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Hello and welcome to another episode of The Odd Laws podcast.
I'm joll Wisenthal and I'm Tracy Alloway.
Tracy, you know, we've been doing this podcast for ten.
Years, I am aware. Yeah, no, a whole decade.
And we've been doing episodes about big picture things and things that have changed and what's different now in twenty twenty five or twenty fifteen when we started. And some things are the same, some things that are different, etcetera. But I think, and we've mentioned this before, I think the one thing that could not be more different here's the raids environment. We were right in the middle of, like the zerp decade or the Zerp era, maybe in
twenty fifteen. Maybe at that point, the FED had tried to hike one time already and then the market sort of slapped it down and said, oh no, no, no, no more, We're not ready for more rate hikes, et cetera. The raid environment could not be more different than when we first started this podcast.
Absolutely. Can I say one thing about the anniversary, Yeah, so we started the podcast in November twenty fifteen. Yeah, we were going to celebrate for the month of November, but we're now in December, So are we going to make this a two month celebration.
Well, you know, we're having our ten year anniversary party in December, so I think it's allowed. Well's just believing, you know, it's allowed to bleed the ten years into both months, given that we're formally celebrating in December. I think this is how I'm rationalizing this framing for this conversation. Since yes, we're no longer we're technically no longer an anniversary month.
I guess it's our party and we can celebrate as long as we want however we want. But you're absolutely right about the rates environment, and you know you could see that if you go back and look at some of the old episodes. The other thing that strikes me looking back at the old podcast episodes is how many of them were about shadow banking, which of course nowadays recall private credit. And that's another thing that's changed enormously.
So the private credit market now basically rivals the public credit market in terms of size, and there's obviously a lot of concern about what that means. The outlooks lots of differences.
Lots of differences. Yeah, completely dramatic and setting aside the big picture questions, there are also some small picture questions, maybe how you put.
It, immediate questions.
At the time we were recording this, it looks like the December meeting is basically a lock that there's going to be a cut. But up until recently there was a lot of market uncertainty.
If we recorded this two weeks ago, it would have looked very different.
It would looked very different, and you know what happens after December highly uncertain on many dimensions the follow through for the rate cutting cycle. There have been increases in various credit concerns of various source. We've had a few small blow ups, but you know, nothing that big. But like what Jamie Diamond called the cockroaches, we mentioned it on the show that suddenly people are talking about credit default swaps uncertain high tech companies, which is very unusual.
But there's that's what Star Wars meme. I haven't heard that word in a long time, that's right.
But with the AI build out and how much that's getting financed by various forms of credit, suddenly people are talking about the fact that big tech companies are credits, which we don't really think about very much. And so there are some big picture of things, but also some things happening right here and right now that weren't further understanding and further explanation from the people who really understand
them absolutely well. I'm very excited to say we really do have the perfect guests, someone who we've had on the show before, but someone we love speaking to. We are going to be speaking with Dan Ivison. He is the CIO over at PIMCO, which of course everybody should know about. So Dan, thank you so much for coming back on the Outlaws podcast.
Thanks for having me, and congratulations on the big ten year anniversary. It's an honor to be invited back during this series of podcasts.
Thank you so much.
Yeah, very kind of you to say, let's start small picture. I think this episode will be out before the meeting. The market is saying it's going to be a lock. They're definitely going to cut rates. But beyond that, when you look into twenty twenty six, there's sort of two
different questions. There's the ongoing uncertainty about who is going to be the next FED chair, and then there's just the questions about how much appetite this existing committee has to continue a rate cutting cycle, So I'd love to get you know, what are you thinking about for the twenty twenty six and what we could be expecting.
Sure, so you know, we do think the Fed's likely to cut rates at the upcoming meeting. We also think that this is a FED that would like to get rates a bit lower into twenty twenty six. The challenge, of course, is that we expect to see a little bit of reacceleration in the economy during the first half of the year, and we also expect inflation to remain
comfortably above the central bank targets. So you know, we believe this FED when they say they're going to continue to focus on the data, we do think the data is.
Going to be a bit confusing.
The general view you know today at PIMCU, with significant uncertainty, is that they probably do get rates down another half of percent or so next year, which is close to
what's being priced into the market today. But again, if you see meaningful reacceleration in the growth data, and more importantly, if you see even a modest up ticket inflation, this FED, you know, even with a new chair, will will likely be willing to remain on hold and then I think the other point, and this came up with one of your recent guests, is that there's the front end policy rate and then there's the reaction out in longer maturities.
We do think there's a chance if this FED cuts aggressively into strengthening data higher inflation, you may actually get a selloff in the long end of the curve. So that could be a bit self defeating, and I think something that will be a topic into next year if we do get that reacceleration that we expect.
There's a lot you said there that I want to follow up on just in that one answer, but just very quickly, what is the idea, the gist behind why you expect dead Q on reacceleration.
Yeah, A lot of it's you know, related to significant momentum, you know, in terms of capital investment, you know, associated with AI as well as the delayed positive growth impact.
Of the so called Big Beautiful Bill.
A lot of the corporate tax extensions happened retroactively for the consumer of the household in many instances, you're going to begin to see the direct impact in terms of positive refunds coming into the new year. So again, you know, plenty of uncertainty, you know, a lot of cross currents in this economy, but we do think there's the chance that you'll get some moderate reacceleration in the first half
of the year. You know, we're looking at a growth environment, you know, for next year in the United States at least somewhere in the one and a half to two percent type range. So again that's an environment we're from a traditional tailor rule perspective. We don't think that the FED needs to cut a lot more from here, although you know, we do think that this FED, particularly with new membership and a new chair, would like to get rates lower.
Since you mentioned the new chair, this is more of a long term, thoughtful question. But obviously, for the majority of your career as a bond manager, I don't think FED independence has really been much of a concern, right. We certainly haven't seen the degree of headlines that we are seeing lately with Kevin Hassett emerging as the front
runner for the new FED chair position. How do you as a bond manager view that particular issue and do you have to start handicapping the way you invest because of this?
I think to a degree, I think if you go back several decades, you know, you can question the concept of FED independence a little bit, and I think even from the perspective of this fed's expanded mandate in recent years, what the market's really focused on is independence related to the setting of policy rates, which you know, of course have a direct impact. So from that perspective, we are
monitoring the situation like other investors. We do think less independent FED has implications, particularly in longer maturities, where you may need a bit more risk premium when you're dealing with uncertainty around FED independence. But generally speaking, when we think about you know, who's being considered for the FED role, including Kevin Hasseert, you know, we do think that there'll
be a general spirit of independence there. We still think, you know, the chair is one vote, so to speak, and we have a committee that will continue to focus on the dual mandate. So yes, it's a consideration, it's an input into our decisions. It's not a major concern. We do think that you know, the group that's being considered are you know, certainly highly qualified and will likely you know, continue to take a sufficiently independent view regarding monetary policy.
Let me ask you kind of the same question, but with a slightly different framing. It's December twenty twenty five right now, so we've had like over four years now, I think over four years now of the FED missing on its inflation on the two on getting inflation durably back to two And if the FED is going to continue cutting as it looks like it's going to do in December, that signals a further willingness to ease policy
even with inflation over its ostensible target setting. Aside the strict question of independence, do you think the FED, regardless even the current composition and the likely composition going to be forward, is just not going to take two percent seriously as perhaps it might have in the past.
Yes, that's a great question, and I think that in a general sense the two percent target matters, but not so much the current inflation rate. You're absolutely right. We've been operating, you know, and living with an inflation rate meaningfully above their target for quite some time. But when you look at inflationary expectations, and I think when you talk to central bankers you know here in the United States as well as outside this country, the inflationary expectations
piece is what's critically important. So when you look at longer term break even inflation rate, they've continued to be very very well behaved. You saw a bit of an uptick at the upbreak of the war in Ukraine, and then you saw an uptick around the tariff announcements earlier this year. But when you look at a ten year tip break even rate, just to use one of several proxies, no one measure is perfect, you're down around two and
quarter percent on CPI inflation. So to the extent that inflationary expectations remain well contained, we do think that the central banks willing to look through some of the more higher frequency data to the extent that you see those longer term expectations become unanchored. We do think that's a risk for a FED that's too aggressive in cutting rates here.
We do think that the mindset will change, not only the mindset of the Fed, but we think the market reaction could be counterproductive, not only in terms of higher long term interest rates, but an impact on risk assets as well. So you know, the markets have let the Fed get away with running fairly accommodated policy into a
three percent type inflation world. Because again, there are a lot of other forces at work that very well could be disinflationary over the long term, and there still is significant confidence in global central banks and being able to generally keep inflation close to the target on a longer term basis. So you know, again, so far, so good, but you know, this is all going to be a key source of uncertainty, you know, into twenty six and beyond.
I feel like uncertainty is constantly the keyword on our podcast nowadays, since longer dated expectations and yields keeps coming up. In this conversation, I got to ask, do you believe in the term premium or rather, is the term premium a useful concept to you as a big bond investor?
It is, and you know, when we look at you know, where we're going to invest, you know, we like to get paid for, you know, taking more risk. We do, you know, see an elevated term premium certainly relative to where we were five or ten years ago, and that's made longer maturity investments a bit more attractive. With that said, there's lots of reasons why the term premium should be higher. Inflation is one of them. Global debt levels, US debt
and deficit levels are another. We probably live in a world today given what's going on in terms of focusing on tariffs and bringing back supply chains, you know, to domestic markets, the need for you know, higher risk premium.
So you know, as a firm today, we we like longer maturity bonds more, but we're still you know, tend to keep our positions concentrated in shorter maturities, and we would expect over the next few years a little bit of additional underperformance in the very very long end of the yield curve. So we do think it's important. It's interesting people focus a lot on the deficit situation in the United States. As an investor, you don't want to lend to a perfect high quality credit you get paid
so much to do so. So in some sense, we want, you know, just enough fiscal irresponsibility where we and our end investors get paid more to lend, but not so much where it becomes a concern in term the overall viability of the system. So we think we're in the midst of that type of market environment today, but things can go a bit too far if we don't get the deficit or the inflation situation under control. Over the next couple of a few years.
Can you talk about the role of bonds in a portfolio? Again, this is something that in twenty fifteen, bonds fit beautifully into a diversified portfolio because they were paying something, but also they had that nice and verse correlation and so you got that natural hedge, et cetera. We haven't had that very like that beautiful inverse correlation between risk assets and bonds for a long time, which undermines one of the cases for the diversified investor of having like a
big slug of perhaps longer duration assets. How do you think in twenty twenty five, how do you sell the case that diversified investors should still keep some allocation to duration or fixed income.
Yeah, so it's interesting. I know this is a ten year anniversary show, so you know, went back it looked at the performance of bonds versus other things, you know, over the last ten years, and the divergence in performance over the last decade has been remarkable and it explains a lot. If you look at the S and P five hundred over the last ten years, in absolute terms, you generated a return of about fifteen percent a year adjusted for inflation. I think it's up close to twelve
percent or so I'm rounding a little bit. When you'll get the performance of you know, the Bloomberg aggregate index over that ten year period, the return annually has been below two percent in absolute terms. When you subtract inflation, you ended up with negative returns in bonds for ten years. So not only has the correlation broken down, but you
didn't make any money in owning bonds. When you look at the starting valuations today under any type of reasonable longer term valuation framework, none of which have to mean revert quickly, but you know, you look at a you know, a Schiller pe type arrangement or equity risk premium type argument. You don't need a great correlation on bonds versus equities.
What the relative valuations would suggest is that there's a good chance that bonds outperform stocks over the next five or ten years, or at least have returns on a risk adjusted basis very very close to stocks. So you don't have to rest on a correlation argument. You know, you don't have to focus on well bonds do well during periods where people are losing their jobs or you know,
income growth is negative. You can just from a pure valuation perspective, find the acid class quite attractive absolute and relative. I think the second point around correlations is that correlations between stocks and bonds will tend to break down when inflation is the primary risk factor. Today, yes, inflation is above central bank targets, but there's a lot of uncertainty
on the economic side. You do have this complex economy where tremendous value you know within the tech sector, tremendous capital and investment, yet lower income households are feeling considerable pain. If AI is very very successful at increasing productivity, that could mean significant job loss across key segments of the economy. So the bottom line is that risks are more balanced.
We don't think correlations are going to ever come back to the really, really neat clean levels you know a decade or so ago, when inflation simply wasn't a problem at all, you know, across the global economy. But we have seen correlations improve a bit, and we would expecting to go forward basis correlations to improve further. I think it's important again to look at a global opportunity set. I think that the correlation arguments are stronger in areas
of the world that have the best fiscal position. But in general, you know, not only do we think that the valuations are quite attractive, you know, we do think the correlations will be a bit better certainly that we experience.
It's coming out of the culture tray.
Twenty fifteen, bonds were an easy sell. It turns out they weren't the best investment. Twenty twenty five maybe a harder cell, but the math says that now is actually the time to expand your exposure.
Well, I guess in ten years when we do the twenty year anniversary, we will be able to judge. But Dan, you know, since we're talking about why people should buy bonds, one of the surprising things that happened this year was we had the big tariff drama and we saw markets go down, We saw a bond yield spike. Everyone was talking about the sell America trade. So this idea that you didn't want to hold onto US assets because of
all that policy uncertainty. And now you know, in December twenty twenty five, yields have come down quite a lot, although I have to say the dollar is still fairly weak. You were always kind of resistant to the sell America idea, and you pushed back on it. What did you see that perhaps others didn't.
Well.
Again, I think a lot has to do with starting valuations. After a significant period of underperformance across the US fixed income or global fixed income, you ended up with a decent valuation cushion. So I think that's always important in markets. Yes, there was news that in a narrow sense was negative for bonds and negative for US bonds or US assets in particular. You started with a decent yield cushion. You know, we began the year, you know, with yields ten year treasuries,
you know, up near five percent. A five percent yield even in a three percent inflation worlds not that bad. I think the second point, though, you know, we weren't overly convicted in just owning the United States. And I think if I could, you know, you're part of the most important thing I can say today is that global bond investing is back. For so many years, capitalists poured into the US markets. It's poured into the US markets focusing on private credit, you know, which has grown you know,
the most here in this country. But very very quietly, you've seen underperformance across the global fixed thing come opportunities set where today even you know, from a US dollar based investors perspective, there's great yield, great sources of diversification. So it's not that we were, you know, insistent on just owning US assets. In fact, we've gradually diversified into
other areas of the market. We just thought that there was good value and good yield in the US, a sufficient cushion, and then by extending into these other markets, a great way to generate incremental return by good old fashioned relative value trading in markets today that are less correlated than they were during those years coming out of the global financial crisis and where you just have a really really exciting time to troll dual fashion training across
yield curves, across markets and avoid what.
Changed because it seemed like, you know, it felt like international investing across any acid class was like a real suckers thing. It's like, oh, this is going to be the year that we're going to diversify internationally. You didn't get paid at all for it. Flipped such that actually both stocks too, because international equity markets have done very well and have outperformed the US. It's kind of surprising
in many respects. But what switched such that now there's been real opportunities to make money.
Looking abroad, Yeah, well again, valuations have improved. You know, we talked about, you know, the real poor performance of the US bond market over the last decade. As we all know, yields were outright negative in many areas of the world, So we talked about low yields. You subtract that low inflation rate, you end up with a negative number, and big portions of the global fixed income opportunity set you'd have to subtract anything you started with a negative number.
So a lot of this has just been the repricing of markets that started not only at low levels, but negative yield levels. Then the second piece relates to policy coming out of the global financial crisis. Not only were yields low, but you've had such incredible policy activism where on any signs of economic weakness you had a massive fiscal response, a massive monetary paul response COVID, you know,
the ultimate example of that. And today, you know, with debt levels and deficit levels where they are, policy makers don't have that flexibility. So you're back to an environment where markets increasingly have to stand on their own based
on fundamentals and that's just an exciting time. It means more risk premium in markets, more term premium, higher yields, with significant valuation cushion absolute and relative to what looked to be quite expensive equity markets, and then just less correlation. You have situations even over the course of the last couple of months where a political surprise in Japan or
France creates lots of local volatility in those markets. Uncertainty and French politics impacts UK politics because they have similar challenges in terms of getting their deficit situation under control in economic productivity higher. So it reminds us a lot more like the mid nineties, you know, back before you had this massive volatility, suffocation from policy, and again with deficits where they are, with inflation where it is today
versus central bank targets. It's likely that over the next several years, you know, you're going to continue to be in this type of environment good value, good relative value, and then much less correlated markets, which you know lead to you know, some some good opportunity to generate incredential return above starting yield levels.
Well, we wanted to talk about private credit as well, because, as we said in the intro, this is one thing
that has changed quite a lot since twenty fifteen. People obviously have different characterizations of private credit, but I'm curious how you think about that space and how you would define or how you would measure things like transparency and opaqueness and customization in the credit waterfall and things like that, because again, one person's extremely transparent market can be another person's opaque morass of potential defaults.
Yes, I talked for the rest of the show here in this topic. First of all, surprise it took this long to get to the private credit topic. But look at you know, not much of this is new. You know, when I joined PIMCO back in the late nineteen nineties, I spent the good portion of my initial time at
the firm focusing on the underwriting of private assets. You know, we call them pure privates, but these were you know, four A two privates that were created as part of the Securities Act of nineteen thirty three, one forty four A privates, which are quite popular. I think the first one was issued back in nineteen ninety. The technology that's being utilized to fund AI infrastructure today, some of these off balance sheet contingent or make whole guarantee type frameworks
were around in the mid to late nineteen nineties. The difference today is that you have this massive capital investment need, so the deals are larger, but a lot of the technology has just been dusted off, so to speak, for the new era. And the other point that's important, and when we're talking about historical returns, I think this explains a lot, is that what's been so unique in terms of credit asset performance in general has been the post global financial crisis period. Well, we have it at a
sustained period of economic weakness. In fact, one of my favorite data series is looking at how lower quality lending performed since way back during the Michael Milken days when
he helped to create that market. If you go back to the early nineteen eighties all the way up to the global financial crisis, if you had just blindly bought the lowest quality credit that's out there proxy by high yield senior secured loans direct lending blend the index, you would have ended up with only about a half a percentage point of incremental performance versus high quality bonds over that entire period. And the way it worked was that
you made a lot of money. You have a lot of money, a lot of money, a lot of money. Then you gave it all back. Then you made a lot of a lot of lot, gave it all back, and we'd go back to the late eighties when you had
that period initial period of aggressive underwriting. You had the savings and loan crisis of the early nineties, you had the LTCM or the Asian Financial crisis in the late nineties, than the Internet bubble and the telecom issues of the early two thousands, then of course the Global Financial Crisis.
That was a more normal credit environment since the GFC just blindly buying the lowest quality credit on the board, whether it's private credit or lower quality public credit, you generated seven percent a year more than high quality bonds, and that explains a lot. Not surprisingly, you've seen massive growth in that area of the market. Now, you know, weaker credit tends to perform well when stocks go up fifteen percent a year. But again, you know that's where
we are today. I hear all the discussion about God, you know, underwriting's worse than the public side versus the private side. The reality is, when you've grown this much, when you've lent so much money to weaker quality borrowers, when covenants have weakened, when spreads are tight, when equities have gone up consistently as much as they have, you're going to have challenges in these markets. So when we think about credit, we look at it under sort of
two continuums. One liquidity. Certain assets are completely illiquid. The only decision you get to make is the purchase decision, so you better be right. And then at the other end of the extreme, you have very very liquid assets where you can change your mind on a regular basis. And then you have economic sensitivity. You have assets that are very insensitive to the economy, that are very very
high quality. Then at the other extreme, you have assets with a tremendous amount of economic sensitivity, a tremendous amount of sensitivity to AI related disruption, other forms of economic weakness, an anticipated competition, and you just want to make sure you get paid enough. And with stocks near all time highs, with spreads tight, with covenants weak, they are going to
be problems. And I think as an investor, you just need to acknowledge that you're not getting paid what you got to take that risk five or ten years ago, and you just want to be defensive. You want to be skeptical, But it's not so much private versus public.
I think it's just thoughtful underwriting and just understanding that we're at a time where, given the strong historical performance, given the fact that we haven't had a sustained period of economics slowing for a long time, some complacency has worked their way into these higher risk areas.
Of the market.
Well, talk a little bit more about competition in private credit, because I imagine it's good to be PIMCO when it comes to sourcing deals and maybe negotiating the terms. But does even someone like you, a truly big bond manager have to deal with competitive pressures where if you don't agree to one bond term, someone else will swoop in and agree to it and take it away from you.
Absolutely.
And again, I think the other point about public and private markets is that they're well integrated. You know, we could talk about convergence, you know a bit a bit later, have have some views there.
But you know, when an.
Issuer looks at their options, they're going to test the public option, they'll test the private option. And there is a lot of competition, a lot of competition for market share. When you look at a lot of the managers, particularly in the private credit space, they announce very very aggressive growth assumptions. You know, as an investor sometimes you know, I wish in certain quarters people would talk about, you know, if we can find value for the end investor, we
will grow this much. All too often, you know, after a pretty bullish environment for credit, it's was simply going to grow a lot. So you know, we do see time and time again situations where you start the underwriting process, you get down to the point where it's time to get into a final round and you don't get the terms that we feel we need as extenders of credit
in this marketplace. And that's just again symptomatic of the fact that there's a lot of demand for these assets and there's a lot of demand relative to the supply across many segments of the market. And that's true not only of below investment grade risk, but it's very very true of certain transactions with an investment grade rating, at least from a rating agency. So you know, given tight spreads, given the competition, you just have to say no. And
I'll go back to my earlier point. What's so exciting about this market today is that you do not need to take on aggressively underwritten credit to generate return the high quality area of the market, especially if you expand globally. If you take advantage of liquidity, which typically means flexibility for end investors, you can have a high quality portfolio where you don't have to sacrifice return. Very different than where we were ten years ago, but again pretty exciting.
Now we can go up in quality without again giving up return and in some cases ironically picking up expected return.
I want to go back to something you said, and I didn't quite get it, but I think it's important, and of course it's very interesting to our audience. You're talking about the AI financing, and I think you said something contingent, makehold guarantees. I don't tell us about these
financing as you see them. And what is the history, How novel are they relative to past financings, or how much is it that these are structures that were very much in place for something else are now being reproposed into this new exciting area.
Yeah, I'll start with what's new, which is lending to support the growth and AI and related infrastructure.
There.
You're talking about several trillion dollars of investment need. So that's what's new, But you know what's not so new is this idea that companies would like to keep a good portion of their debt off their balance sheet or come up with structures that limit their overall financial liability or give them some flexibility to manage that liability over time, and as an end investor to lend to those companies.
You know, it's important to acknowledge that lenning against tech firms, lenning against AI infrastructure, lenning against AI chips is risky. That could be a real good investment if you own the equity, may not be a great investment if you own the bonds, where at most you get your coupon and you hope to get par back at the end
of the day. So a lot of the underwriting of these transactions, and there have been a lot and we expect a lot more to come over the course of the next few years, is to understand the form of that guarantee and understand the entity that's providing that guarantee, whether it's in the form of lease payments or other type of makehold type arrangements. And these types of structures are what have been around for many, many years. You know,
back in the mid in late nineteen nineties. You know a lot of times these would be done by Wall Street financial institutions, sometimes across a segment of their business where they would use a corporate guarantee to arbitrage a bit of the radio agency frameworks. At other time times these deals were backed by large ships, equipment, other areas
of the market. So it was the same type of analysis, the same type of underwriting checklist, which involves a lot of lawyers to ensure that you understand the guarantee how you have to realize on that guarantee, and that's not so different today.
And just to be clear, the guarantee we're talking about here is okay, here is a hypothetical SPV that owns a data center and it borrows money and finances, et cetera. And the guarantee question is how much will the tenant of that data center, which didn't want to have all that DEBTA on their books, maybe like a Facebook or one of the hyperscalers, how much are they actually committed to being a tenant for the long term They're basically that's what we're talking about.
Absolutely correct. And why it matters here is you're typically talking about investment grade rated counterparties on these transactions where the infrastructure itself, the assets that are partially backing the d a lot of stablone basis would achieve a very very low rating. So how do you create a structure where you improve the credit quality while meeting the needs of those that are looking to borrow within this market.
So again, the whole key is to make sure that something that the radio agencies may assign investment grade rating too, is in fact investment grade from a fundamental credit quality perspective. And I think that's another theme. You know, in talking about private credit, you know there are more economically sensitive, lower quality loans, and then there's been a lot of
growth on the investment grade side. It is very, very dangerous to assume something has an investment grade rating just because of the rating agencies assign a rating to it. It's critically important that you do your own credit work. Today, all too frequently you will have an investment grade rating from one entity. And again, market participants for years have always joked, if you can only find one investment grade rating, it's pretty fair to assume everyone else's below investment grade.
So the bottom line is that there's been a lot of aggress of underwriting going on, even with instruments that carry an investment grade rating at least from one entity. And again when spreads are tight, when documentation is relatively weak, it's just critically important that you do your own fundamental credit work. I do think Pimpco has some advantages in that area, both in terms of experience and resources, but it's super important because you're not always getting the terms
that you want. When you do, you can unlock tremendous value for your clients. But this is an environment where we have to be really really selective as a bond investor at least.
Yeah, when I think back to the twenty fifteen environment, I remember a lot of people were writing stories about
the triple B bubble in investment grade. So Triple B is the lowest tier of investment grade and that had been absolutely exploding post financial crisis, and everyone expect not everyone, A lot of people expected that to end in tiers, and instead it ended with all those like Triple b's getting upgraded and a lot of junk getting upgraded as well, and having a bunch of rising stars, which I don't think a lot of people were necessarily expecting, but talk
a little bit more about the rating agencies. What are the pressures that you think are perhaps driving them to rate some of these structures higher than they otherwise might be.
Well, again, there are multiple radio agencies that have different philosophies to how they arrive at a rating, and there's going to be understandable disagreement, you know, within markets. But issuers are quite shrewd. You know, they're going to go
to where they get the most favorable ratings treatment. This has always been the case, and I think the important point to notice that when stocks are going up fifteen percent a year, when the economy is growing, when you don't have a sustained period of economic weakness, even poorly underwritten credit will mature. We experience that in an extreme sense,
you know, during the two thousands. What we try to do, is active investors is to underwrite two weaker economic environments, environments where you know those underlying entities or the infrastructure you know that you that you're lending against go into a period of weakness. And I think that's where you know, good fundamental credit work in this type of environment that we're in today that's very much driven by rating arbitrage.
You know, seeking out investment grade ratings, you know, for an insurance balance sheet or reinsurance balance sheet as an example. You can lead at times to aggressive decisions. So I think it's just a nature of the fact that you have multiple agencies and some will be more optimistic in certain areas than others.
But that's great.
You know, if we didn't have those sources of disagreement, that wouldn't be opportunities to generate incremental return, you know, versus passive alternatives.
While we're here on credit. Actually, you know, there's probably about a month ago or a month and a half ago, that's when we were getting all those headlines about tree color. And that was when Jamie Diamond made the sort of famous crickets thing. I was getting real corea cockroaches.
I hate cockroaches and I like crickets, So I want to make that clear.
Crickets are lovely. Yeah, right, I should not associate them with credit blow ups. That's completely unfair to crickets. It's fair to cockroaches. Jamie Diamond made those cocker I was getting worried. I saw all these heads like going another antity took a hit on this another entity. I was like oh, this is very familiar. I don't like I don't like how many times the same company appears in the headlines. But we haven't gotten that much actually since then.
It's not like there have been five more of those. I'm just sort of curing is setting aside some of the data center, the sexy private credit stuff that everyone's focused on. Do you do you think over the last several years, was there some systematically bad underwriting going on, especially over the last few years, or were there isolated cockroaches the first cockroach before they had a chance to lay eggs and make babies, the lonely cockroaches.
Yeah?
Yeah, So look again, because there's been so much growth in lending to lower quality companies, and again, the last major cycle was lending to lower quality households. Yeah right, you know, there's going to be areas of excess, and I think people are focused on these areas.
But again, when you look at.
The cumulative delinquencies and losses, yes they've increased a bit over the last few years, but these situations have been relatively isolated. But again, anytime you've had this much credit expansion, you're going to have challenges, and these challenges are happening in a relatively strong economy, so we don't think this
will be a catastrophe. The word I've used is that there's likely going to be disappointment in certain areas of the credit markets that have performed exceptionally well over the last ten to fifteen years. But that shouldn't be viewed as an overly controversial statement. That's how markets work. You know, credit was very cheap ten or fifteen years ago, high
quality bonds were very very expensive. Today, credit spreads are near all time tights, equities are near all time highs, and valuate high quality bonds looks reasonable relative to their history. So you know, starting valuations tend to be pretty big drivers of future turns. If the economy continues to grow, if stocks keep going up fifteen percent a year, yes, these will be relatively isolated situations, but if you get into a period of economic weakness, losses will go up
and they'll likely be some disappointment. I think that's the best way to categorize it. And then I think the second important point when you look at markets in a longer term historical context, is that regulators hate bailing out the same sectors twice back during the GFC, it was lending to the consumer. It was excessive lending from the banks that caused all of the problems, almost took down the financial system, and not surprisingly, the regulations towards the
banks and towards consumer lending was massive. And today when you look at the world, the household balance sheets, certainly middle income and above cohort groups hasn't been stronger this strong, and several decades there's record amounts of borrower equity in these areas of the market have been very, very strong.
From an underwriting perspective, the areas that escape the scrutiny of the last time, you know, a lot of lending to non financial corporates, a lot of this mid market private lending that came out of that period relatively unscathed from a regulatory perspective, has grown a lot. So I think a lot of this just relates to longer term cycles.
PIPCO is talking in a much different way back in two thousand and five, in two thousand and six, where we were screaming from the rooftop saying that you know, what was going on was so irrational that there were major problems ahead. That's not where we are and That's why I sometimes sound a bit more negative than we are. I think that the idea of disappointment is the way people should think about some of these areas of the credit markets. And the good news is you don't have
to accept disappointment. You can simply accept the fact that you had a great performance run and that by going up in quality, expanding into a global opportunity set that hasn't been sufficiently embraced just yet, perhaps voting a little bit of non dollar exposure gets you in the same place with much more resiliency, much more downside protection, and a lot more liquidity or flexibility to change your mind in the future as well.
Since you brought up household balance sheets, can you talk to us a little bit about your housing outlook, because I believe PIMCO has been pretty bullish on mortgages recently, but at the same time we've seen a slight slow down in the housing market. But then again, we still have long term structural tailwinds, such as a massive undersupply
of homes in the US. Where do you see that going in the coming years, particularly, you know, if we were to see inflationary pressures start to pick up and those longer end yields start to rise.
Yeah, so we are very bullish on housing related investments in the United States as well as in other areas around the world. Agency guaranteed mortgages still traded very widespreads relative to corporates. Even in an absolute sense. We think it's a very high quality, liquid area of the market that again makes a lot of sense to own a cross a variety of different mandates. We also like lending in the non guaranteed area against the house simply because borrowers have record amounts of equity.
So when you lend its collateral. Yeah, that's what it sounds like. You love collateral.
Yeah, we like good documentation and good, good, good collateral. You know, at least all else equal. But you know, it's not a major bet on the directionality of homes. When you're lending against a household that has seventy percentage points of of borrow equity, your home can go down quite a bit and you're very well protected. That same dynamic exists you know, over the UK, across Europe, you know,
and even in other parts of the world. So you know, again regulators don't like building out the same sectors twice that's pretty good acid allocation advice. It's quite straightforward. But also, you know, you have much better fundamentals across households. But to your specific question around housing, it's a tough situation. We do think that homes are going to remain elevation from a valuation perspective, and affordability is going to remain
quite constrained because there's no easy answer. You know, you bring the mortgage rate down, the home price goes up. You know, affordability doesn't change in a meaningful sense. What we really need in this country and other parts of the world are more homes, more housing units. And again because of a lot of the post global financial crisis regulation, it's been real hard to build new homes. So our base case view is that home price is going to
moderate here on a national level. You could see, at least in real terms, you know, some steady declines over the course of the next several years in certain markets that are a bit overextended, you know, a bit more volatility. But we do think that you know, home price is going to remain elevated from a historical perspective, just because of the fact that people have locked in very, very low mortgage rates thirty years, you know, not just five or ten years. You know which which we're you know,
mortgage durations, you know, popular pre GFC. So you know you're not going to see you know, two much turnover. And unfortunately that means that homes for you know a lot of younger Americans are going to remain out of reach. But but again, maybe some incremental benefit, maybe you know, this administration get mortgage rates down a bit through some creative policy the next couple of years. By the way,
we'd like that given pimco's current positioning. But again without without building new homes which are going to take you know, many, many years. You know, there's no easy solution.
I want to go back. You mentioned this idea, there's there's an optimal amount of fiscal profligacy from the perspective of the bond investor. Maybe you want them to push it a little bit because then you get paid a little bit for taking it on. But obviously you don't want them to push so forth where you get some fiscal dominance spiral leading to higher and high inflation. You want to find that sweet spot, you know, I mentioned we're talking a little bit about politics, earlier about whether
independent central bank can be sustained. But when you look abroad, you know, it seems like in a lot of pretty major current we're not the only country that's having political volatility these days. We're concerned about the approach that the new Japanese PM is going to take it. So we know that rates are higher in Japan. France, very indebted country. They seem to have like a new government every two weeks. I like lose track of all the times their government
collapses and so forth. The UK, very indebted country. The moment anyone takes office, their approval ratings plunge to negative thirty or whatever. There's a lot going on on the political front, and that sort of determines whether countries are even it's even possible to run what might be more
responsible fiscal policies. Is that something that I don't know keeps you up at night, is the right term, But is that something that's a big part of your work is trying to understand, especially when you think abroad, understand the political dynamics and all these countries that are happening right now.
Yeah.
Absolutely, And you know we get together once a year, you know, talk about the outlook for economies and markets over a five year type timeframe. And you know, one of our advisors I think put it well was that, you know, we used to live in a world where you know, economic outcomes would drive politics. If economies were strong, you know, politicians usually ended up in a in a good situation. They're they're, they're, they're, they're, they're stay in office.
Today it feels like it's a bit reversed where political priorities, geopolitical tensions are driving economics. And I think you see that to a degree with tariff policy, you see it, you know, to a degree with with various forms of reassuring. You see it in terms of these populist tendencies across markets. So they're all very, very important and a lot more
important than they were in the past. And I think it takes a lot of humility from someone like myself and others that grew up you know, doing you know, discounted cash flow analysis and you know, derivative pricing as
opposed to understanding the political economy. So you know, we think that that's important both from the perspective of gaining in edge in markets, but also understanding that sometimes will be wrong and when you're running the debt levels that countries are running or your deficits in overall debt levels,
there's going to be some unpredictability. And that's why this idea of looking to exploit a global opportunity set prudent diversification targeting some countries outside the US that aren't running you know, six seven percent deficits, and there are high quality countries out there, Australia being an example, Germany being another example, even the United Kingdom, although they have a lot less policy flexibility than we do, given that there
were smaller open economy with their own currency offer attractive yields. So this is less about picking your favorite country from our perspective, it's more looking at take advantage of attractive opportunities around the globe, with some tilt towards those countries that are balancing their budget and that do have a better overall fiscal picture. And we haven't talked about emerging markets,
but they are. You know a few emerging markets that you know, this cycle got ahead of inflation, that have been in some sense more fiscally prudent than their developed market counterparties, and that have very very high yields even
ad just for inflation rates. So even some diversification in some of the higher quality areas of the emerging markets, from our perspective, represents real good value or real good sources of diversification in return versus some of these assets you know here in the United States that have performed real well historically, but where when you look at the likelihood for forward performance just just look a little bit less interesting.
Actually, this reminds me thinking back to twenty fifteen. Twenty fifteen was actually a big year for PIMCO because it was your first full year without Bill Gross, right, who left in late twenty fourteen. Can you talk to us perhaps how the culture of PIMCO has changed over the past ten years, and how you would describe that evolution, because I imagine it's been a long time, it must have shifted a little bit.
Yeah.
Look, well, you know, the way Bill left the firm was an ideal, to say the least. But you know, Bill left us in an incredibly strong position. You know, he created a lot of the frameworks that we still use today to make decisions. Bill was a strong personality, but he believed in teamwork and believe that investing was a team sport, you know, so to speak. So from that perspective, there didn't need to be a lot of
change or certainly not radical change. But over this period, you know, markets have become you know, so much more specialized. Client needs have evolved, you know, over time, the introduction of a more sizable private opportunity set has been important. Technology, big data, using you know, trading techniques, portfolio trading in other automated you know type, you know, trading strategies are
all critically important. So you know, we're a much more specialized firm today, which is a function of again, you know, evolving client needs, but also just you know the realities of this world that we live in today, where data is abundant, much less expensive to access. So from that perspective,
we've needed to adapt, you know, even more global. So you know, we tend to utilize regional committees in regional decision making structures, but a lot stayed the same at least in terms of mindset, and we try to really leverage you know, the history and the experience the firm
has had managing and navigating through more challenging markets. Twenty two is rough, you know, from both stocks and but you know, in general, you know, the environment's been reasonably forgiving, but you can always get into these you know, tougher periods, and again we try to use these structures that you know, build put in place and buill deserves.
Trying to about a credit for.
It's funny in your last answer there there were like five things you said that could merit full follow ups or even full follow up episodes, like about changing client needs over time, or what happens when the cost of data goes from costly to fairly affordable, et cetera. All those sort of interesting things. But just my last question,
and it sort of relates to technology. You know, when it comes to AI in investing, we've talked a little bit more on the short term like high frequency side and the sort of models that they use and the signals that they use, and how that sort of relates to AI and their application. But for a firm like PIMCO and when you're thinking about longer term holding periods and you want to have some a good collateral and
good documentation, et cetera. Currently today, have you found ways to apply cutting edge AI technology to the process of good security selection.
We have, and we're finding ways to utilize the technology at an accelerating rate. We do some of this and some of our you know, more quant focused strategies, you know, where we look to use AI to actually drive alpha, But just AI as a tool to drive efficiency has been will be critically important to managing an investment platform.
Just the ease in which you can access data that you can use AI to help support overall analysis, both at the company level, the individual investment level, but even coming through economic history and understanding some of these geopolitical trends in themes that are hard, at least intuitively to grasp are going to be critically important. In fact, before our discussion today, spend considerable time with our head of technology and our head of implementation talking about various firm
wide initiatives. And I think the only other point is my own use of AI, both at home and at the office has gone up almost exponentially over the last year or two. And I'm the last person you want to rely on to understand this technology. It's the younger folks that we hired over the last year that are
helping us with a lot of this perspective. So this is going to be quite disruptive, probably productivity enhancing, you know, at the economy wide level, but it's also going to lead to considerable disruption, and it's important that we don't get disrupted and that we use this technology to drive client returns. But you know, it's going to be important in so many ways and we're really really embracing it here here at Pimco.
Dan Ivison, thank you so much for coming on odd Laws. That was a fantastic conversation. Really appreciate you taking the time, and we're going to check back in with you in twenty thirty five and see how well you got how well one got paid for taking a little bit of duration here.
Great Joe Tracy, thanks again and correct congratulations on the big milestone and so much.
We thank you so much. Dad really appreciate it.
Thank you guys, Tracy. I thought that was greatly I really enjoyed talking to Dan. Fantastic overview.
Yeah, so a couple of things stood out to me. So number one the idea of no more free lunch and credit, although people have been talking about that for a while now, and obviously with the great environment changing, you can see that argument. The other thing that I really liked was his description of policymakers don't want to bail out the same thing twice.
Yeah, that's interesting framework or way to think about it.
Yeah.
Absolutely, And it kind of reminded me of there's another person in credit who used to tell me a line about how he invests, which is follow the bad guys. Right, So, like the guys that blew up in one part of the market usually, you know, start doing.
Something to act, they're going to get their acting. Are you saying they're going to get their act together? Or they're going to do something I'm saying, they.
Move to the new thing, and then that blows up. And so if you can just identify the bad guys and just follow their career trajectories, just short everything the bad guys do.
I love that. I love that take.
You know what was really I had not realized that stat he said about how little you got paid for taking for buying poor credits up until the GFC. Yeah, and then post GFC is just totally flipped that you just got you should just go as far out on the credit at risk curve as you possibly can, and
you've just walloped anything safe. And I knew that, I guess on some level, but the extreme of that statistical divergence, but you know, you have to think we had that well it was more than a hiccup in twenty twenty,
but we did bounce back very fast from it. So really what we were looking at is, you know, well over fifteen years now of the lines just going up, and you have to think about what are the things that accumulate over that time, or the patterns that accumulate, or the habits, etc. And this idea that there's a lot of safety at the far end of the risk curve and that people don't care and that maybe now some of the perception that there's safety at the far
end of the risk curve and how much that's been burnished into people is very interesting.
Absolutely. The other thing he said that I thought was very poignant was the idea of you have all these private credit firms starting up right and promising these astonishing returns for investors. And he made the point that, like, you can't just say you're going to make all this money at private credit because like those deals might not be out there and available to you. You have to
do it on a risk or value adjusted basis. Yeah, and as I say that, I see a headline in Bloomberg about Capital Group getting into private credit as well. So this is the thing. Like it's a booming market. There are a lot of competitive pressures, both on the lender side and also on the credit rating side, and you can see people really scrambling to get into the market and accumulate as much as they can. And so the temptation, of course is to you know, accept lower terms,
accept lower quality totally. All right, shall we leave it there.
Let's leave it there, all right.
This has been another episode of the Odd Loots podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway.
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