Fixed Income Outlook  |  Q2 2018

Sector views

Fixed Income Team

Sector views

Credit strategies remain attractive in the current environment

Surprisingly, as bond yields rose during the quarter, spreads remained relatively stable. [Spreads are the yield advantage offered by riskier types of bonds over comparable-maturity Treasuries.] Spreads for investment-grade and high-yield corporate credit, as well as mortgage credit, finished the period near their lows for the current market cycle. We think this is justified by the fundamentals underlying these market sectors, namely solid economic growth, rising corporate profits, and a strong housing market. We believe the fundamental backdrop continues to support risk-taking in these sectors, and we think this is particularly true in structured mortgage credit. As a result, we continue to have a positive outlook for securitized mortgage products, such as CMBS, agency IO CMOs, CRTs, and non-agency residential mortgage-backed securities.

High yield: Supported by favorable fundamentals

We evaluate the high-yield market through three lenses: fundamentals, valuation, and technical (the balance of supply and demand). As of quarter-end, we thought the fundamental environment and technical backdrop were positive, and valuation was neutral. Looking at fundamentals, we think corporate fundamentals are likely to remain strong. Issuer defaults have begun to creep higher, with forecasts for a 2% to 2.5% total default rate in 2018, which is still low based on longer-term history. Recovery rates have risen.

Regarding valuation, high-yield credit spreads — the yield advantage high-yield bonds offer over comparable-maturity U.S. Treasuries — widened slightly in the first quarter, but remain below the long-term average. It is worth noting that the overall credit quality of the high-yield market, by most measures, is higher quality than the average high-yield cohort. The average bond price within the index was close to par value, i.e., face value. As a result, the asset class is in a range of fair value, in our view, given corporate fundamental strength. Against this backdrop, we think performance will be driven by coupon income with limited capital appreciation potential. Regarding technicals, we are not anticipating a significant spike in new supply. In light of new provisions governing corporate interest deductibility passed as part of the U.S. tax reform, it's possible that new-issue supply could sharply decline. If this happens, we think it could benefit existing bonds, assuming the demand for yield persists.

Bank loans: Benefiting from strong fundamentals and the rising-interest-rate environment

Loans performed well in the early months of 2018 amid a volatile backdrop for risk-driven assets. Rising interest rates bolstered the asset class, as loan coupons — their stated interest rates — adjusted higher. Bank-loan coupons are linked to the London Interbank Offered Rate [LIBOR], a widely used benchmark for short-term lending among banks that tends to move in step with the federal funds rate. In late February, three-month LIBOR eclipsed 2% for the first time since the 2007–2008 financial crisis. We think it's possible that the Federal Reserve could increase the fed funds rate four times during 2018. If that occurs, LIBOR also would continue to rise, and coupons on existing loans would, in turn, adjust higher from current levels.

More broadly, we think the loan market continues to be supported by a favorable fundamental backdrop. The U.S. economy continues to expand, aided by a reacceleration in global growth. Corporate fundamentals — sales, earnings, cash flow, and debt management — have continued to strengthen, in our view, providing a supportive environment for risk-based assets, including bank loans. The loan default rate rose to 2.5% during the first quarter but remained below the long-term average range of 3% to 3.5%. Importantly, we believe strong sales and earnings among loan issuers, coupled with a record pace of refinancing, may extend the current credit cycle for at least a few more years.

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