The Absence of Bad News Can Be Good News
2015 was no bore: It gave us the first Fed rate hike since 2006, the longest pullback in credit since 2002, the first negative year in High Yield debt returns (-4.47%) since the financial crisis, and one of the largest and longest-sustained drops in metals and energy prices in modern history. A quick survey of published research, and the opening days of 2016, suggest markets anticipate more of the same this year. Investors should be wary of this level of pessimism: when a lot of bad news is already built into prices, all it takes for risk assets to earn the hefty premiums they have accrued is the absence of more bad news. In this Commentary, we will go through the major events moving the fixed income markets – the bear market in credit and how it is shaping opportunities; the Fed lift-off; Emerging Markets, and finally, some thoughts about how the Oil sector’s long-term future may diverge from other hard commodities.
Credit Opportunities Have Improved In Investment Grade, But Look Beneath the Index Averages In High Yield
We spent November and December adding to positions in electric generation companies and Commercial Mortgage-Backed Securities (CMBS), and opportunistically picking up some other credits that came under selling stress. We feel very positive about most of our holdings from a valuation point of view. The vast majority of our credit exposure is domestic, and oriented towards consumers and real estate, far from the storms of Energy, Materials, and Emerging Markets (EM). Yet those credits are still earning an average of more than 250 basis points (bps) over U.S. Treasuries. The average triple-B spread reached 228 bps at year-end, up from 135 bps in the middle of 2014, and well above its long-term average. On the other hand, High Yield valuations, outside of energy, are less compelling, with spreads only slightly above the long-term mean of 341 bps.
Many of the large energy companies that formerly occupied the triple-B universe have dropped into High Yield. The extreme bifurcation in High Yield is visible in the number of non-defaulted bonds trading at very distressed levels, which we define as bonds trading at or below $70. In the index, nearly 11% of non-defaulted High Yield bonds trade at or below $70, topping the 2011 high of 4.7%. About three-quarters of those are from the Commodities sectors. For Energy and Metals/ Mining, 32% and 50%, respectively, of non-defaulted bonds are trading below $70.
The past few quarters have been ‘risk-off’ markets, and higher yielding credits have fared poorly. Managers have been engaged in an extraordinary amount of window-dressing the past two quarters, further beating up the credits that have already underperformed. We have seen unpopular EM-oriented bonds go up and down $10-15 over quarter-end. A Novo Banco bond, in what may have been a case of hurriedly grabbing the wrong prospectus, fell over $50 on December 30th and recovered almost the entire amount by January 4th.
In sum, credit-oriented investments are experiencing heightened volatility. We haven’t reached historic valuation extremes yet in most sectors, but we are approaching them, and this bear market in credit is getting long in the tooth. We continue to make adjustments on the margin to add durable credits at attractive yields, which we expect will produce handsome returns over the longer term.
Yields Finally Move Up
While nobody should have viewed the Fed move as a surprise, short-maturity U.S. Treasury rates played a bit of catch-up in the fourth quarter. Long-maturity U.S. Treasuries had already sold off in the first part of 2015, but maturities from 3-15 years actually rallied on the year through September. Then in the fourth quarter the short end of the curve moved higher to reflect the Fed Hike, and eventually the entire curve ended up higher. Most notable were movements in six-month and two-year U.S. Treasury rates, both up about 40 bps for the year and at post-2010 highs. The U.S. Treasury 30-year bond also ended the year more than 25 bps higher than it started. In the ‘belly’ of the curve, five- and ten-year rates only rose about 15 bps for the year, but nearly twice that much just in the fourth quarter. All U.S. Treasuries produced negative returns in the fourth quarter, but for the year, only the very long end of the curve lost money.
Despite Rate Increases, U.S. Treasuries Outperformed for the Year
Excess returns to credit1 for most sectors have been persistently negative since last summer, which we marked in last quarter’s Commentary as the beginning of this credit bear market. Asset-Backed Securities (ABS) stand out as the sole outperformer in credit for the year. Other results generally followed credit quality tiers, although bank loans, primarily a High Yield market, fared much better than triple-B bonds. As in other quarters during 2015, being heavily invested in credit instruments hurt results, but our structured product focus was a major positive in the context of a negative year.
ABS Spreads Widen Moderately In the Fourth Quarter
Though the ABS and CMBS subsectors generally exhibit a weaker linkage to broader credit markets, their spreads did widen moderately in the fourth quarter. We believe these credit subsectors continue to offer attractive compensation relative to similarly-rated Corporate notes (see figure below). Spread levels over U.S. Treasuries rose between 10 bps and 25 bps across most ABS categories. Spreads on new issue tax lien ABS, however, widened by 75 bps relative to earlier 2015 transactions. This was the result of a sizable spread concession to one new issuer, and BBH took advantage of the particularly attractive value offered by this strong, triple-A rated credit. The wider spreads reflected dealer reluctance to hold much inventory over year-end, with more than one dealer explicitly noting bank capital charges as justification for a weaker bid.
In the CMBS market, shorter-tenor single-asset/single-borrower transactions performed in line with ABS, with about 25 bps of widening across the capital structure. Ten-year new-issue conduit deals, which are frequently a cross-over purchase for long corporate investors, widened early in quarter by 25 bps and 75 bps, for senior and triple-B rated subordinate tranches, respectively, but then appeared to stabilize in following months.
Fund Flows Turned Relentlessly Negative
No doubt liquidity-driven selling has contributed to the pricing pressures on Corporate bonds and CMBS. Monthly fund flows in Investment Grade and High Yield credit turned visibly negative over the last 18 months, keeping pressure on spreads. Several high profile fund liquidations exacerbated outflows in December. Note, however, that the conventional wisdom about the danger of Exchange-Traded Funds (ETFs) was off-base. It was mostly open-end funds that produced the biggest outflows.
Emerging Markets, Particularly Latin America, Underperformed
The primary fundamental sources of stress continue to be the uncertainty around Chinese growth (affecting metals and other resources), the oversupply of oil, and the effect of those two trends on resource-intense EM economies. The majority of U.S. dollar-denominated (USD) EM Corporates remained under pressure in 2015 as well. The market as a whole, measured by the Barclays EM USD Aggregate Corporate Index, managed to outperform U.S. Treasuries in only four months of 2015. It ended the year down only -0.5%, primarily due to European EM returning +23.6%. Latin America, exacerbated by political turbulence, weak commodities prices, and the Brazilian bribery scandals was the negative stand-out, returning -9.5%. It is difficult to separate EM performance from the effect of China’s less-than-stellar economic performance. Years of huge infrastructure investment in China triggered a sustained boom in commodities prices, massively improving the terms of trade of commodity-oriented EM countries. Furthermore, the low-yield environment driven by the Fed’s monetary easing caused EM countries to receive substantial capital inflows. Today, with terms of trade and the Fed’s policy reversed, the resulting environment has been hostile to EM assets.
Oil & Gas Are Not Like Other Commodities, They Have Less Sensitivity to China
We continue to view the oil and gas situation as separate and distinct from China, unlike the metals sector. This is for the simple reason that while China has been dominating metals demand, taking 40-50% of the world’s steel and copper, it only accounts for about 12% of the world’s oil demand. In addition, China and India (whose growth grabs fewer headlines at present) still have room to grow both total oil consumption and per capital oil consumption rapidly. This is significant because both economies are still growing much faster than the western world (even allowing for recent slowdowns), and together, they make up 36% of the world population (the U.S. and EU are 10% combined). India’s population is also growing much faster than China’s. Both countries consume far less than the world average consumption of oil per capita, and even a slow catch-up to the rest of the world implies substantial demand growth.
Even at today’s elevated levels of supply, the world’s production is only about 2% above demand. This is a small surplus, when you consider the following:
- Consumption is growing close to 1%-2% per year, and the potential upside of demand growth from the two largest and fastest-growing nations is strongly supportive to growth over time.
- Well depletion reduces production by over 5% annually without capital reinvestment. Reinvestment has plummeted: E&P capital expenditures by the world’s largest companies are now down about 40% from their 2013 peak.
- Oil demand is highly inelastic, so small changes in demand and supply make for dramatic price moves. We believe large financial speculators increase that volatility and cause prices to overshoot.
- The Middle East, where the bulk of reserves viable at today’s prices resides, is increasingly unstable. This also increases volatility.
While difficult to time, it is likely we will see more volatility and eventually a rebound in oil prices in the next year or two, even if Chinese growth remains slow. Durable companies that make it through the trough with production capacity will profit handsomely when it happens. Most of our additions in the sector have been in the safer periphery – electrical generation and sustainable energy – but we remain on the lookout for durable value in the sector, and we are confident that the collateral and security interests we hold in our existing energy credits will have substantial value in the recovery.
A Final Note on Municipal Bonds
We encourage you to read our Municipal Commentary (as well as our Structured Commentary) this quarter. Some think of the Municipal Bond world as sleepy, but it has been anything but sleepy in the last few months. Puerto Rico (which we have never owned) is set to default on some obligations soon, and gridlock in Illinois and Pennsylvania is posing new tests to appropriation structures that the market has taken for granted for years. Despite the fundamental headwinds, Municipal Bonds were the best performing sector in the U.S. bond market last year. We have always been active in this sector, adding positions that we view as offering particularly attractive reward for risk, typically due to guarantee or specific revenue pledges that aren't immediately clear to retail investors.
We look forward to meeting with you soon and wish you a happy and prosperous New Year.
Andrew P. Hofer
Neil Hohmann, PhD
1 Credit returns less U.S. Treasury returns