Morgan Stanley’s Khanduja on Bond Risk Reward

one hundred basis point mark. That we're at right now, but you know, the market has had a lot of time to kind of digest what's going on with tariffs and what that might mean. We're definitely wide from where we were, you know, beginning of the year, where spreads were around some of the titles levels we've seen over the history of the index. But you know, we've seen some improvement across a couple of different metrics. Issuance has

spen pretty solid. ETF flows is another area that we've been seeing over the past you know week, We've seen a little bit of improvement there, but you know, looking kind of a little bit longer term over the remainder of the year, in our eyes, we think spreads could push, you know, wide from where we're at right now. We have an ordinarily squares model that we look at on our end for investment grade. We have two models there.

Both are kind of pointing to the one forty five one sixty five basis point range, so indicating a little bit of a mispricing there. So we think spreads can definitely push wider from from where we're at right now.

Morgan Stanley Investment Management. He's head of the broad markets Fixed Income team and a portfolio manager for funds including the Eaton Vance Total Return Bond Fund, which has a ticker of ei b a X and the Eaton Vance Total Return Bond ETF, which has a ticker of the e V t R Vishal, thank you so much for joining us today.

month there. But I think one thing that was very clear from April was that bards delivered on their dual mandate, which was income, total return, especially the zero to ten year part, and then the negative correlation. Yes, we can speak about the different parts on the curve of how we behaved during the entire month of April, but overall, bonds did what they were supposed to do in client portfolios. Great.

of bonds. Also, I think the other thing that is going to be very clear as you look through these that these are very transparent, long only bottom up focused. So you shouldn't expect these portfolios on five to six thousand CUSIPs that you would typically see in some of the passive portfolios out there, or the benchmarks as well, which probably have double the amount of those CUSIPs. Should be very focused on three to five hundred bonds bottom up selected, and that's where we think that the most

consistent part of alpha comes within fixed income. Happy to elaborate more on that, but that's primarily primarily what we are trying to achieve in these two portfolios.

the next one. Who are the buyers and sellers of this bond? And what is the economic or non economic incentive to be involved in that sector, asset class, or band specifically? And then valuations? What do valuations tell us in terms of how much is already priced in and

how much is not? So those three sort of verticals help us decide or answer the question, is there a catalyst to be able to get that extra total return, extra income, extra spread compression from this particular investment in our portfolio versus what the benchmark owns or versus what the other alternatives are to invest in that part of the curve. I'll give you also one more piece there

of information our mentality are investing or doing. Our due diligence on any investment is focused on what can we buy that today gives us better return for similar amount of risk as the benchmark or a passive allocation or in certain different times we also ask ourselves the question, which is what can we actually invest in that gives us similar amount of return but lower risk than what

can typically a passive benchmark provide today. So that mentality of risk reward also governs what exactly goes out or goes in into the portfolio at any given point.

that peer group, if you will. So we have done our analysis in terms of how much versus a typical benchmark do we need to consistently outperform by to be in that top quintile, and then how much underperformance do we need to avoid to avoid the bottom a half of the of the peer group. So that sort of versus the benchmark versus the peer group and what are we trying to achieve is very clear within the team

at any human point. The differences now are very respect are very respectful to the vehicles or the rappers, as you mentioned. Even on that one, the mutual fund, the forty act can do a little bit more below investment gage, which is typically your spread risk sector that we allocate to at particular times within the economic pycho, we can do about thirty five percent below and Mustrom grade, so that truly brings in the best ideas from our high yal team into the portfolio when the time is right.

In the specific bonds, the ETF can do twenty percent below in Mustrom grade in bond math terms. The other differences could be explained in a way where the tracking error allowance for the mutual fund is zero to four hundred basis points versus the tracking error allowance for ETF zero to two hundred. Even with those differences, the similarities of trying to achieve that top quintile we think mathematically is possible and is consistently possible to deliver on it.

So we wanted to provide those two wrappers for clients who are now debating towards active ETFs in their allocations and be able to do that in a liquid fashion. And then respecting what we can deliver within our philosophy and process of total return franchise, and then within within that ETF rapper which is a lot more liquid versus the mutual fund.

value proposition look like? You know, are you seeing a little bit more advantage to one over the other, especially given the uncertainty that we might be seeing over the next couple of quarters.

the US. I think that is a very liquid way that you can invest in the securitized market. So those are our three big pillars of what the portfolio at any given point will be made of. I think right after twenty twenty, I think prior to the vaccine came coming out, investment grade corporates were dominating our spread, duration, attribution within the within the portfolio, secured was much less, and we were slowly with steadily reducing our government balan

sheet exposure, which was a ballast of the portfolio. We traveled through twenty twenty one and twenty twenty one, especially with a lot more corporate balance sheets on the billow investment grade side, and then increased our secured allocation as well securitized credit again trying to access that consumer balance sheet,

which was very strong during that time as well. Twenty twenty two, as we all know, we were hiding away from anything that behaves like a bond or anything that had a fixed rate bond feature because of what was happening with growth and inflation and the fact trying to catch up. So the quadrant was high growth, high inflation, which typically, as we've learned through CFA and other programs,

is that's the time where correlations breakdown. So we were trying to get away, get more floating rate exposures, but still believing that the balance sheet on the corporate and

consumer side were very strong. Now you travel through twenty twenty four, I think that's where we thought if you go back to that initial construct of fundamentals technical valuations, where valuations were getting to a point where they were not giving you any room for error on fundamentals and technicals deteriorating, that's where we moved away from corporate balance sheets and got it started to build up our balanced again,

which was government balance sheets. So we were coming into twenty twenty five with the least amount of corporate exposure, least amount of credit overweight that we've ever had in the last five years, right, so the ballast was a lot more. Now the month of April goes back into technicals deteriorating, valuations adjusting, and future fundamentals at least potentially deteriorating. Given that we are going to be in a low growth environment, we can discuss whether it's going to be

high or temporarily high inflation. At that point, that gives us a loosening of valuations, and we are slowly and steadily trying to go back into corporate balance sheets which are very strong, and then to now compensate us for at least fifty percent of recession coming through in the next twelve months. So that's how we sort of philosophically and a processwise think about which balance sheet to investment.

Apart from all the hard work that are analysts, we have about one hundred and fifty analysts out of the two hundred and twenty five investors on the team, so very bottom up focused. That's where I think a lot of the hard work gets done in picking out the best ones to invest in. After that top down coom, I.

that we bring to the table. Yes, your typical IG analysts, high yeld analysts, but then we have high yield and bank loans, two different parts of the capital structure, looking at the similar balance sheets from a different perspective of

what they want to get out. So and then we have global as well as US focused analysts that that typically so, for example, a bank analyst sitting here in the US will give you a very good relative value of what should we be getting paid for this table balance sheet in the next twelve months of lower growth and slightly higher inflation. Similarly, I think we have value measures that our European analysts will come out with for European franchise banks that we have an overweight today within

our portfolios as well. So I think that bottom up relative value is the focus that we spend a lot of time and effort on that decides actually how our portfolios are positioned at any given point.

function to it is other dominant two pieces. Yes, we have good amount of propriety models. We have a eight member macro team or developed market macro team that only focuses on country level balance sheet in the ramifications and interest rates curve exposures as well as then FX quite a bit of interest in that one, as you can imagine at the moment. But breaking all of that work down today, how our we position. We are a lot more confident in our conviction level on the zero to

seven year part of the curve. I would say that even that zero part is less conviction because we are still not very sure of when exactly would the FED actually come in. I know the two presidents that they've set the moment that they very clearly see from the data that their tool mandate is in danger of achieving. I think they'll come in an act, or financial stability is at risk, they'll come in an act. Those are

the two presidents. We don't think that in the next two to three months those presidents are going to be met or either one of them. So maybe in the back half. But then as you get out from that zero to one year, but then try to get out into that three to five year mark, our conviction level is much higher that FED will be dubbish. And they have quite a bit in the toolkit to actually bring down and anchor down the front part of the yield curve.

So that's where most of our exposures are. And then you bring in the macro work that our team is doing. Then if you try to travel out from seven to thirty year part of the curve, a conviction level reduces because then the variables of demand supply, the variables of not having a very credible and sustainable deficit reduction plan, and then what does that mean for term premium in

the long end. Those are the variables that reduce our conviction level whether we'll be eking out or we'll whether we'll be able to eke out that dual mandate from the long end of the treasury curve. So that's how we are sort of going through our conviction level, traveling the key it duration parts of the curve, if you will, and then trying to make sure that we have the highest conviction in parts of the curve that we are

the most expressed. In another way simplistic way to say this, we are in steepeners, overweight in the back in the front end, and significant underweights to the twenty and thirty year part of the curve at the moment.

that part of the curve. So invest some great managers, for example, will never look at a foreign angel or potential for angel situation because then there'll be force sellers in that environment, or the other way around, where high yield investors are always very cognizant of rising stars because that eats away into that potential yield or a negative yield environment versus their benchmark or market capuit debt capated

benchmark that they have to beat. On the high l side, that becomes a fantastic high sort of alpha or high information ratio region for us, given that we have an analyst on both sides, and total return strategies allow us to actually take out alpha from this from this inefficiency. So I think we can talk about some of the auto sector names today which are very clearly priced for angel situation and is getting shunned by some of the

IG investors. That becomes a fantastic one for us. Again, Yes, we have to look at the fundamentals and valuations apart from just focused on the technicals of foreign angels and advising stars. The other big part, the second point that

we also focus on SAM is sort of differentiated. And that's why some of our results if you look back on the total return strategy of more consistent upside capture, more consistent avoiding the downside capture or standards being lower, is that we pick our best ized ideas from high year. We don't follow a sleeve approach. What do I mean

by that? Our high yeal team typically every year looks at or any typical year looks at about eight hundred two one thousand issuers and they dwindle it down to about three hundred approximately for their high yield only strategy, which is trying to beat a debt gap weighted benchmark.

What we are trying to do for total return strategy is we've built a process where we say that we don't want all those three hundred names because all those three hundred names might not have a total return catalyst today. So give us the top fifty to seventy five names that have a total return catalyst, are liquid enough and are in that single be low single bee to dower b range that they are actually providing much more spread pickup and you'll pick up versus what I could do

in the high yeal side. So if I can try to encapsulate some of the comments I made at the beginning of the call where best ideas, fundament technical valuations, and bottom up focus. This high yeer process then allows us to allocate to best ideas from a team that is already looking at best ideas for that high yeld strategy.

So looking at the higher teams information ratio and sharp ratios over years, and then you allocate in a way that you're picking out the best of their best if you will, and allocating to the total return strategy that in itself for every toller that can gets invested for the total return strategy in high YEO is much more efficiently used very similar to what we do in investment grade corporates securitize assets and then when we investment in

government balance sheets as well, so that mentality and process is scaled up in a way that it brings in those ideas into total return accordingly.

given sector. I think all of these limitations part one is trying to make sure that we are at any given point diversified enough for the strategy that there our clients are trying to allocate to. Also, I think we are very cognizant that our clients have a lot of choices. They have great sector funds at any given point that they can allocate to. So we don't want to be that sector fund risk reward that a client is trying

to get. So we will never be a high yeal fund, or a or an EM fund or a bank loan fund. I think that there are other fantastics str is that other parts of our franchise run, but I think this one is the best ideas both from a top down sector allocation as well as from a bottom up security

selection at any given point. So yes, our guidelines track all of that, and we have extensive sort of second and third layer of risk teams as well that keeps us in our success zone, if you will, so that we are not steering anywhere close to our gutrails of risk as well as diversification on that board.

non financials of fundamental balance sheet health. I know, Q one of twenty twenty three, we went through a regional banking scare here in the US, but at that same point, one of the big Jesent banks were actually getting upgraded in the second week after the crisis that we were going through in the beginning part of March of twenty twenty three. So I think a lot of the franchise banks have done a lot of hard work after the GFC,

and regulations have played a big part as well. A lot of them are now high quality single A banks. But when you look at what we are getting paid in terms of spread levels here in the US versus what we could as a franchise banks in Europe, quite a bit more spread compression potential as well as starting yield that you could get to. So yes, some of that banking exposure that we had was in European financials.

We could apply that same logic of cleaning up the balance sheet becoming a lot more debt holder friendly over the years after that twenty twenty twelve twenty thirteen crisis that that region went through. I think those banks are also very fundamentally strong and do provide that valuation pickup. So we were allocated to some of those sort of balance sheets in financial balance sheets in Europe during this time.

there as well. So I think all of those pieces had to be done correctly over the last three to five years, and that's what we've done. So quite a bit of our ETF trading today goes through portfolio channel. Quite a bit of our ETF today we are able to take about eighty percent seventy five to eighty percent of any creates and redeems in kind in our even man ETF. All of that is the byproduct of all the work that our traders, not only on the investment grate side, but even on the high yeld side that

we've seen that have done over the years. We're bearing the fruits of that. And then yes, I think some of the counterparties on the other side have done a fantastic job of allocating resources and allocating resources in a way that helps their partners on the other side. So liquid is better, but ask exactly is decreasing in the secondary market and the pinpointed risk exposures that you can get in a basket level are also very sort of

appealing to us as investors. Financials versus non financials, decompression trades, if you want to put up triple B versus double B on those sides, I think both those are also getting very liquidly done. So you can customize now to a level some of these portfolios and baskets so that you can sort of find junior risk exposures within portfolios in very liquidly.

It was just about uncertainty that we heard in this earning earning season at this point, and I think that one is sort of your next step towards before you start seeing some demand destruction from a labor market perspective as well as from a consumer and GDP perspective on the back half of the year. So profit margins is

another one. All that sort of that term will encapsulate sort of whether this inflation is temporary, whether balance sheets are able to pass down some of that inflation to consumers and small businesses on the other side, or are corporate margin is going to get start to get affected, which then is a precursor towards your labor market weakness coming through. So deficits and profit margins, those are the two spots that we have focused on.