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December 2023 / VIDEO

P&I Webinar – Is Your Fixed Income Allocation Positioned for Yesterday, Today or Tomorrow?

Christina Kellar: Hello everyone. Thank you very much for taking time out of your day to join today's session titled is your fixed income allocation positioned for yesterday today or tomorrow. Asset allocation considerations for public defined benefit plans. I'm Christina Kellar, Solutions Strategist, in the Global Multi-Asset Division at T. Rowe Price. I'm joined here today by my colleague Saurabh Sud and Lowell Yura. Saurabh Sud is a member of the Global Fixed Income Investment Division at T. Rowe Price. He's also Portfolio Manager of the Dynamic Credit strategy and Co-Portfolio Manager of the US Core Bond strategy. He's also a member of our Global Fixed Income Investment Team with a specific expertise in credit markets. We also have Lowell Yura who is T. Rowe Price's head of Multi-Asset Solutions North America and a Portfolio Manager again in the Global Multi-Asset Division.

Lowell and Saurabh, thank you very much for your time and in advance for your insights today. We've brought Lowell and Saurabh to combine a top-down and a bottom-up fixed income perspective with three primary objectives on our minds today for the audience. One, we'll share some of our latest thinking in the current macroeconomic backdrop and market environment and considerations for our own cross asset and intra fixed income portfolio positioning. Two, we'll discuss what those implications may mean for public plan asset allocations going forward. And three, and I think of particular interest to this audience, will highlight some of our findings from proprietary research.

We at T. Rowe Price conducted surveying public plan decision makers on their asset allocation, philosophies and their expected portfolio changes for the road ahead. We certainly have a lot to unpack today and we will leave time at the end for questions submitted by you. We really look forward to a really engaging dialogue between both Lowell and Saurabh today. What an interesting and exciting moment to be having these discussions with our clients. I'm thinking back to the unprecedented amount of investment history that we just lived even in just the last two years with truly rapid rate hikes in the Fed's fight to tame inflation. And as a result, we've seen fixed income forward rate expectations really shift up meaningfully, leaving potentially a lot more options on the table than investors had in the last 15 or 20 years or so. We've seen those CMAs re-rate and decisions on how to allocate capital become potentially more challenging in the road ahead. And we were really excited about the potential – the options that that lie ahead for asset allocation decisions for public plans.

So with that backdrop in mind and public plans undergoing their asset allocation reviews and potentially resetting SAAs with their staff, their board, their consultant, we know that there's now potentially more options on the table. But before we look forward, I thought it would be great to start with Lowell and actually take a step back and revisit the history that brought us here today. Lowell, you've been having asset allocation discussions for nearly 30 years. Can you talk a little bit about how we arrived at the current market environment? And then two, what that's meant for public fund allocations over time.

Lowell Yura: Thanks Tina. I think we're having some technical difficulties, but I think I heard most of your question. You nailed it by saying it's a really interesting time. In my 30 years, I have to say that asset allocation discussions with various investors, particularly public plans, has never been this interesting, at least in the last 20 or 30 years. The reason for that is the economic environment that we're in today, but also how we got there, and as you said, what that's meant for plans. If we take a step back and we think about the environment that we live through going back 30 years, we've lived in a secular decline in interest rates that's been well talked about. As each month passes, there's increasing evidence that this secular decline – interest rates may very well have bottomed out in 2020 when the 10-Year hit 0.5%.

So let's take a look at what that's meant for asset allocators by looking at this chart, which really shows asset allocation trends over a large part of this period, and a couple of things stick out. One is that there's been a massive increase in the allocation to alternatives, and particularly alternatives that provide an illiquidity premium – particularly private equity. At the same point in time, the primary funding source for these assets has been public markets and particularly fixed income allocations which have dropped by nearly a third over the past 20 years. That is a major shift that incrementally year by year was very small. But when you compare the portfolios that we have today compared to what we've had in the past, they are wildly different, they have significantly more illiquidity risk and they have significantly more directional risk. In fact, we estimate that the average portfolio today of a public plan has a minimum of 5 to 7% more equity risk in their portfolio because of the mainstreaming of private market assets.

Christina Kellar: Thank you, Lowell. That's an excellent revisit of the history that brought public plans to the average asset allocation that they lie in today. I want to bring Saurabh into the conversation and have him spend a little time talking about the evolution of fixed income markets as well, as there's been a lot of change in both the average credit quality, market structure, et cetera. So Saurabh, can you give us some of your thoughts there on the fixed income perspective?

Saurabh Sud: Sure. As it was already covered, interest rates have backed up, right? But that came along with the fact that interest rate volatility has increased a lot in the cycle, which is the next slide, on slide four, please. What we saw from a recent Jackson whole paper is that 80% of Treasury market illiquidity is explained by interest rate volatility. As this interest rate volatility has gone up, Treasury market illiquidity also has gone up. If you go to the next slide, please, you can see that over on the right hand side, as Treasury market illiquidity as measured by this chart has gone up and come down modestly recently. What you can also notice in the chart at the bottom is that passive share in fixed income has gone up over time – over these past several years now. As passive share increases and as dealer capacity utilization increases, that creates an environment for market dysfunction. And that's exactly what happened in the UK in September 2022, wherein 10-Year Guild yields went higher by 2.75 basis points in a matter of less than two months.

Now those risks are still prevalent in the Treasury market right now as the US Treasury ramps up coupon supply going forward – where a lot of traditional buyers of Treasuries are on buyer strikes such as foreigners due to higher hedge costs, or even banks due to their own deposit crisis at this point in time. What that implies is that it's a really tough environment, and you need to think like a liquidity provider in these environments when you are a fixed income allocator.

But it's all not bad news for fixed income. If you go to the next slide, you can see that ratings quality in high yield, for example, has grown. It actually has become a more BB-oriented index – gone from 37% pre GFC to almost 60% now. In bank loans, that has deteriorated somewhat over that same period. So if you can find assets, which are yielding 8 to 10% in the high market on a secured basis, which an active manager can help you find, those are really attractive opportunities relative to long term risk, asset expectations modeled by a lot of asset allocators.

Now when rate volatility dominates a credit bond, it is really important to be selective and think about all the duration risk, as well as the credit risk, embedded in a credit bond. If you go back and look at the three year rolling returns of the IG index since the 1930s, you can notice whenever there's been a three down year, down year, three year, which is the first column of negative returns on a three year rolling basis, that usually tends to deliver somewhat of a OK return in the next three years. But that's not always the case. The hit rate is not as high as you would have expected. Yes, there were periods such as 1974 or even 2008 when you deliver double digit annualized returns uh over the following three years. But then there were some periods where the following three year returns were still negative or really small to even have mattered to your portfolio. So again, the impact of correlation and impact of rates is really important and I'll talk more about that later, but I'm going to pause here.

Christina Kellar: Thank you, Saurabh. That's an excellent look backward. A couple of things that you said in your comments in response to my question were really resonant to me. You mentioned the point of being selective, which to your comment, we will come back to later. But I want to stay with the correlation point for a moment. If we look back to 2022, it was a particularly challenging year across equity and fixed income markets. We've all cited the numbers right – equity down 18%, core bonds down 13%.

It makes sense that in that proprietary survey that I mentioned at the top of our call, when we asked public plan decision makers what their top concern was for their fixed income allocation looking forward, they noted that it's the overall portfolio construction and whether it's positioned to deliver expected objectives in the environment ahead. So while absolute numbers in 2022 were very much in the red across many asset classes, being on the right side of duration and curve positioning and sector positioning really could make meaningful difference in benchmark relative outcomes. So you really had a really impressive 2022 and the Dynamic Credit strategy, and I just wanted to get your take on 2022 and then the role of fixed income ahead.

Saurabh Sud: Sure. You know, that's actually the first question I get these days is “Ok in context of double-digit drawdowns and credit assets. How did you deliver a flat return?” And I tell clients I didn't do anything differently. We had time to do three things. Number one is we are trying to create a complementary return stream to traditional fixed income assets. What that means is our correlation to fixed income assets will be positive, but it will be a lot less than one. And that goes back to this point here is we are on a forward-looking basis, not just backward-looking basis, constantly evaluating the correlation of interest rate risk to our credit risk exposure. So that we are doing constantly. And in 2022, we were positioned correctly because we saw on a forward-looking basis that changing, and it has not changed in the last 20 years. So for asset allocation allocators, it didn't matter for 20 years. But now it matters. And again, having a forward-looking view on this is really important.

Which takes me to the next point. Active management is very important. What that means is two things. Number one is that interest rate active management is really important. A lot of credit managers are able to manage credit risk, but they don't take equal active bets in duration risk. That's the feedback we're getting from a lot of clients, and we are at zero price are trying to do that. And that brings me to the chart over here is three year returns for most credit assets that had a fixed rate were close to, or negative, or close to zero essentially, and not handily beating cash returns over that three year period. Something like bank loans was positive because it had no embedded interest rate risk, and in fact, it benefited as interest rates went higher. So duration management becomes the key and a forward looking view on correlation becomes the key, especially at a time like now when it has changed relative to the last 20 year history.

Christina Kellar: Thank you, Saurabh. That's a really great set up for the next question that I have to bring Lowell back into the fold. So Lowell, let's go back to the total portfolio perspective and kind of honestly the setup for today's discussion between you two. So coming back also to the survey that we submitted for public plan decision makers. When we came back up for the total portfolio level and asked the same decision makers what their primary concern was going into 2023, their response was most often evaluating and modifying broad asset allocation targets at the total portfolio highest level. So with the history in mind, active management, et cetera, everything that we've discussed so far, Lowell, could you talk about why this time in particular is such a unique decision point for asset allocators?

Lowell Yura: Sure, Tina, and I think there's a lot of rhetoric around this unique environment. And let me start by talking about what may not be so unique, and what's not so unique is the fact that we have cash rates at 5%, 2% positive real yields, 2.5% maybe 3% of depending on where you are on the curve. That's actually not unique when you look out over a much longer period of time, that's actually quite normal. Well, it's actually much more unique is the environment post GFC. And so that's unique in the context of the last 15 years under which we saw the asset allocation changes that I talked about earlier. But what's really unique and likely the first time being faced by asset allocators is what you see here. And that is capital market assumptions are resetting to these levels from a long period of low rates. And what that means for pension plan sponsors and all investors for that matter is that the shifts that took place over the past 20 years – more risk taking, more illiquidity risk – those portfolios will have no problem hitting their expected return on asset assumptions. And that's the first time that's really going to be felt by allocators, which in turn gives them much more options. And that's what I meant by saying, asset allocation discussions have never been more interesting, more dynamic because allocators have many more options to achieve their return on asset targets by continuing year after year to take more directional risk, more liquidity risk.

And as Saurabh was saying, the environment where we are today – the uncertainty about correlations – that really brings into play the ability to allocate to such strategies. The other thing that I would say is that high quality fixed income with a negative real yield for a large part of the last 15 years is no longer costing anywhere near as much as a part of the portfolio. And so, the focus of a lot of our discussions has been on, hey, we've reduced the liquid fixed income portion of our portfolio dramatically to achieve those returns on assets. Now that we have room to think about different things in our portfolio than we've had an opportunity to do in the last 15 years. There is no shortage of options that the folks that we are talking to are thinking about.

Christina Kellar: All great points, Lowell. And as I listen to your comments in response to that question, I keep hearing a narrative of choice that lies on the table for public funds. And to your point, we've seen some public funds start to undertake an SAA review with their staff board consultant and then potentially change off cycle, took a different approach. And I keep coming back to the survey that we submitted into the marketplace. Polling public plan decision makers on those philosophies going forward. And to your point, we actually saw that uncertainty come through in the data, mixed results regarding plans intended future for their fixed income allocations. Some reported that they planned to broaden asset allocations within fixed income looking forward. But, those numbers were actually higher when we looked backward. So more plans were actually making those changes over the prior five years than expecting to do so in the upcoming five years. So in short, fewer respondents were actually considering it today. And then in addition, you mentioned that chart about the evolution of the average public fund allocation over time. We're still seeing in our survey expectations to increase allocations to private credit and private equity. So I want to challenge you a little bit on this narrative. Are you implying that the trends that we're seeing or expecting will reverse quickly back to the response to the trend of 15 years of history in the average allocation chart you showed at the top? Or do you expect those changes to be more incremental over time?

Lowell Yura: It's a great question, and I think it's been puzzling to some, but it actually, when you think about history and you think about the long term time horizon of public plans, it makes absolutely perfect sense to take a step back, think about things and incrementally start to think about change. If you actually go back to the structural change in rates following the GFC, it took many, many, many years to make for those changes to occur over time. And that's because of the uncertainty of whether this is a shorter term time period where rates will temporarily be low and then pop back up to the normal levels that I talked about earlier, 3 to 4 to maybe 4.5% cash rate, positive 1 to 2% real yields. Well, after 15 years of not seeing that reversal, you could imagine that those trends started to accelerate because year by year, it became more convincing that this was perhaps a regime that was going to last quite longer.

Now, this change happened so suddenly and you think about why it happened so subtly coming out of COVID, the inflation concern surprised everybody. The Fed was behind the curve, the Fed raised rates, it took them a while to raise rates. And as that started to unfold, there was this rhetoric in the market that, oh, this is temporary, this will pass. We'll come back to lower rates. Maybe not the rates that we saw post GFC and during COVID, but maybe back to 1% Fed funds or 1.5% Fed funds, where rates kind of were for the 15 years prior to when they bottomed out. But in each passing day and each passing data point, there is more and more evidence, and more and more people starting to think, well, jeez maybe this is going to last a bit longer and it's just like the post GFC environment. And so this wait and see approach is extremely rational, extremely prudent because of the time horizon. You don't want to just react to big changes in a very short period of time. You want to be purposeful, you want to think about your options, and you want to not just set up your asset allocation for a single cycle, but set up your asset allocation for multiple cycles.

So we actually think that it's never been a better time to really start to think about: What would I do with my asset allocation if rates stay at these levels for the next several years? And what would I do if they move higher? And what would I do, if anything, if they revert back to where they were and move lower.

Christina Kellar: All excellent points and teeing me up perfectly for bringing Saurabh back into the into the mix here. On the right path looking forward, because to your point, Lowell, some listeners in today's conversation might be thinking that this story seems too simple, right? And we're certainly not implying rightfully that these trends in asset allocations over the average public plan will reverse quickly. But I do want to start to think about the tactical, the shorter term perspective on fixed income positioning that Saurabh you'll be well equipped to address.

So of course, while these could be attractive entry points for levels for income, the total return outcome could be uncertain, right? We still don't know if the Fed will continue to hike through 2023 and into 2024 or higher for longer. Can you please talk to us a bit about your views with your global cross sector mandate as well? On how long and if the Fed will need to hike further in order to tame US inflation. We saw a pretty hot print today again in order to get back to that 2% target. And then again, given you have a global remit, can you just comment on global central banks more broadly as well?

Saurabh Sud: Sure, Christina. So I mean, at the beginning of the year, a lot of clients were asking me our bonds back, right? Because that's what they were hearing in the marketplace and I argued against it. Now, of course, for a while, when rates were rallying, I didn't look as good. But if you study interest rate cycles, you will get to what I'm arguing for. So let me get to that in one second. But let me give a quick backdrop on how we arrived here. So in 2021, when inflation was going higher, the Fed and other major central bankers kept saying “transitory, transitory” and that was a policy mistake in our opinion because we were studying the Polish Central Bank, we were studying the Czech Central Bank, and they were aggressively reacting to high inflation. And we thought it was just a matter of time before it came to the Fed or to the ECB. So we were set up for the rate, short trade going into 2022 based on our work analyzing other central banks in the eastern European market.

And so that helped – of course, that didn't tell us how far the Fed will go, but we thought that the Fed will be aggressive and that's what happened. Eventually, that's what happens in all cycles. So phase one of a rate hiking cycle when the Fed is hiking rates, tenure goes into a strong uptrend. Subsequently, it enters into phase number two, which is when the market is trying to figure out what the terminal level of rates will be for the cycle. That's when tenure goes into a long sideways consolidation marked by number two in all these cycles. So, history essentially rhymes.

I believe we are in the transition period from phase two to phase three. Now, what is phase three? Phase three is essentially that the Fed has won on its inflation mandate, the Fed has stamped down inflation. So inflation starts coming down. Everyone starts believing that we will enter a soft landing. Sounds very familiar right? To right now. But this is what happens towards the end. When the Fed hikes for the last time, the 10-Year peaks within plus or minus four months or the last Fed hike. So we expect that in November, the Fed likely goes one more time and keeps it higher for longer. And that is around that period in Q4 or Q1, is when the 10-Year is expected to peak. Now, of course, it could happen sooner, it could happen slightly later. But that's broadly my expectation of where we are transitioning from phase two to phase three – which is, phase three is defined as the final blow off, sell off in the 10-Year.

And that becomes a durable buy opportunity in the rates market. Because that leads usually to phase four, as the Fed stays anchored on tamping down inflation and likely commits another policy mistake of keeping rates higher for longer when data starts slowing. But they are still concerned about inflation, which is a more backward looking indicator. And that leads to phase four when rates start rallying dramatically. So we are in the midst of transitioning from two and three, and then subsequently, I would expect phase four. And so as I said earlier, yes, bonds are back. Yes, yields are attractive, but now it's not exactly the time for the best total returns. But yes, if you can be selective and you know, capture yields, attractive yields on safe assets, IG rated paper at 6, 6.5% or high yield paper with lower interest rate risk at 8 to 10%, that's really still attractive.

Christina Kellar: Excellent points. And you're tying it really well to some of the points you made on being, you keep saying the word selective. So I want to just underscore that, as we also asked our respondents from that proprietary survey back earlier this year. We asked them their views on the benefits of active management and they commented that – the most frequent response rather for the top benefit of active management was that it can potentially diversify sources of return generation. I want to stay with you for a second because you're really building to that narrative. Do you have any thoughts on that, on that finding?

Saurabh Sud: Yes, 100%. If you go to the next slide – now a client has – we made it simple and let's just analyze the last couple of years since 2021. The client has simple options. Number one, they don't do anything, right. So they are allocated to a benchmark strategy which is case one, let's say this high quality investment grade and that still delivers negative returns. So that's case one on this chart showing negative returns. Now, the other thing the client can do, of course, is just strip out the interest rate risk. So find assets that have some spread risk, but strip out interest rate risk, and that becomes case 2A. So find floating rate assets that have delivered positive returns over this period.

Now, of course, what we are arguing for is that it doesn't have to be just stripping out interest rate risk. What if you actively manage that interest rate risk? So that takes you to case 2C. So again, your Sharpe ratio is still above one and you're generating better returns than case 2B. And of course, it's way better than case one in the first place. And then the final scenario is that you create a portfolio which you know, hedges out both interest rate risk and credit risk and just creates an alpha oriented solution. Of course, the total return potential will be lower, which is what is shown by case four – it's lower than 2C.

But you can, in the end, blend these two aspects and create a portfolio where the manager can actively manage duration and actively manage across sectors, which of course our clients want to do. But we hear from our clients also that they're not as nimble as a fund manager can be. So that brings a blend between case four and case 2C to create a portfolio, which is not just created for this one environment, which is the last two years, but that portfolio can also be long duration, which a portfolio in this case two way of stripped duration risk won't be long duration. So when that phase four that I was describing to you happens and, and a lot of people have gone into floating rate assets or even private credit assets, then you don't get the benefit of the total return potential from interstate duration risk, where now it has repriced to a much more favorable level for you. So again, the idea is to think active and be selective and then at the same time allocate tactically across sectors and manage duration more actively.

Christina Kellar: Thank you, Saurabh. And I want to offer Lowell, I'd love for you to jump in on this question as a multi-asset portfolio manager, can you speak a bit to the role of strategies that have more flexible mandates across duration, across curve, across sector? Like Saurabh described in a multi-asset context.

Lowell Yura: Absolutely. And Saurabh nailed it when he talked about the flexibility that these strategies avoid and as plan sponsors think about 2022 and that spike in correlation and what that meant. We always say never give up on high quality bonds as your ballast in your portfolio. It's a central principle to our approach to portfolio construction. However, we also say, never look for opportunities to incrementally provide strategies that may protect you in environments where those correlations may rise. And that's what these flexible strategies offer.

The second reason, and this is equally important, is fixed income markets are much more dynamic and change much more quickly than equity markets. Yes, equity markets change, the sector weightings change, the characteristics change. Obviously today, we have a high concentration in large cap tech, both with AI focus. Those are really, really important details. But the difference in fixed income markets is bonds mature. They have an ending date and bonds are issued. And the bonds that are issued have a characteristic that is based on the environment and the issuance environment, as well as the demand environment for those type of bonds. Think about the mortgage bond market right now with home sales slowing. Those are going to slowly trickle through into the indices.

And so a strategy like Saurabh that has the flexibility to go a lot of different places and adapt to this quickly changing market. He talked about the evolving high yield market earlier with some of his slides and how the quality has improved and how bank loans have grown relative to high yield. All of those things and more so even on a global basis, all of those things provide untapped opportunity. And by adding a strategy like that to a portfolio, it doesn't require the asset allocator, the folks in our division, to change the asset allocation. We embed a strategy like Saurabh’s to be able to quickly adapt to these environments much more quickly than we could by conducting another asset allocation study and shifting allocations around. It's already embedded. And so, it's really those two reasons. It's one, is adding a little bit of protection when stock bond correlations rise, and two, adapting much more quickly than an allocator can to evolving markets.

Christina Kellar: That a great response. And so, we're coming up on about 35 minutes into the session. I want to give our audience a bit of time to submit questions to the Q and A box on the screen. I've already seen some really good ones come through that I'm going to tee up to Lowell and Saurabh in just a few more minutes. So please continue sending them in. But before we hit the audience questions, Lowell, I want to stick with you for a moment because you just made some points that reminded me of recent conversations we've been having with our clients, many of whom are actually on the line today. So any themes that are jumping out to you, given your recent conversations, and in particular, what sticks with you the most right now?

Lowell Yura: I think our clients, and I would suspect, all public plan sponsors, CIOs, investment team heads, and staff are very well aware of their asset allocation. But if you look at a chart that we have here on page 13 – if you look at this chart, what this chart actually shows in the blue line is the actual notional equity exposure that you'd get out of any report. It's the percent allocation of public and private equity. And if you look at that, you'd say, well, jeez, that's contradicts what you said earlier, the equity allocation has declined when you look at it that way. The green line takes into account the factors embedded in the broader portfolio. And the fact that within private equity rather than public equity, you're getting more beta. We use an assumption to say, hey, you're getting 20% more beta in private equity. We used an assumption to say you're getting 40% equity exposure in hedge fund allocations broadly speaking. And same for some of the other alternatives. Those are rough estimates and those are embedded in the green line. What's really interesting is how wide that gap has gotten. And so that is not necessarily the surprise that we're hearing the most, because again, investors are aware of that. What's actually really surprising is when we look at the strategies because of the wide ranging exposures in the strategies. If you have a heavy allocation to early stage venture, the equity be is going to be much higher than it is to higher quality, less, more stable venture.

What about the level of leverage in various illiquid. That's going to increase beta. What about the credit exposure? How has that evolved? And when you look through these allocations and when you look through to these specific strategies, we are hearing over and over again, how surprised they are at how much directional risk they have taken as a result of the last 30 years of declining interest rates and the need to kind of move out on the risk spectrum. And the second thing that we hear more about, but not as much as I think we should expect to. And that is the surprise at how little high quality duration is in the portfolio. Yes, folks are aware that fixed income allocations, particularly at a high quality liquid, fixed income has dropped. But again, going back to the point earlier about implementation, many have implemented to strategies that are heavily weighted towards credit. We're seeing this move to private credit. And so, when you go from public credit to private credit, which are wrapped bank loans with no duration and you add it all up, you're seeing a much, much lower duration than people would expect and a much higher concentration to corporate credit. And so those two things together are having people a bit concerned, but a bit less concerned than I think they ought to be. And I think that's partly because having less fixed income in your portfolio, less duration in your portfolio, was a great thing in 2022. And so, in the event of a more traditional risk-off flight to quality, we're starting to see more of our clients work with us and stress test their portfolios against a range of environments, both traditional and less traditional with regard to risk-off and correlations between stocks and bonds.

Christina Kellar: Thank you, Lowell. And Saurabh, I want to offer a similar question to you. We've spoken a lot about your Dynamic Credit strategy, but you're also Co-Portfolio Manager of the US Core Bond strategy. So some of Lowell's comments just now are sticking with me to offer to you too. How would you summarize today's environment and where you're seeing opportunity and how you're positioning for it?

Saurabh Sud: I think it's an idea rich environment for fixed income. That's what it is. You have to be selective and active management can really help you. But if I were to take a step back and reconcile my comments that I'm going to make next to what Lowell just said, in my view, for an asset allocator, there are three buckets of fixed income investing, right? Number one is traditional fixed income, benchmark oriented. Number three on this side is illiquid private credit or hedge fund. So, this is liquid public market, and this is illiquid non-public market. But then there's something in between, which I feel in my client interactions, I find a lot of clients are under allocated to and that's the solution that we are trying to offer to make sense of something like 2022 or to offer liquidity in your portfolio and still deliver returns and yields such as some less liquid options out there. Because some clients, they went and over allocated to the illiquid segment as Lowell was describing earlier, but they still have liquidity needs of several hundred million dollars a year to pay out from their assets. And to make those liquidity needs, you still need an income stream, which is less diversified than say the benchmark assets, and also the illiquid assets on the other side. So, that's what I would say you need to think about as an asset allocator.

In terms of environment, of course, as I described, we are looking for a peak in rates in the coming quarters. Of course, a lot of people have been arguing for that. In the previous quarters, I think it's ahead of us. It's not time yet. But bonds guests will be back from a total return perspective. But in the meantime, you can generate very attractive returns without taking a lot of interest at risk. Because at this point in time, rate volatility is dominating the total volatility of a credit bond. So you have to be careful. So you have to supplement and do credit work to find securities and situations where you can find IG rated stuff in 6 to 7% area where you can buy high rated secured paper in 8 to 10%. And these are contractual bonds. These are in line with long term risk marked, risky asset, return expectations over the long term. So when you have contractual cash flow oriented bonds in that zip code, it becomes really attractive and at least that's where you need to start doing work to start thinking about how and when to allocate. And of course, timing still is important from a duration perspective, but they are still, as I said, an idea rich environment.

Christina Kellar: Excellent. Thank you Saurabh. So I'm going to start turning into Q&A for today's discussion. And the question that was submitted in advance that I thought would be really great to ask you both was really well positioned in the context of even just the title of today's discussion is your fixed income allocation positioned for yesterday, today or tomorrow. And when we overlay that with the current macroeconomic backdrop that they both touched on, I want to tee up this question. “As a fiduciary and a long-lived entity, why should my asset allocation depend on the next economic cycle going forward?” So Lowell, maybe I'll turn that to you first, and then Saurabh, please jump in based on those comments.

Lowell Yura: Thanks. I think it's a great question and it speaks to the way we throw around terms in this industry. We're all guilty of it. We talk about cycles and we just assume that cycles mean the same thing to everyone, but they can mean very different things. And also cycles are much longer now than they were in the past. And the person that has that question is right, you really shouldn't be investing for a given cycle. You should be investing through cycles, and particularly as a going concern, as the question stated. However, every single plan is different, every single plan has done different things. And all we're saying is reevaluate where you are today compared to where you were maybe 15 years ago before we started the structural lower rate environment and say, have the changes that I've made, are they significant such that if this higher rate environment stays longer, warrant reconsidering a change? And so that goes back to the comment I made earlier. It took several years for these changes to occur as people were convinced more and more that rates were staying lower. And so it's a good point in time to kind of reset and say, hey, let's look at where we were today. Let's look at where we are today and let's compare that to where we are pre GFC. And doing so will prepare you for or avoid surprises when we have traditional selloffs and flights to quality like we did in the GFC. The last thing any sponsor wants is unintended surprises.

Christina Kellar: Saurabh, would you add anything to this?

Saurabh Sud: I'll probably simplify it by taking these two assets and then complicate it by making it a technical response. But what I'll say is if you know you're a long lived entity and your time horizon is say 20 years. Ok, so just as an example, you have two assets, asset A and asset B and you know that both these assets will deliver the same return at the end of 20 years, but one of them has higher volatility. The question then becomes, how do I find the asset which will be lower volatility? Right? And that's part of the whole active selection aspect that I'm describing here. Now, of course, you can reorient the question by saying I'm just trying to find the asset that will deliver the most return. I'm reframing the question back to you by saying what if we know that both these assets will deliver the same, but at the same time, you know which asset you want to allocate to right now, which would be the lower vol asset. And then when these locations appear, then you allocate to the other asset. And that's how you compound returns, which will be more than those two assets individually, in my opinion, which is why I think analyzing cyclicality of any asset through a cycle gives you some understanding of how your return stream might be slightly different towards the end.

Christina Kellar: Great points. Saurabh, you touched on a couple things related to your duration, positioning and view ahead already, but another question submitted by our clients listening in. What duration is your sweet spot? So I could interpret that to mean, how you're currently positioned and roughly your flexible remit across duration positioning and dynamic credit. And then Lowell, I'm going to offer you the same question to kind of nuance this from the total portfolio strategic perspective, please. So Saurabh you first.

Saurabh Sud: I think every cycle is different but towards the end of any rate hike cycle, as you know, the Fed enters into a pause and eventually into a cutting cycle. Of course, that's pushed out a little from this point onwards, in my opinion. But when that happens, usually the belly of the curve starts outperforming the long end of the curve. So the curve tends to steepen as we go in. Now, the curves are inverted. I would expect with the 12 to 18 month view, the curves tend to steepen. So in my opinion, if we were to enter into a phase four eventually in the next couple of quarters, then it will be a bullish steepener. So my sweet spot would be like the belly of the curve of the Treasury market from that perspective.

Christina Kellar: Lowell, anything from a top down perspective and kind of how we think about duration and multi-asset view?

Lowell Yura: The way I would think about this is that it's best to be purposeful with regard to selecting your duration. But if you look at the data from public plans, as we showed earlier, the allocations have dropped by about 10%, perhaps even more. And also what we know is very, very commonly, the core part of these portfolios are benchmarked to the Agg, which has a 7-8 year duration depending on what year it is. And so, what we've seen is this passive approach to “Ok, we're dropping our allocation to core bonds, we're not doing much different.” And this is this is a general statement. I should say we are seeing some very creative solutions and creative approaches by many of the folks that we talked to as well. But what I mean by an active solution is hey, if you thought about your duration, like I said earlier prior to the GFC and it was at 30% or 33% and it's now down at 20% and it's a third lower. Well, the sweet spot might actually be extending your duration by a third and that would offset the reduction in duration that you experienced over the past 10 years. Now, we'd also want to consider, and we suggest that you consider, the amount of exposure that you have to credit because as you mentioned earlier, being short duration and being overweight credit can be two very highly correlated positions. And so, and again, in a traditional risk-off environment where your credit exposure, particularly your corporate exposure, will suffer. And in that environment, you get a flight to quality, you don't have that duration that you had in the past. So there's no single answer. But what we do suggest is that you look at it and you think about it in the context of stress testing and what you, what the board, what the investment committee, what the staff is comfortable with in various scenarios.

Christina Kellar: Thank you, Lowell. I think that's a really an excellent closing point. So that's about the amount of time that we have allocated to Q&A. And Lowell, just continuing on that point that you just made in your close. There really is no single solution here. But we stand by ready to partner with our public fund clients to help think through these decisions with them and with their consultants in order to really triage quite the bread and optionality that's on the table that might not have been 15 years ago. So Lowell, Saurabh, thank you so much for your time and insights today. On behalf of both our clients, consultants on the call and others on this session today, and on behalf of my co-panelists at T. Rowe Price. Thank you for making the time to listen in and join us. We really hope today offered some insights and perspectives both on asset allocation considerations, as well as fixed income positioning for the road ahead for public defined benefit plans. We're committed to partnering with you to discuss these critical themes and more as we venture out onto the road ahead. Thank you so much for your time and have a great rest of your day.


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