Longer Runway for a Soft Landing
Recent Market Developments
Shift to high yield issuance positive for both bonds and loans
The Fed’s dovish pivot and the perceived end of the rate-hike cycle have led to a swing in sentiment in favor of high yield bonds, especially among retail investors. Stronger demand for high yield has manifested itself in a recent surge in secured high yield issuance, pushing a meaningful amount of non-investment grade supply from floating-rate leveraged loans back into the high yield market.
The shift in appetite among asset classes is driven by sentiment on leveraged loans, which began to turn negative in late 2018 on slowing global growth data, then accelerated in January 2019 as a result of the Fed’s stable rate policy. Loans have predominantly been a floating rate trade, and with the Fed shifting to a more accommodative stance, retail loan funds have experienced meaningful outflows: $20 billion over the last eight weeks of 2018, followed by an additional $5.5 billion through February 2019.
New issuance reflects these trends:
- Growth in total high yield net of refinancing: Through February 2019, high yield new issuance net of refinancing grew 59% year-over-year to $17.3 billion. Gross of refinancing, high yield new issuance has declined 12.7% to $38.8 billion. For 2019, we expect both gross and net new high yield issuance to rebound by 10 – 20%, consistent with inflows to the asset class.
- Surge in secured high yield: In January 2019, secured high yield issuance reached $9 billion, making it the busiest month since early 2016. Back then, heightened issuance of secured high yield debt was due to a wave of distressed exchanges in the Energy sector.
- Decline in leveraged loans: Overall leveraged loan issuance has declined by 42% year-over-year to $43 billion. This is apparent in declines in refinancing (down 90% year-over-year) and M&Arelated loan issuance (down 13% to $35 billon). Much of the 2019 M&A financing clearly shifted to high yield, with $12 billion of new high yield M&A-related supply coming to market through the end of February, 70% above the historical 10-year average for the first two months of the year.
The combination of fund flows and issuance trends have led to the point where loan and bond yields are on top of each other. This loan underperformance relative to high yield is something we have not seen in a long time. As a result, some loan issuers have tapped the bond market instead to meet their funding needs. Coupled with a light forward loan calendar, this dynamic has led to our view that loan issuance could decline by 20 – 25% in 2019.
Corporations who recently chose to issue secured or unsecured bonds in the place of expected loan issuance include:
- Dun & Bradstreet
- Johnson Controls Power Solutions
- Community Health
Compounding retail investors’ negativity, deteriorating formation of collateralized loan obligations (CLOs) has also weighed on loan demand. The expectation that loan and CLO supply will likely decline this year should create technical tailwinds that could drive spreads tighter in the near term. Fundamentals would certainly support tighter spreads in loans and CLO liabilities.
Investment Upshot: The technical tailwind from a much lower supply of leveraged loans and CLOs will likely lead to near-term spread-tightening and reversion to the mean on spreads vs. high yield. We remain constructive on both the high yield and leveraged loan markets.
Self-Help and Quality Improvements Temper BBB Concerns
Since the 2008 financial crisis, the percentage of the investment grade credit market rated in the BBB category has steadily increased. It now represents approximately half of the overall investment grade index. At $2.6 trillion, BBB debt is over twice the size of the entire high yield market. A straightforward narrative, which has been the focus of the financial press, highlights the possibility of fallen angel debt overwhelming the high yield market during the next downturn, causing substantial harm to the real economy. We take a more nuanced view:
- Defensive credits: While the growth in the BBB segment of the market is beyond question, the risk profiles for most of the large cap BBB credits are completely different than typical highly levered cyclical companies. Most of the incremental debt growth in the BBB market now resides on the balance sheets of companies that are less sensitive to the business cycle and are better able to protect their ratings. These tend to be concentrated in defensive sectors that will benefit from stable cash flows during periods of economic weakness.
- M&A-related: Much of this growth can be attributed to large debt-funded acquisitions by companies such as Verizon, CVS and Anheuser-Busch InBev. This transaction-related downgrade may prove transitory. In fact, AT&T and Verizon, two of the largest BBB credits in the market, have both announced debt reduction as a top priority over the next several years with the ultimate goal of reestablishing an A credit rating.
- Self-help: Additionally, most of the large cap BBB credits should be able to take advantage of their scale, diversification and flexibility to utilize multiple financial levers during periods of difficult operating conditions. Most important, we have recently watched several large BBB companies respond to challenging operating results with aggressive actions for the benefit of bondholders:
- Anheuser-Busch InBev cut its dividend and continues to consider asset sales in order to reduce its debt load.
- General Electric slashed its dividend and announced a number of divestitures, buying time as it stabilizes core operations.
- Kraft Heinz more recently announced a significant dividend cut. It is also exploring asset sales in order to strengthen its balance sheet and maintain investment grade ratings. These actions clearly benefited bondholders to the detriment of shareholders as the stock price subsequently declined by over 30%.
The increase in leverage since the financial crisis is real and we will surely see a number of fallen angels during the next downturn. However, as we have recently observed, not all BBB credits are the same. A thorough understanding of each individual credit and their ability to defend their ratings can uncover some great investment opportunities.
Collateralized Loan Obligations (CLO) Snapback Potential
CLO issuance got off to a slow start in 2019 with low issuance in January, which is not uncommon. Since late January, however, the CLO primary market has fully come back to life. Much of the CLO issuance coming to the market year-to-date has been characterized by:
- Underwater loan portfolios comprised of loans purchased prior to the loan market volatility of late 2018 at prices above current market levels.
- Creative structures aimed at tapping every pocket of available demand for CLO AAA-rated tranches.
On the back of this supply growth and unlike other risk assets, CLO debt spreads have actually widened slightly since mid-January. For instance, CLO BB-rated tranches now yield 4.4% more than BB-rated high yield debt, which is the widest basis in almost three years.
This substantial year-to-date lag in CLO performance—compared to the rally in loan prices—could soon reverse based on expectations of reduced supply for the following reasons:
- Narrow CLO arbitrage: The excess spread between the yield on the underlying CLO loan portfolios and the cost of the debt tranches has compressed to the tightest level since the 2008 financial crisis. The current tight CLO arbitrage is rendering new issue CLO equity returns unattractive to investors. As a result, we view a meaningful slowdown in CLO issuance as likely.
- Less refinancing: We expect a meaningful slowdown in CLO refinancing issuance in 2019 because the refinancing option is simply not in-the-money for most CLOs that will become eligible to refinance their debt.
The projected reduction in total CLO supply due to both challenging CLO arbitrage and a meaningful slowdown in refinancing activity should provide a positive technical backdrop for CLO debt spreads.
Investment Upshot: Unlike other credit risk assets, CLO debt spreads have not retraced most of the sell-off of late 2018. Given the current wide basis between CLO debt and corporates, and favorable supply-demand dynamics, we believe CLO debt is set up well to outperform in the coming months.
We continue to see value in most credit markets and remain defensively positioned on interest rates.
Government Bond Markets*
Given the current flatness of the yield curve in the U.S. both in absolute terms and relative to other sovereign debt, we remain modestly cautious on long duration.
Global Interest Rates and Inflation
The rate of expansion in economic activity peaked during the summer of 2018 and will likely continue to decelerate into 2019. The Institute for Supply Management (ISM) manufacturing index was at 61 in August 2018 and has since fallen to 54 while the ISM New Orders index dropped from 65 to 56.
Still, despite the deceleration of growth in the second half of 2018, the U.S. economy continues to expand at or close to trends. We continue to expect the economy to continue growing around 2%, tied to the following expectations:
- FOMC’s newly discovered patience with respect to future actions in monetary policy generates a range-bound market in rates and stable expectations for monetary policy.
- Ten-year Treasuries trade in the 2.25% – 3.25% range for the next few quarters.
- The yield curve steepens modestly, especially at the front end of the curve.
In our view, the calibration of monetary policy for the rest of 2019 will involve tapering Quantitative Tightening rather than rate cuts. An extended pause in rate hikes by the Fed should eliminate the need for stealth tightening inherent in QT.
Core inflation measures remain sticky since commodities and oil prices have gravitated away from the panic levels of December 2018. The Fed will likely remain on hold for 2019 as it reassesses progress on the inflation front and evolves its policy framework. A more structural shift in breakeven inflation rates and repricing of term premia is also possible in the case of average inflation targeting by the FOMC.
Given the current flatness of the yield curve in the U.S. both in absolute terms and relative to other sovereign debt, we remain modestly cautious on long duration as we look for opportunities to take advantage of price swings tied to expectations on monetary policy.
We continue to like TIPS relative to nominal Treasuries, but less so on an absolute basis since real yields have dropped and come closer to our forecast of equilibrium fair value.
Adjustments to our European government debt views reflect incremental caution on macroeconomic challenges. Over the last couple of months, European economies have decelerated more than previously expected and shown signs of an industrial recession. As a result, we have reduced our underweight exposure to longer-duration bonds.
In a couple of years, following a prolonged period of negative rates, we expect rate normalization.
Within Europe, we are more constructive on semi-core (France and Belgium) and the euro periphery (Ireland, Spain and Italy). EU elections in the spring could bring added volatility to European markets as a barometer of populist sentiment.
In the U.K., Brexit represents an ongoing saga. Clouds of uncertainty will continue to hang over the Bank of England. We are neutral overall toward duration in U.K, expecting a range between 1% and 1.6% over the next 12 months.
In Canada, housing is showing signs of slowing. The Bank of Canada is more cautious overall and has relaxed its previous hiking bias. We remain neutral duration despite flatness of the yield curve. We prefer to hold provincial debt over government bonds due to attractive spread levels.
With a slowdown in Australian inflation, real rates seem relatively high. Uncertainty on China trade remains. Over the last six months, growth has slowed to its weakest pace since the financial crisis, culminating in the Reserve Bank of Australia also moving to a neutral monetary policy bias, and the market is pricing in at least one rate cut over the next 12 months.
Investment Grade Sector*
More accommodative monetary policy should allow for better technical dynamics throughout credit.
We took advantage of a temporary widening of spreads in the fourth quarter of 2018 to increase our exposure to U.S. agency mortgage-backed securities (MBS). During the subsequent period of significant tightening, we lightened our positions, moving back to a neutral position.
- Potential for further tightening: We think that the flatness of the curve is keeping the banks from becoming significant buyers of MBS, but this could drive spreads even tighter if the curve steepens on the margin, as we expect.
- Attractive characteristics: From a money manager’s perspective, we believe that Agency MBS are still attractive to hold in portfolios due to their spread, liquidity, quality and currently muted prepayment sensitivity.
In the fourth quarter and early in the first quarter, commercial mortgage-backed securities (CMBS) spreads moved wider primarily due to new issue supply rather than fundamental quality concerns. We used this opening to add to our CMBS exposure.
- Selective exposure: We were particularly active in new-issue last cash flow (LCF) bonds, as well as seasoned AA parts of the capital structure.
- Less idiosyncratic risk: We continue to endorse the idea that CMBS has added appeal due to its low exposure to idiosyncratic risk relative to other credit markets and its more attractive spreads relative to corporate credit.
We believe asset-backed securities (ABS) remain attractive relative to Treasuries, although swap spreads have tightened fairly significantly since fourth quarter widening, which caused us to reduce our overweight position.
- High-quality short duration: These assets trade off of Libor.
- Consumer-linked: The ABS market is supported by strengthening consumer balance sheets.
Strong underlying house price appreciation data and housing affordability measures continue to support the credit risk transfer (CRT) market and our overweight position on mortgage-backed credit (MBS credit).
- CRT value: Relative value has largely shifted from the legacy distressed credit market to the Credit Risk Transfer (CRT) market.
- Attention to quality: We are seeing some degradation in the collateral quality and structural quality of recently issued CRT deals, which we have largely been avoiding.
Investment Grade Credit
Based on the expectation in the U.S. and across developed economies for economic growth to slow but remain comfortably positive in aggregate, investment grade credit appears to be fairly valued at this point:
- Manageable risks: This soft landing outcome will allow most companies to continue to manage their debt profiles in an investment grade framework. We only expect to see significant downgrade risk at companies with challenged business models.
- Renewed demand: The more accommodative monetary policy from global central banks should allow for better technical dynamics throughout credit. While demand is not expected to be as strong as it was in 2016 and 2017, the Federal Reserve’s pause on rate hikes for an extended period will encourage yield-seeking investors to return to the credit space.
- Steady supply: With supply continuing to generally track 2018 levels, appetite remains among issuers to proactively execute liability management transactions that extend the duration of the credit universe. Modest M&A volumes should also help to maintain consistent issuing patterns.
- Tighter spreads: While credit fundamentals should remain supportive and technical factors are in good shape, valuations are now more challenging. Spreads across all currencies have been tightening during 2019, and have generally reached levels where the upside is more limited.
The biggest risks to investment grade credit today are an earlier-than-expected return by the Fed to rate hikes, a surprise outcome in trade policy and a worse-than-expected outcome to Brexit. We do not believe any of these risks are priced into current spreads.
Within the Municipal space, we favor short-term maturities, floating rate bonds and extending long maturities from 10 to 12 years, as follows:
- Valuation full in parts of municipal markets: High-grade one-to 10-year tax-exempt municipal bonds seem fairly to fully valued due to strong fund flows and moderate supply growth year-to-date. Moreover, the five-year and 10-year parts of the curve seem particularly rich on a historical basis.
- Technical support: Although 2019 supply should increase from anemic 2018 levels, the technical backdrop is favorable in light of less market concern about rising rates and the potential for stronger fund flows.
- Favorable economy: The economic backdrop is still favorable, although a downshift in growth and a slowing housing market could create some budgetary headwinds relative to 2018.
- Investment grade opportunities: Investment grade taxable municipal bonds offer competitive option-adjusted spreads relative to investment grade corporates and should also benefit from strong technical factors.
- High yield stability: The backdrop for municipal high yield bonds is favorable as a sidelined Fed should benefit carry investing and lessen the likelihood of fund outflows due to rising rates.
Currently the 10-year AAA muni-to-Treasury ratio is 77%, which is below the historical range of 80% – 100% and the lowest reading since 2010. Our current view is that the richness in 10-year municipal bonds is an anomaly driven by a perfect storm of factors: strong fund flows, programmatic buying from ladder strategies, tepid new supply and lower concern about rate risk. We would have to see this ratio hold in the face of several straight weeks of strong new issue supply and more rate volatility before believing that some kind of paradigm shift has occurred.
High Yield & Emerging Markets Debt*
We see reasons to be constructive on loans.
High Yield Credit and Leveraged Loans
The U.S.-based high yield market returned 6.57% through the end of February, consistent with other risk assets. (The S&P 500 rose +11.16% over the same period.) The high yield market has benefited from:
- Dovish Fed policy
- Positive inflows of $10.2 billion, which partially reversed outflows of $43.1 billion in 2018 outflows
- Expectations for a positive outcome on U.S. – China trade
The last twelve-month (LTM) default rate for high yield as of February end declined 70 bps to 1.11% when the $16 billion iHeart default of February 2018 fell out of the calculation replaced by the $44.8 billion Windstream default in February 2019. We expect the 2019 high yield default rate to remain near 2%, well below the historic average default rate of 3.5%.
While loans have rebounded from the fourth quarter sell-off and have performed well through February (up over 4%), they have lagged the U.S. rally in high yield and equities. Still, we see some reasons to be constructive on loans:
- Discipline: Retail outflows and weaker CLO demand over the last three months has brought some discipline back to the loan market. While loan structures are hardly investor-friendly, they are becoming less issuer-friendly than they were during the first nine months of 2018.
- Relatively low defaults: According to data from Leveraged Commentary & Data (LCD), the default rate of the leveraged loan index will fall to just 0.88% when two large defaults roll out of the calculation in March 2019. Save no fresh defaults, that would be the lowest rate in almost seven years.
Emerging Market Debt
Compensation potential remains ample both in hard currency and local currency emerging market debt given the magnitude of the correction last year.
While yields and spreads in emerging market sovereigns and credits have recovered from multiyear highs, they continue to provide attractive excess risk premia relative to developed market credits:
- Reversal of outflows: Partly supported by a better liquidity outlook, emerging market debt has seen a reversal of the outflows that dominated in 2018. Inflows have largely targeted hard currency strategies.
- Technical support: In hard currency space, net new issuance in both sovereign and corporate credits will also likely be lower in 2019 than in recent years.
- Moderating return: Our return expectations for the balance of 2019 are now more moderate considering the strong market recovery experienced early this year.
We see value in local currency debt, as well:
- Undervalued currencies: Emerging market currencies continue to be largely undervalued and provide positive and above-average real yields.
- Technical support: Technical factors remain largely supportive given extensive redemptions and risk reduction across emerging markets in 2018.
- News flow sensitivity: Local currency emerging market debt risks performing better than expected if economic news improves; for example, if China shows signs of recovery in the third quarter.
With uncertain medium- and long-term dynamics, FX volatility is likely to increase going forward.
While labor market and inflation data remain robust across the major economies, other indicators of economic activity have shown pronounced signs of slowing. The current dynamics of economic activity and central bank policy have led to:
- Lower FX volatility: Implied volatility has declined to levels last seen in 2014 following a dovish turn by many central banks. With uncertain medium- and long-term dynamics, FX volatility is likely to increase going forward.
- Carry-seeking behavior: As estimates of future spot volatility falls, the attractiveness of currencies with higher yields tends to increase.
In the event of a breakout from the current environment, exchange rates would be the primary mechanism for restoring equilibrium, which could present opportunities for a relative value currency strategy.
U.S. dollar: We are modestly underweight the U.S. dollar. The Federal Reserve took a more dovish stance following recent asset-price-led tightening in financial conditions, which has reduced the dollar’s interest rate differential to other major currencies.
One imminent factor is the large U.S. debt issuance due in the second half of 2019, reflecting a large quantity of existing debt maturing and the need to fund recent fiscal deficits. Because the U.S. requires foreign funding, and there is no reason to expect an increase in demand for U.S. debt, such a large increase in supply should trigger either higher U.S. yields or U.S. dollar depreciation.
Additionally, in the event of an agreement between U.S. and China on trade, we would expect the U.S. dollar to reverse some of its recent strength.
Euro: We are modestly underweight the euro. In the eurozone, the Purchasing Managers’ Index (PMI), which reflects the economic health for manufacturing and service sectors, has stabilized, albeit at low levels.
Sluggish growth in China and potential U.S. tariffs on European cars have weighed on the external sector. Still, despite recent deceleration, economic growth is expected to be at or above trend for 2019.
ECB monetary policy remains accommodative reflecting continuingly weak inflationary pressures.
In the spring, European parliamentary elections and Spanish elections may again cause concerns about the stability of the eurozone.
Norwegian Krone and Swedish Krona: These two Nordic currencies are undervalued from a long-term fundamental perspective. Both central banks are in hiking cycles, so there is room for these currencies to appreciate significantly. This is especially true for Sweden where the evidence suggests that negative real and nominal rates have led to significant capital outflows from the country.
Fixed Income Investment Strategy Committee
About the Members
The Neuberger Berman Fixed Income Investment Strategy Committee consists of 18 of our most senior investment professionals, who meet monthly to share views on their respective sectors to inform the asset allocation decisions made for our multi-sector strategies. The group covers the full range of fixed income, combining deep investment knowledge with an average of 26 years of experience.