Fixed Income Outlook  |  Q1 2018

Fundamental conditions are supportive for risky assets

Fixed Income Team

Fundamental conditions are supportive for risky assets

Securitized debt: Attractive opportunities 
despite crosswinds

Within mortgage credit, we think commercial mortgage-backed securities could benefit from employment growth, low interest rates, and a continuation of the current economic expansion. Significant press coverage has described challenges to brick-and-mortar retailers by online shopping. While we recognize the challenges, we're also encouraged by the fact that many mall operators are attempting to repurpose their space to attract new types of tenants. Consequently, we don't believe this shift in consumer preference will necessarily lead to widespread weakness in the commercial real estate market.

We believe the non-agency RMBS market continues to be supported by an improving housing market and shrinking supply. The tax reform plan that was passed in December is a modest negative for the housing market due to the new limitations on interest deductibility. More broadly, however, existing home prices have been rising steadily since 2012, while the supply of available homes has dropped to levels not seen since 2005. As a result, we think the supply-and-demand dynamics are quite favorable for home prices, particularly as millennials begin to reach prime ages for household formation. Also, we continue to like agency credit risk-transfer securities on the basis of fundamentals and underlying collateral, but have become more cautious from a valuation perspective.

High yield: Fair valuations constrain upside

High-yield issuers' credit metrics improved over the course of 2017, in our view, and 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. At the same time, recovery rates have also risen. As for technicals, we are not anticipating a significant spike in new supply. In light of new provisions governing corporate interest deductibility passed as part of U.S. tax reform, it's possible that new-issue supply could decline. If this happens, we think it could be beneficial for existing bonds, assuming the demand for yield persists.

The asset class is not compellingly cheap, but is in a range of fair value, in our view, given corporate fundamental strength. Against this backdrop, we think performance in 2018 will be driven by coupon income with limited capital appreciation potential.

Bank loans: With sustained gains, credit cycle rolls on

We have a positive fundamental outlook for bank loans and a neutral view on valuation and technicals. As the U.S. economy continues to expand, corporate fundamentals — sales, earnings, cash flow, and debt management — are likely to remain strong, providing a supportive environment. As of December 31, the average discounted spread over LIBOR in the S&P/LSTA Leveraged Loan Index was about 4.2 percentage points, below where it began the year and also lower than the long-term average. Roughly 70% of the loans in the index were trading at or near par (face value). In our view, these data portray a loan market where valuations are not overly attractive but also are not exceptionally rich. With a relatively high percentage of outstanding loans trading at par, there appears to be limited near-term capital appreciation potential. The default rate may rise modestly in 2018, but we believe it will remain 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.

Investment-grade bonds: Tighter spreads make valuations less attractive

We continue to have a constructive outlook for investment-grade credit despite the fact that valuations are not as attractive as they were a year ago. We plan to continue emphasizing bonds issued by banks and other types of financial services companies. Many of these firms have strengthened their balance sheets, and their earnings have become much less volatile, in our view.

Emerging-market debt: Favorable economic environment offset by risks

We are cautiously optimistic as we look to the year ahead. We believe the acceleration in global growth will continue well into 2018, fueled by many developing countries. At the same time, there will be modest downside risks to growth in China in 2018 given the imbalances in the economy. We are cognizant that the deep financial and trade links between China and emerging markets, especially Latin America and Asia, render the latter vulnerable to a hard landing.

We think any flare-up in geopolitical risks, including in North Korea, Russia, and the Middle East, could weigh on emerging-market debt. Separately, Brazil and Mexico will hold presidential elections in 2018. Electoral cycles and changes in governments could result in economic and financial policies that are not favorable to investors. There is some headwind risk that investors will reallocate funds from emerging-market assets.

Municipal bonds: Monitoring the effects of stimulus

We will be closely monitoring the debt ceiling debate, a budget resolution for the next fiscal year, and the confirmation of President Trump's nomination of Jerome Powell as the next Federal Reserve chair. As always, we will continue to rely on in-depth research and our experienced market insights to evaluate new and existing holdings for attractive income and return potential.

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Securitized debt: Attractive opportunities 
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