FidelityConnects: After the Fed: Fixed income perspectives

[00:00:49] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. Happy Friday to you. Japan heads to the polls Sunday in a pivotal election for fiscal policy and for the yen. The yen remains in focus as ongoing weakness is putting renewed pressure on the carry trade. Is the official trade unwinding or is it officially over, for instance? What might the implications to bonds, Treasuries and other forms of fixed income be overall? Joining us here today to break it all down is fixed income institutional portfolio manager, Beau Coash. Warm welcome to you, Beau. How are you today? 

[00:01:25] Beau Coash: Hi, Pamela. All is good. We've got lots to do, there's so much going on out here. I looked at our research, our head of research puts out the most read, or most read research pieces of Fidelity, we have 15 pieces, that's 200 pages of reading for me this weekend, everything from space to semiconductors to the AI spend, a little bit about the yen, not as much front and centre as some of these other topics, but looking forward to getting into all that.

[00:01:57] Pamela Ritchie: I'll come back to it again in a sec, actually, because there's more to say there. We'll come back to that. One of the things that is fascinating in sort of headlines, and we really need you to unpack this and help us understand the context behind it, as we all know, software has sold off. This is an AI discussion. There's a disruption within there. AI's future, essentially, has been questioned. Maybe it's overdone, maybe it's not. Mixed up in that as the sell-off happens it's not just shareholders, it's actually bondholders and there are questions around the bonds that these companies have issued over the years, software companies doing that. There's a rattle there. Tell us a bit about how concerning that is one way or the other.

[00:02:43] Beau Coash: Just to give context, Mag-7 is in the high grade index. We've got almost all of them represented, not massive but they're building positions. They're issuing a lot of bonds, last year about $200 billion, this year expected to be close to $400 billion. Oracle already came out and did a $25 billion deal last week in multiple maturities across the curve. They could have done 100 billion just in that one issuance, they ended up doing only 25 billion. The deal came last week and it's probably two basis points wider, not a big deal from issuance. These big names are holding up okay in our market, they're high quality. They'll start coming under a little more pressure when they start bringing more issuance. Obviously, what you've seen over the last couple weeks the software names in the equity space have taken a bit of a drubbing from potential obsolescence risk from players like Anthropic and their Claude AI, which you could hypothetically do all your software on your own PC and create your own things. Now, it's a far reach to think that these companies are not going to be around but--

[00:04:08] Pamela Ritchie: It's overdone, maybe.

[00:04:10] Beau Coash: --it did throw a little bit of a warning shot. In private credit and in high yield there's a decent software exposure in the indices there, believe it or not, because of the LBO and activity in that space, names that you would know like McAfee, Dun & Bradstreet, Athena Healthcare, there's a lot of names in that space. There's Citrix which I think it's on everybody's tech stack, I know it's on Fidelity's tech stack, Tibco and some of these other names that have been LBO'd. Some of those names were down 10 points last week in private credit/syndicated loans. This is a small sector but it punched a little bit of a pack, a drawback in spreads. The single-B index last week was about 20 basis points wider, that's a pretty big move coming from just one sector, probably the biggest thing that I've seen really since April in terms of spread widening event. Now, that's come back a little bit but I'll stop there.

[00:05:25] Pamela Ritchie: In fact, one of the stories in exactly what you do has been credit spreads have been so tight. At certain points over the course of the last six, seven months the question has been, well, if they're that tight, there's only one direction for them to go, and that's widening. Then you see something like this. Again, I guess we just ask you for the context of how we should be thinking about this. This is one particular event but it's a big event because it's tied to AI.

[00:05:52] Beau Coash: A big event that has taken a lot of air time on all the financial news shows and a lot of excitement and big promise for cost savings down the road. In terms of the impact, the actual impact, if you just step back and focus on what we're really seeing, we were talking to our business cycle person this morning, we're still in mid cycle so that seems fine. That's the probably the biggest outcome, a 60% probability that we're in mid-cycle, a very low probability of recession. Check that box. Earnings for corporate America and around the world are going up double digits so companies seem to be doing fine. Check the box. It seems like we're better than we were at the beginning of the year when there was a lot of uncertainty about tariffs and spend and everything else. It seems like we bounced back a little bit from that little gap back in the first quarter, or after April.

[00:06:59] You've got all those things going for you and now earnings are coming out and they seem to be fine. You check all those boxes and you're like, we're pretty benign right now except we do have super high valuations for spread product, which means what you would charge to lend to a company is very tight so you're not getting a lot of cushion in case something goes wrong with those loans, if that makes sense.

[00:07:30] Pamela Ritchie: It does, and that's very interesting. It sort of extends to another piece of this of this story where we see just all kinds of issuance which has been well telegraphed for the hyperscalers. They've been doing it in different types of vehicles and it's been happening in different ways so it's not directly on their balance sheets, and we sort of know this story about it. It is the enormous pile that needs to be issued, it appears ...  well, supply is already pretty insane ... how do we get there? Can we get there? I've heard 2028 being at $3 trillion is what needs to be raised in debt markets to make data centres happen...

[00:08:10] Beau Coash: From now till 2028.

[00:08:11] Pamela Ritchie: --over time. That's sort of what ultimately needs to be hit and that's everything from energy to ...  it's the build-out essentially. Is that all going to be okay?

[00:08:24] Beau Coash: That's a great question. We've done some work on how companies are paying for all this. You come to the bond market, which we've done, the bond market did 200 billion last year. We're thinking that the hyperscalers will come in for about 400 billion this year. We're also seeing a trend with companies where they're basically taking out operating expenses. Meta just announced a big layoff. I think those companies are really focused on making sure that they are disciplined through this CapEx process. It's OpEx for CapEx swap-off is what you're probably going to see from most of these companies just to have discipline. Then they have to just get used to talking to debt owners.

[00:09:12] Pamela Ritchie: How different is that? Just remind us how different that is because they're used to doing equity raises, right, and talking to investors about it.

[00:09:20] Beau Coash: I think I mentioned briefly, back 30 years ago one of the big med tech companies was doing a road show. That's when you still did road shows for big underwritings and debt. The company was asked, where do you want to be rated? They said, I don't know, somewhere around triple-B. There was a gasp from the audience. The next question was, well, how much do you really want to raise in this fundraising and they said, well, at these rates I would do as much as you gave me. There was a second gasp that came out. They got exactly no orders from the Boston visit and we had to call the bankers and say, you better clean up or teach this management team how to speak to bondholders because if they're going to write as much debt as the market will bear  then there's no price discipline whatsoever. If they don't know what the difference is between a low triple-B and a high triple-B it's going to be a non-starter for the bond market to really back this company and get confidence that they know what they're doing around bondholders.

[00:10:26] Pamela Ritchie: That's so interesting. There's a communication, almost a training situation that probably, not just hyperscalers but lots of companies who are in the business to make sure AI gets to where it needs to in terms of the build-out.

[00:10:41] Beau Coash: It's a communication training but also they have to walk the walk. They have to then do what they say they're going to do. If they have a target in mind of leverage they have to start putting that out to the bond market to make sure that everyone knows what the game plan is going to be, and if there's a left or right turn what that means.

[00:11:00] Pamela Ritchie: Years ago in the financial crisis big banks, I think HSBC, I remember there was a headline, HSBC ended up ... no one could pay, ultimately, their debt payments so HSBC and becoming the owner of chicken farms in India at one stage. That was the collateral that had been put up and that's what they owned at the end of it. We're seeing now very well-backed and well-thought through pieces of collateral but it's different types of collateral, isn't it, It's things like GPU backing and chips. The H100s are actually the collateral for the loan. That's what you'd get, for instance, if things went south. It's just interesting.

[00:11:47] Beau Coash: We had jingle mail back in the GFC. That's when residential owners that didn't have any equity left would put their keys in the mail, send it back to the bank because they had no equity, and they called it jingle mail, and then the banks didn't want it. You have these--

[00:12:06] Pamela Ritchie: Liquidators.

[00:12:07] Beau Coash: --advantageous groups like KKR and Blackstone, they went out and started buying a bunch of single family homes and then they rented them and then eventually resold them. They're the ones who were buying up this opportunity. There's always savvy players in the market that will clean up the mess. Now, some of the issue with technology is some of that can get obsolete pretty quickly. You can get a chip, lend against a chip that's got X value today and what if it loses 70% of its value and can't cover the cost of that loan? Those are things that the underwriters and the people who buy those asset-back bonds ... a lot of that's getting done right now in the private credit space. That is in the private space not in the public markets. The public markets, there is some data centre activity securitized but it's very small as a percentage of exposure so you're not going to start seeing a lot of focus on that yet, although there is 30 to 40 billion of paper that was done last year and that's supposed to be going up to 150 to 300 billion at some point in time pretty quickly as another source of raising funds to do all these data centres.

[00:13:26] Pamela Ritchie: That's absolutely fascinating. Do we even talk about interest rates anymore? What is the boring but fascinating case for bonds right now? These are some of the big things that are going on in terms of debt origination but what else?

[00:13:40] Beau Coash: You're so right. These are like the news headlines. It's causing some widening but if you looked at the performance year-to-date, I look at single-B performance is still doing pretty well even though single-Bs were off 20 basis points last week. I think single B's, I looked up today, they're still up 30 to 40 basis points on the year and we're only one month. We're not talking about writing things down to nothing, although private credit, there's a bunch of names that have lost 10 points so trading around par, syndicated loans and private credit should trade around par which is $1,000 per bond. There's a handful of names they're trading at 90 cents on the dollar right now as a trade-off. That's significant if you have to sell the bonds today. Most people don't have to sell the bonds today because it's an institutional space.

[00:14:36] Pamela Ritchie: Let's go macro wide for a second here, the discussion, you know, interest rates, we'll talk about the Fed a little bit, but I think even more broadly the discussion that goes into currencies, which we don't need to stay into for too long, but it fits with this sort of sell America discussion. In a lot of cases it seems to be just simply incorrect and that foreign investors are not selling Treasuries at a clip that is notable. Take us there and to what extent it's important to listen to.

[00:15:10] Beau Coash: Because we're bond investors ... there's other fixed income investors that use a lot of FX and the reason why we don't is because FX doing currency is a lot of risk. We're in a product that's about a 5% annualized risk a year, that's up or down 5%. When you add currency that can be 15% on most currencies so you're adding a lot more risk to the portfolio than your underlying product would give you. That's one of the main reasons why we don't use it. Now, there's other firms that made a lot of money last year on a relative basis using currency and they were the best performing asset manager out there last year. That happens once in a while. It's not a consistent source of alpha because of the volatility. That's our view.

[00:16:11] It doesn't mean that we shouldn't be paying attention. To your point, in terms of flows we have not seen any big sellers of US Treasuries. That was a narrative that was out there. We track it from a technical perspective. We want to know kind of what direction Treasury yields are going, that's one of the technical ways of understanding where things are moving. We do keep our eye on it. We think that there is a movement towards being a non-US investor, people trending more to non-US versus US as a diversifier because everybody was in ... the crowded trade was US over the last five years so it feels like that could still have some legs to it. We're just not as focused on the valuations and the minute impacts that can happen because of it.

[00:17:04] Pamela Ritchie: That brings us nicely to the discussion of the Japanese election which is mostly hinged on whether the current prime minister, who sort of comes from the vein of Shinzo Abe, is going to continue raising rates, essentially, and therefore providing an interesting product for local Japanese investors to buy. They didn't have something interesting with actual interest, literally, that they could buy locally, they had to go abroad for it. For purely local reasons there could be a sell America trade just because you see those investors going home.

[00:17:44] Beau Coash: The BoJ owned all the bonds. At zero interest rates the BoJ had to own all the bonds because there's no retail demand or global demand for that product. Once they get more attractive relative to competitor market yields they'll be able to get a home market started. Hopefully that behaviour fits the buyer and that it works. I think Japan is still one of the largest holders of US Treasuries, Germany is another large holder, China still holds a decent amount but I'd say Japan and Germany probably are the two biggest than China. There's those games that people play and hopefully the technicals can hold up and we'll be in good shape but those are things that can move a needle a little bit. We're not thinking that those are massive either value destructors or creators in the portfolio.

[00:18:54] Pamela Ritchie: When we look at something like the earnings story going forward, which looks bright and sunny, actually, for global companies in a lot of cases, the case for bonds right now is what?

[00:19:14] Beau Coash: A couple years ago after rates rose dramatically we were pounding the table. We put out a white paper, if you don't like bonds now maybe you just don't like bonds. That got a lot of giggles. That's when the yield curve was inverted. We're now at 70 basis points steep, which means that we went from a negatively steep yield curve, an inverted yield curve, to now one that's 70 bps. On average our yield curve is about 100 basis points from 2 years to 10 years so we still have about 30 basis points to get to the average but many times the yield curve can go up to 150 to 200 basis points on a big change. That's not our main bet but we still think there's some room to go on the steepening which should create some value in bonds. We think we're starting off at a very fair level.

[00:20:14] We're not super cheap. I think if you look at the Treasury yields right now look like they're at the 70th percentile. Two years, three or four years ago they're up near the 100th percentiles in terms of cheap. Today they're at the 70s, still cheap. You compare that to credit, high grade credit, we're in the first percentile in spreads. We've never been tighter and that's not even doing adjustments for duration and quality which would then make it the absolute richest that we've ever had in the history that we followed spread product in high grade. We're at the very tights in that space but we still have very attractive yields, which is why we still have good yield, and we've got about a 5% yield right now in US fixed income, high grade fixed income.

[00:21:08] Pamela Ritchie: Do you like the high yield as well?

[00:21:09] Beau Coash: In core products, core plus products and the [indecipherable], roughly 5%.

[00:21:16] Pamela Ritchie: That speaks to the positioning ultimately, if you're going to talk about what it is it comes across as 5%.

[00:21:23] Beau Coash: Yes. We've got an underlying base, let's say the 10-year Treasury is at 4,20, and you've got about 70 to 100 basis points in spread on average, that gets you to that 5 to 5.20%. That is your starting yield and you've got, hopefully, some fiscal discipline coming at some point so we're not going to be writing gobs and gobs and gobs more Treasuries, we'll be very savvy about where we do it, maybe at the very front of the curve. These are all things that still have to play out but we still think there's some value in fixed income, especially when you think about equities. I don't think we're in a bubble either in equities anymore. I felt a little more bubblish just a month or so ago but I think starting in October, November that trade has come off a bit. Now, you can say that we're pretty neutral-ish, it's pretty fair now. There's been a redistribution out of the Mag-7 into the rest of equities. S&P's not dropping like a stone which means that there has been a re-distribution, a broadening of the rally. We're not down, the S&Ps not down 10, 20%, even though some of the software names and some of tech names are down 10, 20, 30% over the last couple, three months.

[00:22:49] Pamela Ritchie: There's been a ... some people like the word rotation, some people don't, but there is sort of a collective whew, it didn't take everything else down with it.

[00:22:57] Beau Coash: But there's not a massive sell, there's not a massive sell in the Mag-7. There's a sell but not a massive sell that ruins the S&P. That's the important part for now.

[00:23:10] Pamela Ritchie: That's the important part for now. To the extent that the AI theme is indisputable and it's where everything is going, it's where we're going, what is the correlation or lack of correlation between stocks and bonds with this big theme in the market?

[00:23:29] Beau Coash: We've been debating is 60/40 dead, is everything correlated to equities now? It's all about the starting yield. If we had very low yields, which means no cushion against an economic problem, or let's just say a new regime comes in and wants to raise rates again, or we get another spike in inflation, or earnings is really good so consumption pops and we need to slow things down, those are all things that you look for where you'll lose correlation. You'll keep correlation if we don't have any of those pop and we're at 5% and it's mostly Treasury yields so people should feel pretty good about having that big base of yield coming from Treasuries. We're hoping at some point in time we get a spread widening event where we can take some of our Treasuries and buy risk assets much cheaper, which happens once every couple, three, four years.

[00:24:40] Pamela Ritchie: That's more of a bump in the night rather than an interest rate cut.

[00:24:45] Beau Coash: It would have to be a credit bump in the night. Interest rate cuts will be positive for the bond market in general unless the cut is coming from something that we don't see coming right now, a big downturn in the economy, a big unemployment rush, something that will undo the benign environment that I kind of laid out. Big, big misses on earnings, huge unemployment numbers, reasons to make things more easy in terms of the Financial Conditions Index. Right now Financial Conditions Index, they're fair, we're on the easier side, but if we get really tight and things get tougher for people to buy groceries and things like that then we get into recessionary type levels and then we have to drop rates dramatically to get things moving again.

[00:25:45] Pamela Ritchie: You don't see anything in unemployment or the employment story that rattles you? There have been some numbers out in the last couple of days. No? Okay. That's good to know.

[00:25:56] Beau Coash: The numbers are shifting lower, they're not dropping off. I think we talked before, we were on 401k or the DC plans for 14% of all US companies, 40% of industrial companies, we're seeing it rolling lower but not dropping like a stone. You'd look at the chart and say, yeah, things are definitely not what they were a couple years ago but they're not dropping off the map, so you can't look at that and say, we have an unemployment problem. That's in the face of all the craziness that we've seen in basically stopping immigration and having people sent back, that's in light of all that. I think it feels like employment is okay. It's completely benign but it's not terrible.

[00:26:57] Pamela Ritchie: Tell us a little bit, if you don't mind, about the nominated new chair for the Fed, Kevin Warsh. Love to know your thoughts. Do you know of his work? Just share with us your thoughts.

[00:27:13] Beau Coash: We had Jurrien talking this morning, [indecipherable] asset allocation. We know Kevin Warsh really well. He's been complaining about the Fed for a long time. We've talked to him many times before this. We also knew Rick Reeder. I worked for Rick at Lehman Brothers so I knew Rick really well. We were kind of rooting for that. At the end of the day it's all about can the Fed maintain their independence and will this head of the Fed be able to maintain, or will say that this Fed is independent, even though Kevin has been lobbying for lower rates for a long time. Apparently, he was all over the fact that he blamed the Fed for the GFC and keeping rates very low. We'll see kind of how it goes when he gets in the seat. It seems like everyone seems to really adopt the administration's views once they join it so we'll see, we'll see what happens. It's a hard thing to forecast. You would have thought Scott Bessent would have really had his own, you now, he really followed the lead of our president. He wasn't as individualistic as he has been in the past. It's just a fun ... it's an interesting thing to watch people go and tow the party line instead of saying things that maybe are good for that position. We'll see what happens.

[00:28:57] Pamela Ritchie: Do you think once he gets into the role and is then running the show he's able to maintain the independence? I mean, it's sometimes different when you're still getting nominated to when you are actually driving the bus. I mean, I'm just curious if you think there's a difference there. You don't know.

[00:29:13] Beau Coash: Our President said similar things. He said everyone wants to tell me these things beforehand and they change when they join. That's why it's impossible to kind of predict what Kevin Warsh will do once he goes in and sees the sausage, how it's getting made, the decisions they have to make, what he wants his legacy to be there. It all is in the cooking and what goes into the pot. We'll see what happens.

[00:29:45] Pamela Ritchie: We're excited to have you running the ship here and having the steady hand at it. Thank you for bringing us up to date and taking us where the story for bonds is. It's fascinating, this expanding economy. Thanks for your time, Beau.

[00:30:00] Beau Coash: Thanks Pamela. We'll see you soon.

[00:30:02] Pamela Ritchie: See you soon. All the very best. That's Beau Coash joining us today on Fidelity Connects. It's Friday so we'll let you know what's coming up next week. On Monday investment director Tom Stevenson, he joins us for a discussion on global markets live from London. He'll discuss the latest headlines moving markets in the UK, Europe. Actually, the Japanese election will have happened, we'll have the results so we'll  go into that, but really the global story for investment.

[00:30:26] On Tuesday portfolio manager, Darren Lekkerkerker, friend of the show, will be on the webcast. This is for a big chat, an in-depth look at what's driving North American equity funds today, where opportunities may emerge. You can also get the latest updates on Fidelity North American Equity Class and Fidelity American Equity Fund, new funds, including insights to help you position portfolios in a shifting market environment. That will all be there in that conversation with Darren. That's with live French audio interpretation.

[00:30:56] On Wednesday of next week we'll have our exciting live Q&A with Louis Têtu. He is the executive chairman of Coveo, pioneer in AI-powered digital experiences from Quebec. We're going to be hearing his perspective on the next wave of AI breakthroughs, practical strategies for leveraging some of these advancements, deep knowledge he has to help you understand some of these things. Host Charles Danis, he'll go live with Louis, that's at 10:30 Eastern for a French language webcast and I'll be speaking with him at 11:30 in English. We look forward to next week and seeing you then. Thanks for watching today and have a good weekend. I'm Pamela Ritchie.