Guy: Welcome to “MIM Cuts to the Chase” podcast series. I’m your host Guy Haselmann. Today we will discuss long-short credit strategies.
Guy: Our guest today is Josh Lofgren, a portfolio manager and member of the investment grade credit team for MetLife Investment Management where he leads the long/short credit strategy. MIM manages a total of $638 billion; Public Fixed Income Strategies account for approximately $355 billion in assetsiii. Welcome Josh.
Josh: Thank you. It’sit nice to be here.
Guy: Let’s get right to it and Cut to the Chase. Financial markets during the past, say, 2 years are starkly different than the prior decade of relative calm, low volatility, and abundant monetary accommodation. Could you comment on what adjustments you and your team are making to adapt accordingly to the new market environment.
Sure – to your point, it’s a far different environment now. The “Fed put” is gone and volatility is back – which certainly creates some more challenges, but it also creates more opportunities which is exciting for us. We’re in an environment where the market is often failing to differentiate credits – and instead they’re just trading issuers in the market like they’re widgets – when in reality there is a massive difference between the fundamentals of these issuers and their ability to withstand an economic downturn.
The impact of the current economic stresses on a restaurant operator who is contending with wage inflation, food inflation, labor shortages, and slowing consumer spending is vastly different than the energy company who is pulling a commodity out of the ground whose price continues to benefit from a significant supply/demand imbalance.
So our team is laser focused on forecasting which issuers have balance sheets that are built to withstand what is likely to be a continued rough patch for credit. We’re asking the analyst teams to really stress their models to identify the winners and losers – and having the outstanding level of credit expertise that our team should be a benefit as we seek to provide consistent and attractive risk adjusted returns for our clients.
Guy: The characteristics of financial markets are certainly different today from when inflation was anchored around 2% and central banks were providing constant and aggressive accommodation. – As you say, the “Fed put” is gone. When I was a PM, I saw first-hand that managing a fund has different challenges when the level of monetary and fiscal accommodation shifts, or when the economy is growing or slowing or when inflation is high or low. I believe experienced Portfolio Managers who’ve traded through these shifts and cycles have a greater edge. Care to elaborate on that?
Absolutely – we feel experience is paramount. There are many market participants who have never seen a significant economic downturn. One of the biggest ways we see this issue manifest itself is in the liquidity, or lack thereof, provided by dealer desks. Banks are less willing to extend balance sheet than they were a decade ago, and so street traders are less willing to act as principal risk takers, and oftentimes are merely match makers between counterparties. So I believe one significant edge on the buy side comes from having an experienced trading desk with deep relationships on the street that is able to source liquidity in ways that other firms maybe can’t.
And from the portfolio management side, I feel a deep playbook that’s been developed over many years and many economic cycles is vital. The end of significant central bank support has also brought an end to the ‘buy the dip’ mentality. The post-great financial crisis period of Fed accommodation that you mentioned basically brought future returns forward. It borrowed from the future. In other words, annual portfolio returns were well above annual historical averages. Everything seemed to perform well.
Going forward, I believe the financial markets will spend several years being more “two-way,” In which active managers who make distinctions between companies and securities have more opportunity to outperform passive strategies. Security fundamentals and valuation will likely play a more impactful role for portfolio performance.
Guy: Tell me more about what your clients are saying about their asset allocation and their portfolio construction conversations?
We have many clients that are benchmarked to an index and so like always, those conversations are centered around our approach and ways to try and generate positive excess returns through security selection and sector rotation. There’s always a lot of nuance to those conversations on how we might do that, but the song remains the same so to speak as to our overarching goal with those clients.
Where I’d say the conversations have really changed and evolved are those with our clients and prospects that are focused on absolute returns. Most of that cohort are folks who view fixed income as the “safe” option in their asset allocation. You often hear it’s a ballast to their equity allocation – because for years those asset classes have been negatively correlated.
And that’s the premise of the traditional 60/40 portfolio. You have that 60% in stocks that provides capital appreciation, and then 40% to fixed income that should give you income and risk mitigation. Well that 40% this year isn’t giving you either of those attributes.
Guy: There has been some talk that this was the year that the 60/40 portfolio died?
It certainly had one of its worst starts to a year in history. The most well-known fixed income benchmark in the world, the Bloomberg/Barclays Agg – is down 11% this yeariii, with equities down 20%iv. We think for some of these end users that there are better ways to allocate that 40% - or whatever their desired fixed income allocation is.
At MetLife Inv Management we’ve built a business on the back of traditional fixed income solutions. But we also recognized a need for alternative fixed income solutions. And that’s what Long/Short Credit is. So at a high level –L/S Credit is intended to be an absolute return strategy. What that means is that we’re trying to generate positive total returns regardless of the market environment. We think there’s a place for that type of strategy in every investor’s portfolio. Now more so than ever. What we’re trying to do in the Long/Short credit strategy is to take advantage of the inefficiencies in the credit market without exposing ourselves to the gyrations of the interest rate market. We think there’s a pretty compelling case for certain investors to own this strategy versus a traditional fixed income strategy or as a compliment to it.
Guy: Using a long-short credit as a risk mitigation strategy makes sense and also fits into your comment earlier about preferences for active management over passive strategies, so could you elaborate – and provide some other reasons why you believe it’s an allocation strategy that make sense in today’s market environment?
We’ve been spoiled for years with a downside cap courtesy of the Fed. You could allocate capital while almost having a built-in stop-loss. This is a different market. Rate vol is historically high, spread vol is high, and therefore fixed income has had a far riskier profile than most market participants are accustomed to.
We think in today’s environment – you want to be allocated to a strategy that has the potential to shelter you from a further downdraft in returns. But then also has the ability to flip the switch when market signposts begin to signal that we’ve reached an inflection point. And we think that’s what a long/short credit strategy could offer….The ability to help protect on the downside without sacrificing the potential to participate in the upside.
Philosophically we’re trying to deliver higher correlation to up markets and zero correlation to down markets. So we don’t think of a Long/Short credit strategy as a tactical allocation for when volatility spikes and fixed income total return forecasts look bleak, but rather we believe it’s an all-weather strategy that is worthy of a core position in an asset allocation.
Guy: With net exposures of long-short credit strategies so much lower than a long only strategy, how should performance be measured?
We believe the strategy should be thought of as an absolute return vehicle and the best benchmark therefore is the return that can be earned by cash.
Guy: From a portfolio point of view, aside from your performance objectives and other attributes that you mentioned, what are you and your team hoping to achieve.
Our team aims to maintain a low correlation to broader fixed income indices and tries to minimize interest rate sensitivities. We focus on idiosyncratic trade ideas. The goal is to create a strategy that can act as an attractive portfolio diversifier, volatility dampener and one that mitigates downside risks for a multi-asset portfolio.
Guy: Given so many economic and geo-political uncertainties, specifically with the Ukraine war, the pandemic, inflation, and divergent global central bank policies, I agree that it makes sense to find opportunistic risk mitigation strategies. Do you have any final thoughts?
Yes. I believe – for the reasons you just mentioned – that this is the ideal time for portfolios to consider adding to long short credit. I believe implementation of the strategy should have a focus on a few key tenets some of which I mentioned, but it’s important so I will summarize.
First, we believe it’s important to partner with a manager who has robust resources across research, trading, and portfolio management and that seeks to uncover attractive total return ideas across the quality and maturity spectrum.
Second, we feel the strategy should seek to minimize interest rate sensitivity and find idiosyncratic trade ideas that are inherently low duration.
Third, it should aim to provide low correlation to broad fixed-income indices such as the Bloomberg Barclays Aggregate Bond Index or any credit-heavy index. Afterall, long-credit should be an attractive diversifier and volatility dampener.
And lastly, it should aim to act as a downside risk mitigator through proper portfolio construction and rigorous risk management framework. Done correctly, we feel the strategy has the potential to earn positive returns in any environment or market cycle.
Guy: That is a perfect place to end. Thank you, Josh, for sharing your insights.
Josh: Thank you.
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