In an extract taken from the Pension Plan De-Risking, North America 2019 Report, David Grana, Head of Production at Clear Path Analysis, interviews Peter Ehret, MD & Director of Internal Credit at Employees Retirement System of Texas on the subject 'With yields still riding low, where are Fixed Income Managers finding bonds to manage their portfolio?'. Click here to download the full Report.
David Grana: Do you feel like we are going to continue to see low interest rates for a prolonged period of time? In your best estimation, what does that timeline look like?
Peter Ehret: I would start by stating that these are my personal views and not those of the Employees’ Retirement System (ERS). I do think that we will continue to see prolonged low interest rates. We have already seen this for a long period of time, but it is very likely to continue. This is due to the high level of debt that it is in the system. It isn't just household and corporate debt, but also sovereign debt. A system this loaded with debt, makes it more sensitive to changes in interest rates and credit availability. Small increases in rates quickly creates a lot of pain for debtors, which in turn, quickly slows the economy. When the economy cools, we get right back to where we started, with rates coming back down in a strong bid for safe harbor investments. Of course, something can come in to derail this pattern, perhaps it will be a break-out of inflation independent of growth, but it certainly isn't here yet and doesn't seem to be on the horizon. In terms of how long this can continue, it could still be multiple years.
David: Do you feel it is in the range of 5-10 or 10+ years?
Peter: I am not sure that decade forecasts are worth a lot in the capital markets, but in my view, it will certainly continue for at least the next couple of years. Eventually, we will also face an economic downturn, which is likely just something else to constrain rates. In essence, the same basic dynamic of today should stay in place. With the global economy where it’s at today, and current debt levels, there will be a continued sensitivity to rate changes and a natural lid on rates.
David: In spite of low yields, why are Treasuries still such a key component to the pension fund?
Peter: It is a good question. Why would anyone own Treasuries with rates where they are? Seems silly on the face of it. But even with very low rates, there is still an investment case for them. In some environments, Treasuries can still outperform. For example, in an environment where fear comes back and another downturn ensues, even at the current yields, Treasuries would likely do very well. It’s also important to note that pension plans have payments to make. They simply can’t miss them - ever. It is important to maintain funds on hand to make sure that they are able to meet their obligations no matter what is happening in the market. The safety and liquidity of Treasuries is unmatched in getting this job done. These investments also often serve as a great portfolio diversifier. So, they remain an important plan component despite current rates.
David: What are some other forms of credit that pension funds are turning to for higher yield?
Peter: The search for yield is driving some new ideas. But there is also the ongoing development and deepening of the capital markets. The latter is healthy, but the former can bring problems and risk. Areas like emerging markets, high yield, bank loans and distressed are more traditional areas with growing expertise and interest. Direct lending has also really taken off. Another idea isn't really new, but is to become more tactical and being better able to respond to transitory opportunities as they emerge in existing areas.
David: Is private credit still playing as important a role in the pension world as it was 18 months ago?
Peter: It is, and direct lending remains one of the hottest investment areas driven in part by the search for yield and a belief that there is a pool of under-banked borrowers. While good opportunities and good managers undoubtedly exist, investors need to understand the difference between shortages in available credit and shortfalls in creditworthiness. Observing a borrower without access to credit in an era where central banks have flooded the globe with liquidity and inferring that there is a credit shortage is likely a bad conclusion.
A better conclusion is that the borrower likely has serious credit worthiness issues and that making a direct loan would be a very high risk. It may still be a good investment, but it is important to understand the risks being taken.
David: Do you feel that it has further growth?
Peter: It seems to be continuing to gather interest and does seem to be growing. I would expect this growth to continue as long as it works.
David: How are credit managers reacting to the Fed pullback on QE and the reduction of its balance sheet?
Peter: It is really just the same as overall Fed policy watching. Perhaps the one caveat is that of dollar liquidity within the balance sheet component. But there truly isn't anything special about the balance sheet, per-say. There is nothing that forces a balance sheet reduction, so it isn't a separate issue that investors need to fear outside of normal Fed policy setting. Lately, Fed policy has just been more of the same - dovish because current conditions can't seem to tolerate higher rates and a quick Fed retreat when cracks appear.
David: Is it causing a re-think for investors or is it business as usual?
Peter: It does create some odd outcomes. Rates are low because growth is weak, yet low rates encourage risk-taking in a search for returns. But low-growth dims the prospects of those investments working out. So, there is a balance to be struck between needing the returns and yield, while not overreaching in a weak economic environment. In the U.S., the economy is fine. You can even judge it as being strong in terms of unemployment figures, but the overall growth number is not high, and it is aided by large Federal Government deficits. It is a continuation of theslow growth environment that just can't break out to the upside and allow for higher rates.
David: What kind of opportunities do you see in the world of emerging market (EM) credit?
Peter: EM fits into the category of people simply becoming better investors over time, learning additional markets, and globalizing the opportunity set. This will grow for investors in this healthy way of expanding investment frontiers outside of the simple hunt for yield.
David: Are there specific segments within the credit market that look interesting?
Peter: There isn't one significant opportunity right now. In part, this is what underpins the idea of trying to become more tactical and looking more opportunistically to be better able to respond in a timely way when opportunities emerge. Of course, ideas discovered in bottom up research also exist in any market.
David: Has there become a more discerning way of looking at the opportunities whereby you don't simply lump things together into one bucket?
Peter: Yes. It is easier to differentiate over time and simply to have access to more buckets. Technology has made it easier to look at opportunities and understand them. Across the world the way business is done is also more standardized, including the way companies conduct financial reporting and the way they interact with the investor base. Even in the US, technology has opened up huge amounts of additional information to sift through for ideas and improved the function of markets.This is part of the overall trend I mentioned with markets deepening and becoming more sophisticated over time. It is a very healthy way of opening more opportunities, rather than just looking for yield.
David: Do you have any final thoughts on this topic?
Peter: We are all watching and waiting to see what is going to happen with growth. The biggest concerns seem to be outside the U.S. right now. But even at home, growth probably remains modest. Of course, rates will move around, but they probably remain capped. So, the need for discipline will remain. Do things that make sense, not things that low rates simply seem to force. I should also point out that we all live in a global economy now so, there is a whole world to watch for clues.
David: Thank you for sharing your thoughts on this subject.