Head - Fixed Income Strategy
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US tax reform, strong earnings and global synchronized growth should stabilize risk sentiment this year
With long-term US Treasury rates stabilizing, US investment-grade (IG) corporates were able to post their first positive month of 2018. Albeit small, IG corporate benchmarks gained 10 basis points (bp) in March, bringing year to date returns to -1.9%. Of course, the best performing components of IG last month had been the areas beaten down the most from the rise in US rates (i.e., long duration and AA/A rated issuers).
While rising US yields are largely responsible for IG underperformance this year, weakness can also be attributable to rising US-China trade tensions. With the rise of global risk aversion and equity volatility, US corporate benchmark spreads have widened 25bp to 110bp. This is largest move wider in benchmark spreads since the oil recession in 2016.
Changing supply dynamics and rising hedging costs have also played a role. Though IG supply started the year slow, recent weekly volumes have been in line with 2017’s record pace. More notable has been the pick-up of issuance in longer-dated maturities, which has increased 60% versus the same period last year. Moreover, the demand from European investors has slowed, as the rising cost to hedge USD has reduced the yield pick-up from buying US corporates. This waning demand, has exacerbated the underperformance, in our view.
However, with yields at 6-year highs, we increased our view last month on US IG corporates to outperform from neutral - Figure 1. Moreover, Citi Private Bank’s Global Investment Committee (GIC) also increased their existing overweight to US IG, by reducing some of their overweight in US high yield bonds. The committee has favored higher yielding US assets for some time, and viewed the move higher in US corporate yields as a way to barbell their overweight in global equities.
Figure 1: US IG corporate yields are the highest since 2011
That said, we remain overweight US high yield. Despite a more challenging outlook, we still expect returns between 4-5% for 2018. US tax reform, strong earnings and global synchronized growth should stabilize risk sentiment this year. As long as periods of weakness isn’t driven by any change in fundamentals, sell-offs will likely be shallow and short-lived.
If anything, US high yield has displayed significant resilience in the face of increased market volatility. Since the late-January peak in US equities, US high yield has declined 1.3% versus -9% for the S&P 500. We think this is due to several factors: One, fundamentals remain strong. Earnings are growing, refinancing risks are low and default rates are falling. Two, benchmark yields above 6.0% still offer relative value, when compared to other global markets. And three, US HY does not suffer from the same type of volatility associated with the sell-off in US technology leaders Facebook, Apple, Netflix and Google. In fact, Netflix is the only FAANG issuer below IG (and isn’t considered tech), while the others are all high quality IG issuers.
US variable rate high yield bank loans also offer an attractive complement to HY bonds. LIBOR rates are expected to rise over the next 12 months, which should continue to fuel demand for floating-rate assets. Repricing and refinancing risks remain elevated, with roughly 75% of the loan universe trading above par. However, with average LIBOR-spreads around +375bp, this implies an all-in yield around 6.0%, which is fairly comparable with US HY bonds. More important, during bouts of risk aversion, bank loans are much less volatile -Figure 2.
Figure 2: Loans continue to exhibit even lower price volatility
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.