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Good morning. For our third Friday interview, we talked with Rick Rieder, head of fixed income at BlackRock, probably the most important bond investor in the world. He is responsible for some $2.4tn in assets.
Rick Rieder on Treasury supply, short yields, thin spreads and private credit
Bond investing has been a painful profession in recent years. Even the best in the business were crushed in 2022. This year, though easier, has still wrongfooted plenty of investors: broad corporate bond return indices are flat and Treasury funds have taken losses.
That is changing. November is on track for the best month for bonds in 40 years. Consensus holds that rates have peaked, in large part because inflation isn’t the threat it once was. Nonetheless, anxieties linger: recession risk, above-target inflation, an inverted yield curve, huge deficits. Rieder, who’s been in bond market for three decades, acknowledges all of this, but nonetheless sees a landscape rich with opportunity.
The interview below has been edited for clarity and concision.
Unhedged: We all know why the short end of the yield curve is higher: policy has forced it higher. But it is less clear why long yields have risen and whether they will stay high. What’s your view?
Rieder: It goes without saying that inflation stayed sticky high. The three- or six-month moving averages seem to be trending towards the mid-to-high twos, depending on the metric you use, in the first quarter of 2024, and then by the end of 2024, the low-to-mid twos. But it’s been sticky.
Meanwhile, growth has been surprisingly high. I’ve been pretty out there about my view that the US economy is much more resilient than people give it credit for. We have a 70 per cent service-sector economy. Historically, there’s only been 13 quarters of negative growth in 100 years of the service sector. Many people were overly bearish on the US economy, and I think part of why rates have moved higher is that the economy has proved resilient.
Lastly, I think markets underestimate the amount of supply of duration and Treasuries coming to the market. While we’re doing this interview [on Tuesday], there’s $626bn of Treasuries coming this week. We got $252bn on Monday. Today at 11:30 in the morning, we got $122bn and then another $130bn at 1:00. It’s unbelievable.
In the past 10 years, the average rate on Treasury bills was 0.8 per cent. Now we’re pricing at five and a half. That’s a lot of yield coming into the system! And investors don’t have to go out on the yield curve; you can stay in the front. So part of why rates are staying high is (a) the amount of issuance and (b) most people are like, “Wow, five and a half staying in the front end with no risk?”
Between more supply, the Fed lifting rates, and the inverted yield curve, there’s a reticence to take yield curve risk. The term premium is not that exciting relative to what it’s been historically, either. That confluence of events has created the paradigm that’s lifted long rates to where they are today.
Unhedged: Do you think long yields can resume their climb?
Rieder: I do. Rates can go a bit higher from where they are today. Again, you’ve got to absorb a lot of supply. Eventually, as inflation falls, getting real rates to a level that is merely restrictive will mean bringing rates down, maybe 100 basis points. But I don’t think the Fed will start doing that until the second half of next year.
Unhedged: For anybody who doesn’t have to match duration, why not just hold cash? Why go out on the yield curve at all? Why isn’t cash the all-purpose strategy for today?
Rieder: We’ve done things like buying commercial paper, one-year commercial paper at six and a quarter. You don’t even have to do anything with it!
Today, I think the world’s different. You have a slowing economy and inflation approaching 2 per cent. So ask yourself: what is the break-even from buying three-to-five-year assets? For example, if you buy three-year investment grade credit, rates go up 200bp, and you hold it for a year, you would still make money. That is impressive. Let’s say, which I think is right, that the Fed and the ECB and the Bank of England are motivated to start cutting rates. You can hit high single-digit to low double-digit returns on high-quality assets in the belly of the yield curve, that three-to-five-year range. The convexity of returns is the best I’ve seen in decades.
I’ve been pretty adamant about my view that the front end to the belly of the yield curve is pretty attractive, even just to capture a yield. Not just in Treasuries, but also in mortgages and investment-grade credit, the ability to build 6.5 per cent or 7 per cent yielding portfolios without going out beyond, say, the belly of the curve and without going aggressively down the credit spectrum is pretty darn attractive today.
Unhedged: How far do you take your services-oriented view of the US economy? Is it that a recession is virtually impossible, barring a 2008 or Covid-level crisis?
Rieder: A modern economy is supported by technology. People say we haven’t seen productivity growth in the past decade. But to say that there aren’t productivity gains from GPS, mobile communications, payments improvements, Internet delivery, is crazy. There are huge productivity gains taking place because you’re shifting from a goods-oriented economy to a technology-oriented, service-oriented economy, including the demographic shifts that cause spending on healthcare and education.
When you have 70 per cent of the economy revolving around consumption, and especially around services, the bar for recession becomes really high. You need a pandemic or a financial crisis to create one. That’s one part. The second part is an unemployment rate that’s under 4 per cent. Even if unemployment rises above 4 per cent, we still have high wage levels, over $1tn in savings, and a consumer that’s delivered. In a 70 per cent consumption economy, you would need capex and business spending to fall off a cliff [to have a recession].
It’s not impossible that residential real estate comes under pressure, à la the financial crisis or the savings and loan crisis. Part of why I think the Fed should stop is caution about this market. It’s holding up really well because inventory levels are low, because you have a 3.9 per cent unemployment rate. But if unemployment moved up significantly, and you had forced selling of homes, that could be a real mess. A big portion of household wealth is in homes. Commercial real estate could create, say, $40bn-$50bn in losses; it’s not a structural dynamic of the US economy. Residential would be. But without a residential crisis and assuming consumption growth stays around 2 per cent, you’d have to really crush business spending to get a recession. I’m pretty sanguine about growth. It’s moderating, but I’m comfortable about it.
Unhedged: Why bother taking any credit risk at all? Corporate bond spreads over Treasuries are quite thin, in some cases historically thin. Of course, some absolute-return investors are going to nab whatever incremental return they can find. But from a risk-return point of view, is credit risk attractive right now?
Rieder: I’d say it’s a B-. But it’s not a C. Why are you getting these sorts of yields in credit today? You’re getting them because the risk-free rate is so darn [high].
When rates were low, companies termed their debt out. I thought this stat was unbelievable: 72 per cent of high-yield companies refinanced when the fed funds rate was under 1 per cent. I remember going through 2020-21 and asking why aren’t companies issuing more bonds. Some did, but many said “we have enough”.
What do you do with these spreads? Well, gosh, I’m getting to buy companies at yields that are really high because the risk-free rate is so high. The technicals in high yield are incredible because you don’t see a lot of issuance. I can clip coupons and I’m getting companies at a cheap level.
Every day, I go through where the soft spots are. There are some, in sectors like retailing, parts of media, tech etc. But it’s largely priced in. So if you assume somewhat higher default rates in high yield, a lot of those fragile issuers, like those that haven’t termed out debt, the market is pricing in that risk today. Look at triple-C’s [where average spreads are nearly 10 per cent, right in line with historical averages], for example.
My sense is you’re going to have some increase in defaults, certainly in high yield. But it’s really hard for investment-grade companies to default.
Unhedged: As a person who is known as a public markets bond guy, has what you do been changed by the rise of private credit?
Rieder: It has. In my funds, I can use private bespoke financing both on corporate and structured finance. My view is that a 60/40 portfolio today should be more like 60/30/10. In equities, assuming you have a two or three year window, you’ll get your 8-11 per cent return consistent with return on equity. Then take 30 per cent and buy high-quality yielding assets, stay in the belly of the curve, but keep your beta largely in equities. And then with the final 10 per cent, I would do private credit and structured finance.
I’ve been doing this for 36 years. If you’re in a rush to put a huge chunk of private credit to work in the market, I wouldn’t do it. But the ability to see and structure assets is pretty attractive — setting covenants, structuring cash flow sweeps, protecting collateral. I would argue in many cases you’re controlling your own destiny (obviously alongside others that are participating in a given deal).
My sense is that you’ll get so much money into the space that it’ll squeeze out opportunity, like always happens. But today I feel like because you’re at the nexus of the banking system tightening lending standards, reducing risk-weighted assets on balance sheets and money coming into the market, you have a window that is still pretty attractive for investors.
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