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| Jeff Phlegar |
Phlegar is chief investment officer and co-head of fixed income at Alliance Capital in New York. He oversees$168 billion in fixed-income assets managed by Alliance, from a daily investment policy and managerial perspective. What's your take on the recent back-up in junk bonds?
The high-yield market is lately highly influenced by some of the outflow that is going on from mutual funds. The mutual fund industry, according to the Affiliated Managers Group data, has experienced about $4 billion in outflows year-to-date and that caused some pressures on valuation. At the same time, a number of issuers are tapping the new issue market and so the old rule of supply and demand is kicking in.
What are the triggers for these outflows?
Historically, high yield had a relatively low correlation with interest rates. It appears the recent outflow started with the emerging market sector. The emerging market sector was under pressure throughout April and May and some of the contagion started spilling over into other high-yield sectors, including high-yield corporate bonds. It is our perception that a fair amount of de-leveraging took place among hedge funds. They axed some of the portfolio products such asiBoxx in the investment-grade market and high-yield market. This has put pressures on valuations.
What's your thinking on the mortgage-backed market?
There are some interesting dynamics going on in the mortgage market today. As we all know, banks have been huge buyers in the mortgage-backed securities market over the past two years. They have increased their mortgage-backed securities portfolio since they have experienced a fall in their [consumer & investment] demand. It is interesting to look at the month so far in terms of nominal mortgage-backed spreads. They are 25 basis points tighter as of last May 21 while the option-adjusted spread is 15bps wider. What has happened is there was a significant decline in interest-rate volatility as priced in by the options market. Certainly, there are concerns about rising rates but the overall perception is that there is limited downside at these types of options-adjusted spread levels in the mortgage-backed sector given the pent up appetite from some government-sponsored entities for these types of securities.
What impact do Fannie Mae and Freddie Mac's plans to shrink their MBS portfolios have on the market?
We believe that Fannie and Freddie are shrinking their portfolios because they do not see any attractive arbitrage opportunities in the market. They have been quite disciplined in terms of making sure that they can properly hedge and still earn a positive order, that is, attractive spread on their assets versus liabilities. But we believe that option-adjusted spreads have widened over the past month. This, we think, makes MBS look attractive to the agencies. We believe they might increase their portfolio.
How will slack demand from banks impact the MBS market?
We recognize that in absolute dollar amounts, the banks own significantly more than they did since the last time we saw a rising interest-rate environment. There is more duration in the hands of the banks. We don't think that banks will be in a position to liquidate their securities portfolio even if consumer & investment loan demand were to increase. If you compare and contrast the current environment with 1994, the biggest difference is that the capital position of the banks today is far stronger than it was in 1994. In fact, the banks have excess capital at this point in time and the banks are focused on improving on it at interest margins. Selling securities is not necessarily the best solution. We are not betting on banks being large sellers.
Will MBS be attractive in a period of low volumes and low demand from banks?
We actually believe that the biggest bet mortgage-backed players are making is the volatility bet. Volatility has come down quite a bit and with volatility down, nominal spreads are much tighter but option-adjusted spreads are wider. If one buys mortgages and does not hedge volatility associated with them in volatility bet, then we will argue that mortgages are not as attractive. But to those that are absolute-return oriented and look to hedge out the volatility bet, mortgages are more attractive today than they have been at any time this year.
Are there any new trends in the market that you think investors should keep an eye on?
The evolution of the credit default swap market is one that most investors must keep a watchful eye on. This has grown in excess of a $3 trillion notional market over a short time. Activities in this market are having a meaningful impact on the valuation of cash securities.
How do you look at Interest Only loans?
Sub-prime IO loans concern us. When we invest in sub-prime paper, the one thing that comforts us is that it is an amortizing paper rather than a non-amortizing paper. We are better buyers and better fans of the amortizing paper than IOs. We certainly encourage rating agencies to identify the risks that are creeping into IO pools. Whether that gives us comfort is difficult to say. We tend follow a wait-and-see approach with the type of housing price appreciation that we have seen. We are not that keen on anything that is going to extend out the credit risk of our investments.
Do you have any preference when it comes to Wall Street research?
The hallmark of our investment organization has been research. We employ as many researchers in fixed income as we do portfolio managers. This is not to say that we are discounting what we get from the Street, but internal research is the best form of bona fide value addition.