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MAY 4, 2022
Rich Familetti, CIO of Total Return Fixed Income at SLC Management, discusses how inflation and rising rates are impacting bond markets in the U.S.
Steve Peacher: Hi everybody it's Steve Peacher, President of SLC Management, this is another episode of “Three in Five.” Today once again and with Rich Familetti who runs our total return bond team and portfolios. And so, Rich thanks for taking a moment.
Richard Familetti: Thanks Steve, thanks for having me again.
Steve Peacher: So, obviously a big focus in the markets these days is inflation and the move in interest rates that is related to that, and of course the Fed raising interest rates. You know the move we've seen in the backup in yields recently, you know, isn’t completely unprecedented, but it's been pretty far and pretty fast. And obviously inflation and the Fed’s move is a key driver of the moving rates, and you run bond portfolios. , as you look at the current environment and you're talking to clients, what are you telling your clients about your take on the current market situation?
Richard Familetti: So it's been really since the 90s that we've seen these kind of, whether drawdowns in bond prices or increases in interest rates or this type of volatility. Now rates were higher then, but it's been that long since we've seen this big of a move in rates. Interestingly it's great because we haven't had to talk clients into bonds at these levels. In fact, we've seen more interest in adding to their bond allocation and that's a reflection of a few things. One I think is when rates rise pension funding improves, longer duration pools funding improves. Increasing your bond allocation is a hedging strategy that improves funding and reduces risk to the pension fund. And so higher rates, both in for public and private pension funds has been great for funding and so we've seen a lot of inflows either new clients or existing clients with inflows into the longer duration space with higher rates. The other thing that we've been talking to clients about is in the short duration space, so long duration great for a longer duration liability, short duration at this point is interesting, particularly in investment grade since the yields are now for two-to-three-year maturity or duration bond portfolios are north of 4%, and so we think that the Fed has actually would at least interest rates have gotten a little bit ahead of the Fed in the short end and so with two- and three-year notes around two and a half to 3%1 and then add spread to that and form of securitized debt or corporate credit risk or CLOs, collateralized loan obligations, and you can have a portfolio with a four plus percent yield with a ton of principal protection. And so, clients have shown a lot of interest, that's another area where we've seen client interest and it's an easy conversation to have now the yields are significantly higher.
Steve Peacher: You know you’re a student of the bond markets, and so I know you think a lot about rates and where you think rates are going, but at the same time I don't think you'd like to take big bets on direction of interest rates in the portfolios, that's a pretty blunt instrument. Great when you get a right, not great when you get it wrong. And you use a lot of other levers as your team construct portfolio, so in light of the move in rates, how are you positioning portfolios in this environment?
Richard Familetti: You said it, we don't we don't really bet on interest rates, so there are ways to take advantage of the rate move and probably the one of the more interesting ones, with the increase in not just in rates but in rate volatility, is to try and own a portfolio that’s got a higher convexity. So, convexity sort of a bond geek concept, it's essentially the change in duration or the change in interest rates sensitivity of a bond or a bond portfolio to changes in interest rates. In practice when rates go up bond prices go down, but a bond that has higher convexity does not go down in price as much. And so, to the extent that we can own, so for example, lower coupon bonds tend to have higher convexity than higher coupon bonds, to the extent that we can find bond we increase the complexity of the portfolio. Another way to add convexity that we've done some and we'll probably do more, is moving from 30-year bonds to 40, 50 or even 100-year bonds. Interestingly, the duration of a 30-year bond and a 100-year bond are about the same. But the convexity of the of the longer bond is significantly higher, with rate volatility higher or with rates rising to the extent that we can add income and convexity to a portfolio, the return profile and improves greatly. A couple of other things we’ve been up to, another way to add convexity is in the mortgage securitized market. Pass-throughs are a big part of the bond market, but they have very negative convexity, so they actually go down faster in price as interest rates rise than a bond with positive convexity. And so a finding securitized credits that have a better profile versus mortgage pass-throughs as it relates to convexity is a great way to add return as well. And maybe one other thought from a credit investor, what sectors will fundamentally be better off in a higher rate environment and financials are probably the most obvious and certainly insurance companies and such benefit from higher interest rates. And so, we've seen the fundamental picture improve for financials despite wider credit spreads in general.
Steve Peacher: You know it's always important I think in markets when you see a strong consensus in a given direction for an important variable to stop and think about what are the reasons why that may not play out. And the consensus view is often very much influenced by recent activity in the market, so recently we've seen rates rise that's been a countertrend to the last few decades, so it feels to me like they're either is a consensus or there's a consensus building that rates are going to keep rising. So, what's the opposite argument, what's the argument that in fact that's not going to be the case that rates are actually going to turn around and go back down?
Richard Familetti: Interesting, I mean we think that there's probably as good a chance of rates falling from here as rising, despite the inflation picture which is pretty poor in the short run, and maybe we can sort of figure inflation into the thinking. One thing is, and I sort of mentioned it earlier, short term rates have already risen are way ahead of the Fed and they're probably pricing in 10 or 11 moves by the Fed. You're getting a pretty high yield and probably pretty good principal protection from the short duration space, in fact you could make the case that it's gone too far and that rates could actually fall in in the short end to the extent that the Fed isn't as aggressive as investors think. That's one area where it seems relatively obvious. If you move out the curve and to sort of think about the inflation picture in general, if in the longer term, and maybe we can talk about the short term and inflation, but in the longer term you think inflation is a monetary phenomenon, then the feds really moving in the right direction to curtail inflation. And some data points to consider around that concept are, one – the dollar has rallied versus the Swiss franc, and we think that’s an interesting relationship to follow as it relates to how aggressive or how effective the Fed is being in the opinion of the markets. The Swiss Francs are a hard currency and we've actually seen a rally there. The other thing is gold prices really have been in a range, it's not like they broken out so those are two things they’re saying the Feds doing the right things that relates to the monetary phenomenon known as inflation. So, to the extent that that's true that can absolutely mean lower rates in the not-too-distant future. The other thing is, and I wouldn't say that we expected a recession anytime in the near term but it's reasonable to think that the economy could slow over the next year or two, I mean inflation does create demand disruption and demand disruption means a slower growth, and so also sort of bullish for interest rates. One other interesting point, you know this huge spending bills in Washington didn't materialize and so, in theory with maybe some changes in November in terms politically, and so the fiscal picture could improve greatly. And so reduced deficit spending along with the active Fed could absolutely lead to lower treasury yields.
Steve Peacher: Well, it is interesting in the bond markets because of the nature of markets you can ferret out a lot of information, you can determine if mathematically what kind of Fed expectations are built into the short end of the curve, you can look at the future inflation expectation components, so you do have a bit more information to work with than trying to figure out what's built into a PE ratio on the equity side. Well that those are really helpful comments for some important and complicated topics. I like to end with these with a personal question, so you’re a music fan, especially a live music fan living in New York City so you've got a lot of venues, not so much during Covid, those are coming back. You and I have been to see a blues band and in Chicago who I think that the leader of that was an octogenarian, so that was interesting. But anyway, my question is as somebody kind of on the forefront, loves music loves live music, what are you listening to right now?
Richard Familetti: I’ll tailor the answer around our, around our geography. So, for Canadian friends I’ve been listening to this band called the Wine Lips, and they're a Toronto based band, young fellows and they're really great. And I had the opportunity to see them just recently live, but I would give them a listen on Spotify or whatever and I’m sure they play dates in Toronto, really fun. And then coming up, this is for our Boston people, is this ‘Boston Calling’ music festival I don't people have heard of it but there's some great bands Metallica, The Strokes, Nine Inch Nails, so all bands that’ll blow your ears out, that sort of fun. And then one last one I’ll mention is this band called Wet Leg, which has a funny name, but they're band from the Isle of Wight in Great Britain, anyway, great pop music they had this this fun single it's called “Chaise Longue” and once you hear it it's like a one of these instant classics you'll probably hear forever. And so that's a fun sort of pop music band that I that I’ve been listening to lately.
Steve Peacher: All right, those are great recommendations I wrote all those down. And living in Boston I gotta I gotta get more on the Boston Calling music festival. So, those are great recommendations Rich thanks for taking some time, and thanks everybody for listening to this episode of “Three in Five.”
Richard Familetti: Thank you, Steve.
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