Liquidity and Volatility in the Bond Market with Shilpa Lakhani, Head of Portfolio Management-Fixed Income Solutions at DWS

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. Today's topic is liquidity and volatility conditions in the bond market. And we are joined today by Shilpa Lakhani, Head of Fixed Income Portfolio Solutions in the Americas for DWS. Shilpa, welcome.

Shilpa: Thank you for having me, Stewart.

Stewart: We are thrilled to have you. And we start this one like we start them all. What's your hometown, what was your first job, and what's a fun fact?

Shilpa: I was born in Flushing, Queens, New York City. I've been at DWS my entire career, so over 18 years. And a fun fact about me is that I love vegetarian cooking and I spend probably an hour or two a day cooking for my family, three meals a day.

Stewart: Wow, that's really cool. Very cool. Well, thanks for that. That's great. We share something, we're both fixed income geeks, and I use the term geek in the most adoring way. It's the largest asset class of our listener base and it's important. And I think liquidity and volatility are big deals any day of the week for an insurance company, but right now particularly important as we've seen what's going on in 2022. What are the biggest concerns that you have right now with the macro environment as we go into the new year?

Shilpa: The macro environment has been extremely challenging this year, and these are not normal market conditions that we're typically used to, and there's just so much perversion in the marketplace. If you think about 2022, the market conditions that we've experienced are defying normalcy on all fronts. Inflation is at 40-year highs. We have tight financial conditions, curve inversion, one to two standard deviation daily move in Treasury yields. The Fed funds, according to mathematical models, be it the Taylor Rule or the first-difference rule, Fed funds and terminal fed funds rates should be much higher, 7% to 8%, if follow those methodologies.

There is a chance the Fed could be undershooting. The Fed is losing money right now. Not that it really matters, but they are paying more on their reserves than they're earning on their portfolio. Commodity curves are in backwardation, which is exactly the opposite of what policy-makers and politicians want. The war, of course, between Ukraine and Russia, the historical strength of the dollar. And it seems like this year, amid all of these market conditions, the Fed put has lost significant value. So the market's reliance on the Fed to stabilize markets has been repriced significantly.

And if we take it back to the bond basics, and you'll appreciate this, Stewart, if we boil it down to the basics, this is the first year in recent memory that every single risk premium captured in a bonds price has been challenged. Think about it, the premia, there's credit risk, there's duration risk, liquidity risk, convexity risk, spread risk, inflation risk, price risk, reinvestment risk, have all been addressed in 2022. 

Credit risk, sure. Debt growth has receded over the last few years, but leverage could absolutely rise as the macro backdrop deteriorates.

Duration risk, we all know what's happening there. Long-duration assets got absolutely crushed in 2022. Convexity, traditionally negatively convexed sectors such as munis, high-yield, and mortgages are now all positively convexed. So the options in those sectors are deeply out of the money.

Spread risk. Spread risk, as we all know, has been virtually wider, or risk asset classes are virtually wider across all fixed-income risk assets due to the risk aversion in the markets this year. Inflation risk. Sure, inflation risk is front-loaded, so the front part of the curve has been most impacted. But what about the purchasing power of your longer-duration cash flows?

Price risk. Price risk, we all saw what happened to bond prices this year, and so many of our clients went from going to having a portfolio from very large unrealized gains, to now experiencing very large unrealized losses. And that happened very quickly this year.

And finally, of course, maybe the silver lining in all this: reinvestment risk. At least we are seeing reinvestment yields that we haven't seen in quite some time anywhere between, God, at this point, 6% to 9% in fixed-income markets, depending on your risk tolerance. So as you mentioned, a very, very exciting time for fixed income, amid a very precarious macro backdrop.

Stewart: It's interesting, we had a podcast with Aaron Diefenthaler, who's the CIO at RLI, and he mentioned that Treasuries are an investible asset class again, so you can buy Treasuries and raise your book yield a lot of times. So it's really, really an interesting time. You mentioned spread widening in corporate land. Does that, in your mind, mean that there's a recession pending, or is it something else?

Shilpa: Stewart, wider corporate bond spreads can mean multiple things. There is a common perception that wider corporate bond spreads indicate or signal pending recession. But so far this year we think the narrative is somewhat different and much more nuanced than that. So the widening and spreads we've seen for most of 2022, we believe have been more of a function of duration aversion amid a ferocious Fed hiking cycle and worsening market liquidity. We think those two factors prevail much more than serious recession fears.

If spreads were truly expected to indicate a material slowdown in GDP, all-in yields would be materially lower. To put in other words, there's probably more predictive power in Treasury yields rather than spreads. And so we all know what happened to Treasury yields this year. So far this year we don't think the widening in spreads has truly reflected a possible recession. And so in our mind, we think there's likely more pain to come over the next few weeks at least to reflect weakening macro data and higher recession probabilities.

So far this year, if you look at all credit fundamental charts, credit fundamentals are fairly favorable. Issuers took advantage of the low rate, tight spread environment from March 2020 to late 2021 to clean up their balance sheets. Leverage has declined in the investment grade market and high-yield market, and interest coverage remains fairly robust. And so while deleveraging may continue, it's going to be at a slower pace.

Net leverage, on the other end, may worsen. And so as the economy navigates through fairly rough waters over the course of the next three quarters' condition, these economic conditions may put pressure on operational growth and margins. And therefore companies may look to M&A or equity buybacks to unlock shareholder value, which is again, equity-friendly activities at the expense of debt holders.

And finally, looking back at previous hiking cycles, the latest being December 2015 into 2016, high-yield spreads were significantly wider leading into the first hike. And so keep in mind, back then economic conditions were far different. Labor markets weren't nearly as tight. Unemployment was around 5% and core inflation was below 2%. So we think there's still more pain to come in the corporate bond market.

Stewart: You mentioned a moment ago that these are not normal market conditions, so can you quantify or explain how abnormal they are? And it might be a difficult question to answer, but it's the best way I can put it.

Shilpa: Yeah. Normal market conditions reflect general sentiment in the market, volatility in the market, liquidity in the marketplace, consensus. It seems for a good part of 2022 there was no market consensus view. People had different views on risk assets, how equities would perform, fixed-income spreads would perform. I think everyone just knew that the Fed was late to the game and they're going to be aggressive with monetary policy.

But what that impact was on risk assets has created a wide dispersion in views. Where are the Fed funds rate is going to end up in 2023? Where are that terminal Fed funds rate is up for argument, it seems like the 5% was the new 4%. Now it seems like 6% is the new 5%. So the market likes clarity, particularly around monetary policy, and there's a conflict, a strong conflict, between what the markets want, which seems like a Fed pivot. But every time the market reprices a more dovish Fed, Chairman Powell comes out and says, "No, we are on pace to tighten monetary policy as much as possible to control inflation." So in terms of market transparency or the transparency that markets typically want, we haven't necessarily seen that this year and that's led to higher volatility and tighter financial conditions.

Stewart: And so you mentioned the Fed and you mentioned aggressive tightening, but earlier you said that, based on some models, the Fed may be behind the curve. I guess my question is, how has aggressive Fed tightening impacted the liquidity in the marketplace?

And implied in that question is, where do you think the Fed is, ahead or behind the inflation number right now? Given that we just yesterday saw a reduction in inflation, massive equity market rally, but doesn't seem like, to your point about the Chairman, Powell, it doesn't seem like they're pivoting at all. So how should we be thinking about that?

Shilpa: To our previous conversation that we just had, another abnormal market phenomenon is the poor liquidity in the marketplace that we've seen in 2022, particularly the challenged liquidity in the Treasury market. Looking at the delta in yields, and so the differences in yield across maturities along the yield curve with what technicians call a relative value curve fitter, liquidity in the Treasury market is the poorest it's been since 2010, when the economy back then was reeling from the Great Recession. We were dealing with the Greek financial crisis. And if you remember that flash crash happened in 2010. So the liquidity in the Treasury market has been, again, the poorest it's been in over a decade. And it's equally as ugly.

Same goes with the very liquid mortgage market. There simply is no marginal buyer now that the Fed has stepped back for years. The Fed was the natural marginal buyer. Before the GFC it was the banks, but banks pale in comparison to the clout the Fed has had over the last few years. Some argue that the tightening, as I just mentioned, was a little too late, but some argue that the unwinding of the balance sheet now is too quick, too fast. For example, during the last tightening cycle, the Fed ended quantitative easing in 2014, but it didn't start to trim its balance sheet until 2017. This time it's happening all within months. That is obviously putting a lot of stress on liquidity in the marketplace and exacerbating the sell-off that we've seen in rates.

So what are the implications? Of course, there's so many when it comes to liquidity in the fixed-income markets, but typically for fixed-income core asset classes, in a constrained liquidity environment, these asset classes tend to then become highly sensitive to flows. Which brings me to the broker-dealer community. They are the supreme liquidity providers. So if there are volatile market flows, broker-dealers will likely not be able to provide adequate liquidity. And so aside from the year-end, negative seasonal technical, banks may have to face a reduction in risk-weighted assets, which will constrain their balance sheets and affect their ability to take on risk.

And so these banks are going to need to maintain capital ratios above their requisite ratios. And so it's going to tighten up the ability for dealers to take on risk. And that has first-order effects on credit formation and market liquidity. And that reduction, RWA, hits across all sectors, not just corporate. So liquidity will continue to be a headwind for fixed-income risk assets and Treasuries for the balance of the year.

Stewart: There's a lot of information in there. My job on these podcasts is to play armchair CIO. If I'm the CIO of an insurance company, how should I be positioning myself to address the volatility that you're talking about and the poorer liquidity conditions? And to maybe add to that question a little bit, does it matter if I'm a PNC insurer with a little shorter duration benchmark, versus a life insurer with a longer duration benchmark?

Shilpa: That's a great question. At the current moment, credit fundamentals seem relatively healthy, but that doesn't mean recovery values are meaningless going deeper into a credit cycle. So deep dollar discount bonds, whether you're a PNC company or a longer duration investor like life companies, deep dollar discount bonds with optionality make a lot of sense to us. Virtually, as mentioned, every traditionally negatively convexed asset class is now positively convexed. Mortgages, munis, high-yield, sure. Again, the call option are way out of the money, but there's far more upside than downside. And so currently, given still a precarious macro backdrop, we advocate both our shorter duration investors and or longer duration investors to stay liquid. If the Fed pivots overnight, those options of those very high-quality asset classes I just mentioned, are worth a lot more. And so again, we advocate purchasing deep-discount, higher quality credit, munis, discounted mortgage specified pools, and to those who have the ability to take risk down in the cap structure, there are opportunities in high-yield as well.

Active portfolio management and rebalancing, Stewart, has become very expensive this year. Typically, easy trades like rolling down the yield curve are less possible in curve inversion. Liquidity, as I mentioned, is extremely spotty and choppy and very poor this year at times. So managing portfolio turnover has become increasingly challenging. We've seen these big swings in spreads. And typically, just given that I've managed money through multiple market cycles, it should be easy to go long when spreads compress, and easy to go short or get into cash when spreads widen. Instead, we're now chasing scarce assets and selling positions that are hard to find later. Therefore we advocate to clients to have a longer-term view on asset classes and play it more strategically than tactically.

Stewart: That sounds like very good advice. And I guess, on the back end of this thing, is there anything that you're avoiding right now amid what you've pointed out are very challenging market conditions?

Shilpa: We think strong balance sheets will be rewarded here in the near-term, including stronger consumer balance sheets as well. The consumer has yet to feel the pain of higher prices. I'm sure the wage check is higher, but consumers are spending a lot more of their checks. So we don't favor some of the subordinated tranches of consumer asset-backed securities, for example. We're cautious on consumer banks as well. So financial services tied to the consumer will feel pressure as charge-offs and delinquencies rise.

Certain parts of the economy are still reeling from the structural and behavioral shifts from the pandemic. So we are fairly cautious on office, single asset, single borrow, CMBS deals, along with mezzanine, so subordinated tranches of conduit CMBS deals. We think there's still a lot of breaks in the market, in the commercial real estate market, that need to make its way through. Again, with the stronger dollar and weakness out of China, we are advocating an underweight in EM credit at the moment.

And finally not adding floating rate exposure here, CLOs and the leverage loan market have some negative fundamental and technical factors to work through. So much more constructive on fixed rate versus floating rates. Those are just some of our views that we have and some asset classes that you probably want to avoid here in the near-term.

Stewart: That's good stuff. I don't know if you're going to want to go there or not, and I'm just going to toss this question out. Over your head is a screen that just said that the ftx.com crypto exchange filed for bankruptcy this morning. Does the volatility and turmoil in crypto create any flight-to-quality tailwind in the fixed-income market at all, or do you see those markets as unrelated?

Shilpa: I tend to think that crypto has a second-order effect on fixed-income markets. I think if you look at crypto performance and equity performance, there seems to be a higher correlation there. But with fixed income, it seems like the equity volatility leaks into spreads at the margin. But fixed income spreads, all things considered, have behaved fairly well this year.

It's been a slow widening in spreads. We haven't seen the jerks that we've seen in a very volatile equity market. So I think crypto has a higher correlation or higher impact on probably equity markets than what seems like a very well-behaved IG corporate market.

Stewart: Very, very interesting. And just, you've been at DWS, you mentioned, 18 years, your entire career. I'm sure you remember your first day. And I guess the question I have, and I talked for years and I always ask our guests, what would you tell your 21-year-old self starting out in your career? Given current market conditions and the opportunity set that exists in the financial services industry, what advice would you give yourself today?

Shilpa: You have to evolve just as financial markets evolve. I started in 2004, which was pre-GFC. And you would call the end of the bull market days where you had favorable market conditions, a credit market that was functional, and quickly, within a few quarters, you saw those credit markets deteriorate. And being in fixed income, the credit markets were leading the crisis basically, the credit markets were the culprit, or I should say the match that ignited steep selloff and financial crisis that occurred.

And so the credit market's changed quite a bit. The credit market's evolved, the banking system evolved. So with that, I think that means an investor needs to evolve with the markets as well. To anyone who's looking for a career in the financial service market, just you have to be nimble and be ready to evolve as the markets evolve.

Stewart: That's fantastic advice. Shilpa, thanks very much for being on. I've learned a lot today. I always learn a lot from our podcast guests and this has been no exception, so thank you very much for joining us.

Shilpa: Thank you, Stewart. Been a pleasure.

Stewart: Shilpa Lakhani, Head of Fixed Income Portfolio Solutions at DWS. Thanks for listening. If you have ideas for podcasts, please email me at podcast@insuranceaum.com. My name's Stewart Foley, and this is the InsuranceAUM.com podcast.

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