Is it Time for Fixed Income?

Greg Campion: Fixed income markets have experienced a strong resurgence over the last year plus, driven in part by the attractive yield on offer from higher rates and an economic backdrop that is largely surprised to the upside. But with uncertainties ahead ranging from elections to inflation to economic growth, what can investors expect from their fixed income allocations in 2024 and beyond?

Martin Horne: This has been the longest economic recession that any of us have talked about in all of our careers. I mean, we've been talking about this thing for years, so put yourself in that boardroom that runs that manufacturing business. You know it's been coming. You've been running your inventory down. You've been managing your CapEx level. You've been managing your cashflow levels. You've been conservative about how much you have borrowed. All of these people factors, because we've been so down on life, have played into the profile of the market. And again, with yields pretty much across the board in top quartile territory I think it's one of the most attractive markets that I've seen again in my career.

Greg Campion: That was Martin Horne, global head of public assets at Barings. And this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion. Coming up on the show, is it time for fixed income? Before we get into the conversation, if you're not already following us and you're interested in hearing our latest thoughts on asset classes like high yield, private credit, real estate, and more, just search Streaming Income on Apple Podcasts, Spotify, YouTube, or wherever you get your podcasts. With that, here's my conversation with Martin Horne. All right. Martin Horne, welcome to the podcast.

Martin Horne: Nice to see you.

Greg Campion: Nice to have you here. It's been a while since you've been on the show, so I'm excited to have you back. I'm excited to be in London today, so thank you very much for hosting me. We have St. Paul's in the background and lots of beautiful scenery. So it's very exciting for me and I'm psyched to dive in and talk about fixed income markets. Now, before we get into the nitty- gritty of fixed income in terms of where you're seeing relative value today and all that kind of stuff, which I want to discuss, let's just start high level and talk a little bit about the macro backdrop. Obviously there's a lot going on there when it comes to rates, inflation, et cetera. But just set the scene for us, if you wouldn't mind, in terms of how you and the team are seeing that macro backdrop today.

Martin Horne: Yeah, I guess when I think about what's changed since we last sat down and had a conversation, then rates and the path of rates were still on an upward trajectory. The economy was holding up pretty well, yields were in really good shape and looking attractive to most investors. But investors weren't really allocating because there was still some uncertainty as to where the path of rates was going, how aggressive it would be, and what the ultimate fundamental impact of that rate movement was going to drive out of the economy. Today, one of those big uncertainties has been removed. Pretty much every central bank have said they're done on the upward movement. It would be a huge shock to the market if that wasn't the case. And now the speculation is mainly around, well, when do rates start to reverse? When does inflation hit the magic 2% and stay there for a while? And what is the impact on the markets of when that reversal of movement occurs? What's similar is the economies are still holding up relatively well. There's some softness. Yes, there is some softness. But with the removal of that uncertainty, what we have started seeing unlike 2023 is investors have started to allocate. And you've seen pretty much every asset class start to see positive flows in the January and February period of 2024. As investors feel a bit more confident about the upward movement and now start to speculate on what they need from their asset allocation over the next two or three years,

Greg Campion: Do you think that markets have gotten ahead of themselves at all? So if you think about if rate hikes are kind of off the table, central banks have kind of put those off the table. And I think the market's been angling very much toward multiple cuts this year. But now as we sit here late February, there's a sense that maybe the market's over its skis in terms of expecting rate cuts to come in terms of how many and when they come. Do you think the market's over their skis on that?

Martin Horne: Yeah, and I think we kind of said this last year as well. The inflation push- pull factors are there for everyone to see. On the slightly longer term, it feels like we are in a more inflationary world and the factors that feed into that when you think about the energy transition to renewables, that's kind of inflationary. Geopolitical events that-

Greg Campion: No shortage.

Martin Horne: ...involved supply lines being redistributed in different ways, not necessarily to the longest and cheapest sourcing, that's inflationary. When you think about inefficiencies in the marketplace that causes energy to be heightened in spite of economic growth, that's inflationary. Think about politics generally and the curbing of natural migration of people around the world. Again, these are inflationary factors that are all going to feed into a longer term, probably higher for longer scenario.

Greg Campion: Let's say we're at peak rate today. Let's say economic growth starts to slow down and I'm sure the picture is a little bit different in the US versus Europe. But let's say broadly speaking we're at peak rate, economic growth starts to slow down. Do you start to get worried that fundamentals could deteriorate, that you could start to see a spike in defaults? Where are you on that fundamental picture today?

Martin Horne: Yeah, I think what we need to focus on is our use of language there. So when you talk about spikes in defaults, people automatically think that's going to be a really bad situation. Actually, most default expectations for this year in the context of a slowing economic environment are kind of 3 to 4%, which is not far off the long- term average. Slightly above. But really nothing to get too excited about. Some of the backdrop to why that is the case is that we really haven't had an exuberance of risk appetite for it's going to be approaching five years now, and that runs all the way back to 2020 COVID. So you think about what happened there, the largest industrial shutdown since World War II, we were not risk on at that point and we weren't risk on really for the next two or three years. We had a brief period in'21 when we felt pretty good about the world and then inflation came to pass, then rates started to move in. Then Ukrainian invasion and all the geopolitical events and rate movements that have gyrated the financial world around over the last few years, none of that has led to excessive risk appetite. As a result, even in our higher risk markets in the fixed income world like high yield, you've got the highest quality market that we've ever seen in my career. And so companies are not over levered in spite of the fact their interest burden obviously has increased and will increase as hedging programs roll off. But it doesn't mean that there is an excessive anxiety within our markets and you can see this reflected in the ratings profile that you're going to gain a significant increase in defaults. I looked at some of the stats before I came in the room and about a year ago the high yield market had about 9% of the market in CCC territory. Today, 9%. Exactly the same. There's been barely any movement in the asset categories and you've still got the highest quality profile that I've seen. So companies are kind of set up for it. And all of that is don't lose sight of the fact that again, even if we do move into a economic recession, this has been the longest economic recession that any of us have talked about in all of our careers. I mean, we've been talking about this thing for years. So put yourself in that boardroom that runs that manufacturing business, you know it's been coming. You've been running your inventory down. You've been managing your CapEx level. You've been managing your cashflow levels. You've been conservative about how much you have borrowed. All of these people factors, because we've been so down on life, have played into the profile of the market. And again, with yields pretty much across the board in top quartile territory, I think it's one of the most attractive markets that I've seen again in my career.

Greg Campion: So I guess there is an upside to pessimism, at least if you are the CFO of a high yield issuer. Now, back to that idea again of peak rate because obviously rates are such an important driver for the performance of fixed income markets, and if we're right and we are basically at peak rate today and the next moves in rates are lower. What does that mean for the performance of fixed income markets? Obviously you don't have a crystal ball, but I'm wondering, I guess for instance, can history be a guide in terms of what may be ahead for fixed income markets based on where we are in the rate cycle?

Martin Horne: Yeah, I think history can give you pointers, but does it really kind of lay out the rather unique set of circumstances we're in today? Not really. When I started my career in the early'90s we were going through globalization, the use of the internet and the stretching of supply lines as far as we could possibly go given consumers access to the cheapest possible goods. And in many ways we are going, I wouldn't call it anti- globalization, that's too strong, but we are seeing some reaction and retrenchment away from globalization and all that means that on a fundamental basis, the markets are changing. And the financial markets constantly evolve as well in terms of the sophistication and we'll go into the amount of products that are funding those markets, the changing profile of banks and what they will and won't fund, and the opportunities that provides different levels of investor bases. All of this is changing. I think what's different and the opportunity you can look at is when I look across the fixed income market, because the rate rise we saw in'22 and onwards was so significantly aggressive in over such a short period of time, most of the fixed income markets are still at a significant discount to par. And the significance of that is that there's basically two scenarios that can play out from here. One is that rates remain pretty high, in which case yields are going to remain high, in which case investors are going to benefit from a high yield environment in a fixed income asset class that doesn't have all the uncertainties that some other investment opportunities such as equities where you're relying on PE ratios and the justification of those has. So you've got that kind of one element, rates stay high, you benefit from yields. The other element is rates start to come down and if rates start to come down, that discounted pricing point and it ranges from mid'80s to mid'90s depending on which asset class you are in, will start to rise because the base rate differential between what you're getting paid from an income perspective will start to move more in alignment. So in a way, you've got to kind of win- win. And as a credit guy, I hate saying that. But the discount to par that you have in these markets forgives a lot of sins. In both scenarios you're either going to get excessive capital appreciation because rates are going down and pricing is going to move up or you're going to still benefit from a much higher yield environment, and my expectation is we are not going to see zero base rates for quite some time. My crystal ball is as good as yours, but there's a lot of factors out there in the world that tell me we are not going to see excessive risk appetite and we're not going to see base rates move into negative territory. So this isn't a one- year allocation to fixed income that's going to make sense to investors. I think over the longer term, they're going to benefit from a higher yield environment and they should really think about strategic allocation over the medium term because at least that will provide them certainty in a world that has a hell of a lot of uncertainties.

Greg Campion: Yeah. Let's talk a little bit about that allocation for fixed income, especially relative to some of these other asset classes because there's a couple of things that we've seen that have gone on in recent years. One is equity markets have had quite strong performance. Now you have skeptics of that, people pointing out that there's a very heavy concentration in the top five or so stocks in the S&P 500. As you were kind of alluding to, some concerns around valuations there as well. So that's one end of the spectrum. The other end of the spectrum is on the money market side. We've seen massive growth in money market funds in recent years, I think the number is something like 6 trillion are allocated to money market funds today. So those are kind of opposite ends of the spectrum. One high risk, one very low risk and they've I think seen a lot of fund flows for different reasons. One chasing growth. The other probably more a function of the fact that rates have gone higher and money market funds have become attractive. But I'm curious as you think about that, how does that start to unwind or should that unwind and should some of those assets come back into fixed income? And I guess maybe it's hard to make that call at a market level. But let's say put yourself in the shoes of a pension fund manager or an allocator of assets. Let's say you wanted to rotate back into fixed income for all the reasons that you just mentioned. How do you think about timing something like that, or do you think about timing like that? Maybe it's too cute to try to play when high yield spreads are at this level or at that level, but how do you think about that kind of relative value and that allocation shift broadly?

Martin Horne: Well, fixed income, the beauty of it is the certainty. We talked about the discounted price and the fact that with yields where they are they forgive a lot of sins. When you compare the dividend profile of something like the S& P to just buying treasuries today and buying treasuries is a much better bet, so then you go into other fixed income asset classes and you're going to get substantially more income depending on which of those asset categories that you choose. And then you move into the CP market and investors can look you in the eyes and say, well, okay, but I don't know when rates are coming down so why don't I just stick here and as soon as I see the rate movements, then I'll make my reallocation decision. The problem with that decision was illustrated significantly in November, December last year with everything rally that we mentioned before. So if I look at Global IG, it had returned to investors between January and October last year, 40 basis points because it was yo- yo- ing up and down with different rate expectations as the curve moved up and down. And then people got comfortable that central bankers were done and in November and December it returned about 8.3%. In two months it just snapped and the average price went from about 87 to 92, but it's still hovering in the 92 kind of region. And that shows you that if you try and time the market and the market just decides, actually we're done on that, you are going to miss those returns. So you can still buy into global investment grade at 92 pence to the pound. You can still buy into global high yield at 91 pence to the pound. And if you try and be too cute about the timing, inevitably you will miss that market rally and the return potential that it provides you. In 83% of the times when the high yield market has been at more than 7% in the last 30 years, the following 12 months you get a return of more than 11% on average. So at these yield levels, there's almost no circumstances where the high yield market doesn't give you a positive return. And the only example where that didn't happen, by the way, was the lead up to Lehman's. And I would imagine if there are investors thinking we're going to get a black swan event Lehman's, well frankly they're not going to come out of CP anyway. They're just going to stick where they are. Most global commentators would suggest that's unlikely. But black swans are black swans and that's why we never see them coming.

Greg Campion: Yes, I think that's a great point around where yields are. It's a great starting point. And I think that's really worth noting what that's meant historically. But I think it's also a really good point just around how quickly markets can change and turn on a dime. And the stats that you were quoting about IG last year, I mean it's incredible, something like 95% of the IG returns last year came in the last couple of months of the year. So it's almost like a whipsaw effect and your point is really taken around it's very, very difficult to try to time that in any way that really makes sense. So if you do think that we're at peak rate and the next moves are lower, that makes a lot of sense to starting to think about that allocation shift. I guess as you look across that broad fixed income universe, so the teams that report into you here at Barings are many and varied. So on the fixed income side it's things like high yield and investment grade, it's emerging market debt. It's also things like CLOs where we've got a big business, ABS and on and on. So it's a really broad group of fixed income asset classes to consider. So we've mostly been talking macro, high level rates, et cetera, but when you drill down into the asset class level, I'm curious what you're seeing today, what looks particularly attractive, what looks less so, where are you seeing that relative value today?

Martin Horne: Yeah. That's probably the most difficult question you can ask because pretty much every asset class is in top quartile yield from a historical perspective. So everything looks good. You're like the kid in the sweet shop where you're staring through the window and it's all looking good to you. There are some sort of more minor, I would describe them as technicals that are going on to specific asset classes. So for example, bank behavior is changing, we mentioned this earlier. They're having to pay out pretty high deposit rates right now, so they've got to go and find asset classes in a low growth environment that pay them higher yield levels to fund the higher deposit rates. So you've seen banks stop buying up things like CLO liabilities, which is going to provide technical strength to that market, and that's going to provide technical strength to the loan market as an onset of what CLOs do. So there's the more minor things. There's also some stuff in the privates that will be very, very positive for them. So in the private market, banks having to take a step back from commercial property probably means that there's an opportunity there in real estate debt. We are going to see some opportunities from some of these more minor technicals. Ultimately though, what we tend not to do in this organization is walk through the door and say, you should buy this because it's better than all the other things.

Greg Campion: Yeah, of course.

Martin Horne: Because investors requirements are so specific. So if they want income, really look at the variable rate asset classes such as liquid loans, CLOs, private debt, these are very high income component asset classes. If they want high rated because they're not feeling so good about the market, then investment grade at 92 pence to the pound, that's going to look pretty good from you. If they're thinking more about the fixed income markets and they want an asset and liability match, well pretty much everything is at a discount and you're going to again benefit from that rate rising environment. So you can really tailor the product solutions to your expectations around the market. What I'm not worried about is rates moving up, he says confidently, because that would be a major shock to the market. And then frankly everything's going to sell off. I'm not so worried about the fundamental environment because I think actually corporate's in particular in a very, very good shape. So I do think being positioned here gives investors the luxurious position where they can look at what they're actually trying to achieve over the next three, four, five years and have confidence that allocation opportunity is going to last for a while. I think we will be in a higher rate environment for a while. It might not be where we are today, and there's reasons to get on with that allocation call. But ultimately I think they are going to benefit from more fixed income exposure because the market has got itself in a place where it all looks pretty attractive to me.

Greg Campion: Yeah, yeah. I mean on the variable rate asset classes I know the team has put out some research recently on that front as well, just talking about the attractiveness of the contractual income that you get and just the fact that you're at a really great starting point from a yield perspective in a lot of these asset classes. You've already kind of quoted some of the stats on high yield in terms of what that's meant historically. Obviously we can't take history as any guide necessarily, but it's an interesting data point. So to me it sounds like you're saying everything looks pretty attractive, depends on what you're really looking to solve for.

Martin Horne: Yeah. And I should have added that in that environment multi multi- asset capabilities are probably the nice balance that you can get from an asset manager because your starting point is pretty good. If we think about what will happen in the rate environment and what that will mean for different markets and which ones will accelerate the quickest and which ones might need a longer term investment threshold or thought process, that will change quite a bit I would imagine over the next 12 to 18 months depending on what we see coming out of the central banks and all the other geopolitical events that are like gyrate us around. So being nimble, I think, and giving your manager with a holistic product range the ability to be nimble and take advantage of those opportunities is probably quite a neat way to go if that's within the gift of the investor.

Greg Campion: Yeah. That makes sense. You mentioned private debt and let's just touch on that because I think everything we've discussed so far has been really focused more on the public fixed income markets, but it's almost an incomplete discussion without talking about what's going on in private credit markets. Obviously that market's seen massive growth, I think it's something like$ 1. 7 trillion in the direct lending space today. So huge growth. Investors have increased their allocations to the space. Managers popping up left and right. That's a whole separate discussion. But let's talk about just where these two markets are sort of overlapping or coming together or maybe even where there are blurred lines between these two markets. So you're starting to see things like private credit investors go up market compete with broadly syndicated lenders in certain places, but how are you thinking just generally about the interaction of these two markets. If you are an investor trying to put money to work in credit broadly, how do you think about that?

Martin Horne: Yeah, they are blurred I think in several areas. You've certainly seen with the amount of money that's been raised in private debt and moving to multi- billion transactions, which was never meant to happen if you go back a few years ago. I think that market is going through what I call some growing pains. It's going to represent long- term value to a lot of investors, really nice attributes to that marketplace. But equally, a lot of money's been raised and when a lot money's been raised, people tend to chase transactions and spreads will come in. The positive on an ongoing basis is across the globe, insurance markets are deregulating. What happens when insurance markets deregulate? They look for spread premium products and I think privates will always have to offer some sort of spread premium to the public markets, otherwise they don't really have a reason to exist. I think that's largely held up historically, it might go through some bumps in the road. For us, it's about manager selection and making sure we've got managers with the right discipline to take you through those bumps to have produce the right asset selection in the first place and be able to defend those assets if the economy has a little bit of a wobble and to navigate through a high yield environment where they're going to have to have sponsor relationships that they look to and look for those sponsors to support those deals. So I think the private credit market's got a good long- term future. It's going to go through some bumps in the road. It's going to be difficult to ramp as quickly as they possibly have in the past. That should mean in my mind that you get more mixed products between publics and privates, so you ramp with the publics rather and then allocate into the privates as those asset classes with the higher yield content become available. We haven't really seen that from clients to date because actually ramping hasn't been such a big issue. But I think it's an increasing narrative in the marketplace and people are going to be focused really on managers that not only have the fundamental credit discipline, but also have that ability to provide a wider asset profile that maybe makes up for some of the bumps in the road that may exist from time to time when it comes to fully allocating the capital that's given to them.

Greg Campion: And not to make this too much of a Barings commercial, but I think that point around manager selection becoming that much more important, especially if you think about things like going across private and public markets and if you are doing something like ramping with broadly syndicated loans, you obviously need a manager that is very familiar and very active in that market and then can easily manage that handover to a private credit team. So again, not to make it too much of a Barings commercial, but I think it is important to make sure you have broad teams with a lot of experience in both of those markets.

Martin Horne: Agreed. And we can make this a Barings commercial.

Greg Campion: Okay. All right, so I think you have made a compelling case around fixed income and the attractions of fixed income broadly in 2024 and beyond. It seems like there's a lot of tailwinds, there's a lot of reasons to be optimistic, and I know as you alluded to earlier, that can be a hard thing to do for a credit manager who's naturally wired to be pessimistic. Not you per se, but credit managers in particular. But let me ask you to put that pessimist hat back on for a second. What could go wrong with this thesis? What are the biggest risks you're worried about?

Martin Horne: Yeah. I think, look, from the fully employed state we are in a lot of this developed markets with corporate balance sheets having been managing to this environment for a while, I still think we're in reasonable shape from a corporate perspective. I actually think as tragic as a lot of the geopolitical events we're seeing map out around the world are, one of the offshoots of that is it's difficult to be optimistic right now. There's too many things when you look at the world that are headwinds to optimism. What that means is I don't think credit disciplines run away with themselves anytime soon, I don't think you're going to get an excessive risk environment. I think the central bankers that's going to theme into what central bankers are prepared to do, they're going to be cautious around the marketplace. They're not going to move too quickly. They're not going to be too aggressive regardless of what the market tells them. So the higher the longer thesis for me plays out. You can never dismiss the things that you don't know are coming and what the last two or three years of shown us is there's plenty that can come along that you didn't see coming. But I think from where we are for the next one or two years, ex some exogenous shock that the world isn't currently mapping out, the fixed income markets look pretty good for me. You heard the slight hesitancy in my voice because that's not a natural thing to be over positive in this environment. There's just so many headlines and every night we go home and the news is frankly depressing. But I do feel that there is an investment play here that will be substantial for investors in the future and provide a level of uncertainty in a world that has no certainty.

Greg Campion: Yeah, that's a really good point. It's almost counterintuitive, but to think about the fact that there is so much bad news maybe that's actually a reason to be optimistic because it might keep central bankers in check. It might keep CFOs in check. It might keep markets from getting irrationally exuberant. Even if it is depressing to see the latest election news or obviously all the tragic geopolitical events that we're seeing develop around the world.

Martin Horne: I think that's a real contrast. The last time we were in this sort of yield environment, it was pre Lehman's. And remember the excesses of those markets and the excessive risk appetite. A UK politician stood in parliament and said the era of boom and bust was gone forever, and there was a real expectation that we could never go backwards. Actually where we are today, people are still pretty cautious and I think they're going to remain that way, and that brings with it a market discipline that I think will remain and that brings with it an opportunity in the right type of asset allocation.

Greg Campion: Yeah. Okay. Well, I'm tempted to leave it there. Let me just ask you before we finish up, any key parting messages that you would want to extend to our listeners? Let's assume they're managing a fixed income allocation or considering it, anything you would want to leave them with today?

Martin Horne: Well, I'm in the fortunate position doing the job I do to have a lens onto a lot of what companies look like today, and it looks okay to me. It doesn't look great. The headlines are what they are. There is a softness to earnings generally speaking, but actually balance sheets will hold up and that makes the need to allocate now and not sit on your hands actually quite pressing in my mind. Because these markets could become technically positive quite quickly and a lot of the returns that are available might be missed if investors wait too long. I think you can have confidence in spite of all the headlines you can have confidence on what the world looks like. There is a took quarter yield opportunity everywhere. And now's the time that investors will really benefit from putting their foot forward and making that allocation decision in a way that's really going to serve them well over the next two or three years.

Greg Campion: All right, folks. You heard it here. If you turn on CNBC or CNN or any of the major news networks, you may get a negative story. But if you tune into Streaming Income with Martin Horne you're getting some reasons for optimism, so that is good to hear.

Martin Horne: Sunnysider.

Greg Campion: There you go. Martin, this is a pleasure as always. Thank you for your time. I appreciate it.

Martin Horne: Nice to see you.

Greg Campion: Thanks for listening or watching this episode of Streaming Income. If you'd like to stay up to date on our latest thoughts on asset classes ranging from high yield and private credit to real estate debt and equity, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, and more. And if you have specific feedback, you can email us at podcast @ barings. com. That's podcast @ B- A- R- I- N- G- S. com. Thanks again for listening and see you next time.