Nobody Goes There Anymore, It’s Too Crowded
If you are finding it difficult to reconcile the excellent returns of 2019 with the cautious tone of economists and professional investors, you are not alone. One pundit called last year “the most unloved rally in history”.1 The New York Times described the mood at the annual Economic Association Meeting as “dark” with “a widespread sentiment that the current expansion is built on a potentially shaky combination of high deficits and low interest rates.” 2 Fund flows to equities and bank loans were actually negative, they were paltry in high yield, while hundreds of billions of dollars flowed into cash instruments and Treasuries. Insurers bought high grade credit and pension funds bought Treasuries, but both were net sellers of equities. Treasury yields rallied and, despite steepening incrementally with three rate cuts, the 2-10 year spread remains near its post-crisis lows at 0.28%.
In the midst of all this caution, the S&P 500 returned over 31%, high yield returned over 14%, loans returned nearly 9%, and Investment Grade (IG) credit outperformed Treasuries by nearly 7%.
It reminds us of Yogi Berra’s famous alleged quip about a popular restaurant: “Nobody goes there anymore, it’s too crowded.” If domestic institutions are allocating so conservatively, what is supporting the rally in riskier assets? Why are long Treasuries rallying while risk assets outperform? It’s because global capital flows have been dictating yield curve and credit spread behavior recently, not U.S. institutional investors, We have described this development in our last two Quarterly Fixed Income Strategy Updates, which we summarize again briefly below.
- Central bank balance sheet expansion has pushed rates and spreads downward. Sensing economic weakness, the Fed reversed course in the second half of 2019 and dropped rates three times. Considering that the economy has been growing and unemployment is low, monetary policy is surprisingly accommodative. The European Central Bank (ECB) also resumed corporate credit purchases in September of 2019.
- Low and negative yields in Japan and Europe have pushed non-$US investors into the USD on a hedged and even unhedged basis, capping long Treasury yields and pushing spreads downward. Massive foreign demand for positive yields has also fed a substantial growth in “Yankee” issuance (USD issuance by non-U.S. issuers) and, more recently, “Reverse Yankee” (U.S. issuers issuing in Euros or Yen).
- A stable to shrinking supply of USD credit securities is now also supporting spreads. Corporate net issuance grew rapidly in 2017 and 2018, but has leveled off in 2019. The supply of high yield bonds is shrinking, and direct lending is absorbing an increasing share of new deal-related lending.
- Vastly increased and growing U.S. Treasury issuance, mostly in shorter maturities, has absorbed central bank liquidity, pushed spreads lower in short maturities, and increased the need for short-term funding (repo). This is certainly one reason the Federal Reserve is being pressed to provide more liquidity.
For the time being, these factors keep the U.S. yield curve relatively flat, and support the rally in USD credit. But the growing dependence of U.S. bond markets on central bank and foreign purchases is worrisome. Foreign investment can be fickle, and reverse direction rapidly. Foreign investors have become the largest investors – by far – in USD credit. The credit pullback in the fourth quarter of 2018 and the money market dislocation in the third quarter of 2019 revealed this fragility.
Given the prolonged economic expansion over the last decade, and the overextended state of yield and valuations, observers are keeping an eye out for signs of “late cycle” behavior, both in economic fundamentals and asset values. We agree with these observers that extended complacency can cause prices to overshoot, then cause investors to crowd the exits to get out of the way on signs of weakness. However, a preponderance of economic data suggests an economic downturn is not imminent. Manufacturing is in a sectoral recession, U.S. exports are flat-to-declining, and business investment is still anemic. This is offset by strong data in the larger components of U.S. gross domestic product (GDP), as well as steady growth in jobs and incomes, a healthy consumer sector, and very low unemployment claims.
While there is reason for confidence on the U.S. economy, corporate earnings are exhibiting a clearer late-cycle trend. Earnings growth trended to zero in 2019, similar to the last credit cycle in 2015-2016. The positive effects of the tax cuts on margins are in the past. Needless to say, lower corporate earnings power is a negative for credit.
For more late cycle behavior, look at credit markets themselves, often touted as the “canary in the coal mine” of risk assets. Credit valuations are over-stretched, credit discipline a too relaxed, and leverage high.
Our investment process requires that we only buy bonds that offer generous compensation for their credit quality in a historical context, as assessed in our valuation framework. The frequency and size of opportunities in this filtered investment universe drives the number and size of our credit positions. In corporate credit, valuations today are at the very expensive end of their historical range. We demonstrate that frequently for our clients in the chart below, the percent of the investment grade index that is eligible for purchase under our valuation framework.3 Today the percentage is only 7%, close to the lowest level in the last 15 years.
There is one offsetting trend that continues to drive favorable technicals for credit investors in certain credit segments – the disintermediation of banks from commercial and consumer lending and their replacement with non-bank, independent finance companies. Collateralized loan obligations (CLOs) and direct loan investment vehicles such as business development corporations (BDCs) have risen as fixed income sectors over the last decade. And non-bank financial companies, as they grow, have increasingly turned to the asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) market to diversify their own financing sources, resulting in an acceleration of new supply in these bond sectors (see chart on the right).
Credit investors are less often familiar with these growing fixed income segments – non-traditional ABS4 and CMBS, CLOs, and BDCs. A dozen or two investors may participate in an issue, rather than hundreds in most corporate debt and traditional ABS. Deal sizes, $500 million or less, are often too small to be meaningful to the larger fund managers. Limited investor awareness coupled with heavy new supply creates a healthy technical for investors. Spreads over Treasuries available in these sectors are typically 75 basis points5 to 300 basis points higher than similarly rated credits in the broad credit indices. As a medium-sized asset manager with long experience in structured products and these non-bank finance sectors, BBH has been well-positioned to take advantage of opportunities in these segments.
Performance dispersion is another sign that we are late in a credit cycle. A broad movement in spreads is almost always preceded by an accumulation of problems in individual sectors, such as the energy sector in 2015 and telecommunications in 2002. Several sectors, mostly cyclical, underperformed in 2019 and are experiencing rising credit difficulties: telecommunications, retail, healthcare, energy, basic materials, and capital goods.
Fortunately, return dispersion produces valuation opportunities. Through the year, we were able to selectively add opportunities from underperforming sectors, including healthcare, energy infrastructure, and retail.
A tick upwards in defaults and credits trading at distressed levels may also reveal an inflection point. Defaults have turned up modestly, but a large number of loans, particularly in the underperforming sectors, trade well below par (see charts at the top of the next page).
When earnings turn down, leverage can magnify and accelerate credit underperformance (as shown in the chart in the middle of the next page). While corporate interest burdens are low, given low rates and spreads, overall leverage is increasing in the private sector. Recent loosening credit trends have actually masked the full extent to which this leverage has increased. Many companies have been measuring their leverage against “adjusted” cash flows that are much higher than actual cash flow, disguising the rising leverage trend. It is comforting that many companies have extended maturities, but larger leverage burdens become unmanageable when earnings decline.
To these indications of a turn in the credit cycle, we add impeachment, the political uncertainty of a highly polarized election year, and rising uncertainty in the Middle East, to the list of risks lurking for markets. We anticipate increased volatility in the next year or two. While we can’t be sure these risks will be realized, we are certain that credit markets aren’t paying us adequately for them.
Portfolio positioning and performance
We are fairly pleased with portfolio performance in 2019. After the opportunities presented in 4Q 2018, we had an excellent first half of the year. As these opportunities realized their price targets, portfolios have become more conservatively positioned. A few opportunities in less-favored sectors like healthcare and energy infrastructure, as well as the higher yields available in structured product helped our diversified accounts keep up with indexes despite our lower overall risk profile.
Another way to see the increasing conservatism of our portfolios is to look at the spread duration (sensitivity to credit spread changes) over time. Our all-time low in credit exposure was just before the 4Q 2018 swoon. The overall level of credit risk remains near the lows of the last four years, below our portfolio benchmarks, and well below that of the last spread peak in 2016.
Compared to the US Aggregate, in our representative Core Fixed Income account6 we are underweight spread duration overall, underweight corporate credit, and overweight structured products (which have little representation in the index).
In credit quality terms, the vast majority of our exposure is in BBB and A-rated obligations – where most of IG credit now resides. Our high yield exposures are low compared to a few years ago, and focused in BB-rated bonds and loans.
The best evidence of how our portfolios are structured is to observe their behavior over the past few years. Over the past two years, the months when credit underperformed, such as May and August of 2019, have generally been the best months for relative outperformance.
We remain credit-oriented in our process. We spend most of every day looking for credit investments that meet both our valuation and credit hurdles. However, these hurdles look very high in today’s market. When credit is expensive like this, the opportunities that pass our criteria tend to be shorter, with an emphasis on secured credit, and that is amply reflected in our portfolios. Shorter credit responds proportionately less (in both directions) to spread changes. Secured credit, and Asset-Backed Securities (ABS), in particular, are less volatile. ABS exhibit very little correlation to corporate credit.
Neil Hohmann, PhD
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. The securities discussed do not represent all of the securities purchased, sold, or recommended for advisory clients and you should not assume that investments in the securities were or will be profitable.
Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries. This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners. © Brown Brothers Harriman & Co. 2020. All rights reserved.
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1 Matt King, Citibank, January 2020
3 Our valuation framework is a purely quantitative screen for bonds that may offer excess return potential, primarily from mean-reversion in spreads. When the potential excess return is above a specific hurdle rate, we label them “Buys” (others are “Holds” or “Sells”). These ratings are category names, not recommendations, as the valuation framework includes no credit research, a vital second step.
4 Traditional ABS includes prime auto backed loans, credit cards and student loans (FFELP). Non-traditional ABS includes ABS backed by other collateral types
5 Basis point is a unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of a financial instrument
6 The Core Fixed Income Strategy’s Representative Account is the account whose investment guidelines allow the greatest flexibility to express active management positions. It is managed with the same investment objectives and employs substantially the same investment philosophy and processes as the Core Fixed Income Strategy.