The Long View: Eric Jacobson - The Entire Face of the Bond Market Has Changed

Key Concepts

• Active Management vs. Indexing in Fixed Income: The core debate of the paper, exploring why active management can be more effective in bonds than in stocks due to market structure.
• Market Fragmentation: The bond market's complexity with numerous sectors, subsectors, and bond varieties from the same issuer, contrasting with the uniformity of common stocks.
• Inefficiencies: Opportunities in the bond market arising from complexity, limited investor audiences, and structural market reasons that active managers can exploit.
• Structural Trades: Long-term strategies employed by active managers to capitalize on persistent inefficiencies in specific market segments.
• Derivatives and ETFs in Fixed Income: The expanded toolkit for bond investors, including options, futures, credit default swaps, and ETFs, offering exposure and hedging capabilities.
• Private Debt/Credit: Debt issued by non-bank entities, encompassing direct lending to middle-market companies and asset-backed finance.
• Level 1, 2, and 3 Assets: A valuation framework for assets based on the observability of their inputs, with Level 3 assets being the least liquid and most subjective to value.
• Semi-Liquid Funds (Interval Funds, Tender Offer Funds, BDCs): Investment vehicles offering periodic liquidity rather than daily, holding less liquid private debt.
• Investor Motivation and Practices: Historical observations on asset manager motivations and industry practices, particularly concerning yield generation and investor outcomes.
• Closed-End Funds: A specific type of investment vehicle historically focused on yield generation, with a distinct investor base.

The Bond Market: Fertile Ground for Active Management

Eric Jacobson, a senior principal for fixed income strategies at Morning Star, discusses his recent paper arguing that the bond market is a more fertile ground for active management than often perceived, especially compared to the increasing popularity of stock indexing. He posits that the fundamental differences between stock and bond markets make active strategies more viable and often necessary for optimal outcomes.

Impetus for the Paper: Jacobson observed a trend where investors, accustomed to the success of stock indexing, assume it's equally applicable to bonds. However, he believes the underlying mechanics of the bond market are significantly different, leading to potential misunderstandings and suboptimal investment decisions. His paper aims to highlight these differences and the value of active management in fixed income.

Higher Success Rates for Active Fixed Income Managers: Jacobson notes that active managers in fixed income generally exhibit higher success rates than their stock-picking counterparts. While acknowledging that performance can vary over time and that indexing can be effective, he argues that competent, reasonably priced active management can outperform indexes over time, particularly in areas with market inefficiencies.

Key Argument: Market Fragmentation and Inefficiencies: The central thesis is that the bond market's extreme fragmentation, with its multiple sectors, subsectors, and the sheer variety of bond structures even from the same issuer, creates inherent inefficiencies. Unlike common stocks, where a share of IBM is generally the same as another, bonds from the same company can have dozens of variations (e.g., call features, different maturities) affecting credit and risk. This complexity requires specialized knowledge for competent buying and selling, unlike the rapid, efficient trading of stocks.

Levers for Active Bond Managers: Active managers can exploit these inefficiencies through "structural trades." This involves identifying areas of the market with:

• Complexity: Securities that are difficult for the average investor to understand, limiting the audience.
• Smaller Issue Sizes: Less liquidity and fewer investors.
• Limited Investor Base: Areas that investors tend to avoid due to complexity or other factors.

These factors can lead to securities being priced more attractively than their fundamental value might suggest. Active managers can repeatedly capitalize on these opportunities for steady, long-term gains, often measured in terms of yield spread over Treasuries. Jacobson emphasizes that consistently making large market calls on interest rate movements is far more difficult than exploiting these structural inefficiencies.

Expanded Toolkit: ETFs and Swaps: The bond investor's toolkit has expanded significantly. Beyond traditional bonds, active managers can utilize:

• ETFs: Providing exposure to specific fixed-income segments.
• Futures Contracts: For broad market exposure.
• Options: On bonds and swaps.
• Credit Default Swaps (CDS): To gain or hedge credit exposure, either to individual names or indexes.

These instruments can be used to exploit dislocations and inefficiencies, even if they are minor. For example, a manager might choose between buying a bond directly or using a CDS to gain similar exposure, opting for whichever appears cheaper. Jacobson stresses that derivatives can be used responsibly to control risk and capture market efficiencies.

Case Studies and Real-World Applications

Automobile Debt (Early 2000s): During the early 2000s, automakers and their suppliers became increasingly indebted. This led to their weighting increasing significantly in corporate bond indexes. Jacobson contrasts this with stock indexes, where increased weighting might reflect strong performance. In bonds, increased debt means increased risk. Companies like GM and Ford eventually filed for bankruptcy, negatively impacting bond indexes that held them. Active managers, however, could have identified this strain and reduced exposure, avoiding losses.

Euro Crisis (circa 2011): Similarly, during the Euro crisis, countries like Greece became highly indebted. This increased their weighting in European government bond indexes. Active managers could have recognized this growing indebtedness and reduced exposure to such sovereign debt.

Surge in Treasury Issuance (Post-2008 Financial Crisis): Following the 2008 financial crisis, the surge in Treasury issuance, particularly at longer maturities, fundamentally altered the composition and interest rate sensitivity of broad bond market indexes. This shift means that investors holding broad bond indexes may be taking on more interest rate risk than they historically did, impacting their stability and hedging capabilities against stocks.

The Difficulty of Timing the Market

Jacobson discusses the tendency for investors to engage in tactical fixed-income investing, attempting to time entries and exits from cash and bonds based on interest rate expectations. He cites Christine Benz's observation that investor return data often shows poor timing.

Why Timing is Difficult:

• Interest Rate Volatility: Predicting interest rate movements is exceptionally challenging. While there were periods in the 80s and 90s where betting against rates seemed more feasible, the market has become more complex.
• Asymmetric Risk/Reward: Betting against interest rates can lead to significant losses if wrong, with limited upside potential.
• Structural Trends: Post-financial crisis, low interest rates persisted for over a decade due to structural economic factors, making bets on immediate rate hikes costly for those who positioned for them.
• Market Temperament: Short-term market movements can be driven by sentiment and expectations rather than fundamentals, making them difficult to predict.
• 2022 Example: While 2022 saw dramatic yield increases due to inflation and central bank actions, Jacobson notes that anticipating the exact timing and magnitude was extremely difficult, even in retrospect.

He likens market timing to predicting the weather, acknowledging it's more complex but still highly unpredictable. He distinguishes speculation from investing, highlighting that tactical plays often lean towards the former.

The Role of Indexing in Fixed Income

Jacobson clarifies that he is not against fixed-income indexing entirely. He believes it can be a cost-effective way to gain core exposure to highly liquid, high-quality segments of the bond market, such as Treasuries and investment-grade corporate bonds.

Limitations of Indexing: However, he emphasizes that core indexes often exclude significant parts of the bond market that offer opportunities for active managers. These include:

• Collateralized Loan Obligations (CLOs): Complex debt instruments.
• Non-Agency Mortgages: Evolving and diverse mortgage-backed securities.
• Other Niche Segments: Various specialized areas that don't fit into broad index construction.

Furthermore, due to market evolution since the financial crisis, broad bond indexes may carry more interest rate risk than in the past, a factor investors need to understand.

Private Debt and Private Credit

Jacobson delves into the growing world of private debt and private credit, explaining the terminology and landscape.

Nomenclature:

• Private Debt: Broadly refers to debt originated or issued by non-bank entities.
• Private Credit: Typically refers to direct lending to middle-market companies, often through private placements that are illiquid and held on balance sheets.

Asset-Backed Finance: A significant and growing segment of private debt involves securitizing pools of assets that generate cash flows. This is akin to mortgage-backed securities but can be more customized and specialized, involving non-bank actors. While some of these deals start as private placements, they are often securitized, making them more tradable and liquid than direct loans.

The State Street ETF (PRIV) Example: Jacobson uses the State Street ETF (ticker PRIV), a joint venture with Apollo, as an example. He explains that despite the "private" label, these funds often hold a significant portion of asset-backed securities that, once securitized and given industry identifiers, are more liquid than anticipated. This contrasts with the common perception of private credit as highly illiquid.

Level 3 Assets: These are assets that cannot be valued using readily observable inputs and require significant manual pricing. They are typically illiquid and less transparent. Direct lending private debt often falls into this category. Asset-backed securities, if properly packaged and securitized, can be classified as Level 2 assets, offering more transparency and liquidity. Funds with a high proportion of Level 3 assets signal less transparency and potential valuation challenges.

Semi-Liquid Funds (Interval Funds, Tender Offer Funds, BDCs): These vehicles offer periodic liquidity rather than daily. Investors can buy in, but redemption is restricted to specific periods, and managers may not be obligated to fulfill all redemption requests, especially during crises.

Risks of Semi-Liquid Funds:

• Illiquidity: Investors must be comfortable with their money being tied up for extended periods, potentially months.
• Unintended Consequences: The restrictions on redemption can mask underlying risks. If large investors face issues and are forced to sell, it can impact the underlying markets.
• Lack of Transparency: The private nature of these markets, coupled with less regulation, means that hidden risks and interconnections between entities can exist, similar to the dynamics observed before the 2008 financial crisis. Jacobson emphasizes that while not identical to 2008, the lack of transparency in private debt markets means unexpected risks can emerge.

Doing Private Debt Well: Morning Star has assigned medalist ratings to some private debt-focused interval funds. Jacobson highlights that favored funds typically have:

• Familiarity and Track Record: Managers with a long history in similar strategies (e.g., PIMCO).
• Reasonable Risk-Taking: Not taking undue levels of risk.
• Robust Resources: Significant staffing and financial backing to manage complex strategies.
• Appropriate Vehicles: Investors should understand the liquidity constraints of the chosen vehicle.

Historical Perspective on Mutual Fund Practices

Jacobson shares his early career experiences and observations about industry practices that motivated his desire to work on behalf of investors.

Motivations and "Mediocrity by Design": He encountered firms where investor outcomes were not the primary focus. Some operated with a "profitability sweet spot" mentality, aiming for average or slightly better performance without striving to be the best, thereby minimizing resource expenditure and maximizing profits. This led to what he describes as "mediocrity by design."

Gimmicky Bond Funds: In his early career, he witnessed the proliferation of "gimmicky" bond funds, such as "option income funds" and funds using cross-hedging currencies, primarily designed to generate higher yields. These often "blew up" periodically, leading to the introduction of new, similarly structured products. This experience taught him valuable lessons about the potential for yield-driven strategies to involve hidden risks.

Evolution of Practices: He believes many of these practices have diminished as lessons were learned, and the industry has become more aware of the need to prioritize investor interests. However, he cautions that new generations of product developers may still create overly complex or "too clever by half" offerings.

Closed-End Funds: Jacobson's early work at Morning Star was on the closed-end fund research team. He notes that historically, closed-end funds, particularly bond funds, were designed to generate high yields and appealed to an older demographic comfortable with yield-based investing. As the market evolved and managers offered similar strategies in different formats, Morning Star began to cover funds more broadly, focusing on strategy rather than just the delivery vehicle.

Memorable Interactions with Bond Fund Managers: Jacobson recounts an experience during the height of the 2008 financial crisis with legendary fixed-income investor Dan Fuss. While Jacobson felt anxious about the market's collapse, Fuss was "giddy" with excitement, seeing opportunities to buy beaten-down corporate names. This contrast highlighted Fuss's deep-seated investor mindset, ready to capitalize on market dislocations, a stark difference from Jacobson's own apprehension. He also mentions instances where fund managers attempted to get him fired for critical research, underscoring Morning Star's commitment to independent research.

Conclusion

Eric Jacobson's insights underscore the nuanced nature of fixed-income investing. While indexing offers cost-effective exposure to core markets, the inherent fragmentation and inefficiencies of the bond market create significant opportunities for skilled active managers. The expansion of financial tools, the rise of private debt, and the complexities of valuation and liquidity in semi-liquid funds all demand a sophisticated understanding from investors. Jacobson's career journey highlights the importance of investor advocacy and the enduring lessons learned from historical market practices and the pursuit of yield. He advises investors to be acutely aware of the risks, transparency levels, and liquidity constraints associated with different fixed-income strategies, particularly in less regulated and less transparent markets.