CONTRIBUTORS
Robert O. Abad
In recent weeks, we’ve discussed the factors fueling the sharp bear-steepening of the US Treasury (UST) yield curve and the potential impact of higher interest rates on credit markets. The principal concern is that a “higher-for-longer” rate environment could further dent corporate valuations, raise worries about issuer refinancing and default risk and even pose the risk of destabilizing another area of the economy. Despite these concerns, we maintain a positive outlook for credit markets for three main reasons:
- Recent statements from US Federal Reserve (Fed) Chair Jerome Powell and other Fed governors indicate a more cautious approach to monetary policy, strengthening our conviction that the Fed likely will refrain from further rate hikes.
- The US economy is supported by a robust corporate sector and resilient consumer base which should allow the economy to slow without slipping into negative growth (i.e., recession). Moreover, companies have been proactively preparing for an anticipated recession, fortifying their balance sheets to withstand potential economic challenges.
- Historical data spanning a 40-year period reveals that fixed-income, especially corporate credit, has consistently shown strong performance following periods of UST bear-steepening. This historical trend adds to our optimism regarding the resilience of corporate credit in the face of UST volatility.
Exhibit 1: 12-Month Returns Post Yield Curve Bear-Steepening
Source: Western Asset. As of October 31, 2023. Aggregate is represented by the Bloomberg US Aggregate Index; investment-grade (IG) corporate is represented by the Bloomberg US Corporate Index; HY Credit is represented by the Bloomberg US Corporate High Yield Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
As highlighted in Exhibit 2, all fixed-income options are currently more appealing due to higher overall yields and higher income generation. We think credit is the way to take advantage of this environment due to the considerable spread above the risk-free rate, coupled with a supportive fundamental backdrop. More importantly, while attractive income serves as the main driver for investor returns, there is also the potential for additional returns if UST rates continue to rally or if spreads tighten further.
Exhibit 2: Yield-to-Worst Across Fixed-Income Sectors (Past 10 Years)
Source: Bloomberg, J.P. Morgan, Morningstar LSTA. As of October 31, 2023. Yield-to-Worst (YTW) is the lowest possible yield that can be received on a bond apart from the company defaulting. All sectors shown are yield-to-worst except for Municipals, which is based on the tax-equivalent yield-to-worst assuming a top-income tax bracket rate of 37% plus a Medicare tax rate of 3.8%; and Leveraged Loans, which is yield-to-maturity. Indexes used are Bloomberg except for emerging market debt and leveraged loans. Euro investment grade (IG) is represented by Bloomberg Euro Aggregate Corporate Index; US Treasury is represented by the Bloomberg US Treasury Index; asset-backed securities (ABS) are represented by the Bloomberg ABS Index; mortgage-backed securities (MBS) are represented by the Bloomberg US MBS Index; non-agency (NA) commercial mortgage-backed securities (CMBS) are represented by the NA component of the Bloomberg CMBS IG Index; investment-grade (IG) corporate is represented by the Bloomberg US Corporate Index; municipals (muni) are represented by the Bloomberg Municipal Bond Index; Euro high yield (HY) is represented by the Bloomberg Pan-European High Yield Index; NA residential mortgage-backed securities (RMBS) are represented by the non-agency, residential portion of the Bloomberg US MBS Index; EM Corporate is represented by the JP Morgan Corporate Emerging Markets Bond Broad Diversified Index (CEMBI Broad Diversified); leveraged loans are represented by the Morningstar LSTA Leveraged Loan Index; emerging market debt (EM) USD is represented by the JP Morgan EMIGLOBAL Diversified Index; US HY is represented by the Bloomberg US Corporate High Yield Index; EM Local is represented by the J.P. Morgan GBI-EM Global Diversified Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Given our outlook at this time, we have biased our multi-asset credit portfolios to seek to take advantage of the opportunity in higher quality credit. We believe the risk/reward potential of owning high-quality high-yield and investment-grade corporates remains an attractive opportunity for investors despite the already strong performance year-to-date (YTD). Higher quality allows investors to still capitalize on the generous yields in today’s fixed-income market, but also to endure a downturn should the economy slip into recession (though this is not our base case). We also believe commercial real estate is likely to present an opportunity later in the year and we are allocating significant resources to that sector in preparation.
Here we highlight the opportunities we see in each of the following fixed-income asset classes:
- High-yield credit: In the US, yields around 9% are providing significant cushion to offset modestly higher defaults as peak fundamentals adjust to higher rates and slower growth. We continue to see opportunity in service-related sectors such as airlines, cruise lines and lodging, and remain cautious on companies that have closer ties to housing-related activity which therefore lack pricing power. In Europe, we believe corporate fundamentals are decent based on recent earnings, and we view yields north of 8% as fair. Given more macro headwinds, we are more focused on higher quality new issues and short-dated yield-to-call opportunities.
- Bank loans and CLOs: The loan market has delivered double-digit returns YTD and continues to benefit from strong technical demand due to collateralized loan obligation (CLO) issuance. We favor defensive sectors that have strong competitive positions, less cyclical industry dynamics and decent asset coverage. These include health care, property & casualty brokerage and environmental waste management companies. In the CLO space, we continue to see value in AAA rated tranches, which are currently offering yields north of 6%. With the structural protections of CLOs, an AAA rated security can absorb 60%-80% of the loan portfolio defaulting without taking a loss, which is well in excess of our expectations for a default rate of 3.5%-4.0% over the next year.
- Investment-grade credit: While yields on US investment-grade credit remain elevated, spread levels remain fair. We continue to maintain overweight positions to banking, energy and select reopening industries. In Europe, corporate fundamentals are deteriorating in some sectors, albeit from a strong level. Higher European government yields may ultimately be problematic for credit but after a firm 3Q23, spreads look reasonably attractive on a historical basis, particularly for shorter maturity paper.
- Mortgage and consumer credit: In the residential mortgage-backed securities (RMBS) space, we’re opportunistic on credit risk transfer (CRT) securities as well as non-QM deals that present attractive borrower profiles and higher credit qualities. In the commercial MBS (CMBS) space, low leverage exposures on high-quality real estate with meaningful borrower equity present compelling opportunities to lend in both the conduit and single-asset single-borrower (SASB) market. New origination screens particularly attractive on a yield versus credit risk basis; however, some high-quality seasoned credits offer attractive total return opportunities, in our view.
- EM debt: Yields across the emerging market (EM) asset class are near decade highs. While we’ve maintained a constructive outlook for EM, we’ve also maintained a cautious stance given the greater vulnerability of the asset class to US rate volatility, US dollar strength and geopolitical risk. That stated, we see US macro conditions and interest-rate dynamics aligning with our expectations and a Fed that appears to be adopting a more cautious stance on policy tightening. All of these factors lead us to the conclusion that EM (e.g., local market and frontier market debt) now looks compelling from a risk/return perspective.
In closing
Throughout this year, credit markets have demonstrated impressive resilience despite challenges such as extraordinary UST volatility, unexpected economic data and geopolitical turmoil. Looking ahead, we have the US presidential election and a number of pivotal elections across other parts of both the developed market (DM) and EM world that could introduce additional uncertainties. That stated, we think the cloud of uncertainty that has been hanging over credit markets the past year—particularly the risk of Fed overtightening—appears to be lifting. We believe this clearer outlook should set the stage for credit outperformance as we move into 2024.
Definitions:
The Bloomberg US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury.
The Bloomberg US Treasury Index measures US dollar (USD)-denominated, fixed-rate, nominal debt issued by the US Treasury.
The Bloomberg Municipal Bond Index covers the USD-denominated long-term tax-exempt bond market. The Bloomberg US Corporate Bond Index measures the investment-grade, fixed-rate, taxable corporate bond market.
The Bloomberg US Mortgage-Backed Securities (MBS) Index tracks fixed-rate agency mortgage-backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC).
The Bloomberg ABS Index is the asset-backed securities (ABS) component of the Bloomberg US Aggregate index and comprises credit- and charge-card receivables, autos loan receivables and utility receivables.
The Bloomberg Euro Aggregate Corporate Index measures the corporate component of the Euro Aggregate Index. It includes investment-grade, euro-denominated, fixed-rate securities.
The Bloomberg US Aggregate Bond Index is an unmanaged index of U.S. investment-grade fixed-income securities.
The JP Morgan EMBI Global Diversified Index is a uniquely weighted USD-denominated emerging markets sovereign index. It has a distinct diversification scheme, which allows a more even-weight distribution among the countries in the index.
The JP Morgan GBI-EM Global Diversified Index consists of regularly traded, fixed-rate, domestic currency government bonds, which international investors can readily access. It excludes countries where local market investing is subject to explicit capital controls, but eligibility consideration does not factor in regulatory/tax hurdles.
The JP Morgan Corporate Emerging Markets Bond Broad Diversified Index (CEMBI Broad Diversified) is a uniquely weighted version of the CEMBI. It comprises only USD-dominated emerging market bonds. The countries represented in the CEMBI Broad Diversified are the same as those in the CEMBI.
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixedrate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and Standard & Poor’s is Ba1/BB+/BB+ or below.
The JP Morgan Leveraged Loan Index is a market-weighted index that tracks the performance of institutional leveraged loans.
The Non-Agency (NA) component of the Bloomberg Commercial Mortgage backed Securities (CMBS) Investment Grade Index measures the market of US Non-Agency conduit and fusion CMBS deals with a minimum current deal size of $300 million.
The JP Morgan Non-Agency (NA) Residential Mortgage-backed Securities (RMBS) Credit Index tracks a combination of sector- and vintage level jumbo, CRT (credit risk transfers) and legacy RMBS, reflecting the outstanding debt in the market.
"AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality, and are commonly referred to as "junk bonds."
A collateralized loan obligations (CLO) is a security backed by a pool of debt, often low-rated corporate loans.
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
An Asset-Backed Security (ABS) is a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities.
Pioneered by Freddie Mac in 2013, credit risk transfer (CRT) programs structure mortgage credit risk into securities and (re)insurance offerings, transferring credit risk exposure from US taxpayers to private capital.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.