Fixed Income Outlook  |  Q3 2019

Sector views

Fixed Income Team

Sector views

Corporate credit spreads may tighten

In the second quarter, a sizable decline in global interest rates was the biggest development. Spreads — the yield advantage bonds offer over comparable-maturity U.S. Treasuries — tightened across asset classes, driven by dovish Fed commentary and easing trade tensions. Within this environment, corporate credit, mortgage credit, and prepayment risk generally performed well. In corporate credit, we think spreads as of June 30 represented fair value, based on generally supportive business fundamentals. In an environment where the Fed and other central banks have adopted a more dovish tone, we think spreads could remain steady or tighten slightly in the months ahead.

Favorable outlook for mortgage strategies

We continue to have a generally favorable outlook for mortgage credit, including commercial mortgage-backed securities (CMBS). We think the underlying fundamentals for commercial real estate appear stable, supported by a growing labor market, interest rates that remain historically low, and a positive U.S. economic backdrop. That said, we think these favorable factors will be partially offset by higher capital costs and low capitalization rates. (Capitalization rate is the rate of return on a commercial investment property based on the income that the property is expected to generate.) Elsewhere, within residential mortgage-backed securities (RMBS), we continue to find value among legacy RMBS, where we think a steadily shrinking market and stable investor base provide a supportive supply-and-demand backdrop.

Most risk assets modestly outperformed during Q2

High-yield bonds in demand

High-yield bonds rose 2.60% for the second quarter, as measured by the JPMorgan Developed High Yield Index. The asset class outpaced high-yield bank loans but trailed the broad investment-grade fixed-income market. Despite global trade uncertainty, we think the fundamental backdrop for high yield remains supportive, aided by favorable corporate earnings, a strong labor market, and solid U.S. economic growth. Defaults declined materially during the past 12 months and are now at a level last seen in 2014. We think defaults are likely to remain low for an extended period.

The market's technical backdrop improved this year, aided by a combination of modest net new issuance and a return to strong fund inflows. New volume (net of refinancing-related new issuance) was $46.6 billion year to date, slightly higher than in the same period in 2018. Meanwhile, flows into retail and exchange-traded funds totaled $12 billion, compared with outflows of $24.5 billion during the same period last year. Turning to valuation, in June, high-yield spreads partially retraced the widening in May and remain tighter than where they began the year. Overall, we think spreads look fairly valued.

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The global economy has cooled in 2019 as the fallout from the ongoing trade rifts, waning business confidence, and financial market volatility have kept the lid on expansion.