Fixed Income Outlook  |  Q3 2017

Sectors: Trends remain in place

Fixed Income Team

Sectors: Trends remain in place

Securitized debt: Prepayment and credit risks remain attractive

We continue to look for value in areas within interest-only collateralized mortgage obligations (CMOs), although we have been more cautious in our allocation relative to mortgage credit. More generally, we find prepayment risk attractive in an environment where mortgage lending standards have yet to ease materially. Additionally, we find reverse mortgage interest-only securities (IOs) compelling due to their valuations, stable prepayment speeds, and lack of convexity.

In mortgage credit-sensitive areas, we think investors should consider commercial mortgage-backed securities (CMBS). The underlying fundamentals for commercial real estate continue to be stable overall, as employment growth, low interest rates, and a positive GDP trajectory provide a tailwind for the CMBS sector. Nonetheless, we believe the growth in property prices experienced over the past few years will be difficult to maintain going forward. While we do predict some regional mall-related losses, we do not believe it will translate into fundamental losses at the BBB- tranche level.

Among agency credit risk transfer securities (CRTs), valuations in both mezzanine and subordinated tranches are fairer, in our view, but investor participation continues to increase and the underlying collateral has a strong outlook. Additionally, we continue to find value in the legacy residential mortgage backed security (RMBS) market. Improving housing fundamentals are helping homeowners, with loan-to-value ratios falling, homeowner delinquency rates declining, and more borrowers staying current after mortgage modifications.

High-yield bonds and bank loans: Expecting yields to grind tighter

Outside of March 2017, the high-yield bond market has had a good run year to date, and our outlook is for continued strength and further yield compression. While this outlook for the asset class is positive, we are slightly more cautious on the fundamentals. With respect to high-yield valuations and "technicals," or the balance of supply and demand, our view is neutral.

Looking more closely at fundamentals, first-quarter U.S. corporate earnings were the strongest since 2011. High-yield issuers have improved in terms of various credit metrics, and we expect continued strength in corporate fundamentals. However, our outlook is tempered to a degree by the various uncertainties surrounding the ability of the Trump administration to implement key aspects of its policy agenda, particularly tax reform and major U.S. infrastructure investment. Additionally, we are cautious on the energy sector due to ongoing supply/demand dynamics and questions surrounding OPEC, which have driven oil prices to $45 per barrel.

Considering valuation, high-yield credit spreads — the yield advantage high-yield bonds offer over comparable-maturity U.S. Treasuries — continued to compress during the period, and the average bond price within the index was close to par, or face value. As a result, the asset class is not compellingly cheap, but is in a range of fair value, in our view, given corporate fundamental strength.

As for technicals, new issuance of high-yield bonds totaled $148.5 billion for the year-to-date period through May 31, 2017, which was 19% higher than the same period in 2016. However, 65% of newly issued bonds year to date were used to refinance existing debt, as corporations sought to capitalize on tight spread levels to refinance and extend their maturities. According to data from JPMorgan, the amount of new issuance excluding refinancing is at its lowest level since 2011. Meanwhile, high-yield retail fund flows were negative for the year-to-date period (-$9.1 billion), compared with inflows of $7 billion for the first five months of 2016.

Turning to bank loans, issuance was the second-highest total on record for the first five months of the year. As with high-yield bonds, a significant amount of this new issuance — roughly half in the case of bank loans — represented refinancing activity. While the yield curve has flattened at the long end, short-term interest rates have generally risen through the first half of 2017. With 3-month LIBOR (London Interbank Offered Rate) at roughly 125 basis points at period-end, bank loans have continued to offer slightly more attractive coupon income to investors. Moreover, as 3-month LIBOR and the federal funds rate are highly correlated, we think that any future Fed policy tightening will only enhance the attractiveness of bank loans for investors seeking income that is hedged against interest-rate risk.

Corporate credit and EM debt continue to lead

Investment-grade bonds: Solid fundamentals and strong demand

Demand for investment-grade bonds in the second quarter of 2017 was robust, particularly from large investors such as global government agencies, supranational entities, and sovereign funds. Thus, while corporate spreads have tightened since the start of the year, we think fundamentals and demand will continue to bolster this market segment.

Looking forward, we think that strong U.S. corporate fundamentals may support the profit margins of investment-grade companies. Moreover, for the financials sector, the combination of potentially less onerous regulation and the Fed's continuing path toward interest-rate normalization may lend further support to fundamentals.

The yield curve flattened as rates rose on the front end and fell on the long end

Emerging-market debt: High investor interest despite political shocks

Domestic political shocks continued to occur across the emerging markets throughout the first half of 2017. In South Korea, for example, the president was removed from office on corruption charges. In Turkey, the government held a referendum on a constitutional change that many observers see as a sign marking Turkey's illiberal future. In South Africa, President Jacob Zuma came under intense political pressure for deeply embedded corruption. And in Brazil, President Michel Temer, the former Vice President who took office last year following the impeachment of Dilma Rousseff, appeared to become embroiled in his own corruption scandal. These developments, which matter for the economic outlook for these countries in many ways, didn't do much to deter investors.

We believe a variety of forces are aligned that may enhance the attractiveness of the asset class for many investors. Significantly, we think political risk has declined across the developed markets. The recent elections in Europe support this view, and we think these election results suggest the region will maintain its commitment — in the near term, at least — to accommodative monetary policy.

Overall, we maintain a bias in the fund toward dollar-denominated sovereign debt and have a greater sense of caution with respect to emerging local debt and foreign currency exchange risk. Interest rates have largely fallen in the United States so far in 2017, and we do not see inflation rising to a level that would prompt more aggressive action from the Federal Reserve. That is good news for emerging-market sovereigns with dollar-based debt obligations.

Municipal bonds: Fundamentals are sound, but policy-driven volatility is on the horizon

From January to May 2017, investor sentiment generally improved, especially for higher-yielding municipal bonds. The pace of new issuance was generally light, and demand slightly outpaced supply — contributing to rising prices and a narrowing of credit spreads of lower investment-grade as well as high-yield municipal bonds. Viewed in a longer-term context, the tighter spreads seemed relatively fair to us, especially considering that defaults among municipal issuers remained low and isolated.

In late May, President Trump presented his tax plan, which was light on details. However, such as it is, the proposed plan would reduce the overall number of individual tax brackets to three, eliminate targeted tax breaks, and repeal the alternative minimum tax, among other things. The good news for tax-sensitive investors is that the tax-exempt status of municipal bonds was not addressed in the recently announced tax outline. Treasury Secretary Steven Mnuchin publicly affirmed the administration's preference to keep the interest deductibility of state and local bonds. Furthermore, we do not believe the currently proposed lowering of the highest personal income tax bracket from 39.6% to 35% will materially affect demand for municipal bonds.

The new administration has stated that tax reform remains a major policy goal. However, we have not seen major tax reform in over 30 years, and we believe it will continue to be difficult to achieve today given the current political climate. As such, we believe it is too early to boldly reposition tax-exempt portfolios. That said, we continue to closely monitor tax policy developments in Washington to see what form the final tax plan takes, and how it may shape the outlook for municipal bonds.

Next: Currency: Don't look to the dollar for leadership

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