Brad Tank, CIO – fixed income at Neuberger Berman, looks at how market volatility in Q2 2019 has changed his assessment of value and positioning across several credit markets.
Government bonds and inflation-linked securities
US government bonds – neutral
Current market pricing seemingly implies 100 bps of rate cuts over the next 12 months, but we view this as premature in the context of a US economy still growing above potential. We prefer two- to five-year maturities, as well as very long maturities.
Government bonds and inflation-linked securities
US Treasury Inflation-Protected Securities (TIPS) – overweight
The Federal Reserve has a strong desire to see inflation modestly higher. As such, we maintain an overweight on TIPS, although at modestly lower levels than earlier in the year.
Consistent with our preference for the long and short ends of the yield curve, front-end TIPS should benefit from the tariff increases.
However, intermediate TIPS might suffer from reduced demand from China and the perception of tariffs as a tax on consumers.
Longer-dated TIPS also appear attractively priced relative to fundamentals by about 25 bps in real yield.
Government bonds and inflation-linked securities
European government debt – mixed
We anticipate the European Central Bank will maintain negative rates for an extended period of time, to counter-balance economic deceleration and trade war uncertainty.
As a result, we continue to like 'flatteners' at the long end of the curve, with a preference for 30-year over 10-year European government bonds.
We also like spread trades in the broader, semi-core European Union. We remain bullish on peripheral debts, especially Portugal, and are tactically managing exposure to Italy based on how the political framework evolves.
Meanwhile, in Germany and France, we are underweight short-end maturities and the 10-year bucket.
Investment grade credit
US investment grade credit – modest overweight
While US credit has rallied significantly year-to-date, we are already seeing some spreads widen from their tightest levels of the year.
Overall, fundamentals remain stable, leverage in aggregate has plateaued and earnings are slightly beating low single-digit growth expectations. Still, idiosyncratic risks remain elevated.
Moreover, the introduction of trade and tariff uncertainty has fuelled volatility and weakened credit spreads, which are not immune to these risks.
Although a slowdown is likely factored into valuations, weaker-than-expected global and US-based growth could put more pressure on spreads in the second half of the year.
Technical support for US credit should come from manageable supply of new issues, trending in line with last year. Demand, however, remains in question as the cycle extends.
Investment grade credit
Europe investment grade credit – modest overweight
Long-term valuations in European credit are approaching fair value and reflecting fundamentally robust credit quality for both financials and non-financials.
In the near term, accommodative European Central Bank policies and negative rates continuing into 2020 are supportive of euro credit.
Furthermore, the situation with cross-currency swaps remains very favourable for US dollar investors buying euro-denominated assets.
Corporate hybrid debt also continues to offer value. UK utility hybrid bonds in particular appear oversold due to Brexit concerns.
High yield credit and leveraged loans
US high yield credit – modest overweight
Fundamentals supporting the non-investment grade universe continue to be constructive. Revenue and cash flow are growing modestly, while leverage is declining. Technical factors also remain supportive.
New issuance in high yield and loans has declined 11% and 46%, respectively, from reduced 2018 levels, while high yield inflows and loan outflows have moderated.
Meanwhile, credit differentiation has returned to the market, and performance has varied by rating. Year-to-date, BB/B/CCC have been closely tied in high yield, while higher quality loans, BB/B, have outperformed CCC loans.
High yield credit and leveraged loans
US leveraged loans – overweight
Loans and short-duration high yield are likely to navigate the expected volatility better than US and European high yield.
Valuations remain attractive, even when adjusting for the fact rates are not likely to rise in the near term.
We expect revenue and cash flow growth to slow, but interest coverage remains strong, near five times. Moreover, leverage has also come down, as aggressive LBO financing slowed.
Loan supply and demand remain balanced, with 2019 new issue volumes down and very limited refinancing activity so far.
Heavy retail outflows have slowed, while institutional and CLO demand has remained strong. This has been enough to absorb net new issuance this year, which we expect to continue, and has provided a positive technical backdrop.
High yield credit and leveraged loans
US Collateralised Loan Obligations (CLOs) – overweight
While CLO new issue volumes through April tracked close to last year’s record pace, in May we started to see the slowdown we have been expecting.
As a result, spreads for CLO mezzanine debt tightened. As high yield rallied again in June, the basis between CLO mezzanine debt and high yield once again came closer to a multiyear wide.
CLO arbitrage continues to be near the tightest level since the financial crisis, rendering new issue CLO equity returns unattractive. As a result, we view continued slow CLO issuance as likely.
This should provide a positive technical backdrop for CLO debt spreads, which currently are still well wide of the levels at the end of Q3 2018.
Emerging markets debt
EM hard currency – neutral
We continue to have a balanced position in hard currency in our blend strategies. Our long bias in sovereign debt is funded with an underweight in corporate credit.
Technical support is neutral for sovereigns because inflows have slowed, positioning has remained elevated, and needs for new issuance have diminished.
Non-investment grade sovereigns remain attractive in absolute and relative terms when compared to US high yield credit.
Notwithstanding a reduction in overall risk profile, our hard currency sovereign portfolios continue to have a high-yield bias.
Emerging markets debt
EM local currency – neutral
Given the prevailing downside risks to growth and deteriorating expectations of a resolution of the US-China trade deadlock in the short term, we have reduced our allocation to local currency markets to a small underweight position in our blended strategies.
Furthermore, the underlying active emerging markets foreign exchange exposure in our local currency strategies has been effectively neutralised.
Technical factors are slightly more supportive for local currency issuers, given lighter positioning and less crowded holdings of local bonds by non-residents.
Brad Tank, CIO - fixed income at Neuberger Berman, looks at how market volatility in Q2 2019 has changed his assessment of value and positioning across several credit markets.
Brad Tank, CIO - fixed income at Neuberger Berman, looks at how market volatility in Q2 2019 has changed his assessment of value and positioning across several credit markets.
The global soft landing is upon us. Global economic growth has slowed, and markets have become more volatile - rife with fears of hard landings, recessions and market crashes.
But in many cases, dramatic movements in market prices turn out to be not much more than temporary overreactions to changing theories.
At these times, the real investing opportunity is to recognise and exploit short-term dislocations.
After the de-risking of credit instruments in the first and second quarter, we think the outlook and opportunities are sufficiently compelling for investors to begin re-deploying capital into select fixed income markets while remaining cautious on the scope of central bank easing currently priced into markets.
Here, we outline how market volatility in the second quarter has changed our assessment of value and positioning across several credit markets.
