Fixed Income Markets Review and Outlook

SPREAD SECTORS:

US INVESTMENT‑GRADE CORPORATES: As in recent months, the market’s focus continues to be higher-beta commodity and energy-related sectors, which have contributed to increased volatility and wider spreads. T. Rowe Price credit analysts continue to find opportunity in select financials and lower-beta sectors.

EUROPEAN CORPORATES: Speculation of ECB bond buying dominates the medium-term outlook. Direct corporate bond purchases could further squeeze spreads. However, it’s not all about the ECB, as the European economic environment of low growth, low inflation, and low rates remain supportive of credit even if valuations are stretched.

US HIGH YIELD: The overall fundamental picture remains intact—outside of the commodities space. We continue to see a relatively muted default outlook through 2015. If oil prices remain low for an extended period of time, we will evaluate the impact to our 2016 default outlook. Overall valuations and market yields are getting more interesting now as they start to approach 7.5%, albeit likely with some volatility still to come from the energy sector. Spread levels are starting to imply a higher default rate than we are currently expecting.

EURO HIGH YIELD: Fundamentally, little has changed over the quiet year-end period. New issuance is yet to get underway and market cash balances are reported as high. Risk appetite is expected to be driven by the extent of ECB accommodative action but may be tempered by concerns over potential volatility. The Greek elections are an example of a possible trigger. While valuations are less attractive, Euro high yield has been less volatile than US high yield.

BANK LOANS: The fundamental backdrop remains intact with low forward default expectations and a minimal near-term maturity profile. Loans still appear to offer a more defensive way to play solid high yield fundamentals with lower volatility. The market remains supported by a strong collateralised loan obligation bid, which is currently more than making up for retail outflows. And importantly, the sector has a materially lower exposure to the commodities sectors than US high yield.

AGENCY MBS: Spreads across the sector have cheapened considerably, but the moves appear warranted given the greater uncertainty in the market. The fundamental backdrop for MBS is becoming more challenged with increasing prepayment concerns, as well as new policy efforts to ease credit standards to support housing.

EM DOLLAR SOVEREIGN: Both investment-grade and high yield sovereigns are attractive versus US credit, but the market is increasingly idiosyncratic (Russia, Venezuela, and other oil-related names, in particular).

EM CORPORATES: Valuations are attractive relative to the US credit across the ratings spectrum. Commodity price weakness has a mixed impact on performance but is generally a headwind to spread compression. Our enthusiasm is tempered by poor liquidity, particularly in the high yield segment of the asset class.

EM LOCAL: Bonds have been performing well, but currencies remain weak. Both trends appear more extended. Yield spreads are near their tights versus US Treasuries, but local currency bonds look relatively cheap to other global sovereign bonds. However, local bonds are looking expensive compared with EM sovereigns issued in dollars.

DEVELOPED SOVEREIGN MARKETS:

US: The labour market continues to maintain strong momentum, and the Fed’s communications indicate a mid- 2015 liftoff to the hiking cycle. The Fed continues to look through energy-related headline inflation weakness, keeping the liftoff in rates on track. Relatively strong growth conditions would suggest higher yields, but the market’s focus on inflation expectations and global weakness continues to hold yields down. Until those conditions change, any rise in yields will be limited.

EUROZONE: The growth and inflation outlook is expected to improve later this year, but monetary policy is likely to remain accommodative for the foreseeable future. Negative yields in the front end of the German curve are pushing demand further out the term structure. Sovereign bond quantitative easing should constrain yields at low levels. However, valuations are extremely expensive.

JAPAN: Core inflation continues to undershoot, dragged lower by energy prices. Fourth-quarter growth signs have been more encouraging after a very weak third quarter. While longer-term debt dynamics look unsustainable and Government Pension Investment Fund rebalancing will be an offsetting outflow, the BoJ’s bond purchase programme is expected to dominate and support low yields.

UK: Benign inflation and concern about the drag from a weak eurozone has seen market pricing push out the timing of rate hikes; the Bank of England has validated the first move coming only later in 2015. We continue to expect only a modest hiking cycle given the interest rate sensitivity of the economy.

CANADA: Growth data remains relatively resilient, and we expect Canada to benefit from the US recovery and stronger export growth. Inflation has returned close to target. Downside growth risks have grown recently with the sharp decline in oil prices. The market is under-priced for a resumption of rate hikes from the Bank of Canada later this year, though it could lag the Fed and have a shorter hiking cycle given the higher starting point.

AUSTRALIA: The Reserve Bank of Australia (RBA) is content to stay on hold for now but has been disappointed by the recovery in non-mining sectors of the economy. There are downside growth risks given the ongoing decline in commodity prices and terms of trade. On balance, we expect the RBA to remain on hold for an extended period but acknowledge the door for further easing is open.

2015-GL-1360