Fixed Income - Review and Outlook

SPREAD SECTORS:

US INVESTMENT‑GRADE CORPORATES: Higher-beta commodity-related sectors and a steeper credit curve following a collapse in risk-free rates have contributed to increased volatility and wider spreads year-to-date. T. Rowe Price credit analysts continue to find opportunities in select financials and lower-beta sectors.

EUROPEAN CORPORATES: Spreads have drifted lower, responding positively to the ECB’s QE package. Although modestly rich to fundamentals and to US investment-grade corporates, negative yields on core government bonds are leading to strong demand for high-quality corporate bonds.

US HIGH YIELD: Overall valuations and market yields are still interesting but are not as attractive as in January. Volatility remains likely given the energy sector’s impact. Spread levels are still implying a higher default rate than we are currently expecting. If oil prices remain low for a more extended period of time, we will need to evaluate the impact to our 2016 default outlook.

EURO HIGH YIELD: In relative valuation terms, European high yield spreads are well inside the US post the energy-driven US sell-off. Despite appearing less attractive, the European sector outperformed both US and global high yield in January. With QE, inflows and positive tone is expected to continue despite the sector looking less compelling on both a spread and yield basis.

BANK LOANS: Loans still appear to offer a more defensive way to play solid high yield fundamentals with lower volatility, although valuations are not quite as cheap as in January. Loans performed more defensively than high yield in the recent sell-off but were not immune. There are now discounts to be found, with 80% or more of the sector trading below par. Importantly, loans have a materially lower exposure to the commodities sectors than high yield bonds. The market remains supported by collateralised loan obligation issuance.

AGENCY MBS: Spreads cheapened considerably in January. Elevated levels of market volatility in the US Treasury market and mortgage borrowing rates at 18-month lows have led to a higher degree of directionality in spread movement. Cheaper valuations versus Treasuries and other spread sectors reflect a weaker fundamental backdrop for mortgages, as investors revise expectations for faster prepayments in the current low rate environment, and net supply numbers for the year are adjusted higher.

EM DOLLAR SOVEREIGN: The sector is attractive versus US credit—both high yield and investment grade—but is increasingly idiosyncratic (Russia, Petrobras, Venezuela, and other oil-related names, in particular). Commodity and currency moves will claim victims, and Fed liftoff may challenge less-liquid asset markets.

EM CORPORATES: Valuations are still attractive versus similarly rated US credit. Within the EM asset class, sovereign versus corporate valuations are more neutral and nuanced at a bottom-up intra-country level. Our enthusiasm is tempered by poor liquidity, particularly in the high yield segment of the asset class.

EM LOCAL: Yield spreads are near their tightest levels of the past three years versus US Treasuries, but local bond valuations still look relatively cheap versus other global sovereigns. EM local market performance remains unusually bifurcated: Bonds have performed well, but currencies remain weak. Both trends appear increasingly extended. But until global growth picks up, EM currencies will remain under a cloud.

DEVELOPED SOVEREIGN MARKETS:

US: Inflation expectations have stabilised, but global growth conditions are holding term premiums low and capping yields. Yields have moved higher from their recent lows in the past month, however. The move higher in inflation expectations and stronger labour data has allowed the Fed to win back the market narrative for the time being. How risk assets perform with a mid-2015 rate liftoff on the table will be crucial in determining the near-term direction of yields.

EUROZONE: Negative yields toward the front end are pushing demand further out the curve. Sovereign bond QE should constrain yields at low levels. However, valuations are extremely expensive. Growth and inflation outlooks are expected to improve later this year, but monetary policy is likely to remain accommodative for the foreseeable future.

JAPAN: Core inflation continues to undershoot, dragged lower by energy prices, but growth has picked up following weakness in the second and third quarters of 2014. 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 the market pricing push out the timing of rate hikes; the Bank of England has validated the first move coming only later in 2015. The general election in May could see a potentially messy result.

CANADA: Although current growth has been reasonable and inflation close to target, the Bank of Canada (BoC) has shown itself to be more concerned about downside growth risks following the sharp decline in oil prices. The BoC delivered a surprise rate cut and looks likely to maintain a dovish bias. The market is very expensive by any historical measure, but an easing bias and threat of a further rate cut could keep the market better supported even in the face of rising US yields.

AUSTRALIA: The Reserve Bank of Australia (RBA) has also opportunistically cut rates, taking advantage of the benign inflation environment and trend of easing monetary policy globally. There are downside growth risks given the ongoing decline in commodity prices and terms of trade. A further rate cut is possible, and the RBA is likely to remain accommodative for a considerable period.

2015-GL-1360