Fixed Income Outlook  |  Q2 2020

Sector views

Fixed Income Team

Sector views

Trends in the mortgage market

Mortgage credit strategies underperformed during the period, including synthetic exposure to commercial mortgage-backed securities (CMBS) via CMBX. CMBX is an index that references a basket of CMBS issued in a particular year. CMBX tranches rated BBB- and A performed poorly as spreads widened substantially.

Strategies targeting prepayment risk also experienced adversity. Lower interest rates and indiscriminate selling by investors proved to be material headwinds for agency interest-only collateralized mortgage obligations (IO CMOs) and inverse IO securities, despite refinancing activity remaining subdued for the most part. The negative result here was partially offset by favorable tactical mortgage basis positioning. Mortgage basis is a strategy that seeks to exploit the yield differential between 30-year agency passthroughs and 30-year U.S. Treasuries.

We plan to take a cautious approach to increasing portfolio risk over the near term. In CMBS, we continue to have exposure to the A- and BBB- rated tranches of CMBX. In our view, hotel and retail properties are likely to be meaningfully affected by the coronavirus. However, the CMBS exposure is diversified by property type, and we believe CMBX continues to offer a unique investment opportunity. Within prepayment-sensitive areas of the market, we plan to maintain agency IO CMOs and inverse IOs backed by more seasoned loans. We believe this segment of the markets will have less sensitivity to refinancing risk in a low-interest-rate environment.

Corporate debt comes under pressure

The favorable market environment for corporate credit — both high-yield and investment-grade — collapsed during the quarter. The withdrawals from corporate investment-grade bond funds and ETFs, especially short-term debt, reached record levels during the quarter. The spreads on investment-grade bonds, or the risk premiums investors demand to hold these securities over U.S. Treasuries, widened to levels not seen since the financial crisis. As a result, the Bloomberg Barclays U.S. 1-3 Year Corporate Index dropped 1.53% during the quarter.

Prior to this period, we took steps to reduce risk in our portfolios on the view that volatility was likely to rise and valuations in certain sectors, particularly corporate credit, were becoming increasingly unattractive. Within corporate credit, our emphasis here continues to be on security selection. Overall, we are constructive on the outlook for the investment-grade corporate bond market. On a valuation basis, we think spreads are attractive as the market is currently pricing in substantial downgrade risks. The situation remains fluid, but our base case is that the markets will stabilize, and then recover over time. Furthermore, we think there is an attractive liquidity premium in the market currently, which is most apparent at the front end of the yield curve.

High-yield bonds declined by double digits during the past three months. That said, excluding the energy sector, we have a fairly constructive view on corporate fundamentals and supply-and-demand over the intermediate term. We now think valuations are very attractive because high-yield spreads have widened. Regarding fundamentals, fourth-quarter 2019 earnings largely exceeded expectations. However, we are closely watching sectors vulnerable to the disruption caused by the coronavirus. In addition to energy, we are also monitoring the impact on gaming, lodging & leisure, retail, and several other cohorts.

As for supply/demand dynamics, new-issue activity stalled in March amid the market volatility. There has been $18.7 billion of net new issuance (net of refinancing) year to date compared with $24.9 billion during the same period in 2019. On the demand side, high-yield mutual funds and exchange-traded funds experienced outflows of $16.7 billion in the first quarter, compared with inflows of $18.8 billion in the first three months of 2019. Lower new-issue supply was met by diminished demand.

From a valuation standpoint, the average spread of the JPMorgan Developed High Yield Index rose to about 9.5 percentage points over Treasuries in March — the widest spread level since early 2016 and well above the 20-year average of 6.1 percentage points. In our view, spreads at this level offer a broad range of attractively valued investment opportunities. We think the market's substantially higher yield is compelling because of generally lower global yields.

The biggest risk to our moderately constructive outlook is the still-to-be-determined impact of the coronavirus on economic growth, corporate earnings growth, and cash flows. Additional risks include price volatility in oil and other commodities, policy missteps by global central banks, and heightened geopolitical tension. In high yield, defaults are likely to rise, although both fundamentals and the supply and demand appear more constructive, as spreads have risen to more attractive levels.

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