Stewart: Welcome to another edition of the InsuranceAUM.com Podcast. My name’s Stewart Foley. I’ll be your host. Investment grade fixed income is overwhelmingly the largest asset class held by most insurance companies, and it’s a topic that’s always front and center for our listeners. And today we’re going to be talking about public credit with Jake Gaul, CIO of Jennison Fixed Income. Jake, thanks for taking the time and being on today, man. We appreciate it.
Jake: Happy to be here.
Stewart: So let’s get this started the right way we always do. Let’s start with where did you grow up? What was your first job of any kind, not the fancy one, and a fun fact?
Jake: So I’m born and raised in the Boston area. I grew up in Hingham, Mass, on the South Shore. I now live on the north side of the city in Winchester, Mass. My first job was, I think after my sophomore year in high school, I worked at a boatyard.
Stewart: Oh, wow.
Jake: Cleaning up boats, sanding the boat bottoms, painting them, repairing them, doing grunt work. That was my first job.
Stewart: Inhaling carcinogenic chemicals.
Jake: Yeah, used a lot of-
Stewart: I’ve had one of those jobs myself.
Jake: A lot of chemicals, a lot of acetone, a lot of oil paint. And your last question, Stewart. Fun fact, correct?
Stewart: Fun fact. Yeah, absolutely.
Jake: I don’t know how fun this is, but it’s on the top of my mind. But my oldest son just got his driver’s license and thankfully he’s safe, but he totaled not one but two cars in the first week of having his license.
Stewart: Oh, no.
Jake: It’s only fun because no one was injured, but it’s not fun because we went from having two cars to zero cars.
Stewart: Holy cats. Two in a week.
Jake: Two in a week.
Stewart: That’s amazing.
Jake: One was a one car accident. No other car involved. The second one, unfortunately, there was a car involved. Like I said, no injuries, so just a little bit of inconvenience and some money and the damaged ego.
Stewart: Wow. Yeah, I can relate. My daughter’s turning … And we like to timestamp these. We’re talking on Tuesday, April 25th, and my daughter’s going to be 18 on May 9th. She’s a good driver. We’re all happy there, so it’s all good. But I’m sorry to hear that.
Jake: It’s all right.
Stewart: I think anytime we’re talking about credit right now, certainly banks and that whole situation is top of mind for a lot of folks. It’s a portion, significant portion, the credit market and of a significant or a reasonably significant piece of most insurance company portfolios. What’s your view on banks and the potential longer term impact of the banking crisis?
Jake: I’m still not convinced that there is a banking crisis evolving. At the outset of, I guess, Silicon Valley Bank’s failure in, I think it was the second week or third week of March, followed by another couple small failures, although it’s dangerous to try to categorize something like that as idiosyncratic, it did feel idiosyncratic at the time in terms of the drivers of those bank failures. Adding Credit Suisse, which if you’ve been in the markets in the last decade, that shouldn’t have been a surprise to anyone in terms of some of their missteps. I’m not convinced it’s a systemic crisis, and in fact, I’m more convinced it’s not a systemic crisis. Interestingly, heading into this period, we’ve had a constructive view on banks, especially from a fundamental perspective, from a credit quality perspective. We’re not alone in that. We’ve had clients tell us that it’s a “crowded trade” that doesn’t always make it a bad trade, but that’s been our view, and I think it’s been actually validated in the last month and especially the last few weeks with banks reporting earnings.
What matters for fixed income investors is different than what matters for growth investors. And what we saw in Q1 results of the bigger, larger names was really supportive in terms of strong capital, only a modest deterioration in asset quality and loan quality. In some cases, the big banks improved liquidity. I think it’s obviously important at this point to distinguish between some of the weaker names, the more concentrated books and the bigger money center names, which I think are pretty insulated from some of these challenges. Now, that’s not to say that if the cycle turns down sharply, all banks won’t have some challenges. You’re seeing rising pressure on profitability as banks have to pay more for deposits. At the same time, a deterioration, a small deterioration in loan quality, which could get worse. Commercial real estate’s at the center of some of these expected loan challenges, more of an issue for smaller regional banks than the big guys.
Stewart: Yeah, it’s interesting, and you can pass on this question if you want. I was at an event last week in Bermuda and somebody had the idea that, or suggested that the banks are going to be potentially subject to a higher capital charge for owning long duration assets or for the kind of mismatch that SVB got into. Do you have a view on anything that you think is going to be … And I’m in the same camp you are, I think it’s idiosyncratic and the timing of the fact that SVB and Credit Suisse happened about the same time, but the reasons were completely different. Do you see any kind of additional regulation or any kind of additional constraints that are going to have an impact on the availability of credit from banks?
Jake: Yeah, a couple early conclusions I had, trying to think through what at the time, pre-Credit Suisse failing, I think it was $500 billion of assets in the banking sector failed overnight. And what are some of the implications? I think the implications are there will be more regulation around small and medium sized banks. That’s already been happening. Some of the, I would call super regional banks have been subject to borderline G-SIB, Global Systemically Important Banks, status. But that scrutiny is going to move to smaller banks slowly. The second conclusion that I had, which I was more convinced about was bank management teams watching this play out, the absolute natural human reaction, function is to pull back and that means get more conservative. And it has gotten more play, I think, from strategists in the press. And there’s been some early signs that financial conditions and lending availability and standards have been tightening.
What’s really interesting to me is the senior loan officer survey, something that The Fed puts out each quarter, the last one they put out was in January, in January already showed significant tightening and credit availability from small and medium sized banks. That was in January. Those numbers will get updated soon. And importantly, those surveys went out to banks after these bank failures. You’re going to see more regulation and you’re going to see greater banks pulling back, which is going to not necessarily have a huge impact on underlying names, but should impact the overall economy negatively.
Stewart: Yeah, that’s some interesting observations there. Thank you. What about corporate earnings? Specifically potential signals for corporate fundamentals and technicals, what can you tell us there as an update?
Jake: Yeah, I think if you go back last year, it’s really hard to generalize in terms of the direction of corporate earnings. You got all sorts of different industries embedded in, for example, the S&P 500. You have financials, you have commodities companies, you have consumer businesses, you have insurance companies. They all have different drivers. Some are more cyclical than others. I would say that what has made us more cautious was when you look at the speed of rate increases that took place last year at kind of accelerating rates, my initial conclusion was it’s really just going to widen the range of outcomes for earnings for companies with more of a risk to the downside. That’s still our view. Now, fast forward, we’ve had three quarters of earnings in this kind of higher rate environment, or maybe four, and companies have done on balance a pretty good job of managing through it.
On balance, there have been some challenges, but if you look at some of the consumer sectors, P&G for example. Pepsi, another one for example, if you look at the way that they’ve been able to pass on inflation and some at the expense of volumes, very impressive. There’s been some negative signs as well. Actually just today, UPS, definitely a real bellwether for what’s going on and kind of business spending and the consumer spending. They missed their numbers and guided down for the year pretty significantly. I still go back to, I think the range of outcomes are pretty wide, balance to the downside. I don’t see any real trends. The part that’s held up pretty well for the overall economy’s been employment and demand for labor in the services sector has been high. That could change. It’s changed in certain sectors, in the tech sector.
But that’s kind of how we’re thinking about the earnings picture is you never want to underestimate US companies’ ability to manage earnings. You look at ’08 and ’09, the world thought companies would never get back to pre GFC profitability. They got back within a year. It’s amazing. And companies in aggregate continued to grow profitability for some time. The challenge now, I think, and I’m not an expert in macro by any stretch, but the challenge now is with persistent inflation and in some cases labor shortages, the ability to manage profitability is going to be a lot harder going forward. If you look at expectations for earnings on the S&P 500 for the remainder of the year, they’re still pretty elevated in our eyes.
Stewart: Insurance companies are investing their cash flow marginal dollars. And when I look out across the corporate credit landscape, where do you see value and are there things that you think are overpriced?
Jake: Yes and yes. At a high level, we live exclusively in the dollar denominated, high quality developed market, dollar bond market. We’re not involved in a big way in high yield. We’re not involved in a big way leverage loans or EM. In our universe, I would say in general, we don’t see a lot of value. If you look at how our portfolios are positioned, we are generally speaking pretty underweight corporate credit risk overall. We’ve been more underweight corporate credit risk, but we’re pretty underweight overall. Valuations, if you look across the credit curve, the quality spectrum, they’re least attractive in our opinion in the long end and in the long high quality end, if you look at where levels are relative to history and also comparatively better value in the front end of the corporate credit market.
But that’s been persistent and that’s also worrying to some degree. There’s been better comparative value too in the higher quality securitized markets, particularly ABS. But demand has been kind of, I’d say more spotty there than it has been on the long end. And some of that could reflect an institutional versus retail dynamic. But yeah, a long way of saying, I guess that we see not a lot of value in credit overall, a little bit in the front end and a lot less in the back end.
Stewart: And I probably should have started here, but for those who aren’t familiar with Jennison, can you talk a little bit of background in the firm, size of the firm, and what asset classes you’re managing? Because I want to get into your strategy for the investment grade market in particular, but I think some background would help.
Jake: Sure. We’re I’d say a midsize institutional manager. We run roughly $50 billion in high quality investment grade bond mandates. And we have a good sized equity business that’s run out of New York. We’re in Boston. That’s bread and butter has historically been large cap growth equity, but has also built a good size business in global growth equity. Very, very good long-term track record. On the fixed income side, our mandates really span from very short duration treasuries to 25 year duration strips. We manage full credit portfolios, we manage a hundred percent treasury portfolios and everything in between.
We have a good size share in the defined benefit corporate space. We have a good size share in a stable value market. And on DC platforms more broadly. And we are really indifferent or I’d say agnostic in terms of what benchmarks we run against. A unique way about Jennison is that we really try to apply our investment views across all of our portfolios. We have a single group of portfolio managers that on a team basis manage all the portfolios we run against, whether it’s a long credit, intermediate credit, or anything in between.
Stewart: That’s unique. That’s an interesting approach. And so when you look at the investment grade market as a whole, can you talk a little bit about how your strategy and approach allows you to capitalize on opportunities as they come up?
Jake: So we have a narrow focus and I think that that is like a lot of things, it’s a benefit, but it’s also, it makes kind of scaling and growing our business a little more challenging, but clients really like it. We really try to be an expert in a single asset class and not spread ourselves too thin. The other dynamic about our team structure that I mentioned is that single team approach. Every firm has a team approach. They have multiple teams. A lot of firms will have a core team, a core plus team, a global bond team, an insurance focused team, but that’s multiple teams. We have a really single team approach where we have kind of an expert in single sectors and we all work together to apply those ideas across all of our portfolios. What’s nice about that is it allows us to be nimble.
We have a pretty streamlined decision making process. There’s fewer of us to get onto the same page, but we have a good record longer term or an active record in moving around our allocation or our active risks in the portfolio, whether that’s buying or selling spread product, shifting positioning on the curve, trading mortgages like we did heavily in 2022 with all the volatility. We have I think a pretty distinct ability to be nimble in the market. And we’re also, I believe, a pretty favored counterparty with a lot of the dealers in credit. That single team approach, fewer decision makers, makes us a counterparty that gives answers to dealers pretty quickly. We may not bid or offer on all their ideas, but we’ll certainly give them an answer pretty quickly. And so that in turn puts more ideas in front of us that we don’t always choose to trade. But that nimbleness has definitely served us well in periods of volatility in our … If you look at our performance track record, we tend to do quite well in challenging periods for credit markets.
Stewart: When you look at high quality ABS and CMBS, what’s your view on those valuations as you look out there today?
Jake: Yeah, so I mean, again, positioning’s always a pretty good illustration of that. We have as healthy, overweight, high quality asset backed primarily auto loans and credit card trusts. And we have really minimal positioning in the CMBS sector overall. We own a few higher quality deals. We’re definitely more cautious there. If you look at valuations in ABS and CMBS, they’re screening exceedingly cheap and I think they’re probably cheap for a reason. When you look at CMBS, not all names, but in general you look at some of the challenges, I think that there’s comparatively better opportunities on the consumer side, which drives consumer ABS.
One, I think there’s been a pretty big difference of opinion in terms of the health of the consumer, and that will certainly impact to a large degree how some of these ABS deals do. But I’m more in the camp that the people’s confidence that all the wealth and savings built during COVID have provided a huge cushion for the average consumer. I don’t entirely believe that. I don’t think the numbers support that, and I think that that’s real wages just for inflation have been negative for two years. Most people in assets took a hit last year. It doesn’t really feel logical to me that the consumers as healthy as some of the statistics out there purport them to be. But that said, if you’re buying up in a cap structure like we are with credit enhancement, it’s a very, very good fit for our high quality clients.
Stewart: Yeah, that’s really helpful. And I mean, one of the things that as a card carrying bond geek, whenever I see the yield curve invert, my spidey senses say to an extent, which is a hard thing to do, yield curve has been persistently inverted for some time. What comments do you have on the shape of the yield curve and what are you expecting?
Jake: So just as a disclaimer, I’m not the firm’s expert on yield curve. We are very active in yield curve in terms of not making directional interest rate bets in our portfolios, but trying to capitalize on distorted kind of relationships across the yield curve. And so right now, I would say we’re taking that opposite view that you point out, we have a steepening bias in portfolios. Historically, the way we’ve thought about trying to add value in the yield curve, where portfolios allow us to, is if you look historically at different interest rate hiking and cutting periods, shape of the yield curves mean reverting over time.
The level of interest rates are clearly not, but the shape of the yield curve is, and so we have, I would say somewhat of a contrarian view, but we have been building a steepening position on the yield curve, which is not a bet on The Fed pivoting and cutting rates aggressively, but more of just a mean reversion play. Embedded in that position really is not a solid view on where we think inflation may or may not be in 12 months time. It’s really just a mean reversion trade. Interestingly though, every cycle’s different, but our yield curve expert reminds me that, and this statistic always surprises me, the average amount of time in Fed cycles between the last interest rate hike and the first cut is six to nine months.
Jake: So you could take away from that on average in hiking cycles for whatever reason, we all know monetary policy works for the lag, but I think that data tends to show that hiking cycles tend to break things or certainly contribute to slower growth. If you look at the pace of hikes in the last 18 months, it’s almost without precedent. Again, we’re not making forecasts on what The Fed is or is not going to do, but it does feel like it’s probably a pretty attractive time to build a steepening bias in the portfolio where you can. Listen, every cycle is different and I am sympathetic to the view that some of the causes of inflation this time around are perhaps structural, but in that scenario, it’s also plausible where maybe The Fed doesn’t come in and start an aggressive cutting campaign, but there’s a scenario there where the market starts to reflect a higher rate environment in the back end of the curve, and the whole term structure starts to rise and get more upward sloping.
That’s kind of how we’re thinking about the yield curve. We use it as a, I’d say as a secondary lever in portfolios, second to very active sector rotation and really important security selection, which I really lump together. You can’t do one without the other, but we do try to look at taking positions on the curve and we’re extreme levels and we’re certainly at extreme levels.
Stewart: Wow. Outstanding. I learned so much on every one of these podcasts. I’m a dedicated fixed income geek and proudly so, and it’s great to talk to someone who’s sitting in the CIO seat of a fixed income operation there. It’s great to hear your views. I just have one question that’s pseudo new for 2023. If you could have lunch with anyone alive or dead, who would it be?
Jake: Michael Lewis, the author, for sure.
Stewart: Oh wow. There you go.
Jake: Actually, if I could go back and answer your question, a fun fact related to Jennison, he in Liar`s Poker, his kind of breakout book, all about bond trading, there’s a quote in the book that refers to one of the founders or one of the early PMs at Jennison, that refers to this gentleman’s name. I think it was Andy Carter at Gennison Associates. And it was actually spelled with a G, not a J. And I sent Michael Lewis a Bloomberg just to clarify why he misspelled it. Was it intentional to hide our identity, or was it a mistake? He never got back to me, but I’ve been a huge fan. I’m not an enormous reader, but I do read all of his books and I think he’s just a brilliant mind, and I would, yeah, that’d be my top choice.
Stewart: Wow. There you go. Good stuff. Well, listen, thanks so much for taking the time. I really appreciate you being on, Jake. I mean, I’ve learned a lot and investment grade fixed income is a big part of most every insurance company portfolio and certainly will be of interest to our listeners. Thanks for taking the time.
Jake: Yeah, happy to do it. Nice talking with you.
Stewart: You too. We’ve been joined by Jake Gaul, CIO of Jennison Fixed Income. If you like us, please rate us and review us on Apple Podcasts. We certainly appreciate it. My name’s Stewart Foley, I’ve been your host and this is the InsuranceAUM.com Podcast.
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