Alternative Strategies Fund Sub-Advisor Matt Eagan (Loomis Sayles) on “Harvesting Risk Premia Across the Cycle”
August 2015 Interview
Matt Eagan is the Vice President of Loomis Sayles and portfolio manager for the Loomis Sayles Fixed Income Group. He has 25 years of investment industry experience as a portfolio manager and fixed-income analyst. Along with Kevin Kearns and Todd Vandam, Eagan has managed the Strategic-Alpha Fixed-Income sleeve of the Masters Alternative Strategies Fund since the fund’s inception. Our conviction rests on the demonstrated skill, experience, and discipline of the entire portfolio management team, supported by Loomis Sayles’s deep resources in credit research, macroeconomic analysis, and risk management.
Your strategy has a lot of elements to it. And a lot of potential different inputs. Can you walk us through it?
First, it helps to take a step back to look at what are now called “unconstrained” products. It’s kind of a new terminology that’s been wrapped around something that’s been in the marketplace for a while. But I think it helps to look at how we define unconstrained.
Since it’s hard to put in a nutshell for the product itself, I think it’s helpful to at least look at what it isn’t, which is traditional fixed-income.
The characteristics of traditional fixed-income [include] the benchmark orientation, typically wrapped around a very high-quality benchmark like the Barclay’s Aggregate [Bond Index]. So risk is really measured in terms of the tracking error to that benchmark and the ability to earn an excess return to that.
Investors generally use traditional fixed-income for its key characteristics, which are the income generation, the liquidity, and ballast.
It’s important to point out that the predominant risk factor with these types of products is term-structure risk because they are so tightly wound around these high-quality benchmarks.
We’ve seen more investors want to reduce their dependency on term-structure risk for obvious reasons here. And fortunately, there are plenty of ways to do this while staying firmly in the fixed-income space.
You do that by turning to other risk premia: credit-spread risk, global risk factors like riding other yield curves, currency risk; emerging-markets risk; and others that generate more idiosyncratic returns like the convertible bond market. So there are a lot of different risk factors that we can access as fixed-income investors. What you need to do is open up the opportunity set.
I would say at Loomis Sayles, we’ve obviously been doing this a long time. We’re no stranger to multisector portfolio investing. Loomis Sayles Bond—that’s one of our multisector opportunities.
We place this [multisector] category in two broad ranges. One is a total-return opportunity. These strategies tend to still have a benchmark, but they have a lot of flexibility to invest outside of that. These are typically long-only. And they generally manage to an absolute volatility. They’re less concerned about drawdowns. They’re going for total return, which makes them not as great in terms of a pure absolute or a pure alternative to traditional fixed-income.
Enter the non-traditional absolute return, which is where Strategic Alpha falls in. Here, we get rid of the benchmark. We provide more flexibility in terms of shorting. So we’re getting to more of this capability of being much more tactical: separating and isolating beta and alpha opportunities.
With our base Strategic Alpha product, we are more concerned about drawdown and that is in order to position that strategy as a good alternative to traditional fixed-income where investors are concerned about ballast and drawdown.
What I would say about the sleeve we manage for Litman Gregory [is that] it’s a different animal. We worked closely with Litman Gregory to provide a risk/return profile that fit well with their multimanager approach.
So in some sense, it’s a bit of a hybrid; the multisector going for a high total-return [with] the willingness to take on more volatility. It’s certainly still absolute return, and we are mindful of drawdowns. But it is not as averse to drawdowns, temporary drawdowns, in order to go for possible returns.
Then lastly and importantly, I think Litman Gregory and I have had a mutual understanding. I think it’s specified right in the documents. The fund can take large positions with respect to our high-conviction ideas. So they want to be able to access our high-conviction ideas, and we can weight those fairly heavily in the portfolio given that the sleeve is just one part of a diversified multimanager fund.
So this is very unique and different than our standard product. One that was crafted for Litman Gregory.
Can you touch on your team’s core philosophies?
The first is about harvesting risk premia across the cycle. We believe that investment cycles drive the level of risk premiums available in the market. And very broadly speaking here, what we’re looking at are—in terms of risk premia—what I call the three C’s: a curve or term-structure risk, credit-spread risk, [and] currency or global—other yield-curve types of risk factors.
There are subsets of those. Those are broadly the three that we are able to access. Although, I would throw in an additional C, which would be common stock, or [an] equity-type of premium through our convertible bond and our equity strategy that we can implement in this product.
So our macro philosophy is that we are students of the cycle. We really study history. We think that history, while it doesn’t necessarily repeat, it does rhyme. And we do a lot of work in determining and identifying where we are in the cycle and how risk premiums should behave during the cycle and how they’re valued currently.
How does Loomis Sayles conceptualize the credit cycle?
We think by doing our homework there, we can harvest risk premia and protect it.
A good example of this classic case would be the high-yield market. Typically [you] get paid about 250 basis points (bps) of premium to invest in high-yield markets through this cycle. What I mean by that is, the return that you get above and beyond realized defaults.
But the risk premium varies significantly over the cycle. We’ll describe in a moment how we define the cycle. But the risk premium for high-yield is widest and most-attractive just after the downturn in a period that we call “Credit Repair.” Returns just happen to be skewed for investors to the upside for taking high-yield risk, which is not a usual pattern for fixed-income investors, which tend to have a negative skew, generally. That’s definitely a time you want to be exposed to high-yield.
Stylistically, we will maximize our exposure to high-yield, for example, during the Credit Repair phase. Then slowly we’ll reduce it as the cycle ages and spreads contract. By the end of the late expansion period and going into the downturn, we’ll generally be flat to even short high-yield risk as we enter that downturn.
Secondly, we talk about generating alpha through security selection. I know Loomis Sayles is well-known for its fundamental research effort. It’s our research analysis that gives us a strong understanding of the intrinsic value of securities. We think the credit market is very inefficient and often misprices specific risk. That’s generally due to liquidity factors or just plain fear and greed.
So this gives us the ability to constantly go into markets and generate alpha by selecting securities to purchase that are trading below intrinsic value. Then for those securities trading above their intrinsic value, we look for shorting opportunities there.
Then finally, capital preservation is important. We know this is an absolute-return strategy. Obviously, permanent losses are of the sort that we want to avoid—outright defaults and such that you can’t recover.
But we will accept temporary drawdowns in order to profit from mispriced opportunities. Generally, we are seeking opportunities that have an expected payoff that is better than 1-to-1 for the potential drawdown that we see.
From a top-down [perspective], as we talked about in the high-yield scenario, it varies through the cycle. So you’d be much more willing in the Credit Repair phase to take on credit risk and absorb some additional drawdown to capture that [positively] skewed return. Whereas if you fast-forward to today, you might not be as willing to accept as high a level of deep drawdown for a more muted upside return.
What is the expected risk level of the Strategic Alpha strategy?
I would say we’re guiding investors to understand the standard deviation of this product can be around 6% to 8% through the cycle.
That will place it well below a high-yield, but significantly above, say, an aggregate type of index—a traditional fixed-income category.
But we’re not slaves to this. As was mentioned before, we take what the market gives us. We’ve been running with a much lower standard deviation recently, because we again were trying to manage return and drawdown expectation and volatility.
We’ll be willing to run with a lower volatility, and perhaps even a slightly higher volatility, for a short period of time. You think of an extreme example in 2008. You don’t want to slavishly take in your volatility at that point because you’d be selling at the low point. You actually want to accept that risk, because again, the returns are skewed to your favor.
That’s how we think about that.
Can you describe the overall objectives and the tools you use to try to achieve those?
When I add all of this up, success for us is that we obviously generate a return. We’re looking for a Sharpe ratio that is greater than one over the cycle. And obviously if you think about our risk objective, you can get an idea of where we’re targeting.
We also like to see that our drawdowns are not excessive, and that we have a very low correlation, and that we have a diversification effect for the portfolio. We like to see a very low correlation to broad fixed-income indexes.
So there’s a sort of multiple dashboard of measures that we look at to define our success in this category.
It’s a global strategy. We do tend to be U.S.-centric, because that’s the largest bond market. But we do have capabilities to go outside the U.S. in developed and non-developed markets.
Asset classes or really more sector classes pretty much run the full gamut. We can play virtually any sector out there. We do have the ability to use equities, and we have used them fairly sparingly, but we can increase that up to 35% in the fund.
The instrument type is obviously cash bonds and derivatives. We use primarily plain vanilla type interest-rate derivatives, futures swaptions, and swaps.
We use foreign-exchange forwards and options. And we’ll use credit default swaps, credit default swaps indexes, and equity-type of options around this. And, of course, bank loans.
Can you walk us through your use of derivatives?
We say “alpha earned without leverage.” I want to point out that we don’t use a prime broker. And we aren’t borrowing—physically borrowing—money, but we do have derivatives capabilities. That can lead to some sense of leverage.
We’re able to emphasize credit and actually increase our exposure above 100%, to about 150%, using credit derivatives. We can also use our interest-rate derivatives to adjust our duration exposure—even go outright short in the portfolio.
All of those derivative exposures, when added up, can obviously lead to more than 100% notional at-risk.
Then finally, our duration range. I think that’s important to mention. It’s negative five to [positive] 10 years.
Can you tell us about the team?
This is a very typical team structure at Loomis Sayles where we have a relatively nimble group of investors at the product-team level. In addition to myself, as portfolio manager, we have Kevin Kearns and Todd Vandam, who’ve been with the fund since inception.
Kevin has a background in the hedge fund world. He manages our credit long/short hedge fund. He’s been instrumental in terms of developing this, with the shorting capabilities of this product way back when. And Todd Vandam, I’ve worked with for a long time. He served as our credit strategist for a while and is now a portfolio manager here.
You’ve talked a lot about the credit cycle. Can you talk about where we are now and how that translates to the current portfolio positioning?
Absolutely. If I think about the current cycle, the downturn was in 2008, started around 2007, going into 2008.
The Credit Repair was around 2009. This was a period where if you think about it from a credit perspective, corporations are really trying to repair their balance sheets. They’re really on the side of creditors at this stage, for improving their credit fundamentals. And high-yield and credit really does very strongly, better than stocks, typically. By the way—default rates often spike or reach their pinnacle here. So even though the default rates reached their peak, the losses associated with those have already been realized.
Then we enter the recovery period. You start to pass the baton over to equities, and equities have already obviously had a strong run. I believe right now we’re in the late-cycle expansion. Credit generally starts to look a little bit weaker here. You have to be careful with this, because your upside is not that great. And you’re potentially on the downturn coming forward. We’ll talk a little bit about that in a moment.
I’m talking about the U.S. cycle here. But when you look at China, I think China is obviously coming through a growth slowdown. Some of that is secular. Some of it is cyclical. I think they’re in the mode of actually priming the pump and reducing rates. So they’re coming out of the other side. And I would expect to see that country start to bottom and lift up. You should start to see the fruits of that easing coming down the pipeline in the next six months or so. Or potentially longer.
So it really depends on which area we’re talking about. But those are some of the broad themes. Certainly, the globe is not in sync. When you look at places like China, where it is, and Europe and Japan—more stagnating and in a very easing mode. We have different stages of economic cycles and business cycles.
[We have] a regime tool that we look at. This helps us think about how we want to invest through the cycle, as we were talking about. It allows us to run the portfolio and look how it behaved through the cycle from a historical perspective.
Granted, this is backward-looking, but it allows us to see what type of drawdown risk would be associated with the portfolio through this cycle. What’s the type of opportunity provided by the portfolio through the cycle.
You can’t really manage a portfolio always thinking about the absolute worst drawdown in a downturn. We really have to decide where we are in the cycle and then look at and sort of pull out all of the phases in the past of that particular set.
If we look at late expansion, for example, we would put all the late expansions together in a row. And just look at how this portfolio would behave in that environment.
That helps us go toward the areas stylistically where we think there’s still value.
Generally at this stage, credit continues to do relatively well. And it doesn’t offer a lot of upside, but it offers carry. And it tends to outperform from an excess-return perspective versus Treasurys.
So the absolute return is not great, but the drawdown is obviously also not significant at this phase of the cycle.
What we just talked about was more of a backward-looking area. Through our process, what we look at is forward-looking returns through our macro and our sector teams. We’re always looking ahead and saying, for where we are in the cycle, here’s what we think the returns will be, based on current valuations and what we see.
So what we do is, we plot different sectors in terms of their risk and return. We define this based on the projected return that we see, our base case return for the asset versus this potential drawdown given the cycle that we’re in. So it is cycle dependent.
For example, last year, high-yield was quite rich. It actually fell below [a level that] signified that the return we would have expected out of high-yield would’ve been less than 1-to-1 for the potential drawdown associated with that. That’s unattractive to us. We want to harvest ideas where we can get at least a 1-for-1 tradeoff [of return] versus drawdown.
High-yield happened to fall below this line quite significantly by June of last year. And we reduced our exposure to credit in general. We maintained our bank loan exposure, because bank loans still looked like they had a good risk/return, which was consistent with our view that it was a good late-cycle investment. It offers carry with very little duration risk and good up-in-capital-structure [positioning].
We went from about 14% in bank loans in the second quarter of last year and 11% in high-yield. So about 25% in speculative-grade credit. Today, we’re looking at 38% in speculative-rated credit, with about 11% in bank loans and 27% in high-yield.
So we’ve actually increased our allocation to high-yield, partly at the expense of bank loans. And the reason is that high-yield has become much more attractive.
As we think about the risk premium that we generally get in this phase of the market, it generally is well below 250 bps. Right now we’re thinking the risk premium is in excess of 300 bps. It’s very unusual and it reflects the fact that the oil sector is really driving the widening of spreads here. So you have to really look at the sector and disaggregate the two.
If you look at the high-yield market, for example, the option-adjusted spread (OAS) right now is 559 bps. The yield is about 7.2%. And the dollar price is $96. That looks pretty cheap. But you have to consider that the energy sector, which is about 13% of the overall market, is trading at a 960 bps OAS, 11%—a little over 11%— yield, and an $82 price.
So what we’re actually seeing here is that there’s one sector already in the downturn, well into the downturn. Twenty percent of the energy sector is trading at a spread of over 1,000 bps. Which as—a rule of thumb is—generally considered distressed.
And there are a lot of companies that are trading at very low dollar prices as well.
So we think this provides an opportunity. By the way, high-yield as a sector has traded off because of the fears about oil. A very similar thing occurred in December of last year, and we’re getting a rebound effect of that again as oil prices decline. So we’re seeing money flow out of high-yield.
We think high-yield ex-energy is attractive on its own right, so we’ve been adding there as well. And then high-yield energy—within that sector—there are good opportunities to invest there. We can talk about certain things that we’re seeing.
So, credit is elevated. It’s not at our maximum that we would be. Because again, the upside versus downside and where we are in the cycle would not merit a very large allocation. But nonetheless, we’ve got about 38% right now in bank loans and high-yield allocations, [with some of the] high-yield [related to] energy.
What are your thoughts on the Federal Reserve, and how does that compare to what you think the market’s pricing in? And what does that mean for the portfolio?
This move by China [to devalue their currency] throws a big question into what the Fed’s going to do. I think we’ll see how this shakes out. It could delay it a bit beyond September.
Our view is that the economy domestically, at least if you look at it just without looking overseas and what’s happening there, that the U.S. economy can withstand a rate hike. And that if you look at broad measures of unemployment, there’s been a lot of healing there.
I wouldn’t be surprised to see the headline unemployment rate falling below 5% in the next eight months or so. And even the U6 number coming down to a level that would be closer to what would be deemed a non-inflationary unemployment rate level.
So the Fed is taking notice of this. Inflation is not an issue right now. I don’t see that as being an issue, as long as oil stays low. We think oil’s going to rise, but it’s going to be probably not something that’s going to move the needle on CPI for another 12 months or so.
So, inflation is not a big deal.
I think what’s less important is when they start. Whether it’s the beginning of next year or September of this year. What’s more important is the pace thereafter. I think it’s likely to be gradual. I think the market is underpricing still in the shorter end. Even though the Fed has signaled gradual, the market is still pricing even a more gradual approach than the Fed is suggesting through its dot plot.
So I think the curve is likely to flatten, and we’re playing that in the portfolio with a flattener. We don’t think you get paid for taking a lot of term-structure risk, which is why we’re keeping our duration at a nominal rate of three. And the way that it’s constructed, it behaves more like an empirical duration—of about 1.5 years.
But we have a flattener where we’ve used eurodollar futures to take out duration on the short end. And we’re long investment-grade credit, in the 10- to 30-year part, to give us some exposure to the long end of the curve with some spread. That’s how we’re playing it. But I do think this move by China is going to be troublesome for the Fed, because I think it’s going to put a lot of pressure on them from Congress, for example, to take note of that. But we’ll see how that progresses.
There are a lot of elements of risk management embedded in your process. One interesting thing we recently talked about was your recent VIX futures trade. Can you describe that and the way you think about it?
Yes. We have a lot of different tools that we can utilize to take advantage of different markets that we think are perhaps priced too aggressively. They can oftentimes also hedge the portfolio. So when you think of our book, we’ve got obviously a good amount of credit risk in the book for the reasons that I talked about.
And we noticed, for example, that the equity markets were obviously wobbly here. The equity markets have lost a lot of breadth. They’ve been chopping around with the S&P 500 in a range-trade for a while. As has the advance-decline ratio. Meanwhile, we saw VIX running at very low, low levels.
The VIX trade can be a tricky trade, because you have to go out the curve, and the curve is quite steep. You tend to pay negative carry for that.
But when it gets to extreme levels, and the VIX comes through 12 on the spot and low-15s in the October contract, we thought that was a good risk/reward to put some money into the futures and at the same time to offer some hedge— broad hedge—to the portfolio. So we’ve put some notional to basically go long volatility, to take advantage of that view as well as to offer some ballast to the portfolio.
Those are some of the ideas that we’ve utilized to provide some tail-risk management in the portfolio—really going after things that are priced pretty aggressively in the marketplace.
Will continued U.S. dollar strength cause emerging markets and emerging-markets debt to struggle? What opportunities does that create for you in emerging markets and/or currencies?
Well, we’ve been—in this portfolio—we’ve been long the dollar for quite a while. Last year, we generated good alpha from being long dollar versus primarily the yen and euro, which we felt would be the weak reserve currencies because of their central bank policies.
We also played that by being long equities in Europe and Japan, as well. That quantitative easing (QE) trade.
The other area that we focused on last year was shorting emerging markets. So some of the emerging-markets trades that we had on were just shorts on certain big current-account-deficit countries.
We had a variety on Turkey, Brazil; we had some shorts on in South Africa.
By the time the end of the year rolled around in the first quarter, we felt that the dollar was long in the tooth in terms of its valuation. It did come back a lot. So we got rid of our long-dollar bias and have been picking our spots very carefully.
So we moved some of our shorts into Asia prior to this move in China. We felt that a lot of the Asian economies—with the weakest in China—were losing competiveness and would potentially be lured into using their currencies to try to improve their competiveness, particularly versus Japan, where the yen had really devalued so much. So we shorted the Korean won and the Taiwanese dollar. That worked out well recently.
We’re still short some of the other emerging-markets currencies, like the South African rand. So we still see pressure on emerging markets. We don’t have a lot of exposure—long exposure. It’s really de minimus in the portfolio. We still think there’s going to be some pressure on the emerging-markets space.
Aside from that, we have some various pair-trades like long the [Australian dollar] versus the Canadian dollar. Or long the Norwegian krone versus the Swedish krona.
One thing I’d say about the dollar—I do think after this latest move, I think there’s a lot priced in. I think the dollar could move sideways to slightly higher. I think the biggest gains are behind it. So I know there’s still a very big dollar long position. But I think a lot of that is becoming stretched.
I think it wouldn’t take much. For example, just a view that the Fed might become more reluctant to raise rates, for example, could take the dollar down a couple of pegs. Because the trade is just so stretched from a positioning standpoint. I think it is vulnerable. So we’re trying to not overplay that hand too much, because it has been good to us.
We’ve all read and heard a lot of people worrying about liquidity in the credit markets, or lack thereof, because of the withdrawal of prop-desk capital and banks as market makers. What’s your view there? Is it a big risk or an opportunity? How does it affect the way you manage the portfolio?
I really think that liquidity is an opportunity. Now you have to have liquidity in your portfolio to do that.
We’re actually running with about 15% cash or cash-like securities in our book. So even though we are taking some risk in areas of the market, we still have a fair degree of cushion and ballast in the portfolio.
That cash is providing us the ability to bid down on securities or on some names that are coming into the market in the high-yield space, for example.
So, it’s a double-edged sword for long-term investors, though one of the assets you bring to the market is your ability to assume some of that liquidity premium when it’s available.
We’ve talked a little bit about energy. We can buy Chesapeake Energy, which is obviously under a lot of stress with the oil prices. But that’s a company with a current market cap of $5.5 billion. A par debt of over $11 billion. So an enterprise value in the market of something around $16 billion or so.
But you can buy some of that debt at $0.70 on the dollar right now—with a 10.75% yield. And I think a lot of that is just because people are selling, and the dealer community backs up their bid. They’ll only buy that security from somebody else when they know they can pass it through to another buyer.
I think if we can do our homework in a company like Chesapeake—if you can buy it at that dollar price, you’re basically creating that company at about an $8 billion enterprise value. I think that’s well below what that company’s energy reserves are really worth.
So that’s what we do best. I don’t know exactly when the bottom is. Those bonds could still drop because of that illiquidity. They could continue to get priced down. But I want to be in the market buying them if they go down.
That’s a great real-life example. Thank you for your time and your insights today.