This recent correction was about rates, not fundamentals
Over the last few weeks, we have seen volatility return to global equity and fixed income markets. After peaking on January 26th, the S&P 500 with dividends declined -7.85%, while the US 10-year Treasury declined -2.25% (through April 24th). While tariffs and the threat of trade wars have certainly contributed to risk-off market sentiment, we believe this recent pullback in both US equities and fixed income is primarily a function of financial markets reacting to the prospect of rate policy normalization by the US Federal Reserve (“Fed”). Rate policy normalization refers to the steps the Fed is taking to raise short term rates to more normal levels and ultimately reduce the Fed’s securities holdings currently on the balance sheet. At the same time, we believe the Treasury will need to increase its issuance given recent tax cuts and that this will likely translate into higher rates as the Treasury competes for funding from a shrinking buyer base. It is worth noting two things: 1) we saw a dispersion of returns within markets during this period with US equities, US 10-year Treasuries and investment grade corporates experiencing the sharpest declines compared to high yield bonds and leveraged loans; and 2) we believe the current correction was not a function of deteriorating credit fundamentals or a systemic crisis. As would be expected in an environment dominated by rate concerns, high yield and loans – with their strong coupon and shorter duration profile – better protected capital compared to US equities, 10-year Treasuries, and investment grade corporates. Despite outperforming each of these asset classes (except loans), high yield has seen multiple weeks of outflows – suggesting investors are punishing an asset class that has proven to be resilient in the face of rate increases and acts as a powerful portfolio diversifier.
Fed on path to normalize rate policy before cycle turns
With a bloated $4+ trillion balance sheet and a low Fed Funds rate, the Fed has limited monetary policy ammunition, at present, to combat the next recession. There is a sense that we are likely in the latter stages of the economic cycle and so a greater need for the Fed to act, especially since positive economic data and increasing inflation pressures provide numeric cover to normalize rates. The dot plots (member views on where Fed Funds rate should be at year-end) suggest that the US central bank will continue to raise rates throughout the year given supportive economic data.
Rising US deficits will likely put further upward pressure on Treasury rates
At the end of 2017, the Trump administration was able to pass its tax cuts, which according to the non-partisan Congressional Budget Office, is likely to increase the deficit in the coming years. Given the prospect of rising deficits, investors expect the Treasury will have to increase its issuance to meet the funding gap between tax revenue and government spending. This means that Treasury supply is likely to increase.
At the same time, demand for the asset class is likely to decline as certain buyers are anticipated to reduce their purchases. In its quest toward normalization, the Fed has committed to shrinking its balance sheet by allowing Treasuries that mature to roll-off without re-investing the proceeds. According to the Federal Reserve, we can expect to see a 35% reduction in the size of the Fed balance sheet over the coming three years. So the Fed, the largest buyer of Treasuries, will be buying less in the future. We believe foreign buyers are also expected to buy fewer Treasuries going forward as well. For example, Euro and Yen buyers face significant hedging costs that make holding Treasuries less economical. Finally – China – the single largest foreign holder of US Treasuries remains a wild card. It remains to be seen how far the US is willing to push in its trade war with this important US creditor.
Dispersion of returns – it’s not all bad
A string of positive economic data and increasing inflation pressures led to a sell-off in Treasuries (price moves inversely to yield), investment grade and US equities as investors feared the Fed would move faster in its normalization drive. The US 10 year is now at 3%+ (as of April 24, 2018) – a yield last seen on a sustained basis in 2011.
Within fixed income, however, it was not all bad. We have noticed a dispersion of returns as high yield and loans, with their higher coupon and shorter duration profile have been able to better protect capital. As you can see in figure 1, loans are up over 1% since the January 26 market peak with high yield bonds only slightly negative as coupon income offset more than half of the price decline of the asset class. Unfortunately higher quality fixed income did not have sufficient coupon to offset most of the rate move, while equities in our view were revalued on higher discount rates.
High yield and loans not correlated to Treasuries
Conventional wisdom holds that in times of increased volatility and turbulence, asset class correlation converges to 1.00. That is, asset classes that are otherwise uncorrelated seem to decline in periods of market stress to a largely similar degree. The one exception to this rule is generally Treasuries that rally (yields decline) as investors seek safe havens. A close examination of recent data, however, tells a different story. Since January 26th, the only markets that are truly correlated (correlation greater than 0.70) are investment grade markets to Treasuries. Interestingly equities have a positive correlation to Treasuries (0.32) while US high yield and loans have a negative correlation to US Treasuries suggesting that US high yield and loans represents an attractive portfolio diversifier.
Credit fundamentals are strong
Is this the beginning of a recession? We emphatically say “no” as we do not see a return to excessive leverage and general economic data remains strong. According to JP Morgan, leverage declined for a 6th consecutive quarter while interest coverage ratios (a company’s ability to make its contractual interest payment) are at a 2 year high.
Another important metric that highlights the improved quality of high yield is the percentage of CCC-rated bonds that make up the broad US high yield market. In early 2008 (January 31, 2008), 18.5% of high yield companies were rated CCC. As of April 25, 2018 that figure is 11.5%. Credit quality is actually better today (end of April) than before the recession despite being nine years into an economic recovery; the high yield market is being disciplined.
Dispersion of returns means active management matters
As we enter the latter stages of the economic cycle and stimulative monetary policy is withdrawn, we expect to see increasing dispersion of returns across high yield and loans. In such times, active management matters tremendously because issuers will compete for capital and certain issuers will be challenged with larger coupons or limited capital market access. An investor blindly buying the market via an index or a macro-oriented approach could be exposed to challenged issuers, while actively managed, fundamental credit portfolios, such as those managed by Muzinich, may avoid this disaster.
As we have demonstrated, high yield and loans have better protected capital in this recent market pull back. In today’s environment, we believe high yield and loans act as a powerful portfolio diversifier. It is impossible to time markets. Given strong fundamentals and a solid coupon, we believe an allocation to high yield and loans is warranted in order to cushion market volatility. In this way investors will be paid to wait until there is greater visibility in rates.
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Past performance is not a guide to future performance. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Where references are made to portfolio guidelines or features, these may be subject to change over time and prevailing market conditions.
The prices of fixed income securities fluctuate in response to perceptions of the issuer’s creditworthiness and also tend to vary inversely with market interest rates. The value of such securities is likely to decline in times of rising interest rates. Conversely, when rates fall, the value of these investments is likely to rise. Typically, the longer the time to maturity the greater are such variations. A Fund investing in fixed income securities will be subject to credit risk (i.e. the risk that an issuer of securities will be unable or unwilling to pay principal and interest when due, or that the value of a security will suffer because investors believe the issuer is less able or willing to pay).
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