Episode 3: Word is Bond

Episode 3: Word is Bond

On this not-to-be-missed episode of the Value of Time podcast, we’re diving deep into the bond market: at a time of rising inflation and interest rates, what should we expect, what can we do, and why the heck would we even want to own bonds at a time like this?! We’ll get the answers to all of this and more with industry veteran Eddie Bernhardt of Invesco.

Read the podcast transcript:

Jim Ayres:

Welcome back. After a brief hiatus, we're back with a new episode of Value of Time podcast. I'm Jim Ayres, CIO of Pacific Portfolio, a private wealth advisor and institutional investment consultant in Seattle, Washington. Once again, we're here to bring you news and insight on current developments in the economy and financial markets.

Jim Ayres:

Like it or not, the end of the year is upon us. Unfortunately, there's no sign of any kind of year end low yet. Not in the economy, certainly not in the political arena and definitely not in the stock and bond markets. I know I don't need to remind anyone how volatile 2020 was, but ultimately, we had a solid showing. We're on pace for another good year this year as well in 2021. Stocks are up a little over 29% year to date through early December. And volatility has reemerged over the back half of the year. But quite frankly, that was probably overdue. This has given us a couple of decent pullbacks, one in September, and then again, more recently during a pretty rough month in November as renewed concerns over the COVID virus had flared up, first with the Delta variant, and then more recently with the Omicron variant.

Jim Ayres:

While the news on the vaccines' effectiveness looks recently good for now, this is certainly something we'll need to keep an eye on as a better or worse outcome on this front will likely be one of the bigger drivers of consumer and investor sentiment and behavior going forward. At the same time, the Federal Reserve, which has long been seen as the stock market's BFF, thanks to the massively accommodated monetary stimulus they put into the system, has recently risen instead to the top of many investors' list of worries. Inflation, as we all know too well, has run hotter and for longer this year than anyone had predicted, including the Fed. This morning's headline CPI number at 6.8%, the core CPI at 4.9%, these are the highest levels we've seen in 40 years. The good news on this front is that we don't see these price pressures persisting indefinitely, although they could certainly push into next year.

Jim Ayres:

So far, the bond market seems to agree with us. These conditions have given rise though, to what looks to be a hawkish pivot by the Fed. All expectations had previously been for the Federal Reserve to err very broadly on the side of caution and go out of their way to remove accommodation as gradually as possible. Recent rumblings though are pointing to a meaningfully shorter timeline than previously indicated for the removal of much of this accommodation. This isn't necessarily a deal breaker for the markets, although it does help to fuel renewed uncertainty for stock and bond investors. In light of this, I think the timing for our topic for this month's podcast could hardly be any better. We're going to try to assess the current outlook for the fixed income space as it's facing conditions that most investors have never experienced in their investing lifetimes.

Jim Ayres:

To help us navigate this strange landscape, we have Eddie Bernhardt, senior portfolio manager and head of managed accounts for Invesco. Good morning, Eddie. Thank you for being with us. I really appreciate you joining us. I admit I was afraid when we first had to delay this podcast that we might miss our opportunity, but if anything, I think the situation on the fixed income front has become even more intriguing over that time. I'm really hoping given your expertise, you may be able to provide some insights and really help us get a feel for the big picture here. So perhaps we could start with kind of the 30,000 foot view, if that's high enough for you of your outlook right now on the fixed income space.

Eddie Bernhardt:

Sure, happy to, and thanks for having me. I focus on U.S. dollar investment grade fixed income as a starting point because it usually plays that role as that safe haven, that ballast, that place to put money in and compete with inflation, if not outperform it. And the outlook right now is not very straightforward or simple. And so I'll break it into pieces. The outlook from an economic perspective is that inflation, which printed today from a CPI perspective at a relatively historic high with a north of six number on the headline and north of four on core. And you would normally assume that for a bond investor, that would be a horrible day. That would mean bond prices down, yields way up. That is not the case. You would have looked at these rates today and said, "Is the bond market even open?"

Eddie Bernhardt:

It's hardly functioning. Well, it's functioning. It's just not very viable. So the outlook is for an extremely challenging environment for fixed income investors, where inflation pressure is likely to remain with us into the first half of '22 and possibly beyond, where fixed income rates, treasury rates are relatively low, where the Fed is easing off its bond buying program, but that won't likely create tremendous opportunities immediately or quickly for investors to get more yield, where corporate credit spreads are close to all time tights, where muni relative value ratios, muni to treasury is how we think about it, ratios are near all time tights. So this is not an easy market and our outlook is that effectively, it won't get any easier for fixed income investors in '22. We don't think that there'll be wonderful, magical opportunities that present themselves. We do think there will be more volatility. There'll be a trend in the front of the curve higher and in the long end more volatility, which will create some buying opportunities. But it's not as if we're going to suddenly have rates that offer a better than inflation yield for buying something safe and liquid anytime soon.

Jim Ayres:

So it's interesting. I feel like, as kind of a layperson who doesn't eat, sleep and breathe this stuff every day the way you do, I feel as though you've just thrown quite a few grenades at me. It doesn't paint the rosiest picture as if I'm an investor with any kind of meaningful allocation to fixed income. I'm kind of worried by some of the things that you're saying there. I'm hoping as we walk through this, perhaps you can let me know how I'll be able to sleep at night over the next 12 to 24 months. But some of the things you've talked about, while they sound scary, how scared should we be? I mean, the inflation numbers recently have been eye popping.

Eddie Bernhardt:

Yes.

Jim Ayres:

And I think everyone's trying to reassure themselves that it's not going to be this way permanently, that we're going to see things come back down. On the other side of that coin, I think there's a growing sense that, well, the Fed is seeing inflation numbers too, and they're starting to worry and they're going to be more proactive than anyone expected. I think we've been looking for them to be very patient. They are not giving patient signals right now. They're giving more aggressive signals, and that in and of itself could derail a bond portfolio. So can you put a bit of a finer point on the individual items in terms of that sounds scary, is it really? And if so, the next question I'll throw at you, what the heck can I do about it?

Eddie Bernhardt:

Yeah. So scary in the short term, unlikely. And so, for example, if I had told you that inflation had risen, almost doubled this year and that we're reaching numbers we haven't seen in 30 plus years, and we were starting from rates effectively close to zero on two-year treasuries, on five-year treasury, almost 10 years, they had a zero handle on the front. There wasn't even a coupon, there was a zero and then a decimal and then a number on the par trading, the market rate for 10 years, and that we're higher this year. Rates have gone higher, but they haven't blown through the roof. And you might sit there as an investor without looking at your statement, and I had just said some things that said, "Oh, rates were really low. Then they went up and inflation fears were up."

Eddie Bernhardt:

And you would say, "So how have we done this year as an investor in, let's say a passive one to 10 year treasury portfolio?" Well, you're flat. Your year to date return is zero. So if you're panicked about losing money from a total return perspective in this environment, I would say just don't forget, inflation and rates are volatile. And yet investment grade fixed income has been relatively steady, even though prices have moved a bit. So the risk of extreme losses in terms of the price of the bonds you own, if you own funds or a pooled vehicle, unlikely in the investment grade world. The concerning part, if you're a financial planner, if you're a client and you're having a conversation with a client and you say, "Well, we assumed your fixed income portfolio would return something around 4% to 5% over the next 10 years. And we assumed inflation would run around 2%."

Eddie Bernhardt:

And now we're looking at fixed income portfolios, they're returning somewhere between call it negative one and three, just throwing out a range of likely possibilities. And inflation's running well above two. What does this mean as an end client? It really means that you're purchasing power is declining and your returns in the safe haven of your portfolio aren't keeping up with that decline in purchasing power. And so that is a material issue long term. It is not a crisis this quarter in a price. Look at the stock market volatility over the last three years and go look at the ag or look at an investment grade index or a muni index. And you would suddenly realize the volatility in equities, that's where all the volatility has been and fixed income, it's been really steady.

Eddie Bernhardt:

So you still get that steady. You still get that relatively low volatility. You're just not getting nearly as much upside. Very likely, I mean, to get a five plus percent return on a fixed income index right now, presupposes that rates have to drop from here, negative. Now that's happened in other markets around the world. I guess my caution here is it's much more of a long term story around the benefits of fixed income versus inflation and around really the upside potential, at least until there's more of an opportunity in rates or spreads or relative value in fixed income.

Jim Ayres:

So you're raising a good point, and jumping ahead here to some of the things I know we wanted to cover in this interview, it really does kind of turn the whole financial planning and objectives story on its head when you flip those numbers between expected bond market returns and inflation. It helps feed into that story going around regarding the death of the 60-40 portfolio, historically certainly for the past several decades, if you just had the portfolio of stocks and bonds, you did extremely well. We're looking at the economic backdrop, which other than the inflation we've been talking about, doesn't actually look that bad to us, but just looking at the tremendous performance we've seen in stocks over the past decade and saying, "Okay, we can't project that level of return going forward. It's going to necessarily be more modest.

Jim Ayres:

And then you take this fixed income outlook, which as you're saying is not necessarily catastrophic, but you can't really expect to get too much from it. People have seen capital gains on their bonds as rates have dropped, and that's just not realistic to look for going forward. So what does an investor do? And we've always kind of as asset allocators and divers had stocks and bonds and low correlated assets to help diversify and enhance risk adjustable return. But if you still got a meaningful exposure to fixed income, is this the time when you say, "Okay, I no longer want to be 60-40, I maybe want to be 60-30-10." And if so, what goes into that 10? The liquid alternative space has broadly disappointed most investors over the past 10 to 15 years. Is there an opportunity there to sidestep out of fixed income? And if so, where do you go?

Eddie Bernhardt:

Yeah, so if you start with the client and you start with the client goals and mandates, and I know that's where you start with your clients, fixed income, let's say I've had these before. A wealth manager actually had a conversation with me related to his mom's account. And his mom was relatively elderly, and spent for just simplistic terms, $100,000 a year. And she had $3 million in the bank. And he basically called me and said, "I don't care what our rates are. And I don't care if I inherit. I want a bond maturing every year for the next 30 years, effectively a ladder of bonds that just mature, that are treasuries, that meet that need of my mom." And he did a little inflation calculation. And in some years he stepped up the number and effectively he was trying to meet her needs.

Eddie Bernhardt:

He was trying to match her liabilities with a certain asset. And that was a way to say, "I'm not going to take any risk. I don't expect a terminal value on this portfolio. It's an asset liability match to the client need." And that made perfect sense, even though as you can see from stock market returns, this was a few years ago, he really left a lot of money on the table, but he didn't care because that wasn't the goal. The goal was to meet his mom's cash flow needs. I think it comes back to that with the 60-40. I think that's an optimal portfolio, at least historically, it's been optimal in many settings using what happened in the past related to capital markets. I think this market environment challenges an advisor to be a bit more nimble, a little bit more creative and a little bit more thoughtful about what to do with an allocation based on a client need, because the other side of this is we're all trying to solve for a client cash flow need, or a set of goals, cash flows plus a terminal value on the portfolio when they pass away what they want to pass to heirs or to a university or some charity.

Eddie Bernhardt:

And I think the conversation has to shift a little bit to being risk aware, effectively saying, "What is your number one priority? How are we going to meet that?" And then these are all secondary and whatever we do now to achieve these secondary goals, there's going to be risks involved. And we just don't want to trade off that primary goal for those secondary goals. So if you're still looking for certainty and you're looking for safety, you're going to be hard pressed to find something to replace investment grade fixed income, dollar denominated in the currency that people are spending. If you want to take more of a tactical approach or to look for opportunities away from fixed income right now, there's lots of conversations around private debt and real estate as replacements. And those are I think legitimate categories. In some cases, you're giving up some liquidity and credit quality to pick up income.

Eddie Bernhardt:

If a client doesn't need liquidity and is willing to take able to take the credit risk, that makes a ton of sense. In real estate, it's a different asset class. It has a better performance in inflationary environments than lots of different fixed income instruments. The other thing I'd say, and yes this is biased, active fixed income is performing at least in our world of SMAs, really performing well versus ladders and being opportunistic, for example, during the COVID selloff, is a meaningful way to capture returns in fixed income. Being opportunistic, if there is a taper tantrum part two, there's meaningful opportunities. So it's looking for that disciplined active manager. And if you go out there and you look, there's a different story between fixed income and equities and active management currently, and there are lots of active managers who are able to position appropriately and inconsistently outperform the market. And so the answer's mixed. It's not as simple and straightforward, I'd say, but that's where we're hearing a lot of our clients look these days is into real estate, into private credit and lucky for us if they were buying their own bonds, or if they were going into ladders, they're viewing active management in our performance as positive and a way to differentiate for clients.

Jim Ayres:

You know, that's interesting because I think there's probably a pretty broad misconception then among many investors regarding active and passive. I think given what they perceive as challenges on the horizon, the thought of well, I can just buy these bonds, buy high quality liquid bonds and hold them to maturity, at least I get my money back and a slight yield, but particularly it sounds like given the degree of challenges and the range of challenges and the volatility and opportunities that may exist, you do make an interesting point that you're not going to be able to take advantage of those if you're just sitting in a buy and hold portfolio, as opposed to an actively managed one.

Eddie Bernhardt:

I will also say more and more wealth is accumulating in the U.S. outside of retirement accounts. And that means there's more capital gains implications for transitioning and moving portfolios around. Well, if you're taking a tax optimized approach that we're taking, we're trying to capture losses in our fixed income portfolios while we're maintaining an economic position. In other words, a seven year muni bond, Seattle Convention Center versus CTAC, and you can do a swap. They're different issuers, slightly different ratings and structures. Okay, we get that, but really investment grade securities if you find the right convention bond, and you're able to maybe capture a loss on selling a bond and then increase yield, and really maintain that duration that you want in the credit quality. That's an example of sitting there and saying, there's relative value that there's more value we can offer than just trying to necessarily outperform the market.

Eddie Bernhardt:

But it's also after tax considerations. There's this other piece of the puzzle for us, which is during the COVID selloff, again, I go back to that, lots of advisors wanted to rebalance into equities and they were in certain settings, they thought they'd be able to sell a fund at one price. And then it was down three, four points very quickly because there wasn't enough price discovery. We were able to partner with advisors to solve those issues. I think there's a holistic approach here that clients should be aware of, which is it's not so simple as an index and a newspaper. It is their unique needs. And then it's how you manage those, that portfolio to their needs, taking all these considerations, including tax, including volatility and income. And that's what you do. But I'd say it used to be a little bit simpler. I think we could put money into certain structures like a 60-40, and rebalance systematically. And historically you get a certain result. I don't, I'm not presupposing that's the case anymore.

Jim Ayres:

Well, it's interesting. I mean, you make a very interesting point with regard to the tax optimization. I mean, you're talking about things that people very frequently associate with an equity portfolio, harvesting losses, not typically something you find or expect to find in a bond portfolio, but certainly sounds as though, and particularly since these clients tend to be generally speaking very tax sensitive, something that could really add to the bottom line. It makes me think about another area of expertise that I know you have with your team. And it's also an area that is hot right now, and that's the ESG front. I know you guys do something on the impact side. And again, it's not something that people typically think about on the fixed income side. They'll get very granular in their ESG equity portfolios, and then just maybe buy a green bond fund or something like that. What are you guys able to do on the fixed income side? Because again, as an outsider, it doesn't seem like the bond market lends itself quite as easily to this sort of approach. But I know lots of clients are saying, "Okay, it's great. You did the equity side. I want my whole portfolio to reflect my views."

Eddie Bernhardt:

Yeah. And this has been, it's an evolution in client demand and in marketplace sophistication here. When we started doing this eight plus years ago, it was very wealthy clients coming to us and saying, "Fixed income portfolio, I want it to reflect my values. I'm concerned about the environment. Create a system, find a way to get the data on municipalities and build portfolios that can do this for me and my family." And so we had to do it from scratch, and so we, and the municipal market is a relative data desert compared to the corporate bond market. Some disclosures are delayed, some are nonexistent. Many municipalities are not necessarily responsive to our outreach when we ask for data or we ask them to share on certain things related outcomes. So the bottom line is we've had these capabilities for a long time.

Eddie Bernhardt:

What is it? It's basically values aligned investing, whether it's ESG or impact. In the muni space, we would argue we can measure the impact of certain investments. Picture a wind power project along the Gorge, whether it's on the Washington side or the Oregon side, that's actually meant for Southern California rate payers. And so we're sending power south and you can look at effectively how clean that project is and what the outcomes are there. And we can tell the client, this is how much clean electricity is coming from this bond that you bought. And it trades at around the same level, as an old school, natural gas plant. The bond rating agencies, and the market as a whole looks at as similar structures, similar credit quality. And so we basically bias towards, we only invest in those positive projects. Other examples of this, and by the way, those bonds perform just like anything else that was A or AA rated in that category.

Eddie Bernhardt:

Veterans housing, I don't think that's a contentious concept of housing veterans in low income housing, and those bonds are available and ready to market. And they're usually AA in many different settings and they've got tremendous financial backing behind them. And we can tell the client, this is the number of units in this development. And so that really is when you think about fixed income, come back to the qualities of the portfolio. If you get the duration right, and you get the credit quality right, whether it's ESG impact or not, it's just a standard portfolio, you're going to get very similar if not the same results, because it's not this security bias in the equity market, where if you pick Salesforce or Oracle, you get two very different outcomes depending on how their earnings. Most bonds, it's all about getting your cash flows and the stability of the entity and no change to the regulatory environment.

Eddie Bernhardt:

Very few material events in the downside related to muni bonds that are unique to one issuer when we're talking investment grade munis or corporate bonds. And so if you get those portfolio characteristics right, you allow the client to make more selections that align with their values. We've had more interest in faith driven portfolios. Same concept applies. You get the duration right, you get the spread right and the security selection, you're going to have a very similar, if not the same portfolio performance. But our experience tells us there's another side of this, which is the clients want to know what they own and why. And so one piece is to offer this performance report that's traditional to fixed income. And the other is to add a piece that says a blurb per bond, why you own it, because then it's that values alignment with the client.

Eddie Bernhardt:

We find that it helps demystify these very strange names of securities in a client portfolio. They can say, "Oh, it wasn't clear that that was a housing authority. It wasn't clear that that's for clean water or a restoration project." And so connecting with the client in that way, we think it has a benefit. We think it does do that values alignment. And again, the performance over the last eight years is basically on top of the core strategy. You don't see much material volatility at all. In more volatile market environments, the ESG impact strategies typically slightly outperform. In risk on environments, they slightly underperform over the long term. It's a rounding error. You can't really tell which one's which. So it's very interesting to step back and look at it and say, "I can represent my values in a fixed income portfolio, my personal beliefs or get ESG investment without costing myself anything from a performance perspective, at least historically."

Jim Ayres:

Yeah, I think that's been a real eye opener for investors as they feel this need to move towards this values based approach. Seeing that they don't necessarily have to sacrifice on performance really kind of removes the last hurdle to implementing this. I think it's interesting. A lot of people tend to think of bonds as a more boring space compared to stocks, but this really opens up a whole new avenue to implementing a bond portfolio. Now I was curious, you did mention a number of times if you get the duration right and you get the spread right. And that can be really, really tricky. Looking at what happened earlier this year, for example, no one was anticipating the really, really rapid run up in rates that we saw. And I was looking at the consensus expectations the other day for Wall Street analysts. And really no one's looking for anything terribly dramatic to happen in the rates market next year. How much faith should we be putting in the outlook for rates? And particularly, I want to tie this back into what we should be expecting from the Fed and kind of get your personal view, how aggressive do you expect them to be once they start moving in that direction?

Eddie Bernhardt:

Well, let's start with economists and rates expectations. So when I meant, let me clarify something I said earlier, when I meant you get duration right and credit spread right and security right, it's really against your targets. And so as a portfolio manager, our team actually in Invesco managed accounts, we are not active, aggressive duration positioners. And so we try to stay near the benchmark, a little above, roll down, a little above, roll down, because we own individual bonds. We don't want to create a bunch of churn in client accounts. We also know that the bet that most portfolio managers get wrong is duration. And so we took that out of our equation and looked at relative value and security selection and when to be risk on. And those are things that we have a much higher probability of getting right than duration.

Eddie Bernhardt:

So to your point, how much credence do I give those who call rates? I mean, are they able to predict the next COVID? Are they able to predict what will happen when with chips and supply chains? Are they sitting inside Fed meetings, dictating policy? No. So they're making their best guess. And quite frankly, the concerning part about all of this and what I'd watch more closely is actually how investors are positioning themselves against neutral. So if you're a pension and you've been overweight equity risk for years, that's been fantastic and you're underweight duration, fixed income, but that presupposes you have a mandate that tells you, you need to get closer to home at certain times. In some cases they actually have requirements. So that actually has turned into somewhat pent up demand for fixed income. And what you see is more and more conversations like this, where advisors are thinking, how much should I own?

Eddie Bernhardt:

And am I max low point? That again, if we see a swing back in a fixed income, if risk markets see material volatility, you could see rates go lower here for certain. And so step back and think about, well, what's driving rates. Why are rates so low? And it is global supply and demand. If you're a Japanese investor today, you've got a choice between a Japanese government backed bond, 10 years out at zero, a German bond at negative 35 basis points, plus you've got to hedge the currency or the U.S., 150-ish, which after the hedge, you actually have a positive return. You have a better yield than in your own market. So the reason we're seeing flows is because there's something like 10 trillion, 10 to 12, maybe 14 depends on the day, trillion in negative yielding bonds around the globe.

Eddie Bernhardt:

And we have an open capital markets and we have tremendous amounts of money seeking a return. And so when we talk about rates, I think we picture a time 40 years ago when the U.S. was still tremendously and by far the largest economy in the world, and where China was just getting its feet underneath it as a country, let alone as an economy. And Europe was still rebuilding post World War II and Japan was rebuilding, and nobody had heard of the BRICs effectively. So our economic fundamentals, our money supply, our policies related to rates and inflation, they really mattered to our bond market and the rest of the world. Well now more and more, this global open 24/7 trading environment with liquidity sloshing between buckets around the world very quickly, our rates are very much impacted by European rates and Japanese rates and the openness and access to the Chinese capital markets and what's happening in Australia and Canada.

Eddie Bernhardt:

But it really does come down to the big liquid markets that were compared to in Japan and the Eurozone, the ECB driven market, and the rates that are lower than ours. And so when we have these conversations and I hear, I last week had a conversation with a wealth advisor who effectively said, rates have to go higher. And I said, why? Because inflation's higher. And I said, inflation's still been moving higher and rates are not moving materially higher. I think you have to accept the disconnect. I also think you need to look at the yield curve differently. The Fed is getting out of the QE business relatively quickly here and easing off the purchasing program and going to exit very likely, very quickly. They're just going to focus on the front end, effectively the price of overnight money and they're signaling, they're going to increase that price.

Eddie Bernhardt:

So the front end is going to respond to Fed funds, futures, expectations, and will reflect that really clearly. And so you're seeing twos, threes, and fives rise. You're not seeing that on the long end, and the long end, I would say reflects possibly an outlook by investors that they don't think inflation will be here forever, or that the Fed can raise rates substantially beyond what, two, one and a half and maintain that for an extended period of time. They're also looking at global opportunities to put money to work and saying, "Boy, I'm not sure I really want zero in Japan or, negative in Germany." And so two different yield curves effectively responding to two different inputs. So this is when I come back to a certain amount of acceptance. And the acceptance is that this global capital markets, with all of its excessive savings, seeking out yield in a world where two central banks are maintaining extremely low rates around us, it will cause unique outcomes in our market where we have substantial negative real yields on government and corporate and muni bonds that are investment grade.

Jim Ayres:

You've really just, you've covered a lot of ground there in a very brief passage. And much of what you're saying feels challenging to me as a financial advisor. I could easily throw myself into that camp of, "Well, yes, rates have to go up. Of course they do." The 40 year declining rate cycle is over and we've hit bottom and economic growth is good. Inflation is high. Rates have to go up. Listening to what you say though, I can easily see the counter argument to that, but it does, as you just noted, leave one with the prospect of pretty much any bond you own after inflation has a negative real return, which is not exactly encouraging for someone who may very well have a sizable allocation there. Oftentimes, objectives are tied to a T-bills plus rate, but at the end of the day, we're all trying to at least keep pace with, if not outperform inflation in order to preserve purchasing power. It's somewhat unsettling.

Eddie Bernhardt:

Yeah. And by the way, I'm not saying that rates can't go up. I'm saying absolutely they could, but why haven't they? And what's going to change that trend, I don't know. And if I'm an investor, first off, by the way, I'm sure all of your clients come to you regularly, give you a big hug and say, "I'm so glad I have exposure to the equity markets. You've done such a wonderful job. And over the last many years of owning fixed income, we've gotten great returns. Here's a great bottle of wine. I miss you. I will call you. You're a fantastic human being." I don't think they do that. They take for granted the fact that they've gotten tremendous returns, they've outpaced inflation, asset prices, if they've owned an asset, if they've owned their own home and other properties, if they've owned equities, if they've owned bonds, they've had this tremendous outcome. Trees don't grow to the sky and beyond to the sun.

Eddie Bernhardt:

So I do think setting expectations around asset prices relative to economic conditions and growth. What we're going to see next year is probably slower growth than we saw last year, in the U.S. at least. We could see a synchronized global economic recovery start to take of. That would be great. We're definitely going to see inflation at least in the short term, no, maybe not definitely, but it seems likely to maintain itself. That is a challenging market with relatively low rates. It's a challenging market for fixed income. So in the short term, I wouldn't have high expectations necessarily for your bond portfolio. If rates start grinding higher, if global central banks start shifting their policies to allow rates in those countries to rise or pushing them higher, if something were to happen necessarily to the value of the dollar, there's lots of scenarios I can write where rates rise. It means not great returns necessarily in most aspects of fixed income in the short to intermediate term. But then you get back to a more normal rate environment versus inflation. Inflation comes down, rates go up. That is certainly a possibility, but a lot of things have changed in the global economy and in our capital markets. And those are reflected in current yields today.

Jim Ayres:

Well, we do have some great clients and many of them do actually give us hugs or bottles of wine, but even when they do, they follow it with the question, which is why do I own bonds in my portfolio? I hear you guys talking in your meetings and webinars, how bleak the outlook for fixed income returns are. Why do I own them? And if nothing else, with duration risk being high, with spreads being tight, we bring them back to the, it's an insurance policy against the risk you're taking in the rest of the portfolio. It's stability, it's liquidity. It's the ballast. Can we count on that? I see a lot of articles out there talking about the infamous quote, this time it's different. Your fixed income may not give you the protection that you expect when it really matters. Is there something about this setup that we've got going on that actually feeds some credence into that possibility?

Eddie Bernhardt:

I think it depends on what you own in fixed income. So let's look at what happened. And I keep coming back to this because it was one of those moments that reminds you exactly why you own your fixed income. In the COVID disruption in March of '20, we have a portion of our clients choose us for basically ultra short cash management like, so one-ish duration, government bonds, corporate bonds, and taxable munis. And what did it do? Well, it was basically flat in March. All other asset classes were down 20 plus percent and there was tremendous volatility. This very short, very safe, very high quality was effectively flat and offered stability in the portfolio and a source of liquidity to invest in asset classes that are underperformed. I think when you're in a year when you're seeing stocks go up at the levels they have, people start to ask those questions.

Eddie Bernhardt:

When they see inflation at these levels, this would be the peak moment to ask that question. And just the volatility you see in stocks will remind you again, in a very short time period, we saw a 5% sell off, and you saw bonds effectively yawn and keep going. I don't think they're suddenly going to add. Investment grade fixed income is not going to suddenly add a lot of volatility to your portfolio. And if you want to manage that portfolio, you go up in quality and you go lower in duration, if you think that's coming. I actually think there's some new opportunities right now, which we haven't seen in a while. Floating rate notes, corporate floating rate notes, corporate credit quality is quite good right now. You can own floaters that are investment grade. That's one of the most popular strategies we're running right now.

Eddie Bernhardt:

And there's a great team of credit analysts and all the people behind it and obsessing about these individual bonds. And as the Fed raises rates, these bonds, their coupon's going to reset higher. We'll see how their value goes along the way. That's not necessarily scary and bad. So the bond market, it's a big bond market. There's lots of different choices to make. If you're long, heavily long, 10 to 30 year treasuries and munis at these rates, I would understand having a little bit of heartburn because you've got really low rates and you've got high inflation, and there seems to be a risk there. Understand that you can manage that. You can add floating rate. You can reallocate to shorter duration bonds. So I guess I would say your clients are right to ask the question. You can make adjustments in the portfolio to adjust to their concerns or lower the volatility effectively of that part of the bond portfolio, so that's more stable rather than possibly negatively correlated to risk sell off, but the same issues that we're describing around the globe around savings, around low rates, they're the reason that you're not seeing our treasuries unwind from current levels and create lots of volatility. And again, I don't see that changing quickly or anytime soon.

Jim Ayres:

I like the fact that you brought up floaters, because one of my questions to you was going to be what else can an investor put into their bag tricks that might help in this environment? You mentioned if you're worried about the risk of, of fixed income, you can go shorter duration. You can go higher quality, you trade off return when you do that. You get paid less because you're taking less risk. We always caution people you don't want to be reaching for yield. Reaching for yield gets you burned 99.9% of the time. Is there something like the floaters, for example, that people can be doing that may not be top of mind for everyone, may not be real common knowledge, but that can help expose them to a source of return that they may not be getting if they've just got a typical core investment grade, fixed income portfolio?

Eddie Bernhardt:

Yeah, I think floaters are an essential part of that. I would say that in certain market environments, high yield can play a role without necessarily reaching aggressively in that direction or loans could play a role. They're just extremely tight right now. And so I would come back to an active manager that's going to live in the market all day, every day and allocate to those markets when they sell off, that's still an opportunity for sure. There's still opportunities in it. But muni high yield can perform exceptionally well and add yield post a volatility event. And so post COVID, it has been a fantastic asset class and very tax efficient. So opportunistic, somewhat tactical plays should play a role here.

Jim Ayres:

Right. I think that you hit the nail on the head right there in terms of waiting for the right opportunities to present themselves on some of those more specialized asset classes. Kind of turning back to the more traditional fixed income space and asking a question that I think mostly stock market investors are asking right now, assuming we do get a rising rate environment and understanding there's pressures pushing towards that and pushing against that. But if rates do start to rise, at what point does the bond market start to become attractive from an income opportunity? And I think as you said, a lot of people have been overweight equity pretty heavily for pretty long. And at some point, bonds actually will start competing for that capital. Where's the sweet spot? Where does that start siphoning off the support for the stock market that we have?

Eddie Bernhardt:

That's a great question. And I can't, I don't know. Well, you know when you start to see it, I had the head, the CEO of a firm that I worked for for a time used to send out an email every Mother's Day, reminding that there was no greater gift to your mother than a bond, because it paid twice a year and it maintained its value. And nothing said love to mom like that bond. And so he encouraged each of us to buy something out of the inventory and give it to our mothers that year, every year. And I would, I'm a fixed income person. I live in these markets and actually, I hate to say it, but I do enjoy the volatility. It's actually a fun time when we usually find great opportunities.

Eddie Bernhardt:

So I would say watch for a flattening yield curve. We're still relatively steep. That's a point where you start to realize duration may have value here. It's actually counterintuitive. When you start getting a two year bond that has a very similar, if not the same yield as 10 year, why would you buy the 10 year? Well, because you want to lock in that yield if rates fall. So that's one of those indicators you watch for. I'm not going to pretend this is going to be a normal cycle. There's been nothing normal about it thus far. And so I'm not sure that normal relationship will apply here, but that's one of those indicators that I will be looking for, absolutely. I will be looking for spread volatility. You say, you talk about clients reaching for yield. Well, there's this other thing when we're looking at credit, when corporations start reaching for deals and they start borrowing aggressively to do expensive deals, or they start giving money back to shareholders and start undermining us as creditors.

Eddie Bernhardt:

Those are points that you start to get concerned as an investor about what's happening in the market and why, but so I'm looking for opportunities to add yield in spread product, and I'm looking for a flattening yield curve. And those would be decent indicators of kind of tumult to come in risk assets. I think it's important to remember that munis, treasuries and corporates aren't perfectly correlated with each other. And they are generally not correlated very well at all with risk assets. Corporates are the most correlated to equities. And so that relationship still holds. It still has value. If you did see an equity selloff, where are you going to get fresh capital to go reinvest? It's likely your bond portfolio. And at some point, I think investors who have seen, and we're hearing more of this now, we're seeing more inflows for this reason, they're starting to look at their equity portfolios and say, "They've run up a lot. It's time to capture some of this off the table and something that's not perfectly correlated to those risks and live to fight another day." I still think that has merit, that sort of active reallocation to core positioning.

Jim Ayres:

No, I agree. I think that the discipline to take advantage of what the markets will hand you is going to be key going forward. I also agree, as you said, this has been anything but normal for a while now. And I don't see that changing anytime soon. I think the insights you've given us today are very helpful. I think you've given people a lot to think about here and a good picture of what things look like in the trenches. I want to thank you for joining us, Eddie. This has been fantastic. Couldn't have gone any better, very much appreciate you joining us today.

Eddie Bernhardt:

Happy to. Thank you very much.

Jim Ayres:

Thanks for joining us, everybody. Please tune in again next month. In the meantime, feel free to give us a call with any questions or check us out at www.pacific-portfolio.com. (silence)