Trading through inflation

Published on 24 January 2022

Many buy-side traders will not have seen an inflationary environment before, and with central banks balance sheet and risk appetite carrying impact along with interest rate, even experienced investors may not have experienced a market facing the volatility predicted for 2022.

Scott Kimball, co-head of US Fixed Income at BMO Global Asset Management, explains how vol has crept into bond markets and how the retail access to bond markets though mutual and exchange-traded funds will affect investor flows and risk.

As a relative value investor, Scott also talks through the pros and cons of accessing liqudity in the primary vs secondary markets.

Dan Barnes: Welcome to Trader TV – your insights into trading for professional investors. I’m Dan Barnes. In 2022, inflation is the big story. It could be impacting investments across asset classes. Joining me today is Scott Kimball, Co-head of U.S. Fixed Income at BMO Global Asset Management, and we’re going to be discussing how investors need to think about inflation in trading and investment decisions.

Scott, great to have you back on the show.

Scott Kimball: Thank you for having me, it’s great to be here and Happy New Year.

Dan Barnes: Happy New Year! So tell us, first of all, what effects could inflation have upon fixed income market investing in 2022?

Scott Kimball: I think the big one that we have to just put out early in this year is that we got to a very low volatility place in fixed income for much of 2021, particularly in credit markets. What’s interesting is the inflation frontier, particularly the rising and persistent inflation that has now prompted the Fed to suggest that they need to move, not just forward with tapering, but perhaps move forward with raising the federal funds rate.

That’s what has implications for credit, much more so than the pandemic. That could spur a lot of volatility because what we’ve seen is that when we look at corporate bond yields, the contribution to the yield from the government market has been very low for a long time. But the excess spread that makes up the rest of it, that’s compressed a lot. And that is very sensitive to market volatility and in this case, things that spur market volatility, such as inflation.

Dan Barnes: And then how might that seem to play with the central bank activity itself?

Scott Kimball: Central bank activity is something that we have to, I guess, contextualize to a specific time frame, because it used to be central bank activity just meant the federal funds rate. Now it means the size of the central bank’s balance sheet and how much risk they’re taking. Because when we say the Fed’s been buying treasuries, we think, ‘OK, they’re buying treasuries. That’s got some M2 money supply implication. That’s of course of business.’

But then there’s MBS on the book. That’s got spread, that’s got volatility to it. It’s not a risky asset in the way most investors think of risk, but it does carry with it prepayments and convexity and things that do ebb and flow and do cause variable total returns.

So the central banks as a whole have changed their role dramatically in the marketplace. They’ve been buying so much of these instruments that what’s left for us investors to buy is significantly reduced. It’s forced us to go out the yield curve to capture higher quality yields at a higher rate, or to go down in credit quality and buy low quality investments in order to earn our carrier and just to try to keep pace with inflation.

So because of that reduced supply, because of their consumption, the dynamics of what we can buy in the markets has changed dramatically. So I would say that from an asset managers perspective, if the Fed is going to be pulling back on buying treasuries and MBS, we have to ask ourselves, ‘what was the discount mechanism we should have applied to adjust for that?’ We never really figured that out. We just now know we’re coming out of that likely, and we’re going to see how it unfolds. So again, going back to that nasty V word, volatility. It’s not the typical thing we focus on in the bond market, historically, but it’s become in vogue over the years, and a lot of that has to do with the central bank involvement.

Dan Barnes: What do you think this might collectively mean for trading volumes, over 2022? And what are the implications for volatility, as you’ve alluded to there?

Scott Kimball: So I look at this as a function of where investors have gone. Look at the composition of the marketplace, it used to be high yield was almost entirely, institutionally out. So that means pension funds, whether they’re corporate or they’re public, endowments, and foundations. Now it’s owned over 50% by retail investment in mutual funds and ETFs. That’s a different proposition because their ability and their access to market and what toggles their decision making can be very different from institutions. It’s not necessarily a strategic asset allocation or as committed as allocation in the same way.

So volatility across credit markets that should be on the rise this year, but high yield in particular, emerging markets, areas where you have had new entrants to the fixed income marketplace take advantage of those markets to meet their yield assumptions. Those are areas that I would really focus on and be ready to cut your risk when spreads look tight, and the market lulls itself to a comfortable place, but aggressively be buying when things are weak. There’s going to be a lot of tremendous opportunity that these volumes can create, particularly when we talk about things like high yield.

Dan Barnes: We’ve seen that primary markets are a massive source of liquidity and, of course, pricing information for bonds investors in addition to secondary markets. Do you think that we’re going to see a change in activity as we see potentially rates rising and inflation risk increasing?

Scott Kimball: Yeah. Demand for primary issuance ebbs and flows. We talked a bit about the Treasury and the Federal Reserve’s involvement in financial markets, owning so much of the less risky portions of fixed income and that’s probably pushed subscription levels. If we see them back away, it’s likely to perhaps adjust some subscription levels where maybe there’s not such an overwhelming demand for new issuers of primary paper.

We look at the primary market as a really strong indicator of our secondary market trading volumes and whether or not we think we should be living in the secondary markets more than primary. You see a lot of deals that are announced. They’re talking about your garden variety industrial name, let’s say a high BBB, Treasury Plus, 135 basis points is the talk. By the time they print the deal, it’s Treasury, plus or minus 105, plus or minus five, so 100 basis point is more likely to print and they squeeze all the value out. So from our perspective, it’s relative value investors. 35 basis points in this rate environment means everything.

So we actually tend to back away from the primary market when we see high subscription levels and what we call non-economic behavior when it comes to where these deals are printing. We say non-economic because if a company is issuing debt and their leverage is increasing, but compensation for that doesn’t exist, that gives us an indication that perhaps the market’s not really thinking about the value or where things fit in the credit cycle standpoint.

The credit cycle is everything. Right now we don’t know where we are in the credit cycle, except to say that we have to be hell of a lot closer to the end of it than we were at this time last year. Just look at where spreads are and you have a central bank who’s told you they are willing and they are able and they are ready to transition policy.

Dan Barnes: If we look at the risks that are being created for investors at the moment, how might an asset manager best manage those?

Scott Kimball: So there are some risks that we think in the past may have been a strong focus that maybe now we can just take a step back and say that’s unlikely to be the cause of stress. Default rates is one that will speak to. Corporate America is flush with cash, credit markets are wide open and we had a huge event early in the COVID period where we saw that the Fed will take risk and they will step into credit markets, so the default rate is likely to remain low, structurally. That leaves the question of then, where is my risk going to come from? Well, we’ve seen the duration of high yield extent. A lot of lower coupon, lower yielding instruments with longer dates. That’s the recipe for creating duration.

Because of that, there is an elevated amount of sensitivity to rates. In the past high yield was the spot to be when you’re worried about inflation or rising rates in fixed income. It’s still probably going to do better than investment grade or some other parts of fixed income. Governments in particular, or sovereigns and taxable duties. If there is not deflation, we don’t think we’re near that, but stagflation, where we have energy prices fx, pushing input costs and pushing supply chain prices higher and growth is not keeping pace.

That’s probably a storm for high yield, particularly longer duration, high yield. So high quality BBs, fallen angels, things that carry with it a duration of five and a half or six years. At the same time, there is a defensive property to fixed income. We’ve done a lot of trades out of subordinated to senior bank paper. We’ve been buying a lot of utility paper. When see this sort of compression, we have to keep in mind that higher quality fixed income for our clients that need fixed income for diversification, liquidity, those properties are still in place. If we’re going to diversify our portfolios against risk, high quality fixed income absolutely has its place and particularly in institutional investors asset allocation.

Dan Barnes: So then what perhaps should investors be asking of their asset managers this year?

Scott Kimball: Where’s my money? I think that one thing I’ve discovered in fixed income, there’s been a lot of money that’s gone into private credit and distressed in other vehicles, that I think from a board management standpoint, they don’t show a lot of volatility because they’re not liquid, they’re not marked as much. But there’s also a lack of understanding about what might be in some of those instruments. So understanding where your money is is important and the same thing goes in our world, in liquid markets.

You may have allocated to high yield, but are you in CCCs? Are you in quasi or a publicly traded distress type names, maybe some fallen angels on the energy side that are now in the CCC market? Are you still using bank loans?

There’s a lot of questions I would be asking about where your money is in fixed income, because when you start seeing environments where people are looking for yield and they’re chasing yield. The yield is the decision maker and people navigate it, they gravitate towards where the coupon clipping is going to be best. And they say to themselves, ‘maybe I’ll sort out later exactly what it is we’re buying.’ Maybe you had excellent managers that are doing a great job in those markets. And that’s great, but understand what exactly are the instruments that are comprised in those portfolios.

If this does become the policy transition that the market has been honed in on for 15 years, where we’re truly seeing inflation, we’re truly seeing a Fed that’s pushing toward the higher neutral rate again. There’s going to be a lot of implications for these asset classes. Fixed income in particular, it’s time to get under the hood and understand how the car drives.

Dan Barnes: Absolutely. Scott that’s been great. Thank you so much.

Scott Kimball: Thank you for having me. Look forward to talking again.

Dan Barnes: I’d like to thank Scott for his insights and of course, you for watching. To catch up on our other shows our to subscribe to our newsletter, go to TRADERTV.NET