Combatting Higher Rates & Inflation in Liquid Credit Portfolios

Martin Horne: I'm confident that this market will be volatile this year. I can tell you, myself and the team here are really excited by that opportunity because it's the best asset selection opportunity that we get. And if we do what we've done historically, and we stay focused on what's important, I think that there's a real opportunity in contrarian position, and across the board, I think active management, regardless of what asset class you're in, which geography you're in, has got to be the way to go right now because just taking big helicopter views on life really won't pay off. There are too many things that can go wrong with that sort of positioning.

Greg Campion: That was Martin Horne, Head of Public Fixed Income at Barings. And this is Streaming Income, a podcast from Barings. I'm your host, Greg Campion, and today we're talking about investing in liquid credit markets during periods of rising rates and high inflation. My guest today is Martin Horne, Barings' London- based head of public fixed income. In the conversation, we cover how today's environment for rates and inflation is similar and different from those that we've seen in past cycles. We also talk about how credit issuers are faring today from a fundamental standpoint, and we discuss strategies for managing a fixed income allocation through periods like the one we're in today, including the pros and cons of investing in floating- rate assets, short- duration strategies, and more flexible credit mandates. So with that, please enjoy this conversation with Martin Horne. All right. Martin Horne, thanks for joining me today.

Martin Horne: Absolute pleasure.

Greg Campion: Appreciate having you back on the show. Today I think is a very timely conversation. I think that there's a lot of talk in a lot of headlines today about concerns about rising rates and certainly concerns about inflation. Probably those are topping investors' worry list today for fixed income markets more than anything else. So you have obviously been through a few cycles in your career. And so it's-

Martin Horne: That's your way of saying I'm old crosstalk.

Greg Campion: So it's not the first rate rising cycle you've seen. It's not the first bout of inflation you've seen. So let's talk about that. I mean, I think that would be a good place to start maybe just to get high- level background on how you're thinking about this environment today.

Martin Horne: Yeah, sure. I mean, like so many situations we've seen over the past few years, there's some unique elements to what we're going to go through and what we're likely to see this year. There's some elements that I think you can point to history and say there's some historical context as well, and I think it's probably important to bear both in mind. One of the things that can get lost when you see markets exhibiting the volatility that we've seen in the early part of 2022 is that the economy is in relatively good shape in a lot of areas of the world. And you can lose that in the noise of financial market headlines. And generally speaking, I think one of the things that is consistent is when you get rising inflation, it's generally a relationship with an economy in reasonable shape. When you get expectations of increasing interest rates, they generally occur, historically, when the economy is in reasonable shape to absorb those sorts of rate rises. And that's where I can see some consistency and should give people some comfort. On the other hand, though, and remember my background is credit, so I always like to bring the lights and the dark in some disproportional measure, is that the causes of this inflation feel very different to me. If we think about two or three of the main headlines, you've got energy. Obviously, there's a structural issue with energy in the world that has caused the energy pricing to rise as quickly as they have. Arguably, we've moved too quickly into transcending to other forms of energy without having appropriate storage or capacity to allow this seamless transition that the world is trying to make. We've had supply side disruption since World War II. We've never had such a large scale industrial shutdown as we experienced during COVID. Whilst we are opening up, COVID isn't solved everywhere, and a lot of what we buy as consumers in the west is made elsewhere in the world where supply side disruption is an ongoing feature and likely to be an ongoing feature in 2022. And then we've got a people deficit that's creating wage inflation and the cause of this haven't really been nailed down. There's speculation around the impact of government subsidizing workers, not to be in the active workforce. Some of that has largely fallen away in certain jurisdictions, and you're still seeing record numbers of vacancies in the US and in the UK, for example, that created a deficit that should be filled over time. But nonetheless, it's created this wage level of inflation, which is feeding into companies' numbers now. The other thing that I'd say is relatively consistent is, and probably more positive than we've seen, historically, is a lot of consumers have an ability to absorb in the near term, this inflation. And I'm going to caveat what I've just said. There's certain sections of society that have saved money during the pandemic. Some of them have made reasonable returns on personal investments. And for things like the legislature, when opening up fully is achieved, you are still going to see a bump in demand and consumers wanting to get out there and consume, in some way, recognizable to their historical fashion and trends. I think the areas of the world and the sections of society we need to be most conscious of, though, are those least able to absorb these price rises because they will have to change consumption patterns. So companies that are relying on low- income sections of society, geographies that have less government subsidization to help consumers get through, particularly food and fuel inflation, those are the areas that we should be very, very selective about what we're going to do and what we're not going to do. And then the final nugget I'd throw to you is the concerns of the market were not necessarily baked around inflation, but they were baked around central banks' reactions to inflation. And where we really saw curves start to move up and equity markets start to sell off was this realization that actually base rates may be moving, and they may be moving faster than perhaps we assumed in large parts of 2021. Now there is a question mark as to whether or not base- rate movements actually control things like the deficit of people that I've just described. Do they control the supply side disruption of an ongoing COVID pandemic in parts of the world? Do they control structural deficits in the energy market? I mean, you can make an argument, actually, they may be somewhat inadequate. And that means that as a world, we are exposed to policy mistakes at this point. And I think one firm prediction that I think most people would be willing to stand behind is, as a result, 2022 is likely to be characterized by lots and lots of volatility as markets react either positively or negatively to new data points that give them either comfort or a level of discomfort that the policy being enacted is having a positive or negative effect.

Greg Campion: Okay. Okay. So we've got a pretty complicated and nuanced picture, I would say, that you just painted. So on the one hand, if you're seeing rising rates, even if you're seeing inflation, maybe that's endemic of the economy performing pretty well, but you have all these other structural factors to consider, including some of the workforce dynamics that you mentioned, some of the dynamics around energy that you mentioned, and then of course, the impact that central banks are playing in all of this and people try to predict central banks' next move. So a very complicated picture, certainly complicated to figure out, I would imagine, as a fixed income investor. So if you think about how markets have reacted to all this so far, right? So we've seen the 10- year shoot- up to two percent- ish range. We've seen some pressure in different areas of bond markets. I guess one question I would have for you is how much of this concern around rates and inflation and some of these factors that you mentioned, how much do you think is already priced in now at current valuations, given some of the moves that we've seen?

Martin Horne: That's a really difficult question to answer. I can give you a fundamental picture, which says, actually, in some areas it looks like quite a lot, but it doesn't mean that the volatility that's incumbent in markets at the moment won't create an even higher price point. And that's what I think we've got to bear in mind. If you look at where 10 years are right now, it's not that far off from where we were in 2019. So there's a context for you. If we're opening up and the core level of consumers in certain geographies are in good shape, then actually it doesn't look that aggressive if I forget about the two years in between. But then you see that just the aggressive nature of the moves, and equally, one of the factors we didn't mention in the last answer was we're coming out of a global zero base rate environment, which is very, very different from some other points of inflationary pressures we've seen, historically. And that means the moves upwards have tended to be exacerbated. I read a stat just last week saying in the month of January, 70% of the negative yielding debt on the planet disappeared between December and January with the yield moves that we saw. That's an incredible stat in terms of the trillions of dollars that are involved in those types of statistics. So we-

Greg Campion: Sorry, what do you mean that it disappeared? You mean it went from negative to positive?

Martin Horne: It from negative to positive yielding.

Greg Campion: Okay, okay, okay. Yeah, yeah, yeah.

Martin Horne: Because the curve moves in the price action as a result of that. So you're seeing some excessive moves. If you look at what those curves look like right now, the market is basically pricing in the short term some fairly aggressive base rate moves. I mean, I'll focus most of the comments on the US because it's most talked about. But it's anywhere between five and seven, depending on who you speak to. No one realistically thought the ECB was going to be raising rates in 2022. And yet there's been some commentary that suggests that's a possibility, and that's sent bonds into positive territory for the first time in a long, long while. So short term, people are expecting rate moves. The market is then flattening out relatively quickly. So I just looked on the screen, and you've got two years at 133, five years at 178, and 10 years at 192. So really, the market is saying to you, " The Fed is going to come in, or the central bank is going to come in. They're going to deal with this inflation, and then we're going to move to a de- inflationary environment where it's all low growth and it's back to where we were and talking about all the things that we were talking about back in 2019." That seems to be an interpretation. And with that excessive moves, there are points that definitely seem to be paying you too much. I looked at the high- yield universe today and single- B spreads were up above five percent. In old- school terms, when you're getting five percent risk premium, it implies default levels in line with what we saw post Lehman's. And yet the credit environment is nowhere close to that, and I'd be happy to expand on that statement. So I think there are definitely points that are paying you for the fundamental risk that you are taking. Is there technical risk that actually there could be a wider price point down the line? Yes, there are, and there's technical risks as ever that the market is pricing in events that are subsequently proved to be incorrect as they did, mostly through 2021, when curves stayed very, very low and embedded from a historical context, even though inflation numbers were telling you, actually, there's more going on in the world and maybe the markets should have paid more attention to that.

Greg Campion: Yeah, yeah. Okay. Let's come back to that point on high- yield bonds because that's really interesting. But maybe before we do that, just to finish up on the inflation conversation, I feel like there can be a tendency to get a little too focused... market observers to get a little too focused on prices on a screen and thinking about what higher rates are going to do to prices on a screen without necessarily thinking through the impact on the fundamentals of the actual credit issuers, right? So let's just talk a little bit about that because I want to make sure, given that your team, and really all the teams at Barings, are so focused on doing fundamental analysis, what are you seeing as you look at the credit issuers, whether it's in high yield or even investment grade issuers in terms of their ability or their financial flexibility to be able to weather higher inflation and higher rates?

Martin Horne: Yeah. When you take a big step back, and the team here has run some research that compared the state of the high- yield market to other periods where we've gone into a tightening environment, and those periods were 2004, 2013, 2015, Q4 of '17 and Q4 of'21. And in every occasion, currently, the high- yield market has got a lower leverage in a much higher liquidity position than it had previously. Now, just to give you that dark and light moment again, we've never had the potential for a tightening of this magnitude. So I believe that the health of the consumer balance sheet is good enough to absorb even extended periods of inflationary conditions. I think just as importantly, you've got to consider the health of the consumer, because ultimately all things land on the consumers and they dictate which direction our economy is going. And I think in many, many jurisdictions, the consumer is in pretty good shape to absorb it. And we've seen the evidence of this through the company's data that we're getting through our business at the moment. Generally speaking, businesses are able to pass on prices, and generally speaking, demand has not been adversely affected. It's early in the inflation cycle. And again, this is why I would delineate between what type of consumer you're looking at and which jurisdiction you're looking at them in. Some consumers, when energy prices start hitting them in the backend of Q1, are likely to feel the pain, and that's likely to change their ability to consume. And that's an issue for some companies. So we've got to keep an eye on it and not be too complacent about the ongoing impact of all of this. But in terms of liquidity, and gearing companies are well able to absorb it, the other impact that you may not have considered is over the last year, in particular 2021, and to a certain extent, at the back of 2020, there was a massive level of new issuance as companies realized that they were clear that they had to raise capital to give them a buffer to get over the pandemic, which had an undefinable end date. So they built out these capital reserves, and now we seem to be getting to a vaccine- led, Omicron- led solution to the pandemic. And in some cases, they built up excessive reserves and that is now, unintentionally but positively providing them with a buffer to get over the inflationary environment they may find themselves in and absorb some of the margin hit that some of them may be able to get to. And equally as unintentional, some of that refinancing activity has pushed out their maturity wall. So actually, there isn't that cliff edge moment where all of a sudden all these companies are going to have to come to us and ask for refinancing and extensions at very high leverage levels because they're getting hit by inflation. They have, to a large extent, got a runway to see them through these inflationary conditions. So again, it's not in my nature to be overly positive, but I think it's as good a profile as you could ask for, given the extent and size of the technical challenges that we are going to be faced with as we transition away from a zero base rate environment to a positive rates environment. And as we transition, I think hopefully to seeing central banks unwind some of the build- up of assets they've had on their balance sheet.

Greg Campion: So it seems, again, like a pretty complicated and nuanced picture, both with positives and negatives. So I take your point fully that starting at a level of rates that you could see a magnitude of rate hikes that we haven't seen before in those previous cycles, but the other side of that coin is starting from an optically better place when it comes to leverage and liquidity. So a mixed picture. So, okay. So thinking from the perspective of our clients as they think about, " Okay, how do I manage my own fixed income allocation?" in this environment that's just been described so eloquently by you, Martin. How do they do that? I mean, what are their options here in terms of approaching the next couple of years from a fixed income perspective?

Martin Horne: Well, they've got a lot of tools to choose between, and really if I'm ever looking at a client in the eyes, to answer that question, I'm asking a lot more questions of them before you answer it because it really depends on what the rest of their book looks like and what they're trying to achieve from the exercise and what their overall investment objectives are. But for example, the tools available and the obvious ones are you go first rate variable rate products to an inflation link products, tips, floating rate loans, corporate loans, you can go publics or privates on that front, less well known is the structure credit market, the CLO liabilities, which can range from investment grades, pretty high yielding investment grades relative to anything else you can buy, all the way down to the sub investment grade, double- B tranches, which again tend to be a lot more high yielding, but can suffer spikes of volatility during market excitement. So there's lots of options around pure floating rate. Equally, they could go for a duration controlled strategy. Most of our clients will be familiar with short duration strategies of various types, and they run through all sorts of different jurisdictions, be they EM or DM, with different collateral mixes involved. There's obviously hedging options that you can overlay into those duration strategies that give you some comfort that if there's excitement that you weren't expecting, that that volatility context will be dampened. Then you can look at just plain shorter duration assets, not variable rate, but fixed, still high income levels. You can take advantage of the recent market sell- off, and there I'm thinking about just pure high- yield bonds. Most people shy away from fixed- rate instruments in this type of environment. But actually, if the context is they're paying you handsomely because of the volatility and the duration profile is only three to four, you can pick a relatively short maturity portfolio and clip the high income and the secondary market opportunities, and really high yield doesn't suffer the sort of volatility you tend to see from much longer dated investment grade corporate debt because of the short nature of that marketplace. So it's an option to think about for investors, particularly if you believe that we'll return to a relatively healthy economy with a spread tightening environment. And then the final one, which is the one I always advocate because we just had a discussion where we've pointed out dark and light, dark and light, and equally, depending on if you walk in the room, very clever people will believe in either side of that argument, is to give yourself mandates and strategies with managers that can manage for you as they see the market developing, as they see the opportunity set develop. Really flexible credit mandates that allow you to dial in and dial out of opportunity sets in a really fast growing environment, I think, is the way that really big institutional clients, certainly, and some wealth clients as well should be thinking about getting more consistent returns and not having to constantly reallocate and lose bid offers between different asset choices, give themselves the flexibility of making those mandates open ended so if there's something better they can do with their money, they can take it out and go and do something else. So these are the options that are available to you, and it's not that one is intrinsically better than the other in all cases. It really depends on what the investors are trying to choose from. But I would suggest that they should be thinking actively about this if they're concerned about some of the market you metrics we've discussed.

Greg Campion: Mm- hmm( affirmative). Yeah. Thank you. That's a great overview of some of the ways to approach this market. One question I want to ask you, it's a followup and it's almost maybe like a real- time example. So you're talking about these more flexible credit mandates. And so looking at what's going on in the market at this very moment, you've seen a lot of concern about rates. You've seen a lot of concern about inflation. Maybe as a result of that, you've seen an out- performance, as I guess you might expect, of floating rate assets, specifically loans, right? And so it seems like there's probably a lot of good reasons for that. I think people recognize the senior secured nature of loans and, of course. floating rate. And an interesting point around that is a lot of the loans, and you tell me if I'm describing this right or not, I may not be, but a lot of loans, given LIBOR floors, or I guess SOFR floors going forward, given the floors, they have not really fully benefited from their floating rate nature in recent years. And maybe that is about to change where you're actually truly going to see the benefit of floating rate. So long story short, you've seen a rotation into that, but I think maybe what you're saying is with these types of flexible mandates, you can look at something like that and then compare it to... Let's give high- yield bonds as an example where you mention maybe if you're looking at single- B or double- B rated high- yield bonds, actually, maybe they've been the victim of this rotation and maybe now they offer more value than you might expect. Is that how you and the team are thinking about it?

Martin Horne: Yeah. Look, our philosophy around investing in credit has always been that there's a reward for being divergent to the market, generally speaking, if you invest in analytical capability and pick your spots. And the basic philosophy is founded by the fact that we are not subscribers, that markets are these all- seeing, all- knowing entity. Markets almost always overreact in severe movements like we have seen. And that's because of the uncertainty premium that market pricing seems to demand, and if you can pick just underlying good companies and good asset pools, the beauty of credit is you have a maturity war. So regardless of what is going on in the market, sooner or later, that company will have to repay you. And certainly, if you take secured positions that a lot of the developed market provides you with, if that company doesn't pay you, you end up owning the company, which isn't a bad downside if you've hit the wrong end of a cycle point. So I think there is moments where asset selectors should really, really shine, to answer your question, and there will be points in the bond market right now that we think intrinsically are offering you excessive value because markets are inefficient and there's lots of investors out there that have their allocation decisions based on technicals, not fundamentals. If you're a fundamental buyer when technical selling is going on, you generally pick up a much, much bigger premium, and generally you will outperform your benchmarks. And that's our historical experience for years and years and years. So I'm confident that this market will be volatile this year. I can tell you, myself and the team here are really excited by that opportunity because it's the best asset selection opportunity that we get. If we do what we've done historically and we stay focused on what's important, I think that there's a real opportunity in contrarian positions. So dialing into some fixed rate instruments that have clearly been beaten up too much, given what the company's doing, the likelihood of refinancing action, the likelihood of M& A action, and all the other things that can play into those decisions, that's where I think active managers are the way to go. And across the board, I think active management, regardless of what asset class you're in, which geography you're in, has got to be the way to go right now because just taking big helicopter views on life really won't pay off. There are too many things that can go wrong with that sort of positioning.

Greg Campion: Yeah. Thank you for context, Martin. I think that's really important. It's interesting for me to think about these periods of volatility and how they can ultimately be opportunities to generate alpha, and I know that that's something that your team has really focused on quite successfully over the years, is really generating alpha during these periods where markets are in transition or extreme periods of volatility and that sort of stuff. So last question for you, I just wanted to ask you to put yourself in the shoes of our clients and to think about the next, let's say, 12 to 24 months, and to think about, again, managing their fixed income allocation through a period where, as you say, you're expecting volatility. So tell me, what would you be keeping an eye on or what would you be watching if you were in their shoes?

Martin Horne: Well, I think the main thing that's going to keep the market focused is policy mistake and new data points because, once again, and I think we're all tired of saying this, this is uncharted territory, given the size of the potential tapering and given the nature of the inflationary conditions that we're facing down, and given the fact that for the globe and with the DM lens, we have to remind ourselves of this. We are not out of the pandemic yet. The globe is not. There's lots of regions in the DM where it feels very much like from our daily lives that we're back, but unfortunately, the globe and trade in the globe is inextricably linked, and we need to keep an eye on that. So it's going to be central bank behavior, the impact on inflation, the impact of the ongoing pandemic, any other geopolitical events that's going to upset us from time to time. But those generally are short- lived bouts of volatility. I think that the first three of those are the ones to keep an eye on, central banks, COVID, and inflation. That's really, for me, what's going to be important to us. And that volatility context will provide an opportunity if we do our job properly.

Greg Campion: Yeah. That makes a lot of sense. All right, Martin. Well, thank you so much. You have, I think, done a great job shedding some light and maybe some dark, too, on what we can expect over the next year or two, and giving us a great idea of what you're looking at. So thank you as always for joining. Let's connect again soon, but really appreciate your time.

Martin Horne: It's a pleasure.

Greg Campion: Thanks for listening to episode number three of season six 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 and emerging markets, please make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcast, Spotify, Google Podcast, and more. We publish a new episode every other week. And if you have specific feedback, you can email us at podcast @ barings. com. That's podcast at B- A- R- I- N- G- S. com. Thanks again for listening and see you next time.