Cut to the Chase: Seizing Fixed Income Opportunities

Cut to the Chase: Seizing Fixed Income Opportunities

Rob Costello

Hello, everyone. My name is Rob Costello, and I’m a Client Portfolio Manager here at Thornburg Investment Management, coming to you from our headquarters in Santa Fe, New Mexico. I want to welcome all of those attending this webcast that we call Cut to the Chase: Seizing fixed income opportunities. I’m delighted to be joined by my colleagues on the Thornburg Global Fixed Income team. I will go ahead and make some introductions. First, we have Christian Hofmann, who is head of fixed income at Thornburg and who joined the firm back in 2012.

Christian oversees the entire fixed income organization and serves as a Portfolio Manager on a global fixed income team.

We also have Lon Erickson, who is a Portfolio Manager on the global fixed income portfolios and oversees the global fixed income team, which manages a total of 16 billion in assets under management.

Next, we have Eve Lando, who is a Portfolio Manager and managing director for our municipal bond platform, which manages 6 billion in total assets.

And we have Ali Hassan, portfolio manager on the Global Fixed Income Team, a Portfolio Manager on a number of strategies and who joined Thornburg back in 2013. So there’s a lot to cover over the next 25 to 30 minutes. So let’s jump right into the discussion. And let’s start with Christian and Christian, the Fed meets this Wednesday, and at this point the market is a little unsure as to whether the Fed is going to cut 25 or 50 basis points.

So two questions. First, what do you think the Fed decision will be on Wednesday? And second, with the market pricing in ten cuts over the next 12 months, do you think that that path is too aggressive?

Christian Hoffmann

Sure. So we’ve debated this on the desk a lot. It’s certainly some excitement that we’ve seen in our market digitally. So we’ve been on hold since, you know, last summer, 2023.

We’ve long thought that 25 made sense because that’s what the Fed seems to have telegraphed. 50 would be more of a drastic move. And we haven’t seen a lot of foreshadowing of that event. That said, we’ve had a little bit over the last couple of days and when we stepped off the desk this afternoon, the market was pricing in really a 65% chance of that happening.

So philosophically it makes sense. I think it’s really about the Fed not trying to surprise or alarm the market, but zooming out whether it’s 25 or 50, that’s actually less important versus that path that you’re talking about. So we’ve seen this movie before where the market starts to front run the Fed and actually price in much greater pace of cuts than the Fed is projecting for and telegraphing. Generally that can create some volatility and uncertainty in the marketplace.

The Fed likes markets to be aligned with with its own messaging. We’ll have the summary economic projections this this Wednesday. So I think we’re potentially in place for some volatility. We’re also, I think, set up for really some excitement in fixed income.

Rob Costello

And let’s let’s turn to Lon and we’ve we’ve seen the fixed income markets really front run some of these these rate cuts.  You know, we go back earlier in the year, the market had a higher for a longer mentality. The ten year treasury peaked at about 470 in late April and now we’re down below three, 362. We as we speak. And there’s also been a lot of chatter around the yield curve and the the yield curve on inverting from two years out through the rest of the rest of the yield curve.

So I’m going to keep this question very general, but how do we feel about interest rates at the current levels right now?

Lon Erickson

Sure. So, yeah, lots of lots of moving parts to that question. And I think frankly, too, the yield curve and rates. But I think overall, you know, we still really you know, generally I still really like duration here.

I think it’s very interesting. You know, certainly, you know, just as your comment suggests, we’ve seen 100 basis point rally. So I would say that we’re probably closer to fair value than, you know, notably cheap. You know, having said that, we still say it’s it’s interesting. It’s really about the real yields that are available on the marketplace. You know, if you just using a ten year tip as as a proxy, you know, we have about 1.6% available to to us as investors.

And that’s pretty interesting given that we spent a lot of time over the last decade, in fact, most of it below 1% and notably so. And in fact, for about three of those years, we were below 0%. We were negative. And so to get to where we are today, that’s still pretty interesting. No, I think it was just as Christian said, I think volatility should be expected, given given here.

We’ve seen a slowing economy. We have economic data, ping pong back before in between good and bad. The Fed almost certainly is going to reduce rates, but the market is still trying to figure out how many cuts and at what pace. And of course, we have a pretty big election, you know, as all noted. And that creates uncertainty and way of uncertainty that tends to lead to volatility.

But just because there’s volatility doesn’t mean we need to be frightened of duration and of putting some of that on. Just keep that in mind. You’re building a position and perhaps not build it all at once. Keep some dry powder in reserve and be ready to add to it at opportunistically. Should rates increase again.

Rob Costello

And let’s go over to Eve and turn to your specialty, which is the municipal bond market.

And I think this is a good segue way to Lon’s comments about the level of Treasury yields. How do muni bonds look in terms of their relative value on a tax adjusted basis to Treasuries?

Eve Lando

Sure. Munis look solid. The chart on the screen follows peaks and valleys of relationship between 30 year munis and treasuries. And as you can see, we have been less expensive, but we also have been more expensive as well.

So looking at things as they are right now, I think there is a wonderful chance of finding value in munis. So the ratio is just one part of the story and we are probably a bit more expensive right now, more so in the short end, less so in the long end. However, as I said, it’s just one part of the story.

In terms of munis, there’s things like absolute yield. There is credit story and there’s also tax exemption. Absolute yields, just like Lon mentioned, we’re way better than we used to. And looking at, let’s say, double A-rated municipal bonds issued in ten years. We are looking at tax adjusted basis at around 5%, which is quite attractive. Taxable Muni is similar story though, as a public university that issued a taxable muni about two weeks ago and they came to market ten year doubly at around 470.

Talking to Lon earlier, very similar to what he sees in the corporate market, dare I say even a little bit better credit quality. Of course, we know less volatility in downgrades. There are less defaults, less bankruptcies, but there is also less volatility in trading levels. So there is more stability in overall muni returns.

And last but not least, value of tax exemption. And we feel it will be even more valuable whatever the results of upcoming election.

Rob Costello

Okay. So we’ve we’ve gone through some some rate talk. Let’s let’s segway over to credit and Ali, credit spreads. Have we have leaked a little wider recently. But but overall remain tight versus historical levels. Share with us your comments on credit right now and in particular, what level of credit, what level of what spread level do we think makes credit very interesting.

Ali Hassan

Sure. Maybe I’ll take it in turn. First, talk a little bit about the environment today and pricing, what that means going forward in terms of what kind of return we could see going forward and whether it’s well priced. And then last, I’ll take your question about where’s a good entry point in our in our mind.

So on the on the first point, credit spreads, as you see in the chart, are at the tightest level that they’ve been in the last decade. In fact, you have to go all the way back to 2007 and the late nineties, which are two ominous points in time, given that we had, you know, big asset bubbles popping just after that to see credit spreads as low as they are today. And we know from what Lon was saying, there’s a lot of uncertainty. And what Christian was mentioning about the election, that there could be a lot of volatility coming up.

And there’s a turning point in terms of the economy about whether we get a soft landing or a hard landing. But pricing today in terms of credit spreads are sitting tighter. And then even in the most benign economic environments, they’re not really pricing either a soft landing or a hard landing. They feel like they’re pricing a no landing scenario.

So we think the market is misjudging and mispricing risk today. In terms of what that means with respect to where we could see a good entry point into high yield, if you think about what a 500 or 600 spread implies, 500 or 600 spread implies a default rate that we haven’t seen since the global financial crisis, which is an exceptional stress point.

So at that point, if you see credit spreads gapping out to five to six hundred, I would say that’s a yellow light where you should start entering the market in force and then it’s a full green light if you’re moving beyond that because you’re getting compensated over and above for that. And if you look at the history, we have seen the market panic so much so that credit spreads gap to even a thousand basis points and that’s when you’re really getting paid super normal return to take risk and high yield.

So with that, I think, you know, I would say that’s that’s a that’s when we’d have a yellow light and then a green light to enter the markets.

Rob Costello

Yeah, No, I appreciate those thoughts, Ali. And we’ll get back to credit and other sectors of the market a little bit later in the discussion. Let’s turn back to the Treasury market and I’m going to come back to Lon again.

There is a lot of chatter. It’s almost a persistent chatter about investor confidence in US treasuries over the long run. I mean, this year we’ve had these headlines on about weak US Treasury auctions. There’s always the headlines on elevated budget deficits. What is your opinion of all of this? Is this is this overblown now or is there legitimate concern?

Lon Erickson

Sure. So, you know, it’s a very interesting topic and it’s a lot of fun to debate. You know, I think as far as it pertains to the markets today and as we try to figure out how to think about how to go forward from here, I don’t think it tells much of the story. You know, we’ve all kind of had different versions of the uncertainty that we see in the marketplace today and what kind of volatility that has has led to plus given 100 basis points rally that fall in rates that we saw earlier.

I think that has a lot more to do with what we’re kind of seeing with auctions and with the Fed on deck trying to figure out, you know, what, where, where we’re going to go from here, from from a rate environment than, say, the actual budget deficit. You know, now that said, you know, longer term, does it matter? At some point? Yes, you know, it will. I don’t think we can run the kind of deficits and ultimately become like a couple of hundred percent to 300% of of GDP in terms of our overall debt load and not have it have some impact. But really, I think what we have to remember is the U.S. is still by far the largest, most dynamic economy in the world.

And that creates a lot of flexibility and a lot of, I guess, for lack of a better word, freedom to have act as we want in there in the short run, but even in the long run, because we are still the reserve currency as well. And so that does help keep a cap on what rates are as some of those dollars in the marketplace are reinvested back into treasuries.

And I think that will continue to be the case for a long while. But at some point, I think folks are generally right. We do have to kind of get our fiscal house in order. But I think the market is a long ways before it really causes us trouble and say the Treasury market in a major permanent way.

Rob Costello

Yeah, And we when we go back to 2011, we saw the downgrade of the U.S. Treasury from the S&P and were a great falling period came right after that. We saw a really strong rally. So, you know, in some ways it is very, very paradoxical. We’re going to shift back to the muni market again. And Eve, tell us about what the supply demand dynamics are like in the municipal market today. You know, what does that tell us about how munis may perform going forward from the tax supply?

Eve Lando

Rob, the tax exempt supply this year has been phenomenal. We are up about 35%. But see, 50 billion issued so far compared to last year and we are about 35% higher than the year before. So can’t really complain about supply. It’s there every single week we’re looking at 8 to 10 billion in supply coming to munis. So things are good.

However, it is still not enough to make up for about several years, I’d say, of under issuance and tax exempt. Other markets have doubled or quadrupled in sizes, while munis have stayed at the 4 trillion mark in the past ten years. Part of it is maybe fiscal discipline that we lack elsewhere.

Part of it could be just a lot of deferred projects around the country. At the same time, the high net worth in the country have tripled. So that means that for in terms of demand, we are looking at so much more dollars chasing this tax exemption, so much more people can take advantage of tax exemption or should take advantage of the tax exemption in their portfolios.

So on the supply side, much better this year, not enough on demand. So much demand out there. And in terms of what it does to spreads very similar, there are some spreads that are way, way below the averages. But again, on absolute levels, things still look pretty good.

Rob Costello

And one area that we we haven’t touched upon yet is is securitized bonds space.

And this obviously covers a lot of areas of the mortgage back market, commercial mortgage backed securities, asset backed securities, etc.. So, Ali, maybe a bit of a challenge for a 3 to 4 minute answer, but what are the opportunities that we’re seeing in the securitized space right now?

Ali Hassan

We could do a really a brief and quick tour. You know, one of the areas an indicator of growth and innovation in the market is looking at the esoteric ABS space.

And we’ve seen a tremendous amount of new issuance and that market is back online. But I think, again, you know, it’s it’s an indicator of perhaps a little bit of froth in the markets and an indicator of caution for investors in in those markets. One particular area that we’re very cautious on is the whole business securitization area. The reason is because you can basically create the same corporate you can find, you know, better value in corporate bonds than the whole business securitization space. So that area of innovation is not interesting.

Areas that we do see as interesting is on the margin is commercial mortgage backed securities. There you can find trophy assets that are providing very good compensation and still very low leverage. So a lot of margin of safety there.

Another area that is extremely interesting is the residential mortgage back space.

There you can find good compensation over treasuries, very low leverage, 40% LTVs and very high quality households and high flow cycle households. The housing market is still holding up quite well. There is a shortage of supply in terms of housing. That’s a very difficult problem to fix from a political perspective. So there could continue to persist, you know, a strong housing market.

And if we do get rates coming down, you can buy some of these mortgages at discounts as we get refinancing that actually provides better total return as well to to that segment of the market. T

he last area I’ll touch on is the consumer ABS market there, because we’re seeing some deterioration in the lower end of the consumer. We prefer the higher end consumer.

Those those securities on the senior basis amortize within two years. So very little credit duration risk and still getting very good compensation because they’re priced within two years. And so therefore very high up on the curve in terms of the carry and compensation that you can get there.

Rob Costello

Yeah, and that’s a good point, especially with the the yield curve being inverted for quite a while. These are the types of spaces that you’re actually getting some some good yield versus going out out the curve, even though it’s less, less, you know, less timing risk if you will.

Ali Hassan

Exactly right.

Rob Costello

But this is a good way to dovetail on these comments as it relates to the municipal market. I’m going to go back to Eve here.  And because both the residential and commercial markets matter a lot when it comes to tax revenue. So how our trends in both the residential and commercial space impacting the money market?

Eve Lando

Sure. Great question. There will be impact, of course, for sure, but it will be a muted impact and it will take a long practice, longer than in other markets, time to play out. So why not so much worry about the residential, commercial real estate and munis? Three things. First is diversification in tax revenues. Second, assessed values. And third is attachment of liens.

So the first one, diversification in munis. Usually whenever we look at, let’s say, general obligation bonds, these bonds are the the ones that most rely on property taxes, whether, again, residential, commercial. Usually we are seeing at most 10% in one entity providing tax revenues. On average, we’re probably talking about 3 to 5%. So quite low impact and again, not immediate. Why? Because of assessed values being an average. So they’re always looking in their backwards and they always capture, you know, two, three, five, ten years. And we’ve had some quite strong years. So it will take time for those averages to come down as localities as states issue issue these assessed value bills.

And lastly, attachment of liens quite strong if, let’s say, commercial property is going through a loan modification, change of ownership, you name it usually travels with the tax lien attached and they will get paid one way or another.

So the work that Ali does, the taxable team is doing is really, really helpful to our market in terms of indications, in terms of direction value. And I think we are just seeing the credit work being back in vogue.

Rob Costello

So I appreciate that that insight and we’re going to go back to Christian. We started with Christian. We’re going to we’re going to end or do the final question with Christian.

So we’ve covered a lot of ground, actually a pretty short period of time on various fixed income markets, on the investment opportunities that we see. Given the broad opportunity set that comprises fixed income, what, in your opinion, is the best way to pull all these ideas together?

Christian Hoffmann

For folks that have spent a career in fixed income, this is an exciting time, particularly relative to a decade plus, where we had, you know, zero interest rate policy. And really you had to take a lot of risk just to get, you know, a small amount of return. We’ve really gone back to normal or, you know, what you’d like to see in fixed income markets.

You’re able to get healthy returns in nice income without taking a ton of duration risk, without taking a lot of incremental credit risk. And again, this is something you haven’t seen for a decade plus. Also, your ability for your fixed income portfolio to provide ballast to your other asset classes and I think is reset that broke in 2000, 2021.

But there’s a lot of good arguments why you should see more normal relationships continue and persist. So it’s an exciting time to be in fixed income again. I think we will see volatility as we’ve talked about during this call.

We have, you know, a very close election. We have, you know, a chairman is coming to the end of his term. It’s probably very much, you know, concerned about his legacy. And again, we had zero interest rates for a very long period of time, then hikes where we haven’t seen, you know, since Volcker. And now we’re going to be on the other side of that and see interest rates start to come down. There’s also been a tremendous amount of cash sitting on the sidelines. I think that’s finally in play for a variety of reasons.

So you’re going to see assets move around, you’re going to see volatility. And we’re we’re pretty excited.

Rob Costello

Christian, Ali, Eve, Lon, thank you for your insights today. And thank you for all for attending this webcast.

And thanks, everyone for watching. Please rate this webcast if you get a chance. If you see the pop up window appear. We’d love to hear what you think. We will be making the replay available as soon as we can, and we will let you know of future webcast as well. And please go to LinkedIn and type in Thornburg Investment Management. We have a lot of great content there and you can also check out Thornburg.com for great information and to sign up for emails. So, thank you all for attending this Thornburg Investment Management webcast and we will see you next time.