Conservative approach to credit strategies
For some time, we have held the view the Fed was attempting to normalize interest rates, and that it would continue to raise its target for short-term rates as long as the markets seemed to be accommodating these increases. Given the volatility that pervaded markets in the fourth quarter, we now think the Fed is likely to pause, perhaps until the second half of 2019.
In fixed-income markets, we continue to favor mortgage credit, prepayment risk, and corporate credit. However, because we are in the later stages of both the economic and credit cycles, we are taking a somewhat more conservative approach than previously. We are doing this by purchasing securities with less price sensitivity to changes in yield spreads, while also seeking greater credit protection by investing at more senior levels in a deal's credit structure. After asset prices dropped in the fourth quarter, yields are higher across many market sectors. We think this may give us the ability to generate greater income in our portfolios.
The portfolio's exposure to commercial mortgage-backed securities via the CMBX — an index that references a basket of CMBS issued in a particular year — hurt results during the fourth quarter as the index's average yield spread widened substantially. The prices of credit-sensitive securities decline as yield spreads widen. Investments in agency credit risk-transfer securities and pay-option adjustable-rate mortgage-backed securities were further detractors after delivering generally steady performance during the first nine months of the year.
Fundamental backdrop for high-yield bonds look positive
High-yield securities struggled during the fourth quarter as investors shifted away from riskier categories. High-yield bonds declined 4.65% during the fourth quarter, as measured by the JPMorgan Developed High Yield Index, trailing high-yield bank loans as well as the broad investment-grade fixed-income market.
As we enter 2019, we have a positive outlook for market fundamentals and think valuations are more attractive in the sector. The fundamental backdrop for high-yield bonds remains supportive, led by corporate profit growth, a strong labor market, and rising employee wages. Including distressed exchanges, the U.S. high-yield default rate was 1.9% as of December 31, 2018, below the long-term historical average of about 3.5%. We think default rates could remain below average for the next year or two, and possibly longer, for two key reasons: the relative financial health of high-yield issuers overall, and the fact that many have refinanced and extended bond maturities into the future.
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