High Yield Bond 1Q19

“Investors find it hard to imagine a world where central banks don’t come to their rescue.” — Matt King, Citi  Research

1Q19 MARKET REVIEW: Risk assets rebounded from a difficult 4Q18. Central banks abruptly shifted to a more accommodative policy in early January, sparking the rally. The Bloomberg Barclays Aggregate Index posted a 1Q19 total return of 2.94% bolstered by a combination of tighter credit spreads and lower U.S. Treasury (UST) yields.

THE ECONOMY, INTEREST RATES & THE FED: UST yields collapsed in March following the Fed’s policy meeting. Despite robust economic data, investors worried about the Fed’s view of the economy, along with warning signals about a potential recession after a portion of the UST yield curve inverted.

INVESTMENT GRADE CREDIT: Investment grade (IG) credit rallied alongside the equity market in January and February and held their ground in March. IG credit was the Aggregate’s best performing sector as credit spreads tightened 30bps. BHMS maintained a defensive posture in its IG credit portfolios as corporate spreads approached fair value, but continued to find opportunities in select credits.

HIGH YIELD & BANK LOANS: High yield (HY) and bank loan markets also rebounded in 1Q19 and both outperformed IG credit. The HY market posted one of the strongest returns in nearly 10 years. BHMS is constructive on single-B bonds and loans due to relative value and solid fundamentals.

AGENCY MBS, ABS & CMBS: Mortgage Backed (MBS), Asset Backed (ABS), and Commercial Mortgage Backed Securities (CMBS) each posted positive total and excess returns in 1Q19. BHMS increased its allocation to MBS and maintained an overweight in ABS and underweight in CMBS.

LONG CREDIT & LONG DURATION INVESTMENT (LDI) TRENDS: Long Credit’s 1Q19 performance erased its 2018 losses. Despite an increase in pension liabilities, funded status increased from 84.2% to 89.2% in 1Q19 due the strong performance of equity markets.

“Good questions outrank easy answers.” — Paul Samuelson

THE ECONOMY, INTEREST RATES & THE FED: Interest rate volatility was virtually non-existent in the first two months of 2019, but UST yields belatedly joined their European peers and fell drastically in March. The 10yr UST yield sank 31bps in March and 27bps in 1Q19 to 2.41%. The UST yield decline followed the Fed’s mid-March meeting, after Fed officials unexpectedly reduced their forecast for 2019 rate hikes from two to zero. Officials also announced the Fed’s balance sheet contraction due to quantitative tightening (QT) will likely end in 2H19. The balance sheet has declined from $4.5T in assets at its 2016 peak, to $3.7T currently. The Fed estimates ~$3T will remain on the books, almost four times the pre-crisis level. Capital markets spent March focused on the inversion of the front end of the UST yield curve and what it may say about the likelihood of a recession. Increased demand for intermediate and long USTs left the three-month T-bill (3mo) yielding more than all maturities extending to ten years. The inversion of the 3mo-10yr UST curve has occurred prior to the last seven U.S. recessions, which usually begin 12-24 months later. However, as typical at the time of initial curve inversion, economic data in the U.S. remains relatively robust. The unemployment rate fell in March to 3.8%, near a 50-year low. CPI fell to 1.5% y/y, the lowest reading since September 2016. Slowing inflation translated to strong real wage growth as average hourly earnings grew 3.4% y/y in March. Dire economic data proliferated in Europe, especially Germany. Manufacturing PMI in Germany collapsed into contraction territory in January and fell further in February and March. The yield on the region’s safe haven asset, the German Bund, sank to a negative rate on the 10yr for the first time since October 2016. In a positive sign for the global economy, sagging Chinese economic growth appeared to have bottomed following government stimulus measures. Evidence for a rebound emerged in improved global trade data and metals prices.

BHMS OUTLOOK: It is difficult to rely on historical analysis to determine the importance of the recent UST yield curve inversion. The current cycle is unique considering the low level of yields compared to previous inversions and the continued use of extraordinary monetary policies across global central banks. However, the market seems increasingly convinced the December 2018 rate hike to 2.25% – 2.50% was the last of the cycle, and several Fed officials seem to publicly agree. If the market is correct, then the Fed will have to face the next recession with the least cushion for potential rate cuts in its history, whenever it begins. Meanwhile, the ability of Congress to assist in combating a recession with fiscal stimulus may be more limited than in the past. The U.S. fiscal deficit is likely to reach 5.0% of GDP in 2019, the highest outside of a recession or war since at least 1900. The average U.S. recession has added an additional 400bps to the deficit. Above average stimulus would take the U.S. deficit to its highest level since WWII.

“Everything is relative; and only that is absolute.” — Auguste Comte

INVESTMENT GRADE CREDIT MARKET REVIEW: Credit sharply rebounded in 1Q19 after a difficult 2018. Spreads narrowed dramatically in January and February, then held steady in March despite increasing global growth concerns. The IG Credit Index’s option adjusted spread narrowed 30bps in 1Q19, producing the best total and excess returns of any major sector in the Aggregate Index. Industrials posted the strongest sub-sector returns, with Energy spreads 45bps tighter. The easing of global trade tensions and rebounding commodity prices boosted demand for virtually all industrial sectors. The technical drivers underlying credit’s performance were mostly positive. IG credit inflows totaled $67B, the largest quarterly inflow since 4Q17. In a reversal from 2018, intermediate maturity demand surpassed short maturity inflows in 1Q19. Total IG Credit issuance was $390B in 1Q19, a 1.1% decline y/y. The modest decline was sufficient to remove issuance as a potential impediment to spread tightening. Foreign demand for U.S. Dollar (USD) IG Credit failed to grow. Strong inflows from Asia were canceled-out by European-based investors’ outflows. Non-U.S. investor demand grew consistently in the post-crisis period until early 2018, when higher USD-hedging costs erased the yield advantage offered by USD Credit over European and Japanese fixed income. The share of the U.S. Corporate credit market held by non-U.S. investors peaked at 40% in 2017, but had fallen to 38% by the end of 1Q19.

OUTLOOK: The fundamental outlook for credit remains mixed. The increasingly large BBB segment has faced increased scrutiny from investors. The BBB market has almost tripled in size since 2009 to nearly $3T, while its weighting in the Corporate Index has grown to 50% from a pre-crisis weight of 35%. However, a wide dispersion exists between the fundamental health of BBB+ and BBB- issuers. Additionally, the risk-reward profile is more attractive for many BBB issuers than much of the A-rated segment.