Time to Dust Off the Playbook for Easing?
Investment Implications Overview
We think investors should lean toward adding portfolio risk as the outlook favors a continuation of slow but positive growth and as central bank policy begins to adjust in the next 12 months.
We have identified the following global pockets of opportunity:
- Rate-related opportunities: In the very near term, we believe that the market has overpriced the extent of Fed easing and we’d expect some retracement to higher yields. We have been writing about our expectations for yield curve steepening between points like 5-year and 30-year maturities since last summer and we think investors should maintain exposure to steepening curves.
- Inflation-related securities: The most significant opportunity we see in the rates space is now in inflation products. Both the Fed and the ECB are explicitly signaling that policy will be eased or remain easy until inflation moves higher, and we expect these securities to perform well over the next couple of quarters as growth stabilizes and inflation moves modestly higher.
- Floating rate exposure: While we think a recent widening in spreads represents a tactical market opportunity for many sectors across credit markets, we see the most value, perhaps unexpectedly, in floating rate products like bank loans and collateralized loan obligations (CLOs). While these sectors will likely face the headwind of a falling LIBOR rate in the future, outflows (or limited inflows) into these sectors are creating a short-term valuation discrepancy.
- High-quality U.S. high yield: Spreads are attractive at approximately 275 – 300 bps over treasuries for portfolios of diversified, domestically focused BB rated issuers with low loan-to-value (LTV) ratios. While fundamental growth has slowed this year, the year-to-date upgrade/downgrade ratio stands at a very strong 8.6:1. BB rated credit has outperformed B and CCC rated credit year to date, particularly since market volatility increased beginning in May and we expect this trend to continue.
- BBB rated European credit risk: Opportunities exist in credits with reasonable leverage profiles and can provide enhanced income to dollar-based investors on a hedged yield basis. Direct support from the ECB purchase program provides technical support, as well.
- High yield Emerging Market sovereign risk: Recent risk aversion pushed yields to approximately 8% for high yielding sovereigns, generally. They now offer attractive valuations, in our view, relative to the investment grade countries, which have performed well year to date.
- Local currency Emerging Markets: The potential for a weaker dollar could create outsized returns in the second half. These issues also offer upside from a long-term valuation perspective, as real effective exchange rates (REERs) are near the bottom of their historical range.
Recent Market Developments
Unprecedented demand for European investment grade credit
We see unprecedented interest from non-euro investors in euro-denominated investment grade fixed income, due to the potential roll-down return available from the relatively steep euro yield curve and the potential gains to be made by hedging out euro risk, especially for U.S. dollar investors.
Fundamental, technical and macroeconomic factors suggest continued strong demand for EUR credit. Focus on BBB rated exposures.
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We see unprecedented interest from non-euro investors in euro-denominated investment grade fixed income, due to the potential roll-down return available from the relatively steep euro yield curve and the potential gains to be made by hedging out euro risk, especially for U.S. dollar investors. But are the fundamentals of euro investment grade equally attractive? Senior Portfolio Managers Partick Barbe and Julian Marks explain why the world is looking into euro investment grade, and where they would look for active opportunity.
Rate and inflation expectations in the U.S. may be ahead of themselves
As we look forward to the second half of 2019, we expect rates will likely be eased as the Fed reacts to this combination of weaker growth, rising tail risks from the trade sectors and lower (albeit transitory) inflation pressures.
Current market pricing implies four rate cuts over the next 12 months. Although the U.S. economy is still growing above its potential, risks are rising for the next four quarters, especially if the trade outlook worsens. We believe rates will likely be range-bound, and while current expectations for Fed easing look excessive, we are transitioning to a Fed-easing environment.
Prospects for a weaker U.S. dollar
We’ve been discussing the growth and inflation environment and its impact on bond markets, but currency markets have been at least equally dominated by political developments. The third quarter of 2019 will bring several consequential developments.
The dollar is vulnerable to weakening in the second half of 2019 and 2020. Carry-oriented investors should not be complacent.
U.S. housing markets opportunities
We believe the recent slowing in the pace of U.S. housing price appreciation (HPA) from mid-high single- to low single-digit growth is a sign of a healthy functioning market, as opposed to a sign of problems in a speculative market. The strength of the housing market will ultimately be determined by the strength of the balance sheets of the consumers and their ability to service their mortgage debt obligations.
Sustainable housing price growth and solid consumer dynamics favor positioning in mortgage credit securities such as legacy subprime residential mortgage-backed securities (RMBS) and Credit Risk Transfer (CRT).
Non-agency residential whole loans growing volume
Extending a trend that began several quarters ago, we expect origination volumes in high-quality, non-agency residential mortgages will continue to grow, particularly during the summer real estate season. As lending rates continue to grind lower, we believe near-term origination volumes will be further aided by the increased refinance activity within the space.
Quality non-agency mortgage whole loans and securities are attractive for investors who can invest across a full spectrum of mortgage instruments.
Emerging markets select investment opportunities
Projections for economic growth in emerging markets are subject to increasing risks from the failure of the U.S. and China to reach a trade agreement and from disappointing PMI numbers in both the U.S. and the euro zone. These risks are somewhat cushioned, however, by strong consumer spending and easier financial conditions in developed markets, which are so often the end-markets for emerging markets production.
We believe emerging markets high yield bonds are attractive following the sell-off. Spreads have widened to the point the gap to investment grade has surpassed levels in May when the sell-off began.
Market volatility in the second quarter has changed our assessment of value across several credit markets, especially in areas like European investment grade, high yield and emerging markets.
Government Bond Markets*
We prefer the barbell approach using the front end and long end of the yield curve for government issues and TIPS, and we continue to like spread trades in the semi-core EU.
Government Bonds and Inflation-Linked Securities
U.S. Government Bonds, Neutral: Current market pricing seemingly implies 100 bps of rate cuts over the next 12 months, but we view this as premature in the context of a U.S. economy still growing above its potential. We prefer two- to five-year maturities, and very long maturities as well.
U.S. TIPS, Overweight: We believe the Fed has a strong desire to see inflation modestly higher. As such, we maintain TIPS overweight although at modestly lower levels than earlier in the year. Consistent with our preference for the long and short ends of the yield curve, front-end TIPS should benefit from the tariff increases, but intermediate TIPS might suffer from reduced demand from China and the perception of tariffs as a tax on consumers. Longer-dated TIPS appear attractively priced relative to fundamentals by about 25 basis points in real yield.
European Government Debt, Mixed: We anticipate the ECB will maintain, or extend, negative rates for an extended period of time to counter-balance economic deceleration and trade war uncertainty. Furthermore, we continue to like “flatteners” at the long end of the curve, with a preference for 30-year European government bonds over 10-year.
In the core countries of Germany and France, we are currently underweight short-end maturities and the 10-year bucket.
We continue to like spread trades in the broader, semi-core European Union (EU). We remain bullish on peripheral debts, especially Portugal, and we are tactically managing exposure to Italy based on how the political framework evolves.
Canadian Government Debt, Underweight: Growth in Canada fell over the past two years due to slowing business investment and weaker trends in exports. The Bank of Canada has relaxed its previous hiking bias and moved to neutral while the bond market is pricing in almost two rate cuts over the next 12 months. We maintain a neutral stance on duration as the resilience in the labor market (strong employment and wage growth edging higher) and aggressive market pricing contrasts with elevated uncertainty coming from trade and disappointing growth prints.
Australian Government Debt, Neutral: Australian growth has slowed in line with the loss of momentum seen throughout developed market economies. Continuous trade friction between the U.S. and China is also expected to affect growth prospects as downward pressures on commodities remain in place. In Australia we maintain a modest overweight in duration in spite of almost three rate cuts priced into the curve as early cracks in the labor market, subdued inflation and ongoing housing market stress point to a more sustained deterioration in the macroeconomic outlook.
Investment Grade Sector*
More accommodative monetary policy should allow for better technical dynamics throughout credit, especially in Europe.
U.S. Agency Mortgage-backed Securities (MBS), Modest Underweight: We are recommending a slightly underweight exposure to agency MBS, following a significant move lower in rates that could catalyze a refinancing event. We think that the continued flatness of the curve combined with lower rates is keeping the banks from becoming significant buyers, which is negative for spreads.
Commercial Mortgage-backed Securities (CMBS), Overweight: CMBS spreads tightened modestly in the second quarter and we remain overweight the sector. We continue to endorse the idea that CMBS have added appeal due to lower exposure to idiosyncratic risk than other credit markets combined with more attractive spreads relative to corporate credit. We still find value in the seasoned natural AAA, AA and A parts of the capital structure.
Asset-backed Securities (ABS), Modest Underweight: We have generally reduced our exposure to the ABS market as we have found better relative value in other fixed income markets. Because they trade based on the interest rate swaps curve, ABS have become less attractive as swap spreads have continued to tighten relative to the Treasury curve. Consumer balance sheets remain strong, which bodes well for the fundamentals, but in our view valuations are ahead of themselves.
Mortgage-backed Credit (MBS Credit), Overweight: Residential MBS credit remains one of our most significant securitized overweights. Relative value has largely shifted from the legacy distressed market to the Credit Risk Transfer (CRT) market. Strong underlying house price appreciation data and housing affordability measures continue to support the CRT market.
Investment Grade Credit
U.S. Credit, Modest Overweight: While U.S. credit has rallied significantly year-to-date, we are already seeing some spreads widen from their tightest levels of the year. As discussed earlier, the introduction of trade and tariff uncertainty has fueled volatility and weakened credit spreads, which are not immune to these risks.
In the second half of the year, global growth concerns will likely weigh on the performance of spreads. Although a slowdown is likely factored into valuations, weaker than expected global, and especially U.S.-based, growth could put more pressure on spreads.
Overall, fundamentals remain stable, leverage in aggregate has plateaued and earnings are slightly beating low single-digit growth expectations. Still, idiosyncratic risks remain elevated.
Technical support for U.S. credit should come from manageable supply of new issues, trending in line with last year. Demand, however, remains more in question as the cycle extends.
While hedging costs have moderated slightly, providing some relief, currency-hedged yields generally favor European credit at this point.
Europe Credit, Modest Overweight: Following a difficult 2018, European credit has performed strongly so far in 2019. This is resulting in long-term valuations approaching fair value and reflecting fundamentally robust credit quality for both financials and non-financials.
Accommodative European Central Bank (ECB) policies and negative rates continuing into 2020 are supportive of EUR credit in near term. Furthermore, the situation with cross-currency swaps remains very favorable for USD-based investors buying EUR-denominated assets.
Corporate hybrid debt also continues to offer value. The hybrid bonds of U.K. utilities in particular appear to be oversold due to Brexit concerns.
Municipals, Underweight: In the first half of 2019, municipal bonds staged a strong rally tied to tight supply, diminished concern about rising rates, strong fund flows and increased demand in high tax states due to the state and local tax (SALT) cap. Municipal high-grade valuations are now very tight relative to Treasuries with the 10-year AAA municipal to Treasury ratio currently around 80%, which is at the low end of the historical range of 80 – 100%.
Strong summer technical factors are expected to cause the size of the municipals market to shrink, which could allow ratios to stay lower for longer. Credit spreads continue to tighten as low supply and strong fund flows overpower the market.
We favor credit stories on the short end of the curve as the credit curve is more positively sloped than the high grade curve. Moving slightly beyond 10 years can lead to better yield pickup and roll-down potential.
April tax receipts at the state level were generally strong, reflecting solid economic growth from 2018. Weaker figures from December 2018 were probably an anomaly.
High Yield & Emerging Markets Debt*
Both fundamentals and technical factors support the non-investment grade universe.
High Yield Credit and Leveraged Loans
U.S. Full-Market High Yield, Modest Overweight: Fundamentals supporting the non-investment grade universe continue to be constructive: revenue and cash flow are growing modestly while leverage is declining after aggressive financing already declined toward the end of 2018.
Credit differentiation has returned to the market. Earnings shortfalls and negative news dragged down outstanding bonds like Mallinckrodt, which dropped seven points on a change in Medicaid pricing. On the flip side, Sprint long bonds surged seven points on positive comments from the FCC regarding its potential merger with T-Mobile.
Performance has varied by rating. Year-to-date BB/B/CCC have been closely tied in high yield while higher quality loans, BB/B, have outperformed CCC loans. Investors have been cautious on lower-rated credits since the fourth quarter sell-off of risk assets.
Technical factors also remain supportive. New issuance in high yield and loans has declined 11% and 46%, respectively, from reduced 2018 levels while high yield inflows and loan outflows have both moderated. Liquidity has been good with 2019 trading volumes up 16% vs. a very illiquid fourth quarter across risk assets.
With spreads near T+475 across non-investment grade markets, we believe that investors are fairly compensated for the current low default rate environment.
U.S. Short-Duration High Yield & Leveraged Loans, Neutral: Given the current trade tensions, loans and short-duration high yield are likely to navigate the expected volatility better than U.S. and European high yield. We remain constructive on the loan market(s) in 2019, focusing on the coupon return for the remainder of the year after a very strong start. Valuations remain attractive relative to other fixed income alternatives even when adjusting for the fact that rates are not likely to rise in the near term.
Fundamentals remain constructive. We expect revenue and cash flow growth to slow, but interest coverage remains strong near five times. Leverage peaked in mid-2018 and has come down as aggressive LBO financing slowed since the fourth quarter volatility in risk markets.
The default outlook continues to be benign. Despite the negative technical implications of a more dovish Fed, it is likely that their recent actions extend the cycle. The recent escalation of trade wars has not led us to increase our default rate.
Loan supply/demand remain balanced with 2019 new issue volume down and very limited refinancing activity so far. Heavy retail outflows have slowed while institutional and CLO demand has remained strong. This has been enough to absorb the net new issuance in the loan market this year, which we expect to continue. The net result of limited new issuance and more limited recent outflows has provided a positive technical backdrop in the past few months.
We have reduced our EUR loan positioning view this year at prices near par and reinvested in USD loans trading at discount prices of 97 to 99.
Collateralized Loan Obligations (CLO), Overweight: While CLO new issue volumes through April tracked close to last year’s record pace, in May we started to see the slowdown in CLO supply that we have been expecting. As a result of reduced supply, spreads for CLO mezzanine debt tightened over the month of May, largely ignoring the softness in high yield and loan markets. As high yield reversed course in the first half of June and rallied again, the basis between CLO mezzanine debt and high yield is once again closer to a multi-year wide.
Given the fact that CLO AAA spreads remained wider than year-end 2018 levels, CLO arbitrage continues to be near 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 continued slow CLO issuance as likely.
The projected low CLO supply due to challenging CLO arbitrage should continue to provide a positive technical backdrop for CLO debt spreads, which currently are still well wide of the levels at the end of the third quarter 2018.
Emerging Market Debt
Emerging Markets Hard-Currency Sovereigns & Corporates, Neutral: We continue to have a balanced position in hard currency in our blend strategies. Our long bias in sovereign debt is funded with an underweight in corporate credit.
Technical support is neutral for sovereigns because inflows have slowed, positioning has remained elevated, and needs for new issuance have diminished. Non-investment grade sovereigns remain attractive in absolute and relative terms when compared to U.S. high yield credits in our view. Notwithstanding a reduction in its overall risk profile, our hard currency sovereign portfolios continue to have a high-yield bias.
Emerging Markets Local-Currency, Neutral: Given the prevailing downside risks to growth and deteriorating expectations of a resolution of the U.S. – China trade deadlock in the short term, we have reduced our allocation to local currency markets to a small underweight position in our blended strategies. Furthermore, the underlying active emerging markets foreign exchange exposure in our local currency strategies has been effectively neutralized relative to the benchmark. Technical factors are slightly more supportive for local currency issuers given lighter positioning and less crowded holdings of local bonds by non-residents.
Developed currency markets continue to be dominated by political developments while investors wait for clear direction from relevant macroeconomic data.
Currency markets continue to be dominated by political developments. 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, Modest Underweight: Renewed trade tension between the U.S. and China boosted the USD. In this environment of uncertainty investors have been reluctant to reduce USD holdings which have been accumulated since the beginning of the year. Despite the gradual positive momentum for the dollar, a number of meaningful dynamics have gradually changed over the quarter.
First, the interest-rate gap between the U.S. and the rest of the world has narrowed substantially as the market aggressively repriced Fed expectations. The average yield gap between the U.S. and other G10 currencies has narrowed by about 60 basis points since its peak in Q4 last year. Second, signs that the U.S. economy has started decelerate have begun to emerge in the data.
It is probably too early to be confident in calling a top for the dollar as an important element is still missing: evidence of stronger data from the rest of the world and, most notably, in Europe. It is worth noting that many investors still consider the USD a safe-haven currency. However, with the dollar being the highest-yielding G10 currency and running a dual deficit and positioning already stretched, we are less optimistic about the dollar in a risk-off situation.
Euro, Modest Underweight: At the European parliamentary elections, the risk of a significant increase in anti-establishment forces was avoided, but the elections left the union with a fragmented political picture that is likely to slow down the already-crowded agenda. However, signs of gradual recovery in European data should not be underestimated. We prefer to express this view through the Scandinavian currencies, which offer better value and domestic dynamics.
Norwegian Krone and Swedish Krona, Modest Overweight: 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.