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Is the Door Closing on Corporates?

Western Asset manager Ryan Brist expects a lot of risk in the corporates market in 2013-14, as banks pare risky lending practices and opportunities to enter or exit the bond market shrink.

Michelle Canavan: Hi, I'm Michelle Canavan, mutual fund analyst at Morningstar. I'm here today with Ryan Brist, head of U.S. investment-grade credit at Western Asset Management and lead manager of Western Asset Corporate Bond.

Thanks for joining us today, Ryan.

Ryan Brist: Thanks, Michelle.

Canavan: I thought maybe just getting started, Western has always kind of been known as a credit-focused fixed-income shop. Can you maybe just talk about what you think sets your team apart from your credit research and management capabilities?

Brist: I think you're right. I always tell our clients and consultants that when you manage credit portfolios, when you manage a portfolio of 80 to 110 different companies, you have to have the resources to do it right. And one of the things I'm most proud of about Western is that we have 34 people dedicated to research on a full-time basis. It's a very senior group actually. The average tenure is 17 years in the credit market. I think that their focus on management and some of the more subjective kind of qualities of evaluating credit really comes through and ultimately hopefully through our returns for our clients.

Canavan: Speaking of returns, 2012 was a really great year for Western Asset Corporate Bond. Maybe you can talk about how you were positioned going into the year and your outlook and kind of the things that really generated that great return.

Brist: We did have a solid year. I appreciate you acknowledging, and I say humbly that we had good year. But at the same time we're very proud. I think of 2012 as kind of the year of where the sun, moon, and stars kind of aligned together, and I'd first start by saying that that's a rare occurrence that that happens.

If you looked at our attribution of returns, we had pretty good security selection. We were in the right sectors, and we were down in quality relative to our benchmarks. And that added returns. The attribution of returns kind of along those lines, our main overweight was in the bank and financials sector. We were willing to be down in the capital structure in hybrid and trust preferred securities where we felt very comfortable from a research perspective. The simple story was that loan losses are less on the bank balance sheets. There has been undeniable balance sheet improvement and less risky activity by the banks. That kind of all culminated into tighter spreads in the sector. Over the last kind of two to three years, Michelle, it's been a really unpopular and uncomfortable bet to be in, and I think back to your Western question, I think that's where we really kind of try and distinguish ourselves, within our really tight risk framework. We like to be in sometimes those uncomfortable and unpopular areas of the marketplace, and ultimately they pay for our team.

We were pretty neutral in 2012 in the industrials sector, and that's where our kind of research team really kind of honed their skills. I think that there was a lot of acquisitions within industrials. Industrials weren't the cheapest sector but there were a lot of good situations, like Eaton Corporation bought Cooper, Ecolab in the chemical sector bought Nalco, Rock-Tenn which is in the paper and packaging sector bought Smurfit-Stone. And in each of these situations, a company did a strategic acquisition where they temporarily increased the leverage of their balance sheet. I think that our research team kind of really had a chance to evaluate the strategic nature and if we agreed with the strategic nature of the acquisition. Each of those acquisitions was associated with a bond issuance. And we capitalized on those, and those paid us. They aren't as valuable now in the marketplace but they paid our portfolios in 2012.

Lastly, I'd mention that we were really underweight electric utilities and technology. Electric utilities, there's a little bit of a arms race in renewable resources, and we think not only in the U.S. but around the globe electric utilities have big capital-expenditure budgets in the next three to five years. So that means there's going to be great supply in bonds, and we're going to have an opportunity. Maybe a company will make a mistake, and it will reprice the sector. Our analysts also did a pretty good job, Michelle, in terms of situations like Dell and Hewlett-Packard in technology. We had almost zero exposure to the technology sector in 2012. And you know what we do in the bond market--our number-one M.O. is to try and avoid principal loss or decline in price and avoiding sectors--the technology sector really paid us in '12.


Canavan: Some investors are talking about after this great year of credit in 2012, that a lot of the value is gone from the corporate markets. I guess, what would you say to that?

Brist: I agree. I think the market's pretty picked over here, and it's important to remember that spreads were 90 tighter on the credit index in the year 2012. We historically would call that a great two years of spread tightening. So, we got a lot of returns in a short amount of time, and we still think there's value in credit. But we got to recognize as a deep-value manager at Western that prices aren't the same as they were a year ago, and we're kind of positioning or repositioning the fund. We still like banks, there are still some industrials situations, but we're going to be lesser in those sectors in 2013 than in '12.

So, I'd agree with that. And I think that over the next 18 to 24 months, we're going to be watching for tough situations. There's a fancy term we use called idiosyncratic risk in the bond market, and that's just simply single-company risk or single-name risk. And we've seen a lot of those bondholder-unfriendly situations just pop up in the last couple of weeks. So we're going to be on guard, our antennas are going to be high, and try to avoid those situations in '13 versus '12.

Canavan: And there's also an opportunistic component to your portfolio. So, I guess, if you look at some situations of noncorporate positions that were beneficial, can you maybe just talk about some of those?

Brist: Yes. Our portfolio, the foundation is basically 80% high-grade corporate bonds, but we can go into emerging markets, we can go into non-investment-grade, and we even have a ability to do a currency component in the fund. We've been anywhere between kind of 5% and 25% in high yield during the last three years. Right now, we reside at about 8%, at the lower end of the range, and I'd even argue that that high-yield component is lower-duration and higher-quality right now.

We're short in the currency markets; 1.5% in the yen, and that's been a popular, very publicized trade in the last three months. But our global team over in London really hit this trade for us at Western. It's kind of good to have other areas in these resources help out your fund, but that was a borrowed trade from another resource within Western, and this fund has the opportunity to take advantage of those trades. I think that yen trade, for as much press as it gets, it's a fairly easy-to-understand trade. We know that there are kind of export problems within Japan. There's kind of agitation in the South Sea versus the country of China. And I think that the Japanese trade actually was kind of byproduct of a lot of the fiscal cliff that we've seen in the paper that if the U.S. has a high debt-to-GDP problem, then what about Japan? And so it really kind of laser-beam focused on that situation. Not to mention that [Japanese prime minister Shinzo] Abe kind of ran under the auspice of that, "I'd lower or I'd try and reduce or depreciate the currency versus global currency."

So, a lot of pieces of that story came together kind of all at once in a quick fashion, and we got some of it. I want to highlight that that's not the foundation of the portfolio, though. It's an opportunistic trade, and it's kind of at the edges, if you will. But it has been additive, and we have the ability to participate in those trades.

Canavan: Looking over the next 12 months, what do you see as kind of the biggest concerns about the market?

Brist: There's a lot of risk. I think, if you talk to people in our broad strategy committee led by our chief investment officer, Steve Walsh, I think we'd say that, probably our number-one concern over the next kind of 18 to 24 months is how does the Federal Reserve ultimately exit this kind of unchartered territory that we've entered in. And we have high respect for the Fed at Western and what they've done in their response to the crisis over the last two years. The one thing that's been super consistent in the marketplace is that the Fed has done what they said they are going to do.

But at the same time, we do have some concern that maybe over the next 18 months that there's going to be some bumps and bruises along the way in terms of exiting. The market is going to continue to test that notion if we can kind of exit this kind of unchartered policy or this asymmetric policy that we've experienced. So that's an issue.

I mentioned leveraged-buyout risk and some of this idiosyncratic risk. Probably the third thing that we spend a lot of time on is liquidity in our portfolios. And we're in a little bit of a newer bond market in the sense that for the last two years, we've kind of fretted about a lot of the global legislation--Basel III, Dodd-Frank, and the Volcker Rule. And we're about to enter a time period when they are about to kind of dig their heels in, and now we're going to live under these policies. So maybe there are unintended consequences.

But the one thing that we know is that banks are engaging in less risky opportunities going forward, and that they have smaller balance sheets. And that window or that door to exit and enter the bond market is probably smaller than it was before, and so we are maintaining a little bit higher amount of liquidity in our portfolios, a higher amount of Treasuries than we have relative to the past. There could be bouts in 2013 and '14 of this kind of lack of liquidity in the marketplace rearing its kind of ugly head.

Canavan: Well, great. Thanks a lot for your comments today, Ryan. We really appreciate it.

Brist: Thanks, Michelle. Thank you.

Michelle Canavan Ward, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.