. Now, defaults are quite interesting. Normally, it flows through to defaults. But in this covenant light world we live in, within some of the lower quality areas of the credit markets, particularly the loan space and even now the private credit space, it may not be a default, but it could be a credit loss through structurings outside of bankruptcy. But the bottom line is that when you look at the last 15 years or so, you had consumer credit sectors massively regulated coming out of COVID, where despite the fact that Now, again, it's 15 years in the past.

29:56The regulation has been so strict. It's so hard to extend credit to anyone other than the highest credit quality borrowers in these areas. Documentation, when you go to refi your mortgage, if you remember, is about this thick. It's ironic that, you know, about this much documentation to get a new mortgage, when the covenant package on, you know, a single B corporate entity, you know, in the loan space or now even in the private credit space is about this thick in terms of precautions. So we do think that's where there's some excess that's building up, where there's some complacency. So when you have that recession, we do think that there's going to be some disappointment.

30:29I also think that you need to make the distinction between the fixed rate and the floating rate credit markets. I mentioned earlier a lot of investment-grade names, a lot of high-yield companies locked in longer-term fixed-rate liabilities or debt during the low-yielding environment. When you look at the high-yield corporate bond market today, defined as mostly the fixed-rate segment, much higher quality, lower leverage than it's been in the past, with a lot of the more aggressive lending migrating into loans, migrating into the private credit space. So I think you have to make that distinction where there's been significant growth, arguably concerning growth, where you have floating rate risk, feeling the full brunt of central bank policy rates.

31:10I think that's where you have the greater risks if you had some type of earnings shock or recessionary type outcome, especially if it's stagflationary in nature. I don't want to sound overly alarmist, but I think that's the least interesting area and the area where investors may be the most surprised in terms of credit losses being at least a bit higher than they anticipate. If you have enough of a recession, it could be quite the downgrade in loss cycle there. You touched on the Fed's reaction function. So if you go back 30, 40 years, whenever there was an economic downturn, they'd be very quick to cut rates.

31:47And that's gotten quicker over time. Do you feel that in an environment where inflation is sticky, it's staying higher for longer than most people anticipated, including the Fed, maybe their reaction function is going to be more constrained because they don't want to stoke inflation again? Is that more analogous to the 1970s if anybody's looking for a historical period? Yeah. I think you go back to the 70s, you can even go back to prior periods where there were more modest but still inflation pressures there in the marketplace. I think the big difference today is that you have much higher debt stock around the globe, which also reduces overall flexibility and it can create some monetary policy challenges.

32:27You're seeing it with the Bank of Japan right now. They're in a bit of a predicament because they want to remain accommodative, but they want to keep real rates low given the massive debt stock. But the market's telling them, hey, you can't do this much longer necessarily unless you want some problems with your currency. So we think that there'll still be a will in terms of central banks trying to be active to help engineer positive economic outcomes. The real question is, will they be effective? Will markets let them? Because if you're concerned about inflation and inflation expectations, then markets and the economy by extension doesn't necessarily respond as favorably as it has in the past to these significant interest rate cuts.

33:11So we think that the central banks and other fiscal agents will be more careful in providing accommodation because of higher debt levels and the inflationary experience that we've gone through. We also think that there's a risk, and maybe it's a tail risk, but it's still a meaningful risk, that markets don't respond as policymakers hope. So we think both of those are significant risks. Now, there's other interesting questions now, too, with a cleaner banking system and with a lot of the more economically sensitive and aggressive risk being transferred out into the non-regulated sectors and segments of the market.

33:47There may be less of a direct desire or pressure to react if the problems are emanating out of the banking system. That's sort of a separate side note. But bottom line is, yeah, whatever probability you had of policymakers coming to the rescue in the past, you should take those probabilities lower and therefore be a bit more defensive in terms of mindset as to what a recession and what the resulting investment performance could be if you got into that type of underlying environment. And you're describing stuff we talk about and think about all the time and why we're really, really focusing in this world of high equity prices, tight credit spreads, you know, finding ways to generate similar returns, similar income without taking that type of economic sensitivity or not needing to rely on policymakers coming to the rescue every time you have a negative growth shock.

34:38As a bond investor, you're always thinking about the downside. Another thing that's elevated today are geopolitical risks. How do you think about that? And how do you factor in this big unknown? One is, you know, back to this humility point. When we all went to school to learn the stuff we're doing today, you know, they didn't really teach us how to, you know, we did some cash flow analysis and things, but, you know, derivative pricing, but didn't really, you know, teach us easily on how to incorporate this geopolitical risk. So I think you need, you know, independent outside advisors to help assess probabilities in this arena.

35:09You also need to look at these types of shocks and realize that the best cash flows out there in the world can become quite impaired in a world of this significant geopolitical uncertainty. War, unanticipated political decisions that can impact the economic and regulatory climate where your investment is situated. Sanctions tied to geopolitical concerns can change the nature of prudent portfolio diversification. So all these factors are very, very important. And what we're doing, again, we have a dedicated outside global advisory board of accomplished individuals with tremendous experience and perspective across geopolitical issues around the globe.

35:48It's also nice because they're independent, and we try to allow them to maintain their independence so they're not influenced by internal PIMCO discourse. They can give us very, very clear and objective views. Then also doing a lot more scenario analysis around geopolitical uncertainty and trying to understand and think about diversification in this new, more uncertain world that we live in, where it can't just be geographic. It has to be tied to political alignment, other sources of strain and stress. I think what we've ended up with are perhaps less concentrated positions, geopolitical overrides where we may like a cash flow in isolation or an investment in isolation, but because we can't get comfortable with other forms of uncertainty, we require a higher yield that may not be there, and therefore we say no.

36:35And then just spending a lot more time on these issues in realizing that these issues are going to be much more influential, we think, over the next several years than they were in calmer times. Do you have any particular concerns about the upcoming election? And how are you thinking about that? Well, it's going to probably be a volatility inducing event. What's going to matter a lot is the mandate that either party gets, meaning if Biden or his replacement remained in the White House. The Democrats have control of one or both houses of Congress in a clean Republican sweep. There's going to be a lot more policy flexibility.

37:14In a macro sense, we think that that probably means a bit more pressure on deficits, perhaps, at least over the near term, a bit more pressure on inflation, steeper curves, more volatility, and of course, with Trump, a lot more global policy uncertainty. So we think at a minimum, this could be a volatility type event, an event that leads to some major shifts in both absolute and relative valuations. Now, what are we doing? It's still early to predict ultimate outcomes. Probabilities have certainly shifted for appropriate reasons over the course of the last few weeks. But we're very excited that we're going into this period with a lot more liquidity than we've typically had, more of an up in quality bias across portfolios.

37:59And with up in quality tends to come more liquidity. And with liquidity, you have more portfolio flexibility. And we're not doing this just because we're concerned, oh my God, we got a Trump-Biden rematch or something close to that, perhaps. It's more that the market setup has allowed us to maintain attractive yields and attractive portfolio positioning while increasing liquidity. So we're not quite sure how things play out. The tails are certainly fatter than they usually are around accepting election results, noise around an election, a contested uncertain outcome to this election. And again, it's not just the United States.

38:37We have some political trends and uncertainty across Europe. We still have war in Europe. We got French election uncertainty, a surprising outcome on the election side in Mexico more recently. So I think in general, expect more surprises, more volatility tied to some of these more idiosyncratic type election issues. So that's what we're doing is not ready to place big chips down yet in terms of who wins and impact on different sectors or segments of the market. But I think we have some positions on that are consistent with a more clear, forceful election outcome. And then if there's volatility, as long as it's not too significant, we'd actually welcome that.

39:16Because I think it would give us an opportunity to use some of that liquidity to generate some client value. Yeah. And basically, given the underlying risks geopolitically and also within our country, you basically require a larger margin of safety to take the risk. And essentially, what that could do if the market's not offering that is to put you in a more defensive position that gives you the dry powder to take advantage of potential opportunities. That's correct. And then back to the point we talked about earlier. when spreads are tight, when equity valuations are full, when the implied probability of hard landings is low, be patient and be willing to give up a little bit of incremental return.

39:57Go up in cap structure, up in quality. Buy things with government guarantees, agency guarantees. And that's, I think, the key of active asset management are finding ways to find proxies out there in the market that can generate attractive income where you're not giving up too much by being defensive and still maintain flexibility to add to positions when valuations become more attractive. So that's the mode and the mindset that we're in currently going into this election period or just in general, given where valuations are currently. One of the risks, we've talked about default risks, but one of the risks that bond investors face is inflation.

40:35And if we just look at what is discounted in markets, the markets are pretty confident inflation is going to go at least closer to its 2 % target. How do you think about investing in tips given that risk and where markets are pricing? Yeah, tips are a nice asset. And you're absolutely right. For all the chatter about central banks being late, Pala being late, people losing confidence in the Fed. When you look at break-evens, you look at the fact that equity valuations are at all-time highs or near all-time highs after the last few days. Credit spreads are very, very tight. Still a lot of confidence in central banks being able to engineer positive economic and financial market outcomes, including getting inflation back down to target.

41:15So we own tips. I didn't look at them today, but we're at around 2.2 % the other day. We had even dipped a little bit below that, and that's CPI inflation. So as I'd mentioned earlier, we think that inflation will likely be higher on a structural basis over the next several years, and inflation volatility will be materially greater than it was pre-COVID. And you get to buy an asset that protects against higher inflation without having to pay much premium, if any premium at all. And then at the moment, when you look at our forecast for inflation versus what's implied in the tips market, there's pretty good value in the very front end of the yield curve as well.

41:55It's a bit more of a technical trade, but from time to time, the tips market's nice because you can isolate a very specific headline inflation view and lock in that view versus what's priced into the tips curve. We happen to be in that environment over the last several weeks where we're beginning to do more of that as well. But we think tips are great. They're a nice asset to own, we own them, even though I didn't, in this podcast mentioned, oh, God, a deep concern is inflation re-accelerating. It's a risk. Yeah, there seems to be some asymmetry there. If you think about the odds and inflation surprises below what's discounted versus above, it seems like the odds are tilted heavily in favor of inflation surprising to the upside.

42:39I think that's right. And it's a nice asset class. It's actually an interesting one. It's a bit out of favor in the sense that a lot of people bought tips thinking that they would protect – buying tips in isolation because they'd protect against an inflationary environment. And we know that in a tip, you have the real rate exposure, then you have the inflation break-even exposure. So, yes, they've helped on the inflation side. But, of course, to get inflation under control, central banks had to take real rates up a lot. So you lost money on a tip. You wouldn't have if you did it hedged with the treasury.

43:13So you actually have this interesting technical dynamic in the market where tips aren't a particularly loved asset class at the moment. In fact, a lot of people that bought tips when inflation was really high are selling. I think that's one of the reasons why you have this nice situation where despite the fact that inflation risks are elevated, you still can buy these instruments at pretty low, longer-term, break-even rates. So I think they're the great investment. You don't overthink it. You have a core allocation. And you just own it. You hope they don't have to outperform a lot. But if they do, it means that other areas of your portfolio probably aren't doing so well.

43:48So we think it's a really nice asset class. And we're in the trade. So if we look forward five to 10 years and you were to compare high-quality bonds to equities, you mentioned equities are pretty richly valued. How do those compare on an absolute return basis and also on a risk-adjusted basis? Yes, I'm glad you said five or 10 years because, you know, all these longer-term valuation frameworks don't necessarily work very well over the short term. And, you know, equity markets have a lot of momentum. There's a lot of innovation. Again, bond guy tend to be more negative. But this AI innovation is exciting, at least in a macro sense, although I'll have a reason to be negative on that in a second too.

44:26But, you know, bottom line answer to your question, those types of returns, you know, with these yields where we are today, when you go out there and look at yields where they are today versus equity valuations where they are under a Shiller P or some type of equity risk premium type framework, you would expect bonds to do very well relative to equities on a go-forward basis. In fact, there's a lot of scenarios that would suggest that you could actually out-return equities over the next five to 10 years. You certainly are in a position where it's highly likely that you will have materially better risk-adjusted returns than you've had in in many, many years.

45:05And again, simple math, as I said earlier, is that over a five-year period, you buy a high-quality bond portfolio in default remote cash flows, and you can generate a mid - to high single-digit return. Those have been historically pretty good returns for equity markets and up there at current PE ratios. You have real good odds of doing quite well. Same is true versus cash as well. Cash is still the highest yield on the board, but similar arguments here now that investors at these high real and nominal rates should be locking in some higher returns as well. Not to get off on a tangent on the AI side, but just one point there.

45:43AI is a very exciting technology. It could lead to a sustained period of higher productivity. It could drive earnings growth for many, many years. But the more productivity-enhancing AI is, the more disruptive it may be as a technology as well. So back from a bond investor's perspective, someone that's making decisions within the corporate credit space, what may be good for the economy more broadly may not be so good for old economy corporates that are being disrupted. So, you know, I think AI is an exciting technology that we do think will likely have a material macro impact over the longer run in the form of potentially higher productivity, higher real rates, all else equal.

46:20It also can be quite disruptive and another argument for much more careful and active credit selection and remaining nimble in the market because this stuff's changing very, very quickly. And with that, you can see sectors that look well-protected all of a sudden become less well-protected as this AI technology shifts and as you begin to see winners and losers and the impact of that exciting technology. Yeah, you definitely want to lend to the winners, not the losers. Yeah, or if there's two highest stakes as to whether you are the winner or the loser, step back and require more risk premium. So yeah, absolutely agree with that.

46:55And what do you think about real estate lending? As many of the traditional lenders have stepped away, maybe there's more opportunity there to get a yield above the risk on a relative basis. Well, it's great. It's a very exciting area of the market. It's a great opportunity over the course of the next few years, let me be clear. There is more strain and stress in the real estate markets, both debt and equity, than may be suggested by current valuations because we know these valuations are sticky, and when you look at public proxies around what cap rates should be, there's still this massive gap.

47:28And that gap needs to close one way or another. And that's going to lead to attractive opportunities. So with a fresh balance sheet and a focus on the more resilient sectors and segments of the market, it's a great opportunity for investors. Multifamily is a great example, the biggest area of the commercial real estate lending markets. Phenomenal long-term fundamentals, just like single-family housing. All the post-GFC regulations not only made it hard to lend against homes, it's also made it hard to build. So we haven't built enough units relative to household formation on a national basis. Unfortunately, we built too much in some of the cities that were seeing a lot of the inward migration.

48:09So the Sun Belt multifamily now is going through a period of strain because we built too much the last few years. Once we get through that period, and there's going to be some challenges in that space, on a national basis, very, very attractive, long-term structural tailwinds. So one of the most exciting areas that we see, and you don't have to do it in the office space or the weak retail sector. You can do it there and get some real eye-popping returns, but you can do it in areas that are going through a short-term period of pain because of the rate shock and overbuilding, and we think generate very, very attractive risk-adjusted returns.

48:45We're doing it in the private side of our business, also doing it on a targeted basis in some of our more liquid strategies as well. Well, we've covered a wide range of topics today, including AI, which has been pretty interesting. Why don't we close with if you have any unique investment insights that you'd like to share with our audience? I don't know how unique they are, But there's lots of talk out there today of golden ages and trends in markets. And what I've said is I think 2022 was a horrible period. Everything went down. And bonds were meant to protect. When other things went down, bonds for a long time went up.

49:27But it was a rough period because everything went down. And I think in the process, people discovered the wonders of non-market-market accounting. It's great even emotionally when a price doesn't move. So, you know, we just think we're in a world today where when you step back and think about simple and basic asset allocation decisions, you can go all the way back to the last crisis. Regulators don't like bailing out the same entities twice. That's why we've had massive regulation on banks, massive regulations across the mortgage and the consumer lending space. When you're investing as a credit investor or a fixed income investor, it's great to target over-regulated sectors, sectors that haven't allowed to grow, sectors where excess hasn't been allowed to build.

50:07It's right out in front of you. Lend to those types of entities. And then when you look on the flip side, areas that may have benefited from sticky marks, benefited from this very, very go-go economy supported by one of the biggest fiscal responses we've seen in history, where you see significant growth, weaker covenants, lending to lower quality companies that will get in trouble if you stay higher for longer and you have any type of earnings shock. The areas talked about the most where there's the most, I guess, perceived enthusiasm are areas where you want to be a little bit more cautious. So sometimes these markets are quite complicated.

50:45Sometimes the simple, basic, obvious asset allocation decision is sitting right in front of you. So I think that there's a lot going on in the world, lots of uncertainty. Does inflation come down? Does the Fed cut? How much do they cut? All the geopolitical noise and uncertainty. But sometimes there's just very, very simple and basic asset allocation decisions investors can make. And I think lend to the consumer, be cautious about lower quality, you know, floating-grade corporate borrowers is one of the most obvious ones I've seen. And then lots of interesting things to do in the middle. Then the other one is, again, just, you know, humility, patience, long-term orientation.

51:17Take what the market gives you, just to reiterate a few lessons I learned along the way, you know, from mentors and colleagues at PIMCO and across the industry. This is great, Dan. I appreciate your time and for sharing your insights with us. Thanks. Really appreciate you having me on the show. Thanks for listening. We hope you enjoyed this episode. Please visit our website at insightfulinvestor.org to access past shows and learn more about our podcast. If you have questions, feel free to email us at info at insightfulinvestor.org. And if you enjoyed the discussion, please subscribe to this podcast to ensure you don't miss future episodes.

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