Featuring:
Mike Buchanan
Chief Investment Officer
Western Asset Management
Ongoing market volatility may not surprise investors -- but the potential of a multi-sector bond strategy to deliver reliable income might. In this episode, discover how a dynamic credit allocation can help investors manage risk and stay resilient from Mike Buchanan, Chief Investment Officer at Western Asset Management.
A Franklin Templeton company, Western Asset Management is the investment advisor for the Western Asset Diversified Income Fund (WDI). Learn more about the Fund here.
Transcript
CEFA:
Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association.
Today we are joined by Mike Buchanan, Chief Investment Officer with Western Asset Management. Western Asset Management is the investment advisor for Western Asset Diversified Income Fund, symbol, WDI.
Hi Mike. We're happy to have you with us today.
Mike Buchanan:
Really happy to be here and thanks for having me.
CEFA:
Mike, I mentioned the Western Asset Diversified Income Fund, an actively managed strategy that invests in a broad range of public and private fixed income securities. Can you discuss the investment strategy as well as the key objectives of the fund?
Mike Buchanan:
Sure. The mission of WDI is to look for higher levels of reliable, predictable, consistent streams of income across all areas of fixed income. We do have a secondary goal of capital appreciation but really think of it as an income-oriented portfolio. We leverage Western Asset's expertise and a whole host of different areas. So, think corporate credit, and that means investment grade credit, high-yield, loans. That's both U.S. and non-U.S. Structured Credit, which includes residential mortgage securities, commercial mortgage securities and more ... everything from hotel lodging, to industrial, retail office as well as probably to a more limited extent asset-backed securities. And then finally emerging markets in all forms. And the way we think of emerging markets, that's emerging market corporate securities, it's dollar-denominated sovereign securities, it's local currencies that are sovereign. So really looking across all those areas and making dynamic allocations across those sectors as we see relative value opportunities. And one thing, I think it's an important thing to note, is that all these sectors, although they're somewhat correlated, don't move in tandem. They have periods where one's outperforming another, the prospects for one are either more encouraging or more bleak. And so we really do try to be dynamic and use the idea of sector rotation to add value for our investors.
CEFA:
With regard to the exposure the strategy provides to private credit markets, are there unique characteristics to this area of credit and does private credit provide a degree of diversification to a portfolio that investors may not get from more traditional fixed income investments?
Mike Buchanan:
So the whole topic of private credit is really interesting and we all probably hear about this disintermediation, what I call the lines are blurring between public liquid credit and private credit. And there isn't a rigid line between those two, meaning something's not distinctly just public or it's not distinctly just private credit. More and more we're seeing things that are somewhere in that border territory. And what's great about WDI is it can really take advantage of some of those, what I would call more private-like investments. And the tradeoff, really, I think as everyone knows, is that when you buy a private security, you're giving up some liquidity. And what we've found is the advantage we get for giving up some of that liquidity is we're able to negotiate a better structure that could be like call protection that could include better collateral claims, so including more collateral in the overall loan that we're making, as well as just an overall better yield, better pricing.
So WDI, again, because of the closed-end nature, can take advantage of some of those less liquid opportunities and some of the more private credit areas that we invest in. And that includes both corporate as well as structured credit. So yes, WDI is definitely taking advantage of that for investors. I think managers that can look at the whole spectrum ... everything from private and pure private [credit] all the way to very liquid public [credit] and make those relative value calls and can make those assessments about when it's appropriate to take less liquidity in exchange for a better structure, more yield, more return--those are going to be the managers, the investors who have a competitive advantage going forward.
CEFA:
Mike, we mentioned that this strategy invests in a broad range of securities. What is your process to evaluate this investment universe to develop a workable set of potential investments?
Mike Buchanan:
It's a really good point. I mean, it's a big universe of securities that we start with. I say it starts with resourcing. If you're going to manage a portfolio like WDI well, you have to have adequate resourcing, and that means you have to have made the investment in specific teams that have an expertise in each one of these areas that we invest in. So that's really the starting point. And at Western Asset, we certainly have made an investment in all those areas that I mentioned earlier that span from corporate credit all the way to emerging credit and different forms of structured credit. We have deep teams with a distinct focus on fundamental research. That's very, very important to us.
To get more to the question, each team has a qualitative and a quantitative process that they use to home in on specific opportunities within their investible universe that they feel have a favorable risk-reward skew. And then from there, what we really do is we have what I think is a really great process for looking at and comparing and contrasting relative value across the different sectors. We're able to look at investment grade credit and compare it with what we're seeing in non-agency mortgages and perhaps compare that to what we're seeing in emerging market corporate bonds. So we've been doing this for a while, having those relative value discussions and it really does give us the insight and the perspective that we need to make those dynamic allocation decisions that I mentioned earlier.
CEFA:
How do you then make specific security selections and allocate those positions as you build your portfolio?
Mike Buchanan:
Another really good question. I'm the lead portfolio manager on WDI, but I work with other portfolio managers as well. We work with each team to really understand and try to home in on the specific investment that we're talking about and then consider if it is consistent with the goals and the objectives of WDI? Over time our portfolio managers in these sectors have these conversations, they really have an appreciation and an understanding for what those goals and objectives are for WDI. What's unique about those? Again, I would say just as one example that focus on income is really, really important. Not as much of a focus on total return, but just on consistent, reliable income. They understand that we could sacrifice a little liquidity if we think we're getting a better overall credit, we're getting more collateral claim, and we're getting better structure. So it's a very customized approach. Again, we work specifically with each team to talk about all the securities that are potentially candidates for investment within WDI, and then we really go through the more difficult process of selection as well as the sizing of those investments.
CEFA:
What factors or events would lead you to sell a particular portfolio security or significantly change your portfolio allocation?
Mike Buchanan:
Let me start with that second question. In terms of what would cause us to change our portfolio allocation? Again, as I mentioned, this is a dynamic strategy. We are constantly looking at all the sectors that we can invest in and we're comparing and contrasting fundamentals, technical conditions, overall valuations, and really making that difficult relative value call. Where are the best opportunities for our investors in WDI? And we take that very seriously and we do take advantage of it. The process that guides us in that is a committee, we call it our Global Asset Allocation Committee. That's a committee where I'm one of the co-chairs. And that really gives us the framework for discussion again, where we look at the things that I mentioned, fundamentals, technicals, relative value. And we have the team leaders really going through and debating and discussing the merits of the particular sectors. And ultimately these are the insights that we use to guide our allocation decisions.
In terms of the first question you asked, what I would call ... a little bit on our sell discipline. When do we sell a security out of WDI? There are few conditions that would necessitate a sale of a security in WDI. The first would simply be if fundamentally we got something wrong. And that's something that we do a lot of disciplined, fundamental work on: the securities that we put in the portfolio. And I'd like to say that a hundred percent of the time we're going to be right. But we constantly have to go back, evaluate how these credits are evolving, how the outlook may or may not have changed and make ongoing decisions. And sometimes when we get it wrong and you start to see that a credit is moving in the wrong direction, you see evidence of deterioration or impairment and you're starting to get concerned that ultimately this is going to be a security that won't be able to deliver on that reliable consistent stream of income. We take immediate action on those, and we sell those securities assuming that they are above what our estimated recovery value is in the event of a default.
So that's the first way a security is sold--if basically we got it wrong, or it's going in the wrong direction, we think there's risk of impairment not delivering on what we ultimately set out to do when we invested in that security. Also, I would say a security becomes a candidate for sale when it reaches or exceeds its relative value target, and that's determined by the analyst who follows that investment as well as the portfolio manager. At the time of investment, they make relative value targets. And when a security hits that target, it becomes a candidate for sale. This doesn't mean we automatically sell it, we look for other securities that can give us a superior risk/reward, a superior level of income and return. And sometimes that takes a while. So it doesn't mean when it hits its relative value target, it immediately is sold, but it's certainly a candidate for sale. And we're always looking for ways that we can enhance the overall income characteristics of WDI and we have a pool of securities usually that are in that relative value target area that we can choose from. So there's a lot of work that goes into selling securities and we're very cognizant of the primary focus of income on WDI and making sure that we can keep those consistent reliable streams.
CEFA:
Mike, the Federal Reserve has held rates steady, the rate of inflation has improved, and while the US economic growth has been resilient, the policies of the new administration have introduced some volatility to investment markets. Where do you see the fixed income markets currently and what is your outlook for the rest of 2025?
Mike Buchanan:
You said the key word there, volatility. Coming into 2025, we expected a year where you were going to see elevated uncertainty, elevated volatility, and a lot of that was simply the administration's policies on everything from trade and tariffs, to immigration, to taxes, to deregulation. There were a lot of unknowns and a lot of ambitious policy initiatives that may or may not ultimately get to the finish line. And we knew that would come with an element of uncertainty. So it's not really surprising us that we're seeing so much volatility and so much uncertainty so far this year. But we do ... and you alluded to this. We ultimately see inflation going lower. It's like you'll see a temporary uptick that comes from tariffs, but that's not going to be ongoing. And that ultimately you will see inflation slowly but surely making progress toward the Fed's target of 2%, and we think that'll give the Fed room to lower their policy rate.
Now does that mean that the rest of the curve is going to go lower with that policy rate? That's probably a little more debatable there. We do think we're likely to see the curve steepen from current levels, meaning that the shorter rates are going to move more quickly lower than longer rates. But, ultimately, we think that unlike two of the last three years, rates are not going to hurt you in 2025 and are perhaps more likely help you; be a little bit of a tailwind. So that's a good starting point. Just having a backdrop where rates are either stable to going lower, you combine that with high yields that we have now and that's a byproduct of some pretty difficult years in fixed income with yields going higher. It has reset valuations. So in all those areas that I talked about yields are relatively high. And what's nice about that is you always have to not just look at yields, you have to look at the overall fundamental backdrop. And right now our view is the fundamental backdrop is actually pretty solid. Corporations are in good shape from a balance sheet standpoint, earnings standpoint, margins, and so you move over to other areas that we invest in. Again, it's a pretty solid, sound fundamental backdrop.
So that means that you're going to enjoy that high yield; that's a starting point. You're probably going to give up only a little due to impairment because of a good strong fundamental backdrop and you're obviously earning a lot income on the way. So when you put it all together, our view is and has been that 2025 is ultimately going to be a good year for fixed income, and WDI is certainly in a good place from a structural standpoint to take advantage of that.
CEFA:
What are the most significant risks you consider in the current environment?
Mike Buchanan:
It's really interesting where we are right now. So it's recession. I would say any credit-oriented portfolio, that's always going to be one of your biggest risks is that you get your base case wrong. And again, our base case is more of a soft growth, but still positive growth scenario with inflation trending in the right direction and fundamentals holding up well. But, if we were to slip into a recession, obviously that starts to put more pressure on fundamentals. It usually translates into spread widening. And what could possibly cause that recession? Because again, I mentioned we think we're at a pretty good starting point when it comes to the economy, when it comes to corporations, even when it comes to the consumer. We're at a decent starting point in terms of where we are now. But obviously tariffs have become front and center and, as we're speaking today, it's unclear if we are going to start to get some trade deals.
And it's really unclear--are these tariffs or are these tariff negotiations designed simply to just achieve better trade outcomes of better trade deals with our key trading partners, which I think the markets would be okay with. Or is it something more than that? Are we really trying to rebuild the industrial base in the United States? Are we really trying to bring manufacturing back to the US? And I think if the administration really digs in on that, that's a much more difficult thing to do. It's a much more difficult thing to see to fruition. And it obviously brings a lot of uncertainty from our trading partners. I think depending on which direction these tariff negotiations go, that could be the difference between our base case and then something more scary that could lead to a recession. Again, if the administration really digs in and wants to make this about rebuilding the industrial base and bringing all manufacturing back to the US, that's just going to take time. There's no real certainty on that and probably brings with it a whole host of different challenges.
CEFA:
How is the WDI portfolio currently positioned and how has this changed over the past few months?
Mike Buchanan:
So one thing that we've been doing recently ... I mentioned that volatility that we've seen in the market and the spread widening that we saw. In particular, in the beginning of April. So, recently, we were able to take advantage of that and use some of the borrowing capacity that we have to go after attractively priced securities at wider valuations. If you look at the portfolio at the beginning of the year versus where we are now, we have been gradually adding a little bit to our high yield exposure. It's been a little more focused on high quality, high yield. Again, you won't get as much income with higher quality high yield, but you're buying securities that have the ability to endure economic challenges. So if our base case is wrong, if we slip into a recession of some sorts, I think the kinds of securities that we're buying, or at least adding to the portfolio, are more durable. They can hold up better in that kind of environment. So we've been carefully adding to some of the higher quality high yield. We've added a little bit to our loan book as well. But, again, using new cash that we've drawn on our borrowing facility to accomplish that.
Another thing that we've been doing pretty much over the last couple quarters is moving to a little bit of a higher quality bias. So looking for those swap opportunities that will allow us to go, for instance, from a single B rated security to a double B rated security or go from an unsecured security to a secured security. It's really an acknowledgement of trying to get a little more defensive, understanding that the outlook, the economic outlook is just a little more cloudy. It's not as certain, and as much as we have conviction in our base case, we know that other cases around that including a recessionary case, aren't an impossibility. There is a probability. So we want to make sure that we can muscle through those types of environments and really have minimal harm or impairment to the income streams in our portfolio.
CEFA:
Where are you seeing the best opportunities to put new capital to work?
Mike Buchanan:
I guess the way I would think of that question ... I will comment on one particular area, but it's more about patience. Because, again, at the beginning of the year we said this is going to be a year where there's going to be some volatility, there's a lot of uncertainty, and what we want to do is be in a position to take advantage of that volatility. So we are being more tactical, like I said on this recent spread widening, we added some exposure in different areas. I think if the markets were to perform well over the next few months and spreads tighten, I don't think we would be shy about selling into that a little bit because, again, I think with volatility it means you're just going to have opportunities to add securities in the portfolio at more attractive levels. So we're really exercising patience; we're trying to be disciplined about that. We're trying to be disciplined about when is it the appropriate time to perhaps sell a little bit? When is it an appropriate time to take advantage of volatility, to buy at wider spreads?
And in terms of what we target, again, the market's going to give us some guidance on that. I would say one area that we're watching pretty closely, and it is closely correlated with rates. But if we were to start to see a more reliable trend lower with respect to interest rates, and not just policy rates, but a little further out the curve, the five year, the 10 year, if our conviction was higher on that part of the rate environment moving lower, you could definitely see us moving a little more aggressively into some of the commercial mortgage securities that are out there in the market. We've got a really good team that looks at that and is constantly doing analysis there.
And, like I said earlier, they look at all different sectors within commercial mortgages, and they do think that fundamentally that sector has been turning for the positive and we're starting to see more new issuance. Unlike some of the other areas in the market, valuations still look relatively attractive when compared to historical averages. So there's definitely some opportunity there, but it's very correlated with the direction of rates and we want to have a stronger view on that. So I would say that's just one area where we're very involved in terms of keeping our eye on what's going on there, identifying some potential securities that we'd want to move on, but we just need a little more confidence in terms of the direction of interest rates.
CEFA:
Mike, how do you see an allocation to a diverse, actively managed fixed income strategy like WDI best positioned in an income-oriented investor's portfolio?
Mike Buchanan:
I think WDI is a really powerful strategy for income oriented investors. The current distribution rate in that 12 to 13% range is really attractive, and I think if you look historically, look at our dividend, we've had a good track record of either stability or being able to increase that dividend. I think that can just serve as a key component of an income driven investor's portfolio because of that high, consistent income. And it really complements other, perhaps more growth oriented securities, that might be in a portfolio. Especially in tax advantaged accounts. When you look at the current environment and the uncertain outlook--we talked about tariffs, geopolitical uncertainty, volatility--we believe that a well-diversified bond portfolio with broad exposure to income producing asset classes is just a valuable addition to almost any investor's portfolio. And, again, given the uncertainty, it just makes a lot of sense in our view to have an income strategy playing a role in your portfolio today. The other thing I would say is maybe not recently, but over the past few years, equities have performed well and we think it's prudent that if you have a strategy that provides compelling yield as a diversifier, especially as investors look to navigate through the market challenges ahead, WDI is a really good candidate for that.
CEFA:
Mike, thank you so much for taking the time to join us today.
Mike Buchanan:
Well, thank you. I really appreciate the opportunity.
CEFA:
And we want to thank you for tuning into another CEF Insights podcast. For more educational content, please visit our website at www.CEFA.com.
Podcast recorded April 2025.
Disclosure
This material is not and is not intended as investment advice, an indication of training intent or holdings or the prediction of investment performance. All fund-specific information is the latest publicly available information. All other information is current as of the date of this presentation. All opinions and forward-looking statements are subject to change at any time.
Western Asset Management disclaims any responsibility to update such views and/or information. This information is deemed to be from reliable sources; however, Western Asset does not warrant its completeness or accuracy. This presentation is not intended to, and does not constitute an offer or solicitation to sell or a solicitation of an offer to buy any security, product, investment advice or service (nor shall any security, product, investment advice or service be offered or sold) in any jurisdiction in which Western Asset is not licensed to conduct business, and/or an offer, solicitation, purchase or a sale would be unavailable or unlawful.