Where are the best opportunities in fixed income?Contributor Oksana Aronov
Investors can profit from the good and the bad while avoiding the ugly.
Investors seeking fixed income opportunity must take into account today’s regime of ultra-low global yields and weak market liquidity. With the Federal Reserve moving towards an interest rate hike and the dramatic reduction in trading capacity, investors need to redefine what constitutes value and safety as well as when and how to deploy capital into markets distorted by multiple rounds of quantitative easing.
An improving U.S. economy is constructive for credit. Recent volatility has been primarily driven by the slowdown in China. This has put pressure on commodities and by extension on the high yield sector, roughly 17% of which is comprised of commodity-related companies.
The case for ongoing pain and increasing defaults in the energy and metals and mining parts of high yield is not without merit, given the combination of global oil oversupply and weaker demand from a slower China. So why are we placing high yield credit in the “good” bucket? Because away from the woes of those sectors, there is a significant incongruence between high yield fundamentals (steady) and prices (falling):
- High yield has consistently shown resilience through rising rate cycles, since a growing economy is positive for the sector. The current spread of 585 basis points (bps) is higher than in the run-up to any of the last four hiking cycles. This spread level implies a 4% default rate – much above the current sub-2% level.
- Spreads, ex commodity-related industries, look attractive at over 500bps. Excluding energy, high yield defaults are sub-1%.
A steady housing backdrop supports pockets of the securitized market. We see value in the non-agency mortgage market. Housing market data is coming in strong, with home price appreciation up 4.9% over the last year. We like areas of the non-agency market that move with home price appreciation – and do not depend on favorable inflation reports or global risk-off sentiment. The sector’s steady income, low correlation to risk markets and modest rate sensitivity are all attractive. As this market is less frequently traded, investors with an ability to provide liquidity are well positioned.
Continuing with the real estate theme, we see exceptional opportunities in private commercial real estate lending. There are mid-market and transition finance deals looking for liquidity providers. Those willing to do careful due diligence can lock in yields of 5.5% to 7%.
We are short emerging market debt in a variety of ways. This is where our view on opportunities is unique in that we look at them from both a long and a short perspective. Emerging market commodity exporters have been broadly impacted by the collapse in commodity prices. This, as well as modest global growth, a weaker China, Fed tightening and a strong U.S. dollar, will be a headwind for most emerging markets. Considering the relatively low compensation, we do not feel the risk-return is attractive.
We are also not constructive on generic investment grade credit, agency mortgages and municipals, given their significant sensitivity to a rate increase. While we can debate the magnitude and timing of a Fed hike, none of these sectors has enough coupon cushion to absorb the gyrations of a market adjusting to the reality of higher rates.
We live in a world dominated by price-insensitive buyers, like central banks which have driven the prices of sovereign debt securities to all-time highs. To negatively impact the market, such buyers do not need to turn into sellers, but simply decelerate their rate of purchases. We don’t pretend to know what trajectory central bank policy globally will take and think it is extremely precarious for investors to link an investment strategy to the words and promises of central bankers.
We call central bank activity a wild card and are therefore not willing to take the long or short side of this trade. Our strategy instead is to stay out of these markets entirely and maintain a liquidity buffer that will allow us to stay opportunistic in offering our capital where and when it is most needed.
Investment implications include:
- The high yield sector is not homogeneous. Disciplined, security-selection-oriented investors will be rewarded as the bid for the sector re-emerges in a world starved for income.
- Persistent commodity-related pain may be offset by hedging via emerging markets.
- The imminence of a Fed move means traditionally “safe” areas of fixed income are riskier than ever.
- Key sectors are not driven by fundamentals today, but by the wild card of central bank activity. This includes all developed market sovereign bonds, especially those trading at negative yields.