Fixed Income Asset Allocation Insights: Eyeing Select Global Opportunities

Credit spreads widened in March as regional bank failures in the US (Silicon Valley Bank and Signature Bank) and Europe (Credit Suisse) spurred increased volatility in both sovereign rates and risk assets and a slowdown in capital market activity. Despite initial concerns that these failures could mark the beginning of more systemic banking contagion, the US Treasury and Federal Reserve took significant steps to guarantee that depositors at these failed banks would remain whole and to backstop deposits at other US banks that may experience a contagion effect; and meanwhile, Swiss authorities were able to broker an emergency sale of Credit Suisse to UBS. These actions helped calm investors’ nerves and bring stability back to markets. In the face of these challenges, the Fed increased the federal funds rate by 25 basis points (bps) at its March meeting amid prolonged elevated inflation and a robust labor market. The European Central Bank (ECB) increased rates by 50 bps in March, as inflation remained well above the central bank’s target of 2%. Despite the headline number moving lower, led by Spain, the core number has been stickier than anticipated, with European wage growth now outpacing the US, and index differences driving stickier core inflation.

With fears of a full-blown banking crisis having subsided, we expect credit spreads to remain largely rangebound as we approach the end of the Fed’s rate hike cycle. We remain of the view that a more forward-looking Fed and tightening lending conditions will result in slowing economic growth, a more uncertain consumer, and a corporate earnings slowdown in developed market economies, which should further reveal itself in the second half of the year as the lagged effect of rate increases takes hold. We’re also beginning to see some weakness in the underlying US data, with both jobless claims and JOLTs missing consensus, and while nonfarm payrolls remained robust, this may prove temporary as the backdrop weakens. Conversely, we expect an improvement in fundamentals in some areas of emerging markets, and Asia in particular. As a result, we maintain a marginally defensive bias in portfolios, while looking for select opportunities to take advantage of attractive valuations at the issuer level. In addition, with the US now potentially weakening relative to other markets, we are looking for opportunities to expand more globally and favor areas with improving fundamentals.

Leveraged Finance

John Yovanovic, CFA, Head of High Yield Portfolio Management

Fundamentals Fundamentals are starting from a position of strength, but we expect earnings to remain flat to down for the next two quarters. Default rates ticked down at 1.91% on a last-12-month (LTM) basis1 (according to JP Morgan data as of 3 April), essentially unchanged from last month. While starting from a position of fundamental strength, we anticipate a deteriorating trend in the earnings outlook.

Valuations Spreads have rallied a bit from March wides, but option-adjusted spreads (OAS) remain attractive at 478 bps.2 (according to the Bloomberg HY Index as of 5 April). The near-term trading range remains 400-600 OAS, with better valuations somewhat offset by turmoil in the banking sector. We retain our 3% default rate forecast. Credit is attractive over the long term, but the macro forecast continues to suggest near-term headwinds.

Technicals Inflows in the week ended 11 April totaled $3.8 billion, a slight reduction in the year-to-date (YTD) outflows, which now total $12.4 billion (with a four-week average of $173 million). Month-to-date (MTD) issuance at 11 April stands at $10.6 billion and brings the YTD total to $51.1 billion, which is in line with the $50.8 billion issued during YTD 2022. Supply has picked up, but outflows plus calls, tenders, maturities, and coupons remain light, resulting in stable technicals despite market volatility. (Technicals based on JP Morgan Securities data as of 11 April 2023.)

Investment Grade Credit

US Dollar Investment Grade Credit

Dana Burns, Portfolio Manager, US Dollar Investment Grade Fixed Income

Fundamentals While fundamentals have peaked, they remain strong. We see the current regional bank stress as contained. Aggressive central bank activity has increased the possibility of a more meaningful economic downturn.

Valuations After the recent backup in spreads, select credits look attractive. However, market appetite for credit will be tested in the primary and secondary markets over the coming weeks coming out of the earnings period.

Technicals The technical backdrop has softened with decreased foreign demand due to high hedging costs. At present, the primary market has cooled significantly in response to issues with select regional banks and earnings season.

Non-US-Dollar Investment Grade Credit

Roberto Coronado, Portfolio Manager, Non-US-Dollar Investment Grade Credit

Fundamentals Neutral. Companies in general continue to beat expectations, and net leverage is slightly below 2020 levels, so balance sheets remain in good shape. We will monitor how inflation affects the bottom line.

Valuations Neutral. Credit spreads are materially tighter from the end of September 2022, but we could now see a move wider again due to recent concerns in the banking sector. Our view that the index will trade in a tight range in the coming months is being tested right now.

Technicals Positive to neutral. The market saw outflows for the first time in five months due to the bank concerns. However, supply also decreased due to the volatility in the banking sector. We expect inflows to return in the second quarter but see a busier primary market as well.

Emerging Markets

Sovereigns

Anders Faergemann, Portfolio Manager, Emerging Markets Fixed Income

Fundamentals Emerging markets (EMs) excluding China will likely see slower growth this year – but given well-maintained fiscal balances, debt-to-GDP ratios will be unaffected, as the link between growth and debt ratios has weakened since before 2020. And compared to developed markets (DM), EM growth differentials will widen sharply. Where a strong terms-of-trade shock led to foreign exchange reserve drawdowns last year, this will reverse or has already done so this year, assisted by still-robust metals prices and softer imports. Asia remains the strongest region, and the rating upgrade/downgrade trend was positive for EM in the first quarter. Market access remains one of the key issues this year for high yield (HY) credits.

Valuations HY spreads have remained sticky after the March selloff, propped up by the fall in US Treasury yields. The EM BB bucket continues to screen favorably versus US counterparts. HY spreads remain at their November 2022 highs, at 900 bps, but still about 100 bps narrower than their October wides. Investment grade (IG) has continued to grind tighter, taking total index spreads to 487 bps (up 40 bps YTD). (Source: JP Morgan as of 11 April 2023.)

Technicals We see a more neutral picture. Net issuance will be negative in 2023 again, but redemptions were frontloaded in March and April this year – leading to a surge of issuance in January. We do not expect this to continue, and believe net issuance will turn negative in April. Inflows are now negative YTD, but still positive last month. We expect this to turn with the US dollar on a weaker footing and EM/DM growth differentials widening.

Corporates

Luke Codrington, Corporate Portfolio Manager, Emerging Markets

Fundamentals Our HY outlook has improved, reflecting the current fundamental outlook. Looking at our Credit Trend (CT) distribution, IG remains unchanged, but the HY distribution is now positively skewed (17% Positive versus 11% Negative), mainly driven by Asia, where positive CTs rose by 11% to 30% and negative CTs dropped to 16%. Furthermore, the latest earnings results came out better than our expectations (17% beat versus 11% missed). LatAm had an equal split between beats and misses, but we saw a positive skew in Asia (19% versus 7%) and Central and Eastern Europe, the Middle East, and Africa (CEEMEA), at 8% versus 4%.

Valuations Over the last month, the CEMBI BD spread to worst (STW) widened 42 bps to 343 bps, with HY (+81 bps) underperforming IG (+22 bps). In IG, the widening was across all regions, and BBBs underperformed the higher rating buckets; however, in HY, Asia (+ 108 bps) continued to underperform against other regions, driven mostly by the Chinese property sector. The EM corporate indices widened against DM over the last month, IG by 15 bps and HY by 34 bps. YTD EM corporate BBBs have widened 30 bps versus US BBBs and 23 bps versus sovereign BBBs; EM corporate BBs have widened versus US BBs by 55 bps and sovereign BBs by 26 bps. We think current spreads look attractive versus sovereigns and DMs given the fundamental and technical backdrop, as our positive outlook revisions reflect. (Valuations and technicals, below, based on JP Morgan data for the CEMBI Broad Diversified Index as of 10 April 2023.)

Technicals March supply totaled $17.5 billion, which marked the lowest volume for the month since 2010, excepting 2020. YTD supply stands at $76 billion, which is down 25% year-over-year (YOY) and is at its lowest run rate since 2016 ($50 billion). Net financing in March was down $31 billion due to limited supply and robust cash flows of $48 billion, bringing YTD net financing to negative $40 billion. We don’t expect this month’s supply to exceed the average for April ($44 billion), or the negative net financing trend to continue, with scheduled cash flows of $36 billion. We believe the technical picture remains strong given the limited expected issuance and scheduled cash inflows, combined with expected inflows into the asset class over the longer term.

Securitized Products

Andrew Budres, Portfolio Manager, Securitized Products

Fundamentals Technicals have trumped fundamentals currently as banking turmoil has directly impacted mortgage-backed securities (MBS) valuations. Interest rate volatility, ironically, is off considerably from its peaks, but the model-driven approach to examining MBS is in the back seat right now.

Valuations MBS spreads are clearly in the “cheap” category again: They are in the 99th percentile for wideness versus IG corporate bonds.

Technicals Technicals are now the number one issue facing MBS investors. From the FDIC-seized portfolios, to the reorganizing of bank balance sheets, the outlook on supply (selling) is murky.

Non-US-Dollar Currency

Dmitri Savin, Portfolio Manager, Portfolio and Risk Strategist, Emerging Markets Fixed Income

Fundamentals We have been surprised by the ECB’s willingness to be viewed as an inflation fighter and its desire to tighten monetary policy beyond market expectations. The ECB is likely to remain more aggressive than the Fed in tightening monetary policy in the first half and may be slower in reversing/easing, as the monetary policy lag in the eurozone tends to be longer than in the UK and the US. In Japan, new Bank of Japan (BOJ) governor Kazuo Ueda has signaled that yield curve control will continue, for now.

Valuations Rate differentials remain key for currencies. Since the epicenter of the recent financial instability was in the US, and the US dollar’s status as equity volatility hedge has been eroded, the euro may turn out to be the winner from the regional bank turmoil. We have moved our 12-month EUR/USD to 1.10 and maintain our 12-month forecast for USD/JPY at 132.5.

Technicals Concerns about the US economic outlook after several weaker data points last week resulted in a modest reduction in US dollar shorts. US dollar positioning is now net short 20% of the total foreign exchange options outstanding.