Brian Kloss, Portfolio Manager of the Legg Mason Brandywine Global Income Optimiser Fund sits down with Legg Mason’s Peter Cook to discuss, global income investing, the COVID-19 market crisis, government stimulus, negative interest rates, liquidity, and the macro outlook.
1. The evolution of the Income Optimiser strategy and what it is designed to deliver.
2. Brian’s background as a bottom-up credit investor and what that means for today’s environment.
3. Income Optimiser’s process and investing through the European debt crisis and oil wars.
4. The Team’s thinking and positioning preceding the COVID-19 pandemic.
5. The view from the investment floor as the COVID-19 market crisis unfolded through Q1, 2020.
6. The current fixed income opportunities and how the Income Optimiser team is analysing them.
7. Investing in the era of unprecedented fiscal and monetary stimulus.
8. The Income Optimiser Team’s positioning and outlook for 2020.
9. Global income investing with negative interest rates & opportunities for yield.
10. Liquidity and the role it plays for investors and investment managers.
Thanks for joining us Brian, to kick things off, could you give us a little background on what the Income Optimiser Fund is designed to do for investors?
Absolutely. The Income Optimiser strategy grew out of conversations with clients who were looking to take what Brandywine’s known for, a top-down macro approach to investing, but apply that more to an income- focused approach. To use that top-down insight and blend it with the bottom-up fundamental analysis that’s required when you’re investing in credit instruments.
So, to think about what that entails. From the macro side, it means evaluating policies, fiscal and monetary, modelling the business cycle, interest rate and currency forecasting. From the fundamental aspect, it means all the security-specific research, evaluating business models, covenant quality, capital structure positioning, liquidity, insolvency risks. And then, of course, we have rolled up all those facets of the investment process into a decision-making framework. So, that was the challenge and the opportunity that we saw in conversations with our clients and eventually led to the Income Optimiser strategy.
For me, what makes the strategy so compelling is that it’s got a flexible approach. We don’t need to be allocated in a rote fashion to each sector. We can allocate more to a segment if there’s a valuation anomaly that we think we can exploit, so that dynamic sector rotation is critical. So, the strategy is designed to be an active fund, to be dynamic, to be flexible, and to deliver income in a more thoughtful way.
You've worked on the Income Optimiser team for several years, but recently, I think it was this year, you stepped into the lead portfolio management role. Could you tell us a little about your background in markets?
So, I think I cut my teeth in a really unique position. I started my investing career at a firm that specialised in both high yield and small-cap equity. I loved that experience because you see both the debt and the equity sides, and what’s unique about that is you get to see how corporate management tells two different stories.
Management will go to a conference for fixed income investors and tell one story. Then at a conference for equity investors, they’re going to tell a different one. And usually, at the fixed income conference, it’s about reducing debt, and then at the equity conference, they’ll tell you that they’re going to spend as much money as they can and grow as fast as they can. So, it’s our job to figure out where the truth lies, usually somewhere in between.
But I think what I took away from doing a lot of bottom-up credit work is how important the macro- economic analysis. Because when you think about these credit instruments we’re talking about today, it’s usually something outside of our arena that causes the spreads to widen.
And of course, we see that now with COVID-19, but it really applies across market cycles. And especially in the context of the Income Optimiser and global fixed income investing, because not only do you have an asymmetric situation in fixed income which is limited upside relative to the downside, but as I mentioned before, you also have to get the currency decision right as well. Which is why it’s so helpful to be sitting here with Brandywine Global and our macro-economic research, because if you can take that macro- economic research and make sure you’re allocated to the right, whether it’s geography or the right asset class, then you can go a long way to protecting your portfolio.
One last thing that sticks with me from my time in the business is the saying that, to be a good portfolio manager, you need to be a good analyst. To be a good analyst, you need to be a good trader. To be a good trader, you need to be a good portfolio manager.
And really what that means is that to be successful at investing, you’ve got to know all of these different aspects of our business, and as I’ve gone through I’ve seen it first-hand, how true that is. And that’s is special about the structure and team we have at Brandywine Global. Just given how integrated we are as an investment team, we’re able to make sure that we implement it that high-calibre way, and we don’t end up getting siloed and not bringing the best ideas to the table.
Earlier you mentioned combining the top-down macro and bottom-up fundamental into a single investment process, could you give us an example of how that approach has played over the life of the strategy?
Absolutely. There are two significant points in the history of the strategy that come to mind. The first one was early in its inception, and that was around the European sovereign crisis. What was happening from a macro perspective was, Mario Draghi (President of the European Central Bank 2011-2019) had committed to supporting the European Union. It was his famous bumblebee speech; he was going to do everything he could to support the union.
What happened after that speech was, Portugal, Ireland, Italy, Greece and Spain or the PIGS, as we referred to them then, all of those sovereign yields were around seven, eight, per cent, very elevated levels. And once he committed to supporting the union, you started to see those spreads tightened and those yields come down.
Our thinking then was, once the sovereign heals, the banking system heals, that allows you then to allocate to corporates and structured credit at very wide spreads because that’s the next process in the healing of the economic system when that happens. We were then able to rotate the portfolio from having more of a
U.S. bias at that point in time, to a very significant allocation to European corporate and structured credit.
European Sovereign 10-Year Yields
But what’s critical about that decision is we made this portfolio rotation on a hedged basis because, with everything you do in a global bond strategy, there’s got to be a view on the currency.
So, we had the view that spreads would come down. However, with what Draghi was going to do, the Euro was going to come down very significantly, and so what you would gain by the spread compression, you would lose on the currency if you bore that risk within the currency. So, we hedged out that currency risk.
Fast forward a little bit towards 2015, a similar situation arose, but this was in energy. If you recall, crude oil prices started that year around $100. We had a view that oil prices were rather high, so the portfolio had very little oil exposure. In addition, from a fundamental perspective, credit instruments didn’t offer a lot of value. This was when yields on high yield corporate credit within the energy space were probably trading at four, five, six per cent - so not much value for the risk we were taking.
As the year unfolded and we got to Thanksgiving in November, the oil price was around $80, and then we started to drop, and we entered 2016 at what was then a very low level.
So, what was happening then? You may recall, there were some very unique things happening in energy at that point in time. Not that anybody really wants to rehash it, but you had the technology, U.S. fracking, that flooded the globe with excess oil. And as the U.S. started to produce more oil, you actually started to see less oil being imported into the U.S., which meant those petrodollars weren’t making it into the global system, so that had an impact on the U.S. dollar defunding around the globe.
In addition, there was this new dynamic between OPEC and the U.S. The U.S. doesn’t have a national oil entity that can tap the producers and tell them to reduce production. That creates consternation for Saudi Arabia and Russia and incentivises them, as the lowest-cost producers, to try and hurt the production capacity of the U.S. by lowering the global oil price, which we just saw happen in the first quarter, when they went into all-out-war around the production of oil.
Oil Prices, Crude Oil, WTI, Global Spot, USD1
That was the dynamic that caused the oil price to fall in 2016, and subsequently, energy sector credit spreads to blow out. Because of our macro and fundamental view, we did not have a large exposure going into that. And so, as spreads widened, we were able to provide liquidity to the market, take that risk in and capture the spread compression that happened through 2016.
Those two examples, I hope, illustrate how we incorporate both the top-down macro and the bottom-up fundamental into our process and why need to think about what’s happening on a macro perspective, as well as at the fundamental level, down to an individual security basis.
Fascinating, and I'd love to hear how that process was employed in the lead-up to and recent aftermath of the COVID-19 pandemic?
Let's start with the macro. As we look across asset classes, we're looking for valuation anomalies; we're looking for mispricing of asset prices across these fixed income sectors that we've talked about. Whether they're investment-grade credit, whether they're below-investment-grade structured credit loans, emerging markets, whether they're hard currency, or local currency, or sovereigns, or corporates in emerging markets, and finally whether or not safe haven duration can play a role as a ballast.
Looking back at the tail-end of 2019 and coming into 2020, it's worth remembering the challenges the global market had overcome at that time. If you recall, 2019 had some very volatile periods, especially in the third quarter around August. At the beginning of 2020 we had just signed a Phase 1A deal between the U.S. and China and central banks across the world were being very accommodative. So, part of our macro view was that we're going to have a more benign growth environment compared to the challenges of 2019. So, in a relative sense, we thought 2020 looked like it might be more benign than 2019, but critically we had to look at the fundamental view as well.
As we reflected on the fundamental bottom-up research we were doing, there were signs that made us cautious; covenant quality was very lax, and valuations were trending expensive. So when we placed those signs in the context of being nine years into an economic recovery, as well as some of the insights from our macroeconomic models and some of our coincidental-type of indicators with respect to businesses and economic conditions in the U.S., the result was we took a relatively defensive positioning for the strategy going into 2020. That, again, is the marriage of both the fundamental picture and macro picture.
More specifically, in terms of positioning, our investment-grade corporate allocation was very short, maturities of three, four years in very high-quality space, so maybe about fifty to fifty-five per cent of the strategy. The below-investment-grade corporate credit was at probably one of its lowest allocations in the history of the strategy, so call it around thirteen per cent, but very much in Double-B space, and maturities, again, short maturities but with a focus on what we call TMT, (telecom, media and technology) space. We also held some healthcare, and avoided energy, again, given macro concerns around this oil supply issues coming into 2020.
This is where we're bringing that top-down again, with the bottom-up fundamental based on valuations, to construct a portfolio that we think is appropriate for the economic conditions we're in for the risks and rewards that we see as available to investors. As we put that together, I think that's what really allowed us to weather the volatility.
Again, we're not perfect, and we're not always going to have a positive return in every challenging period, but we were able to weather the volatility and the significant spread widenings that we saw in March, pretty well.
And how did the beginning of the year play out, I mean, could you give us some colour on what you and the team were seeing as we started 2020 and what happened to the portfolio in March?
Sure, happy to. So, the first shock to markets was when the U.S. killed an Iranian general, in Iraq. That was Januar, and you saw the first signs of a risk-off – it's almost forgotten now, but that was an important moment. What followed was the COVID-19 pandemic moving from China, across Asia and then in Iran and Italy. And I guess culminating you might say, in the U.S. where we then had a prescription by policymakers that we were going to shut down the global economy or call it maybe 60% of the global economy.
What resulted was a historic spread widening in investment-grade credit. Credit spreads blew out to four-hundred basis points over U.S. Treasuries.
U.S. Corproate Bond (BBB/Baa) Spread vs U.S. Treasury 10-Year2
I wouldn’t even call those recessionary levels. I would call those depressionary levels. Generally, we only see those probably once or twice in somebody’s lifetime.
To give you some context, using Triple-B bonds as the proxy for the credit markets, the spread widenings we saw didn’t quite reach the spreads we saw during the Great Financial Crisis of 08-09, but the speed of the price changes was record-breaking. In the below-investment-grade space, it was the fastest 200 basis point spread movement in history. It took, I believe, nine-days, and those were the worst nine-days the high-yield market had ever seen. In the Triple-B space, it took a little longer, but it was very fast as well.
Part of the reason for this was that because the nature of the crises is so novel, the shocks to the system are very hard to address and adapt to without a policy response from central banks and from the legislature, which surprisingly to us did happen in the U.S. much faster than we would have anticipated. We would have thought that this would have been dragged out a little bit longer and used a little bit more for a political gain as we go into an election year here in 2020.
That allowed us to take that short duration allocation of our investment-grade portfolio, and reallocate it to what was a new issuance market that offered us the ability to capture spreads that were 400 basis points over U.S. Treasuries. Again, that was at depressionary-type of spread levels. Then over the corresponding, call it next three to four weeks after that, from the end of March into April, you saw those spreads collapse by 100 to 150 basis points.
As we move forward, the opportunities will probably be to move into more of those fallen angels (bonds that drop from investment-grade to below-investment-grade) that are going to appear as we go through the balance of this year and into 2021. Then maybe we’ll even have a chance to dip down into a more significant allocation towards below-investment-grade credit. But at this point, there’s still a lot of uncertainty out there.
From an investment-grade perspective, if we continue to move as we expect, you’re going to see probably another 50, 75, maybe 100 basis points of spread compression, but it’s not going to be as quickly as we just saw that first two-hundred. It’s going to take another six, to twelve months for that to happen. But again, this is where we have to bring everything together. Whether or not we see further spread compression and positive performance from risk-assets generally is going to be contingent on the way that re-opening is done.
It’s not going to be a clean opening of the global economy. We’re going to have fits and starts. I was thinking of it, and everybody can think about it in a different way, but I was thinking of that as standing up on top of a canyon. You’re looking across it, and there’s huge fog over everything, and it’s starting to lift. Now you can just begin to see how deep it is, and you can start to see how wide it is. But you don’t know how fast it’s going to lift and what you’ll be able to see as it does. Are we going to be able to open up and still be socially distant? Are businesses going to be able to operate under this new condition, and are we not going to have a significant outbreak or a second wave of the virus?
There’s quite a number of factors that we’re going to have to think about, but at this point in time, we think we can bear a little bit more risk than we have had before, but understanding that we may need to try to manage that through maybe some of that safe haven duration, or perhaps even reducing it should the recovery start to turn in a way that is not necessarily expected.
I like your analogy of the canyon Brian. Now, you mentioned that in the aftermath of the market turbulence, you were buying in the corporate new issue market, and still today you are evaluating different investments. Could you potentially talk a little bit about how you and your team are thinking about the opportunity set right now?
We have a fantastic team that is continuously looking for value across the credit markets. Right now, we’re focusing on the investment-grade space. Within that space, we see opportunity in technology, media and telecom, and to a lesser degree, healthcare. And then as we look a little further down the risk spectrum, we’re looking at opportunistically taking exposure in infrastructure names. This is driven by our analysis that the next wave of stimulus and support from governments is going to come from infrastructure.
The opportunity in infrastructure is another one of those cases where our analysis in from a macro level and fundamental level is converging. From a macro level, we see it as likely that government stimulus will be directed towards infrastructure spending, and from a fundamental level, the bottom-up valuation of the names we’re looking at is compelling. So, for instance, in the basic materials sector, we’re looking at things like copper companies and chemical companies, and that’s really our focus at the moment.
It’s recently been confirmed that the Fed is going to be buying corporate bond ETFs. Could you talk a little bit how you’re thinking about Central Bank interventions on the monetary policy side? And also, if you’d care to, how you’re dealing with trying to figure out where fiscal stimulus will be allocated and how that’s affecting your portfolio management decisions?
Absolutely. So not only are they, as you’ve just pointed out, going to be buying ETFs but also providing equity capital. They don’t necessarily have the framework set up, but they’ve set up special purpose vehicles and funded them with equity of call it, $425 billion, which they’ll actually be able to lever and have what we would call firepower of about $4.25 trillion to support the investment-grade market.
If you think about it from a credit investor perspective, we’re effectively seeing the Fed put a floor under the
U.S. investment-grade corporate credit market at this point. They haven’t put a backstop on the below- investment-grade market. So, we’re going to be a little bit more cautious as we think about it below investment-grade. However, as we think about it playing out in the political arena, if you think about employment, our analysis indicates that greater than fifty per cent of employment comes from below- investment-grade credit or companies with below- investment-grade credit. So just based on how politicians are incentivised, we probably would expect some type of support or at least a movement for supporting that market. But in the shorter term, on a monetary basis, we think that the investment-grade spreads probably have seen the wides for this crisis.
Again, that’s using the generous assumption that the virus is going to be controlled, and it’s not going to come back with a vengeance. If it does, that’s going to be a different issue for us, and we’re going to have to address that as that happens.
Fiscally, in the U.S. the first wave of stimulus was directed towards providing employment benefits and supporting the company.That was through the Coronavirus Aid, Relief and Economic Security Act (CARES Act). The next will actually be something to try to provide growth in jobs. We believe that you’re going to see governments direct stimulus beyond traditional infrastructure. So, not only the roads and bridges that everybody tends to think about, but also things like 5G.
We’re sitting here today, conducting these conversations over the internet, and then we’re going to be sending audio files back and forth. So, in this new era of, let’s call it digital business, a lot of the focus is going to be on improving that technological infrastructure. And we think that’s a compelling sector for investors to think about where they want to deploy some capital as we move forward.
We’ve touched on it a little bit already, but could you tell us a little bit more about your macro view and how you’re positioning the strategy going into the rest of 2020.
I think our base case, as we think about it, is that as a global economy, we want to strive to re-open. But we need to do it in a thoughtful and prudent manner where we minimise the risks.
As we monitor various countries’ executions of that type of approach, our view is to continue to increase the investment-grade exposure and spread product, and to think about moving down in quality as we have more confirmation that we’re able to manage the virus.
For that to happen, we want to try and rule out that second wave that we’ve been talking about and that the businesses that have been closed for eight, nine, ten weeks or however long it’s been, are able to open when the orders are lifted and that they can open.
If we remain closed for another four weeks or eight weeks, it’s going to be very challenging for these businesses to open given that they probably don’t have the economic flexibility, i.e. the capital to withstand a being closed for three, four, five months. That’s that fine balancing act and why there’s so much pressure on governments to start to think about re-opening the economies.
Since the March turmoil, we were able to change the strategy composition somewhat. So, we added a little bit of duration through these long-dated corporates that came to the new issue market, as well as adding a little more to some of the high yield positions that we really liked that got caught in the downdraft.
It’s worth noting that, at this moment, we have a bifurcated market and high yield. By that, I mean below- investment-grade companies debt are either trading at four, five or six per cent or you’re trading at twelve, thirteen, or twenty-five per cent. It’s a very bifocal market. At the higher yields, it’s energy, retail. You see the JC Penney’s of the world, the airlines. And then on the other side of the market, you’ve got the cable companies, Charter, Cablevision. You’ve got high-quality hospitals like HCA. You’ve got wireless players, even the low-quality Sprint that merged with T-Mobile now is trading relatively strong.
Then separate from high yield is structured credit. That’s probably still the most dislocated market that’s out there. The AAA’s in that space are being supported by central bank policy, but the rest of the capital structure has not been. This is because there are still many issues facing that market that we have to understand. Take, for instance, the commercial mortgage-backed securities market, what’s office space going to look like? What’s that demand going to be? Are we going to have the same footprint that we had after this two, three years out? So, we have to think about it at that.
Are the hotels going to be the same? Are we going to have the same travel schedules that we had? Just in our industry, as an example, are we going to have one person go out to the client and then do a video conference call from the office of the client with everybody back at the home office? Which means instead of two or three hotel rooms, are we only going to have one? Instead of two or three flights, we’re only going to have one. These are all the issues that we’re in the midst of analysing. We have to do a little bit more work on it, to really understand where the opportunity set is and whether there’s value on the table or if the space has to be repriced.
So broadly speaking, we’re constructive that we’re going to start to see some recovery. What we need to figure out is how strong that recovery is going to be and whether we are coming back to a world that is supportive of the various capital structures we’re analysing. If airline travel does not come back, then the capital structures of the airlines are going to be challenged, and we’re going to have to assess that.
So again, in that case, and as with the structured credit market, I think you see the marriage of macro and fundamentals; how fast will the economy recover from the macro and what will the world look like for this sector’s capital structure from the fundamental perspective.
We have many opportunities, especially because of how we were positioned going into the crisis in March. But there’s still so much that we can do, that we’re going to do, and that’s how we’re thinking about moving forward.
Brian, one of the things we hear from investors when we talk about global income investing is concern about the sheer volume of negative interest rates, and especially the sovereign space now. Could you talk a little bit about how you think about these negative interest rates and the current yield opportunities across the globe, as you see them?
Certainly, so if we think about the negative interest rates, we’ve actually just seen some of the T-Bills in the U.S. go negative. Europe’s had them for a while. In the shorter term, we think it penalises economic growth and penalises savers and creates a challenge for us as investors. It’s something that we have a very strong question around whether or not it’s appropriate.
I think the European Central Bank (ECB) is starting to come around to that view that they may do more harm than good. It doesn’t mean they’re going to come off the negative rates, but what they’re doing is making it advantageous for banks to lend and to capture that spread. For instance, if a bank can borrow from the ECB at, I don’t know, minus two per cent, and lend at zero, they can still capture that net interest margin, which they hadn’t been able to do prior to this. That’s good for banks, for lending and the economy.
So, we would prefer not to see negative rates, but it is part of the world we live in. So, we also have to not confuse what we wish or what we think should happen with what is reality. And so, in that context, if we believe you could actually see German Bunds go more negative, that’s something we have to consider as to whether or not it’s an opportunity to capture as a total return opportunity or just as a ballast to the overall portfolio risk.
It’s a very fluid situation. If, for instance, a country gets hit with a second wave and there looks like there might be deflationary pressure, then a negative interest rate could go more negative, and it would be something we have to consider. Japan, for example, has had deflation or very low inflation and near or below zero interest rates for decades. So, it’s something that we’ll have to continue to address. It is difficult, but it is reality, and our job as investors is to deal with the world as it is.
That said, and turning to the other part of your question, at least at this point in time, despite having the negative rates on the front part of the U.S. curve, I should point out that in this environment there is tremendous opportunity to capture yield and create value for investors in both sovereign and corporate credit.
So, where we can find opportunities today? I think those yields when you were three, four-hundred basis points over U.S. Treasuries on those new deals that we highlighted in investment-grade corporate credit - those are attractive. I think some of the spread widenings in those TMT and healthcare names that we mentioned that in the investment crate space are very attractive.
And the one that we’re still working through is structured credit because that could be maybe the most attractive market at this point, given that a lot of other assets that we just talked about saw a significant spread tightening in April due to the policy response from the central banks and from the legislators in various countries.
But circling back to your point on negative yields, I’d just highlight that in spite of their prevalence, we’ve seen that global bond managers have been able to add value for clients. We’ve been able to do that in corporate credit. We’ve been able to do that in some structured credit. We’ve done it in sovereigns in the peripheral of Europe. And we’ll continue to look across those various asset classes to find the opportunity to capture both yields, running income, as well as the potential for total return while trying to avoid significant drawdowns.
Thanks, Brian, so my last question for you has to do with another theme we’ve been hearing from our clients, and that’s liquidity. We saw, as you mentioned, some big moves and very illiquid markets in Q1, 2020. How do you think about liquidity when running the strategy.
Yes, I think the month of March and first quarter generally, was a big reminder for investors that you have to be very cognizant of the type of vehicle that you’re using to invest. For instance, a Fund like ours in Australia that has daily liquidity is daily valued. So as an investment manager, we have to be very concerned about liquidity, and that can mean passing on certain sectors of the credit markets altogether.
For example, I think opportunity set in in private credit today is probably attractive, especially if you really find those entities that have significant value. But since those markets don’t give you the ability to trade those types of instruments on a daily basis, and not just trade, but also to settle and get your cash, I think that may not be the right place to be in a vehicle like a daily-liquidity Fund.
So, liquidity is always on our minds because as recent markets have shown, it’s easy to take for granted and like trying to borrow from your bank, as soon as everyone needs it, it can be gone.
Well, this was fantastic Brian. I could sit here and pick your brain all day, but I know as you mentioned, there’s so much to work on out there, and I want to be sensitive to that. So, thank you so much for taking the time to speak with me, and I look forward to our next conversation.
Thanks, Peter. I appreciate the conversation tonight and all the support from our clients in Australia and around the world.
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Legg Mason Asset Management Australia Ltd (ABN 76 004 835 849 AFSL 240827) is part of the Global Legg Mason Inc. group. Any reference to ‘Legg Mason Australia’ is a reference to Legg Mason Asset Management Australia Limited. The information in this article is of a general nature only and is not intended to be, and is not, a complete or definitive statement of the matters described in it. The information in this article does not constitute specific investment advice and does not include recommendations on any particular securities. These opinions are subject to change without notice and do not constitute investment advice or recommendations.