High-Quality Bonds Look Attractive Today
With little valuation difference between riskier and safer credits, Mike Collins and Mike Lillard of Prudential Total Return Bond Fund are taking the opportunity to upgrade their portfolio.
Eric Jacobson: Hi, This is Eric Jacobson from Morningstar. We're here today with our Fund Manager of the Year awards, and we're talking to a couple of gentlemen who are involved in the running of Prudential Total Return Bond Fund. They are part of the PGIM fixed-income team, which is newly rebranded from Prudential.
I've got Mike and Mike--Mike Collins, Mike Lillard. Thank you so much for joining us today.
Collins: Our pleasure.
Lillard: Thanks for having us.
Jacobson: First of all, congratulations on winning manager of the year. We're really excited about it. We talked about the fact that you guys are sort of, in terms of reputation, getting known by the industry on the retail side, up-and-coming, people starting to get some traction knowing you.
Let's talk about 2017 and maybe start off a little bit with what are the things that worked well for the Total Return strategy?
Collins: We actually fired on all cylinders in 2017--maybe one of the reasons we're here today. We have a really diverse set of different trades and positions that all worked well. From a duration positioning, we were tactically long any time rates in the U.S. backed up. In fact, even today with rates at the higher end of the range, we've been adding a little bit of duration. We've had a big yield curve flattener on. We don't believe there are enough, or were enough, Fed rate hikes priced into the front of the curve, so we have a big short in the front of the curve, and offsetting that with a long at the back of the curve, that's worked really well in 2017. And continues to do OK.
In the credit sectors, we've rotated down in terms of high-yield and investment-grade, we've reduced exposure to some of the more levered industrial credits. We've rotated into higher quality, mostly AAA structured products, and also things like banks and even some sovereign debt. So clearly upgrading the portfolio and all those things worked well last year.
Jacobson: To the degree that that upgrade has been on track there, is that more of a valuation issue? Are there things in the market you're particularly concerned about?
Collins: It's really for two reasons. One is a valuation issue. You can sell A industrial corporates or even some BB high-yield bonds at spreads that are tighter or close to the same spread you're getting on a AAA CLO, or collateralized loan obligation, or a AAA CMBS. So the valuation is really compelling. There's a mispricing, I think, in those markets. And also, it is definitely an up-in-quality, more defensive trade, right. Not that we see any real credit risk or recession risk on the horizon, but if we do have a dip or a downturn in the economy, this higher-quality structured product will actually hold in really well in our mind.
Lillard: From a relative value perspective, a lot of that stuff is still cheap. Some of this AAA CMBS, AAA CLOs. We see those things, the CMBS, like 70 basis points over swaps. That could easily get up to 40. Then the AAA CLOs, 105. That stuff could get into 60. So they have almost as much upside as some of these other sectors, and much more defensive in case we get a downturn that we don't see. But you never know.
Jacobson: I appreciate you guys coming in and talk to us. Congratulations again on manager of the year, and good luck with 2018 as well.
Lillard: Thanks a lot.
Collins: Thank you, Eric.
Jacobson: For Morningstar, this is Eric Jacobson. Thank you for joining us.
Eric Jacobson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.