Capital Ideas^TM

Intro to podcast interview

Will McKenna: This week on Capital Ideas we've got the first of a two-part series to celebrate 50 years of managing fixed income portfolios at Capital Group. We’ll be talking to current long-tenured and a few retired portfolio managers about their experiences and lessons learned over decades of investing. My colleague Dan Indiviglio will first talk with Kirstie Spence, a portfolio manager who specializes in emerging markets debt, and John Smet, the retired principal investment officer of the Bond Fund of America. I'm your host Will McKenna, let's get into it.

Interview transcript

Dan Indiviglio: I'm speaking with Kirstie Spence, a fixed income portfolio manager with responsibilities for a few of our funds, which includes being principal investment officer for the Capital Group, Emerging Markets Local Currency Debt LUX Fund. She also serves on the Capital Group Management Committee. She has 27 years of investment industry experience all Capital Group. Earlier in her career at Capital, Kirstie was a fixed income investment analyst and her coverage included sovereign debt in emerging markets with a focus on Europe, the Middle East, Africa and Latin America, as well as European telecommunications as a credit analyst. She holds a master's degree with honors in German and international relations from the University of St Andrews, Scotland. She's based in London. Thanks for talking with us today, Kirstie.

Kirstie Spence: Great to be here. Thanks for having me.

Dan Indiviglio: So you joined Capital straight from undergrad as an arts major. How did you learn about fixed income?

Kirstie Spence: Well, I actually joined Capital through our undergrad program, which is a rotational exposure to the business program. And I was definitely an example I think, of a diverse hire in the sense of trying to take people with different backgrounds and expose them to the business. And so I actually had no clue about anything in finance, let alone in fixed income. And so when I heard about fixed income as an opportunity for a rotation, I was very intimidated, didn't really know how to define it, and ended up actually on the trading desk in municipal bonds. But actually some of the lessons that I learned in that first rotation about fixed income have really stayed with me throughout my entire career. And there were some really simple concepts which I think people shared with me almost out of their fear of having this very naive 22-year-old coming onto the municipal desk.

So one example of it was that there was a portfolio manager who was pretty tenured, and he literally said to me, "Your most important job in fixed income is to not lose money." That number one lesson, and it really does stay with you and I'll probably come back to it later. And then the second thing he did was he drew me, literally drew me a seesaw and he said, "When yields go up, prices go down and the other way round." And I will be honest, it took me a while I think in those first few weeks to understand what that concept really meant. But they were really anchoring concepts about how fixed income behaves. And I had had by then some exposure to equities and some exposure to those discussions. And I actually found the simplicity of bond math very appealing. So in its simplest form, and this sort of family dinner party description of what I do. It's an IOU, you're lending entities money, whether it's countries or companies. And depending on the perceived risk of that entity, you are asking them to pay you a different level of interest rate over the lifetime of that bond.

And whether you are doing high yield or structured or treasuries or emerging markets like me, that simple concept of what fixed income is and ultimately the idea that you want to get that money back that you initially lent out, it doesn't change no matter what the asset class. So that simplicity I think is always really important to anchor yourself in as an investor. And sometimes when the markets are hard or the investment opportunity feels quite complicated, really coming to that basic of, am I going to lend this entity money? It's not my money, it's somebody else's savings, therefore, how much risk is it and what interest rate do you want to get paid for that risk? And will they pay back? Is just a really, really important principle.

Dan Indiviglio: Yeah, I like that. I think that I've always felt the same way about fixed income. It gets a bad rap for being complicated, but I've always thought the straightforward math of it versus equities, which are so emotionally driven and there's so many factors that companies have that might affect their equities, it makes sense that there's some simplicity there.

You describe yourself as an optimist in everything and is that an advantage or a handicap as a fixed income manager?

Kirstie Spence: Yeah, it can be both. So I think fixed income, it is right to talk about reputations of the asset classes and I think there are stereotypes around equity investors and fixed income investors and also the type of people that get attracted to it. And in that sense, I think people typically assume that the optimists are on the equity side and the more pessimists are on the fixed income side. So I think you are more unusual if you're an optimist in fixed income land. And whether it's an advantage or disadvantage I think depends. I think the most important thing in investing generally is to be aware of your biases and aware of some of the tendencies that you might have when you are investing so that you don't always lean into those.

So the thing about being an optimist in fixed income, I mean on the one hand you need it to do emerging markets, it is a very volatile, very risky, more equity-like area of fixed income. And it can be super painful sometimes, from many perspectives, economically, financially, politically, from a humanitarian perspective. So actually I think you need some optimism just to want to be in this area of the asset class. And I also think sometimes it can give you that nerve to go into the turnaround stories, which sometimes emerging markets or the higher risk parts of fixed income are, and also perhaps see a side that the market's not seeing. If the market is full of more pessimistic or more downside lookers, than if you are the contrarian, which you are being an optimist in the asset class, then that can be an advantage.

The problem with it is, and this is where I think being aware is so important, is that you can end up falling in love with the story or the idea, which is obviously part of what equity investors are trying to do. They're trying to find that long-term story, but in fixed income we need more discipline than that. There's always a valuation argument. It is important not to become too emotional. And so sometimes that can be the disadvantage because you perhaps don't sell as nimbly as you should do, or you are more willing to ride it down and therefore you are losing money. And that's not the goal as a fixed income investor. So I think you have to be very aware and very careful. And then you also need a balance within your investment team of the ones that are naturally more optimistic and the ones that are naturally more pessimistic. And a lot of my job as a portfolio manager is trying to calibrate the analysts in our team for those biases as well as be aware of my own and the other portfolio managers. So it's how I survive the asset class, but I am quite aware of where the shortcomings can be as well as the advantages.

Dan Indiviglio: So perhaps a cautious optimist might be the way to state it?

Kirstie Spence: Yeah, I think that's right. And there is one other thing actually related to that, which is that fixed income has an asymmetric risk return profile. So you know your upside, which is to get your money back and the coupon you earn, but your downside is that you could lose all your money, which is very different from equity where you have upside depending on how the investment works out. And obviously you have downside too, so that is your starting point is being aware of that asymmetric risk return, but by nature you need to be protecting first rather than trying to capture upside first.

Dan Indiviglio: On that protection point, it's interesting. One thing I've found here working with a lot of portfolio managers over the years is how seriously they take that responsibility of being entrusted with people's savings. And oftentimes I'll hear them tell stories about getting letters of appreciation from their investors that managed to get to their goals through their fund and that sort of thing. And it's always made me feel good about the work they do here and how much they care.

Kirstie Spence: Yeah, no, I think it is incredibly important as an investor to never lose sight of whose money it is you're managing. And I remember very early on in my career, we used to do rotations through the service centers and you would listen to our shareholder services, people speak on the phone to people phoning about their savings and the importance of it and the fact it's for college or for retirement and that really human angle is important to never lose sight of. And there are lots of things in there, it's why we never use gambling terminology when we refer to our investing because it's other people's money. I also do a lot of work directly with clients on the institutional side and there is a huge power in having to sit quarterly or every half year and talk directly to the people who are responsible for their employees and their pension plans or whatever their savings pool is. So that accountability is very important, and I think if you ever lose sight of that, you quickly can become greedy and you lose perspective on what it is you're trying to do.

Dan Indiviglio: Right. Right. What would you say is the most underrated thing about bonds?

Kirstie Spence: Well, a couple of things we've already touched on. So I think they are less complicated. They're actually simpler in terms of what they're trying to do than people would say. And I think some people think that it's just all about maths and it's a bit boring and it's absolutely not at all. Like anything else in investing, there is science, but there's also art and there's judgment and there's the qualitative angle on every investment that you make.

But one of the things I think that gets forgotten with bonds is simply the power of a coupon. The fact that in most bond structures you are paid an interest rate and that annual or paid out quarterly, whatever it is, that that payment is very important in terms of contributing to the total return that you're going to make on the investments. And certainly in my asset class, the capital appreciation or the value of the bond can move a lot over the life of the bond. And there are some things that might be a little out of your control that drive that, which is overall global interest rates or interest rates at the macro level, but still earning that coupon is a quite powerful cushion in terms of protecting that investment. And in the area that I do, it has always been the kind of cushion or the meat of the annual return and it can be very underestimated. So I think people forget about that a little bit in the headline risk of interest rates with bonds and worrying about technical terms like duration. But the coupon is a very powerful thing.

Dan Indiviglio: And it's funny because in the emerging markets coupons have been significant for a long time obviously, but in other markets they're suddenly becoming significant and given all the changes we've seen with interest rates and people are remembering that fixed income actually is income-driven, right?

Kirstie Spence: Right.

Dan Indiviglio: As the name would imply, and they weren't for a long time.

Kirstie Spence: There was a period out there where particularly in G7 markets, over half of the relevant benchmark for G7, so the really developed economies had a negative yield, that's when it does start to feel really complicated about how on earth are you actually going to make money as a saver by investing in this area. We clearly never had that in emerging markets, but you're absolutely right. Now that interest rates have gone up, although it does mean that there's a more uncertain macro and inflation outlook and policy outlook, there is now at least some protection that feels like it's there for investors and that's very attractive and you can see it now with the interest coming back into fixed income asset classes. That people think, okay, good, I've now got some. It doesn't feel so that I'm not being paid anymore for this risk. I've now got some compensation coming in, and then I can abide my time for the overall direction of interest rates. So yeah, it's good to see that the yields are back.

Dan Indiviglio: Right? You've been a fixed income investor for a long time and invested through some crises. What have they taught you?

Kirstie Spence: Well, lots of things. So yeah, in a long career in investing, which now I'm now well over 25 years, and doing emerging markets but frankly also developed markets, there have been many, many crises. I mean very early in my career I joined Capital in 1995 and I became a dedicated emerging market person in late ‘97 and I was doing Eastern Europe, so my very first crisis was the first Russian default in 1998, and I was the analyst on the region. I did take a lot of lessons from the aftermath of that and I think that then set me up quite well for things like when Argentina went through a debt restructuring a few years later and the ability to both identify the risks early on, but most importantly, to know when to then step back in and try and recover some of that value for shareholders. So those lessons on the immediate crises are important. Just how you handle them, how you respond, things you do and don't do wrong. I have had other crises and the GFC for me was one of them where I did lose my nerve. I didn't get back involved and didn't invest again afterwards quick enough. And so lost the money but wasn't able to recoup it as nimbly as some of my colleagues did. And that was a big lesson. And you have to analyze why you did that. Did you get frozen? Were you too scared? Did you think the world was coming to an end? Which I think we did. So things like that.

But that one was a good one for then the COVID and the pandemic market fell off because actually that lesson of something very abrupt that was very dramatic in terms of its impact, but actually then throwing up these opportunity of things that actually probably would be temporary in terms of impact and had really fallen in value. So actually, in that situation, I think it was a good example of using those lessons to rotate the portfolios and be able to invest in some things. So how you respond both in the moment of the crisis but also importantly in the aftermath is really important.

Over the years, I have really seen the collaboration grow. And what I mean by that is the pulling together of the different skillsets, the trying to unpack what's going on, we used a phrase in the global financial crisis, which was connecting the dots afterwards. So we recognized that perhaps we had missed some things going into it, we weren't going to miss them for the next one. So really bringing together equity, fixed income, developed markets, emerging, bank analysts, rates analysts, and really trying to figure out what was going on. But there's another thing that happens when you've been doing this quite a long time, which is that crises keep happening. So when you first go through one you think, gosh, this is so extreme. And perhaps you anchor on something like the '70s oil crisis or the 1930s and you think, gosh, this is a once in a generation or once in a lifetime, but actually it's not. They happen with relative frequency. And so it is also really important to be aware of them, think through possibilities.

In fixed income we have a portfolio strategy group, so we get together two to three times a year. We discuss macro factors and drivers for the portfolios, but we do a lot of scenario analysis, stress testing the portfolios, looking at terror risks. And I can promise you every single time we open up those discussions or we create a scenario, me and others will always say, "Oh, it's ridiculous. That will never happen." It seems too extreme. And I don't say that anymore. Because I've now seen it happen over and over. Where actually the U.S. does lose AAA rating. We do end up, sadly with a war in Europe, we do have a pandemic that causes huge financial disruption. And so it is very important to think them through and use past experience and use quantitative tools to try to at least think about what the impact would be. So, yeah. So crises happen again and again, learning how to respond and learning how to think them through in a sensible, calm, risk-managed way it's part of the job and the role. And they can be the most rewarding periods to work in the financial markets. Much, much more interesting than just a boring coupon clipping year.

Dan Indiviglio: Right. Right. And it definitely does seem like markets always managed to come up with new and dramatic ways to surprise us over the years.

Kirstie Spence: Yeah. They really do.

Dan Indiviglio: And that leads to my next question with when things happen and there's all this information with the 24-hour news cycle and the vastness that has become the internet, how do you filter out the noise?

Kirstie Spence: Yeah, I mean that is a great question and one of the hardest ones to answer or to say I think. But one of the things with investing, as I mentioned before is it is art as well as science. You will never know all the information and you are always working or operating with imperfect levels of information and some level of judgment. And you see it when analysts join us and they are all so smart and they've great skillsets, but when they're doing what we call an initial investment review or a launch of the coverage that we've given them, so it might be a corporate sector or it might be some countries or it might be a range of securities, and they launch every single person that comes in, their frustration is, how deep can they go and how much can they know? When do you draw the line and say, actually I'm ready to make an investment decision?

And it's also one of the reasons we give analysts money to manage in research portfolios because it is one thing having an opinion based on data, it's quite another turning that into a live investment that works for the client or the shareholder. And so that next level of that decision making is really important, but at some point you have to operate with a base of information. I often use the iceberg analogy. It really is only the tip that shows and that's the decision based on perhaps two or three key drivers. And underneath that is a wealth of other information that may or may not be relevant. But really what we have to decide as investors is what we think the two or three key drivers are going to be and over what timeframe, and how they differentiate from what the rest of the market is doing and making with their decisions. And then we apply that to the valuation that's on offer and decide whether or not the investment is worth it.

Dan Indiviglio: Right. A lot of what you've discussed today is based on all your many years of experience. And I wonder what you might say to a new fixed income investor.

Kirstie Spence: And we have lots of them coming in all the time and it's often what they want to know. I think what's interesting about that question is that relationship with new analysts coming in or new investors coming in is symbiotic because the market's also changing all the time. And there is a tendency, I have found, that when we bring people in, their skills are often better, more honed. They might have used different systems, different ways of doing things. And so there is always an opportunity to learn and improve your own skillset from every new person that joins the group. And I think we're very good at doing that, really opening our minds to different approaches. So on the one hand that's important, just us being open-minded as more tenured investors to new ways of doing things or new inputs into the process. But again, I think when people do come in, there is also a danger with the amount of tools and information available and quant resources and our systems and all the things that we have of perhaps, I'm going to keep saying it, but just forgetting the basics. What is it that you're trying to do? What is the time horizon? You're trying not to lose money. Why are you trying to make money? Who's it for and how are you going to do it? You want to get paid back your money and you want to earn the coupon.

And so sometimes I think what you can do as a more tenured investor is just help really anchor the goals of the portfolio. What are we really trying to do here? Push the timeframe. There's a lot of noise day to day. And so if you feel the appropriate thing for our client base and the shareholders is to remind people that perhaps we have a competitive advantage just by thinking out six months longer than the market is currently pricing, that that might be what we do. So I think just helping with that, helping just really simplify the goal and helping to then put their individual ideas or contributions into that broader perspective, I think that can be really, really valuable for analysts and newer investors who are learning their trade.

And also making sure that people don't feel that the way to impress is by being overly complicated. Actually simple theses are almost always the best ones. Because as I keep saying, we can come back to them, you can revisit and you can also decide whether they're working or not, and then you can make a decision. And usually, making a decision either to scale up or scale down and be nimble is often quite a good thing to be able to do.

Dan Indiviglio: Right. Yeah. It's making tangible those impacts that might seem small, but as part of the whole mean, this cooperative process of investing, does it have an impact?

Kirstie Spence: Exactly. Yeah.

Dan Indiviglio: I really appreciate your time and all your excellent insights and thanks so much.

Kirstie Spence: Great. Thanks very much.

Dan Indiviglio: I'm talking with John Smet, a retired fixed income portfolio manager. John started his career with Capital Group in 1983 and spent 36 years at the company. Before retiring, he was the principal investment officer for our core bond fund, The Bond Fund of America, and was based out of our Los Angeles office. Earlier in his career as a fixed income investment analyst at Capital, John covered mortgage-backed securities and railroads. He holds an MBA in finance and a bachelor's degree in economics from the University of Wisconsin Madison. Thanks so much for taking some time out of your day to talk to us today, John.

You had quite the career at Capital for about three decades or so as a professional investor, but today I think you might want to talk to us about a few lessons you learned since then on the other side of the table, not during your day job, but as a retiree. Instead of a fund manager, as a shareholder. So tell us about how that feels and something new you've found.

John Smet: Well, I've certainly enjoyed my life as a fund manager, and I assure you, I'm having a good time as a fund shareholder in my retirement. But I think the thing that strikes me as I sit and look at the world and look at the markets is I just can't believe how blessed I was to have all the resources as a fund manager at American Funds. If you think about the hundreds of analysts that I was able to interact with, analysts and colleagues and outside specialists, it was really an overwhelming amount of information.

So just think about Russia today. I mean, Russia is in the headlines and things seem to be changing daily. I know it is very confusing for me to figure out what's really going on in Russia, but I know if I was back as a fund manager at American Funds, I would have internal analysts who had lived in Russia, who knew the situation, were very competent, but I know we'd have daily briefing with outside experts, ex-CIA member that lived in Moscow. So the amount of information I had to manage my portfolio was huge, and it was very difficult to manage a fixed income portfolio. But as a shareholder without those resources, I can't imagine how you manage a portfolio without having a professional management.

Dan Indiviglio: Yeah, it makes a lot of sense. Are there any other interesting specific examples that you think that you've run into where seeing things happening in markets, it's clear to you that you don't have the research you used to be able to make the same quality of decision?

John Smet: Yeah. I mean, think about where you are today with markets and fixed income. So the questions that all of us are asking is, has the Fed stopped raising rates? Is the Fed going to raise once more, two more times, three more time? Is inflation here to stay? Is inflation going to come down dramatically? What about a recession? Weren't we supposed to have a recession? Are we going to have a recession? What about the budget deficit? It is that meaningful? What about the dollar? Is the dollar going to strengthen? Is the dollar going to continue to be the reserve currency? Where do we stand in the world? How strong are the rest of the world's economies?

So all of these questions we have today are difficult to answer for professional investors with all of their resources. It's really tough sitting there as a shareholder in my dining room, in my kitchen, reading the newspaper, listening to the news, looking at the internet, trying to figure all this out. It's impossible to try and figure all that out.

Dan Indiviglio: Again, that resonates with me as someone who's not a professional investor, but works with folks who are. I've seen a lot of those capabilities that you mentioned. As an individual investor, how do you feel about fixed income fitting into your goals?

John Smet: I'm like a lot of retirees. I have financial goals similar to what a lot of people are thinking about. I'd like to have a good living. I'd like to have some income. I'd like to leave a legacy for my children and grandchildren. We have a family foundation, so I'd like to continue to support my philanthropic efforts. So when I think of those as my goals, fixed income really fills a big part of that. Fixed income first of all can provide income, whether it's cash or bond funds, provide a really nice income right now. Fixed income can provide an anchor in a

portfolio, when you see the volatility of stocks going up and down, knowing that you've got a relatively safe anchor in your portfolio. Oftentimes fixed income does well when equities do poorly.

So I think creating that balance using both fixed income and equities to help achieve your goals of income and achieve your goals of legacy for your children and grandchildren and maybe a family foundation, all of those involve heavy use of fixed income.

Dan Indiviglio: On that note, more broadly even, what would you say about investing for individuals? Clearly different people have different goals in different situations, but is there any view you have on how individuals should think about achieving their goals through investing?

John Smet: I talk to my kids all the time and I talk to my relatives and say, "You've got to get a plan." I see a lot of people, including my relatives and my children, will go on the internet and spend hours trying to save $50 or $100 on an airplane ticket. And then when you say, "Do you have a financial plan? Do you have a 529 for your children? What's your ratio equities and bonds? Do you have money for emergencies?" You get a blank stare. So people don't necessarily have a plan.

I think for me, having a plan and sticking with it is a great thing. I surprised myself. I am pretty busy in retirement, so I don't have a lot of time to sit down and look at the markets and try to plot my financial future. And I like to sleep at night. So having a plan, sticking to it, a long-term plan, and just sticking with that plan and realizing when I set the plan, knowing that markets are going to go up and are going to go down. So I don't really get too worried that markets are down 30%. I know I'm going to be okay. I look upon it as a buying opportunity. So it's really having that plan and really sticking to that plan, I find is very useful as I sit here in retirement.

Dan Indiviglio: It does seem like a lot of folks sticking to that long-term plan can be hard when weird things are happening in markets and it feels like, oh no, I've got to change my plan because look what's happening. But a lot of times that might not be the right decision.

Speaking of such things, you retired right before the COVID era began. It's been a pretty big rollercoaster since then with steep unemployment, strong employment, inflation, higher interest rates, regional bank troubles, all those sorts of things. What “Aha!” moments have any of these caused in your mind since you left being a professional investor?

John Smet: Well, the thing that always struck me when I was a manager at American Funds is when you're dealing with fixed income, it's really important to have a very well diversified portfolio. And unless you have a very large portfolio, it's really hard for individuals who own individual bonds to have a well-diversified portfolio. I think recently we've had in an instance, the Silicon Valley Bank, First Republic, Credit Suisse, I mean, if you own bonds of those individual banks, and those are very high-quality banks, your portfolio would really be under a lot of stress right now. So if you think about a fund like Bond Fund of America, which is a very large fund, a big holding in Bond Fund of America would be a quarter of 1%, a half a percent. Very rarely when I was there, we saw other than Treasuries positions as large as 1%.

And if you were an investor that owned a Silicon Valley Bank that was 5% of your portfolio or 10% of your portfolio, you're not sleeping well at night. So the really benefits of having a mutual fund that's very well diversified when you own your fixed income. The problem with fixed income is that you don't get doubling or tripling of your money, but if you have the wrong bonds, you can lose all your money in that bond. So you really need to be really well diversified. So really as I sit here from my retirement lens, it's really important to have a well-diversified portfolio in your fixed income sector.

Dan Indiviglio: Well, thanks so much, John. It's been great talking to you. We appreciate hearing your insights and taking some time to talk to us, especially during your well-deserved retirement.

John Smet: Yeah. Well, it's been great speaking with you and hopefully we can do it in the future.

Episode outro

Will McKenna: OK, there you have it. Special thanks to Kirstie Spence for spending some time to talk to us and to John Smet for taking time out of his retirement to join us. If you liked what you heard today, please follow us on your favorite podcast platform.

Closing disclosure

We're always trying to get better, so if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at CapitalIdeasPodcastAustralia@capgroup.com.

For Capital Ideas, this is Matt Reynolds reminding you that the most valuable asset is a long-term perspective.

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