Positioning Fixed Income Assets for Market Cycle Shifts September

Transitions Ahead: Positioning Fixed Income Assets for Market Cycle Shifts

Steven Oh, CFA
Global Head of Credit and Fixed Income
Los Angeles

13 September 2018

While macroeconomic fundamentals remain strong, longer term expectations for the start of global interest rate normalization and the continued decoupling of US yields are changing the outlook for risk and return dynamics across fixed income markets. Preparing allocations now can help investors navigate this upcoming transition as accommodative monetary policies worldwide come to an end.

What lies ahead for fixed income?

US credit markets have had a good run over the past decade. Since the financial crisis, investors have been generally rewarded for increasing risk exposures across domestic fixed income segments. Moreover, US debt securities have enjoyed a distinct yield advantage over most other global developed markets, boosted by the Federal Reserve’s gradual interest rate tightening during the past few years even as most other central banks worldwide maintained or implemented additional accommodative monetary policies.

Of course, change is the one constant when it comes to investing. Although we still expect a generally constructive macroeconomic climate for fixed income securities over the foreseeable future, we are also seeing seeds being planted for significant macro shifts over the longer term. We see a number of major themes to watch as investors consider how best to position fixed income allocations in anticipation of these changes.

Global expansion of US interest rate normalization: Rate normalization in the US has been a major theme across fixed income markets during the past several years. Looking ahead, however, this story will begin to change to be about normalization outside the US and the consequent impact on global bonds, as both the European Central Bank and the Bank of Japan appear poised to begin tightening sometime in 2019/2020.

The tail end of US monetary tightening: At the same time, the US is likely to end its tightening cycle both in terms of rate increases and balance sheet contraction, potentially transitioning to a loosening cycle. This will continue the theme of global interest rate decoupling that has dominated global markets since the Fed began raising rates – but this time in the opposite direction.

Less favorable US technicals: With a rapidly expanding budget deficit set to surpass $1 trillion by 2020, the US will need to increase debt issuance substantially, even as US Treasury yields become less competitive on a relative global basis. This is liable to result in a detrimental supply/demand imbalance that could meaningfully pressure valuations.

Lower returns with greater yield volatility and wider dispersions: Generally pricier valuations across spread sectors and continued signs of a late-stage global economic expansion are setting the stage for overall reduced long-term return expectations and potentially elevated volatility. The greater dispersions seen in emerging markets over the past year are also beginning to expand into developed markets, indicating growing opportunities in security selection.

We believe these factors collectively point to an emerging transition period in fixed income. Now is the time to pause and review potential changes in risk/reward exposures across global bond allocations as well as within individual credit segments.

Credit risk is rising

Our overall short- to medium-term view on credit markets continues to be largely positive. The current global investment environment remains generally supportive of credit risk, notwithstanding notable issues such as Brexit, rising leverage in China, and ongoing challenges across select emerging market countries. However, with the general outperformance in risk assets over the past three years, we are now focusing intensely on fundamentals for the strongest risk-adjusted potential, with the knowledge that mean reversion tends to be the rule longer term.

Looking further out, our base case view begins to change beyond 2019. In the current prolonged, constructive investment climate it can be easy to forget that credit cycles are not dead. They simply have become elongated with more pronounced mini-cycles. The European sovereign debt crisis and the more recent commodity collapse are two examples of relatively short-lived credit market selloffs that bounced back reasonably quickly. Nevertheless, history has shown that the longer markets go without a corrective decline, the more excess tends to build up with less valuation cushion to absorb subsequent downturns. With this in mind, the probability appears to be rising for a credit downturn that will last beyond a quick “buying opportunity” market dip.

Riskier credits have generally outperformed over the past few years, indicating it may be time for investors to pare these back.

High-Quality Versus Low-Quality Returns Within Investment Grade and High Yield

Credit Risk 2019

Source: Bloomberg Barclays as of 31 July 2018. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Value shifts from global rate normalization

Over the past few years, the US bond market has offered a global yield advantage on a foreign exchange (FX) adjusted basis that has continued to attract investors and support prices despite the Fed’s monetary policy tightening cycle. As the ECB and BOJ begin to increase rates and commence policy normalization, European and Japanese yields will likely become more appealing to local investors relative to US debt. This should change global demand dynamics as assets start to shift marginally back offshore to pursue higher currency-adjusted yields. Additionally, US Treasury supply will likely significantly expand from a growing budget deficit that is projected to increase government debt to the highest levels in US history.

Steadily rising US deficit levels will require increased US Treasury issuance.

US Federal Budget Deficit

US Federal Budget Deficit

Source: CBO, as of 9 April 2018. Any opinions, forecasts and forward-looking statements presented above are valid only as of the date indicated and are subject to change. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

The technical pressures from this excess supply and softer demand could have major implications for US Treasuries’ traditional role as an effective way to mitigate fixed income risk. Japanese and other foreign investors have materially increased their holdings of US Treasuries since the financial crisis and now represent a material portion of marginal ownership. What will happen when the US has to issue substantially more new securities over the next few years to fund increasing deficits as the volume of foreign purchases starts to shift back, even slightly, to their own domestic government bonds, drawn away by policy changes that result in sufficient yields? For example, we believe a yield of 0.5% on 10-year Japanese government bonds will be a level that will entice a significant portion of bond demand to move back home. Now imagine the same trend playing out across other foreign investor segments as well.

While US Treasuries should continue to serve as a safe-haven insurance policy to protect against extreme market shocks, these deteriorating technicals are apt to result in generally greater volatility than recent historical norms. As such, we are not advocating increasing US Treasury allocations at this time, despite more appealing yields, and are instead focusing on other strategies to shift portfolio risk exposures. However, we prefer US Treasuries over other benchmark developed market sovereign bonds where the negative impact from a change toward monetary policy normalization can be more damaging versus the US, which is approaching the end of its current tightening cycle.

There could be major implications for US Treasuries if foreign purchasers are drawn away to their own countries’ higher yielding bonds.

Foreign Holders of US Treasuries

Foreign Holders of US Treasuries

Source: Department of the Treasury/Federal Reserve Board, as of 17 July 2018. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Emerging markets versus developed markets

Emerging market debt appears to be on a slightly different path than developed market securities, with a probable longer run ahead. Fundamentals generally seem to be several years behind developed markets with greater capacity for expansion, and the inflation outlooks for most of these countries have become more favorable. Many valuations are also relatively more attractive after the segment’s recent selloff.

Still, there are growing dispersions across regions and segments. For example, overall volatility has increased for the broad J.P. Morgan Emerging Market Bond Index year to date. However, yields for sovereign debt in countries such as Argentina and Turkey have experienced much sharper spikes than the general market.

From a broader investment perspective, elevated US dollar volatility spillover and possible trade war escalation are also causes for concern. Accordingly, although the segment remains relatively favorable, investors should continue to be selective in individual security exposures.

Emerging market volatility has broadly risen so far in 2018, but notable dispersion outliers have suffered the bulk of this risk.

Changes in Emerging Market Sovereign Yields

Emerging Market Sovereign Yields

Source: Bloomberg as of 13 August 2018. For illustrative purposes only. We are not soliciting or recommending any action based on this material.

Selective de-risking

Again, we do not anticipate a broad market selloff at this point but do expect segments to act more independently as risk trades more idiosyncratically. Also, while we believe markets will remain largely favorable into 2019/2020, the reality is no one knows what the future holds. History has shown that negative catalysts can emerge quickly and unexpectedly, and therefore a slowdown could come much earlier. Hence, we are applying a slightly more defensive mindset in portfolio positioning. This does not entail wholesale de-risking but rather a modest dialing back, especially in the highest risk components within each asset class where risk premiums have compressed more significantly.

Specific strategies include generally reducing high beta exposures and incrementally lowering duration risk profiles, particularly in developed markets outside the US. In addition, investors should be well served by focusing more on incrementally higher quality credits within segments.

Investment grade credit: At a high level, this can involve trimming BBB allocations and more cyclical sectors over the next year or so. Investors may also want to moderately increase collateralized loan obligation (CLO) holdings, which offer a compelling combination of yield premium relative to comparable corporate securities, floating rates for a degree of interest rate protection, and high-quality safety given that, historically, CLO tranches rated A or higher have suffered no loss of principal when held to maturity.

Leveraged finance: At the current point in the credit cycle, we favor more defensive secured loans over high yield bonds. Investors should consider reducing the highest risk components by decreasing CCC allocations in high yield debt as well as second lien exposures in the loan market. In Europe, emphasize assets that are not as prone to interest rate risk, such as floatingrate loans, and take additional caution in Southern European credit exposures.

Emerging markets: Within the emerging market credit spectrum, we currently think it makes sense to favor higher quality investment grade securities over high yield debt. However, there are targeted higher risk opportunities in strong businesses that were caught in the downdraft of sovereign volatility in countries such as Turkey, Argentina, and Brazil. On the sovereign side, recent (and future) volatility may also offer potential to take advantage of opportunistic selloffs to invest at attractive valuations.

Investors may also want to expand allocations to dynamically managed multisector strategies that can offer greater agility and flexibility to generate alpha and control volatility by more quickly shifting risk assets in changing markets.

An ounce of prevention

When researching fixed income opportunities, our disciplined philosophy is to ensure appropriate levels of reward for every unit of risk. We simply do not believe it pays to dive into the riskiest parts of the market currently, given emerging macro trends. Indeed, it appears to be a prudent time to begin marginally dialing down risk across and within asset classes, while continuing to reap the benefits of today’s strong fundamentals.

Long-term investment success demands avoiding complacency and recognizing the importance of continually positioning portfolios for the next set of market challenges rather than past ones. This forward-looking mindset suggests that a slightly defensive tilt in spread sectors should help investors lock in past credit gains and better navigate anticipated cycle changes of expected lower returns, greater volatility, and a return to global rate normalization.