Still Time Left
Bond manager Cutwater says the strong rally in ‘spread product’ isn’t over yet
Bonds that offer yield above the so-called risk-free rate have had a banner run, but Cutwater Asset Management believes some scoring opportunities remain.
“We’re in the sixth inning, give or take,” said Cliff Corso, chief executive and chief investment officer for Cutwater, which manages $26 billion of fixed-income assets. “For the next 12 months, it’s still going to be a good time to overweight risk within the portfolio.”
Cutwater views investing through the prism of economic cycles, which in Corso’s view are six to seven years in duration and consist of recession, expansion, and maturation. “If you don’t have a sense of where you are in the cycle, it’s hard to understand whether you’re getting appropriate value,” he said. “If you’re in the ninth inning with very tight spreads, you have a bad risk-reward equation if you don’t have a sense that you’re in the ninth inning. You’re not getting compensated for what’s about to happen.”
Cutwater is a counter-cyclical manager, in that it looks to reduce risk in portfolios when froth appears, and add risk — and potential return — amid downturns. “That’s where you have a big margin of safety in taking a lot of risk on, because you’re getting paid for it,” Corso said.
Currently, spreads on non-Treasury issues such as corporate, asset-backed and mortgage-backed bonds are at or near fair value, according to Corso. “We’re not quite near the greed phase, where you normally see animal spirits and prices that are too high,” Corso said. Still, “we are seeing some signs of animal spirits beginning to come back,” he said, suggesting the upturn is nearer the end than the beginning.
BBB-rated corporate bonds yield about 200 basis points, or 2 percentage points, more than U.S. Treasuries, according to Bank of America Merrill Lynch data. That risk spread has contracted from more than 300 basis points in 2011 and 700 basis points in 2009.
Cutwater has seen the equivalent of three full economic cycles, as the firm launched its asset-management business in 1994 after a few early years farming out money-markets assets to external managers. Corso, 52, is home-grown: he joined Cutwater in 1994 as essentially employee #1, and he was born and raised in Armonk, New York, a sleepy 4,300-resident suburb of New York City in which Cutwater is based.
“I started my career in the early 1980s as a commercial bank lender, where I learned how to spread balance sheets and look at credit from a bottom-up perspective,” Corso told Markets Media in a Nov. 8 interview from Cutwater’s headquarters. “That forms a component of the investment philosophy here today.”
In addition to taking long-term and countercyclical views, highlights of Cutwater’s investment philosophy include focusing on spread sectors, separating fundamental credit research from relative value analysis, managing risk throughout the organization, and casting a wide net across the fixed-income universe. “There are a lot of different sub-sectors of the fixed-income market,” Corso said. “People don’t always recognize how broad the market is.”
Cutwater’s assets-under-management pie chart underscores that point. As of September 30, the firm had 24% of its assets in corporate bonds, 20.4% in agency bonds, 20.7% in cash and equivalent investments, 11% in municipal bonds, 9.5% in securitized investments, 8.64% in U.S. government debt, and 5.71% in derivatives.
Cutwater manages its fixed-income securities under one tent, which Corso said is a differentiator. “At a lot of shops, you’ll see it siloed — the corporate team will be sitting somewhere, the mortgage-backed team will be sitting somewhere else, and there’s not a lot of interaction,” he said. “We purposely created a culture where there is day-to-day, almost minute-to-minute, interaction between sector specialists. There is a richness of conversation to find the optimal solution for the client, and the best ideas flow across sectors.”
“The model was created to encourage maximum interaction between sector specialists,” added Jesse Fogarty, managing director and portfolio manager at Cutwater. “The key aspect is identifying risks and then expressing those risks in the most efficient manner. For example in commercial real estate that can be done in the REIT market, or the CMBS market, or the bank market.”
“Idea generation is expected to come from everybody,” Fogarty continued. “It can be a challenging dynamic between portfolio management and credit research folks, but the culture has been created that everybody’s not only expected, but demanded to generate ideas.”
Cutwater’s $26 billion is just a small fraction of bonds managed by asset-management giants Vanguard and Franklin Templeton, but the firm is hardly a peanut — its 85-person shop ranks among the 100 largest U.S. institutional fixed-income managers. Its clients include insurance companies, public and private pension plans, and institutional markets as a provider of structured products.
By strategy, in September Cutwater had 54.2% of its assets in total return, which seeks to beat a fixed-income benchmark such as the Barclays U.S. Aggregate Bond Index, and 29.4% in liability-driven investing (LDI), which seeks to match income with liabilities over a period of years or even decades. Assets under management in the focus strategies have been increasing by 15% to 20% per year, Corso said.
Cutwater’s total-return strategies have added value. Through September 30, its $6.5 billion Core strategy had gained 5.33% annualized since its January 2005 inception, compared with 4.72% for the Barclays Agg. Its Intermediate strategy returned 4.44% annualized over the same period, 11 basis points more than its benchmark.
According to Cutwater, its $600 million Core Composite strategy has ranked in the top quartile of peers over a 15-year span, and its $200 million Long Duration strategy has outperformed 98% of peers since its inception.
But for bond managers, absolute and relative performance numbers can be unimportant when the goal is to cover liabilities. “We see a big move toward liability-driven investing,” Corso said. “Many entities out there, pension funds in particular, have liability streams they need to meet. The best match over the long haul to meet that liability is fixed-income assets.”
An ongoing challenge for pension plans and other asset owners is persistently low interest rates. With the benchmark 10-year U.S. Treasury note yielding about 2.7%, it’s exceedingly challenging for a pension to meet predetermined — and sticky — return hurdles, which may be 7% or even 8% per year.
As a starting point in navigating the current landscape, pensions may need some wiggle room regarding the standard protocol of benchmarking their fixed-income portfolios to aggregate bond indices, which typically hold a large proportion of long-dated government bonds that are the most vulnerable to rising interest rates.
“You don’t necessarily want to be in government paper that has duration,” Corso said. “Yield is a buffer against higher rates, so you want to favor instruments like corporate and asset-backed bonds, and you also want to look towards structure to help soften the blow of rising rates.”
U.S. government bonds make up about 75% of the widely referenced Barclays Agg, about double the proportion of a decade ago, according to Corso. For pension plans, “the trend is headed toward a solutions-based model,” he said.
Within the trend of decoupling from the index and moving toward a more opportunistic, absolute-return framework, one specific manifestation is for asset owners to lean toward more equity-like instruments within fixed income. These may include levered loans, non-agency residential mortgage-backed securities, and high yield issues.
Such holdings can generate more yield than plain-vanilla bonds with less interest-rate risk, but as with any swap in the investment world, there are tradeoffs and there is no free lunch.
“Investors need to be cognizant that more equity-like securities are not going to behave like traditional fixed income in a downturn,” said Fogarty, 42, a 17-year Cutwater veteran. “So a potential concern is that as investors move to higher-volatility securities, they are losing some of the traditional properties of a fixed-income ballast, i.e. stability, income, and a hedge against your equity book.”
Cutwater is an active user of derivatives, in fact the company was a pioneer in the early days of the credit-default swap market in the mid-1990s, said Corso, who holds degrees from Yale and Columbia. Today, Cutwater may deploy derivatives to add duration, replicate credit, or manage risk.
Derivatives have had a rough half-decade, but in Corso’s opinion, the market will increase in size and influence. “The downturn slowed the use of derivatives, and regulatory actions have caused a bit of a crimp in the market, but our view is that we’ll see those products being ramped up through time, particularly the swaps market,” he said.
Cutwater’s macroeconomic views are reasonably constructive, buttressed by its observation that two-thirds of the world shows a stable or increasing gross domestic product. “We think it’s a three-speed world: high-gear in the developing markets, low-gear in developed Europe, and medium in the U.S.,” Corso said.
“We’re bullish on U.S. fundamentals — we think GDP growth will be 2 to 2.5% next year. For the bond market, that implies rates should rise because the economy is improving, and we don’t really need the full power of the stilts the Fed has put under us,” Corso continued. “That 2-3% GDP is a very friendly environment for risk, particularly in the bond market. We want to be defensive on rates and we want to be offensive on adding risk product.”
Any investment strategy can only work with sufficient liquidity, and market participants and observers have said repeatedly that the depth of buyers and sellers in the bond market isn’t what it used to be. “Valuations have repaired from the depths of 2009, but what hasn’t come back to the markets is liquidity,” Fogarty said. “We believe that to be very structural in nature.”
Fogarty noted the ability of the big sell-side banks to provide liquidity in bond markets has been constrained by regulations such as Basel III in Europe and the so-called Volcker rule in the U.S., and willingness to trade has also waned amid choppy, policy-driven markets. On the buy side, larger bond managers have added assets and gained clout, resulting in less fragmentation and more uniformity of opinion.
A multitude of electronic bond-trading platforms have emerged in recent years; Fogarty specifically cited Bloomberg FIT and MarketAxess for their utility, and Goldman Sachs and Morgan Stanley as big banks that have innovated in this area. But while electronic platforms can boost trade efficiency, they generally don’t compel market participants to make trades they weren’t going to make anyway.
“Ultimately, buyers dictate liquidity,” Fogarty said. “So with these open-book platforms, they might help at the margin, but if there are no buyers, there are no buyers. A platform that matches buyers with sellers doesn’t really help…It is not going to reduce this herky-jerky, risk-on, risk-off market. Platforms are not a panacea.”
Diminished liquidity can further diminish liquidity, in a vicious cycle of sorts. “It tends to extend your holding period because the gap between the bid and the offer is painful to cross,” Corso said. “That plays into our style, which is a longer-view and lower-turnover.”
“In these markets you almost have to be counter-cyclical, or else there’s no exit,” Fogarty added. “With every trade we enter into, we have some kind of exit strategy in mind, as liquidity considerations play a larger and larger role.”
Cutwater probably hasn’t traded a Treasury over the phone in a decade, according to Fogarty, and the firms has slowly ramped up its electronic trading of less liquid and less standardized fixed-income issues. “In credit markets, there’s a role for electronic trading but less so on non-homogenous products, where it’s still about relaying color from the street and working with dealers and information flows,” Fogarty said.
Cutwater’s experience in matching assets and liabilities has inculcated a deep understanding of liquidity, according to Corso. “Many managers have had indices and they need to beat it — sometimes you outperform, sometimes you underperform,” he said. “As ALM guys we had real liability streams we had to meet. We couldn’t underperform, because that meant cash flow wasn’t being paid. We were tuned in to not only looking at expected returns, but also matching cash flows all along the yield curve as against a liability stream.”
Married with three children, Corso enjoys scuba diving and spear fishing, apropos for a CEO of a firm named for a stainless steel strap of metal at the bow of a boat that slices through currents.
Cutwater’s bonds-only motif is a calculated decision to stay at sea and not move onto the land of equities, so to speak. “By specializing in fixed income, we feel we have a competitive advantage versus other asset managers that do a multitude of things,” Corso said. “The bigger part of the market we’re focused on will hire separate equity and fixed-income managers. They want separation and deep expertise.”