Fixed income markets will be hard pressed for an encore performance of the second quarter. Risk assets of all flavors rallied in conjunction with Treasury yields falling – whether this is causal or simply concurrent remains to be seen. The market is now expecting the Federal Reserve (the Fed) to cut rates three times – in total 75 basis points (bps) – by the end of the year, and investors are asking two key questions: (1) Can risk assets perform without the tailwind provided by a lowered rate outlook? (2) Is the forecast for lower rates a sign of the end of the 10+ year expansion, or are we simply observing a market cycle within the economic cycle?
While three rate cuts in the coming year may be aggressive, there is no question of the existence of the “Fed put” in this market. Economic data that reflects slowing at the margin can be largely attributed to a decline in confidence and/or activity related to the ongoing trade dispute between the U.S. and (mostly) China. While growth is slowing somewhat, the domestic economy is still expanding, and the level of unemployment and average hourly earnings are not consistent with the notion of a rate cut.
We see two likely outcomes – either the economy finds its footing and continues its expansion, which would be supportive of risk assets but not interest rate exposure (as potential Fed eases begin to be priced out of the rates market), or the economy continues to slow and Fed eases are implemented. In this case, risk assets probably continue to perform well as borrowing rates decline. It’s seemingly a “heads I win, tails I win” scenario for risk assets.
As a result, we remain constructive on Investment Grade (IG) credit for the balance of 2019. While we do not anticipate IG matching its robust performance in the first half of the year, we feel that it will benefit from the current environment and provide attractive relative returns. Mortgage-backed securities (MBS) might see some challenges as lower rates could translate into higher refinancing activity – which means more supply and less carry for mortgage investors. In addition, the Fed’s preference to reinvest runoff from its MBS portfolio into Treasuries has the potential to drive mortgage spreads wider (and Treasury rates lower). Nonetheless, we are neutral on MBS as we think there will be pockets of opportunity in MBS at rate extremes that impact convexity hedgers and prepay-sensitive investors alike.
Back to credit, there are several structural tailwinds that should make IG credit an attractive sector for the remainder of the year. Foremost, an accommodative Fed and lower interest rates have created a conducive environment for issuers to refinance and investors to increase allocations into risk assets. Strong flows into IG funds speak to elevated demand, yet supply has been down 10% year-to-date versus last year and down 20% year-to-date versus records set in 2017. Additionally, demand from international investors is expected to be strong as IG credit yields on a hedged basis continue to look attractive for foreign buyers. IG spreads have tightened approximately 40 bps year-to-date and currently sit 10 bps off the tights of the last 12 months. While we recognize that some of the tightening was a retracement from the sharp widening in the last quarter of 2018, we believe that returns in the second half of 2019 will primarily come from carry rather than spread tightening.
We continue to reiterate our view that a wave of downgrades of BBB credits will not come to fruition. Thus far in 2019, 16 of the largest 25 BBB issuers have reduced debt from the levels at the end of 2018. However, we remain vigilant on this topic and are continuously monitoring the situation, as we recognize that animal spirits from an accommodative Fed and low interest rates could cause issuers to reconsider their commitments to deleveraging.
The biggest question in this market is the path of rates and Fed policy. On one hand, the Fed appears poised to ease to provide support for a slowing economy. On the other, most of the Treasury yield curve under 10 years has interest rates below 2%. While in the short term, these rates could certainly go lower, these bonds do seem to be unattractive long-term investments – especially in the 5-10 year part of the yield curve.
We will continue to monitor data and Fed communications to shape our view of rates and will likely remain defensive given the relatively poor long-term attractiveness of the current level of yields. However, as previously discussed, the current rate environment is favorable for investment grade corporates, so we intend to maintain our overweight to the sector. We do not plan to adjust our mortgage holdings materially, though we will take our cues from the rates market as attractive opportunities may present themselves.
As always, we thank you for your continued support and welcome any questions.
Best Regards,
Eddy Vataru, John Sheehan, Daniel Oh
Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.
A basis point (bp) is a unit that is equal to 1/100th of 1%.
Credit Quality weights by rating are derived from the highest bond rating as determined by Standard & Poor’s (“S&P”), Moody's or Fitch. Bond ratings are grades given to bonds that indicate their credit quality as determined by private independent rating services such as S&P, Moody's and Fitch. These firms evaluate a bond issuer's financial strength, or its ability to pay a bond's principal and interest in a timely fashion. Ratings are expressed as letters ranging from 'AAA', which is the highest grade, to 'D', which is the lowest grade. In limited situations when none of the three rating agencies have issued a formal rating, the Advisor will classify the security as nonrated.
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© Osterweis Capital Management
© Osterweis Capital Management
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