A cautious approach to risk markets
A deliberative Fed and slower global growth are positives for rates markets. Without an abrupt withdrawal of liquidity, people will be more patient in holding bonds, and yields look attractive. However, given our expectation for slower global growth and potentially higher volatility, we approach risk markets carefully.
Over the past year we have experienced a significant re-pricing of credit – spreads are 60% wider than they were just one year ago, and, we believe, offer significant compensation for default and liquidity risks. That’s particularly true for corporate high yield (ex-energy, metals and mining), where it looks like buyers are being over- compensated for both defaults and potential volatility. U.S. high yield companies are, for the most part, domestically-focused, have healthy balance sheets, and are positioned to benefit from above-trend growth.
Likewise, European high yield fundamentals benefit from above-trend economic growth and ongoing ECB easing. We like European financials, specifically hybrid bank debt, but we are cautious about banks with emerging market exposure. Alternative Tier I securities (these receive top short-term ratings from any two Nationally Recognized Statistical Rating Organizations) are attractive in the face of regulatory pressure to improve bank balance sheets; however, we prefer the securities of banks who have completed their financing needs.
We are more guarded in our approach to U.S. investment grade corporates, as many are dependent on global demand. Furthermore, continued easy money increases the opportunities for investment grade issuers to re-leverage. Ongoing new issue supply, especially if paired with outflows as investors move to high yield, would also put negative pressure on spreads.
As an alternative, we like commercial mortgage-backed securities (CMBS). Spreads are attractive when compared with both U.S. investment grade corporates and agency MBS. Like the high yield market, CMBS is poised to benefit from U.S. growth and further strength in the housing market.
Finally, given our concern over slowing global growth, we are quite selective in our emerging market investments. Commodity prices present a major headwind; the effects of a strong U.S. dollar have yet to be fully priced in; and the specter of a Fed hike may increase the risks of emerging market crises. Differentiation among markets is key, and we’re focused on countries that have less borrowing needs; that are commodity importers, not exporters; and that are addressing market-friendly structural reforms.
Although the Fed tried to walk back its decision in the days following the FOMC meeting, its lost credibility was damaging and still reverberates through the markets. Nonetheless, as we look for deeper value, we view this as a further opportunity to search markets for investment opportunities. What we have learned is that the Fed (and other major central banks) will be overly cautious in normalizing policy; low rates and extreme monetary accommodation will be with us for a while.
International investing bears greater risk due to social, economic, regulatory and political instability in countries in "emerging markets." This makes emerging market securities more volatile and less liquid developed market securities. Changes in exchange rates and differences in accounting and taxation policies outside the U.S. can also affect returns.
Securities rated below investment grade are considered "high-yield," "non-investment grade," "below investment-grade," or "junk bonds." They generally are rated in the fifth or lower rating categories of Standard & Poor's and Moody's Investors Service. Although these securities tend to provide higher yields than higher rated securities, they tend to carry greater risk.
CMOs are collateralized mortgage obligations, which are issued in multiple classes, and each class may have its own interest rate and/or final payment date. A class with an earlier final payment date may have certain preferences in receiving principal payments or earning interest. As a result, the value of some classes may be more volatile and may be subject to higher risk of nonpayment.