Fixed Income Viewpoints - March 2016

SPREAD SECTORS:

US INVESTMENT-GRADE CORPORATES: Financials notably underperformed in February as investors unwound long positions amid concerns about the health of the European banking system and the impact of low interest rates on banks’ net interest margins. In contrast, energy and metals and mining names rebounded strongly from distressed valuation levels as commodity prices moved higher. Real estate investment trusts and higher-quality metals credits are areas of interest, along with midstream energy companies whose managements are proactively addressing balance sheet concerns by cutting dividends, reducing capital expenditures, and raising equity.

EURO CORPORATES: Credit spreads are marginally tighter, having recovered from the sell-off in the first half of February. Valuations currently represent fair medium-term value. European banks have materially underperformed, with significant recovery seen in distressed metals and mining names. Expectations have grown for increased monetary policy accommodation at the ECB meeting on 10 March. Expanding quantitative easing (QE) to corporate bonds is an upside scenario.

US HIGH YIELD: February began with significant spread widening and a continuation of the energy and metals sell-off. But in the second half of the month, spreads retraced all of the widening, with investors reaching for low dollar priced bonds and some stability in energy prices. We have experienced a very large amount of “fallen angel” supply over the last month as investment-grade issuers were downgraded to high yield, and the market is absorbing this paper. Overall valuations and market yields are still heavily skewed by the distressed energy and metals and mining industries, but we continue to find interesting ideas away from commodities and even within the highest-quality segment of the energy universe.

EURO HIGH YIELD: Market technicals remain positive, with mutual fund inflows returning across the industry as higher yields brought investors back to the asset class. A lack of a decent primary calendar for several months has led to a build-up of market demand. Sound fundamentals and expectations for active ECB support also remain in place. We look to both the reopening of the primary market and ECB action on 10 March to help the market find direction. European high yield has lagged the U.S. high yield market but is likely to receive a boost when the new issuance market finally starts up.

BANK LOANS: Loans still appear to offer a more defensive way to play decent high yield fundamentals with lower volatility. The sector has benefited from a materially lower exposure to commodities and CCC rated debt than the U.S. high yield market. It also still provides some measure of protection against rising interest rates. Spreads have widened in recent months in response to the move in high yield spreads, as well as weaker technical conditions. The vast majority of loans are now trading below par. Technical factors, including collateralized loan obligation performance and issuance will be key drivers of the market.

AGENCY MORTGAGE-BACKED SECURITIES: Spreads on agency MBS recovered from their mid-February wides as risk sentiment improved, Treasury rates retraced higher, and prepayment concerns eased. We maintain a neutral view on the sector. Spreads are historically cheap versus Treasuries, though arguably more fairly valued in the context of broader market risk factors. However, MBS still appear attractively valued on a risk-adjusted-basis versus credit sectors.

EM DOLLAR SOVEREIGN: Stabilization of commodity prices has supported a risk rally in the sector. With the U.S. high yield market also rallying on higher oil prices, relative value for BB rated EM sovereigns is now fair rather than rich. Investment grade EM sovereigns have outpaced the U.S. investment-grade credit market, so a pause in the rally is likely—potentially caused by increased supply. Idiosyncratic noise from Brazil has turned positive; the probability of regime change has increased, and improvements in Brazil’s external accounts are promising. Greater clarity around Chinese policy will be a barometer for adding risk.

EM CORPORATES: Despite recent strong performance, we maintain a somewhat cautious outlook for EM corporates. The sector’s illiquidity relative to other fixed income alternatives puts a higher bar on a valuation or fundamental-centred thesis for adding to exposures. From a country perspective, some of our highest-conviction names are found in Mexico, China, Indonesia, the Philippines, and—increasingly—Brazil. BBB and BB rated credits still offer the best risk/reward profile.

EM LOCAL: Yield spreads versus U.S. Treasuries have tightened over the past month. As Treasury yields stabilized, large EM markets—most notably Brazil, Russia, and Turkey— drove strong performance in local rates. At the headline level, valuations are less attractive. However, sector-level yields are still somewhat wide relative to Treasuries. EM currencies also performed well over the past month. Recent price action has been supportive of a bottoming in commodity prices. Going forward, currencies are likely to trade in a more volatile range, which supports adding selectively to exposures over time. The potential for resumption of Fed tightening and China-related concerns remain the central risks.

DEVELOPED SOVEREIGN MARKETS:

US: Treasury yields have lagged the sharp move higher in risk assets, oil, and inflation expectations into early March. The hesitant move higher in yields reflects some uncertainty as the Fed, ECB, and BoJ are all scheduled to meet in mid-March. However, domestic economic data has surprised to the upside recently, increasing the probability of higher U.S. interest rates. Assuming risk appetites do not reverse yet again, a strategy of selling U.S. Treasuries on strength appears prudent in the near term.

EUROZONE: The ECB remains engaged in an aggressive program of sovereign QE and may decide to extend the program beyond the current March 2017 end date. The ECB is likely to cut its deposit rate again on 10 March, but the market has fully priced in this possibility, expecting a 20 bps cut this month and another 10 bps reduction next quarter. Consensus growth expectations have been stable over the past month at about 1.6% per annum, but recent economic data has been softer than expected. A lack of inflation implies that rate hikes will not happen for at least three years.

JAPAN: A loss of economic momentum continues with some divergence across the manufacturing and services sectors. Into 2016, growth will likely be supported by additional fiscal initiatives prior to the midyear upper house elections. The BoJ’s negative deposit rate hit a snag as administrative inability to manage negative deposit rates caused a substantial decrease in activity in the interbank market. We expect additional easing by the BoJ through an additional reduction of the interest rate paid on commercial banks’ deposits at the central bank, and possibly through expansion of the qualitative easing programme (e.g., ETF purchases).

UK: Market expectations for the first Bank of England (BoE) interest rate hike continue to be moved back from 2018 last month to 2020 currently by some measures. The profound change has been driven by a combination of softer data, an increase in global risk aversion, and a view that “Brexit” risk will keep the BoE not only on hold but also poised to cut interest rates should the realization of Brexit occur—actual or even anticipated. Exiting the European Union has the potential to disrupt UK economic growth, which has helped support gilts at objectively very rich levels. Meanwhile, Moody’s has highlighted the downside risk to the UK’s sovereign rating should Brexit become a reality.

CANADA: Fourth-quarter growth was weak, as expected, with capital expenditures detracting significantly. Recent stability in oil prices has made the outlook less gloomy, but a period of below-trend growth still looks likely. Inflation has remained contained, giving the Bank of Canada some welcome monetary policy flexibility. While we expect policy rates to remain on hold for an extended period, further easing could be delivered if growth disappoints. Canadian government bonds lagged the rally in U.S. Treasuries through mid-February and are likely to outperform in a rising U.S. yield environment.

AUSTRALIA: Recent domestic data has been more encouraging, with consumption and housing activity offsetting the still-significant mining investment drop-off. With inflation close to the lower end of its target band, the Reserve Bank of Australia has indicated that there is scope for further easing should inflation remain low—the first-quarter CPI print in April will be critical for making this decision.

2016-GL-3617