Ahead of The Curve

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RECORDED EPISODE:

Gregory Hall: Hey everybody. Welcome to the very first edition of PIMCO’s new podcast, Accrued Interest. My name is Greg Hall. I head PIMCO's wealth management business in the United States. I'll be your host. Accrued interest isn't just a clever play on words. With this new podcast, we're going to bring you relevant and practical insights on market movements, areas of opportunity and the risk that might be lurking on the horizon.

We'll host internal experts such as the one sitting with me now, and we will also invite some friends of the firm to share their views and enjoy some good dialog. Most importantly, accrued interest is a critical pillar in our newly launched advisor forum platform, which is designed specifically with financial advisors and their clients in mind. If you're a financial advisor in today's world, we know the demands on your time are relentless, that markets are moving quickly, and your clients rely on you to cut through the noise and help them invest with patience and clarity.

In that vein, each time we do this podcast, I will be lucky enough to be joined by one of our many wonderful account managers who are spread throughout the country so they can be closer to you and your clients. Today, I couldn't be more delighted to have Emily McGrath, a vice president, representing the great State of Colorado, with me for our inaugural episode. Welcome Emily.

Emily McGrath: Thank you for having me. Excited to be here.

Gregory Hall: We're so thrilled you could be here. Thanks for coming in person. We'll do this all together. Okay… Without further ado, we're gonna get to the main event. I want to introduce our guest for today's show, Marc Seidner. Marc's a managing director at PIMCO. He's our CIO of non traditional strategies, a member of our investment committee, and he's agreed to be our guinea pig for this, our very first foray into the podcast world. Welcome, Marc.

Marc Seidner: Thank you very much. Greg.

Gregory Hall: It says here, Marc, that you have 38 years of industry experience. I have two questions. Did you authorize that disclosure?

Marc Seidner: I absolutely did not.

Gregory Hall: It couldn't be more than 37 years. Now, as we sit here at the table, I was reminded just before we started taping by Emily, who was nice enough to remind me the last time, Marc, that you sat at this table and recorded something the person in my chair was Dr Ben Bernanke, former Fed chair. So thank you, Emily for that reminder.

Emily McGrath: No pressure.

Gregory Hall: And Marc, today you've got me and Emily, but we'll do our best to fill, to fill Ben's shoes. All right, we're sitting here in early October. Just to put everything in context, we all came back from our summer vacations. Markets were expecting the Fed to act. We were expecting the Fed to act. The Fed acted, maybe even a little bit more than some were expecting. The consensus, at least if you read the headlines, pretty quickly turn to a pretty uninterrupted glide path of rate cuts. From here, all of a sudden, we get a jobs number last week that maybe throws that glide path into question a little bit. Marc, you're one of the top investment minds in the company. You're also, you know, for my two cents, one of the best communicators of investment strategy to our clients. I'm gonna, I'm gonna start with an open ended question, just given the headlines of the last few weeks, where are we in the cycle? How do we get here?

Marc Seidner: Well, that certainly is an open ended question, Greg, so thank you for starting that way. You and I are both pretty big fans of music, and we'll remember the talking heads and David Byrne, “Once in a lifetime, and you may ask yourself, ‘Well, how did I get here?’ So how did we get here? You've aptly and cleverly named the podcast Accrued Interest. I think accrued uncertainty we had, obviously a massive shock to the economy from Covid creating incredible amounts of uncertainty for all of us, professionally. Especially and even, and even, personally. We had extraordinary amounts of monetary and fiscal policy over the course of 12 to 18 months following the initial shock. We had a rapid rise in inflation, which is something that most investors haven't had to deal with in their professional careers, or even in their lifetimes, and I think that's created this incredible amount of angst for investors, incredible amount of uncertainty, and it's accrued. And in some regards, that's what's creating the opportunity put in front of us. And I might actually, in face of all of this uncertainty, I might ask the two of you a question myself, or call it a pop quiz. I'm going to give you four numbers, and you can either answer or you can defer, and I can tell you what the answer is, but, but 3.879 3.88 3.782 and 4.029.

Emily McGrath: I believe those were my GPAs in college.

Gregory Hall: That's how we hire.

Gregory Hall: I'm thinking Yelp reviews. But since you obviously know the answer to the question, Marc…

Marc Seidner: That would be the yield of the 10-year at the end of 2022 the end of 2023 the end of last month, and as of minutes before I came down here to do this podcast and join the two of you.

Gregory Hall: Isn't that remarkable?

Marc Seidner: So it's remarkable, right? So in the face of all of this accrued uncertainty, interest rates really aren't moving that much. Of course, we've been in a, in a pretty broad and well defined range, but I think that, when I mention this to a lot of people, advisors, clients, even some colleagues, they don't realize that for as much as the narrative has shifted over the course of the last 12 to 18 months. And how violently narratives have shifted, yields haven't really been changing that much. And I think part of how we get here is that accrued uncertainty that creates these, these camps, or these tribes that that are that are quite sort of steadfast in their views. There's the view of, well, interest rates have to head lower, and they will head lower. And every once in a while, they're empowered when inflation prints come in on the light side, or when employment data comes in lower than expected, and that causes a decline in interest rates. It causes a repricing of a path of Fed funds. And then there's the other camp that says, well, post Covid, the world is entirely different. That we have chronic budget deficits. We've got near-sourcing and friend-sourcing, and there's massive capital investment both to to create safety and supply chains, and also even for the greenification of our economies. And they say, well, interest rates should be much higher. And every once in a while, inflation surprises the upside. And just like last Friday, we got a Non-Farm Payroll report that was higher than expected, and everyone shifted to the other side of the of the of the boat, or other side of the narrative, and but lo and behold, when you go back to those four numbers, for all of the violent shifts within narratives, for all of the angst and uncertainty, and that accrued uncertainty, that's what's creating the great opportunity that we find ourselves looking at and trying to capitalize on today.

Gregory Hall: It's amazing the variation around that mean, how steady that mean has been throughout that time, the opportunities to make or lose money along the way. And it's interesting. It reminds me of this old story about a president who said, you know, please just give me a one handed economist. Because all my economists tell me, ‘On the one hand, but on the other hand.’ And, and since we're doing this for financial advisors who I think the end of the day, you know, we need to sort of offer them, you know, just a pragmatic approach to things. I'm curious, Emily, what do you think your financial advisors that you cover would ask Marc, after giving us that awesome rundown in the last couple years of economic history?

Emily McGrath: Yeah, and I was thinking about that as I was coming in here today and I was reviewing my notes of my meetings with my clients over the past two weeks, since the Fed cut rates and the elephant in the room is they, they know that this opportunity set is here, and this this movement in the markets, but they still have clients with money in cash. There's $6 trillion sitting in cash. And my advisors want to know, ‘How do we eloquently express that urgency to clients.’ That you had to make, kind of make the decision right twice when to move out into cash. They made a good decision when they moved into cash, some would say, but they also need to make a good decision of when to move out of cash. So I think that's on my client's mind.

Marc Seidner: Yeah, it's a great point and a great question. Emily, the analysis that I use, or the simple analysis that I use is the smartest people we know, many of us, personally and also professionally, took advantage of extraordinarily low levels of interest rates at the end of ‘20 and at the end of 2020, and throughout 2021, to term out their liabilities. Smart CFOs issued low coupon longer maturity debt, and refinanced shorter maturity, higher coupon debt. And all of our friends and family and even many of us took out mortgages with 2% or two and a half percent coupons. And looking back, that seems extraordinarily smart. Think about how many people have a 2% coupon on their mortgage and a half percent on or have been earning five and a half percent on T bills. I mean, it's, it's remarkably positive carry, and normally we don't get that opportunity. Well, the problem is going to be, now that the Federal Reserve has started lowering short term interest rates, what if that five, five and a half percent doesn't last for forever? I think there's a chance, three years from now and we'll look back and say the smartest investors we knew in 2024 at that moment, with the call to action of the Federal Reserve beginning to lower and normalize short term interest rates will term out their assets. 

Gregory Hall: I love the mortgage example, because it feels so tangible and concrete. I feel like most people in this country who own a home that that it really gets them, they understand that as rates begin to dip, there's an opportunity to lock in a lower borrowing rate. It's a very natural thing, that you learn over years of owning a house. And yet, I think on the asset side of the balance sheet, for a lot of people, it's maybe it's a little bit less natural to think of it in those terms. And so that's probably, I don't know, Emily, if you agree, but that seems like a great framework to for a financial advisor to express to their clients exactly the opportunity that's available to them in fixed income right now.

Emily McGrath: Yeah, yeah. And honestly, it's part of our whole Advisor Forum at PIMCO, with our Advisor Playbook that we've presented for our clients to be able to share with their end investors, is showing that exact story of it was an opportune time to borrow money between 2017 and 2021 and now it's a great opportunity to be a lender.

Marc Seidner: Think about it super simply, right? You got a two, two and a half percent mortgage, you can buy agency mortgage backed securities yielding 5 percent. So you get to pay two earn five. You get to be a bank, basically, Cash is a zero duration asset, and so it's great when interest rates are rising, you get to reset every day, if you want, right? It works in reverse when interest rates are falling. Going back to the question you asked. You know, where are we? How did we get here that that talking head song is titled once in a lifetime. I'm not going to sit here in front of you both and to the advisors that are listening and saying, This is a once in a lifetime opportunity, but it does in a in, you know, thought about in a simple framework, it does seem pretty compelling....

Gregory Hall: Do you think Emily, one of the things you know, as we've talked that, that I think is pretty common from feedback we get in the marketplace, is a little bit of fixation around these point in time data points. So it was amazing to me, as the Fed got closer and closer to cutting rates, the feedback we were getting from clients moved so quickly from ‘This is a tremendous opportunity’ to, ‘Uh oh, I've missed it.’ And I'm curious, Marc, you know that that's something that we, you know, contend with all day long, is, is how, how can we express the significance, the size of the opportunity, and maybe try to focus people away from, you know, the specific data points along the way.

Marc Seidner: Look, markets don't move in a straight line, and so, you know, it on any given day or in any given moment, it may feel like there's an opportunity missed. But markets can deliver the gift of a second bite at the apple. And we may be in one of those moments where you're getting that second bite at the apple. Yeah, non-farm payrolls surprise to the upside have caused a repricing of rate expectations, but that's again, within going back to those four numbers, a pretty broad range, and perhaps creating that opportunity to say, ‘Well, I didn't miss it.’

Emily McGrath: I reflect back on even 12 months ago, when we look at Q4 of 2023 and it looked like in a flash, the entire bond market rallied. And advisors felt that. I always use this analogy with my advisors, that that was a movie trailer, that was a trailer to what can happen in the bond market in a very short period. And the movie actually just hit play on September 18, when the Fed decided to cut rates. And now it's a time to watch it play out. Maybe the greatest Bond movie ever.

Marc Seidner: Now that rates are falling at whatever pace they're going to fall, whether it's whether it's a rapid decline to something more normal, or it's a more gradual decline to something more normal, cash rates are going to go down, and that is going to create a tailwind for a bond market that's faced a headwind for two or three years now.

Gregory Hall: We're on a we're on a path. It won't be a perfect straight line. Rates are moving lower. We feel like there's tremendous value in the bond market today.’ On the whole let's start to get maybe a little bit more specific about where you see value. Because I think one of the things we try to be very cautious of is the set it and forget it mentality. And I think financial advisors, rightly so, are also very cautious of that, especially in the fixed income market that just offers so many opportunities to add value through creativity, through nimbleness, and through expertise. So maybe, maybe just starting with sectors of the market Marc, where you where we see value relative to other sectors where we are maybe a little bit more cautious than the average investor out there.

Marc Seidner: Well, now, now you're going to get me all excited about talking about, about actual

Gregory Hall: It's a fixed income podcast. If somebody gets excited, we've done our job.

Marc Seidner: As you all know, we get up pretty early in the morning around here on the West Coast, working East Coast hours. These days, there's a spring in our step as we as we hop out of bed and head in the office, because the world, and I mean this, the world, is full of pretty compelling opportunities. I'll cover a few quickly... I mean the starting point is bonds are offering attractive entry points in terms of yield. So we want exposure to fixed income. But how do you, how do you get that? You know, a lot of folks say, ‘Well, you know, I'm just going to buy a treasury bond, or a Treasury note, or a passive fixed income ETF.’ I would say that's good, but not enough, because again, going back to those four numbers like we're moving. The narrative is moving violently amongst ranges, which is giving opportunity for the active, nimble to do better than that. And that's both in terms of how you position a portfolio, how you adjust the positioning of the portfolio. Not all bonds are created the same. Treasuries as a starting point, look fine. Mortgages as a starting point, look great. International bonds. The hallmark of 2023 was this notion of US economic exceptionalism. We have US economic exceptionalism because the consumer in the US is in extraordinarily good shape because of locking in low levels of borrowing costs and deleveraging over the course of the last decade. That's not the case in many other countries, where the pass through from higher interest rates through a more floating rate mortgage mechanism is much faster.

Gregory Hall: Yeah, because you can't get a 30 year fixed rate mortgage, generally speaking, in Canada, the UK, Australia, right? That's a, that's a US phenomenon, correct?

Marc Seidner: And that's our job to find out, to find those opportunities, where, as, we would expect. Bank of Canada, I mean, the Fed, started cutting rates two weeks ago. Bank of Canada started cutting interest rates several months ago because the effect of their tightening cycle passed through to their economy much faster...

Gregory Hall: That’s the pass through mechanism.

Marc Seidner: That's the passing mechanism. So we want to be overweight Canadian bonds. We want to be overweight UK bonds. We want to be overweight Australian bonds. Where it's the same theme, same concept, and one of the areas we want to exploit in terms of active management being nimble and finding even better opportunities with the starting point of a pretty attractive fixed income opportunity set.

Emily McGrath: Yeah, I think, I think that's such a fascinating topic that the average US mortgage is typically, I think 92% of them is 30 year mortgages. But you look at Canadian mortgages, and they're typically short term mortgages. Like?

Marc Seidner: One year resets. Same for Australia.

Emily McGrath: They immediately feel the impact that they're paying more or less for their mortgage, within the next month. Like the US economy doesn't feel that. And that's such an interesting concept when we look at when you're looking at international investments.

Marc Seidner: Again, it's part of alpha generation for a fixed income portfolio with a broad, flexible opportunity set, and it also, you know, reflects into economic analysis, and our outlook for the for the world as a whole.

Gregory Hall: You know, we shouldn't forget also, I mean, the stock market has been extremely healthy as well the last couple of years. And equity investors are telling us, they feel, pretty good about the value of corporate America, if you will. What do we think about corporate credit? You mentioned mortgages, you mentioned international rates, and you haven't said anything about credit, broadly speaking. So I'm just, I'm sort of curious where you come down on that.

Marc Seidner: Yeah, the economic the economic fundamentals are fine, as you say. You know, equity markets have done well because companies are generally quite healthy, which is generally a benign backdrop for investing in corporate credit. The only caveat there is that valuation fully, probably more than fully, reflects the strength of equity markets and the underlying strength of the US economy. We talked about mortgages, we're in a unique situation where the nominal spread on a mortgage is higher than the spread on corporate credit.

Gregory Hall: You make more coupon owning a mortgage than you do lending to a company in the US right now, again, broadly speaking,

Marc Seidner: Mortgages are higher quality in terms of their rating, they are more liquid, and normally you'd give up about half a percentage point of interest to own the higher quality, more liquid backed security. But now, because of a variety of factors, mortgages actually yield about 30 or 40 basis points more than corporate credit. So you're getting higher quality, better liquidity, more yield. Again, corporate credit is fine, but as you think about relative value in the opportunity set, valuation just doesn't look all that attractive, and we'd much rather look for other areas that we can exploit that are cheaper on an historic basis and should give us better yield and potentially better return, oh, and also less downside risk in the case that where everyone's wrong and the global economy, and this economy isn't quite as robust as we think it is.

Emily McGrath: Yeah, and people think about bonds as their airbag, like they want it to be the safe aspect of their portfolio. And I think with all of this money sitting in cash, and clients looking to move out of it, looking at these attractive opportunities that you're mentioning, mortgages double A rated, that we're able to invest in and not take on too much relative risk for their portfolios.

Marc Seidner: On the other end of the spectrum is high yield. High yield… all in yields are quite attractive, but the all in yields are quite attractive because the starting point of treasury yields, and higher quality fixed income yields are very attractive. The spread on the high yield index is about 330 basis points. Of that 40% or so comes from the widest trading names. So again, your generic expression of high yield debt is offering you about 200 basis points over, which really does not compensate for liquidity, and importantly, for that lack of safety in a world where you really want the benefit of diversification, you want your bond portfolio going up because you've got a whole bunch of other things in your portfolio that may very well be going down in price at that point. So that up in quality bias and that notion of terming out your assets are two critically important themes for us around the Investment Committee and around the portfolio management group these days. One of the compelling opportunities for fixed income over the past few years, in a rising rate environment and with you know, a relatively positive economic dynamic has been floating rate debt, particularly floating rate corporate debt. Now our concern is that what's been the darling for the past few years may have some negative consequences as interest rates begin to fall down and economic scenarios and tailor risk, economic scenarios become slightly more challenging...

Gregory Hall: This is leveraged loans. This is private credit. Any other examples?

Marc Seidner: No, those are two prime examples. As short term interest rates come down, you're getting less interest, so you have less in terms of your potential return, and you have increasing economic sensitivity, and again, not to not to pound the table, but the corollary to wanting to term out assets is to is to be a little bit cautious or circumspect about floating rate, lower quality credit, which may not provide that, that that anchor to win word or the safe harbor in a port in a storm that that many would look for out of fixed income.

Gregory Hall: Yeah, you got to lean out pretty far on credit to pick up some extra yield. And sounds like you're not super in favor of that. And then you mentioned terming out, and I love the analogy going back to where we started, which is it's an opportune time for investors to think about locking in some great yields longer in their portfolio. Is there a limit to that? As you go further and further out into the future, 10, 20, 30 year bonds. Do we start to encounter, you know, fiscal and other maybe credit issues with governments? Is that something that that you're thinking about today.

Marc Seidner: Are there limits on how far we'd want to go or what we'd want to own?  We definitely think that the opportunity in short and intermediate term bonds, call it two to five year maturities, look much better than 10 to 30 year maturities. The problem with a 30 year bond is, after two years, you gotta wait 28 years. So you're kind of stuck in… you're stuck in the trade. Particularly in a world where look post the pandemic, one of the halt, one of the fundamental hallmarks, is higher levels of debt and higher structural budget deficits that we've had in the past. I know that I think you're having Libby Cantrell on your next one, and she advises us on the political front. And the one thing that she tells us that totally resonates with me is that the one clear loser in the elections is the budget deficit, because we're going to be running six and a half to seven and a half percent budget deficits. And in that world where there's increasing supply, increasing debt to GDP, questions about debt sustainability, there should be a higher risk premia for owning longer duration bonds, longer maturity bonds, than for short intermediate term bonds. So clearly to us, you know, we think in terms of terming out assets. You don't have to, we're not talking 20 or 30 years. You don't have to go there. 2, 3, 4, 5 should be plenty in terms of giving clients a good level of starting yield. And by the way, when inflation falls to two and a half percent, that starting point of yield on not just a nominal yield basis, but on a real yield basis, is a pretty attractive starting point.

Gregory Hall: It may be home bias, but feels to us like fixed income deserves a look bigger position in people's portfolios as both on offense a way to generate yield and income for their clients, and on defense as well. In case we're wrong about the direction of the economy and something does go, you know, poorly, a little faster than we might think.

Emily McGrath: Yeah. And I think people forget where we were three years ago. When I look at starting yields, which you just mentioned, like starting yields look great. That's my only critic. You said good. I think they look great today. And I think it's a potentially exciting entry point, because you look at high yield, where they were yielding in December of ‘21 that's where the highest quality of the fixed income market is yielding.

Marc Seidner: That's a great point. Two to three year maturity or duration portfolios with single average credit quality can be achieved with sevenish percent yields.

Gregory Hall: And I think, I think we should acknowledge right that we predict a range of outcomes. There’s always probabilities, that things don't work out the way that we expect, and then, that's where active management comes back in, which is you can react to changing conditions, as we have over the last several years, and we'll continue to do because you never get it exactly right.

Marc Seidner: Having a framework, being nimble within that framework, maintaining prudent amount of liquidity and dry powder that's going to be the key to success.

Gregory Hall: All right, I can't think of a better sentiment to end on. So thank you. Thank you both for agreeing to go on this journey, to start this journey out with us of the Accrued Interest podcast and joining us for our inaugural episode, So, as Marc mentioned, we've got Libby Cantrell coming up. We'll be recording with her. It'll be just in the wake of the November elections, and she'll be able to unpack those results to the extent that we have them. We'll talk about both the political and the economic and the investment implications of what happens next month. Libby is not only a terrific policy analyst and an advocate of PIMCOs’ and public policy arena. She is probably one of the most popular and requested speakers at wealth management events around the country. Financial Advisors and the firms that employ them are literally ringing off the hook to get her to come and speak to their teams and help them prepare for what's coming in November. I want to say in closing, we hope you'll come back and listen to more episodes as we try to bring more expertise to bear. Help you to help your clients invest well, help you to manage and build your practices over time. We also hope that you'll take a minute and visit pimco.com if you identify yourself as a financial advisor, it will bring you straight to the Advisor Forum section of the website, where you can view the plethora of tools, webcasts, resources, all of which are designed to help you conduct your business more effectively, more efficiently. Thank you for listening to us today, we will see you next time.