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We’ve seen a striking rebound in markets since the middle of June. Stocks have rallied and credit spreads have come in nicely. But the macro situation remains ambiguous and confusing. On this episode of the podcast, we spoke with Pimco’s Chief Investment Officer Dan Ivascyn about the state of markets right now, what he’s invested in, what he’s concerned with, and so forth. This transcript has been lightly edited for clarity.
Key insights from the pod:
What Pimco is thinking about right now — 3:31
Pimco source of edge — 6:03
Where are we in the cycle — 7:43
Can we have a soft landing? — 10:04
Why so many people got inflation wrong? — 13:49
Where the opportunities lie in credit — 22:15
Risks abound in housing — 27:45)
The state of the mortgage market — 35:04
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Tracy Alloway: (00:00)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe: (00:05)
And I'm Joe Weisenthal.
Tracy: (00:08)
Joe, I feel like it's pretty hard to be an investment manager at the moment. I feel like it's hard at the best of times, but at the moment you have this intense volatility. Stuff that is normally volatile, like stocks and commodities, are even more volatile. And then you have stuff that isn't really supposed to be volatile, but definitely is in the new environment. And I'm thinking mostly about bonds.
Joe: (00:32)
Well, and also, the underlying macro situation is just extremely complicated and contested. I mean, like, there's a debate about whether the last two quarters are characterized as a recession and there's kind of legit questions about that. Setting aside NBER vs. two negative quarters, like, how should you characterize this environment in which consumer sentiment is really low, growth is down, employment is booming, inflation is still hot, consumption is still hot? Like, these are just like really difficult environments to understand in part because it is kind of unprecedented.
Tracy: (01:11)
Yeah. And it seems like everyone kind of feels bad and all the survey-based economic measures suggest that sentiment is deteriorating. But at the same time, the hard numbers are really resilient. So actual spending and investment just keep going. And yeah, you're right. It's a really weird environment, particularly if you're trying to put money to work.
Joe: (01:34)
And then I would say over the last two years, like everyone kind of got it wrong at every turn, right. Like everyone said, COVID hit in early 2020 here comes a big downturn and a recession. And actually we had the shortest recession in history and then stocks were at all time highs a few months later, then fast forward a little bit to 2021, people were super positive. Inflation was ticking up, but is likely transitory it's like reopening. And everyone got that wrong. Particularly a lot of investors judging by how fast the repricing happened. The Fed had to pivot pretty quickly when it realized inflation would persist for longer than expected. A pivot really started in November. So it's like at no point has it felt like the consensus has been like, had a good feel on this cycle.
Tracy: (02:23)
At no point has it felt like anyone really knows what's going on? Is that what you're saying?
Joe: (02:28)
Hopefully our guest today knows.
Tracy: (02:29)
Exactly, so on that note we are going to be speaking with someone about all of these very, very big topics. Really the perfect guest, literally the perfect guest. We're speaking with Dan Ivascyn. He is, of course, the group chief investment officer and managing director over at Pimco in Newport Beach.
For those that don't know Pimco, I mean, you must know Pimco, but Pimco has something like $2 trillion worth of assets under management. So making these tough decisions about the macro outlook and where to actually invest every day. So, Dan, thank you so much for coming on thoughts.
Dan Ivascyn: (03:09)
Well, thank you, Tracy and Joe, very excited to, to be here today.
Tracy: (03:13)
So you sit on Pimco’s investment committee. I'm really curious: What's top of mind for the people who have to do something with $2 trillion worth of assets every day? What are you guys talking about? And what's on the top of the agenda for you at the moment?
Dan: (03:31)
Sure. Well inflation is certainly a topic as you mentioned. This has been an incredibly challenging time from an economic forecasting perspective. First a global pandemic, then an unprecedented amount of fiscal stimulus. And now an inflation problem that at least is partially related to those two prior points.
So increasingly we're spending a lot of time talking about this inflation dynamic, of course, how policy makers are going to look to get inflation back towards their targets. And now increasingly markets are seeing what has historically been a fairly obvious trade off. And that's growth in employment and this inflation problem and how will that be balanced over time? In addition to that, of course we're not operating in a normal environment.
We have war in Europe. Lots of uncertainty and ongoing global tension between the United States, other Western countries and China. So there's just a lot of uncertainty. A lot of risk. And we're trying to gain sufficiently broad perspectives to see where we may have an edge. And I think it's important in an environment, as highly uncertain as this one, to realize when at a particular point in time, you don't have an edge and where you're entering markets that represent a lot of risk, a lot of volatility. And I think there's a risk management piece here as well. There's enough volatility where we should be able to zero in on areas where we do have an edge and where we can add value while looking to shelter the portfolio from a lot of the unwanted volatility that we're seeing elsewhere in markets.
So that's one key theme. The second of course is a lot of real-time discussions around this volatility that we've witnessed. Beneath the surface, there's a lot of dispersion across equity markets and fixed income markets. A lot of localized overshooting given markets aren't super liquid, they don't feel distressed, but certainly a type of environment where, using a baseball analogy, there’s a lot of singles to hit while you gotta be careful swinging for a home run, given this radical uncertainty. And the fact that you can get caught off sides pretty quickly in this type of market.
Joe: (05:45)
So why don't you talk a little bit more about you said identifying your own sources of edge. What are they? I wanna get to the actual market environment and your outlook for inflation and bonds and all that. But when you think about where sources of edge come from an environment like this, what's the answer to that?
Dan: (06:03)
Well, I think, I think one relates to markets that are less liquid than they've been in the past. And opportunities to take advantage of some overshooting.
Perhaps a good example is, more recently, over the last few weeks or maybe going back weeks where equities were quite weak, credit spreads were widening and widening fairly, significantly big upticks in the various volatility markets. A volatility market could be in agency mortgage, but it could also be more technical volatility markets. We've seen even over the course of this summer, various levered players, other specialty type styles got a bit over their skis for risk perspective. And I think part of the step back that we witnessed over the last several weeks this pretty powerful recovery into what appeared to be bad fundamental news is tied to a little bit of this.
Tracy: (07:07)
So you mentioned how unusual the economic environment has been. And I feel like this is the source of tensions or problems for a lot of investors at the moment. Like we're used to thinking about a normal economic cycle. It starts, and then at some point it stops. But it feels like what we've seen post-pandemic is not a normal economic cycle at all. How would you characterize it? Like, how are you thinking about it? Is this late cycle? Is it early cycle? It seems very confusing at the moment.
Joe: (07:38)
Is it a cycle outside the cycle?
Tracy: (07:40)
Yeah. Is it even a cycle, who knows?
Dan: (07:43)
Yeah, I think there are multiple cycles or, or at least significant cross currents. I think when you look at cycles, I think it's important to make the distinction between a lot of the Western economies and what's going on in China right now. To a lot of us, Covid is mostly behind us and we're in the midst of a pretty significant Covid-related reopening process. Very strong demand for travel services. A shift away in many economies from Covid-related goods, consumption towards a more normalized… areas associated with a more traditional open economy.
In China, now they're dealing with Covid, other Asian countries are to a lesser degree, and they're in the midst of an environment where economic growth is slow and slowing and inflation isn't a material problem.
And then back to even the US economy. It's very difficult to understand in the sense that we do have significant momentum in a lot of sectors yet we're quickly beginning to see the impact of prior policy tightening on some key areas of the economy as well. So the level of complexity is there, but again, when you have an inflation problem and you have policy makers looking to tighten policy you are going to get into a situation where it's almost certain that you're gonna see some economic weakness.
And then of course the challenge then becomes how does this economic weakness impact inflation? Is there a chance of a soft landing or do we have a situation where probabilities are growing and growing fairly rapidly that we end up in a recessionary environment? Those different scenarios have very different implications on what segments of the opportunities set are gonna perform well both in absolute and relative terms.
Joe: (09:33)
Well let's just get right into that. And of course there's a econ debate. You have folks like Larry Summers and Olivier Blanchard saying like, “Look it is unrealistic. It's wishful thinking to say that we can really get inflation back down to any reasonable level without having a meaningful rise in the unemployment rate.” Do you buy that? Because I think this is the multi-trillion dollar question right now. Can the Fed get back to target without a painful recession?
Dan: (10:04)
Yeah, so I think history is on their side ... Summers and Blanchard for sure. But there's certainly a chance that we see what will feel like a somewhat soft landing now. You know, here at Pimco we have core CPI at the end of this year remaining elevated up near that 5.5% type range. Towards the end of 2023, and take that forecast with a grain of salt, given the extreme uncertainty, but we don't see inflation getting back below 3.5% all the way out to 2023. So we do think that the likelihood is the Fed's going to need to tighten and tighten fairly significantly from here. But we do think there's at least a shot of a somewhat soft landing.
We think officially we're gonna have a recession. It could be a prolonged but fairly mild recession. But again, one of the bright spots, if there is a bright spot here, it’s that over the last few cycles, there appears to be a strong and increasingly strong relationship between the financial economy and the real economy.
And you've already seen in response to moderate tightening thus far a pretty significant impact on financial conditions. Now they've loosened over the course of the last several weeks. But that transmission mechanism appears to be working and working fairly quickly. So again, we have an economy with very strong momentum, particularly on the wage or the employment side, and the Fed and other central banks that have tightened and it appears that they're having an impact on recent economic activity.
So there is a path that I would define a moderate slowdown is a slowdown that doesn't have a material impact on overall credit fundamentals. And I would probably put a 25 or 30% probability to that that type of scenario. And again anytime you have headline inflation up in the 9% type range and unprecedented at least for several decades and a lot of geopolitical risk, including war in Europe, which can deteriorate very, very quickly, you have to position yourself you have to position yourself for at least a meaningful probability of a more material economic slowdown, and what that means, of course, under that state of the world you have a lot more widening to go across most credit sectors. You probably have significant earnings deterioration from this point forward, which will likely lead to weakness and equity markets as well.
So again our general view is that we have a fairly mild, but sustained recession. That's why we continue to be fairly cautious regarding the more credit sensitive sectors of the market. But again, that’s one of a handful of credible scenarios and again, you have to prepare for the worst as an investor. And that means thinking about preserving capital, given the radical uncertainty, as much as it does aggressively positioning to generate total return, particularly in those riskier segments of the market.
Tracy: (13:17)
You know, Joe mentioned at the beginning of this conversation that a lot of people got it wrong on inflation, and I'm not just talking about the Fed of course which doubled down on the transitory idea a number of times. But I'm thinking also just of the broader market. You look at breakevens and those were continuously expecting inflation to peak within a few months. And that hasn't really come to pass. What do you think people got wrong about the inflation outlook? What was it that the market seemed to miss?
Dan: (13:49)
Yeah, I think a lot of participants were looking at in inflationary process in a more traditional sense. I think the pandemic itself was quite confusing. It of course had direct supply side impacts on the global economy. And even more importantly, the policy response on the fiscal side was massive. And sufficiently massive that again, we haven't had a lot of good case studies in history in dealing with such a significant demand side boost at a time where you already had significant Covid related supply constraints. So it's an unprecedented situation.
We talked earlier about these cross currents impacting economies, making it even harder to forecast. And I think in some sense we all, or many of us were, you know, using, you know, prior frameworks at least initially, uh, to think about and to forecast this inflationary process.
Now to your point, a good one, even market pricing didn't envision this level of inflation or how sustained this inflation would be. But at the same time, when you look today at longer term measures of inflationary risk within markets, they too are fairly complacent. And if markets prove to be right, then in fact this inflationary event may prove to be fairly temporary. So it is remarkable if you said inflation would be at 9%, people would be talking about a Fed well behind the curve and you would have a 10-year breakeven inflation rate below 2.5% percent, or looking at a popular rate, like a 5-year forward 5-year rate well below, uh, 2.5% or a yield curve for that matter today that is fairly flat or slightly inverted at levels, uh, below 3%.
So in some sense although policy makers and investors were late, you wouldn't have made a tremendous amount of money through a significant bet on inflation unless you happened to be in some of those commodity markets and particularly the commodity markets that have been impacted as much by the conflict in Ukraine as they were,tied to this inflation rate trend that we've been discussing. So again, markets still may be wrong. There's still plenty of uncertainty around this inflation dynamic on a go-forward basis, but it is quite interesting that although people were late, markets are suggesting that in fact that perhaps things can be just fine with a bit more policy tightening.
Joe: (16:27)
Yeah. Some of these medium term breakeven measures our 5Y5Y forward breakeven never really got too out of hand and are kind of in normal range. That being said, the other phenomenon this year is, I don't wanna say the Fed's been behind the curve per se, cuz that's a little bit of a cliche and I'm never even totally sure what it means, but I would say that it does seem as though at each meeting, they're sort of expressing some hope or optimism that, “OK, we think we're getting closer to a neutral range, we're not gonna go as hard” and then some other data point comes out and it's like, “Whoops, time to increase. Time to go faster again.” And so we got that 75. Are we at a place where maybe the Fed is in a comfortable spot? Or do you think there's still be significant tightening from here that once again, the Fed might have to go a little harder than it hopes in the short term, at least in order to constrain inflation.
Dan: (17:39)
Yeah. First of all, policymakers they'll tend to have an optimistic spin. But certainly the price action of late suggests that what central banks have done so far are beginning to have an impact on economic growth. And a view that a hard landing is around the corner. Credit spreads tightened over a hundred basis points. Using high yield as a proxy, we've see a significant bounce in equity valuations in the midst of moderate deterioration in a lot of the forward economic indicators. So relative to where we were several weeks ago, the Fed has to be reasonably pleased with the impact of their policy decisions thus far. And I think although Powell may have slipped up a touch in suggesting, you know, with a high degree of confidence that we're, uh, or an implied degree of confidence that we're near neutral right now.
I think the key point was that we can begin to focus a bit more on the data. You have seen the beginning of some material signs of economic slowing in a world with massive uncertainty of the geopolitical or traditional economic variety. So I think they're comfortable in the sense that, they've gotten to a point where they seem to have calmed markets over the short term.
This can change very quickly. And when we look at a 9% headline inflation rate, which is likely at least the near term peak, they have a lot of work to do. And we do think that they likely will need to tighten a bit more than what's currently embedded in the front end of yield curves. We don't think they were wildly far away. We still have thought that a three and a half were 4% type funds rate combined with material balance sheet reduction will likely be enough to slow the economy and get inflation back towards their target.
Joe: (19:37)
We're 250 now. So another 150 basis points of tightening more or less is what you see?
Dan: (19:42)
That would be right. Yeah. 125, 150. But again, even under that base case scenario, we're not back to core CPI level within most central bank target zones until probably out into 2024 and there could be a lot of shocks in the interim. Some that may be helpful, you know, to getting inflation back down toward target several, um, events that may not be helpful. And again I, I think humility's gotta be the key point here. But we think about inflation when we think about inflation's impact on the developed markets. You have to be a meteorologist as well. You're gonna go into a period in Europe in particular, temperatures get cold with massive uncertainty around energy supplies and with Russia holding the cards, at least for the time being.
So there are a lot of events that can derail the more positive scenarios that we've described and have been embedded in market pricing. Again, one of the reasons when we add up all of these sources of uncertainty, we see that we've gotten across financial markets over the last several weeks. And we're inclined to take a few chips off the table, get away or reduce exposure to the most economically sensitive areas to the market. Not because our base case view is so dire. It's just that this extreme uncertainty is such that investors should just be careful in some of those more credit sensitive investments where essentially there are forms of a short volatility type trade. And yeah, given that extreme uncertainty, we just don't think you're getting paid enough just yet at these levels to be overly aggressive in those more economically sensitive areas or higher yielding areas the opportunity set. It's a generalization. There's certainly things you can do on the margin, but that's our general thinking given where we are today.
Tracy: (21:40)
Can you talk a little bit more about how you see the credit market at the moment? Because I feel like obviously whenever there's concern about a recession, a lot of those worries are going to seep into corporate bonds which are economically sensitive as you mentioned. But then secondly, even before the pandemic, I think there was quite a lot of concern about froth in various portions of the credit market, things being overvalued and potentially illiquid when the time came to sell. So how are you viewing that space at the moment? Where are there opportunities and what's most vulnerable?
Dan: (22:15)
Sure. So just at a very high level — and I think there's a lot of interesting things going on within the credit markets — we were adding some credit back several weeks ago when high yield corporate bond spreads had gotten out to north of 600 basis points. We thought there looking at historical analysis and thinking about embedded our recession probabilities in those spreads the credit markets were forecasting a very high probability of at least a moderate recession after the rally. Now over the course of the last several weeks spreads look less interesting to us the embedded probability in credit spreads currently of a more moderate recession has dropped down towards, you know, somewhere in that 20, 25%, you know, type area.
So, um, a little bit less interesting today, but back in terms of thinking about the credit market and the structure of the credit market, a few thoughts here. Since the global financial crisis, you've had massive regulation impacting the real estate areas of the credit markets asset backed markets, the market, the financial sector, is heavily regulated today. Not coincidentally, these are all the areas that caused all the problems during the GFC non-financial corporate credit growth in terms of issuance as been significant both public and private markets. And that's where, even before Covid we did see a meaningful deterioration in underwriting standards, more corporate leverage, more aggressive rating agency, frameworks, around putting their ratings on certain types of risk, far fewer covenants.
And when there were covenants not particularly strong covenants, we also saw a significant, uh, build out or growth, in the private markets, which are inherently lower quality, lending markets. So this is where we think there's the weak link this time. If we were to get into a broad economic slowdown, public markets have repriced and they've repriced quite significantly, in certain sectors and segments of the market, private credit markets, that always move a lot more slowly, have lagged and lagged considerably. That dynamic is true within the real estate credit markets as well. If you look at what type of spread you can obtain for like risk in a public CMBS security versus where lending is going on currently in the private space. So I think point number one it's the corporate credit sectors where there's the most excess, it's nowhere near the type of excess we saw in the mortgage credit markets leading up to the global financial crisis.
So don't wanna sound overly alarming, but this is probably the weakest link in the credit chain and where there will be some interesting opportunities for fresh balance sheets, fresh bandaids to take advantage of what will likely be a default cycle over the course of the next few years. And then again, if you have a public bandaid, that's, re-priced quite significantly versus other private markets, it makes sense to take advantage of those opportunities because over time there's gonna need to be convergence. Uh, it can converge with public markets recovering. Um, more likely it will converge by gradual deterioration in marks, um, in a widening of spread levels, um, in the private, um, sector as well. And then the last point I'll make all those areas I mentioned earlier that have been heavily regulated since the global financial crisis we think present tremendous opportunity for investors.
People still get nervous today about housing related risk. Banks continue to trade in a very volatile fashion but they are well capitalized. And the mortgage credit market is near pristine in the borrower qualifications necessary to get a loan over the last decade or so. Those are some high level thoughts consistent with the way we're positioned across portfolios. There's a difference when we’re operating in mutual funds space versus longer locked up alternative vehicles, but those same general principles or the principles we're adhering to at this stage in the economic cycle.
Tracy: (26:30)
So my next question is completely out of self interest, but I bought a house in February of this year. Did I top tick the market? And then secondly, secondly, you mentioned taking on some housing exposure or real estate exposure, and I'm curious what the opportunity is there exactly, because we have seen a lot of people worry about the fact that house prices shot up post pandemic. Secondly, the fact that mortgage rates have shot up, and then thirdly, there's been some sort of market structure weirdness within the arena of mortgage backed securities where things for a while, it looked like the market was sort of like creaking a little bit at the edges as rates went up very, very quickly. So how are you balancing that? Can you just dig into housing a little bit more for us?
Dan: (27:22)
Sure. So, um, you may have top ticked the market. Details to our, our mortgage team we'll run some numbers and let you know just how much you top ticked it by...
Joe: (27:36)
That's a good service offering that service. That's a really nice service. Tracy, you gotta take them up on that.
Tracy: (27:41)
Yeah, I might...
Dan: (27:45)
It is a little frightening how much mortgage data of a highly granular fashion is out there nowadays. But in terms of housing, so we do think housing is gonna slow and slow significantly. We think on a national basis, housing is likely to decline in real terms or inflation adjusted terms over the course of the next few years, our base case view is that home prices stabilize near zero growth or very single digit type growth rates, but it would not be surprising and it wouldn't necessarily have to be overly alarming if you saw home prices decline on a national basis. Now, similar to the comments I made earlier, the complicated, economic environment, housing markets are complicated as well.
As we know, there's been a massive shift in preferences, um, since, uh, the Covid pandemic, uh, desire to live further from the office, certain, uh, vacation and resort communities have gone up in price quite significantly in some areas, there's more land scarcity than others. So there are gonna be pockets where you saw a big increase in demand where they're gonna be outright price declines. Um, you're gonna hear over the course of the next several months more headlines around price reductions price declines. A lot of stories in that regard. And I think if you're underwriting a new pool of mortgages, particularly higher risk type investments, you have to be very granular and very careful in how you underwrite that risk. But from a macro perspective there's still too few homes in this country and other Western nations relative to the number of households that have been formed over the last several years.
So again, that supply-demand dynamic is important. Rents remain elevated. So when you think about the buy to rent decision, although the cost to own a home has gone up, rental rates are going up as well. So that switch is less obvious. And then when you step back and look at price to incomes price, to rents the amount of borrower equity that exists, and again you have a tremendous amount of borrower equity today after several years of significant home price growth. And I mentioned earlier, a near pristine mortgage market from a credit quality perspective. We just don't see a major risk of significant declines in housing on a national level. We do expect though, and you're already seeing this a rise in inventories, a reduction in housing related activity, which is the transmission mechanism or one of the transmission mechanisms.
That's gonna help slow the economy and eventually bring inflation back down towards more reasonable levels. And then last but not least from an investment perspective in housing related areas of the market those investments in many cases aren't tied to what goes on in home prices from here because they've delevered so much. So the typical housing related investment you can buy today is backed by pools of mortgages that were issued 10 or 15 years ago. Embedded loan-to-value ratios in those types of investments today have fallen from 120% back during the global financial crisis down to 40%.
In most cases today a borrower with 60 points of equity in their property, even facing moderate declines in their current home price, are not a big default risk. And even if they are that's the type of loan where you anticipate a full recovery. So a lot of what we like in the market today is seasoned type risk that benefits from the multi years of home price appreciation, and therefore is much less sensitive to what goes on from this point forward.
Joe: (31:30)
Let me go to the other side of things. I mean, just trying to think of your overall view, it seems like not particularly pessimistic, your outlook isn't particularly dire, but clearly risks abound and opportunities to derail or return to a soft landing. All kinds of risks out there. I'm curious though, like, what is your view right now on if and what role a Treasury should have in people's portfolio? Because, and I've asked versions of this question to many people it's like for years, it was just such a great trade to own a slug of 10-year Treasuries. And they went up, the principle appreciated in value. They were a great diversifier to risk assets. They usually went up when the stock market went down in the short term, and now those conditions are obviously changing to some extent 60/40 type portfolios got clubbed that coupon that you're getting each year is getting swallowed up big time by inflation. Is there a role for Treasury ownership.
Dan: (32:28)
Yeah, that, that's a great question. And of course what you're getting is a correlation argument. Are we gonna get back?
Joe: (32:37)
Can we get back?
Dan: (32:37)
Yeah, to, to a degree. And I think you're you're witnessing this now with the recent rally that we've seen in government bond markets, uh, elevated geopolitical risk, you know, both in Europe and China situation signs of deteriorating economy and elevated risks of recession. And now government bonds are beginning to rally on that type of news.
Now we think you get better protection when a 10-year Treasury's at 3.5% versus, you know, closer to two point half percent but we do still think high quality bonds at these higher yield levels will provide some insurance benefit locally. And by locally, I mean, during small moves in markets we we think correlation's gonna be much lower than they've been in the past.
I think that's gonna be the case as long as inflation remains a key risk facing financial markets, but if inflation begins to trend lower up towards central bank ranges. So again this post Covid period of elevated inflation, we do think you could revert back to more traditional correlations and high quality bonds can, provide stronger protections or stronger diversifying benefits a multi-asset type of portfolio, but for the time being, and by the time being, I mean, the next several quarters, those correlations are gonna be highly unstable.
We think in extreme flight to quality situations, signs of a major hard landing in the global economy signs of a deteriorating situation with the war in Europe, or a heightened conflict with China as another example, we think those are scenarios that likely lead to lower Treasury yields. So the bottom line is we wouldn't give up on bonds here. I think investors just need to understand that those traditional relationships that we're fairly strong have weakened, and there's just more uncertainty at least over the short term, uh, in terms of these overall trading, uh, relationships.
Tracy: (34:44)
How are you hedging volatility nowadays and who is selling it? Because it feels like everyone wants volatility protection. And I can remember, once upon a time, not so long ago, Pimco was a big seller of vol protection, I'm assuming you guys aren't doing much of that now.
Dan: (35:03)
We sell a little bit of volatility explicitly. We didn't talk about agency mortgages. These are interesting investments. They benefit from a direct government guarantee or a strong agency guarantee, which is always nice given heightened risk of of a more material economic slowdown and they've widened spread a lot. They're not quite as cheap as they were in the first quarter of 2020. But they are quite attractive on an option adjusted spread basis relative to where they've been historically. So we have been adding back some agency mortgage back securities in an agency mortgage back security represents a form of a volatility sale. We've also on a targeted basis have taken advantage of some volatility sales in the option markets.
That's one of the areas I mentioned earlier where a lot of the hedge funds, other specialists managers have been caught off side given the significant moves in realized volatility. And there has been a few opportunities to provide liquidity and take on some of that risk at what think are attractive levels. But the way that we're we're dealing with volatility or uncertainty now is really staying up in quality in terms of our investments. And I mentioned that we've been reluctant to aggressively add to the weaker areas of the credit markets, where your short volatility from a more implicit perspective. Um, so across a lot of our portfolios today, we've been taking advantage of the widening in areas of the market that represent spread risk, not material risk of, of permanent capital impairment.
And I mentioned agency mortgages in that category. I mentioned the non-agency or the non-government guaranteed mortgages. I mentioned the banks where we have a high degree of conviction that, although those spreads will remain volatile, most banks, particularly US banks, a bit more isolated from the European uncertainty are tremendously well capitalized. They're not taking significant risks at the moment. And then there's a whole slew of other AAA and AA type risk, high quality municipal bonds, other areas of the asset backed sectors, where you have a lot of hard collateral and additional subordination. These are all areas that should be resilient in a period of heightened volatility, in which, in some cases of widen and sympathy with these other markets that are much more sensitive to credit fundamentals.
Joe: (37:29)
Where are the areas that you see are particularly sensitive to credit fundamentals that you wanna avoid, because you don't wanna deal with actual impairment?
Dan: (37:37)
Sure. Well, I mentioned the private markets. And you need to differentiate there what we're referring to there would be more traditional, direct lending mid-market companies that tend to struggle in a recessionary environment more so than larger cap names, the other issues within the private markets, which have have significantly lagged public markets, or the senior secured bank loan market, as an example, is that you have floating great debt. Uh, so borrowers within that space are seeing a direct impact from Fed policy in the form of higher debt service costs. Now, some of those companies will hedge in the cap markets, but typically it's a partial hedge several companies won't hedge. And it's not easy to tell which companies are hedging and which ones aren't.
So that's an area of the market that's gonna be more sensitive to rate policy from here. In fact, we anticipate that if the Fed has to tighten policy materially more than a terminal funds rate of three point a half percent. You'll begin to see a decent amount of stress, um, on that segment of the market. If higher rate policy coincides with EBITDA or earnings deterioration you can even see more problems from a downgrade perspective in that segment of the market. So again, I don't wanna sound overly alarmist here. But in terms of looking for weaker links in the marketplace that's where we would focus and that's where we're being most defensive right now in terms of overall credit positioning.
Tracy: (39:15)
So I think you've outlined a pretty sort of cautiously optimistic approach here, or maybe cautiously opportunistic, where you're sort of, I like that selecting yeah. Selecting quality credits and things like that. What would make you feel comfortable about taking on either more credit or more interest rate risk in general? Is there a particular thing if you saw that happen an economic data point or something in the market where you would just jump right in?
Dan: (39:44)
Yeah. From more of a top down perspective, better valuations as a start stating the obvious. If we got up to a point where you saw some of these riskier segments of the market embed a much higher probability of an outright recession, we would get more comfortable now that's likely up at levels around 700 basis points within the high yield space.
Now, again, you think about high yield in a full blown recession and you can get to a thousand basis point type spreads quite easily. But as you approach that level and you embed more risk of harder landings, we would begin to add to that space a bit more aggressively in terms of the fundamental picture really focusing on this inflationary process. We think headline is hard to forecast and is certainly gonna come down based on what we're seeing in commodity prices today.
But other areas represented in core CPI are gonna bear watching as well. One is housing or owner's equivalent rent. It's been quite elevated. Another is wages that have been running at levels that are that are making central banks uncomfortable, even related to focus on the labor force, and seeing, what percent of the labor force returns to the market providing some cushion and increasing the probabilities that the Fed can bring job openings lower without a meaningful hit to employment. So it's really the details embedded in a lot of these higher frequency economic indicators, that we're monitoring more closely.
Of course, on the geopolitical side, any type of sign of an improvement in the relationship between Russia and Europe, the situation on the ground in Ukraine ... So just a lot of focus on the higher frequency type numbers. But again even if we don't get resolution there, we are going to respond to better valuations, like we did several weeks ago at higher yields and in materially wider spreads.
Tracy: (42:04)
All right, Dan, we're gonna have to leave it there, but thank you so much for coming on all thoughts, really great to have you on the show. And, I'll be sending over my mortgage data to your department. So you can tell me exactly how bad my timing was on, on real estate purchases. Thank you.
Dan: (42:19)
We'll do that. They have some pretty pictures too. They look real good. We’ll turn that around. Yeah. If you have any follow up, please let us know. We love the work you do. It's a great podcast.
Tracy: (42:38)
Oh, thanks, Dan so much
Tracy: (42:48)
So, Joe, I really enjoyed that conversation. There were a number of things that stick out. Number one, the call on real estate. But secondly when he was talking about floating rate loans and the idea of issuers when he was talking about floating rate loans and the idea of some of those companies who had borrowed money at floating rate increments actually becoming a credit risk as interest rates go up. That's interesting to me, because you'll remember that floating rate loans were supposed to be the big hedge for higher interest rates. Like those were the things you were supposed to buy if inflation was gonna go up and rates were gonna go up and now it's like, well they've gone up too much and it might actually be a risk.
Joe: (43:35)
Right. So if you're an owner of those notes then yes you get higher monthly coupons, which is nice in a period of higher inflation, but the cohort of companies that may have issued those...
Tracy: (43:47)
They company might go bankrupt
Joe: (43:48)
Right are not necessarily the more the most credit worthy ones, which raises the risk that if we actually get like a real recession that your inflation hedge, you have to suddenly start to worry about loss of principle.
Tracy: (44:02)
Exactly.
Joe: (44:04)
Also just in general, I thought it was interesting and basically to the point that you just made, we tend to think very broadly about like rates and credit, but it was interesting hearing him, speaking from the perspective of a fixed income investor. It’s like credit is just way too broad a category. And so you mentioned floating rate debt, but also some of his point about like highly seasoned mortgages was interesting.
And this idea that again, how do you avoid credit risk? How do you get some of the upside, but avoid the credit risk in a downturn? Well, one answer might be assets in which the owners or the payers of those mortgages have built up significant equity, such that you're not likely to experience significant defaults. These are all just sort of things that were like a little more in depth than insightful than sort of a typical like headline credit conversation.
Tracy: (45:08)
Yeah. I totally agree. And it sounds like Pimco, I mean, you would assume Pimco would be very good at doing this, but it sounds like Pimco is sort of, they're cautious in the market. They're not adding a ton of risk, but they are sort of tweaking their portfolio for the uncertainties that we just discussed.
Joe: (45:25)
Well, and I think also this is an environment with lots of landmines out there, so to speak in which it'd be easy to stepping on a rake right. And hitting your face. And so this idea that like, you can be sort of optimistic, you think maybe the Fed it's possible that it's turned the corner or getting ready to make a pivot that maybe we're going to soon see lower CPI readings. We'll have some confidence that the line is going down, but there are just so many little things that could go wrong. There's politics, there's geopolitics. There’s the virus, there's other aspects of the supply chain that like, it all sort of keeps you guessing
Tracy: (46:09)
Actually recording these intros. And outros kind of makes me nervous nowadays, cuz there's so much that could happen between the time that we record and when we release. Alright, shall we leave it there?
Joe: (46:19)
Let's leave it there.