Five Questions for Michael Buchanan
Michael Buchanan is the Deputy Chief Investment Officer at Western Asset Management
Q: Let’s address the number one risk out there, the coronavirus outbreak. We cannot put our arms around or quantify it, but how does it impact your approaches to sector allocations?
A: I don't think anyone has any great insight on the impact of coronavirus/COVID-19 as it stands today and how that's going to evolve, but it is certainly a risk. We have a diverse global task force assigned to this topic, including a medical doctor and even someone with very close personal connections to the Hubei Province. We look at the impact of travel restrictions and potential damage to the supply chain. We are doing everything we can to understand that. We have some key take-aways, which can shift as information warrants. It is manifesting itself in risk market pricing.
Our base case, which is about 85 percent, is the outbreak may peak from late February into mid-March. Then the downside case, 15 percent, is the longevity of the virus extends beyond Q1, with greater risks of the virus spreading or mutating. We are going to be watching closely.
The philosophy of Western Asset has always been about diversified strategies and making sure that not all our risk factors are pointed in the same direction. So as much as we have taken damage because of some spread sectors widening, we are getting a lot of benefit from how we use duration to complement that. Duration has been doing great. Diversified strategies are what got us to this point. We believe they will be winning strategies going forward.
Q: More broadly, how are you looking at fixed income markets and where do you see them going?
A: Our big premise is there is always opportunity in global fixed income. We lean on our team to find opportunities we can take advantage of for our clients. But it can be a challenge. If you think about the rate environment, we just busted through all-time lows on both the 10-year and 30-year U.S. Treasuries. Spreads are tight. Low rates and relatively tight spreads really are a challenge.
When we talk to our teams in the different spread categories, a big theme is this is not going to be a year about beta. Meaning you will not get a lot of upside return investing randomly in any of the given categories. What you really have to look for is alpha. That's the opportunity for 2020. Look for idiosyncratic opportunities; the good, compelling risk/reward relationships within each fixed income market. And take advantage of security selection. We are pretty excited about that.
Nowhere is that more apparent than in high yield. Last year our high yield team did a really nice job of extracting alpha from idiosyncratic opportunities while avoiding a lot of the downside. In contrast to what some of our well-respected competitors have been warning about, continuing to pound a bear drum on high yield, we continue to see select opportunity there.
Q: Can security selection provide downside protection given the lack of liquidity dealers in fixed income in the volatility we’ve seen recently? How do you incorporate the impact of ETF sales in a selloff?
A: Yes, absolutely. We have invested very heavily in risk management over the past decade. But as I always say, and I tell all our analysts this, disciplined fundamental credit research is the first line of defense in managing portfolios. Picking credits that fundamentally have the right trajectory – knowing the management teams well, seeing reliable cash flows and having a high degree of confidence they will consistently pay their coupons – those metrics really matter.
It could add to volatility, but ultimately what matters will be fundamental performance. That's how we, and our investors, are going to get to get paid.
As for ETFs, as we all know they are not fundamental buyers. They simply buy the largest, most indebted securities that are in the market. From time to time we see anomalies there. When a lot of money is coming into the market, those larger issues tend to be intrinsically rich. Conversely, when a lot of money is leaving the market, those issues can become intrinsically cheap. Using fundamental discipline to take advantage of buying and selling opportunities is important.
Q: What about investors who ask when should they get into the high yield market – and get out?
A: I have been in the high yield market since 1990. It's embarrassing to admit but investors always agonize over when to get in the high yield market, and when to get out, with the belief that that's how to make real money: you have to time it. Certainly, if someone were really good at market timing, they could add some incremental value. Yet the overwhelming contribution to return comes throughout a cycle – from income.
We stress that a lot. As much as we try to pick the right entry points, and get out at the right times, what really matters is constant coupon clipping. Our team stresses not only avoiding impairment (obviously that's crucial) but the importance of doing your credit work, making sure you get the coupons you are supposed to get on a reliable basis. You get paid back via maturity, or a call, or a tender.
Understanding and looking at the default cycle is important too. When defaults are generally low, that's going to be great for high yield. That means less impairment. When defaults start to increase, that's a time when you may want to pull back on your high-yield risk.
Q: Why do you think so much money has gone into investment grade products?
A: Despite the relatively low level of yields – particularly in investment grade – and relatively tight spreads, it's fascinating to look at just how much money is going into investment grade when you compare it to below investment grade, high yield or bank loans.
This is just retail, but I would argue this mirrors what we're seeing institutionally as well. We have seen powerful technicals (net negative). If we get to a point where some of this money starts to migrate into the high yield market, that certainly could create an even stronger technical appeal.
Michael Buchanan is the Deputy Chief Investment Officer at Western Asset Management, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
Deputy Chief Investment Officer at Western Asset Management
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