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      Fixed Income Investment Outlook 4Q2018

      U-Turn

      Webinar | Fixed Income Investment Outlook: U-Turn
      Our senior investors discuss the coming recession and why they expect a sluggish recovery will lead to an extended period of downgrades and defaults among highly leveraged corporate issuers. Listen to Replay

      Our Fixed Income Investment Strategy Committee forecasts the duration and shape of the coming recession and recovery, and the impact that may have on fixed income markets.

      Download our outlook

      Commentary

      U-Turn

      As the current economic expansion in the U.S. extends into its tenth year, interest in pinpointing its end date continues to grow. Though the timing of the cycle’s turn is interesting and important, we are more focused on the duration and shape of the coming recession/recovery period—whenever it may come—and its potential impact on fixed income markets. Given that the traditional levers of economic recovery have yet to return to pre-crisis norms, we expect the coming recession and subsequent recovery period will be U-shaped—a slowdown followed by persistently sluggish economic activity that leads to an extended period of downgrades and defaults among highly leveraged corporate issuers.

      Trying to predict the timing of a recession can be a fool’s errand; just ask the many prognosticators who have warned repeatedly of the waning momentum of the current expansion cycle, now at 110 months and counting. Cycles don’t die merely of old age, however, and the probability of recession within the next 12 months remains low; a model from the Federal Reserve Bank of New York based on the spread between 10-year and three-month Treasuries, for example, places it at
      14.6%1.

      That said, the growing sense of anxiety among investors as time goes on is understandable. Though the fiscal stimulus enacted earlier this year has increased the probability that the U.S. cycle will soldier on for at least a few more quarters, a variety of indicators suggest the end likely is not too far beyond that. The unemployment rate has fallen to a cyclical low below 4%, and it's uncertain that enough slack remains in the labor force to support continued monthly job creation in the 175,000 – 200,000 range without causing wage and inflationary pressures. A variety of market indicators—such as the strength of the dollar, increased short-term dollar funding costs of credit spreads and the shape of the yield curve—also are suggestive of late-cycle dynamics.

      While the timing of the next recession is an important consideration, perhaps more significant to the performance of long-term investors is the duration and the shape of the subsequent economic recovery. The shape an economic recovery takes depends on a number of factors, including the speed and magnitude of the monetary and fiscal policy response and the reaction of interest-rate sensitive segments of the economy to that response. A V-shaped recession is marked by a sharp, relatively brief economic downturn followed by a pronounced rebound in activity. A U-shaped recession, in contrast, tends to be shallower in depth but longer in duration, with the economy falling into a low-growth malaise for an extended period.

      Though assigning a recession’s alphabetical resemblance is a somewhat inexact science, V has been the basic shape going back to the early 1990s when the U.S. saw GDP growth go from 4.4% to -3.6% to 3.2% over the course of six quarters. Even the 2007 – 09 recession following the global financial crisis could be considered a modified V despite the sluggish recovery given the depth from which the economy was forced to rebound. These most recent recoveries were driven by some combination of monetary and fiscal policy followed by a resurgence in the housing/mortgage markets. As described below, however, it’s likely that the next recession will begin with all three of these tools having less potential for meaningful impact than they have in the past. We believe the coming recession and subsequent recovery period will likely be U-shaped and that a persistently weak economic recovery will result in an extended period of corporate downgrades and defaults.

      Monetary policy. With the Fed’s estimate of its terminal fed funds rate—the rate that it believes supports an economy with full employment, trend growth and stable prices—at around only 3%, the central bank has limited room for rate cuts should economic conditions deteriorate. Compare this with the 5%-plus levels that prevailed at the onset of the three most recent recessions. Similarly, with conventional policy measures failing to alleviate the economic pain of the financial crisis, the Fed was forced to take a variety of extraordinary steps, ranging from zero interest rate policy to “operation twist” to trillions of dollars in asset purchases. Any future efforts on this front—whether a repeat from the financial crisis playbook or a new innovation such as nominal GDP targeting, a time commitment for a low fed funds rate, or an expansion of the type of assets targeted for purchase—is unlikely to generate the elements of surprise and ingenuity that contributed to the success of the previous one, especially given a flat yield curve that offers little in the way of term premia reductions via large-scale asset purchases. The diminishing returns seen by policymakers in Europe and Japan are a good example of what happens when central banks expend all the arrows in their quiver. And with policy rates remaining very low across major economies, as shown in Figure 1, any stab at coordinated global stimulus at this point is bound to have limited impact.

      Figure 1. Policy Rates Remain Very Low Globally
      G10 GDP-Weighted Policy Rate
      Source: Bloomberg, Neuberger Berman calculations.

      Fiscal policy. In January 2018 U.S. policymakers enacted $1.5 trillion worth of cuts to corporate and personal taxes, and soon after passed $300 billion in federal spending increases. While this has helped push near-term GDP growth expectations higher, it also has exacerbated already-challenging federal budget forecasts. The Congressional Budget Office estimates the federal budget deficit will approach $1 trillion next year—or 4.6% of forecast GDP—and continue heading up after that. After spiking in 2008 as policymakers sought to battle the financial crisis, public debt as a percentage of GDP has continued to drift higher despite ongoing economic growth, standing at more than 100% currently. With the government’s balance sheet already extended, enacting additional fiscal stimulus in the next recession will be more challenging and potentially less effective given the starting level of public sector debt.

      Figure 2. The Federal Deficit Should Continue to Widen
      Source: Federal Reserve Bank of St. Louis, Congressional Budget Office estimates.

      Mortgage finance. Monetary policy is transmitted to the real economy via several channels, with the residential housing market being one of the most effective. Looser Fed policy and rate cuts typically result in lower mortgage rates, creating refinancing opportunities for American homeowners. A 1% refi incentive on a $250,000 mortgage, for example, puts an extra $1,800 per year in the pockets of consumers, the equivalent of a 4% increase in average annual wages. A portion of this money is spent, stimulating economic growth. We’ve seen this pattern repeated time and again as mortgage rates continued to move lower; the average rate on a 30-year fixed-rate mortgage has declined from over 10% in the late 1980s to around 4.5% today.

      Mortgages are unlikely to provide a powerful tailwind for the next recovery, however, as the vast majority of homeowners able to refinance at the very low mortgage rates of the past 10 years already have done so. Relatively high home prices and affordability challenges also create headwinds for policy impact. While it’s almost certain the Fed and fiscal authorities will attempt to push mortgage rates lower and support housing prices in response to the next recession, the already-low rates (as depicted in Figure 3) carried by homeowners suggest the incentive to refinance will be much lower than it has been in past recoveries.

      Figure 3. Average Rate of Outstanding Mortgages Remains Low Historically
      Source: Barclays.
      The Outlook for Credit in a U-Shaped Recession

      One of the biggest current concerns among fixed income investors is the growing credit risk in the U.S. corporate market. Two markets in particular should be in focus: BBB rated credit and bank loans.

      A decade of rock-bottom interest rates and steady demand from yield-hungry investors inspired companies to increase leverage, sending the aggregate value of corporate debt outstanding to record levels. All this added leverage has been accompanied by a steady deterioration in the overall credit quality of the market; BBB rated debt now accounts for roughly half of the Bloomberg Barclays U.S. Corporate Index, compared to 38% in in 2007. Further, the BBB market is now one-third larger than the Bloomberg Barclays U.S. Corporate High Yield Index, leaving investors worried that the end of the U.S. economic cycle will result in a rash of BBB downgrades and a disruptive flood of “fallen angels” into the non-investment grade space. Fallen angels are often subject to automatic sale by high-grade index funds and institutional investors such as pension funds that are subject to non-investment grade holdings restrictions, a negative technical that could result in credit spreads in both the investment grade and high yield markets widening to levels that may not reflect fundamentals.

      While we too are concerned about the impact of potential downgrades during the next economic downturn, the current composition of the BBB market may provide some surprising support. As we highlighted in a recent paper, there are specific vulnerabilities—and opportunities—among BBB rated issuers. The BBB segment of the corporate bond market is composed primarily of industrials (71% of market value), followed by financial institutions (23%) and utilities (6%). We would argue that financial issuers should be excluded from an analysis of BBB credit vulnerabilities, as we do not believe that the growth of these issues represents a particular problem for investors. Despite improving their capital positions markedly in the wake of the financial crisis, financial institutions now are subject to far more stringent credit ratings standards, which has created an unusual situation in which ratings for these issuers declined even as their credit quality improved.

      For investors, it’s critical to identify the nature of existing risks and their potential impacts when this economic cycle turns. Even companies in traditionally defensive sectors may be vulnerable to downgrades, with their historically stable late-cycle free cash flow challenged by debt levels more aggressive than was typical in the past and as they are pressured by a drawn out, weak economic recovery.

      While we could derive a downgrade forecast based on historical averages, we think a better way to project the fate of the BBB cohort during the next recession is to consider current market conditions and our expectations for the next recession/recovery cycle in the context of a previous downturn with similar characteristics. We choose the 2000 – 02 recession as our bogey; this industrials-led contraction had the highest level of fallen angels on record, as shown in Figure 4, with a three-year downgrade rate just over 25%. (Note that we are looking at downgrades over a three-year period rather than annually to align with our expectations that the next recession will be U-shaped in nature and thus characterized by less intense but longer-lasting pressure on corporate cash flows.)

      Figure 4. Fallen Angels Peaked in the Early-2000s Recession
      BBB Industrials Three-Year Market Value Transition Rates to High Yield
      Source: Bloomberg Index Services, as of September 2018.

      Comparing the dynamics of the early-2000s recession with the conditions that prevail today we estimate a three-year downgrade rate of 20% for BBB issues, with the ratings actions biased toward the end of the recessionary period. There are two main reasons we expect BBB downgrades will be slightly less pronounced during the next recession. First, 2000 – 02 was characterized by an exceptional level of corporate malfeasance that we do not expect to reoccur; our analysis shows that 6 – 8% of the downgrades during this period were related to the accounting fraud of companies like WorldCom, Tyco and Enron. Second, the sectors that now dominate the BBB portion of the market—health care, pharmaceuticals, pipelines, cable, utilities, food & beverage—generate cash flows that are more defensive to economic downturns than traditional cyclical BBB sectors. Ratings agencies typically are more patient with—and the market less punishing to—defensive companies with high leverage but modest cash flow deterioration, compared to cyclicals issuers with moderate leverage but significant cash flow destruction.

      With the aggregate market value of BBB downgrades likely to be higher than we have seen historically, however, the impact on credit markets will be notable. A 20% downgrade rate applied to the $1.8 trillion of BBB rated issues equates to $360 billion in downgrades, which means that the $1.1 trillion high yield market stands to grow about 33% larger. Of course, the cash flows of some companies will prove more resilient to slowing economic activity than others, and security and industry selection will be critical when the cycle turns.

      Another credit market that will be impacted by a U-shaped recession will be bank loans. Bank loans have been a magnet for capital for several years, as investors concerned about rising interest rates increasingly recognized the unique combination of relatively high yield potential and low duration offered by these securities. The popularity of loans among investors has reshaped the character of the high yield bond market, as many would-be public debt issuers have instead turned to the loan market for their financing needs. The U.S. senior loan market has doubled since 2010 and now exceeds $1 trillion outstanding as it continues to close the gap with the high yield bond market. With this growth, however, has come a notable deterioration in underwriting standards, and recent loan issuance has been marked by lower credit quality, higher leverage and fewer lender protections by way of loan credit agreements and bond indentures.

      Loan defaults should remain low for at least the next 12 months thanks to strong current and anticipated U.S. economic growth as well as the broad availability of capital. As we discuss below, current underwriting behavior suggests that non-investment grade debt in general—both loans and high yield bonds—may experience greater defaults and lower recoveries during the next economic slowdown, especially if our forecast for a U-shaped recession comes to pass. We’d highlight three trends in loan issuance to support this view:

      • Increase in lower-rated issuance. Not surprisingly, default rates grow exponentially at progressively lower ratings. Moody’s Investors Service notes that a record 43% of first-time issuers in the first half of 2018 were rated B32, which typically is the lowest rating acceptable to investors. Meanwhile, 64% of the U.S. speculative grade population has a corporate family rating of B2 or lower, up from 47% in 2006, while the percentage of new loans rated B2 or lower reached an all-time high of nearly 70%. See Figure 5.
      • Smaller—or nonexistent—debt cushions. The increased emphasis on loans for corporate financing has resulted in more top-heavy capital structures for borrowers, leaving fewer subordinated lenders to absorb losses before they hit senior secured debt holders. Since the financial crisis, the share of debt that is subordinated to first-lien term loans—i.e., the debt cushion—on outstanding covenant-lite senior loans has fallen from 35% to around 22%. Moreover, loans today also are more likely to be structured as first-lien-only transactions, meaning that loans are the only form of debt financing in the issuer’s capital structure; approximately 25% of covenant-lite deals have been first-lien-only this year, versus less than 10% in 2007.
      • Weaker loan structures. The typical loan credit agreement has become less restrictive for issuers, thus presenting greater risk to lenders. Influenced by the growth in M&A activity and leveraged buyouts, the definition of EBITDA within many credit agreements—which impacts much of the remaining protections in the agreement—now includes a meaningful amount of adjustments in favor of the issuer, as shown in Figure 6. Credit agreements in general have gotten more aggressive, allowing the issuer such leeway as asset transfers, greater incremental secured-debt incurrence and an increase in the retention of asset-sale proceeds. Such weakening covenant protections have the potential to dilute the position of first-lien loans at the top of the capital structure.
      Figure 5. Lower-Rated Loan Issuance Has Been on the Rise
      Institutional Loan Volume for Issuers Rated B or Lower, in Billions
      Source: LCD, as of September 5, 2018. Note that a Moody’s rating of B2 is equivalent to B rating from Standard & Poor’s.
      Figure 6. Credit Agreements Have Become Less Restrictive for Issuers
      Transactions with EBITDA Adjustments Greater than 0.5x
      Source: LCD.

      We believe the conditions described above are indicative of late-cycle loan issuance. While there initially may be fewer defaults in the coming moderate economic slowdown than there were before the shock of the financial crisis (when the financial maintenance covenants that protect lenders were common), these underwriting tendencies are creating credit risks that could lead to an extended and meaningful default cycle once the current economic expansion ends while also making borrowers that become distressed more susceptible to equity-friendly actions.

      And while the onset of loan default rates may be tempered by the widespread reduction/elimination of protective covenants, recovery rates are likely to suffer. We believe recoveries on this vintage of loans likely will be 5 – 10 points lower than the long-term historical average of 77%, with greater dispersion given the number of aforementioned aggressive characteristics that have crept into the market. Higher levels of secured debt in the capital structure should push unsecured recoveries lower as well; we expect high yield recoveries to be 3 – 5 points lower than the long-term average of 35%.

      Though we highlight BBB credit and bank loans in this report, an extended, U-shaped recession would have wide-ranging implications for credit markets—implications that may be difficult to ascertain from recent historical precedents. Persistently low growth may make it more challenging for companies to reduce leverage or even to maintain it at a stable level. Cash flows are likely to be more volatile, and liquidity considerations will become more important for companies seeking to refinance debt in a weak growth environment.

      Emerging Markets Bowed but Unbroken

      After mounting a sustained recovery in 2016 – 17 on the back of improving fundamentals, emerging bond markets have struggled so far in 2018. Rising U.S. Treasury yields early in the year detracted from the performance of hard-currency issues, while a strengthening U.S. dollar and general tightening of financial conditions hit local-currency bonds as summer began. July offered some respite to battered markets, but this turned out to be the calm before the August storm; hard-currency bonds ended the month down almost 2%, and local-currency bonds shed 6% to bring their decline from the previous peak to 15%. While investment-grade names came out relatively unscathed, troubles in Argentina and Turkey led a general selloff in high-yielding issuers amid tighter financial conditions.

      The 15% contraction in local-currency markets—which includes the impacts of foreign exchange and rates—represents a substantial market event. It ranks among the largest selloffs since the inception of the benchmark JPMorgan Government Bond Index-Emerging Markets Indices (GBI-EM) in 2003, trailing only the 2014 – 15 commodity crunch and the 2008 – 09 financial crisis, and neck and neck with the “taper tantrum” correction of 2013. Historically, we often have seen stronger returns following pronounced selloffs in emerging markets, with significant recoveries often occurring over a one- to three-month horizon; in fact, following the eight previous 10%-plus drawdowns in the GBI-EM, the index on average had recovered close to half of its losses within three months.

      For investors, a key concern is the extent to which the financial volatility we’ve seen in the emerging debt markets will impact real economies. We believe it will remain limited. While countries like Argentina and Turkey will see significant growth slowdowns, the positive global growth environment, low inflation rates and policy responses from emerging market central banks and fiscal authorities should limit spillovers to real economies. Of course, sources of further volatility are widespread: Russian sanctions, ongoing heated trade rhetoric that threatens emerging Europe and China, Turkey’s seeming unwillingness to tighten monetary policy further in defense of the lira, the potential for continued dollar appreciation as the Fed tightens, and difficult October elections in Brazil are but a few examples. That said, we still believe the overall case for a potentially substantial recovery in emerging markets debt over the next few months appears strong.

      Will Italy Make Nice with the EU?

      After March elections failed to produce an outright majority in the Italian parliament, the League and Five-Star Movement—two populist, euro-skeptic political parties—began an extended and fractious effort to form a coalition government, ultimately succeeding on May 31 after 88 days of negotiations and some remarkable market moves; the yield on two-year Italian government bonds leapt by more than 180 basis points at one point, a genuine “tail event.” While the systemic spillover from such movements thus far has been modest, Italian government bonds have remained volatile as conflicting rhetoric out of the Italian government—alternately defiant and conciliatory—has rattled markets concerned that the country will not adhere to the European Commission’s fiscal parameters when it submits its 2019 budget in mid-October.

      We think Italy ultimately will take a pragmatic approach to its budget, due in no small part to the inexperience of the two parties now running the country and the fragile alliance that binds them. Swept into power by aggressive populist rhetoric, neither the League nor the Five Star Movement appear to have the political skill to convert their expensive campaign promises from words to policy. Though the Five Star Movement took a larger portion of the vote in March, the League has overtaken them in subsequent opinion polls, exacerbating tensions. As the two parties jockey to enact their fiscal priorities—ranging from corporate and income tax cuts to pension reform to universal income for the poor—political paralysis is likely and a new election in the not-too-distant future is a possibility. In the meantime Italy’s Economic Minister Giovanni Tria, affiliated with neither party, is expected to push through a budget plan that is acceptable to Brussels, debt investors and the ratings agencies.

      Major structural reforms are needed to get Italy’s public debt under control, and slowing economic growth isn’t helping. The clash between Rome, the EU and the bond market appears to have impacted business confidence, while nonperforming loans in the banking system remain a headwind to corporate lending activity and thus economic growth and job creation. What’s more, Italian banks are major holders of Italian sovereign debt; additional weakness in Italian bonds—quite possible given the recent attention of ratings agencies—would further stretch bank balance sheets.

      Italy in many ways represents a test case for the future of the euro zone. How this challenging confluence of slow growth, political division and burdensome debt is resolved may determine the long-term success of the currency bloc. Investors might take a couple of conclusions away from this. The first is that though it may lie dormant for an extended period, the systemic risk inherent in the euro zone’s structural shortcomings cannot be ignored. The second is that the European Central Bank has very strong incentives to err on the side of caution.

      Market Outlook

      We are modestly underweight nominal duration with U.S. rates closer to fair value and four additional Fed hikes priced in, though we are more constructive on real duration. We remain biased toward TIPS but are reassessing the potential impact of trade policy uncertainty along with spread volatility in the riskier corners of the fixed income markets. U.S. agencies are our preferred investments among securitized assets. We’ve grown more constructive on U.S. investment grade credit, as fundamental and technical factors remain supportive. Among high-grade investments in Europe, hybrid debt continues to offer value. In the non-investment grade space European high yield offers similar fundamentals to the U.S. market at a slightly more attractive valuation; within the U.S. our preference is short-duration high yield. We are anticipating a rebound in emerging markets debt after its massive selloff, and favor sovereigns in both hard and local currency as well as short-duration debt issued in hard currency. The Japanese yen is still undervalued even though it has been the best performing major currency in 2018. With the ECB likely to remain highly accommodative in the face of sluggish inflation, we expect euro weakness to persist.

      Government Bond Markets*

      While U.S. economy has accelerated, Europe has lost a step; Italy could help or hurt.

      Global Rates and Inflation

      With a widely expected hike in late September bringing the federal funds rate target to a range of 2.00 – 2.25%, the Fed is expected to reach the current cycle’s equilibrium rate by the end of 2018 or early 2019. A pause in rate hikes should help reverse some of the extreme year-to-date flattening in the Treasury curve, as we’ve watched the spread between the yields on 10- and two-year Treasuries fall from around 50 basis points at the start of 2018 to current levels in the low 20s. The growth of inflation, too, should pause over the next few months, as the base effects from last year’s second-half oil price rally turn negative and drag down the energy price component of inflation. The strength of the dollar, meanwhile, could take some of the steam off slowly building wage pressures. We remain biased toward TIPS as we reassess the impact ongoing trade-policy uncertainty along with spread volatility in riskier parts of the fixed income markets. We are modestly underweight duration with rates closer to fair value and about three additional rate hikes priced into the market (fewer than suggested by the Fed’s dot plot). We are more constructive on real duration, as long-term yields stand close to the 1% equilibrium level of the current cycle.

      With second quarter GDP growth of 4.2%, the U.S. economy has demonstrated considerable strength of late, driven in part by the improved business and consumer sentiment that emerged from this year’s fiscal stimulus and the rollback of Obama-era regulations across industries. U.S. midterm elections represent a potential turning point, as the prospect of a divided government—quite likely, as Democrats appear poised to retake the House of Representatives while Republicans maintain control of the Senate—may have significant implications to sentiment and economic momentum. Such a slowdown likely would cap the dollar’s rally, helping risk assets worldwide.

      While the U.S. economy accelerates—for now, at least—Europe has lost a step. Euro zone GDP growth came in at 1.5% for the second quarter, below its 1.6% expansion in the first quarter and well short of the 4.2% posted by the U.S. However, we are comfortable with the readings out of Europe. Purchasing manager indexes have stabilized at levels that appear more sustainable than the high water marks established at the end of 2017. Markets could get a boost from Italy should the government submit a budget with a deficit target within the EU’s guidelines—and recent indications are that it will.

      Investment Grade Sector*

      Robust fundamentals continue to support high-grade paper, though ample risks persist.

      Securitized Assets

      We remain modestly negative on agency MBS spreads over the near term, as the Fed’s runoff cap soon will exceed the principal payments on its portfolio of MBS holdings, completely removing the central bank as a buyer in the market. However, the current low refinanceability of today’s mortgage market should prevent widening from becoming too pronounced.

      The supply of CMBS remains modest and is readily absorbed by the market. Spreads in the AA and A segments of the capital structure have tightened and now look reasonably fair relative to the corporate bond market. The appeal of CMBS is bolstered further by its low exposure to the idiosyncratic risk faced by other asset classes, making it something of a safe-haven investment.

      Although swap spreads tightened during the quarter, ABS offer attractive spreads to Treasuries, particularly on the short end of the curve. Going forward, we expect these high-quality short-duration assets linked to Libor will continue to be supported by strengthening consumer balance sheets.

      A significant portion of the legacy RMBS market is exposed to structural interest rate caps, which is becoming an issue given the considerable increase in U.S. dollar Libor rates year to date. Relative value in the space has shifted from the legacy distressed market to the credit-risk transfer (CRT) market. Although we are seeing some degradation in the collateral quality and structure of new CRT securities, the market as a whole should continue to see support from robust underlying housing fundamentals.

      Credit

      Investment grade corporate fundamentals remain solid in the U.S., as companies continue to deliver strong earnings on the back of robust economic growth, particularly in the U.S. The technical backdrop also remains positive, as supply in U.S. investment grade credit is trending about 8% below the pace set in 2017. Corporate spreads have widened off their early-year lows but remain reasonably tight and appear fairly valued given sturdy fundamentals and the encouraging technical backdrop. Near-term risks abound, however, and could result in bouts of market volatility; current concerns include increased trade tensions, ongoing global central bank policy normalization, and a laundry list of geopolitical uncertainties including midterm elections in the U.S., Brexit negotiations between the U.K. and EU, and the Italian federal budget.

      Though we remain cautious on European credit, valuations have become somewhat more attractive over the past few months and the cross-currency swap situation continues to make it advantageous for U.S. investors to buy euro-denominated assets. The ongoing reduction of ECB stimulus and rising political risk are cause for defensiveness, however, and we have maintained little exposure to subordinated financials and peripheral euro zone names. Less mixed is our view on hybrid debt, which is one area of the corporate market that continues to offer clear value, particularly certain U.K. utility hybrid bonds that have been oversold on Brexit risk.

      Municipal Bonds

      Issuer fundamentals remain solid, with strong economic growth and firming labor markets supportive of tax collections, while market technicals have continued to be favorable due to constrained supply and strong fund flows. For example, demand from individual investors has been and is likely to remain strong, particularly from investors in high-tax states like New York and California given the tax bill’s $10,000 cap on state and local tax (SALT) deductions. With these tailwinds, muni credit spreads have continued to tighten in what has been a low-volatility market since January’s selloff.

      Going forward, any potential seasonal weakness from autumn supply increases may present an opportunity to increase duration modestly. The muni curve currently is much steeper than the Treasury curve, and short munis (bonds with maturities of two to three years) appear richly valued for high-grade issues. Until valuations for short munis improve, we favor variable rate demand notes that trade at par with floating rate coupons as well as Treasuries. Future credit spread tightening in the muni market may be modest, but positive carry may cause continued outperformance from lower-rated bonds.

      High Yield & Emerging Markets Debt*

      We see signs of value in European high yield; emerging markets appear poised for a rebound.

      High Yield and Leveraged Loans

      Solid returns over the past three months have made high yield bonds one of the few fixed income sectors enjoying positive year-to-date returns, with lower-rated issues outperforming. We expect defaults among non-investment grade issuers should remain benign and below the historical average, running at about 2% over the next 12 months. The credit quality of the high yield market remains stable, as the operating performance of underlying issuers has been robust; revenue and EBITDA growth have improved as leverage has plateaued, and refinancing activity has significantly reduced the amount of bonds maturing in the near term. The market’s performance may be susceptible to a variety of factors, however, including uncertainty around trade policy, the shifting regulatory environment and potential changes to leveraged-lending guidelines and their enforcement. In addition, spreads within lower-quality securities continue to trade tighter than their long-term median, and technology-driven disruption remains a key risk to certain industries. We expect range-bound high yield spreads, as constructive fundamentals and positive U.S. GDP growth will be offset by increasingly volatile market conditions as the pace of the Fed’s balance sheet reduction increases and the European Central Bank likely ends its bond-purchase program.

      Senior loans also are among the few fixed income asset classes to have generated a positive year-to-date return. As with the high yield market, loan market defaults should continue to trend at a below-average rate around 2%, supported by strong operating performance among borrowers. Loan issuance has been heavy year to date, pushing the value of outstanding loans over $1 trillion; this supply has been met with sufficient demand, however, as CLO issuance has been strong and investors continue to see the appeal of a floating-rate coupon in the face of rising interest rates. Risks are gathering, however. As non-investment grade companies increasingly turn to loans instead of bonds for their corporate financing needs, the resulting top-heavy capital structures leave fewer subordinated lenders to absorb potential losses before they hit senior debt holders. Leverage has increased for new-issue loans, while covenant protections have weakened.  

      With the asset class trading at spreads slightly more attractive than U.S. high yield bonds while posting similar year-to-date returns, we remain constructive on European high yield given our expectations of continued low defaults and strong fundamentals. We have been defensively positioned in the space, with a majority of our exposure in BB rated credits, which account for the vast majority of the European high yield market. We also are seeing some value in U.K.-based high yield paper, especially in the cable and utility sectors. We would note that the cross-currency swap situation currently makes it extremely favorable for U.S. investors to buy euro assets—and unfavorable for euro-based investors to buy dollar-denominated paper.

      Emerging Markets Debt

      The positive sentiment that supported emerging markets debt earlier in 2018 evaporated over the summer and markets sold off sharply. However, the magnitude of the correction, against what are still broadly supportive fundamentals, suggests a potentially sharp recovery could be forthcoming and easy for investors to miss. Pronounced selloffs in emerging markets debt historically have been followed by strong rallies, with significant recoveries often occurring over a one- to three-month horizon. For example, the previous eight 10%-plus drawdowns in the GBI-EM were followed by swift rebounds that enabled the index to recover on average about half its losses within three months.

      In our view, valuations and fundamentals in emerging markets debt—outside of weaker funding situations such as Argentina and Turkey—are starting to align, suggesting a recovery may be on the horizon. Market positioning is beginning to add some extent of technical support as well. Sources of further market volatility—some of which were at least partially responsible for the selloff’s magnitude—are easy to identify. Some Russian issuers may be subject to international sanctions. There is still uncertainty over Turkey’s willingness to tighten monetary policy further. Trade rhetoric remains heated and could threaten emerging Europe and China. The U.S. dollar could continue to strengthen on the back of Fed tightening. Brazil faces a difficult election in October.

      That said, we still believe the case for a recovery in emerging markets currencies debt over the next few months appears strong. While the sensitivity of emerging markets currencies to the above-mentioned risks limits FX visibility, currency positions and valuations remain favorable. We continue to favor hard currency over local currency, and within hard currency we favor sovereigns over corporates. However, we anticipate adding some incremental risk in local currencies, as we see technical support in the current environment along with attractive valuations. (See the “Emerging Markets Bowed but Unbroken” above for more information.) We would caution that while asset allocators may be timely in reducing allocations to emerging markets debt ahead of a selloff, they typically are less successful in reallocating back to emerging markets ahead of any subsequent, and often substantial, rebounds.

      Currency*

      Undervalued yen may benefit from subtle BOJ policy actions; Scandinavian currencies continue to hold appeal.

      U.S. dollar: The dollar has continued its ascent for most of 2018, driven in part by the risk-off bias inspired by ongoing trade tensions, and market participants are now quite long as a result. The dollar appears overvalued on a purchasing power parity basis, and expanding twin deficits, negative current account dynamics, stable inflation and ongoing political instability in the U.S. further limit its appeal. Short-term yield differentials have been supportive of the greenback, however, and the U.S. economy continues to be stronger than other major economies even as data surprises turn more neutral. A full-on trade war would likely inspire a flight to the safety of currencies like the dollar.

      Euro: With ECB policy likely to remain accommodative in the face of sluggish inflation, weakness in the euro should persist. And while PMIs have settled at lower levels in recent months to suggest European growth has moderated, forward-looking indicators imply above-trend growth for 2018 as the region continues to benefit from strong global growth. Risks posed by the political situation in Italy aren’t going away for some time—the release of the country’s 2019 budget is the biggest potential near-term disrupter—while the issue of U.S. tariffs on autos looms unresolved.

      Yen: Though it’s the best performing major currency year to date, driven in part by risk aversion, the yen continues to appear undervalued based on purchasing power parity and real exchange rates. The BOJ has started adjusting policy, and continued solid economic growth and inflationary pressures driven by extremely low unemployment could inspire additional action. Wide yield differentials against the currency in both nominal and real terms, which are exacerbated by the BOJ’s yield curve policy, could weigh on the currency going forward, while a re-emergence of risk-on sentiment could lead to a selloff.

      Pound: Having depreciated significantly since the Brexit referendum, the pound continues to appear undervalued on a purchasing power parity basis, a position bolstered by a late-2017 rate hike that improved yield differentials. Ongoing Brexit negotiations will remain a risk to the pound, however; though progress has been made, talks get more detailed—and likely more contentious—as we move into autumn. Further, the U.K. economy remains challenged; activity data has disappointed outside of services, and the consumer has yet to pick up.

      Swiss franc: The Swiss franc remains overvalued in terms of purchasing power parity. Safe-haven positions in the franc should continue to be unwound should European economic prospects improve as expected; however, uncertain political situations in Italy could spark risk aversion and renewed safe-haven flows. The franc is one of the world’s most attractive funding currencies, and the Swiss National Bank is unlikely to let any rapid appreciation in the currency threaten this status, even as inflation dynamics improve.

      Swedish krona/Norwegian krone: We are bullish on Scandinavian currencies in general and the Swedish krona in particular, especially since its sharp depreciation in late 2017 and year-to-date 2018. Backed by positive economic growth prospects that are buoyed in part by a resurgent euro zone, Sweden’s inflation dynamics are supportive of tighter policy, even if they are somewhat volatile around the central bank’s target. The Riksbank is likely to remain cautious until the ECB begins to hike rates. The cyclical recovery in Europe is also supportive of the Norwegian krone; though economic growth in Norway appears poised to pick up, buttressed by higher energy prices, another leg lower in the housing market could jeopardize this acceleration. A hawkish Norges Bank is a positive for appreciation in the krone, though a flare-up in such risks as trade wars and Italy could lead market participants to abandon what has become a popular trade.

      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.

      Brad Tank

      Chief Investment Officer and Global Head of Fixed Income

      Thanos Bardas, PhD

      Portfolio Manager, Head of Global Rates

      Ashok K. Bhatia, CFA

      Senior Portfolio Manager—Multi-Sector

      David M. Brown, CFA

      Co-Head of Global Investment Grade Fixed Income

      Rob Drijkoningen

      Co-Head of Emerging Markets Debt

      Patrick H. Flynn, CFA

      Senior Portfolio Manager Non-Investment Grade Fixed Income

      Terrence J. Glomski

      Head of Residential Finance

      James L. Iselin

      Head of Municipal Fixed Income

      Andrew A. Johnson

      Co-Head of Global Investment Grade Fixed Income

      Jon Jonsson

      Senior Portfolio Manager Global Fixed Income

      Ugo Lancioni

      Head of Global Currency

      Julian Marks, CFA

      Senior Portfolio Manager Investment Grade Credit

      Thomas J. Marthaler, CFA

      Senior Portfolio Manager—Multi-Sector

      Thomas P. O’Reilly, CFA

      Head of Non-Investment Grade Fixed Income

      Jason Pratt

      Head of Insurance Fixed Income

      Thomas A. Sontag

      Head of Global Securitized and Structured Products

      Gorky Urquieta

      Co-Head of Emerging Markets Debt

      Ronit Walny, CFA

      Senior Portfolio Manager—Multi-Sector

      Top

      1 https://www.newyorkfed.org/medialibrary/media/research/capital_markets/Prob_Rec.pdf
      2 Note that a Moody’s rating of B3 translates to a B- rating from Standard & Poor’s, while B2 is equivalent to B.

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