- The steep sell‑off in risk markets in 2018's fourth quarter brought to mind the previous period of major credit market weakness in late 2015 and early 2016.
- However, several factors lead us to believe that the late‑2018 swoon could be indicative of deeper challenges facing the economy and credit markets.
- We think that investors should tread cautiously in the current environment, where we favor shorter‑maturity debt across the capital structure.
The steep sell‑off in risk markets in 2018's fourth quarter brought to mind the previous period of major credit market weakness, which took place in late 2015 and early 2016. While that market correction created one of the best buying opportunities in the post‑financial crisis era, several factors lead us to believe that the late‑2018 swoon could be indicative of deeper challenges facing the economy and credit markets. We think that investors should tread cautiously in the current environment, where we favor shorter‑duration1 debt across the capital structure.
Sharp Downturn in Oil Triggered Late‑2015 Selling
A severe oil price downturn precipitated the selling pressure in late 2015, with the price of U.S. benchmark West Texas Intermediate crude plummeting below U.S. dollar (USD) $30 per barrel in early 2016 after trading well above USD $100 per barrel in mid‑2014. This triggered concerns that overleveraged energy producers could default on their debt obligations, with perhaps the worst damage in high yield bonds, where the credit spread2 on the Bloomberg Barclays U.S. High Yield Index nearly doubled between June 2015 and February 2016.
In December 2015, the Federal Reserve increased interest rates for the first time since the financial crisis, but the central bank then held rates steady for a year. The extended pause, coupled with rumors that global central bankers had reached an unofficial agreement at a G-20 meeting in February 2016 to weaken the U.S. dollar, led to a rapid recovery in risk appetite and double‑digit returns for high yield bonds in 2016. The reversal in sentiment also set the stage for a very tranquil 2017, which also featured attractive returns for credit sectors.
Recovery in Credit May Be More Fleeting Than in Early 2016
When determining how much risk to take in portfolios, a natural reaction to the higher volatility and selling pressure on corporate credit in late 2018 is to draw comparisons to the previous period of sustained volatility. However, there are several aspects of the current environment that lead us to believe that a lasting recovery in credit sectors is less likely than it was in early 2016.
In 2016, it was clear that the steep decline in oil prices was the primary cause of the downturn in sentiment as lower oil weighed on capital expenditures in the energy industry and, in turn, high yield bonds (energy‑related issuers make up a relatively large proportion of high yield indexes). However, 2018 featured negative returns across a wider range of markets, as few asset classes were spared from material weakness. This indicates that the culprits are much broader and more difficult to pinpoint than they were in 2016.
Broad Range of Factors Highlight Differences in Current Environment
Slowing global growth, tightening U.S. monetary policy, and the withdrawal of global liquidity as central banks unwind their quantitative easing programs likely all contributed to the downturn in risk assets near the end of 2018. In addition, the U.S. is now plainly in the late stages of the economic cycle, with increasing market speculation about a potential recession later in 2019, while in 2016 the economy still had plenty of room to expand. In January 2016, for example, the unemployment rate was 4.9%, compared with only 4.0% as of January 2019.
Another meaningful difference between the current environment and that of early 2016 is that the Federal Reserve’s benchmark policy rate, the federal funds rate, is now likely close to, or even above, the targeted neutral rate (the level that neither boosts nor reins in economic growth). At the beginning of 2016, the fed funds rate was 0.36%—well below zero after factoring in inflation—but it was about 2.40% at the end of 2018. Also, the Fed did not begin to gradually wind down its balance sheet holdings of Treasuries and mortgage‑backed securities (MBS) until October 2017, which removed an important source of monetary accommodation that had broadly boosted asset prices.
Favor Exposure to Shorter‑Maturity Corporates and Securitized Debt
In light of these factors, we are skeptical that sectors with credit risk will rebound to the extent they did in early 2016, and volatility is likely to persist. In our total return, core, and core plus bond portfolios, we favor exposure to shorter‑maturity corporate and securitized debt, which allows us to stay defensive while still earning some yield. We focus on segments that provide enough yield compensation to help offset the negative price effects of a further widening in credit spreads. These include select AAA rated non‑agency MBS and collateralized loan obligations as well as U.S. and emerging markets corporate bonds with attractive prices created by forced selling.
However, there are risks to our cautious view on credit markets. If the Fed is able to slow the U.S. economy while avoiding a recession, our conservative positioning would likely cause our portfolios to lag in a sustained rally in risk assets. A surprisingly strong expansion of stimulus by the Chinese government would likely create a similar situation. Although there is some potential for an upside surprise, we believe that risks are skewed to the downside given the stage of the economic cycle, which informs our portfolio risk allocations.
1Duration measures a bond’s sensitivity to changes in interest rates. [return to text]
2Credit spreads measure the additional yield that investors demand to hold a bond with credit risk relative to a comparable‑maturity Treasury security. [return to text]
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