Legg Mason : In Value-Challenged Fixed Income Markets, Western Asset Advises Investors to Stay Disciplined and Get Smarter

Pia Hahn Madelyn McHugh

(626) 844-9520 (212) 805-6039

Pia.Hahn@westernasset.com mmchugh@leggmason.com

Finding Opportunities Entails Expanding the Fixed Income Landscape

"There is opportunity in fixed income," Mr. Buchanan observed. "We still emphasize the spread sectors, but we are taking some risk off the table. If you were bullish three months ago, all else being equal, you have to be less bullish today solely based on valuation. We are, and we are recalibrating our positions."

"Valuations have shifted from meaningfully cheap to fair. Fundamentals are showing slight evidence of decay, but it's not overly alarming. We have implemented risk reduction strategies across our portfolios, generally through select issue sales as well as certain sector rotation."

Returns across nearly all fixed income categories this year have been strong. And with that in mind, "we ask, is there still opportunity left? Does value remain? The short answer is, yes.

Although it isn't as obvious or emphatic as it was only three months ago. To find real value in this market you need to stay disciplined. Consider each sector of the credit market and the forces driving their valuations. And don't necessarily expect to find opportunities in those areas or portions of the market that have been so rewarding previously."

He cited bank loans and local emerging markets as being the areas where Western sees most opportunity presently.

"We do see select opportunities in structured products," he said. "One to note is commercial loans. Specifically, CMBS spreads have actually widen (become cheaper) as high yield corporates, non-agency mortgages and BBB corporates have all rallied."

Watch the replay from September 22 and download the slides from the Western Asset webcast, "When Value Gets Harder to Find, Stay Disciplined and Get Smarter."

When asked about the credit cycle, Western Asset believes the current cycle is unlikely to experience a significant downturn in the near term.

"We don't see a turn in the credit cycle any time soon," Mr. Buchanan explained. "We've been saying this for a while, but we think this particular cycle has longevity. We do not yet see the signals that would indicate that this cycle is going to turn within the next few quarters."

The macroeconomic themes supporting Western Asset's market view have not changed much.

"As we've been saying for a long time, the global recovery is in process, it's on track, although the pace is miserably slow," Mr. Buchanan said. "We certainly appreciate that the risks are to the downside. This environment will continue to engage central banks, and the accommodation we've seen over the previous four or five years will still be with us in various forms."

The moves of the U.S. Federal Reserve are always a concern, which Mr. Buchanan addressed.

"We think Fed hikes are going to be limited," he said. "Growth has to hit the targets the Fed is looking for; they are watching inflation expectations very closely; and also financial conditions. Until we get improvement in all three of those, we think any kind of meaningful rate hikes going forward are unlikely. So we expect this very low rate environment to persist for some time."

Despite sluggish growth overall for the global economy, Mr. Buchanan noted that, "fixed income results have been impressive to say the least, especially since February. It's surprising to see where we are on a year-to-date basis. If you look at high-yield, we are up over 14 percent year-to- date. Good luck finding anyone who predicted a mid-teens type return or better for high-yield."

"U.S. investment grade started the year with a yield of a little over 3 percent. That we generated year-to-date returns over 9 percent really is something. Emerging markets, perhaps the most hated of the credit markets going into 2016, has also registered very solid results year-to-date."

To Mr. Buchanan, the current fixed income landscape reveals some clear observations.

"I think there's one conclusion, actually probably two," he said. "One is there certainly is a lot of debt you would not call fixed income - you would call it 'fixed loss.' Secondly, if you want to go where yields are, where income is, the U.S. sticks out. If you want any kind of reasonable yield, the U.S. is where you have to be. That's not surprising. We've all heard this story about how the

U.S. markets are attracting overseas money. We are seeing it in various forms."

"We think of the market as a three-legged stool, the three legs supporting it being technicals, valuations and fundamentals. Until recently, are three legs were equally strong. However, now, technical conditions have taken over as the strongest leg of that stool, while the case for fundamentals and valuations has abated somewhat. At Western, we are always looking for the advantage that we get from a combination of a supportive fundamental backdrop, compelling valuations, and robust technicals. It's one of the reasons why we've taken some risk off the table more recently."

Mr. Buchanan suggested that investors look at fixed income from two different vantage points: from a yield perspective, and on a spread basis.

"Not surprising given the ultra-low-yield environment, most fixed income markets - from investment grade through high yield - on a historical basis are trading at very low yield levels."

"But when you look at it on a spread basis, it's not as stressed or stretched," Mr. Buchanan noted. "A few markets stand out: the credit markets in general, but the two markets that we are going to hone in on are U.S. loans and emerging market local bonds. Those areas we've been increasing allocations to. They stand out as outliers and compelling opportunities in this market. We also talk about structured product, where there are select opportunities."

Mr. Buchanan went on to compare bank loans with high yield.

"If you look at the overall spread of bank loans, it's compressed quite a bit to high yield," he said. "The actual yield advantage you giving up to go from high yield into bank loans, depending on how you measure the bank loan yield, is probably only in the area of about 40 basis points to maybe 60 or 70. So you're not giving up a lot of yield to be senior and secured."

The floating rate aspect of bank loans is also proving compelling to the Western Asset team.

As Mr. Buchanan explained, "LIBOR is increasing lately. A lot of the bank loan market had LIBOR floors embedded in them, and LIBOR was well below the LIBOR floors for some time. That is going away. If you do get interest rate hikes and a rising rate environment, you're more likely to see levered loans or bank loans readjust or recalibrate their coupon on a one-for-one basis. You will in effect participate in a rising rate environment. That may not be a big market focus now, but if and when rates start climbing, you could see a lot of technical support and a lot of money coming into this asset class."

"So bank loans are a nice way to play what we call the supportive fundamental environment as well as protect yourself a little bit if and when rates do start to rise. If the opposite happens, if you get this persistent low rate environment, we don't feel like we are giving up too much yield or too much income to be in loans. For these reasons, bank loans are a sector where we've been increasing our allocations."

With respect to local emerging markets (EM), Mr. Buchanan had this to say.

"The divergence between the U.S. Treasury and a diversified basket of EM local bonds has grown quite a bit," Mr. Buchanan said. "Expectations for fundamental improvement emerging-market economies are there. Whether that comes to fruition or not will be seen, but our view is that these economies are demonstrating tangible improvement.

"If you're worried about currencies - and a lot of people have noted that these currencies have rallied recently and it feels like you're getting into this a little late - you need to put it in perspective. Go back to December 2012, and you see a dramatic devaluation in the basket of EM currencies. So the rally we've seen recently is very small on a relative basis to the damage that's

been done. We think there's quite a bit of room for improvement. It is certainly an area where you can get very generous yield in a world where generous yield is incredibly tough to find."

In making his case that "fundamentals might be fraying a little," Mr. Buchanan pointed to the impact increasing leverage is having, particularly on mergers and acquisitions (M&A).

"Global M&A activity has been robust," Mr. Buchanan reported. "2015 was a record year, over $4 trillion, and 2016, although not likely to surpass 2015 is still going to be strong. That's really what's causing the meaningful increases in leverage. So the leverage increase we have witnessed has been more the result of financial engineering… which isn't a positive, but it's certainly more desirable versus what I would call 'organic increases' in leverage, where cash flows and EDITDA are decreasing as a result of top line revenue erosion." Another reason why Western Asset isn't concerned overall about these leverage trends relates to the types of acquisitions they are seeing. Most of the recent activity has come from companies that are acquiring other companies in the same business. And when you look at the synergies, there's a credible case that net cost savings will be realized and leverage will decrease over time. That's really what management teams have articulated: they feel that the timing is a great opportunity, and they are going to buy this company with added debt, but ultimately bring leverage back down to prior levels."

"We view the spike in leverage as somewhat temporary. I think the numbers validate that. On average, when they do an acquisition, companies have increased their leverage

multiple. However, you can see pretty consistently deleveraging thereafter. For instance, Anheuser-Busch buying SAB Miller took a three times leverage balance sheet up to five times, but it has communicated a clear, and we think a concise strategy, to bring that down to three times leverage again by 2018."

"So the fundamentals are reasonably supportive, and certainly not signaling a turn in the credit cycle."

In answer to a question about the impact of central bank policies, Mr. Buchanan said, "One strategy that's served us well over the years, given our overweight to spread product, is having duration. Although at times there has been some breakdown in the correlation, those breakdowns tend to be temporary, and it's been a reliable hedge for us."

"If we're going have an overweight to spread product, typically we'll have longer duration in our portfolios. That's how we've been positioned. It turns out that was very good positioning to have, given not only how risk is done, but also how rates have done, post the Fed announcements.

Most are interpreting the Fed's communication as being a little more skewed to the dovish side." He was also asked to amplify his thinking on the status of the current credit cycle.

"Typically, credit cycles last six to seven years," Mr. Buchanan answered. "We are a good seven or eight years into this particular cycle, kind of the longer end of the range as far as cycles go. But it's not surprising, when you think about the damage that was done in 2007 and 2008. The risk spirits of individuals who are operating companies have been dampened and it's going to take them longer than it typically would to start pursing the risk-taking behavior that ultimately leads to turn in fundamentals."