Morningstar - Q4 2020 - 76

Investors

today. I'm not sure I want to follow the Fed
into that.
Even if taxes are going higher, what will
munis yielding under 1% or at 50 basis points do
for a portfolio? You've got to run more of
a barbell. As for cash, when you move real rates
to negative 100 or lower, cash can still
be part of the portfolio in a barbell, but then
you've got to build cushion in the rest
of the portfolio and find places where you can
get income.
There are some opportunities in China.
Europe is going to keep rates low for an extended
period of time, but there are parts of the
high-yield market over there that are interesting,
and some secured assets.
In the U.S., you've got to be precise about
investing in some of these income markets. The
high-yield market has become what some
call a Frankenstein market: A lot of the high-yield
market is too rich now and then some
parts are distressed. When you put it together,
you get an average yield that's not
as stable.
So, I want to get in the right names. The
securitized market is one place where I think a lot
of the return generation comes from
finding bespoke opportunities, structured
opportunities. Mezzanine funding for
big real estate transactions is a growing business.
But it's all about the research that you
do today, because the bid for yield is going to keep
going and create too much excess. You've
got to be thoughtful about where you're putting
dollars, and not waste beta in places
that are already too rich. I'd rather just sit
in cash.
As for having some inflation protection
in the portfolio, in the TIPS market,
you're still not pricing in the Fed's inflation
target, so I think owning some TIPS makes
some sense.
Some people think the dollar is going to come
under tremendous pressure and that
you should be 30% gold; I'm not there. But

76

Morningstar Q4 2020

I do think having some gold in a balanced
portfolio is pretty good as the Treasury
increases the debt burden and the dollar
depreciates moderately.
And then there's your equity component.
This is a fixed-income discussion, but I think there
are companies that are really stable that are
quasi fixed-income assets.
Mathias: Vanguard is obviously a very
large index investor, but I am in the active
business at Vanguard. I think this is a
wonderful opportunity, almost a golden age
for active investing in fixed income. As
Rick pointed out, what matters now is security
selection. You're not going to get paid
on the beta. Everyone is rushing in; there's
a tremendous search for income everywhere.
That's a natural consequence of the Fed
unleashing as much liquidity into the economy
as it has over the last six months, and
the Fed is telling us it's going to continue. The
fiscal environment will continue that as
well. Hiding out and trying to find your return
through capturing beta is not the way to go.

It's the time to search for true alpha. And
there are really interesting opportunities. We have
an environment where the credit cycle is
likely to be elongated. The Fed is not going to shut
off the recovery. Interest rates are likely going
to stay low. These are market realities that we're
going to be dealing with.
You need to look carefully and do the work
in the lower-quality bands of whichever
segment of the fixed-income market your fund
is focused on-lower-quality investment
grade, middle- to lower-quality high yield-to find
attractive risk/return opportunities.
Definitely have an inflation protection
piece, whether it's TIPS or a break-even inflation
exposure. Even though break-even
inflation levels have come up quite a lot
since the troughs after the worst point of the
virus, they still are well below where
the Fed would like inflation to go and where
inflation probably could go over the next
five to 10 years. So, there is some interesting

value there, or a low-cost insurance policy for
your portfolio.
Where you are on the duration curve also
matters, because we think that the corporate
credit curve is likely to steepen a bit, so
you want to allocate across duration effectively
as well.
Bush: Rick, I've heard you say that making a
distinction between high yield and investment grade
doesn't make as much sense as it might have
in the past, given some of the divergence we've seen
both in valuations and the fundamentals across
sectors. Are there particular sectors that you think still
look attractive today, or do you really need to
get down to the individual name level and idiosyncratic
risk to find opportunities?

Rieder: It's a great question. It depends on the
mandate. We've had this debate internally.
If you run a short-duration fund, and you think
about companies like Amazon.com or
Facebook or Microsoft, they are priced at 60 basis
points. Those companies aren't defaulting,
and that's a good asset for a short-duration fund.
If I think about my whole portfolio, I'd rather
buy those companies in equity and fund them to
buy back their stock in the debt side.

I think today it doesn't matter what the
credit rating is. I'd rather buy a BB company
in healthcare, or in something consumeroriented, in housing, than buy an energy company
that's investment-grade. Now, there are
some good investment-grade energy companies.
It's all about the individual sector.
I think about companies with three different
metrics: leverage, liquidity, and cash flow.
Do you have enough liquidity to get through so
that I can own that credit for a period of
time? And then, do you have enough cash flow
to operate?
Bush: What about the opportunity set in emerging

markets? Obviously, that's a place where you may find
more yield.

Mathias: Overall, emerging markets should
benefit from the interest rate and policy
and foreign currency environments. You have the
Fed with rates at or near zero, European


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Morningstar - Q4 2020 - Cover1
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Morningstar - Q4 2020 - Contents
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