Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley, and I'll be your host. Our guest today says passive bond investing does not exist. That would be Steve Boothe, Head of Global Investment grade with T. Rowe Price. Steve, thanks for being on. Thanks for taking the time. I'm really looking forward to this.
Steven: Thanks, Stewart. So am I.
Stewart: That's great. Okay, so let's start it off like we always do. What town did you grow up in? What was your high school mascot and what makes insurance asset management so darn cool?
Steven: Well, I grew up in Baltimore, Maryland, which conveniently is where T. Rowe Price is located. So I'm a homegrown for now T. Rowe Price lifer. I've been here for over 20 years. I did, to be fair, I served some time in New York. I did my stint, but that's my path. Baltimore to New York and back to Baltimore and I love it all.
Stewart: That's great. High school mascot?
Steven: High school mascot is the Gators, the Perry Hall Gators. Go Gators.
Stewart: I love that.
Steven: Fun fact, I was on the state championship winning baseball team and I won a few wrestling matches as well for the Gators.
Stewart: Wow, nice. My stepson wrestled in high school as well, so very cool.
Steven: Oh, nice.
Stewart: In your mind, and you deal with a fair number of insurance companies, what makes insurance asset management so cool from your perspective?
Steven: I would answer that a couple of different ways. And so as you noted, I run the global investment grade team and maybe let me answer that question from a little higher level. What I find really cool about my day job is first of all, it's global, and I do believe deeply in the benefits of global diversification when it comes to constructing portfolios. The other side benefit to that is that I get to visit a lot of really cool places, Bermuda being one of them, quite often. I would also suggest, given that we touch a lot of different segments of the market. Corporate credit, securitized, and government bonds, we have long duration portfolios, short duration portfolios. At times it's a very macro market, at times it's a very micro market. Sometimes bottom-up matters, sometimes it doesn't. We touch a lot of different markets. We can create a lot of different solutions for any number of clients.
So that to me just adds to the uniqueness and the fun dynamics of being part of the global investment grade market. It's a puzzle, right? And it's a puzzle that we come in every day and we try to solve. And lastly, and I think what's really unique about our market, about the investment grade market is, and Stewart, I think this is really underappreciated by a number of folks, is the underlying market structure of the investment grade market. It has radically changed over the last two decades, and maybe we could talk about this a little bit more in the discussion, but who owns bonds, why they own them. This shift in ownership, in my view, I think is really important and frankly having a profound impact on asset prices.
Stewart: So I started the show with this idea that passive bond investing does not exist and I'm a fixed income nerd for sure. So one of the things I try to do on this show is to educate people about things that they may not be aware of. And one of those things is that T. Rowe Price has a 50 plus year history as a fixed income investor and that you're a significant fixed income powerhouse that I think is often not maybe widely known.
And so as we get into this, I want to hear your view on why you think passive bond investing does not exist. But can we start at where every bond geek wants to start, which is the macro environment which appears to be tepid at best, flashing warning signs that have strategists, the economists and fundamental investors all running around, not sure what to do. I mean are there any key indicators or markets that have your attention, good or bad, as you and your team canvas the globe for opportunities?
Steven: It's a very fair question. So we've been describing this macro environment internally as a fragile equilibrium. And so what do I mean by that? So when you take a step back and think about the overall environment, we have a nominal GDP that is decelerating but remains robust. We have inflation that is decelerating but still uncomfortably high. You have macroeconomic data that is okay, but to your point is not great. But asset prices seem to be pricing off of other dynamics, right? And I think one area where we spend a lot of our time discussing and we've spent a lot of research resources trying to better understand are the underlying liquidity dynamics of markets. Liquidity right now is, I would suggest, the dominant factor when thinking about asset prices. So what do I mean by that? What do I mean by liquidity. So I'm thinking of a couple of different dynamics. One is just simply flows. Flows coming into the market. Flows coming into credit have remained robust. Flows coming into the equity market have remained fairly robust as well.
That's one side of the equation. The other side is supply. The supply of financial assets outside of treasuries is down. So I don't think it's a surprise that you're seeing concentrated volatility in the treasury market relative to other asset classes. Credit is a great example. Credit volatility given where we're in the cycle is uncomfortably low. And this is purely a function of the liquidity dynamics and supply and demand and balance of credit assets.
Treasury market's the opposite. Right now we're in an environment where some of the larger buyers of treasuries, banks, central banks, foreign central banks, et cetera, they've stepped away and we're running large budget deficits. So that supply / demand imbalance is creating what I would suggest outsized volatility within the treasury market.
So what are we focusing on right now? Well, it's that volatility within the treasury market and when and if does it migrate to other asset classes? When does that volatility migrate to credit, for example, when does it migrate to the equity market? Some signs of that this week. I'm a bit skeptical that that's sustainable. So those are some of the things that we're really focused on from a very high level macro perspective.
Stewart: Is the decline or decrease in the availability of credit issuance, is that related to rates being significantly higher and a lot of corporations locking in long-term financing when they were much lower and now nobody, they just don't want to do it now?
Steven: Absolutely. Right now, if you look at the disconnect say in the high yield market of the market rate relative to the average coupon, pretty big delta. And so to corporates’ credit, they did a fantastic job of turning out liabilities during that 2020, 2021 period. The refinancing window got pushed way out in the future and they're reaping the benefits of that now. And this is why you're seeing a relatively less benign volatility within credit. They just haven't had the issue.
Now there's a shelf life to that, right? At some point maturities come due, refinancing risks will take higher. This is more of a 2024, 2025 event in our view. But you're exactly right, Stewart is that corporate America, particularly public corporate America, did an excellent job of turning out their cap structure and buying themselves a fair bit of time as we've gone through what has just been a historic hiking cycle by the Fed.
And maybe one final point here is if you take a step back and think about where we have had issues within the market, right, regional banks for example, where we've seen stress, our private bankruptcies for example, have ticked up higher as well, where you have seen stress stresses where liabilities are shorter dated in nature. That makes sense. That's where the Fed has its most immediate impact. But for those issuers, particularly in the investment grade or higher quality segments of high yield, this hasn't been an issue. But this is a risk for 2024 and 2025 to be very mindful of.
Stewart: So let's flesh out this idea, this passive discussion a bit more. I mean often any passive investment discussion is centered around fees, but you're focusing more on how it impacts market structure. Let's talk about that. Can you elaborate there and kind of unpack that for us?
Steven: So let's maybe take a step back and define exactly what a passive investor is. And so if you go back to the original work of Bill Sharpe and his wonderful paper, you define a passive investor quite simplistically, you own the market portfolio and you do not trade. Now take that concept and compare it to what is also referred to as a "passive product" usually found in ETF wrapper. Well first of all, the first assumption is absurd. As any of us know who should operate in fixed income markets, it's nearly impossible to own the market portfolio. You cannot replicate a bond index.
Stewart: Can't be done.
Steven: It is virtually impossible, can't be done.
Stewart: No. Can't be done.
Steven: Now to be fair, a lot of these providers do a nice job of replicating the characteristics. That's fine.
Stewart: For sure, but it's not the same as owning it, right? I mean you cannot own... I think that's a great point, it is just not possible. Some of those index items, they don't trade and you just can't own it.
Steven: You can't find it. It's just simply not possible. So it's impossible to own the market portfolio. I think that's a fairly reasonable observation to make. Step two might be a little controversial, this idea of not trading. By definition, a passive ETF has money that it puts to work every day. Every day it has flows either in or out and it transacts with the market, it engages with the market. So you might say, "Okay, so why does that matter?" You have flows coming in, you just put that money to work, so be it. But two points here, one is if you look at the direction of flows to the larger passive bond products, look at the flows for the last 10 years, you can literally count on two hands the number of months they've had outflows. It's a one-directional buying machine. Okay? So that's fine.
So think about the impact that that has now. Well first of all, you violated the assumption that you don't trade. So that's out the window. But here's where I start to have concerns and I want to be really clear about something here, Stewart, is that my concerns are based off some wonderful academic research I simply have to give credit to here. The work of Ralph Koijen, Valentin Haddad, Xavier Gabaix, a gentleman by the name of Mike Greene have really been pounding this point for a while, is that as that transaction, as that construct continues to grow in both size and influence, it's impossible to say that it does not have an impact on the market.
Passive investing over the last 10 years has gone from roughly 25% to 35% market share and is nearly all of the flow. How can you logically not suggest that that does not have an impact on day-to-day pricing, on day-to-day price discovery. And what a lot of the academic research is suggesting, and we've done our own work internally as well, is that this is distorting price discovery, but it's creating distortions across liquidity conditions across the market. It's having an impact.
Stewart: And it's also, I mean when you talk about an insurance company, if you think about their liability portfolio, it's effectively a bunch of reverse bonds. That's basically what it is. It's a set of cash outflows as opposed to a set of cash inflows. And depending upon their line of business and their business mix and how it changes over time, their duration and in particular key rate duration, those needs may change. So it's not really, I mean I think an insurance company for sure has to be active in what they're doing just to manage their risk over time.
Steven: Absolutely. So here's where I would maybe, so I think about this from an insurance perspective. Go back to my comment around the flows, the direction of flows. As the larger passive products continue to grow in size and scale, those bonds disappear and don't come back to the market. So if you have duration demands, if you have particular curve demands, it becomes increasingly difficult to construct that risk or source that paper if it's going into a vehicle that never has outflows and frankly transacts regardless of price. That to me, I think it just changes the behavior and the personality in markets in ways that, I'm not sure we fully appreciate this yet.
Stewart: That's really helpful. So security selection is T. Rowe Price's bread and butter. Maybe you could share a bit about how your team is actively navigating current market conditions. And as an example I'd say have there been any major knock-on effects to credit conditions and spreads that you would call out?
Steven: So since the spread widening event in March, post-SVB, credit in general and investment grade, in particular, has been really a one-way tightening train. So why is that happening? Well, first of all, it's that supply dynamic that I mentioned earlier. Supply in the investment grade market is down approximately 10%. There's frankly a shortage of long-dated paper right now because issuers don't want to lock in longer dated financing costs.
And so as demand has remained steady you see this very overwhelming technical kick in because there's just a shortage of paper, there's just not enough supply. And so what that's done is it's just created a more or less gravitational pull and spreads. So despite higher treasury volatility, despite economic data becoming less robust, despite even this week with the VIX migrating from 13 ish to 19 ish in a hurry, credit is trading just fine and it's been a function of this technical.
Now to your point, this doesn't mean you can ignore fundamental risk or sector risk. There's plenty of that out there. The regional bank area is an area of focus, obviously, potentially on the negative side. The energy sector is the opposite. You're seeing credit profiles and ratings migration to the positive in the energy sector. So that's where we're really spending the vast majority of our time. Where can we avoid the landmines but also pick and choose those positive stories where credit quality is improving and make sure that those names and those sectors are well represented across our portfolios.
Stewart: You mentioned the regional banks and we've had a number of folks come on and talk about how there's a fairly significant amount of paper that's in CRE that's in the regional banks. There's been the argument made that there's a shift as regional banks pull out, pull back on lending that the insurance companies are picking up the slack there by way of private credit mandates, right? So can you go a little deeper into the regional banks and talk about how you think this plays out?
Steven: So let me say a couple of things here. One is you're absolutely right on the asset side of the balance sheet, the CRE exposure, it's there. I would also suggest it's well understood and in the process of being addressed and you just highlighted a number of areas where that is being addressed. Insurance companies stepping in and providing that capital and buying those assets at reasonable prices.
Where I would suggest and where our work would suggest is the issue here with the regional banking system is not on the asset side. It's the liability side. So what we experienced in March, it gets labeled as a capital issue. Capital credit quality came under pressure. What we would suggest is that this was a funding issue. This was a funding liquidity issue. So when you're thinking about your regional bank exposure, when you're doing your credit work, what we're focusing on, what we would suggest your listeners focus on is the quality of the deposit franchise.
Is the bank overly exposed to a particular sector? Are they overly exposed to a particular factor? Macroeconomic sensitivity? Because at the end of the day, what we really experienced in March was liquidity drying up because their customers ran into trouble. It really was that simple. I mean, if your deposit base consists of struggling tech companies and crypto companies, what did you expect? This wasn't a capital issue.
Now it can become a capital issue, but where we think, where we're focusing our efforts is on the liability side and analyzing that deposit franchise and deposit base. And look, and this is a completely self-serving comment, we navigated that period quite well. We were able to deploy capital in banks that we liked at much cheaper valuations, and kudos to our banking finance team. I would argue that our banking finance team here at T. Rowe Price is one of, if not the best in the industry. I would take the Pepsi challenge against any of our competitors with our banking finance team. They're just absolutely fantastic. And this is a sector where I believe that deep credit work is really, really important.
Stewart: That's really helpful and it helps me understand it better too. So T. Rowe Price has been a player in the insurance market for quite a while, and I think your presence is larger than is broadly known, right? So we've worked with you for a while, but I mean it's just not well understood. So I know that you have insurance company mandates in this asset class. What I'd like to know is if you'd talk a little bit about, given that our audience is overwhelmingly insurance investment professionals, what are some of the key portfolio considerations when you are looking at insurance mandates in particular?
Steven: I think that when we're thinking about an insurance mandate in particular, it's really about customization. It's really about partnerships. We want to sit down, understand the risks that you're taking, the risk that you want to take. What does the liability side of your balance sheet look like? We want to construct portfolios that frankly makes sense for the clients.
So where we think that we do our best work is when we partner with prospects, we partner with clients and make sure that we're delivering a solution that meets their objectives. And I recognize that as a very broad and to a degree blanket statement, but I do believe that when you walk into a client meeting, you need to be open-minded about what you're going to provide. You can't go in with the answer when I don't even know what the question is yet. And so that's how we think about it and that's how we tend to approach that segment of the market.
Stewart: An advisor and also formerly the CIO of AIG P&C used to say that the thing that he valued the most when talking with managers is a good question and understanding the insurance. Every one of these companies is dealing with a regulatory environment, a ratings environment, a capital position, a tax position, a business mix, et cetera. And they also have personalities around how they view risk. There's not like one definition where everybody feels the same way about it. The insurance companies are notorious for back in '42, we bought a bond like that and it blew up and we'll never do that again. Right? You got to know that stuff. So when you look at this, I mean, for example, the concept of book yield is a uniquely insurance industry phenomenon. How do you look at book yield in particular and how does that separate you from your total return mandates?
Steven: That's a very fair question. I think when we underwrite the individual credits that we're putting into portfolios, that process just has to be different. You have different constraints, you have different time horizon, you have different liquidity needs, different liquidity demands. And so we start at the underwriting process. You can go back to your earlier statement that our bread and butter is the bottom-up security selection, it's bottom-up picking those credits that goes all the way to instrument level. So even down to the particular instrument type or security type.
When we're constructing those portfolios and implementing those ideas, you need to take those under consideration. And liquidity is extremely important in this market. And maybe connecting this concept of liquidity to my comments around passive, right? As the passive construct grows in size and influence, it changes the liquidity characteristics of the market. So you need to think about that when you're constructing portfolios for a more total return construct relative to a book yield construct, for example.
Stewart: Yeah, the liquidity, we talk about it all the time. It is a huge issue, right? I mean it's somewhat, I mean, well I shouldn't say this this should be a question, does that exacerbate the volatility or is it a cause of the volatility that you mentioned earlier? And when you start thinking about liquidity give in private markets, it certainly needs to be a consideration in public markets as well, right?
Steven: Absolutely, a hundred percent. And maybe even extend that a bit further. When you think about analyzing the underlying liquidity of particular issue or bonds, one of the things we look at is does it sit in ETF? If it does. The liquidity characteristics are going to be very different relative to a non ETF bond. And so this idea of liquidity, in my mind I think it's often misunderstood at exactly the wrong time.
Ideally, in a perfect world, you want to be a liquidity provider when everybody else is running for the hills and do the opposite. And so when we think about constructing our portfolios, we always have that in the back of our mind. Can we be a liquidity provider if X, Y, Z were to happen? And if we're doing our job appropriately and constructing well run, well efficient portfolios, that's where we really set ourselves apart, right? That's where we can really be that liquidity provider in sectors that are coming under stress because we know the companies, we know the credits, and we're just capturing that dislocation.
Stewart: Man, I love talking fixed income. It's a lot of fun. It takes me back. I haven't run money live since 2010 and it's a completely different world today. It's amazing. And I love to listen to guys that sit in your seat and have a phenomenal vantage point. So before we let you out of here, I got a couple of fun ones for you. You can take either or both. No pressure; a lot of people take both. What's the best piece of advice you've ever gotten and/or who would you most like to have lunch with alive or dead? And you can have a table of four, including you.
Steven: So on the first bit, the best advice I ever had, a mentor of mine early in this business explained to me that you need to have a lot of conviction, but your beliefs better be loosely held. And that's really resonated with me my entire career because I think some of the best trades I've ever been part of was when we changed our mind, quite frankly. So when you think you have a well-thought-out thesis and you have a lot of conviction behind the idea, better know when you're wrong because otherwise the trade can really get away from you. So that's a bit of a quote or a bit of advice that's really always stuck with me from day one of my career.
Who would I have lunch with? That is a fun question. So as I mentioned earlier, I was a wrestler in my younger days. I wrestled in high school, I wrestled in college and I even coached for a number of years after college at a local university, Johns Hopkins, I'm sure a few people have heard of it. So I would love to have lunch with Dan Gable. And most people have probably heard of Dan Gable. He's a two-time NCAA champ, Olympic gold medalist, often referred to as the greatest wrestler in American history up until recently. I think there's a few folks that could probably take that title now. What I think is really underappreciated about Coach Gable is he spent 21 years as a head coach at the University of Iowa. He won 15 team national championships. Think about that. If you were an active manager and finished top decile for 15 out of 21 years, that's kind of what he did.
Stewart: Wow.
Steven: He had 45 individual national champs and he coached 12 Olympians. I would love to sit down across from the table from him and say, and have a few beers with him because he actually has his own beer as well, "How do you provide that kind of leadership and that kind of mentorship for two decades?" And that to me, I think leadership and mentorship is really underrated in our industry.
And it's hard. It's hard work. I mean, it's hard work generating alpha, servicing your clients and also providing that leadership and mentorship that your team deserves. And I just want to pick his brain about his process because what he achieved as a coach I think is by far and away a bigger achievement than any coach in any sport in history. It's just truly unique. It's truly amazing, and I would love to better understand that process.
Stewart: That is great. That's a really great answer. And I will say this, I've had the chance to spend time with various folks at T. Rowe, and I feel like your team is very fortunate to have you as their mentor. I mean, it's great leadership and you build a great team and it reflects back on throughout the organization. So I mean, you're part of that effort. So well done from my perspective.
Steven: Really appreciate that. Thank you.
Stewart: Steve. I really enjoyed having you on. Thanks so much. Thanks for taking the time and being on with us today.
Steven: Absolutely. It was a lot of fun.
Stewart: We've been joined today by Steven Boothe, Head of Global Investment Grade with T. Rowe Price. Thanks for listening. If you've got ideas for podcasts, please shoot me a note at podcast@insuranceaum.com. Please rate us like us and review us on Apple Podcast, Spotify, or wherever you listen to your favorite shows. My name's Stewart Foley, and this is the insuranceAUM.com podcast.
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