PM Exchange - Renewed Optimism for Fixed-Income in 2023

Michael Buchanan: Welcome, everyone. I'm Michael Buchanan, Deputy Chief Investment Officer at Western Asset. Thanks for joining us today for our quarterly PM Exchange webcast. Joining me today, I have Portfolio Manager Molly Schwartz, along with our head of US High Yield, Walter Kilcullen, as well as head of our London office and former Western Asset Director of International Investments, Mike Zelouf. So after a extremely turbulent and challenging year in fixed-income in 2022, we here at Western Asset, we think that 2023 will prove to be a time of renewed optimism in fixed-income. For starters, develop market government bond yields haven't been this high in a long time. And of course, if you're looking at the market today, even higher today. We recognize that these high yields are also a reflection of the challenging macro environment and the associated fear of how that macro environment may affect the global economy. But keep in mind, not only did risk free assets move higher during 2022, but spreads on the non-Treasury sectors. So corporates, EM, structured credit, they all suffered significant widening during the year. So this valuation backdrop is the starting point that helps fuel our optimism for fixed-income this year. But we also recognize that elevated yields as a starting point don't guarantee that you're going to have strong performance in the upcoming year, other factors need to contribute. So corporate and consumer health, inflation trends, central bank policy, just to name a few. So on today's webcast, we're going to highlight and discuss several of these factors that contribute to our renewed optimism. And in particular, we're going to talk about the case for high quality, long duration fixed-income, as well as the compelling opportunity that we see in certain segments of the high-yield market. We're also going to explore the normal negative correlation between stocks or risk assets and bonds and why that broke down last year and what to expect of that correlation in the months to come. So as always, we've designed this session to be a free flowing conversation among Western Asset's thought leaders as we discuss these topics and probably more topics. At the end of the discussion, there's going to be a brief period for Q&A. We've already received some interesting questions and we're going to definitely do our best to get through as many as possible during Q&A. And so with that, I'm going to jump right in.

Michael Buchanan: And Mike, I'm going to start with you. Not that we need to rehash 2022, but obviously a terrible year for both bonds and equities. The US Aggregate Index lost 13%, almost as much as the 18% decline in the S&P 500 Index. Are the diversification benefits of bonds now structurally impaired? And I know you've done some work on this, or do we think that 2022 is a statistical anomaly? So, Mike, I'm going to hand it over to you to to take that question.

Mike Zelouf: Well, Mike, good morning. There's no doubt about it that 2022 was a difficult year for all investors. But looking back over almost 70 years of data, it was also incredibly unusual. So if we look at the so-called 60/40 portfolio of 60% invested in the S&P 500 Index and 40% in the US Aggregate Bond Index, that portfolio declined by 16% last year, and that's second only to the 20% loss seen in 2018. And importantly, it was the first time since 1974 that bonds also declined alongside equities. The so-called negative correlation between duration and credit also broke down in 2022. You pointed out why the spreads and a combination of higher inflation and much more restrictive monetary policy not only repriced interest rates, but also repriced risk premium on credit bonds. And so as a consequence, what we saw in 2022 was by far the worst year on record for a diversified index of US bonds. But it's very rare to see bonds post negative returns over a 12 month period. In fact, it's only happened 13% of the time since the early 1970s. It's only the second time in 150 years that bonds have declined in consecutive years. On top of that, they've only been four quarters out of 196 going back to 1973, in which both bonds and equities have declined over the previous 12 months. That's only 2% of the time. So in answer to your question, that makes last year very much a statistical anomaly. And we think the diversification benefits of bonds still stand.

Michael Buchanan: Great. Thanks, Mike. Um. So, Molly, I guess this next question I'm going to direct your way. One of the consequences of the environment that Mike just talked about is a yield curve that is certainly inverted or at a minimum flat in certain parts of the curve. You spend a lot of time at the long end of the yield curve. You know, let's talk about value there. Is there any value in the long end? How do you think about that? How do you like to play opportunities in the long end?

Molly Schwartz: Well, the short answer is yes. We find value broadly across fixed income. But if you for me, I'm focused on the long end. I'm going to tailor my comments between the 10-year and 30-year part of the market. Also, it's important to note that it depends a lot on if you're a regular investor or a total return investor or if you have some sort of a benchmark, if you if your benchmark portfolio or a benchmark client, my comments might be a little more nuanced. But I'm going to focus for today on our total return type investors. So if you think about that, the thesis is that the current rates that you talked about even today a little bit better deal, the current rates are providing an excellent starting point. An excellent income producer. For a long time, fixed-income did not provide any sort of income or real interest generation for us. But here where we are now, you can look at the Treasuries and you can get a 4% coupon on a 10-year to 30-year bond. And that also provides a level of safety which we'll talk about a little bit more as time goes on. Another area of focus is in the corporate market, the long end in corporates, you know, again, bonds maturing between 10 and 30 years. If you're able to tolerate a little bit more risk and, you know, move away from Treasuries into corporates, we see really good value there. The idea is that the long credit index is yielding something like 5.5%, north of 5.5%.

Molly Schwartz: One year ago, that was closer to 4%. So if you say, okay, I said a little bit more risk, what does that mean? Well, if we look at what's happened in the US economy over the course of the last year, we've seen 450 basis points, really rapid rate increases, but yet the consumer is still pretty resilient. Unemployment's at all time lows and overall GDP in the US is still positive. So it looks like we're seeing some strength still. And so that's why we're okay lending money to some of these corporations. When we look at the underlying fundamentals of them, they still have pretty strong balance sheets. I'm sure Walter will talk about that a little bit more as he gets in his comments. And pretty conservative management teams. That's what we're looking for. So we're focused on the long end. We like different parts of the market within the 10 to 30 year sector. And it's really important to think about why is the yield curve inverted, right? Or why is it flat? So it's really for a lot of people view it as an early indicator of the economy. But research shows over time it's actually more of an indicator of investor sentiment rather than future economic performance. And the reason why it's inverted is because the Fed has been very active in their fight against fight against inflation. They're looking to get rates higher so that they can bring inflation down. That's caused it to trickle out. People are still willing, even with the front end going very high, they're still willing to buy longer-dated bonds, which is why you see the yield curve inverted. They're feeling in the future that things are going to be better for fixed-income and for the overall economy. So they're willing to go out extended duration. So it's really important. If you think about it, the 10-year is the most closely watched barometer in the world, the US 10-year Treasury, because it's an overall mark for investor sentiment. It's how we all collectively invest around the world. It's all reflected in the 10-year, mortgage rates are tied directly to that. It's really important for the overall economy, which is why it's been a little bit more stable than the front end of the market. For instance, 30-years, on the other hand, are driven by expected future growth, the path of inflation. And it's actually more resilient to what the Fed's doing. The Fed can impact the short-dated bonds all day, but they can't really impose anything on the long end that's dictated by market sentiment. So in that sense, we're feeling pretty good about, you know, extending out and going into 10 to 30 year part of the curve.

Michael Buchanan: All right. Thanks, Molly. Um, you know, Molly, you mentioned income. You talked about corporates. You kind of teed up Walter for this next question. But when we look at high-yield, valuations, obviously spreads wider during 2022, yields higher. I think at Western Asset we're always looking at not just absolute valuations but the intersection of valuations and fundamentals. So Walter, the question for you is when you look at or our team looks at high-yield valuations right now, what kind of conclusions, what kind of opportunities, what are your thoughts on valuations and how that interplays with with the fundamentals in the market?

Walter Kilcullen: Yeah. Thanks. Good morning and good afternoon. Always happy to mix it up and talk markets. I think that's the right question, Michael. I think valuations are really where you have to start off and that's really just prices in the high-yield universe. So currently today you're looking at yields of about 8.75%, about a 420 spread over Treasuries, basically right on top of the historical average in terms of spread. But I would argue 8.75% versus where we were pre-COVID. You have to remember junk bond market was yielding about 4% back then. So here you go at 8.75%, 87 cents on the dollar. That's the average dollar price for a corporate high-yield bond in the US here. You know, I would think that a good value approach active manager using a bottom-up fundamental approach could probably throw off a 9.5% yield without really reaching too far out the risk spectrum. So I think for what we're seeing in the marketplace in terms of lack of excesses, we haven't seen much in the way of releveraging, LBO activity has been muted. Stock buybacks, dividend deals, things of that nature. Some of those transactions that got us into a lot of trouble heading into 2008 into '09, the global financial crisis, we're just not seeing that type of behavior. I think it's really important when you're lending to and investing in a below investment-grade specifically, you're trying to price that default risk. And currently with about a 2% default rate for US high-yield, that's about 2.5% below the historical average. Yet that spread of about 420 over Treasuries is implying about a 6% default rate. So there's a lot of talk about what inning are we in or, you know, I guess a better way to say it is the high-yield market, the credit cycle is not a basketball game where the buzzer goes off and that's it. Game over. Win or loser. It's not a football game where, you know, time runs out and that's it. I think there's been talk for years now: what inning are we in, are we going into extra innings? And I would make the argument that this credit cycle has had many cycles within it going back to the commodity crisis in '15 obviously into Covid in 2020 and the recovery from there and in 2022, clearly high-yield was not insulated given the rate move. High-yield was down about 11%. But we take a step back, we look at leverage metrics, interest coverage, free cash flow generation, and we think entry point wise at 8.75% yield just that carry alone looks compelling.

Michael Buchanan: Okay. One of the things we talk about as a group, Walter, when we get together with the High-Yield Team, is the severity of what happened in 2008, which was, you know, it was a long time ago, but a lot of those it was such a significant event that it does it did seem to resonate with a lot of CEOs, CFOs, boards, and they do seem to be a lot more disciplined in terms of balance sheet terming out, near term maturities proactively. So there's a lot that history can teach us about that. And Mike, I'm going to turn back to you now; this is a little more historical, but when you look at periods where bonds and equities both declined in the years following, does history tell us anything about that? What can we expect just based purely on on history, about what the upcoming months and quarters are going to tell us?

Mike Zelouf: Yeah. So this is where I think history has got a very positive story to tell for the year ahead. So we look back again over about 70 years at periods during which both bonds and equities fell at the same time. And in both those cases, for both bonds and for equities, in the year following that year of simultaneous decline, they both posted positive returns, more than 80% of observations. So 80% of the time both bonds and equities posted positive returns in the year after a simultaneous decline. Moreover, in terms of the degree of recovery, they both recovered approximately 80% of their previous year's losses, with bonds recovering about 88% of their previous year's losses in nominal terms on average. That means that for bonds, about a 9% annualized return in the year after a decline with equities and for equities, an average return of 16%. But as you pointed out earlier, Michael, as the old saying goes, past performance may not be a good guide to the future.

Michael Buchanan: Yeah, that's always the case. So let's take the other side of that and let's say that the Fed and other central banks keep raising rates. And Molly, I'm going to direct this question at you. Just the concept of now, you know, could it be a good time to add fixed income in the face of central banks that continue to behave hawkishly?

Molly Schwartz: Yeah, I'd say definitely. It's impossible to time the market perfectly. The focus is on getting the opportunity right over the long run. So it's one thing to think about what the Fed will do if the Fed will hike, but what is really more important is to figure out what the market's expecting the Fed to do. Because if the market is already expecting the Fed to raise rates, then the prices that you're getting today are already baked into the prices that you're the yields that you're buying. So we think the current interest rate is attractive and at levels we haven't seen in a long time. And so we'd say, yeah, it's time to start dipping your toes in. It's time to start buying bonds. Right now the market is pricing that the Fed will get to some five and a half or five and three quarters, peak rate for their for their Fed funds rate. While currently we're at 4.75% on the high end. So another 100 basis points from here. The point is, it's not the 450 that we saw last year. That's already happened. So we have some to go in the forwards, but maybe less than we already had and it's already priced in. Even the Fed themselves at the most recent FOMC meeting, used the phrase a couple more hikes where in the past they said things like further increases. So even they've alluded to the fact that they're closer to the end of their hiking cycle rather than the beginning. And, you know, to what Mike had said already, if you look specifically at the long Treasury part of the market, after the Fed reaches that peak rate, investors can achieve returns of 7% over the next three months or 12% over the next 12 months, which is just looking like a really good opportunity. You know, we already talked about 2022 was the worst year on record and the odds of us having three years in a row of back to back negative returns has never happened. And so that's why we think it's a good time to start adding bonds.

Michael Buchanan: Okay. Thanks, Molly. Walter, back to you. So, again, you know, I bring up that we're going to talk about high-yield that intersection between valuations and fundamentals. Clearly as you pointed out, you know, eight and three quarters yield even higher, that's a really good starting point for for high-yield. But one of the biggest threats to owning high-yield is always impairment risk. You're dealing and you're operating in a segment of the market where you do have higher default expectations, and that does take away from your overall return. So I was wondering if you can comment a little bit on what our default rate expectations are and maybe weave in how, you know, some of the fundamentals technicals, some of the primary market activity might affect that.

Walter Kilcullen: Yeah, think it's the right question. And I think I mentioned many credit cycles before. Those were periods in time where default rates did spike. You had 7%, 8% type defaults in 2022. You had very similar defaults during the commodity crisis '15 into '16. What does that leave you with, though? That does leave you with a much higher credit quality asset class, you know, almost flushing out some of the weaker players, some of the credits that lose access to capital. I think it's imperative when investing in high-yield that you make sure that the capital structure is sustainable, that these companies have the ability to refinance risk, whether it's via the equity markets, convert markets, bank loan market, high-yield market. And I think that's really been an evolution in high-yield. When you think back to the crisis in 2008, defaults at 13 plus percent. There were a lot of over the weekend filings, Chapter 11, Chapter 7's. And I think what the market learned, management teams and certainly the buy-side investment management platforms, is you have to get ahead of of turbulence. And we've seen that more recently, 2022 specifically. Again, a default rate at 2% and I'd say the bulk of that was really selective defaults, really from coercive exchanges that were offered from companies where rather than file the company, they would reach out to bondholders. Bondholders would would form groups and work with advisors and the management team to figure out how to push out some runway, maybe swap your unsecured risk into a first lien, a senior secured piece of paper, or, you know, ultimately just re-rack the capital structure. So I think, you know, Western Asset's view is that default rates at 2% or 2.25% likely trend higher. There has been some real headwinds in the retail space. Anytime you see a sector like technology grow as rapidly as it has, a lot of that financing during Covid, off Covid numbers, I think you have to be careful in those spots. But if we're going from 2% to 3%, well below the historical average, I think, as I mentioned earlier, spreads here imply, you know, 6% type of defaults. And maybe one last thing on recovery values, which to your point, Mike, you know, when investing in high-yield lending to high-yield companies levered balance sheets, you need to make sure that you're keeping that impairment, that default rate, as close to zero as possible. It's the only way to put up a strong long-term track record. And in terms of of restructurings, the last 12 months, 55 cents on the dollar has been the average unsecured bond recovery in high-yield. That's versus a historical average of about 30 to 35. So I think that's one, people getting ahead of things. And two, just how secured in nature the high-yield market has become. A lot of the issuance we've seen these last several years, specifically during the height of Covid, a lot of those rescue financing deals did come at first liens and second-lien levels backed by some type of collateral real estate, airplanes, cruise lines, things of that nature. So I think that bodes well for the asset class going forward. I think the default rates remain below the historical average, but admittedly likely rise from here.

Michael Buchanan: Yeah, I was going to add, too. And I know, Walter, you and I have talked about this, but one of the things that I think factors into the abnormally low default now and why perhaps going forward, the default rate may not get as high as market expectations, is that, you know, maybe over the past 10, 15 years, larger companies are accessing the high-yield market. A lot of the smaller companies have been able to seek better financing alternatives in the private credit market. So with those larger companies that are in the high-yield market, those typically not all the time, but typically have a little more financial flexibility, they have more levers to pull. So even when you get to those periods where you're facing some challenges, some headwinds, typically they have a better shot of maneuvering through those periods than perhaps a small company with more limited revenue and so forth.

Michael Buchanan: So Molly defaults, usually we're talking about defaults usually that that that that comes in tandem with a recession. So just a big simple question about recession. What happens to bonds if if we're wrong. The soft landing camp doesn't come to fruition and we experience a recession. How do bonds behave, especially in your segment of the market?

Molly Schwartz: So for that case, I'll focus on Treasuries. And the idea first of all, it's not our base case, as you've said already, that there's going to be a recession, but it's definitely a scenario that's worth talking about right now. So the what happens is if it's a mild downturn, it causes worry. Investors seek safety That's provided by bonds. Usually bonds outperform, Treasury bonds outperform because a guaranteed if you have a term guaranteed 4% interest rate that's available right now is better than a loss from equities. In the case of a severe downturn, which causes some desire for safety that, you know, that I already talked about. But it's also met with the central bank lowering rates to help stimulate the economy. It's important to note there has never been a recession here in the US without a substantial fall in the interest rates. And it's for those two reasons either demand drives it and or the central bank comes in and helps as well. So what benefits during the time I mentioned Treasuries or anything also priced off of a Treasury. Investment-grade corporate bonds are priced off Treasuries, right? So while they might have some spread widening, they still get the benefit of the the increased price or the decreased yield from a Treasury bond. Now, given what I said, what if we don't get a recession this year? Is it still good to buy? Because say, oh, they provide great opportunities if there's a recession, what if there is no recession? Is it good to buy? Well, I'd say yes, because you don't even need a recession for bonds to do well from here, given what they're pricing in in terms of inflation and the Fed worry if we just get an increase of the disinflation, which Chair Powell mentioned in his last meeting, or inflation coming lower, even then Treasuries benefit because people will then be less worried about future rate increases, less worried about long run inflation volatility can be restored, as Mike has alluded to already, and historical correlations can return. So then bonds would act as a good diversifier, a great place in a portfolio.

Michael Buchanan: Okay, Mike, I'm going to I'm going to come back to you. As Walter was talking about fundamentals, I thought about this question. When we talked about the correlation between or the diversification benefits between bonds and equities, a lot of what we talked about was based on historical precedent probabilities. At Western Asset, and I know you realize this, we all realize it, but we talk a lot about fundamentals. At our core, we're a fundamental manager. So I want to specifically talk about fundamentals in terms of inflation, monetary policy, and based on those fundamentals, can you explain the breakdown in diversification between bonds and equities last year? And then if you can, which I presume you can, what's the outlook for inflation and interest rates imply for bond and equity market returns in 2023?

Mike Zelouf: Yeah, absolutely, Michael. So and interestingly, listening to both Walter and Molly, you know, the importance here of diversification is because whereas corporate bonds can still post positive returns, you know, with equities, a recession can can do real damage, right? I mean, you can see real declines. So you need something in a diversified portfolio that can offset those declines. So what we've tried to do to help relate equity and bond returns to the inflation and interest rate cycle is to identify what kind of macroeconomic regimes prevail when they both decline together. And so we've identified two such regimes where the correlations break down. And what we've observed is that when both of those regimes occur at the same time, the breakdown in correlation can be truly meaningful and we think that's what happened last year. So the first regime is when you see high, persistent and rising inflation. And as a precedent of that, we saw this in most of the 1970s. And clearly, you know, rising inflation hurts bond valuations in particular in real terms, but it also negatively impacts equities through weaker P/E ratios because investors are willing to pay less for earnings when the purchasing power of their money declines. The second regime is one in which central banks drive interest rates meaningfully higher in both nominal and real terms. And again, based on on historical precedent, we saw such a regime back in the first half of 1994, a period I remember well. When the Federal Reserve really began tightening aggressively after a very long period of stimulative monetary policy.

Mike Zelouf: So in that regime, bond prices adjusted lower, obviously to compensate for the rise in cash rates. But at the same time, equities declined because investors needed higher compensation for dividends, which were being discounted at a higher interest rate. So those are the two regimes and clearly that's what we saw last year. You know, a high, sticky and persistent inflation that was rising. And secondly, a Federal Reserve that pivoted to much more tight monetary policy after one of zero interest rates and quantitative easing. So looking forward to the year ahead. You know, what what kind of shift do we think is going to happen? Well, we think at least one of those two regimes will will end or at least abate. So as as Ken Leech has often said, the path of long term interest rates is ultimately determined by the path of inflation. And as such, as has indicated, you know, moderation, inflation could really cease bond stage a meaningfully meaningful rally next year, in particular as the risks of weaker real returns abate. Secondly, if if we're right and interest rates reach a level during this year that the Fed deems sufficiently restrictive and will allow it to pause its active tightening, then investors can feel comfortable returning to fixed-income markets without the risks of the high levels of volatility that prevailed throughout 2022. And that spike of volatility is the highest really going back to 1981.

Michael Buchanan: Okay. Thanks, Mike. Um, you know, I think we have to conclude the webcast with talking about opportunities. That's really what it's all about. You know, we can talk a lot about high level views and thoughts on the market, but you know what really matters to our clients and how we bring results to our portfolios and our client portfolios is with opportunities, taking advantage of those opportunities in the market. So, Walter, I'm going to start with you. And again, I'll frame it within the high-yield market. What are we seeing in high-yield? I mentioned at the onset of this call that we saw value in certain segments of the high-yield market. So I'm wondering if you can expound upon that and also, you know, somewhat related, but talk a little bit about active versus passive high yield investing. What what our big thoughts are there.

Walter Kilcullen: Of course. Yeah. I think interesting dynamic in 2022 versus sort of mid 2020 all the way through '21. What really worked in in high-yield was a deep cyclical trade. It was reopening trades really that bottomed out in the spring of 2020, were the best performers throughout 2020, the back half there and all of 2021. That was not the trade in 2022. Fears of recession globally certainly provided some headwinds to those credits and have caused the relative value between some of those deep cyclicals. Speaking of airlines, cruise lines, casinos, REITs. I Think you have to put energy in the reopening trade as well. You look at the yields and spreads in those specific subsectors versus noncyclicals. And given our view on the economy, specifically here on the US, the consumer, we think that segment of the market is screening extremely cheap to less cyclical. So we've been spending a lot of time there. There's been a lot of refinancing of some of those rescue financing deals from '20 and '21. But now these companies are making money. I think a global shutdown in 2020 brought some of these credits to to zero revenue and coming out, reopening China, reopening. We think that's a nice tailwind. So when you look at how we're positioned and dedicated high-yield strategies really across the firm here at Western Asset, you'll see those biases in a real manner.

Walter Kilcullen: In terms of active versus passive, I think high-yield is the one asset class that it's pretty easy to go head to head. And you look at the passive high yield ETFs, which gained a lot of AUM in 2021 into 2022, even. Long term performance, good, active, diversified, high-yield managers outperform those ETFs handily. And I think while the ETFs are a vehicle that one can use to be nimble, I think over the longer term, when you look at track records, high-yield specifically is that one asset class where issue selection or stock picking, as the market may call it, is key. And we're happy here at Western Asset to own zero exposure in something that's meaningful in the benchmark in the index. At the same time, we'll own a percent or so of something that doesn't reside in that benchmark that the ETFs have to buy any time they need to create. So I think, you know, head to head, you know, give me our platform versus that passive manager any day.

Walter Kilcullen: And I also think what's compelling here, where are we seeing opportunities, that the front end of the corporate credit capital structures that short duration, high income segment of the market we think looks really compelling. Clearly, you have to do the work, vet the companies make sure these companies have access to capital to refinance. But pretty interesting dynamic in credit where the front end of maturities I'm talking two, three, five years out maturities have the same yields as going out seven, eight, ten years. I think that's a dynamic that probably doesn't go on forever and one that we're certainly taking advantage of.

Michael Buchanan: Okay. Molly, next question for you. Pretty similar, actually. Opportunities. Walter talked about getting the same yield in the short end versus what you can get in some longer-dated opportunities. Maybe make the case for, in our opinion, what's the best investment right now in long-dated bonds? What has the best risk reward in your opinion?

Molly Schwartz: Okay. Good question. So I mentioned already Treasuries. I think I've beat that drum a little bit. The idea there is that with yields close to 4%, we're at the higher end of the range levels not seen in a long time. They provide good, stable income and a diversifier for your portfolio in the event of something more negative happening. But if you're willing to take on more risk, as Walters alluded to, you can go into the corporate market. He talked about short duration, high-yield type stuff. But I would also argue that long duration type credit stuff can also be very beneficial. Right now, even though the curve is flat as far as the overall yield curve goes, if you're getting very high quality companies that are available at five and a half, 6% coupons and these are very high-quality companies that in no scenario over the next, you know, ten, 15, 20 years, will these companies come into any financial distress, then we think that that holds a good place, that can hold a good place in your portfolio as well. You know, it can be very specific to certain sectors. We're looking for ones when we're picking names, we're looking for ones that have strong balance sheets, really conservative managements, because again, we are bond investors. We're not looking for the swing, the fence, tons of acquisition. We're looking for people that are going to deliver on what they say and are reliable. Another case could be made for emerging markets, right? If the idea is that we're nearing the end of the hiking cycle here in the US, most of the emerging markets are a little bit ahead of us. They've actually made the case, you know, they had inflation before us, so they started to fight it before us. And if you're looking at some dollar-denominated bonds in certain parts of the world, that can be really attractive as also another diversifier to the portfolio.

Michael Buchanan: Okay. And Mike, you know, you recently wrote a blog post called "When Diversification Fails and Recovers" as one of you could just expand on that premise a little bit and probably more importantly, explain why we believe the diversification benefits of bonds will recover going forward. I think you hit on this, but this would be a little more kind of some of the some of the the muscle behind it.

Mike Zelouf: Yeah, absolutely, Michael. So in terms of the title, so back in 2000, Roger Lowenstein published a book called When Genius Failed, which chronicled how hedge fund Long-Term Capital was undone by a breakdown in financial arbitrage models in 1997, which were based on the historical correlations of emerging markets to US Treasuries. Unlike Long-Term Capital's experience, though, our analysis suggests there's a happy ending to this particular story. So in terms of the diversification benefits, which is kind of really the crux of what we were trying to get to in the paper. The conclusion we've come to is that if either one of the two regimes that I described earlier on, here, either an end to the persistent high and rising inflation or a Federal Reserve that reaches a more balanced policy, bonds should recover their historical diversification characteristics as their correlations to equities normalize and return to being more negatively correlated. So over the last 20 years, the correlations between bonds and equities have ranged between -0.4 and -0.6. So if again, we see a return to some kind of normality in either one or both of those regimes, we should see bonds return to that kind of diversifying characteristics which should deliver positive returns, but importantly, returns that diversify potential high levels of volatility in equities.

Michael Buchanan:: All right. Thanks, Mike. In the interest of time, we're going to move on to address some of the questions. We did get a lot of questions and we know we won't be able to address all of these, but we're certainly going to try to circle back and make sure that we respond to all these questions in some way, shape or form. So apologies if your question isn't addressed here and was kind of going through these trying to smash a few of them together.

Michael Buchanan:Walter, the first one I'll just throw at you and it's the combination of a lot of different questions, but I'm going to try to summarize it. You hit on it a little bit, but where are we in the credit cycle? A lot of people like to compare that with innings, but however you want to express that, where are we in this credit cycle? And let's talk about the value or the opportunity in cyclicals versus noncyclicals.

Walter Kilcullen: Yeah. Our CIO Ken Leech often says this is about as challenging environment as we've seen in modern day markets and we've never truly navigated our way through and out of a global pandemic. So that's what leads me to sort of throw that "what inning of the credit cycle are we in?" aside. Again, I think that we've seen these these mini resets. We've seen these flushes in companies where they lose access to capital and they need to restructure, you know, in terms of, you know, cyclicals versus noncyclicals. Clearly, if we're bullish on deeper cyclicals, we think there's runway to the credit cycle. So I think we come back to the behavior that we're seeing by management teams that that focus on debt paydown, terming out near-term maturities, being careful on the M&A side, I think that's extremely important. And the primary markets have welcomed it. You know, 2022 was a very light year of issuance in high-yield. And I think, you know, it was in my opinion, and I think the Firm view is it was more about the bid and offer. So where companies were willing to lend, borrow, excuse me, versus where investment management firms were willing to to lend and think it wasn't about there's no price for a deal.

Walter Kilcullen: We saw some of those hung deals in 2022 clear in the back half of 2022 into '23, I think was more about price. So when you get to a moment in the markets like late '08, early '09, where there is no price for for borrowing, I think that's where you got to say, okay, this credit cycle is rolled over and we're going to take some pain. So mark to market repricing and need to work our way out of there. I don't think we're anywhere near that personally. I just think the fundamentals we're seeing are too strong. Consumer balance sheets are strong, corporate balance sheets are about as good as we've ever seen it. I think having a zero rate policy for as long as we did enabled companies to borrow at 4% or 5%, 6% type rates. Lock that in in the high-yield market. So I think we're you know, we're working our way out of out of COVID-19. We have the global reopening continuing. So I would say that, you know, we have we have some time here before the defaults start to pick up materially and potentially you get that low in the primary activity that that causes a cycle to roll over.

Michael Buchanan: Okay. Thanks, Mike. Next question for you. And again, I'm doing my best to try to merge some of these questions; there's questions on geopolitical risks. So Russia, China, the energy markets. Um, and I would even add to that, another good question came in on the debt ceiling and what we think about the debt ceiling potentially defaulting or the US government potentially defaulting on on Treasuries. I know there's a lot of different topics there. So however you want to take that and address that.

Mike Zelouf: Yeah. I'll pick up on the geopolitical point. I mean, certainly, you know, one of the things that from a secular perspective has helped keep inflation low in the last couple of decades, I would say, has been the move to globalization and what the recent and potentially new geopolitical tensions that we're seeing and experiencing doing is making corporations, governments rethink supply chains. We're moving away from a reliance on a single market for energy or components or commodity supply and moving to nearshoring or friendshoring. And that's going to create some sand in the gears. And that may create some volatility which may make the path to disinflation somewhat, somewhat bumpy. But I think the reality is, is we don't know. I think the the degree of political risk premia that we need to be allocated to sovereign markets, in particular in emerging space will need to increase. But that really speaks to doing the sort of deep down fundamental analysis and assessing the extent to which those higher risk premia are priced in and reflected in prices. In terms of debt ceiling, I think Molly, Molly or Walter, probably a better place to answer that one.

Michael Buchanan:Well, I'll even--just because it's a pretty big topic. I'm not going to say we've become immune to it, but the debt ceiling discussion over the last ten years has continued to move to the forefront. It's obviously very political. I think ultimately and I'll probably leave it at this, Molly, and unless you want to chime in on it, that, you know, I think there is the ultimately what matters when you're investing, whether it's a corporate or a sovereign, you know, is the ability and willingness to pay. And I think when you're talking about the US government, there's certainly the ability to pay and there's a willingness to pay, albeit with some some noise around that. So I think that's kind of when we think about that, we're respectful of, of of those discussions, the path of those discussions, the volatility they may create in the market, but also the opportunity. And at the end of the day, again, you know, we look at US Treasuries as backed by the full faith and credit of the US government. They are a great store of value. They will pay and, you know, take advantage of of of opportunities and pullbacks if there are some that stem from those discussions, if they if and when they happen.

Michael Buchanan: And Molly, I've got two. If you want to comment on debt ceiling but the one question that I pulled from the audience was on this kind of interesting what's a more contrarian investment contrarian investment view today going long stocks or long duration?

Molly Schwartz: First of all, well said. On the debt ceiling, I wouldn't add much more to that. But on that note, I would say it definitely feels if you're taking market reaction as the scorecard, it definitely feels like going long duration is way more contrarian than being long stocks. You see bad economic and bad is loosely used term because just slightly worse than expected economic data come in and you see rates really react. The stock market reacts a little bit, but over time there is this bias in the market for people to want to own stocks and get long. So it's easy to pick up on all the headlines. The Fed's going to raise rates forever. It's you know, it's going to break something. And that makes it feel to me like going long duration is a more contrarian view, which is why we're here to talk about it today. We're saying now is the time to to get in there, to add to long duration, use it as a hedge in the case. We are wrong and there is a recession. But if we're not wrong, then we think it's a great store of value. It's a great income producer right now. Now is the time to go.

Michael Buchanan: Okay. Thanks, Molly. I'm going to end it there. You know, we have a lot a lot of great questions. But I do want to keep a, you know, a reasonable time on this. So, again, thanks for to everyone for your questions and to our panelists. Molly, Mike, Walter, really appreciate your participation as we close out our discussion here. Just want to note that we will be directing you to the Firm's quarterly Key Convictions piece, which aggregates our current overall views in an at-a-glance dashboard, and additionally it provides a fixed income outlook section, including current market opportunities and more. So finally, we really do appreciate your feedback, so we would appreciate it if you would please, if you have time, fill out the brief survey at the end of this webcast and thank you very much and appreciate your participation.