When Christopher Ailman became the chief investment officer of the California State Teachers’ Retirement System back in 2000, one of every four dollars it oversaw was invested in government, corporate and mortgage debt. For the past two decades, he’s been steadily whittling that down, to a low of just 10% last year.
Now, the man directing the second-largest public pension fund in the US says it’s time to reverse course.
“Fixed income is back,” Ailman, who manages $318 billion at Calstrs, said in an interview. In addition to higher yields, the potential for significant gains as governments around the world kick off monetary-easing campaigns makes public debt more attractive, he said, even after a recent surge helped global bonds end 2023 in the black for the first time in three years.
Calstrs is exhibit A among a slew of multibillion-dollar money managers pushing back into fixed income after years of boosting bets elsewhere. Almost 70% of institutional investors were bullish on the bond market heading into the new year, according to a recent survey by Natixis, more than any other asset class, including stocks, private equity and private credit.
Of course, “bonds are back” was Wall Street’s mantra this time last year as well, only for them to stumble out of the gate as wagers on a global downturn faltered. The Bloomberg Global Aggregate index tumbled almost 4% through mid-October as major economies prolonged their interest-rate hiking cycles.
Yet expectations for significant central-bank easing in 2024 helped fuel a year-end rebound that many asset managers say is just getting started.
Inflation is on the downtrend across most major markets, including the US, where traders are pricing in roughly six quarter-point rate cuts this year as officials seek to normalize monetary policy. The Federal Reserve has also already begun to telegraph plans to start slowing the pace of its balance-sheet unwind, another potential tailwind for bonds.
If officials are unable to pull off a so-called soft landing and the US economy tips into recession, rates are likely to slide even further, according to Priya Misra, portfolio manager at JPMorgan Asset Management.
“There are more reasons for Fed cuts in 2024, which is why my conviction to own bonds is higher” this year, Misra said. “Bonds have value here — in a soft and hard landing.”
‘Inflection Point’
With 10-year Treasuries yielding over 4% and US investment-grade credit paying roughly 5.2%, public debt still offers enticing rates, according to Loren Moran, who runs the $105 billion Vanguard Wellington Fund.
“Where we’re at is an inflection point — this is a substantially more attractive opportunity set for fixed income than what we’ve seen for the past few years,” Moran said. “We’re seeing the early signs of the impact of that tightening of financial conditions, and there are opportunities at much higher yields to deploy capital.”
Moran has been shifting into long-duration Treasuries since the end of last year, a reversal from recent years in which she targeted US government bonds with nearer-term maturities.
Calstrs, for its part, is planning to boost its fixed-income target allocation to 13% by mid-year, according to its most recent long-term plan, and 14% by the middle of 2025.
On the flip side, it’s cutting its exposure to public equities to 38% in the coming years, from a current target of 42%.
By at least one measure, fixed income still offers some of the most compelling valuations relative to US equities in more than two decades, according to data compiled by Bloomberg.
The so-called equity risk premium shows the profit yield on the S&P 500 – a rough proxy for return prospects that’s the reciprocal of the price-earnings ratio – is hovering around the lowest versus bond yields since 2004.
While higher yields are prompting a revaluation of the role public debt plays in portfolios, there’s little sign institutional investors are pulling back from alternatives anytime soon.Ailman, who last week announced he’s stepping down from his current role in June, was quick to note that his fund relies on various diversifying strategies to hedge against a downturn. Calstrs now has 10% of its portfolio targeted to so-called risk-mitigation strategies including trend following, global macro and risk premia, as well as a 15% exposure to real estate.
Calstrs has also leaned heavily into private credit to boost its returns, which have averaged 8.2% over the past five years, ahead of the fund’s 7% target.
“Given the Fed pivot, we may shift slightly more toward public over private,” Ailman said.
For BlackRock Inc.’s Ursula Marchioni, who every year advises about 1,000 multi-asset portfolios of pension funds and large asset managers, the nascent reallocation to bonds is only the beginning.
“We’ve transitioned into the new macro regime and we’ve seen clients going back into fixed income again,” Marchioni said. “We are coming out from a long period of structural under-ownership of fixed income on the public side.”
Alright, last week I covered Chris Ailman's plans to retire at the end of June and agreed with him that CalSTRS needs to increase its exposure to inflation-sensitive asset classes like infrastructure, timberland and farmland.
I also quickly discussed their risk mitigation portfolio which makes up 8.8% of its total assets and includes trend following, long-duration U.S. Treasuries, global macro and systematic risk premia.
I clearly mentioned that in this environment where the easy part of disinflation is over, I prefer liquid over illiquid alternative investments.
But investing in liquid alternatives (ie. hedge funds) isn't easy, very few shops made money last year in their hedge fund investments.
One of them was Blackstone's BAAM unit which returned 6.9% in 2023:
Blackstone Group's BAAM unit, the world's largest investor in hedge funds, posted a 6.9% return last year, according to a memo seen by Reuters, more than double the 3.1% return of the HFRX Global Hedge Fund Index.
In 2022, Blackstone Alternative Asset Management (BAAM), which oversees $80 billion in assets for pension funds, sovereign wealth funds and other big institutions, returned 4.1%. The return compared to a 16.9% loss in a traditional 60/40 portfolio of stocks and bonds which is often used as a benchmark.
BAAM's mutual fund, BXMIX, designed to give retail investors access to alternative investment strategies, posted a 7.9% return in 2023, its best since its launch in 2014, the memo said.
A Blackstone representative declined to comment.
The gains trail last year's S&P 500 24% surge but they outperformed 2022's 18% dive. Hedge funds often will not beat markets on the way up but will protect capital on the way down.
Joe Dowling, who joined Blackstone from Brown University's endowment fund in 2021, has overhauled the portfolio by shifting where assets are allocated and improving its risk metrics. Last year he integrated the unit's direct investment businesses, including Horizon and Special Situations, into a single Multi-Strategy unit, the memo said.
In the three years since Blackstone's president Jon Gray hired Dowling, BAAM's absolute return business has produced positive performance in every quarter and outperformed a traditional 60/40 portfolio by almost 12% and the HFRX by more than 17%, the memo said. Gray has called Dowling "prescient" in how he approaches investing.
As Dowling reordered the business to invest more broadly in alternatives instead of primarily allocating capital in a fund of hedge funds, BAAM will soon be rebranded and called Blackstone Multi-Asset Investing (BXMA) to reflect the shift, the memo said.
When you're posting figures like that in this environment, it's impressive.
Obviously Joe Dowling and his team know what they're doing and are delivering solid risk-adjusted returns (alpha over their benchmark) and charging fees for it (of course, they're not doing it for free!).
My point is simple, the most crowded talked about trade thus far this year is long bonds but what if inflation stickiness persists, what if the US enters a war with Iran and all hell breaks loose at the same time as the US economy enters a recession?
I know, a lot of what ifs there, the only thing I'm pretty confident forecasting right now is a recession and a bad one at that:
Yield curves are reliable predictors of recessions
— Game of Trades (@GameofTrades_) January 17, 2024
Inversions and steepenings are powerful signals
On average, recessions have occurred 12 months after an inversion since 1969
But only 5 months after a steepening
The current steepening indicates that a 2024 recession is… pic.twitter.com/E6BIlofzqr
And if you read this thread on contracting money supply and risks of deflation, you'd also conclude loading up on bonds here is a no-brainer:
M2 money supply is contracting sharply
— Game of Trades (@GameofTrades_) January 17, 2024
Is the US economy heading for deflation?
A thread 🧵 pic.twitter.com/yYHh6SuH3i
But the 10-year Treasury yield crossed above 4% recently and now stands at 4.11% after hitting a low of 3.78% three weeks ago:
And the 30-year Treasury yield is also creeping up, scaring some investors:
What do bonds know? pic.twitter.com/NVE5bd1UNI
— Lawrence McDonald (@Convertbond) January 16, 2024
Moreover, hedge funds are shorting the 10-year Treasury at a record level:
10-Year Treasury Largest Short Position in History 🚨
— Barchart (@Barchart) January 17, 2024
Hedge Funds are now short more than 787,000 contracts on the 10-Year Treasury, the largest 10-Year Treasury short position in history 🚨 pic.twitter.com/UpbXuyhWIT
So what gives?
Well, I wouldn't read too much into what hedge funds are shorting except to highlight the obvious:
- The easy part of disinflation -- ie going from 7% YoY to 3% YoY -- is over and now comes the hard part, going from 3% to 2%
- Geopolitical tensions in the Red Sea and elsewhere could impact inflation going forward
- Wage inflation could exacerbate inflation stickiness this year
- We can see stagflation, ie lower output and higher inflation
So, while CalSTRS and others are migrating back to bonds, it might not be as simple as you think.
Some of Canada's large pension funds started buying bonds relatively early last year as yields on the 10-year were north of 4% and yields kept going higher, forcing these pension plans to experience some serious marked-to-market losses in Q3 2023 before the big fourth quarter rally.
All this to say, I understand why pension funds are loading up on bonds here as I'm in the severe global recession camp, but making directional calls on long bond yields isn't easy in this environment.
Still, my weekly chart of US long bond prices tells me we are at an important support level and if it holds and bond yields reverse course and head lower, then long bond prices will go higher:
That's a big IF but all eyes will be peeled on the 10-year Treasury yield the remainder of this week, next week and pretty much all year.
Again, sticky inflation will complicate the Fed's job and unless market participants are confident the Fed will cut significantly this year, it's hard making a big directional call on long bonds.
Of course, as I stated in my Outlook 2024, a hard landing in China will change all that and export a wave of deflation throughout the world.
Other than that things are fine in China
— Michael A. Arouet (@MichaelAArouet) January 17, 2024
Chart @MacroKovapic.twitter.com/8zAodS2TCt
China's GDP deflator, a measure of prices across the economy, fell by 1.5% in Q4 2023.
— The Kobeissi Letter (@KobeissiLetter) January 17, 2024
This marked the third straight quarterly decline and the longest decline since 1999.
Even in the 2008 financial crisis, China only saw 2 quarters of declining prices.
Weak consumer… pic.twitter.com/KzvgyptnfN
If that happens, it's bond friendly but it will clobber risk assets.
Anyways, there's a lot to mull over when it comes to US long bonds, I know most institutions are positioned long but it's not as simple as we think.
Below, Jim Bianco joins Fox Business to discuss soft landing vs no landing, interest rates, the impact of geopolitical conflicts on markets & rethinking economic data with Charles Payne.
Great discussion, take the time to watch this.
And Josh Brown, chief executive of Ritholtz Wealth Management, joins 'Closing Bell' to discuss being bullish on the market and if it's overblown or not.