Finding value in mortgages
Despite some recent signs of weakness, we think the U.S. economy is still in good shape overall. As a result, we believe the yield pickup offered by U.S. corporate and mortgage credits relative to lower- and even negative-yielding international alternatives may remain attractive to investors.
We continue to have a favorable outlook for mortgage credit. We think the underlying fundamentals for commercial real estate appear stable. Supports include a growing labor market, interest rates that remain historically low, and a positive U.S. economic backdrop. We also think the pricing of securities in the sector continues to reflect overly negative sentiment toward retail properties. The U.S. housing market has picked up, aided by the substantial decline in the 10-year Treasury yield — a key benchmark for mortgage rates.
Corporate debt fairly valued
Investment-grade corporate bonds outperformed U.S. government and agency debt, mortgage credit, high-yield credit, and emerging-market debt. Generally speaking, after a strong run during the past 12 months, we think corporate credit is fairly valued. Fundamentals within investment-grade corporate credit remain stable; however, some of the economic deceleration may flow through third-quarter earnings. As a result, in our security selection process, we are continuing to remain selective and are pruning certain cyclic names. Our corporate credit holdings — which included high-yield, investment-grade bonds, and convertible securities — performed well due to favorable sector and security selection.
High-yield bond spreads tighten
High-yield bonds gained 0.91% for the third quarter, as measured by the JPMorgan Developed High Yield Index. They trailed high-yield bank loans and the broad investment-grade fixed-income market. As of September 30, the fundamental environment remained reasonably supportive, but we had a more neutral outlook toward valuation and the technical backdrop. As for valuation, high-yield spreads ended the quarter at 4.75 percentage points above comparable maturity Treasuries. For the year to date through September 30, spreads had tightened by almost one percentage point. Energy has been a difficult sector in the market, and the overall market has favored higher quality names.
Supply trends have contributed to the improvement in issuer quality. During the 2007 to 2019 period, issuance of split B/CCC-rated bonds declined from about 38% of total new-issue volume to roughly 16%, according to Standard & Poor's. A dramatic reduction in issuance to fund leveraged buyouts and mergers/acquisitions was a major reason for this downtrend in lower-quality issuance. In 2007 and 2008, upward of 50% to 60% of new-issue volume went to fund leveraged buyouts, and mergers and acquisition deals. By April 2019, this volume had dwindled to roughly 15%.
Term-structure securities bound by rates
In parts of the market where we target prepayment risk, we don't think our allocations to agency interest-only collateralized mortgage obligations (CMO) will have the benefit of rising interest rates in the near term. Consequently, we are focusing on security selection in this area of the market. Finally, our term-structure outlook is that rates in the United States are likely to be rangebound at this stage of the economic cycle. In light of macroeconomic events, duration will be somewhat similar to the rate-sensitive Bloomberg Barclays U.S. Aggregate Bond Index in the near future.