For those readers who know us well, you have surely heard us say that we are “bottom up” fixed income investors who let valuation and credit quality drive portfolio construction. This philosophy is fundamental to our investment process for all fixed income strategies, and does not waver in varying economic environments. We do not overlay a macroeconomic view on our investment process, and as a result will continue to focus our commentary on credit sector activity and opportunities. That being said, we do believe that a few comments regarding the macroeconomic environment are worth note this week as they may help to explain recent market activity, and will certainly have an impact on credit quality and valuations going forward.
Investors hate uncertainty. Uncertainty poses significant challenges in determining valuations. Even if the near-term path of the economy is filled with unpleasant news, to the extent it meets consensus expectations, it may perversely have a calming effect on markets as investors coalesce around an expected outcome. It appears to us that in the past few weeks, a consensus has been developing among epidemiologists and economic forecasters regarding likely outcomes for the virus and the economy – with each reaching its maximum impact in Q2. It is important to recognize that this is now the scenario embedded in fixed income credit valuations. A broader, or more extended duration of infections, with an even deeper impact on the economy, would likely bring yet another repricing of risk assets.
The U.S. economy is primarily driven by consumer spending, and it is hard to imagine a worse scenario than to have the largest segment of the economy (= 69%) confined to their homes. Peak infection rates and a bottoming of U.S. economic activity are expected in the second quarter. Consensus forecasts for GDP are coalescing in a range of down 25%-35% in Q2, followed by a resumption in growth in the second half of the year. This is a far deeper economic contraction than experienced a decade ago during the Global Financial Crisis (GFC). It is also noteworthy that in the GFC, it was stress in the financial sector that led to a downturn in the real economy. This time around, it is stress in the real economy that will challenge the financial sector. Fortunately, banks are far better capitalized this time around and do not require early government assistance.
The Federal Reserve and Congressional policymakers have taken bold actions over the past few weeks to support the economy, provide liquidity to the financial system and trading markets, and to re-start issuance which had become limited as new valuations levels needed to be established. The actions taken by the Federal Reserve are already significantly improving liquidity in the fixed income market, with narrowing credit spreads evident across most credit sectors. We remain mindful that news regarding the virus will surely get worse before it gets better, and that the data ahead is likely to show an economic contraction beyond what any living investor has ever experienced. Given this challenging news flow, we will continue to let valuations drive our investing activities, and we expect to take advantage of today’s more attractive opportunities at a measured pace.
The Corporate credit market has seen significant improvement during the past week with spreads generally tighter by 100 basis points1 or more for the universe in which we invest. Current spread levels for Corporate debt rated double-A through double-B are now generally in a range of 125-300 basis points. We have been pleased to see significantly improved pricing across many of our Corporate holdings this past week. While the anticipated support of the Federal Reserve has certainly helped the Corporate credit market, investor demand for new issuance has been quite robust as well.
According to Barclay’s Credit Research, new Corporate issuance for March was a staggering $272 billion. To put that in context, the next highest month of Corporate issuance was $175 billion in May of 2016. Despite the massive influx of new supply, demand has been strong, and many issues have been significantly oversubscribed. We have been buyers of this new issuance, and have often not received full allocations on our orders as a result of strong demand. Notable improvement has also occurred in the High Yield market. This week we saw the first new issue in High Yield since the beginning of the crisis as YUM Brands (Rated B1/B+) successfully issued a five-year bond, callable in two-years, at 7.75%. The issue was oversubscribed and is now trading in the secondary market several points above par. Non-investment grade bond spreads have tightened well over 100 basis points in the last week. The rally in High Yield may be a false start given the credit challenges posed by a record economic contraction ahead; however, it remains encouraging to see the Corporate credit market functioning, even if at higher spread levels.
Structured Fixed Income
Credit spread levels have meaningfully improved across Asset-Backed Security (ABS) sub-sectors this week with traditional ABS2 experiencing the most significant tightening. Credit spreads for the senior tranches of traditional ABS sub-sectors, such as credit cards and prime automobile loans, have gapped tighter this week by as much as 200 basis points to a range of 75-150 basis points. Non-traditional ABS has experienced some tightening when we have seen it trade, but we are not seeing large volumes of this paper available in the secondary market. This is consistent with our belief that non-traditional ABS is largely held by sophisticated investors such as insurance companies and asset managers who do not need to sell into a distressed market. Credit spreads remain in a fairly wide range of approximately 300 basis points for non-traditional sub-sectors that are less directly challenged by the economic fallout of the crisis, to as much as 700+ basis points for more directly-challenged sub-sectors such as aviation and personal consumer loan issues. While improving, pricing remains at significant discounts to par for many of the structured fixed income securities we hold in portfolios which is a bit frustrating as these marks do not represent levels at which we can buy paper in the secondary market. There is little doubt that many consumers and small businesses will face significant liquidity challenges in the coming months, which will surely lead to a meaningful increase in delinquencies and defaults across industries. We have accounted for these dire scenarios in our stress testing and believe that the structures in which we have invested will withstand the impending uptick in losses.
We have yet to see any new issuance in structured fixed income, but we are aware of a number of issuers gauging potential interest. We expect to see primary issuance restart in both traditional and non-traditional ABS soon, particularly once the Term Asset-Backed Securities Loan Facility (TALF) TALF is re-started (by early May). Given current market conditions, we expect very favorable valuations on new issues, and continue to encourage prospective investors to consider acting now.
In the Commercial Mortgage-Backed Securities (CMBS) sector, spreads are approximately 30 basis points tighter for the week in both single-asset, single-borrower (SASB) CMBS and Conduit CMBS. Senior SASB paper rated triple-A is currently trading at credit spread levels of 200-225 basis points. Lower in the capital structure, triple-B rated SASB paper is trading at a spread of approximately 500 basis points. In Conduit CMBS, triple-A rated paper is trading at close to 200 basis points, while the lower end of the capital structure is as wide as a 1,000 basis points or more for certain structures securitized by retail or hospitality-related properties. The economic fallout of the virus is likely to acutely impact commercial real estate in many different ways, creating significant credit headwinds in the coming month. We believe that senior SASB issues secured by strong performing properties are best positioned to weather these challenges, and fortunately much of our CMBS exposure is in these securities. We do maintain several Conduit positions as well, which face steeper credit challenges. We will continue to monitor these few positions closely and take action if appropriate.
After widening to option-adjusted spread (OAS) levels over 100 basis points last week, Agency Mortgage-Backed spreads (MBS) spreads have tightened to a range of 50-60 basis points this week. Clearly this sector is benefitting from significant Federal Reserve purchases. We took advantage of these wider spreads to add Agency MBS positions to credit-restricted client portfolios.
Municipal bond rates reversed course and moved meaningfully higher this week by 25-50 basis points, retracing some of last week’s very strong performance. Rates across the yield curve are now in a range of 1.25%-2.5%. Liquidity in the Municipal bond market remains less than optimal, but much like the Corporate credit sector, the Municipal market is functioning. New issuance is beginning to reemerge, and we have been selectively active when high quality paper has been issued at attractive concessions. We are mindful that Municipal bonds are not immune to the economic challenges that lie ahead. As with all credit sectors where we are active, our Municipal credit analysts have considered deep recession scenarios when underwriting the bonds we have ultimately selected for portfolios. As a result, we maintain a high degree of confidence in the credit durability of the Municipal bond issues we hold. Successful security selection will be key to performing well in the months ahead, and that is precisely what our investment process is designed to accomplish.
Federal Reserve activity in the TIPS market has been a key driver to TIPS performance over the past several weeks. As an example, 10-year breakeven inflation rates fell as low as 47 basis points on March 19th from a high of 180 basis points earlier this year. Within a week, they had moved back to an intraday high of 124 basis points. During that period, the Fed was an active buyer of TIPS helping clear the market, particularly in off-the-run securities, purchasing all securities that were offered to them. Since March 26th, 10-year breakeven inflation rates have slipped back below 90 basis points as the Fed has become more selective with their purchase activity. We believe the Fed took this action once they realized that their activity was likely going beyond stabilizing the market to driving prices above market equilibrium. As the largest buyer in the sector, they have little interest in driving their own execution costs higher. We expect the Fed will remain more price sensitive going forward.
We remain constructive on TIPS at today’s low breakeven inflation rates. Historically, investors have been rewarded for holding TIPS versus nominal Treasury securities at these breakeven levels. As we mentioned last week, historic monetary and fiscal stimulus combined with the expectation for the repatriation of portions of the U.S. supply chain are supportive for long-run inflation trends. Forward looking breakeven inflation rates, such as the 5-year, 5-year forward rate, are currently around 1.3%. In the near-term, TIPS demand will likely be weak as lower oil prices and a sharp increase in U.S. unemployment will almost certainly place downward pressure on inflation. While past performance does not guarantee future results, increased volatility, larger premiums for off-the-run securities, and weaker auction demand are factors that have historically enriched the opportunity set for our TIPS strategy.
Senior Vice President
Fixed Income Product Specialist
212-493-8247 | email@example.com
Past performance does not guarantee future results
Portfolio holdings and characteristics are subject to change.
Opinions, forecasts, and discussions about investment strategies represent the author's views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.
Issuers with credit ratings of AA or better are considered to be of high credit quality, with little risk of issuer failure. Issuers with credit ratings of BBB or better are considered to be of good credit quality, with adequate capacity to meet financial commitments. Issuers with credit ratings below BBB are considered speculative in nature and are vulnerable to the possibility of issuer failure or business interruption.
Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, maturity, call and inflation risk; investments may be worth more or less than the original cost when redeemed. The value of some asset- backed securities and mortgage-backed securities may be particularly sensitive to changes in prevailing interest rates and are subject to prepayment and extension risks, as well as risk that the underlying borrower will be unable to meet its obligations.
Single Asset-Single Borrower (SASB) securities lacks the diversification of a transaction backed by multiple loans since performance is concentrated in one commercial property. SASBs may be less liquid in the secondary market than loans backed by multiple commercial properties.
Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax.
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE
1 A unit that is equal to 1/100th of 1% and is used to denote the change in a financial instrument.
2 Traditional ABS include prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS include ABS backed by other collateral types.