Putting Today's Fixed Income Markets in Context

Greg Campion: Investors are being barraged at the moment with headlines and sound bites about when the next recession may hit. And while there are certainly risks on the horizon and weak spots in the economy, it may make sense for investors to step back and consider today's fixed income markets through a broader lens.

Martin Horne: It's an orderly earnings decline. It doesn't have the sort of panicked feel to it that many of those big blowup events have. And as a result, I think the outcomes will be much, much better than perhaps the market was predicting.

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. Coming up on today's show, putting today's fixed income markets in perspective. All right, Martin Horne, welcome to the podcast.

Martin Horne: Pleasure to be here.

Greg Campion: I'm excited to have you back here. There's so much to talk about in the world of public fixed income. So I want to dive right in and maybe we can start high level just kind of at the macro level. We see and hear lots of headlines and lots of interpretations about what is going on in the economy right now. Are we heading into a recession? Are we not heading into a recession? A lot of the data that we see are often conflicting. Now you've got a real unique position in that you oversee Barings public fixed income businesses with over 70 investment analysts covering different companies ranging from high yield to investment grade developed market to emerging market. So you're actually seeing what's happening on the ground or what we're hearing from a lot of these companies directly. So with that context and perspective, let me ask you, what are you actually seeing when it comes to corporate fundamentals today, kind of from the bottom up?

Martin Horne: Yeah, I guess it's one of the interesting parts of the job is the lens you get on the data that maybe the public markets don't see. And the access to management is always kind of engaging. The numbers that we're seeing pretty much reflect the public numbers that everyone is seeing. They're a mixed bag. There's some companies that have dealt with inflation relatively well. There's some companies that are exceeding expectations because they've hold onto their pricing power for longer, even though some of the inflationary pressures have dropped away. It's not so much about today's numbers though, it's about what management are doing about it and how you can interpret the relative outcomes. Because I think in my career, this is probably the longest predicted recession or pathway to recession that we've ever known. We started talking about the economy inflationary pressures in Q4 2021, and then that obviously exacerbated with the Russian invasion in Q1 22. And then you know what happened for the rest of 22. It was all about kind of central banks. Got into the winter potentially discontent where actually sentiment was as low as I've ever known it in terms of people predicting bearish outcomes. And we've been through that and actually the outcomes were better than expected. Companies dealt with inflationary pressures. The consumer kept spending, the winter wasn't as harsh in Europe as people expected, there weren't big power outages, production disruption and all of that good stuff. And now we find ourselves where we are today. So what do I take away from it? The one thing is I know what it's not and it doesn't look like a Lehman's type economic contraction. The reason I make that contrast is that people forget that when you're in 2008 and on the run- up to the Lehman's event in September of that year, actually, when you went around and spoke to most management teams up to about halfway through 2008 and you'd say, what are your forecasts for 2008? They were a bit down, but they essentially think that 2009 was going to be a rebound to 2007s level. 2007 was a bull market year, and as a result, their balance sheets were totally still geared up for growth. They were still spending on CapEx. Their cash flows weren't as thick as they could have been. They were building up inventories like growth was coming. They hadn't dealt with any of the headcount issues. They haven't dealt with any of reduction in marketing spend. They hadn't dealt with any reduction in general overheads. And so when the big event happened, the big blowout happened, what happened was much, much more exacerbated from a corporate earnings perspective because everyone all of a sudden stopped trading with everyone else. And the reason you did that is you'd spent a lot of money on CapEx. You had a lot of inventory that you then were worried you weren't going to sell. You had a lot of raw materials, you were worried you weren't going to be using. And so there was this almost a corporate freeze and you had the big, big, big earnings crash. The context of where we are today is because we've been talking about this thing for so long. Pretty much every company that reports tells you about what they're doing about their cost base, their inventory levels are being managed on a thin basis. They are gearing their cash up and trying to de- lever the business because they know when they refinance it's going to be a lot more expensive. And so there is this long lead time in a way, has meant that we're, whilst we might be moving to I think almost certainly an earnings decline, it's an orderly earnings decline. It doesn't have the sort of panicked feel to it that many of those big blowup events have. And as a result, I think the outcomes will be much, much better than perhaps the market was predicting. Certainly what the market was predicting when we went back to October and we had the LDI blow up and we were just moving into winter time and inflation was still on an upward moving trajectory. I'm realistic about the future. I think earnings will continue to decline to a certain extent. That's what central banks need to see happen. They never say it that way, but they need the heat to be taken out of the economy, but actually balance sheets and consumers are in much better place than they have been in some other big events. And we should not forget that the big anomaly about this particular situation is that in a lot of jurisdictions, employment is still near full, natural employment in the US, in the UK where economic situations are constraining. Actually most people who want a job can get a job. Even with the cuts that you're starting to see through some of the white collar industries, employment isn't the issue. And while the consumer is employed, they're likely to keep a level of underpinning demand on a lot of industries that mean that the bottom won't be as bad as perhaps it could be.

Greg Campion: Yeah. Labor market and the consumer is still in relatively decent position. And I don't know, Martin, you're bringing up some traumatic memories for me as a former Lehman employee, that was a tough thing to go through, but it actually is a really nice transition because I wanted to ask you, obviously we've seen some real volatility in the financial space this year. Obviously we've seen the high profile bankruptcies of Silicon Valley Bank and Signature Bank in the US and this kind of forced marriage between UBS and CS on your side of the pond. As you look at fixed income markets, broadly, how all of this kind of action in the financial sector is impacting your view when it comes to restricted credit availability or any other kind of knock on impacts?

Martin Horne: Yeah, I think, look, again, I always try and remind myself when you're in the middle of an event of what history tells you, not that history is a great reflection of current market because actually everything moves on, everything evolves and that every situation is different. And here we are in another unique situation, but it is worth kind of reminding ourselves that after Lehman's between 2008 and 2012, you had more than 90 banks a year go under. And so the market right now is kind of reflecting that we've been through the credits, the SVB blow up, very different situations for different reasons, different structural issues going on there. What they weren't in either case really was a bank that had a capitalization problem in the sense that they had a big bunch of defaulted assets that were going to kind of blow the lights out on any sort of safety cushion you had. Credit Swiss was just a materially underperforming bank for a long, long time. And then when sentiment moved against that bank, what you tend to find is that banks nowadays in this era of apps and Twitter are much, much more vulnerable to a deposit run than they used to be. You can do everything electronically. Back in the Lehman's day, I remember Northern Rock, which was one of the UK banks building societies went under. People were pictured queuing up to get their deposits out. And obviously right now all it takes is a tweet and an app and you can move money really, really quickly between financial institutions, which means at a certain level it's a headline risk, banks are vulnerable. Credits risks, that just the sheer volume of headlines proved too much for it in the end and the kind of mismanagement issues it had. SVB obviously had a asset liability mismatch when it had to go in and try and liquidate assets to meet inaudible. It really struggled and its unique kind of sort of client positioning was an issue as well. And at the time of this recording, we got First Republic, which is under the lens as well.

Greg Campion: Sure.

Martin Horne: Because it produced its numbers last night and people have seen just how significant that deposit withdrawal was. So these are different forms of bank risk, but when you put it in the context of 2008, first of all, banks are far, far better catalyzed. Yeah, there is scrutinies on asset pools like your commercial mortgage exposure in the US which are going to bring certain banks under more scrutiny than others. But actually we've seen far worse from the banking sector. Central banks and governments have shown a propensity to move in and provide confidence to the banking sector when it is required. And you saw that with the kind of Fed's very quick action when some of these headlines all of a sudden reveal themselves. So what's the kind of impact of all of this? It's certainly that banks will move with an element of more caution and that is likely to mean that lending conditions remain somewhat restricted from that market, from some of the enterprises that relied on bank financing specifically to capitalize themselves. That's not so important in the liquid markets where banks rarely underwrite over a longer period of time. Their whole mantra is to underwrite and sell down and then have the trading of the names go between different counterparties. It provides an opportunity for the private markets potentially because if banks take a step back, they can step into that gap and demand structural protections and income levels in excess and it probably puts the power in the hands of the lenders, not the borrowers. If you've got capital, you can deploy it with more security, with better power around structuring with better income potential. That really is the kind of sunny side look at all of this. I just mentioned that for our developed market high yield business, we have never been involved in banks and the kind of unique nature of the risks here are that you very rarely have complete transparency on what is on those balance sheets. So as a house we've always been somewhat cautious about the kind of exposure we take there, tends to orientate itself towards the bigger liquid opportunities in the investment grade arena and the EM arena. I don't necessarily think when you put this into a historical context, the banking situation is as big a game changer as certainly we saw in Lehman's and the sovereign debt crisis. I think those were much bigger issues. Doesn't mean there won't be headlines particularly probably the day after we send this recording out there, there'll be some big headlines, but I think you've got to put those headlines into context all the time of what we've seen before and what the magnitude of those risks really are.

Greg Campion: Yeah. Yeah. Now let's say we do head into an economic slowdown here, whether it's induced by banks pulling back on credit or some other factor. Are there sectors that look to you more vulnerable than others if we do see this kind of slow down scenario play out?

Martin Horne: Yeah, I think that, look, you probably put the vulnerability in two categories. One is the absolute default vulnerability and it's not that interesting for people to hear you say, look, all the cyclicals and consumer discretionaries are clearly in a weaker economic environment. Those would be the ones that you'd be focused on. What I would say though is you remember the historical context of where we are. We're in 2023. In 2020 we obviously had COVID, 21 we were still in lockdowns 22, we had inflationary markets and here we are in 23 and we're dealing with the long walk to a sort of economic contraction, stroke recession. That means that these businesses in cyclicals, there's neither been a significant amount of risk appetite around them and their ability to access excessive levels of debt has been somewhat curtailed by all the events that we've seen over the last four years. So whilst I wouldn't necessarily advocate dialing in insignificant form to cyclicals this side of really having visibility on the kind of depth of that economic contraction, I don't see a lot in, and I'm just going to talk to the high yield market for one second. I don't see a lot in the high yield market where those industries are full of very, very levered names. They'll be the odd faller there all is. The conservatism in placed on these companies has meant that they've had to live under a slightly more constricted environment. And the long walk into this sort of economic decline has meant that those businesses as well have been somewhat preserving cash, keeping inventory levels low, all the stuff that we talked about at the outset of this discussion. Those companies, they are well aware of their vulnerability to an economic downturn and they have been trying to manage around that. So I think, yeah, the obvious ones will suffer. Downgrades are probably a more realistic, a situation that they'll have to deal with. Where you care about downgrades most is probably an investment grade arena in terms of the asset price impact. But there's also some high yield names that the CLOs might start spitting out eventually. We'll see how kind of deep that goes. Again, at the moment, earnings have not looked horrendous. Sentiment tells me one thing, sentiment is still pretty negative. I saw a very negative survey coming out of US consumers today. But the reality, the fundamentals have held up much better and we will see how management teams continue to manage through this process to get them through the other side.

Greg Campion: Well they say stability breeds instability, but I think your point is basically that looking back over the last few years, it hasn't actually been a real environment of excess. Right. We've been dealing with the pandemic and inflation and everything else that you've mentioned. So perhaps some of those excesses have not built their way into the system. Even so though you're seeing some forecasts out there calling for some pretty material rises in defaults. So you look at some of the sell side forecasts out there calling for as high as 10% default rates in 2024. What do you make of that and do you think that there's any likelihood of that or do you think that looks way too negative?

Martin Horne: Well yeah, if you're at 10%, you're kind of at Lehman's. So from the discussion we just had, do I think a Lehman's economic contraction is on? I can't see any way that that can happen. They may be coming at it from the fact that they're looking at refinancing needs growing over time. And again, I would draw them back to 2020. One of the most bizarre times in all of our lives. I remember very clearly opening up my laptop on the first day of lockdown, not knowing if anything was going to work, but knowing I had to sound relatively confident that it would. And then we got into trying to forecast what happens to the levered corporate market and the unlevered corporate market or the lowly levered corporate market when essentially businesses are flat, they can't produce anything, they can't sell anything. We've never seen an industrial shutdown like it since World War II and thankfully none of us are old enough to kind of remember what that looked like. I remember distinctly the first brave analyst that came out with forecast basically said that defaults in 2020 would be somewhere between seven and a half and 25%. And whenever you see that sort of range on a forecast, you kind of know that is just guessing.

Greg Campion: Right.

Martin Horne: And to be fair, who could do anything else,

Greg Campion: Sure.

Martin Horne: But guests during that time? And the way it ended up in 2020 with loads and loads of companies effectively not being able to earn a dime was in most of the high yield categories, it was somewhere between three and 5% defaults. So does 10% with that context for next year seem realistic? No, that doesn't seem realistic at all. The market is somewhat pricing like we're going into a really big event and I suspect we're going into a heightened level of defaults, but 10% just sounds excessive. Debt markets find a way to make things work even when it looks really difficult. And we saw this through Lehman's and sovereign debt and we saw this through the commodity cycle. We saw this through Q4 2018 when there was a difficult moment. Essentially they looked to keep companies alive and earning because they know that they need to keep these companies in a state where they can continue to operate because that maximizes their value. And so when we look forward to refinancing risk next year or the year after, assuming that rates stay elevated as they were, I would imagine given that there's only so much cash a company can use to service debt, you're going to see some picks. You're going to see some creative equity options, you're going to see some refinancing fees, you're going to find that the debt market guys find a way to keep the company in a solvent position because it's in everyone's interest to do so and to take economics in a different way than the market is implying. And that's the experience from years and years of doing this and I can't see any reason why it wouldn't be in everyone's interest to make that happen again.

Greg Campion: Now you mentioned the pandemic period and obviously we saw quite a bit of rating agency action during that period. Obviously not wanting to get caught flatfooted and trying to get ahead of any deterioration in credit fundamentals. You would imagine the same thing would be happening here if we start to see more and more signs that we are in fact seeing an economy that is slowing. So what's your kind of level of concern around credit rating downgrades at this point? Do you expect that that may have a material impact on the overall picture for a high yield or not so much?

Martin Horne: Well, high yield and investment Greg, I wouldn't separate the two when it comes to downgrades because equally they can lead to asset price declines. I'd say to you that downgrades are bound to happen. Downgrades are bound to become elevated from where they are today. But let's put that in context. Our team, investment grade and high yield team get together on a quarterly basis and the last time they did this was at the end of the Q4 earning season. At that point, their view on upgrades rising stars versus downgrades fallen angels was the upgrades and the potential for upgrades in various companies outstrip downgrades by about one and a half times to one. There were substantially more companies that are likely to be put up into investment grade at that point than were going to get downgraded. Part of that is because obviously we had a fairly big downgrade profile coming into the COVID crisis and a lot of those companies have got through to the other side of that. You can see the likes of Rolls Royce and Heathrow and activity levels picking up. So there's certain industries that, and we got to kind of remind ourselves that we only came out of full lockdowns in 22 and it seems like a lifetime a ago, but it wasn't that far ago in our kind of lens. And we've only just had China come out for certain industries just this year. So when you think about the real impact of COVID and lockdowns, we're only going to get a clean year at the start of 24. So again, there is earnings upward revision coming from various global companies that is not quite in the numbers yet. Do I think that kind of sunny side up view holds? No, I suspect it will equalize and maybe even depending on the depth of what we're going to see, maybe move to the downside and be more downgrades than upgrades. That's kind of logical, isn't it? Do I think it's a really, really bad downgrade cycle in the context of what we saw in some of those more dramatic economic events? Doesn't look like it today and let's have a conversation in a quarter or two and maybe we'll revise that. But from what we can see today, it doesn't feel like that's the way that the market is going to go. And so again, this kind of all orientates itself to is the market pricing action, is it overreacting to the negative sentiment because we just don't know. That kind of is what normally happens and we just don't know, but we can draw some analytical conclusions from the context of everything and really drilling down into just how likely a very bad outcome is.

Greg Campion: Hard to say what the Fed and other central bankers kind of do from here. It probably is data dependent, to use the terminology that they usually use. But we do know that we've been in this rate hike cycle for a year now and one of the consequences of that is that cash has become a much more compelling place or a store of value, I should say for investors. And we've seen in really quite a long time now, obviously having been dealing with negative interest rate environments in different parts of the world, et cetera. This is a new factor or at least new in kind of recent years and as a result we've seen material flows into money market funds. So I'm curious, as you think about the different fixed income asset classes that you look after, whether it be high yield or IG or developed EM, et cetera, how are you thinking about the relative attractiveness of fixed income generally relative to cash?

Martin Horne: Well, relative to cash, I think everything is going to pay you more. That's a bit of a sweeping answer, but fixed income is about credit and credit has a maturity date of some worth. I think the vast majority of companies will be able to refinance themselves and from the pricing point we are today that it's going to round strict cash. Doesn't mean that volatility won't be an issue. We're going to see if there's a couple of banks that get themselves into an exciting position over the next few weeks, we're going to see some volatility that's for sure. Almost certainly need the equity markets to correct and they are doggedly sticking at the kind of ranges that we've seen from sort of February, March onwards. But there's lots of commentary that if you believe that there's an earnings erosion on the way that the P multiples don't look that exciting. 18, 19 times forwards is still kind of feels like high if you're going into a recession. But again, there's a huge bifurcation of views out there. So dragging myself relentlessly back to the point of the question, what do you think is attractive? The rather unflattering answer, it really depends on what you're trying to achieve. I'll tell you things that I think you are getting paid to do. You can take duration risk in things like corporate IG. I went around the Middle East to see some investors in January and I had a deck with me at the time that sort of showed them that if you looked at where the global ag is, which is a kind of seven year duration index, if you moved interest rates up on a seven- year basis 100 basis points or moved it down 100 basis points, you got four times the return from a downward movement in the 10 year, sorry in the seven year, then a 100 base points upward movement would negatively impact your asset pricing. So a four to one bet in terms of upside, downside from taking duration was the kind of headline that you were going around with. You look at it now and the 10 year is 10 basis points away from that 360 position that we saw back then. So I really don't think you're going to see a lot of negative movement from taking duration, and that means that if you want to go safe and you want to sort of play it in the upping quality, which most people are most financial new services, you get the managers rolling through and they say go up in quality, that's a very easy thing to do. If you don't want to take any duration, you go into CP because that's a very easy thing to do. I do think that there's better yields to be got based on my view that I think the market is kind of overreacting to a certain extent on the outcome we're likely to see. But obviously you've got to review that outcome. But I also think that you have so many options within fixed income. In IGs, you've got corps or sovereign developed market. If you want more juice, you go EM solves. You go to the privates IG market structured credit, infra securitized. High yield, you get under corporates and or solves you get in the privates area. Some of the EM areas structured credit. All of these options are available to you depending on what you're trying to achieve, more so than any time in the last 12 years, 10, 12 years that actually fixed income looks a better bet than equities right now, if that's the kind of classic portfolio decision that people are making. But it's way too simplistic to say one thing is good and everything else is bad because just the sheer weight of negative sentiment means that the markets are doing what markets always do and pricing very wide to what I think a realistic outcome is likely to show you.

Greg Campion: Now we've talked around this idea of whether or not we're heading into a recession. You've made it pretty clear that whether or not we are heading into a recession, your expectation is that it's certainly nothing on the scale of some of the worst ones that we've seen in our lifetimes. But let me ask you this, because you've been managing fixed income portfolios through a number of ups and downs in economic and business cycles. Is there one or two experiences that jump out at you from that hands- on experience that are kind of guiding you on how to steer the ship today?

Martin Horne: We've mentioned some of them. Markets always overreact to the upside and the downside. That's the kind of theme. Don't think that, I don't share in this kind of view that the market is an all seeing lens of purity in terms of pricing risk. I just think markets are imperfect at different times. You just kind of know when to take advantage of those imperfections. Investors find a way to make things work. Even in the darkest times of the COVID transition, we found a way to just sort of, okay, we think these are good companies. We don't think COVID lasts forever. We're going to bridge this. We're going to put capital in when where we wouldn't normally put capital in. But we can see that there's a kind of rational way to approach this that leaves companies solvent and maximizes returns. And I think that will happen again. You won't time it. Pitching high yield today with an investor that's uncertain about the outlook. I can make a very analytical case around that in terms of the premium to investment grade, how much defaults are getting priced in relative to things like Lehman's and sovereign debt and so forth. If you can make that case to investors in a clear, coherent way, you've got to encourage them to just kind of layer in. Maybe you don't get all in on the first month. Maybe you layer it in and a quarter later you layer it in and then you layer it in some more as the data makes you more assured about that decision. But if I think about the high yield market, for example, on a three- year maturity, average maturity kind of index, what you're getting paid today at yields of 8. 50 and plus just looks way, way more excessive than it should be. Average price in the market for sort of single Bs anywhere between 86 and 88 on a three- year maturity. That wouldn't normally happen. There's different points in that market that I would access, but I think some principles hold true and you've just got to kind of remind yourself of that sort of common sense approach. Not try and overthink it, know what you don't know, all of these kind of catchphrases that come to mind, but they serve you pretty well. Don't try and time it and markets are right now pricing in a very excessive way from anything we've seen in recent history.

Greg Campion: All right. Last question for you, and I may make you repeat yourself here. I'm not sure if I do. I apologize. But let's say you're an institutional investor or allocator responsible for managing a fixed income allocation today. You've got a multi- year horizon. What one move would you be making today to try to set yourself up for long- term success?

Martin Horne: Again, the problem is, is what are you trying to solve for? And I think what you've got is a myriad of options. So are you trying to solve for income? Well, frankly, income's everywhere. Income used to be the battle for most investors, I don't know, back in the kind of 2019. How do I make income? And you'd see people making more and more excessive bets just to get income through the door and deal with kind of long- term liability requirements. If you want safety, you've got options around either moving in secure debt or IG, depending on again, what the rest of your profile looks like. If you're worried about duration, you can do sort of commercial paper, sort of daily draws, structure credit or loans both in the public and private markets. All of these things are variable rate notes and don't give you kind of particular duration exposure. I think, as I said before, I don't think duration should be the battle you're trying to fight. I think any way you cut it, if the economy's going to weaken, then duration is probably last year's event, he says. We'll see. Next few months could make that look very foolish statement. And then geography, people want diversification. When uncertainties there, diversification is a strategy and we've been overweight some keystone markets that you're very familiar with and maybe taking off the generic US bet and diversifying that. I'm not saying the US market to me still looks like a very solid market, but I think you can diversify that by looking around. European equities, for example, have thoroughly outperformed their US counterparts so far this year. EM is obviously a very and allocated marketplace. And then obviously volatility and there's lower volatility asset classes, like the shorter data stuff, the variable rate stuff, the loans, the privates. Because if I went into a room with 12 investors, I'd probably get 16 views on what the outlook is going to be. And I think rather than go and dictate to investors, you should be thinking about X, you really got to ask a more kind of intelligent question. No offense, Greg, but it's about really what are you solving for? What's the weakness of your portfolio given your outlook?

Greg Campion: Yeah.

Martin Horne: Because I recognize that I've just given you a view today, but it is a view based on my kind of read of history and the analytics that we're seeing at the moment. But it could be wrong and we might have to sort of challenge ourselves as the year goes on as more data points roll through. And I think rather than going in dictating to investors, you give them a perspective, but then you say, but what are your concerns and what are you solving for? And they've got a myriad of options right now.

Greg Campion: Makes sense. It's, yeah, completely dependent on what you're trying to solve for, but you have very kindly just teed up probably my next five podcast episodes where some of the asset classes that you mentioned from structured credit to EM debt to IG and others, I'm sure we're going to be talking about quite a bit in the weeks and months to come. So there's a lot going on in all those spaces, opportunities and risks kind of across the board to be considered. But Martin, this has been great. Thank you so much for taking some time. It's great to get your perspective as always. Hopefully our listeners got as much value out of this as I did, but appreciate it and have a good rest of your day.

Martin Horne: No problem, Greg. See you soon.

Greg Campion: Thanks for listening to episode number six of season eight 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, make sure to follow us and leave a review on your favorite podcast platform. We're on Apple Podcasts, Spotify, YouTube, 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 @ B- A- R- I- N- G- S. com. Thanks again for listening and see you next time.