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Max Gokhman
Max Gokhman

Q&A: Max Gokhman, Pacific Life Fund Advisors

The head of asset allocation for $40 billion Pacific Life Fund Advisors (PLFA), Pacific Life’s multiasset investment division, on the continued appeal of high-yield bonds and why he’s staying away from leveraged loans.

It’s always a good time to hold fixed income assets, says Max Gokhman, head of asset allocation at Pacific Life Fund Advisors. That’s simply part of a well-diversified portfolio.

While he doesn’t find fixed income as attractive as equity at the moment, thanks to a low expectation of recession on the immediate horizon, he still sees opportunities on the fixed income side. That includes U.S. high-yield corporate bonds and emerging-market bonds.

Credit conditions are strong in the junk bond market, and fundamentals are strong in emerging markets as well, Gokhman told Wealth Management in a recent interview. Gokham will speak at Informa’s Inside Fixed Income conference Nov. 12-13..

Wealth Management: Do you see now as a good time to invest in fixed income?

Max Gokhman: We think you should always be broadly invested across asset classes. So the question is, do you overweight or underweight fixed income versus equity and other alternatives. That now depends on your expectations of recession. While clouds are gathering, we don’t see a recession within the next six months. So we’re broadly more in equity than fixed income.

WM: Given that outlook, what areas of fixed income are most attractive right now?

MG: Two areas. First, high-yield U.S. corporate bonds. Returns are comparable with equities and there’s less volatility, though volatility can be high in the short term. This is predicated on no recession for the next six months.

Interest coverage is declining, but not to levels we find concerning. Defaults remain below 4%. While spreads are tightening, there’s still a decent amount of yield pickup. Flows into high-yield debt are about $20 billion this year, one of the strongest periods since the financial crisis. Combine slowing issuance with higher demand, and that’s why the bonds are returning 11% year to date.

WM: You said two areas. What’s the second-most appealing?

MG: Emerging-market debt. EM bond issuance is slowing, and the fundamentals for EM debt issuers are improving. Leverage is smaller than it is for U.S. corporations. The average budget deficit of the biggest sovereign issuers is about 2% of GDP, compared with 5% for the U.S. EM bonds should be supported by Fed easing and a depreciating dollar.

We pair our EM bond trade with EM stocks, where we are underweight. If you buy EM stocks, you’re buying into China. The trade war and Chinese deleveraging are hurting EM equities. EM debt is more diversified, with exposure to Latin America. No single country represents more than 5% of the JP Morgan EMBI (Emerging Market Bond Index). We have seen EM equities gain only 6% through Sept. 30, while EM debt is up 13%.

WM: What area of fixed income is least attractive to you?

MG: Leveraged loans. That went away along with the Fed’s rate-hiking cycle. We have seen investors flee from loans at the fastest rate in a decade. It’s an asset class where there’s a mirage of liquidity. Day to day things look fine, and then all of a sudden liquidity gets pulled. You don’t want to be late leaving the party.

About 95% of the market has few or no covenants. There’s limited discipline that borrowers have to follow. It encourages bad behavior, which will lead to more and sharper defaults in cycles going forward.

In the high-yield bond market, credit standards are stronger. You don’t have covenant-lite loans. In the leveraged loan market, investors are bending over backward for yield, and that will break their backs. We are seeing underwriting standards that aren’t healthy.

WM: How concerned are you about government and corporate debt?

MG: We think leverage is a major issue for the government and corporate sectors. Government spending is rising 5% annually. By 2024, all new debt issuance will just cover interest payments on existing debt. The trend of an increasing budget deficit will continue.

Some are arguing for modern monetary theory, but most Economics 102 students could tell you that’s impossible. You can’t print money forever without consequences. One reason we do ultimately expect a recession is debt. It looks like it will exacerbate until it breaks.

For corporations, leverage is going up quite a bit. If you are using low interest rates to borrow for capital expenditures, that’s great. But companies are primarily levering up for share buybacks. That makes it seem like earnings are going up, but long term it’s not productive.

Coverage ratios are falling. We’re seeing higher debt to cash flow. That’s OK with rates falling: You can refinance into lower yields. But when rates go up, it becomes a big issue. The problem can start at the government level and then bleed into the corporate level.

WM: So, when’s the next recession?

MG: We don’t see a recession in the next six months because of the consumer sector’s strength. Consumers remain upbeat. Employment and wages are rising. That can keep us going. But business sentiment is weak. What happens when the soft survey data bleed into the hard data? There are layoffs, consumer spending falls, and it circles back to the corporate side. In the next 24 months the chances for recession are high, possibly even by the end of 2020.

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