Today's Risks Not Lost on the Bond Markets

Steve Walsh: You're welcome, Eric. Happy to be here.

Jacobson: We're really glad to have you. So, one of the things that I just wanted to start off by asking you is, there are so many things going on, on the world stage especially, where do you perceive some of the greatest areas of risk for bond investors right now?

Walsh: I think the two big macro factors that seem to be really having investors so anxious are, first of all, Europe, and that's been front and centre for quite some time. And secondly, and this has certainly been picking up over the course of the last 45 days, the real question is about the state of global growth across the world, not just the sustainability of the US, which the data has turned down certainly recently, but also what's going on in China. We've certainly seen a marked downturn in their economic data over the course of last couple of months.

So the combination of this big European issue that I think investors have really a tough time getting their arms around, and then on top of it having questions about, oh my gosh, we might be heading into a period of much, much slower growth. Those are the macro issues that I think have investors pretty worried today.

A third kind of satellite out there might be politics, just that general issue, given both the transition of power in China as well as our own election coming up this November, and obviously in the last 45 days, politics was a big issue, given the votes in Greece and even in France.

Jacobson: So, slowing global growth being a worry, I take it, then, that inflation is less on your mind now than it might have otherwise been?

Walsh: Yes, it is. For the foreseeable future, we see pretty benign inflation. You can't help think about it a little bit, just given the extraordinary nature of monetary policy. I mean you've got the central banks around the world building up balance sheets at a rate that we have never seen historically. That could potentially be the kindling for inflation down the road if they don't remove that policy appropriately.

But I think we feel we're going to go through a period of fairly sub-trend growth across the developed world for the foreseeable future, which ought to mute general price level changes to something in that kind of 1% [range], maybe in a bad case, 3%.

Jacobson: What is that outlook translating to right now in the way that you're positioning portfolios?

Walsh: Given that you could argue [there is a] big amount of uncertainty, like what happens in Europe and where is the state of growth, that might have you say let's not take risk. That might have you say, you know what, maybe staying away from the riskier sides of fixed income might make sense.

But we think that's not lost on markets. We would actually argue that risk markets are fairly to cheaply priced today because they are aware of that uncertainty. You look at high-yield bonds today at spreads almost 700 over Treasuries or almost an 8% yield. We think that's factoring in a lot of bad or negative outcomes on both the growth and European scenario.

So, developed government bond markets we think are a little stretched. They reflect that anxiety because people want to hold on to something that may mature for them. On the other side of that, within the credit space, we do see in the spread markets some good opportunities in high yield and senior bank debt and emerging-market local currency.

Jacobson: So you mentioned riskier assets in general, and as you know, we've seen some really unusual activity over the last year or so, and what one manager referred to me as "liquidity storms," and this sort of risk-on and risk-off pattern that we've seen, what do you think accounts for that? Do you have a sense of what's driving it?

Walsh: It's been remarkable. Having had the good fortune of being in the business for almost 30 years, it's really been the last three that this concept of risk-on, risk-off, and it's a highly correlated market. When one risk category does poorly, they all do poorly; when one does well, they all do well. And government bonds are doing just the opposite. ... We've had periods like that before, like the Russia default or right around 9/11, or isolated periods when there was a heightened degree of focused uncertainty.

Well, we've been a number of years now with this sort of behaviour. I think it's a function of the ongoing deleveraging, a lot less risk capital in the marketplace today than there has been in prior periods, and as a result that kind of magnifies the movements of asset prices, because there is just a lot less liquidity.

I saw a statistic the other day that in general Wall Street firms are carrying one-fifth the secondary positions in corporate bonds than they did pre-crisis. That might be a measuring stick you could use to understand how much risk is being taken, how willing they are to hold secondary paper. I think it tells you they're one-fifth as likely to want to take risk today as a collective body than they were pre-crisis, and that gives you a lot less liquid conditions and has created this heightened volatility in markets.

Jacobson: Do you think that there is a chance that we could return to some sort of normalcy away from this kind of risk-on, risk-off environment, or do you think it's here to stay?

Walsh: I think it's going to be here more than just for a while. Is it a permanent fixture within the markets? It might be a little bit early to tell, but there should be no uncertainty or ambiguity that the cumulative effects of the Basel rules, the Dodd-Frank rules, and the Volcker rules in specific that address proprietary trading within the over-the-counter markets are absolutely having a dampening effect on volatility. It is pouring syrup over the system, and it just slows it down.

So, you tell me, do we have ... this come to the US--are we going to back away massively from regulatory overreach? Doesn't seem like it, right. Obviously the elections this fall could change that. So, it's a little bit early to say as to whether this is a permanent fixture in our markets, but I think it's going to be here for a while, and certainly having that less liquidity is something that investors need to take into account.

Jacobson: What does that mean for portfolio managers like yourselves that are building large multi-sector, if you will, portfolios?

Walsh: It's more expensive to asset allocate, whether its Western or PIMCO or Blackrock--you name the big firm that wants to move from one sector to another; it is harder to do that. It takes longer to do that; and it's more expensive to do that. And that's certainly one of the tools that an active fixed-income manager uses to add value is asset allocate. I'm going to get out of mortgages and go into corporate credit, whatever the allocation may be. It's more expensive to do that.

But I do think there is a long-run benefit to investors, because at the end of the day, markets adapt. If you tell me the security is less liquid, what have investors demanded before this? Pay me more, give me more spread to own something that has less liquidity.

We're kind of in the transition stage where markets are repricing liquidity, and there's an element of uncertainty as to how permanent that might be, but at some point in time, markets will price in the reality of less liquidity, which means higher spreads, wider spreads, more yield to investors.

The road to get there is tough for performance. It might inhibit a little bit the asset allocation that's occurred in the past, but over longer periods of time, it actually might be a benefit to investors. Who it hurts are the issuers, because they've got to pay more to issue debt, and that has a dampening effect on economic activity. Liquidity, we called it in our letter to the regulators, is the oxygen of the capital markets. One of the great things the U.S. economy had for years was a very liquid capital market that allowed institutions, individuals to borrow at fairly inexpensive rates. We're going to go through a period of testing how much we're willing to have that so.

Jacobson: Great. Thank you so much for taking the time to be with us today.

Walsh: Appreciate it. You're very welcome, Eric.