Total time: 10:04

Michael Walton: Hi, this is Michael Walton. I am joined by Dustin Finley and Thomas Urano. Dustin and I work together on the Institutional Team and Thomas is responsible for the day-to-day portfolio management function at Sage. Alright, so Thomas give us a quick rundown on how our fixed income portfolios fared in 2019.

0:18

Thomas Urano: The fixed income markets had a banner year. 2019 was fantastic from a return perspective. We saw high-single-digit returns, maybe even low-double-digit returns in fixed income, which is outstanding. Sage was able to participate in that market rally fully and outperform benchmarks across all of our strategies.

Dustin Finley: So Thomas, I'm looking at numbers here across the strategies and couple big stories coming out of 2019; one was, as you alluded to, rates. We've been on quite a rollercoaster ride over the last year and a half, with rates at 3.06% at the end of the third quarter of 2018, big rally and rates fourth quarter of 2018 and a flight to quality, and then 2019, the steady climb down in rates, with the 10-year ending at 1.92%. Talk a little bit about how we were able to take advantage of some of those movements within the yield curve.

1:07

Thomas Urano: Yeah, 2019 was an interesting year for interest rate movements. You know, you came off the heels of the fourth quarter of 2018, interest rates had been pushing up and the Fed was raising rates. They did an about face in the beginning of 2019. In January, Powell changed the direction of rate policy and they embarked on rate cuts throughout the course of the year. That led to a tremendous rate rally. We were able to take advantage of that. We came into the year on the heels of 2018. We started 2019 with a long duration posture, so that backup in rates we were able to take advantage of that we added some rate risk into the portfolio. And as rates fell, we were able to participate even more so in that rate rally. So that was a nice move for us. And then as we kind of got midway through the year, and it looked like the Fed was going to do more of this, you know mid-market or mid-cycle adjustment to interest rates, we ended up taking that duration exposure more neutral-ish again and that worked out well. So, at the end of the day we participated fully in the rate rally, which really drove a lot of the price performance that you saw through the course of the year.

2:07

Dustin Finley: And rates aside, the other big story within fixed income was the risk-on environment that we saw, but a little bit of a different risk-on environment than we've seen since the end of the last crisis, where coming out of 2009, it was more of a beta trade. If you had corporate credit in any way, shape, or form, you tended to outperform – that trade has kind of gone away in 2019 and security selection became a little bit more evident. Talk a little bit more about how the team was able to add value with regards to either sectors, industries, or individual credits.

2:36

Thomas Urano: So, credit performance in 2019 was strong. We came, again, coming off the back of the fourth quarter of 2018, credit premiums were in our mind cheap, so we increased the portfolio risk. So along with having higher duration, we had elevated credit exposure starting 2019. So by January 2019, we've taken the risk back up in the portfolio. Credit premium started collapsing again and as you got to kind of mid-year, those credit premiums have gotten, you know, fully valued in our mind again. And so that portfolio, that beta trading credit, like you mentioned, had gone away. And we kind of transitioned from just having market beta exposure in the corporate space to really emphasizing name selection, both on a sector and an issuer basis. And I think those were two key components that added performance for us in the second half of the year. So we were able to garner performance from you know, market beta moves in the first half, but in the second half, really focusing on individual name selection, looking at issuers where we saw favorable fundamentals, favorable margins, favorable cash flows, and that was able to help us in the security selection effort in the second half of the year. So, kind of a tale of two cities, but broadly speaking, we did really well from general market exposure and then transitioning to more concentrated security selection.

Michael Walton: So you mentioned as we got into the second half of the year, reducing our spread risk or kind of overall credit exposure, credit beta. Can you give us some examples of how that took place inside of the portfolio?

4:04

Thomas Urano: Yeah, so more specifically on the details of that trade; that's things like shortening the average maturity of your credit exposure, right. So there's more volatility risk in 10-year bonds than there are in 5-year bonds. What we did is take some of that exposure we held in 10-year corporate bonds, move them into the more of that three-, five-, and seven-year part of the curve, effectively kind of cutting in half the amount of credit premium risk that you carry in the portfolio. So you can still carry yield, but you carry less volatility because you're holding shorter maturity bonds. So we did that from a maturity perspective. We did it from a sector allocation perspective. There were certain sectors in the market where you saw more things like balance sheet use, leverage rising, particularly in like consumer staples and consumer non-cyclical areas. Those sectors were, we saw a lot of companies raising leverage, so we're trying to minimize exposure into those areas. We're looking for companies again with higher free cash flow, higher margin, higher-growth areas. And that kind of gave us a little bit of comfort in the amount of individual credit risk we were taking. So a blend of structural and then company-specific trends we were looking at.

5:16

Michael Walton: So before we get into the 2020 Outlook, something that's been in the news a lot over the last several months is the repo market. And so I'm curious, I know your team has done a lot of research in this area. And I'm curious to get your take on sort of what happened and how it has impacted the market.

Thomas Urano. So the end of Q3 2019, repo became a problem. We saw overnight financing rates jumped to 7% to 10% in mid-September. That becomes problematic for a lot of levered investors – they can't access liquidity, they can't access financing, overnight financing. And anyone who's invested on a levered basis needs that financing. If not, they'd be forced sellers in the market and becomes a concern for the Fed.

6:01

Michael Walton: Okay, and so what are the side effects of the Fed’s response to the repo situation? And maybe even more broadly, is this issue something that, you know, our clients need to be concerned about?

6:13

Thomas Urano: Yeah, our clients need to be concerned about how the Fed handles the repo situation They're still engaged in the market. The side effect is that the Fed is expanding its balance sheet aggressively. The Fed has expanded its balance sheets since the third quarter of 2019 by about $400 billion. They've committed to overnight repo programs. And they're currently buying T-bills to the tune of $60 billion a month. They're committed to $60 billion a month through June. That's $360 billion of T-bills they plan on buying. That's effectively QE even though the Fed doesn't call it QE. At the end of the day, that means the Fed's balance sheet is going to continue to grow, it's probably going to continue to approach the highest point ever reached of previous QEs. So, there's a substantial amount of liquidity that's getting put into the marketplace in order to alleviate the repo market. But the side effect is that all that liquidity then has to go find a home. And I think we saw that through the course of Q4, and even the beginning of this year. As long as the Fed and other central banks engage in quantitative easing, printing of capital, asset prices continue to get pressured higher.

Dustin Finley: So to that end, we can wrap it up. We're two weeks into 2020. The QE party seems to be going strong, music still playing. How do you see the next two quarters playing out and how is our portfolio positioned right now in the near term?

7:37

Thomas Urano: So for us, we’re thinking about QE, we're thinking about the way the Fed is handling the repo situation really as QE and expanding its balance sheet puts upward pressure on asset prices in general. So to that end, we're trying to participate with the market. We don't expect interest rates to move substantially higher, but we do see a policy-driven reason why credit premiums and other risk premiums are collapsing. So we want to be able to take advantage of those. And so we are staying invested in the market. However, we do have a key theme that we're going with right now. That is, given the state, we think the valuations are stretched, what are we trying to do? We're trying to raise overall quality in the portfolio. And that's not just by credit quality or credit ratings, we're trying to raise credit quality in terms of liquidity, issuers, obviously ratings, exposures in the portfolio. But we want to have a high-quality portfolio, we want to raise our liquidity standards, and we want to build dry powder. And while we're doing that, we just want to stay invested in the market. Because I think at the end of the day, as you get through the first half of this year, the market’s going to think about how the Fed winds down this current injection of liquidity. And I think that you may introduce some volatility in the marketplace at that point in time, and we want to try and again raise liquidity, raise dry powder, and have the flexibility to take advantage of some volatility if we get it – which would likely come mid-year as some of these repo and other balance sheet expansion programs come to an end.

9:07

Disclosures: Sage Advisory Services is a registered investment adviser that provides investment management services for a variety of institutions and high net worth individuals. This podcast is for informational purposes only and is not intended as investment advice or an offer or solicitation with respect to the purchase or sale of any security, strategy or investment product. Investors should make their own decisions on investment strategies based on their specific investment objectives and financial circumstances. All investments contain risk and may lose value. Past performance is not a guarantee of future results.

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