We sat down with Lead Portfolio Manager and Deputy Chief Investment Officer Michael Buchanan and Product Specialist Robert Abad to discuss the Western Asset Multi-Asset Credit (MAC) strategy. Since its inception in 2010, this unconstrained strategy has sought to maximize income and expected total return within a specified risk budget by providing diversified exposures to higher-yielding asset classes globally. Mike and Rob discuss the current market outlook, portfolio positioning and the investment opportunities in today’s market environment.
MB: We see three key risks in the market right now that are front and center on investors’ minds. First, there’s clearly a lot of market skittishness around the path of US interest rates, Federal Reserve (Fed) policy and the related strengthening of the US dollar. Our view on rates, as with other fixed-income sectors, is that they are ultimately determined by fundamentals. Both growth and inflation will dictate where rates end up and the pace at which we get there. On growth, we’re a little below consensus given our view of a 2% to 2.5% range. On inflation, we think it remains in check despite recent wage and Consumer Price Index (CPI) prints suggesting a pick-up in trend. We recognize all the elements that appear to be contributing to reflation risk, but we still see headwinds that remain, specifically elevated government debt loads, globalization and technology shifts.
Second is concern over market valuations. Whether you look at spreads or yields, the bottom line is that we’re either at or very near the tights in a lot of different asset classes even with this latest pullback. Our own pushback here at Western Asset is that we recognize and are fully aware of what valuations look like, but we always say that valuations are only half of the story; it’s really about how fundamentals intersect with those valuations. Our view is that valuations should be somewhat rich because fundamentals remain solid. This doesn’t necessarily mean there’s a table-pounding opportunity, but we do think the market seems fairly priced.
Third, there’s a perception that, at least when it comes to corporate credit, we’re late or very late in the credit cycle. In terms of time, we’re definitely in an overextended credit cycle just in terms of the number of months between peak defaults. But as we’ve argued in the past, credit cycles don’t die of old age; they die because there’s a buildup of risk. And not only does there need to be that buildup of risk, but there also needs to be some type of catalyst that turns that risk into fundamental deterioration. We’re not yet seeing a material buildup of risks and there’s probably a number of reasons why, but most notably we would just say that the severity of the 2008 crisis caused an overreaction. This doesn’t mean that we think the credit cycle’s dead, it simply means that in our view, it’s just going to take longer for those risks to develop.
MB: The last few months have certainly been challenging for global credit markets. While our exposures to high-yield, bank loans and structured credit have been positive contributors to portfolio performance (and collectively represent over 60% of our holdings), the combination of idiosyncratic risk in emerging markets (EM) and our duration strategy weighed on overall performance. EM currencies, in particular, were key detractors given the strengthening of the US dollar, but we don’t view the recent period of US dollar strength as the start of something permanent and we remain constructive on the fundamental stories behind our picks across select EM countries such as Mexico, Argentina, Russia and Indonesia.
If we step back for a moment and look at the bigger picture, EM is experiencing a healthy correction after a strong and sustained rally from the lows of early 2016. Today, we’re seeing the asset class buffeted by the trifecta of rising US interest rates, a strengthening US dollar and concerns over a possible global growth slowdown. We recognize that periods of sharp volatility in EM can test investor confidence and patience, but we believe rhetoric about an imminent EM crisis is overblown especially when comparing the stronger balance-of-payments position, improved policy and exchange rate flexibility, more subdued inflation profile and higher debt-servicing capacity of EM today with those of prior decades.
In terms of portfolio duration positioning, we’ve been tactically adjusting our long US duration bias with a focus on the intermediate part of the curve given our counter-consensus view of moderate US growth and inflation momentum as well as our view that expectations for Fed tightening are more than priced in. We’re also maintaining our short duration position in German bunds. While 1Q18 growth in the EU was softer than expected, we think growth over the coming months will revert back to previous above-trend levels.
MB: Since the inception of the MAC strategy, we’ve always emphasized two points: the need for diversified strategies so that no one strategy dominates portfolio returns and the importance of active sector rotation (i.e., emphasizing one sector while de-emphasizing another) to drive alpha in a diversified portfolio. This investment philosophy has served us well during both strong risk-on and risk-off markets.
For instance, high-yield represents an important income-generating sector for our portfolio. We’ve been cautious about the sector overall given its impressive run over the past two years. To date, we’ve been tactical in rotating across the various high-yield subsectors, such as energy and metals and mining, to find those industries and securities that we believe offer the best risk-reward payoff. However, given the strong returns in our energy exposure on the back of the rally in crude oil and industrial metals prices, we’ve been taking down this exposure and redeploying our high-yield proceeds into bank loans, which is a sector that has a more favorable risk-return profile, most notably in an environment of rising US rates.
In the investment-grade space, we’re focused on subsectors or industries that are not in a position to re-lever or where bondholders might be impacted by M&A and other shareholder-friendly activities. For example, we continue to like the energy sector and the metals and mining industries as they are still undergoing balance sheet repair and have benefited from the current rally in commodity prices. We also continue to like financials as we’ve moved past the period of stupendous fines, because regulations such as Dodd-Frank and the Basel accords will keep banks from re-levering, and as the rise in short-term rates should provide the cash flow many investors have been expecting.
Structured credit is another important part of our program and where we have been incrementally increasing our allocation over time. We continue to have a favorable view of valuations in credit risk transfer deals in the non-agency RMBS space and private lending opportunities in the CMBS space relative to fundamental and technical conditions. We believe these types of securities offer investors an attractive return profile with good carry.
MB: We currently view EM local-currency-denominated debt as the greatest investment opportunity. EM currencies are down substantially from their peak in 2013 with pricing that appears to be reasonable given the myriad risks currently observed today. Second, the real yield differential between EM and developed countries is historically attractive at a time when global growth fundamentals have reversed from the headwinds of prior years into a strong tailwind. EM was impacted during the 2013 to 2016 period by a combination of weaker global growth and a sharp decline in commodity prices, even as developed market rates rallied. We believe the reverse may also be true even in an environment of rising developed market rates.
RA: First generation multi-sector strategies were typically tethered to a hybrid benchmark (e.g., 33% high-yield, 33% EM, 33% bank loans), but these eventually failed to keep pace with the evolution of global credit markets. Running our MAC strategy in an unconstrained manner means our portfolio is neither tethered to a low-yielding index nor is it obligated to own specific sectors of an index. This approach offers our investment team the maximum amount of flexibility both from an investment and from a risk-management perspective; this is important, as credit markets have performed impressively over the last seven years, but not without episodes of elevated volatility along the way.
RA: Finding an attractive source of income remains a global challenge for individual investors, pension funds and institutions. It’s a challenge because of the many investment opportunities now available and the complexities involved in asset allocation, market timing and risk management.
Our MAC strategy seeks to capture the income, return potential and diversification benefits offered by credit markets worldwide. These markets include corporate credit within the traditional high-yield and investment-grade space and a host of other sectors that offer compelling income and risk-adjusted returns, such as agency and non-agency debt, residential and commercial mortgage-backed securities, EM debt, bank loans, and USD and non-USD global government bonds.
As an unconstrained strategy, our MAC strategy can shift to those sectors and subsectors that we believe currently offer the best value, by recalibrating portfolio exposures through the primary and/or secondary cash markets. However, it’s important to note that regulatory changes in recent years have made it significantly more costly for dealers to hold inventory. This has constrained market liquidity and made it difficult for market participants to sell or source bonds in adverse markets without incurring high transaction costs. To address this, we use derivatives on credit indices to help calibrate our credit exposures during risk-on and risk-off markets.
As Mike noted, rising yields is a key risk on investors’ minds. To address this concern, our MAC strategy has the flexibility to adjust portfolio duration from zero to 10 years. Moreover, in an effort to mitigate portfolio volatility, our strategy is managed to a target volatility of 5% to 7% which is in line with the historical volatility observed in various unhedged global bond indices. This volatility range allows us sufficient latitude to seek value across global credit markets, while simultaneously acting as a key risk-control factor.
In the current market environment, some of the big worries most investors share involve concerns such as the potential loss of capital (drawdown risk), see-sawing returns (volatility) and the ability to quickly redeem funds when needed (liquidity risk). History has shown that these concerns are warranted as market-jolting events may always lurk beyond the next bend. For example, if we look at just the past couple of years, global financial markets have been roiled by Brexit, fears of a China slowdown, oil market volatility and Fed rate hikes.
To help protect the portfolio from a sustained and material adverse event (e.g., another 2008 episode), our MAC strategy allocates an annual risk budget of 40 to 50 basis points (bps) for tail-risk hedges. These hedges have recently taken the form of put option strategies and put spread option strategies on the S&P 500 Index given their meaningful correlation to higher-beta markets such as the US high-yield market during periods of market turbulence.
Overall, we believe our emphasis on employing diversified strategies, in conjunction with our tactical use of duration and the presence of tail-risk hedges as an additional shock absorber, makes our MAC strategy a very compelling proposition for investors looking for an income solution.
RA: As global markets expand and more countries and corporations throughout the world issue bonds, the global bond market and the potential opportunities expand with it. As a firm emphasizing global breadth and local depth, Western Asset is well situated to identify these changes and reflect them throughout our diversified suite of unconstrained products, including MAC. Western Asset has over 40 years of fixed-income experience with a global platform that spans seven investment offices across five continents.
Given the complexity of global credit and the numerous pitfalls associated with investing and managing risk in this market, we believe investors should consider an asset manager such as Western Asset which has the global scale and resources as well as a proven track record of successfully managing MAC mandates for its clients.
View the Performance and Risk Disclosure for Multi-Asset Credit.