Markets Monthly February 2019 - Fixed Income Biases

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Mr. Manoukian: Hi, my name is Jake Manoukian. Welcome to the
February edition of Markets Monthly. This month, I'm lucky enough to be joined
by Irena Alagic, she's a Fixed Income Specialist on our team. Irena, thanks so
much for joining us.

Ms. Alagic: My pleasure.

Mr. Manoukian: So last time Irena was with us was over the
summer in 2018, and since then, we've seen a pretty substantial period of
market volatility, and when we think about that market volatility, what it
really means in layman's terms is that equities are going down, and when
equities go down, investors usually find themselves caught between this tug of
war between fundamental investing based on your goals and having a disciplined
approach, and then the kind of emotional side of investing. Those biases are
really important to examine as investors, and I just feel that a lot of the
time we frame those conversations in the context of equity investing, but I
have a feeling they exist in fixed income investing as well.

Ms. Alagic: Yeah. Look, we're humans first and investors
second, and what that means is that in a lot of instances, we don't make the
most optimal decisions. We are prone to biases, and those biases can be costly,
and I know we often talk about them in the context of equity investing, but
it's just as pervasive in fixed income, and so what we really want to make sure
we do is isolate some of the most common biases we come across within fixed
income investing, so that we can give fixed income the opportunity to do what
we essentially hired it to do in a portfolio, whether it be income generation,
capital preservation, diversification, you name it.

Mr. Manoukian: Yeah, so I love this idea of, of thinking
about what you hire fixed income to do in your portfolio. One of the most
important things that many investors hire fixed income to do is provide a
cushion against the volatility that equities have.

Ms. Alagic: Right.

Mr. Manoukian: Now, there's this kind of theory that's
starting to bubble up in the market narrative that because interest rates are
so low, fixed income won't have the same amount of that diversification
protection that it has provided historically against equity risk in the past.
What is your take on this theory?

Ms. Alagic: Look, I think the main thing you need to do
really is just to look at 2018 as a reasonable case study, right, especially
the fourth quarter, and especially December, right? In December, the S&P
was down about nine percent, and the Barclays AG Broad Fixed Income Index that
we use was up two, so I think especially as we get later in the economic cycle,
it's important to own the appropriate amount of core fixed income so that you
can get that benefit if we have more volatility, which by the way, we think
we're definitely going to have.

Mr. Manoukian: So the fourth quarter of 2018 suggested to us
that fixed income could still provide that diversification benefit against
equities.

Ms. Alagic: Oh, for sure, for sure.

Mr. Manoukian: So another kind of recency bias that
definitely shows up in equity markets is performance chasing- the desire to buy
assets that have appreciated a lot, and the desire to sell assets that have
depreciated a lot. What is that like, and how does that manifest itself in
fixed income?

Ms. Alagic: Yeah, recency bias really refers to this idea
that you take what has happened recently, and you extrapolate it into the
future, and we absolutely see that behavior in fixed income investing as well,
whether it's chasing positive performance, or selling on the back of a couple
of months of negative returns, and look, it's not that we're saying don't sell
ever. You have to take a step back and consider whether your original
investment thesis has changed, but what we end up experiencing in reality in
most cases is that people don't actually have the discipline to go back and
think through why they own this in the first place, and whether something
fundamentally has changed about the thesis, so we have this experience where
people tend to sell first and ask questions later.

Mr. Manoukian: Yeah. Again, it goes back to that concept of
what might be more important than the short-term price fluctuations-

Ms. Alagic: Right.

Mr. Manoukian: -is really thinking about what the reason
that you have the asset in the portfolio is.

Ms. Alagic: Right.

Mr. Manoukian: So going back to this idea of why hire fixed
income at all- one of the main reasons is for actual income generation, so how
do you think about income generation as a fixed income investor?

Ms. Alagic: Well, it's related to what we just spoke
about, this concept of recency bias, and, you know, selling first and asking
questions later, and we absolutely do see people forgetting that the income
portion of fixed income is supposed to work for them, right? So for most fixed
income instruments, your return is comprised of price return and your coupon,
and if you react and you sell a bond without thinking about, have the
circumstances materially changed, or is this just a temporary price
dislocation, you end up crystallizing the loss, and then you haven't given
yourself the opportunity to earn out the coupon, and the coupon is ultimately
what's going to help cushion your total return experience over your holding
period for that security. And again, if circumstances have changed, then it's
absolutely worth reevaluating, right? But in a lot of cases, again, it's very
reactionary behavior. You just react to what has happened recently, as opposed
to look ahead.

Mr. Manoukian: I might be oversimplifying, but one of the
refreshing things about fixed income investing to me is that as long as that
you believe that the issuer, or the entity that you're lending money to, will
pay you back, you have a pretty good idea of what your return experience will
be like.

Ms. Alagic: Right, right.

Mr. Manoukian: Now, the one that we want to end on is this
idea of reach for yield behavior, that is really, in large part, caused by this
air of quantitative easing, where central banks took a really active and large
position in asset markets and fixed income markets. How are you seeing that
play out, now that the era of quantitative easing is coming to an end?

Ms. Alagic: Yeah. Look, we see a lot of that behavior
still happening, and I think it's just now starting to get unwound. As we sort
of switch from quantitative easing to quantitative tightening, we had a hundred
basis points of Fed hikes in 2018, the balance sheet has been reduced, and it's
going to continue, and what's happened as a result of that is that a lot of
people, a lot of investors have gone down, for example, in credit quality,
without getting the proper compensation for it, or taken on more liquid
investments, again, without getting adequately compensated for it, so at some
point, we are going to have a downturn in credit, and at that point, it's
really going to pay to know what you own. You can't really just rely on ratings,
and there are parts of the fixed income market that are not going to provide
you the same protection as they have in the past, so you really want to take a
very close look at where have underwriting standards deteriorated.

Mr. Manoukian: So it's really important to ask the question
about am I getting compensated for the amount of risk I'm taking?

Ms. Alagic: For sure.

Mr. Manoukian: So we've covered a lot over those four
biases, but I think in times of market volatility, it's more important than
ever to really reflect on those biases with the help of your advisor, and
really to make sure that fixed income is doing the job that we hire it to do in
your portfolios. So Irena, thank you so much for spending the time.

Ms. Alagic: My pleasure.

Mr. Manoukian: Hopefully, we'll have you back in a couple of
months.

Ms. Alagic: I hope so.

Mr. Manoukian: And hopefully, we'll see you next month for
the March edition of Markets Monthly. Thank you.