Kenneth Leech, chief investment officer at the $465 billion Western Asset Management in Pasadena, California, explains why high yield bonds remain attractive, as well as the firm's strategiest toward China and Japan.
Market makers are no longer putting much of a balance sheet behind bond trading. Where do you feel that the most?
Ken Leech: It affects high yield the most. High yield is always a volatile sector because you’re dealing with companies that aren’t the most pristine credits. In the US there are so many high-yield retail mutual funds because we’ve had zero interest rates for six years and investors are frustrated and looking for returns. But they may not understand the risks. High yield will lose money if there is a recession or if interest rates go up. As we’ve seen recently, when retail [investors] start to redeem it forces the funds to sell more bonds into the market. But the dealer community can’t buy all of these instruments because risk-based capital rules make them loathe to take even short-term positions. [So] liquidity breaks down and bid/ask spreads gap out.
Is this the end of the line for junk’s rally?
Yes, it looks as though high yield’s rally has run its course. It’s had a difficult time over the month of July. We were overweight and we have been reducing that over the past quarter as bond prices have risen. We may have been a little too optimistic. But while we are reducing our overweight, we still maintain an overweight position.
Hang on: you will remain overweight high yield?
The recent downturn has several features but an important one is technical. There is a lot of retail money in high yield bond funds and that is the money that is now redeeming. Secondly, there is little liquidity among the major trading houses or investment banks, due to stricter rules on capital, which is exaggerating the downturn. We’re taking advantage of this to add back some positions.
It sounds like you are maintaining positions everywhere that seems vulnerable to a rise in US interest rates.
The global economy is recovering – slowly. It’s healing a bit year by year. Yes, interest rates will normalise, but that will also be a slow process. Investors who overweight non-Treasury sectors still enjoy a little extra yield and, over time, will continue to outperform Treasuries. That includes bondholders of investment grade, high yield, structured mortgages and emerging markets.
What’s your take on China’s ability to restructure while maintaining GDP growth rates?
It’s the view of Western’s team in Singapore that the government in Beijing is sincere with regard to its pro-market reforms. One of its challenges is how to diminish the market share of state-owned enterprises; another is the importance of shadow banking. The logical solution to both of these is to introduce two-way risk for investors. But that leads to the question of whether China can continue to manage its financial system while introducing the possibility of defaults. Right now it seems the number of macroeconomic levers available to the government allow it to provide stimulus for maintaining overall GDP growth [at] around 7.5%. The country is not as leveraged as the West. PMI data [from the Purchasing Managers Index] and data on capital goods orders suggest the economy is picking up.
Those levers: are they enough for China to maintain GDP growth and restructure its financial system at the same time? Or is stimulus coming at the expense of reform?
It seems the government does have the ability to use stimulus measures concurrently with reform. It may need to fall back somewhat from restructuring but it’s a process. You’re going to see a little bit of both: stimulus and reform.
How attractive is emerging-market debt as we look to next year?
It’s a very important sector for us. Western Asset was one of the first to include emerging markets as [part of a] a US core-plus portfolio, back in 1993. Over time it is the only sector within fixed income that improves in quality. Valuations in other segments such as high yield or US investment grade tend to revert to their mean. But Brazil is a better credit today than it was five years ago, and five years ago Brazil was a better credit than it was 10 years ago, thanks to globalisation and countries moving up the growth scale and improving their fundamentals. Among EM corporate bonds, many of these are as sound as corporate borrowers in the US or Europe, but still offer a higher yield.
What has been your biggest currency bet this year?
The yen. The Bank of Japan came forward last year with an ambitious monetary easing policy. It has to provide a lot of stimulus. That led us to short the yen. In fact, the yen has actually strengthened. This position has not yet worked out for us but we maintain it.
So far Japan seems unable to use monetary policy to hit Shinzo Abe’s target of 2% inflation. Is Abenomics going to work?
For Japan to hit that inflation number the BoJ must provide ongoing liquidity. We expected more stimulus in the second quarter but so far the BoJ has showed it is comfortable with inflation rising at a slower rate. So new rounds of stimulus have not yet materialised. But we think the only way to hit those targets is through additional stimulus. That in turn means the government will want to help the yen find a lower level.
How long can you maintain your short-yen stance?
We’re long-term investors, so you have to frame the situation: the Japanese government’s goal is to encourage risk-taking among the public, which is discouraging people to hold government bonds. Therefore more investors will look overseas to find higher yields. But that won’t happen if there is a risk of the yen appreciating. So the government is encouraging a path for the yen to go down. If we were worried that the Japanese economy would grow quickly or that inflation would spike, then we would have to retire our yen position, but I don’t see any evidence of that.