Rates Go South, Bond Investors Go West
Brexit caught investors, pollsters, and odds-makers wrong-footed. The repercussions from Britain’s decision to leave the Euro are highly uncertain at this juncture, but likely to have a significant impact on capital markets for years to come. While the full impact of the “leave” vote is difficult to predict, investors at least appear to agree we won’t be seeing the end of highly accommodative monetary policy anytime soon. In the U.S., investors quickly priced in a halt to Federal Reserve rate hikes and U.S. Treasury rates plummeted to record lows. Federal Funds futures now indicate that investor expectations for the next Federal Reserve rate hike have moved into 2018, with a small probability of a rate cut. In June, 5 FOMC members moved their ‘dot-plot’ projections for 2016 to below 1%. If anything, the policymakers’ dilemma that we outlined in the last Quarterly Strategy Update has worsened.
The initial reaction in fixed income credit sectors to the Brexit vote was a classic “risk-off” trade, but markets calmed quickly in the week after the vote. We were pleased to see that credit markets generally functioned in an orderly fashion in the initial sell-off, and liquidity appeared to be ample. Not surprisingly, higher beta credit sectors such as Financials, High Yield, and Commercial Mortgage-Backed Securities (CMBS) were most negatively impacted. However, even in these sectors spread widening was fairly modest. For the year, all major credit sectors are posting positive excess returns to U.S. Treasuries, with the exception of Mortgage-Backed Securities (MBS), which faced rate volatility related headwinds. Even British banks rallied, while Lloyd’s Bank was able to come to market with a post-Brexit senior unsecured issuance.
Lower interest rates may stick around. U.S. Treasury yields are lower by 13 (2-year) to 32 (30-year) basis points (bps) over the quarter. We think it’s also worth noting how much flatter the yield curve has become over the last two years. Two years ago, the difference between 2- and 10-year rates was approximately 2.2%. Today it is closer to 0.9%, so extending rate duration pays even less than two years ago. The portion of return to longer bonds from “roll down”, as yields decline with seasoning, has declined from 30 bps per year down to about 10 bps. One really has to believe rates will go lower to take on duration in this market.
We expect further rate volatility as negative rates and uncertainty in Europe diminish the potency of monetary policy.
Apart from lower sovereign interest rates, the Corporate Sector Purchase Programme (“CSPP”) launched by the European Central Bank (ECB) on June 8, is a positive technical for U.S. rates and credit. By June 30, the CSPP had amassed nearly 7 billion Euros-worth of Corporate credit, 96% of it purchased in secondary markets. The inclusion of credit purchases broadens the CSPP mandate far beyond the scope of Fed purchases during the Financial Crisis. Initial purchases included substantial amounts of single-A and triple-B rated issuers, such as the finance company arm of the troubled auto giant Volkswagen, the struggling quasi-sovereign Telecom Italia, and even some High Yield issuers such as Spain’s Cellnex Telecom. Soaking up all this European credit, in combination with the disparity in interest rates, is quite likely to continue sending investors to the United States for higher yields.
As we wrote to clients in our special Brexit comment, we do not have much direct exposure to the British economy. Some of our consumer and pharmaceutical companies have 5%-10% of their sales in the UK, which may hurt earnings a little bit, but won’t affect creditworthiness. Experian is a UK company, but with a global business. Obviously potential dissolution of the EU is a major event for the banking sector, but we are not exposed to British or Euro-based banks at present. Our biggest exposures in banks are the U.S., Canada, the Nordics, Australia, and New Zealand. We expect to find further opportunities in banks, as they will be volatile amid the debates over exit timetables, rumors of other countries looking to leave the European Union, and deepening concerns about the Italian banking system.
Corporate credit performance in Q2 followed roughly the same patterns we saw at the end of Q1. Energy and Resources performed best, with other cyclical industrials also performing well. Financials (19 bps wider year-to-date) and REITs (7 bps wider year-to-date) lagged the market in the first half, although REITs recovered (15 bps tighter) in Q2. Given our increased concentration in these sectors, Financials were a drag on performance, while our rebounding Energy, Technology, and Telecom exposures added to performance.
We added to Corporate exposures in the second quarter, including purchases of Medtronic, Royal Bank of Canada, Air Lease, AbbVie, Guardian Life, Spectra Energy, and United Rentals, and reconfigured and extended our Dell exposure. Petrobras rallied sharply back into the mid-90s and we took the opportunity to exit. We lightened our Newell Rubbermaid and eBay exposure for rich valuations, and we sold some Morgan Stanley Trust Preferreds at an attractive premium in advance of a likely call. We also took advantage of an unbelievably persistent rally in the Municipal bond market to lighten our exposure there as well.
CMBS / Real Estate
In prior Strategy Updates, we have written that U.S. commercial real estate leverage is reasonable and property-level fundamentals remain strong. Through the last two quarters we continue to accrue evidence that supports our view. Average Loan-To-Value (“LTV”) ratios in CMBS declined to 62.3% as of year-to-date 2016 from 64.8% in 2015 and 65.8% in 2014.
In addition, the all-property-type capitalization rate average in May 2016 was 6.12%, a spread of 460 bps over U.S. Treasuries compared to the average spread of 365 bps since 2001. This suggests continued demand for commercial real estate assets in the United States and further supports property value growth in the near future. Lower interest rates (loan coupons in 1H 2016 averaged 4.8% compared to 5.8% in 2006) further improve the refinancing prospects for the growing pipeline of CMBS loans facing maturities in 2H 2016 ($33.2 billion) and 2017 ($88.1 billion). BBH experienced substantial principal paydowns in six CMBS holdings in the second quarter, underlining the quality of the credits we hold. Much of this refinancing activity is by banks and insurance companies as 1H 2016 CMBS issuance volume of approximately $28 billion was 46% below the same period in 2015. CMBS loan originations are expected to moderate through year-end over uncertainties related to equity retention requirements that initiate in 2017. The dent in new supply was a positive technical for CMBS in the second quarter. The rally has not come far enough, however, and we continue to believe CMBS are one of the few outstanding values in today’s credit market.
Given their generally short tenor and high credit quality, ABS performed well through both the bull and bear credit markets. Some sectors (such as prime auto and credit cards) are pricing too tight to hold our interest. Yet other asset-backed sectors within consumer and commercial finance continue to offer attractive valuations, as rising issuance over the last several years has been absorbed by a relatively static investor base. Based on our own stress-testing, our positions in these securities are extremely well-protected from even severe recession levels of loss. In the second quarter, we added to three single-A rated notes at a spread over U.S. Treasuries wide of 300 bps. These included ABS notes secured by auto loans from seasoned issuer Credit Acceptance and by senior-secured healthcare loans from veteran issuer Oxford Financial. We also participated in triple-A transactions at spreads between 100 bps and 250 bps over U.S. Treasuries that were secured by high-quality truck fleet, servicer advances, and tax lien assets.
We continue to believe that highly accommodative monetary policy will support risk assets and expect that market volatility will provide increased opportunities to add attractively-priced credit instruments. Economic data continue to suggest lagging industrial activity, mixed home purchasing, and a steady pattern of slow but positive personal income, consumption, and employment growth. Our valuation metrics suggest credit markets are becoming too richly priced in the (non-resource) industrial sectors while underpricing real estate, financials, and structured credit. Those valuation opportunities, underwritten one-at-a-time, drive our portfolio composition.
Andrew P. Hofer
Neil Hohmann, PhD