Fixed Income Outlook  |  Q3 2018

Sector views

Fixed Income Team

Sector views

Credit strategies show continuity tempered with greater conservatism

We favor mortgage credit, prepayment risk, and corporate credit, but are taking a more conservative approach. We are purchasing shorter-duration securities and seeking greater credit protection by investing at more senior levels in an issue's credit structure. Within mortgage credit, we believe commercial mortgage-backed securities will benefit from employment growth, relatively low rates, and economic expansion. Moving on to the residential sector, we favor agency credit risk-transfer securities because of strong housing fundamentals. However, we are cautious about increasing exposure due to high valuations. We find prepayment risk attractive. And the valuations and spreads on reverse-mortgage interest-only securities are also attractive.

In emerging markets, we managed risk by reducing exposure to volatile markets, such as Russia. We plan to focus on investments that we believe offer value. After a decade of greater borrowing by emerging-market governments and companies, dollar-denominated bonds in developing economies are coming under increasing pressure as U.S. interest rates rise and the U.S. dollar strengthens. A stronger dollar makes it more difficult for countries with large amounts of dollar-denominated bonds to repay that debt as it matures. Trade tensions worsen the outlook for countries that rely on exports. The dilemma now facing policy makers in less-developed countries is whether to try to keep pace with the Federal Reserve as it raises interest rates. Higher rates could help stem capital outflows from emerging markets but could also crimp domestic growth.

High yield: Economic and corporate fundamentals a bright spot

We evaluate the high-yield market through three lenses: fundamentals, valuation, and technicals, or the balance of supply and demand. The fundamental environment has been positive, while we have a more neutral outlook toward technicals and valuation. U.S. economic data is favorable, and the unemployment rate fell to a 17-year low. Growth for the U.S. economy and corporate earnings is likely to strengthen over the remainder of 2018.

Turning to valuation, high-yield credit spreads — the yield advantage U.S. high-yield bonds offer over comparable-maturity U.S. Treasuries — were at about four percentage points as of quarter-end. Spreads have remained relatively unchanged thus far in 2018. In our view, the asset class is in a range of fair value given corporate fundamental strength. Against this backdrop, we think performance in 2018 will be driven by coupon income with some capital appreciation potential. But given the firm economic backdrop and strong corporate fundamentals, high-yield corporate credit remains attractive for investors seeking income.

As for technicals, the majority of year-to-date gross new issuance was used to refinance existing debt — a continuation of a trend we have seen for some time. Year-to-date net new issuance of high-yield bonds, excluding refinancing, totaled about $45 billion, down 28% from the same period in 2017. High-yield mutual funds and exchange-traded funds had net outflows of $23.7 billion through June 29. Overall, it appears fund outflows have been offset the positive impact of lower net new issuance.

Bank loans: Steady fundamental and technical conditions

The loan market continues to be supported by a favorable fundamental backdrop. U.S. economic and corporate earnings growth are likely to strengthen further this year. Within this environment, loan issuers have slowly grown their revenues and translated that growth into stronger earnings and cash flows. With the exception of specific issuers in certain parts of the market, defaults remain generally subdued.

The majority of year-to-date gross new issuance was used to refinance existing loans — a continuation of a trend we have seen for some time. Year-to-date net new issuance of bank loans, excluding refinancing, totaled about $167 billion, up 19% from the same period in 2017. Meanwhile, loan mutual funds and exchange-traded funds reported a year-to-date net inflow of $11.9 billion through June 29. Additionally, collateralized loan obligations (CLOs) have been a strong source of loan demand. Year to date, about $153 billion in CLOs have been issued, with roughly half this total representing new CLOs.

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