A transcript of and interview with First Eagle’s money managers titled, “Using Asset-Class Flexibility And Downside Protection To Help Generate Income.”
First Eagle: Sector – General Investing
TWST: To get started, maybe we can go over the three tenets of your Global Income Builder Fund, the asset-class flexibility, the global range and then the focus on the downside protection. So why don’t we just start out with the first one, the asset-class flexibility? Tell me your thought and process on that.
Mr. Caputo: We launched this fund a number of years ago in response to inquiries from our long-term clients who needed an income solution. We spent a fair amount of time thinking about how best to develop a fund that was flexible enough to potentially meet whatever the markets threw at us. The income environment today could be very different from the income environment 10 years from now. Certainly, today’s environment, which we can talk about further, is a very unique environment with repressed rates that have lowered yields in many of the key incomegenerative asset classes.
So really all that leads into the fact that asset-class flexibility has been a key component of managing through this environment. It’s really a matter of not being forced into any kind of artificial constraints, such as only looking at one asset class or even having predetermined weights for our asset classes. Our goal is to hopefully distribute a meaningful income today but also to be able to potentially grow the capital ahead of inflation so that our clients may earn a meaningful income in the future.
TWST: Let’s talk a little bit about what you had mentioned, this being a unique atmosphere because of the low rates. Why don’t you talk a little bit about that?
Mr. Caputo: When we were developing the fund a few years ago, we wouldn’t have anticipated the level of financial repression that has played out, and I would have thought that we would be earning our income differently than how we are today. What we’re seeing is trillions of dollars of fixed income securities globally that actually have negative yields. These are primarily developed-market sovereign bonds, asset classes that have been a staple for income investors for a number of decades now. This has made that general area unattractive.
Rate repression has also spilled over into income-generative equities. So if you look at income equities in the United States, many of them tend to be rate-sensitive. These are utilities, for instance, REITs and financials. Because of the low rate environment, a lot of those opportunities are pretty expensive in our view.
One of the key tenets of our investing philosophy is that we only invest in a risk asset if we believe that we are getting what we call a “margin of safety” relative to our sense of what a business is worth. We have an absolute-value framework. So we typically won’t buy something merely because it’s cheap on a relative basis. This has steered us away from many traditional income-oriented asset classes both on the equity income side and on the fixed income side. Perhaps, Sean, do you want to talk a little bit about where we do see value in fixed income?
Mr. Slein: Sure. And what I wanted to do is just make a few comments about the yield compression and the monetary repression that we are seeing, because as Giorgio had mentioned, there seems to be a sense of complacency and resignation among investors as far as the acceptance of lower yields by reaching ever lower on the credit spectrum for yield. As Giorgio had mentioned, there are trillions of dollars, euros, yen and other currencies that are trading with negative yields. And as a result, there is an elevated level of duration risk that investors are willing to accept.
One thing that we seek to avoid is risks that we believe we’re not being adequately compensated for, and duration is one of those risks. While we haven’t really seen any type of episode beyond the taper tantrum that would suggest that yields could spike higher or that a parallel shift in the yield curve is imminent, we just don’t think that given where we are that we’re being paid to take duration risk. So as a result, we feel that leveraged credit remains the least worst alternative in the fixed income world.
We have the flexibility through our fund to invest in sovereigns, investment-grade and also agencies. But currently, we choose to remain invested in high yield, specifically higherquality high yield, because high yield is more of a credit-sensitive asset class that generally doesn’t have that embedded duration risk that many of the higher-quality fixed income asset classes inherently possess. We’ve seen in high yield, over the past 18 months to two years now, an elevated level of risk enter the market in energy and materials-related sectors. That hasn’t really translated into credit risk throughout the leveraged credit world — though we’ve seen spreads widen somewhat as a result of risk tolerance being lowered among investors. We still think there are attractive opportunities in higher-quality noncommodity-related companies. Yes, default activity is rising, as reflected in the last 12-month rate of approximately 4.5%; however, excluding materials, the default rate remains well inside 1%.