Balance in portfolios and the role of fixed income

Randall: Portfolio positioning has been being overweight duration, so we've taken more duration risk than our benchmarks, with the expectation of rates to fall. That's obviously worked out very well with the way the yield curve has moved.

Thomas: I'm Thomas O'Keefe.

Phil: I'm Phil Neuhart.

Thomas: And today we are joined by Randall Huss, a senior portfolio manager here on our fixed-income team. Thanks for being here.

Randall: Thanks for having me.

Thomas: Yeah, so Randall, speaking of fixed income, can we start with just what is a bond?

Randall: Yeah, so the best way to think about a bond is you are lending money to a company, entity or a sovereign nation. And on the other side of that, they're paying you back an interest rate payment. And then on top of that, at the end of the maturity date, they're giving your proceeds back of what you lended them.

Thomas: So what would the differences be between some of these different—we call them issuers—of specific bonds? What does it look like if you're, say, a government versus a corporation?

Randall: Yeah, so there's three broad types of IG fixed-income types of bonds.

Phil: What is IG?

Randall: IG is investment-grade. So the highest rated bonds by one of the rating entities.

Phil: So we contrast that with what's called high yield. So high-yield, lower-credit-quality investment grade is considered higher credit quality. Is that fair?

Randall: That's spot on.

Phil: Got it.

Randall: So the broad three categories are Treasuries, which are the US government. There are corporate bonds, which are issued by corporations. Basically any company within the S&P 500 is going to issue some type of corporate bond.

And then there's municipalities, which is like your state general obligation bonds or a water and sewer district issuing bonds on the behalf of the municipality.

Thomas: Yeah, so many of our clients have probably voted in their own districts on different bonds within their particular municipalities, right?

Randall: Yep, that's spot on.

Thomas: And these are to fund different projects or different initiatives, maybe some general funds that they might have.

Randall: Yep, and so when they're voting on that, the municipality then issues a bond and investors like myself will go out and buy the bonds and put them in client accounts.

Thomas: Great. Now you talked ratings a little bit. Let's get into that for a second. So ratings are basically a level of understanding credit quality, correct?

Randall: Yes—safety of your lending to that company. Investment grade, super safe. Not to say they don't ever default. That does happen from time to time. But the odds of a default are very low versus what Phil mentioned earlier of a high-yield bond or a distressed bond—definitely lots more yield there, but also a lot more risk that you're taking when buying those.

Phil: And your team, does it focus in the investment-grade space?

Randall: Yep. Solely the investment-grade space for our team, individual CUSIPs within portfolios, but as you know, Phil, the asset allocation team can allocate to high-yield funds.

Phil: Got you. So let's talk about—dig in just a little bit on the mechanics of a bond, right? We've all heard of bonds, but I think it's not commonly understood really how it works. Well, what are the mechanics of a bond investment?

Randall: Yeah, so when a corporation issues a bond, they decide what kind of tenure they want to issue, whether that's, you know, 3 years out the curve, 5 years, 10 years, 30 years, and then that's priced off of the Treasury curve, so what are Treasuries yielding today?

And then there's a spread component to that, so obviously with Treasuries being, you know, the safest type of bond investment, if you're buying a corporate bond you should be paid an additional yield for buying that. And basically they'll come to market, and the market will decide what price they're willing to pay to lend to that issuer.

Thomas: And this comes back to our ratings example that we had earlier. So if you have a higher rating from one of these agencies, then your spread is probably lower.

Randall: Yeah, exactly. That's spot on. So if you're a triple-A company, you might pay 10 basis points additional or 40 basis points additional, where if you're a lower investment-grade company, the yields on those bonds typically, I think, on average right now are 70 basis points higher than what you would get for the same maturity Treasury.

Phil: So that's credit risk, right? What about, something you will hear in financial press, duration risk? What is that? I think it's something that's misunderstood, and really how does that feed into fixed income investing?

Randall: Yeah, so there's two types of broad risk. One we just touched on credit risk. What's the credit worthiness of the company? And the other thing is duration risk, which impacts any bond you buy. The duration risk is telling you the sensitivity of that bond's price to the interest rate curve. So if you have a longer-duration bond, when rates move higher or lower that bond's going to be more sensitive to interest rate movements.

Thomas: And this is essentially—you've got cash flows that are further out into the future, and so it's more unknown what the environment is going to be then.

Randall: Correct.

Phil: Reinvestment risk, I assume, is part of that.

Randall: Yep, reinvestment risk. Obviously, there's different types of bonds, whether they're fixed so they pay a fixed coupon—and Treasuries, they issue zero-coupon bonds. So you're not getting interest payments over the course of the bond. You're buying it at a discount. It's maturing at par. But yes, reinvestment risk obviously plays into that as well.

Phil: And you're looking—so for a given client—you're looking at the yield of that bond, and what is that? The yield to maturity, yield to worst? How do you think about that? What is it?

Randall: Yeah, so every bond, say a company comes to market, they issue a bond at par. They're paying you X coupon. As soon as that bond starts trading, it's going to fluctuate with market moves, right? So if interest rates go up, if interest rates go down, you're no longer going to collect that original 5% purchase yield that you bought it at. It's going to fluctuate with the market.

So when we're buying bonds in the secondary, we're looking at yields. Does it trade where we think it should based off where it last traded, based off whatever is going on in the market?

Phil: Potential risks, I assume.

Randall: Potential risk. You know, does the company have earnings? Has the bond been downgraded or upgraded by a rating agency that could change how much yield or how much spread you're getting in the bond. So it fluctuates 24/7, every day.

Phil: So what is yield to maturity?

Randall: The yield to maturity is telling you your annualized return from when you buy the bond until it matures. So that's what you're guaranteed to earn over the life of the bond.

Phil: What are the components of that return? How does that work?

Randall: You're going to get that in coupon return, and you're going to get it in price return.

Phil: So you buy a bond. You buy it below par, right? In other words, at a discount.

Randall: Yep.

Phil: And it's going to mature at par. Let's say par is $100, right? So you buy it at $98. It matures at $100 so you get those $2, but you also are getting the coupon for however many years. Is that correct?

Randall: That's exactly correct.

Thomas: Yeah, this is great. Let's focus on this, Phil. I like where you're going in this example. Just to break it down even further, right, so Randall, if I hear you—if I buy a bond at $100 and say it has a 5% coupon, I'm going to earn—if I hold it the entire maturity, I know exactly, I can do the math. I know exactly what I'm going to receive because I'm going to receive that 5%, and it will mature at par.

But you mentioned premium and discounts—that I believe, and correct me if I'm wrong here, is if the interest rate goes down, my bond will actually be worth more because I still have my 5% coupon, so that would be trading at a premium, right?

Randall: Correct.

Thomas: But then that premium, let's say now it's at $105, then there is a time decay that will go down to par eventually, right? The bond will always go back to par eventually, correct?

Randall: It should always go to par unless there's a default, which hopefully doesn't happen.

Phil: Knock on wood, Randall.

Randall: Doesn't happen in our space, but, yeah, you're spot on. The coupons are part of your return component and then the price, whether it's pulling to par, amortizing down to par over time.

Thomas: How often does credit come into play, meaning how often are you seeing different bonds upgraded or downgraded?

Randall: All the time.

Thomas: All the time.

Randall: All the time.

Phil: So speaking of downgrades and upgrades, we hear about this phrase rating agencies. What is that, and how many are there? How does that work?

Randall: Yeah, so there's three main rating agencies, and they're looking through the financial statements, talking to investor relations at those companies and saying, "Based off the metrics of your company, what are your cash flows? What are your revenues? What are your margins? How much debt do you have on the books? How much cash do you have on the books?"

Obviously, all that changes over time. They're looking at their financials and deciding based off your financials and your peer universe, here's your rating for what you're doing. And then that kind of functions into how the bonds are priced, right? If it's a triple-A company or triple-B company, the rating agencies do have a factor in the price and the yield of the bond.

But that's not to say that the market doesn't front-run rating agencies. I mean, if we think a bond is going to be upgraded, we're going to be buyers of that before the rating agencies makes an adjustment. If we think a bond is going get downgraded, maybe that's something we don't want to own because spreads may widen out on that bond on an impact.

Thomas: So there's work that needs to be done on our end to almost get ahead of the rating agencies and understand the financials and know what that risk actually is.

Randall: Yeah, no, that's spot on. I mean, the rating agencies, I mean, you take it for a grain of salt. You want to see that they're rated, what the rating agencies are saying. We have access to all the rating agencies. We can read their reports. We can talk to their analysts, but it's just one factor in how we decide what we're going to invest in.

Phil: So Randall, why don't you tell us a little bit about the strategies you all employ within the fixed income investment grade market?

Randall: Yeah, so we have various strategies on the fixed income side, kind of differing by how much duration risk you're taking. So we have an ultra-short strategy—that's buying corporate bonds or all Treasury bonds, all with a maturity of less than 1 year.

We have short-term select, which goes out to 3 years. So our investment horizon is 0 to 3 years, which has been advantageous, you know, moving from that zero-to-one strategy to zero to three this year as rates have fallen.

And then we have longer-dated strategies that some of which fall within asset allocation like our intermediate gov credit strategy, which is government and corporate bonds. And then we have municipal strategies that are intermediate and elongated in nature.

Phil: So let's talk about municipals for a moment. You often hear that they're tax-advantaged. Why do folks say that and why do—especially high-income investors—why are they so interested in municipal bonds?

Randall: Yeah, the income you're earning there is tax-advantaged at the federal level for all municipals and then at the state level, depending on what state you live in and what states you're buying.

Phil: Right, so if you're a high-income earner, high tax bracket, those can really be advantageous.

Randall: Yeah, the best way to look at those is the tax-equivalent yield. And currently, the tax-equivalent yields are pretty robust across the municipal market.

Phil: Depending on what tax bracket an investor's in.

Randall: Exactly.

Phil: So those are your strategies. What about positioning? How are you thinking about the market in this moment?

Randall: Our broad portfolio positioning has been being overweight duration. So we've taken more duration risk than our benchmarks with the expectation of rates to fall. That's obviously worked out very well with the way the yield curve has moved.

But now we're getting tighter and tighter to the benchmark as far as where we were taking duration risk. You know, rates have fallen. It's not as attractive as it was 3 months ago, 6 months ago. So we don't want be taking as much duration risk because it's two-way risk now, right? So that's something we're being thoughtful of.

Thomas: And are all your strategies managed to a benchmark?

Randall: Yes. All of our strategies are managed to a benchmark, and that comes into play when we're building portfolios and how we're positioning portfolios—trying to beat our benchmarks.

Thomas: Got it. And when you are comparing the benchmark to what you're investing in, is that from a credit perspective? Is it from a duration perspective?

Randall: It's both credit perspective and duration perspective. But the interesting thing, and I don't think we've talked about this yet is, you know, the makeup of our benchmarks, right? If you're, you know, an equity manager managing to the S&P 500, there's 500 stocks in there that you can buy.

Phil: Right.

Randall: On our side and on the credit side at least, there's over 10,000 CUSIPs that live in our benchmark, right? So anything that we're buying is automatically an overweight because we're not going to buy one or two basis points of each position. Our clients would have 1,000 positions in there.

Phil: And CUSIPs is another word in stock language saying ticker. It's a bond issue. There's a lot of focus on corporations right now. You know, from your seat, when you look at things like spreads of investment grade, et cetera, how does corporate health look to you from a balance sheet perspective? Are you seeing a pretty healthy corporate environment?

Randall: Yeah, no, I think that's spot on. If you look at where spreads currently trade, they're at or near their historical tights. So the amount that you're being compensated to buy these corporate bonds is tight. That's because their balance sheets are in good shape. Their debt leverage is low. Their cash flows are good. Their margins are high.

So it definitely comes into play when we're thinking about, say, an intermediate gov credit mandate. Do we want to be buying corporates, or do we want to be buying Treasuries? You know, do I want to buy a 10-year corporate bond right now that is trading tight relative to its historical standpoint, or do I want to buy a Treasury and know I don't have to worry about credit risk and portfolios.

Thomas: Hey, let's break down spreads because you've been mentioning this a few times and I just want to make sure I understand. So when there is a higher spread, the difference between the rate that is being offered or the rate that you're getting on a particular issue is much larger than a Treasury yield or rate, which would, to me, signify there's more risk. Is that right? There's more risk and more opportunity, correct?

Randall: Broadly, that is correct. Yeah, so if you look at a 10-year Treasury right now, it yields about 4.1%. If you look at a broad corporate index for a 10-year bond, you're looking at probably 480.

And obviously that 70 basis points of spreads is super tight. I think, on average, it's around 120 basis points. So if I'm buying a corporate bond on a historical metric, I would typically think I would get paid 120 basis points extra versus buying a Treasury where in the current market spreads are just trading tight.

Thomas: So as an investor, if I'm looking at risk, reward or opportunity costs of my investment options, if spreads are low—if somebody tells me spreads are low—I might say to myself, "I'm not willing to invest in the riskier asset because I'm not being compensated for that."

Randall: That is spot on.

Thomas: Got you. So Randall, it sounds like bonds can be very complicated, but also very simple if you just think about—it's a borrower and a lender, and you earn a return over a period of time and then get paid back.

You have to think about credit, you have to think about duration, these are all the risks that we think about, and the trade-offs that we take in investing in fixed income or bonds, right?

Randall: Yeah, no, that's exactly right.

Thomas: Good, well, this hopefully—for me it's been a fantastic conversation to learn more about this key component of our portfolios. We talk a lot about traditional asset classes, bonds, equities, how they fit together in a portfolio, so I've learned a lot here. I hope our audience has learned a lot in terms of how an actual bond works, how you and the team are managing risk as it pertains to duration and credit, how we think about building those portfolios, and then ultimately, how we're going to put those into a diversified portfolio. So appreciate you being here today.

Randall: Awesome. Appreciate you having me.

Phil: Thank you.

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