Beyond Bonds: Exploring Alternative Asset Classes For Inflation Protection With Michael Furla, Managing Director And Head of Fixed Income, The Mather Group, LLC

 

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Michael Furla is the Managing Director at The Mather Group, LLC. He assists the firm’s Wealth Advisors in identifying clients’ investment goals and retirement needs.

In this episode, Zack and Michael discuss:

1. Diversifying Your Portfolio During Elevated Inflation
2. Timing the Market vs. Time In the Market
3. Venture Debt: Is it Really as Risky as it Sounds?
4. The Hidden Risks of “Risk-Free” Assets
5. Capital Structure: Making a Good Company, a Great Deal

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Beyond Bonds: Exploring Alternative Asset Classes For Inflation Protection With Michael Furla, Managing Director And Head of Fixed Income, The Mather Group, LLC

I’m joined by Michael Furla, CFA, CFP, who is the Head of Fixed Income and the Co-Head of the Investment Department at The Mather Group in Chicago, Michael. Thanks for joining. It’s great to have you.

I’m happy to be here. Thank you for having me.

The Mather Group

Before we dig in, tell us a little bit about your background in The Mather Group.

I joined The Mather Group in 2017 as Co-Head of the Investing Department. We are a $9 billion RIA multi-family office that focuses on providing high-net-worth and ultra-high-net-worth individuals financial planning, investment management, tax strategy, and state planning services. We have fifteen locations across the US and we are headquartered in Chicago.

Regarding my background, I started out my career at S&P Global ratings as a Muni bond credit analyst, where I helped construct the Muni bond rating calculation engine that a sign stay local government ratings the city and county in the United States. I helped them build out their internal surveillance system which would identify credits that had a high probability of an upgrade or downgrade. I then went to Morningstar thereafter, and it’s somewhere credit work, but for global corporate debt extrapolating ratings from rated entities to non-rated issuances or bonds based on the capital structure or prior to claims. As I mentioned before, thereafter, I went in The Mather Group in 2017.

The last time we were on a panel together in person, at that point, you guys at The Matter Group are going quite quickly, and it’s probably going even better than expected. You are almost $10 billion now, so congratulations on the growth. What’s mainly driving the growth, do you think?

I would say, first and foremost, good team and leadership. We always have a team mindset. When I joined The Mather Group in 2017, we were managing under $1 billion in AUM or Assets Under Management, and we have almost 9X-ed or 10X-ed in the last several years. We have great individuals. We work as a team. A lot of hard work, blood, sweat, and tears. We are coming in early, staying late, working weekends, but we are doing it for our clients. We are doing it to try to make our mark in the industry. It’s been exciting. The way we describe The Mather Group as a rocket ship or trying to hold on and to propel it forward has been quite an exciting experience.

Economic Queries And Predictions

It’s great to watch it, and a big part of it is how closely you work with your clients and get them access to differentiated strategies in fixed income as well as other asset classes. What are your clients asking you about you these days? There’s so much going on in the markets and so much volatility and risk? I’m very curious about what your clients are asking.

We are getting a lot of great questions from clients. We are getting questions about inflation. We are getting questions about the debt ceiling and the regional banking crisis. We are getting questions about China, Taiwan, Russia, and Ukraine, and the US dollar strength. We provided some thought leadership pieces addressing each of those topics and issues, and the future is inherently unknowable. It’s hard to know what will happen, but what we can do is look at past cycles and empirical data to make better, informed decisions to make sure we are well positioned or whatever may come our way.

When you think about past cycles with interest rates, are there certain periods that you are looking at that you can learn from to use now?

Yes. If you look at the past eras of elevated inflation, if you look at the ‘70s and early ‘80s when we had the Volcker comment and raise rates well beyond where they are now, we can identify certain asset classes that tend to be more resilient to elevated inflation and rising interest rates. There are other asset classes that are more susceptible to it. Right now, we are looking at commercial real estate. They are taking a hit right now. Certain assets are very tied to the discount rates, which allows for their pricing. It’s looking across all asset classes and geographies as well to identify how to bring in a little bit more diversification or create a balance in the portfolio, which usually is how bonds are.

Interest Rate Risk

When I think about fixed income performance, there are interest rate risks and credit risks. It seems like a lot of people forgot about interest rate risk somehow and have gotten hurt quite badly because of that. Many so-called professionals, in fact, many of the banks that are now going under didn’t know how to manage rate risk.

I wanted to talk to you about how you think about managing interest rate risk at a portfolio level and how you think about managing it through cycles. It’s easy to manage rate risk if things aren’t changing, but if we are going to a different paradigm shift, which is happening now with much higher rates and much higher inflation, how do you construct a portfolio that’s all-weather and durable through multiple cycles?

It touched upon earlier comments about how some of these regional banks did not manage their duration risk. There is a mismatch with their asset-liability matching. You have these deposits and then they have these long-term investments and the Fed increased rates 5% in less than eighteen months. What happens is if you have long-dated agency mortgage-backed securities or treasuries, which they had both, and let’s say the duration is 10% on that, if rates go up by 1%, given that duration, the price of the portfolio, given an inverse relationship, will fall by 10%. That’s what they experienced.

While they had them marked as held maturity, they had enough deposit withdrawals or they had to reclassify their balance sheet for some of those assets from halted maturity to securities and then they had to realize those losses. That’s what spurred the fear, the bank run and the rest is history. As you mentioned, the two main wrists or factors when investing in fixed income and creating fixed income portfolios are duration or interest rate risk and then credit risk. I have to look at both.

Going into 2022, we felt with rates so low, and the Fed told us, “We are going to raise interest rates. We have a terminal rate above 4.5%, we decided to take our duration short to mitigate the rising interest rate. In a rising interest rate environment, it is advantageous to reduce the underweight duration. To mitigate that price hit, you’ll take on your bond portfolio. That’s where we are now.

However, if you look at various studies, once that’s near the end of the rate hiking cycle, usually right around that last 1 or 2 rate hikes, it makes sense to increase your duration back to neutral. We believe and I believe that’s where we are now. Given the Feds’ most recent comments, they may be entering a period of a pause and review the data and see if we are at that terminal rate or maybe if we are right almost there.

Getting back to neutral near the end of a rising interest rate environment is advantageous because, let’s say, as Fed historically has, they overhype and they have to drop interest rates and yields compressor fall. If you have fixed stray instruments, you want to make sure you have new or even long duration. As rates fall, bond prices rise and you get that balance or diversification benefit of the portfolio. If you are short duration, it paid off in 2022, but if rates fall by the end of 2023 or 2024, you are going to be caught off.

You are going to underperform on the price side of the return for the total return of bond price and income. Credit, as we mentioned earlier, is quite important and during the end of a rising interest rate environment or a rate hiking cycle, you have to be careful with spreads, especially high yield. Right now, they are a little bit tight, and the Fed is increasing rates to diminish demand and inflation.

They are intentionally trying to slow down the economy. When you are slowing down the economy, you potentially have lower corporate earnings or profits. You have higher unemployment and you have more risk or credit risk with these companies, especially if they are borrowing. Their leverage, the cost of it’s much higher than the cost of capital.

In this current period of near the end of the rate hiking cycle and near the end of a rising rate environment, it makes sense to go up in credit quality. You want to make sure you are not going too down in the credit scale. You will see elevated defaults moving forward. If there is a recession, whether it’s mild or hard, however you want to classify it, it will be more businesses failing and you want to be on the right side of that trade.

Fixed Rate Versus Floating Rate

I think a lot about risk first and moving up in quality. Some of that also comes from the structure of the deals and the seniority of the loans. Being in senior loans that have a lien on all assets, hopefully, at first lien, that’s very nice and keeping the loan to value very low. Loans are also important. How are you thinking about fixed-rate versus floating-rate securities at the moment?

I would say most of our fixed-income portfolios are constructed with fixed rate. We do have a little bit of private credit exposure and that has been expanding. As you’ve seen with the banking crisis, credit is getting tighter. They are getting away from space. There are less players. There are less loans. There’s going to be a mismatch between supply and demand.

With the right type of lenders and with the right type of structuring, as you mentioned, there’s going to be a great opportunity for private credit moving forward as banks exit the space, whether it’s delegatory or they score based on their balance sheets. We are quite excited for the space, but you do have to be careful. You have to make sure that you are investing with the right managers, lenders, good businesses that have substantial collateral, and good cashflow and resilience to economic downturns.

Invest with the right managers and lenders with substantial collateral. Share on X

Timing The Market

What are the other core investment principles that you think about that serve you well through all cycles?

In general, it’s hard to time the market. When you try to time the market, you have to be right twice. You have to know one to get out. You have to know one to get back in. Warren Buffett says this. It’s about not timing the market. It’s about time in the market. Long-term investing, being fully invested in the market at all times. With that, we do make some minor tactical shifts, whether its duration, credit quality, put our thumb on the scale to try to add a little bit of alpha where it makes sense.

We can conduct evidence-based investing and when we look at efficient markets, we believe it’s best to control the controllables. Reduce costs and your taxes, your tax liability, after-tax returns. When we look at an efficient market, we will go beyond indexing. If there’s a higher probability of performance because these markets are less efficient, we believe there’s an opportunity to add value there.

Regarding the cycles and timing all that, we want to make sure we look at factors that have persistence over long periods of time and you want to have exposure to those factors before every point in the cycle. Usually, once the cycle turns, you are too late to the party. It’s not going to pay off. You have to be positioned correctly before changes occur.

Bond Ladders

What are some of the products that you like right now and fixed income? We talked a little bit offline about bond ladders and private credit. How do those work?

We believe it depends on each individual client’s needs. If they don’t need as much liquidity, we can do bond ladders. If they have sizable assets, we can move our way into private credit since they don’t have that cashflow needed for multiple years. What we like to do, our preferred method is to have bond ladders, whether it’s treasury bond ladders, investment grade corporate bond ladders, or if they are in a higher tax bracket and they are in a state such as California where there is a high come tax, tax-free municipal bond ladders.

What we do is we have those as the core positioning of the portfolio, and then we add additional bond ETFs or mutual funds around that as levers. If we want to adjust duration, we can use these ETFs to increase or decrease. If we want to just credit volume, we can use those ETFs to increase or decrease. If we want to overweight-underweight different bond classes, let’s say you are a taxable fixed-income investor, you have exposure to, let’s say, the AGs, so it’s about one-third treasuries, one-third investory corporates, one-third Asian mortgage-backed securities.

Let’s say you want to underweight ADC mortgage-backed securities because the Fed was one of the biggest buyers in the space and they are letting that roll off their balance sheet and you believe that there will be an influx in supply, which will negatively impact the pricing, we can use ETFs to decrease that exposure from bond class perspective. That’s our thought and we believe in global diversification.

While we have a majority of her fixed-income assets that are US-based, we do invest in emerging market debt and developed international debt, but all of the international exposure is US dollar hedged because we are not trying to create a foreign exchange risk. We are going to talk about what would keep me up at night and the currency risk would be one of them for some of these emerging market countries. I’m not trying to deal with that. It can change quickly and it can get real bad real fast. Hedging your bet is the way we prefer to invest.

Private Credit

You made a good point about a diversified portfolio that includes other geographies outside the US. Also, of course, you are investing in private credit, which is very different in many respects versus public credit, such as corporate bonds or treasuries. What do you like about private credit right now given all the bank failures were seeing, which is going to pull back bank lending and create more opportunities for non-bank lenders?

We touched upon this briefly, but with banks pulling out those, regional banks, especially, there’s going to be less players in the space. In past years, when in public fixed income markets, when the yields were very low, these pensions, endowments, foundations had to go out on the risk scale. They went away from public fixed income instruments towards private credit. Since there’s a lot of demand to own that, it drove down the yields in the space. Now, that public fixed income is providing you have treasuries yielding North of 4% or 5%. You have more options.

With that, there’s less demand for Insurance areas, which means there could be higher yields and also, because there’s less lenders, they can demand a higher return. The supply-demand dynamic makes the private credit space more attractive moving forward because there should be a higher demand. With less suppliers or less lenders, there will be more opportunity to ask for higher return by investors.

Those are great points and match with what we are seeing in the market on the venture debt side. For those who don’t know, Silicon Valley Bank, which is one of the big bank failures, and some of the other regional banks were the primary capital providers to startups by providing loans. Unfortunately, SVB and others failed because they had interest rate risk that they didn’t manage properly related to treasuries and mortgage-backed security.

It’s ironic because a lot of people, when I mention venture debt, will say, “That sounds risky,” but 3 of the 4 largest bank failures in history happened and had nothing to do with their loan books. It had everything to do with their treasury exposure and they are more mortgage-backed exposure which technically don’t have credit risk but they have a lot of interest risk.

Investor Psyche

This goes to show that there’s a lot of opportunity right now because of the lack of supply. Within private credit, there were various niches that are attractive. Are there any that you have been looking at and including venture debt that are a good match for certain clients particularly, maybe family offices are ultra-high net worth?

There is this belief and technically, the US Treasury is the risk-free rate for all financial assets globally. As we know, there’s this discussion about the debt ceiling. Right now, we are utilizing extraordinary measures to fund the government, but that will run out shortly. It has been over 100 years since we have had a debt ceiling.

We raised it around 100 times. Given the polarized government, there’s increased risk if they don’t raise, extend, or remove the debt ceiling, that risk-free asset could potentially default. There’s some that say that we have never had a default before but in 1933, technically, you could argue there was a default on some payments by the US government.

In 1971, when we walked the gold standard, you could argue that was reverting back on a promise. In 1977 or so, that was another time there was a missed payment there. There have been multiple occurrences. Historians will argue if it’s a true default or if they alleviate the situation within a fairly short time frame, but it is a possibility. Even the arguably risk-free assets, the treasury in agency mortgage-backed securities, aren’t truly risk-free. There’s a risk to anything.

I want to make sure investors are aware of that because there’s no free lunch and we have to identify the risks out there and with the debt ceiling, there is that new risk that’s elevated compared to prior years. Look at CDS on the situation and it’s elevated compared to prior situations. Regarding venture debt, where the opportunities are, we want to make sure we are more industry agnostic. It’s more of identifying companies that will be led to that have healthy balance sheets that have cashflow.

Investors must always remember that there is no free lunch. They really have to identify the risks out there. Share on X

Venture early in your stage and you are trying to grow that revenue, but we want to make sure that there’s decent cashflow and the structure of the loans is advantageous whether it’s a covenant or the amount of collateral. At this time, we are looking at structure versus specific segments of the market sectors or what have you.

Structure is often overlooked when people think about how to succeed in fixed income. When you think about interest rate risk, some people do. Clearly, not enough people, but a lot of people think properly about interest rate risk and credit risk, but in private credit deal structure is the huge risk mitigator and having ample asset coverage being senior in the capital structure with the lien on assets having very low loan to value and having strong covenants. These are things that can take a good company and make it a great deal.

Conversely, what we saw in 2021, when a lot of people were putting money to work, it was the opposite. You took good companies and put a bad structure around it to win the deal, and now you have fairly risky credits that are all priced too low during 2021 and in ‘22 to some extent. Something we think about a lot about how to structure a good company. That is a huge risk mitigator.

We are about out of time. What are you thinking about in terms of the key themes we should be left with? Before you answer, I will summarize a couple that you talked about. Moving up in quality is key. Thinking about diversification across products and geographies. Thinking about the fact that treasuries are certainly not interest rate risk-free and also perhaps not credit risk for it as well, given the situation with the debt ceiling. What are other things that we should think about?

This goes back to Howard Marks. He has an approximately quarterly memo and on December 17th, 2022, he had the Sea change memo. It’s the investor psyche, which is so important. Alice provided a high level of review. From 2009 to 2021, the investor, it was about FOMO. It was risk-taking. It was below-average inflation. It was historically low interest rates. It was fear of missing out.

Capital and credit quintupled.  In 2022 and 2023 and beyond, it’s not about fear missing out. Its risk of aversions. Inflation is elevated. Rates are higher and more normal. Credit is tighter and capital is less plentiful. People are investing based on considering more risk factors now. It’s a shift in investor psyche that’s important to note. We are entering this new regime of risk aversion, and it’s something that we should consider.

As we deploy capital, we have to be cautious about where we are putting it, and since there’s potennot as many opportunities before regarding how you receive capital to invest, you have to make sure every dollar that goes out, you are very thoughtful and worry about it. Years ago, they said the income was missing and fixed income. I’m happy to say it’s back. Now, whether it’s private credit or public fixed-income instruments, you can get decent income now, so equities and risk assets have to compete more. We’ll see more of that moving forward over the coming years.

Episode Wrap-up

Michael, thanks so much for joining. It’s always great talking to you and hopefully, we can get you back and get an update on all the things you talked about. Thanks, everybody, for reading and see you next time.

Thank you, Zack. Have a good one.

 

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About Michael Furla

Michael Furla, CFA, CFP® has a diverse work experience in the financial industry. Michael is the Managing Director and Head of Fixed Income at The Mather Group, where they are responsible for M&A investment integration, multi-asset model development, bond ladder methodology, and Family Office investment management. Prior to joining The Mather Group, they worked as a Fixed Income Methodology Engineer at Morningstar. Michael also has experience at S&P Global Ratings, where they held various roles including Associate, Rating Analyst, Senior Research Assistant, and Research Assistant. In these positions, they were involved in tasks such as leading teams, operationalizing design requirements, coordinating with application product managers, and completing data and process implementation projects.

Michael Furla attended Indiana University Bloomington from 2007 to 2011, although their degree and field of study are not specified. Michael obtained the Chartered Financial Analyst (CFA) designation from the CFA Institute in 2016 and became a CERTIFIED FINANCIAL PLANNER™ (CFP®) in 2019.