Fixed Income Investment Outlook 2Q19 - NEUBERGER BERMAN
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NEUBERGER BERMAN
Fixed Income Investment Outlook 2Q19
Longer Runway for a Soft Landing
Although we can never be sure what might lurk around the next corner, there are times when the path ahead seems
more or less visible. After a first quarter characterized by a healthy global consumer economy, accommodative central
bank policy, seeming progress on trade negotiations and a return of risk appetite, the outlook for the coming quarter
seems much more stable. The soft landing we’d been expecting has developed, and we expect it to continue.2 FIXED INCOME INVESTMENT OUTLOOK 2Q2019
ABOUT THE
FIXED INCOME INVESTMENT
STRATEGY COMMITTEE
The Neuberger Berman Fixed Income Investment Strategy Committee consists of 18 of our
most senior investment professionals who meet monthly to share views on their respective
sectors to inform the asset allocation decisions made for our multi-sector strategies. The group
covers the full range of fixed income combining deep investment knowledge with an average
of 26 years of experience.
COMMITTEE MEMBERS
Brad Tank Terrence J. Glomski
Chief Investment Officer and Global Head Senior Portfolio Manager – Residential Real Estate
of Fixed Income Finance Strategies
Ashok K. Bhatia, CFA Ugo Lancioni
Deputy Chief Investment Officer – Fixed Income Head of Global Currency
Thanos Bardas, PhD Thomas J. Marthaler, CFA
Co-Head of Global Investment Grade Fixed Income Senior Portfolio Manager – Multi-Sector Fixed Income
David Brown, CFA Thomas P. O’Reilly, CFA
Co-Head of Global Investment Grade Fixed Income Global Head of Non-Investment Grade Credit
Patrick Barbe Gorky Urquieta
Senior Portfolio Manager – European Investment Grade Co-Head of Emerging Markets Fixed Income
Jon Jonsson Rob Drijkoningen
Senior Portfolio Manager – Global Fixed Income Co-Head of Emerging Markets Fixed Income
Julian Marks, CFA James L. Iselin
Senior Portfolio Manager – Global Investment Grade Credit Head of Municipal Fixed Income
Thomas A. Sontag Jason Pratt
Head of Global Securitized and Structured Products Head of Insurance Fixed Income
Dmitry Gasinsky
Head of Residential Real Estate Finance Strategies2Q2019 FIXED INCOME INVESTMENT OUTLOOK 1
Longer Runway for a Soft Landing
Last quarter, we laid out our “soft landing” thesis, forecasting that economic growth would slow without triggering a
recession. This core thesis is intact and strengthening based on underlying growth dynamics and transitions in central
bank policy. Specifically, the cycle’s extension and durability derives from the strength of the U.S. economy—especially the
consumer economy—and the prospect of trade policy stabilization, which can also help steady other developed and emerging
economies. Policy clarity is improving not just at the Fed, but also at central banks in Europe, Japan and China. At the same
time, growth dynamics in China and emerging markets also point to continued low but moderate and stable growth.
From an investment perspective, this state of affairs supports a U.S. Economy Fuels Extension of the Global Cycle
preference for credit markets and an appetite for moderate risk. Over the past couple of years, it has been a common assumption
Continued confidence in the global economic cycle gives us conviction that the U.S. economy is in the late-stage business cycle, with many
to be opportunistic when the market temporarily veers off course and investors focused on the timing of the next recession. Investors were
to recognize changes in valuations due primarily to technical factors. rightly concerned; the current expansionary business cycle, which
Following opportunistic purchases during the December market began in June 2009 and is in its 117th month, will no doubt surpass
volatility, a robust subsequent rally made it possible to rebalance the longest such cycle on record of 120 months (March 1991 to March
holdings and reduce exposures in certain sectors (global investment 2001). In what could be good news for fixed income risk assets, a more
grade, emerging markets and municipal bonds) where some returns dovish Fed and, perhaps surprisingly, the U.S. – China trade war mean
seemed front-loaded. that the expansionary phase of the U.S. business cycle could last longer
than previously anticipated.
As we look ahead, we perceive that elevated and, by now, well-known
concerns around bank loans and BBB-rated debt may be overstated According to the National Bureau of Economic Research, the U.S. has
over the short to intermediate term, making these assets an interesting gone through 11 business cycles since 1945, and the duration of the
place to prospect for risk and yield. We further suspect that the benign average business cycle from trough to peak is about 58 months. Given
environment for central bank policy-making won’t last throughout the current cycle has now lasted double the average, investors appear
2019, and we will continue to see pockets of volatility in the markets. concerned that this expansion could end soon.2 FIXED INCOME INVESTMENT OUTLOOK 2Q2019
Still, despite the deceleration of growth in the second half of 2018, the Signs of Bottoming in the U.S. Housing Market
U.S. economy continues to expand at or close to trends. We expect the While housing starts have missed expectations for over a year, we are
economy to maintain growth around 2% based on: seeing some reasons for optimism into the spring:
• Continued strength in the U.S. labor market • Affordability: Following multiple years of mid- to high-single-
• Signsof bottoming in the U.S. housing market digit price increases, housing still remains affordable by historical
• A more patient Fed measures, with affordability essentially in line with the period of
2001 – 2003. Tailwinds include recent moderation in housing price
Continued Strength in the U.S. Labor Market increases and a drop in the primary mortgage rate by about 60 basis
A tightening jobs market is supporting wages, which in turn should points from the peak.
continue to support consumer spending and help avert a deeper
economic slowdown this year. So far in 2019, the pace of U.S. wage •
Supply: The supply of for-sale homes is currently at 3.9 months of
increases has held up well. After adjusting for inflation, hourly earnings sales volume, below the levels from the relatively benign period of
increased 1.9% year-over-year in February, their strongest gains since 1999 – 2004.
2015. Wage gains are most apparent in the service sectors, connoting
•
Demand: Over the intermediate term, we believe there is strong
resilience in the cyclical economy.
pent-up demand for housing as roughly 32% of all 18- to 34-year-
A softer-than-expected February jobs report, however, paired with poor olds are still living with their parents. If the number of people per
retail sales and soft inflation, have raised concerns about the durability household returns to its 2000 – 2003 average, it will require the
of jobs and wage growth. U.S. non-farm payrolls rose a seasonally formation of almost three million households.
adjusted 20,000 in February, well below expectations and the slowest
•
Builder behavior: Following the housing downturn, regulatory
pace for job growth since September 2017. Taking a step back from
month-to-month noise, on a three-month basis non-farm payrolls have changes increased the upfront fixed costs to build new homes
been notably smooth and jobless claims have not been rising. If you and inspired builders to construct larger, more expensive homes in
look at the mix of jobs being created, strength in small business hiring order to protect profitability. This created a mismatch between the
may also reflect economic momentum. supply of new homes and the demand for smaller, cheaper homes
from younger first-time homebuyers. Since the beginning of 2018,
With the jobless rate dipping at 3.8%, we believe job growth can a decline in the average median price of a new home may reflect
continue due to labor market slack, as more individuals are drawn into better positioning by builders to meet market demand.
the workforce.
Investment Upshot:
WAGE GROWTH CONTINUES IN THE U.S., ESPECIALLY IN SERVICES
Average hourly earnings, three-month average, year-over-year %
Improvement to the U.S. housing market
4.0% supports opportunities in securitized mortgage
3.5%
securities and private mortgage lending.
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
‘10 ‘11 ‘12 ‘13 ‘14 ‘15 ‘16 ‘17 ‘18 ‘19
Total Goods Producing Services
Source: Bureau of Labor Statistics, Neuberger Berman.2Q2019 FIXED INCOME INVESTMENT OUTLOOK 3
•
Regulatory demand for reserves: Regulatory changes since
NEW HOME PRICES TICKING LOWER, CLOSING GAP WITH
EXISTING HOMES 2008 have increased banks’ demand for reserves. In that context,
Median U.S. home prices new vs. existing, 2000 to present (in thousands) we estimate a balance of $1.2 – 1.5 trillion is currently desirable,
compared to the $0.5 – 1.0 trillion originally envisioned by the
$350 Federal Open Market Committee (FOMC). So far, the FOMC has
been able to control short-term rates despite the size of its balance
$300 sheet, but this demand for reserves argues for a permanently larger
balance sheet than in the past.
$250
• Crowding out risks: In the current business cycle, U.S. government
federal deficits have grown, whereas in prior cycles deficits
$200
tended to shrink as the economy grew and the cycle matured.
The combination of fiscal stimulus and tax reform by the Trump
$150
administration and Congress has almost doubled the federal deficit.
As this government debt comes to market, it risks crowding out
$100
‘01 ‘03 ‘05 ‘07 ‘09 ‘11 ‘13 ‘15 ‘17 ‘19 other asset sales, resulting in tighter financial conditions.
New Homes Median Exsisting Homes Median
In the longer run, the Fed’s balance sheet is likely to be primarily
composed of shorter-maturity Treasuries, which dominated allocation
Source: U.S. Bureau of the Census, National Association of Realtors.
pre-crisis, with less emphasis on mortgage-backed securities (MBS).
The exact target duration of the assets will be shaped by market forces
and the path of economic data. Once the balance sheet is normalized,
A Patient U.S. Federal Reserve on Policy Hikes and the the timing of the return to balance sheet growth is an open question.
Balance Sheet If future balance sheet growth aligns with the growth of currency in
The Fed has taken two steps that should provide support for the circulation, as was the case prior to 2008, then the balance sheet
U.S. (and global) economy: would surpass its 2015 peak within three to four years.
• Reiterating the decision to pause rate hikes for the time being With government bond yields falling in the first quarter, we see a
• Announcing an earlier balance sheet normalization at higher-than- disconnect between the level of real and nominal Treasury yields and
expected levels. our expected economic outlook. We suspect the coming quarters will
bring more volatility to interest rates than seen in the first quarter, and
In January, the Fed effectively announced that monetary policy will
more asymmetry toward higher yield outcomes.
be ‘on hold’ for six months, and followed that dovish message in
March with a further signal that they do not expect to hike rates at Europe Faces Political and Policy Uncertainty
all in 2019. The second half of 2018 saw a significant deterioration in eurozone
corporate confidence. This pessimism was fueled by the automobile
In addition, the Fed announced the end of balance sheet reductions
sector, under pressure from new regulation to reduce auto pollution
by September 2019. The Fed is initiating the end of balance sheet
and fears of the global tariff war, which has already impacted exports
reduction, or quantitative tightening (QT), for the following reasons:
to China. This general lack of confidence translated into a significant
•
Dampening effect of QT: Over the last year and a half, the decline in industrial production.
Fed has reduced its balance sheet by $500 billion, causing some
The European Central Bank (ECB) decided early in March to act to
adverse reactions in the market, especially during the fourth quarter
support economic activity by extending its forward guidance. Also, we
of 2018. By our estimates, $200 billion of QT over a period of four
have seen some stabilization in European data in 2019, with better
months ($50 billion per month) has had a similar counter-stimulus
data on capital expenditures and steady consumer consumption.
impact as a 25-basis-point rate hike. This form of stealth tightening
is no longer needed as the global economy continued to decelerate
during the second half of 2018.4 FIXED INCOME INVESTMENT OUTLOOK 2Q2019
Automobile Sector Decoupling from Global Economic Growth
While global macroeconomic activity is expected to remain •
Tariffs and regulatory headwinds: Additional potential
positive, global passenger vehicle volume has reached headwinds for the sector include auto tariffs and increasing
a period of stagnation. The duration and extent of this regulatory burdens. While we consider the threat of tariffs
plateau will vary by region, but the overall effect will be to be transitory and not likely to be impactful to the
slower growth in vehicle sales than economic metrics would industry for an extended period, the pressure on increased
typically imply. This is the first time the auto industry has regulations at a time of limited sales growth poses a more
faced a synchronized global downturn in its three largest durable challenge to the sector. Meeting carbon emissions
markets: U.S., E.U. and China. targets for 2020 in Europe will require significant capital
expenditures and could also result in some meaningful
After years of very low interest rates globally and high levels
fines in the short term, if new standards are not met.
of stimulus and incentives to purchase vehicles, demand for
autos appears to have peaked. Moody’s is estimating global •
Industry transformation: Finally, the industry is in the
auto sales growth of 1.2% in 2019, a slight acceleration early stages of meaningful secular changes. Alternative
from only 0.2% growth in 2018, but a steep drop-off from fuels and autonomous vehicles will require significant
the average of 3.4% growth in the two preceding years. The capital expenditures to maintain industry leadership.
industry has several challenges to overcome if it hopes to Furthermore, ride sharing and ride hailing could result in
resume growth: diminished aggregate demand for automobiles, reduced
ability to differentiate between products (commoditization),
•
China turnaround: Moody’s global estimates embed
and the potential for entire new business models such as
reasonably sanguine projections of Chinese auto sales
subscription-based revenues. These challenges represent
(up 2.0%) in 2019 after a decline (-2.0%) in 2018. The
varying degrees of urgency, but all will require automakers
predicted acceleration in Chinese auto sales, which we
to maintain strong balance sheets and financial flexibility to
have not yet seen this year, is expected to come from a
navigate the coming years.
reduction in the country’s auto purchase tax. In 2017, this
tax was increased from 5% to 10%. Automaker incentives During this period of reduced sales globally, increased
have proven insufficient to offset the impact of the tax regulatory burden and increased business risk, credit selection
and stimulate demand. While a reduction in the tax back is critical in the auto industry. Global growth alone can no
down to 5% will help, it will be challenging to reverse the longer support these credit profiles as it once did.
double-digit declines since September 2018.
Investment Upshot:
The strongest credits in the auto sector will be globally respected brands
with sufficient balance sheet capacity to support investment during a period
of secular change.2Q2019 FIXED INCOME INVESTMENT OUTLOOK 5
As highlighted in the following chart, the labor market in Europe, similar to What’s next for the ECB will depend in large part on the nomination
the United States, remains strong and supports a global soft landing thesis. of its new president after May European elections. The next leader is
unlikely to be as dovish as outgoing ECB President Mario Draghi.
MATERIAL IMPROVEMENT IN YOUTH UNEMPLOYMENT IN THE In terms of country exposure, we have started to increase our exposure
EUROZONE to Italy: we anticipate the end of the government based on a populist
Youth unemployment rate and total unemployment rate, eurozone, 2000 to present coalition since the Five Stars party has lost ground in the regional
elections.
25%
As we expect a growth stabilization and the absence of a no-deal Brexit,
we forecast higher bond yields for long maturities less supported by the
20%
ECB dovish policy. As a result, we maintain an underweight exposure
to the long-maturity bonds. The strong recent rally of core government
15% bonds appears to be overdone.
One investment area we find particularly compelling right now is
10% European bank securities, especially for subordinated bonds, for the
following reasons:
5%
‘03 ‘05 ‘07 ‘09 ‘11 ‘13 ‘15 ‘17 ‘19 Banks are relatively low risk. They have just increased their capital and
•
Unemployment Rate Under 25 Unemployment Rate
are now supervised by the ECB instead of national central banks.
Non-performing
• loans (NPLs) have been reduced to a very low level,
Source: Bloomberg.
except in Greece, although risks do remain at a few banks in Germany
(Deutsche Bank), Italy (small banks) and Greece (high NPLs).
New Stimulus and New Leadership at the European
Primary
• flows are limited by the new TLTRO, excess cash at safe
Central Bank (ECB)
banks and the ECB announcement that some banks need less
In the past, the ECB typically put policy on hold when facing new
subordinated debt.
uncertainties and took its time to understand the magnitude of the
coming challenges, such as Brexit and tariff wars. Still, with confidence
low and economic forecasts falling, the central bank decided to act in Investment Upshot:
advance to stem market pessimism. On March 7, it announced a new
targeted longer-term refinancing operation (TLTRO) that will run from
Positive outlook for European bank credit
September 2019 through March 2021, thereby providing full funding spreads, especially subordinated bonds.
through 2023. The ECB also left rates unchanged through the end of
2019 and committed to reinvest the principal payments from maturing
securities. Emerging Markets Stabilization and Recovery
We believe economic growth rates in emerging markets may have
TLTRO programs aim to foster better credit and spending by lending
bottomed and may start improving, helped by policy reactions in these
at low rates to banks. This third-generation TLTRO proposes quarterly
countries and changes in developed markets. Early leading indicators
two-year lending operations through 2021 at variable rates indexed at
reveal potential “green shoots.” With data near lows, a strong global
the key ECB rate, which is 0% today, but is subject to change at each
consumer economy suggests the slowdown will be shallow.
ECB council. The new TLTRO has another key objective: to offer a source
of long-term funding for banks that under Basel III have to reach a net
stable funding ratio (NSFR) of at least one year of funding.6 FIXED INCOME INVESTMENT OUTLOOK 2Q2019
A few factors support our view of stability to potential improvement in
emerging market growth: Recent Market Developments
Shift to high yield issuance positive for both bonds and loans
• Economic pressures: Growth in emerging markets does face
The Fed’s dovish pivot and the perceived end of the rate-hike cycle
some downward pressures. However, we view the scope of the
have led to a swing in sentiment in favor of high yield bonds,
slowdown as marginal in the context of signs of stabilization.
especially among retail investors. Stronger demand for high yield has
Cyclical indicators such as fiscal and current account balances
manifested itself in a recent surge in secured high yield issuance,
remain well behaved, with lower inflationary pressures providing
pushing a meaningful amount of non-investment grade supply from
room for monetary easing in most emerging economies.
floating-rate leveraged loans back into the high yield market.
• Credit quality: For corporate credits, leverage metrics continue
The shift in appetite among asset classes is driven by sentiment on
to improve while default rates are likely to remain below historical
leveraged loans, which began to turn negative in late 2018 on slowing
averages in 2019.
global growth data, then accelerated in January 2019 as a result of
• Trade wars: Risk of U.S. – China trade-tariff escalation eases as the Fed’s stable rate policy. Loans have predominantly been a floating
negotiations continue with no specific deadline, increasing odds rate trade, and with the Fed shifting to a more accommodative
for an agreement. But the U.S. administration’s protectionist stance stance, retail loan funds have experienced meaningful outflows: $20
remains, with the looming threat of U.S. tariffs on autos, steel and billion over the last eight weeks of 2018, followed by an additional
aluminum against the EU and Japan on national security grounds. $5.5 billion through February 2019.
•
Central bank policy repercussions: With the Fed signaling New issuance reflects these trends:
a lengthy pause in its tightening cycle and the ECB extending
•
Growth in total high yield net of refinancing: Through
its targeted lending program, financial conditions in developed
February 2019, high yield new issuance net of refinancing grew
markets have eased, which should alleviate economic headwinds in
59% year-over-year to $17.3 billion. Gross of refinancing, high
emerging markets. Furthermore, a less hawkish Fed and lower global
yield new issuance has declined 12.7% to $38.8 billion. For 2019,
trade-related tensions significantly diminish U.S. dollar appreciation
we expect both gross and net new high yield issuance to rebound
biases while diminishing drivers of depreciation of Chinese currency.
by 10 – 20%, consistent with inflows to the asset class.
• China deceleration: China growth has slowed but should
•
Surge in secured high yield: In January 2019, secured high
remain above the critical 6.0% level, according to the most
yield issuance reached $9 billion, making it the busiest month
recent government predictions. Moreover, China has responded to
since early 2016. Back then, heightened issuance of secured
slowing growth with policy-easing of its own, including RRR cuts,
high yield debt was due to a wave of distressed exchanges in the
rate reductions, more credit to small and medium businesses, and
Energy sector.
corporate VAT cuts. These easing measures have helped to support
credits within China and have moderated the expected default rate. •
Decline in leveraged loans: Overall leveraged loan issuance
has declined by 42% year-over-year to $43 billion. This is apparent
Investment Upshot: in declines in refinancing (down 90% year-over-year) and M&A-
related loan issuance (down 13% to $35 billon). Much of the
While yields and spreads in emerging market 2019 M&A financing clearly shifted to high yield, with $12 billion
sovereigns and credits have recovered from of new high yield M&A-related supply coming to market through
the end of February, 70% above the historical 10-year average for
multi-year highs, they continue to provide the first two months of the year.
attractive excess risk premia relative to
developed market credits.2Q2019 FIXED INCOME INVESTMENT OUTLOOK 7
Collateralized Loan Obligations (CLO) Snapback Potential
CLO issuance got off to a slow start in 2019 with low This substantial year-to-date lag in CLO performance—
issuance in January, which is not uncommon. Since late compared to the rally in loan prices—could soon reverse
January, however, the CLO primary market has fully come based on expectations of reduced supply for the following
back to life. Much of the CLO issuance coming to the market reasons:
year-to-date has been characterized by:
•
Narrow CLO arbitrage: The excess spread between
•
Underwater loan portfolios comprised of loans the yield on the underlying CLO loan portfolios and the
purchased prior to the loan market volatility of late 2018 cost of the debt tranches has compressed to the tightest
at prices above current market levels. level since the 2008 financial crisis. The current tight
CLO arbitrage is rendering new issue CLO equity returns
•
Creative structures aimed at tapping every pocket of
unattractive to investors. As a result, we view a meaningful
available demand for CLO AAA-rated tranches.
slowdown in CLO issuance as likely.
On the back of this supply growth and unlike other risk
•
Less refinancing: We expect a meaningful slowdown in
assets, CLO debt spreads have actually widened slightly
CLO refinancing issuance in 2019 because the refinancing
since mid-January. For instance, CLO BB-rated tranches now
option is simply not in-the-money for most CLOs that will
yield 4.4% more than BB-rated high yield debt, which is the
become eligible to refinance their debt.
widest basis in almost three years.
The projected reduction in total CLO supply due to both
challenging CLO arbitrage and a meaningful slowdown
CLO YIELDS AT THREE-YEAR HIGH RELATIVE TO in refinancing activity should provide a positive technical
HIGH YIELD DEBT backdrop for CLO debt spreads.
CLO BB-rated tranches spread premium to U.S. BB-rated high yield debt,
2014 to present (bps)
Investment Upshot:
800
Unlike other credit risk assets, CLO
700 debt spreads have not retraced most
600 of the sell-off of late 2018. Given
500
3-Year High
the current wide basis between CLO
debt and corporates, and favorable
400
supply-demand dynamics, we believe
300 CLO debt is set up well to outperform
200 in the coming months.
‘14 ‘15 ‘16 ‘17 ‘18 ‘19
Source: Wells Fargo, ICE BofAML BB U.S. High Yield Index.8 FIXED INCOME INVESTMENT OUTLOOK 2Q2019
The combination of fund flows and issuance trends have led to the
point where loan and bond yields are on top of each other. This loan U.S. LEVERAGED LOAN DEFAULT RATES LOW
U.S. leveraged loan default rate, 2014 to present
underperformance relative to high yield is something we have not
seen in a long time. As a result, some loan issuers have tapped the
bond market instead to meet their funding needs. Coupled with a
light forward loan calendar, this dynamic has led to our view that 5%
loan issuance could decline by 20 – 25% in 2019.
By Principal Amount
4%
Corporations who recently chose to issue secured or unsecured By Count of Issuers
bonds in the place of expected loan issuance include: 3%
Energy
Future/TXU
• Transdigm • Commscope $20b at default
2%
• Dun & Bradstreet • Johnson Controls Power Solutions
• ADT • Community Health
1%
Compounding retail investors’ negativity, deteriorating formation 0%
of collateralized loan obligations (CLOs) has also weighed on loan 2/14 7/14 12/14 5/15 10/15 3/16 8/16 1/17 6/17 11/17 4/18 9/18 2/19
demand. The expectation that loan and CLO supply will likely decline
this year should create technical tailwinds that could drive spreads
Source: LCD, an offering of S&P Global Market Intelligence.
tighter in the near term. Fundamentals would certainly support tighter
spreads in loans and CLO liabilities.
Self-Help and Quality Improvements Temper BBB Concerns
Since the 2008 financial crisis, the percentage of the investment
Investment Upshot:
grade credit market rated in the BBB category has steadily increased.
The technical tailwind from a much lower It now represents approximately half of the overall investment grade
supply of leveraged loans and CLOs will index. At $2.6 trillion, BBB debt is over twice the size of the entire
high yield market. A straightforward narrative, which has been the
likely lead to near-term spread-tightening focus of the financial press, highlights the possibility of fallen angel
and reversion to the mean on spreads vs. debt overwhelming the high yield market during the next downturn,
high yield. We remain constructive on both causing substantial harm to the real economy. We take a more
nuanced view:
the high yield and leveraged loan markets.
• Defensive credits: While the growth in the BBB segment of
the market is beyond question, the risk profiles for most of the
large cap BBB credits are completely different than typical highly
levered cyclical companies. Most of the incremental debt growth
in the BBB market now resides on the balance sheets of companies
that are less sensitive to the business cycle and are better able to
protect their ratings. These tend to be concentrated in defensive
sectors that will benefit from stable cash flows during periods of
economic weakness.2Q2019 FIXED INCOME INVESTMENT OUTLOOK 9
• M&A-related: Much of this growth can be attributed to large
debt-funded acquisitions by companies such as Verizon, CVS and
Anheuser-Busch InBev. This transaction-related downgrade may Investment Implications
prove transitory. In fact, AT&T and Verizon, two of the largest
BBB credits in the market, have both announced debt reduction as
Overview
a top priority over the next several years with the ultimate goal of Opportunities in Some High Yield Market Laggards
reestablishing an A credit rating. Many fixed income securities with higher yields have
underperformed the broader credit markets year-to-date. In
• Self-help: Additionally, most of the large cap BBB credits should be particular, we are constructive on high yield debt and leveraged
able to take advantage of their scale, diversification and flexibility to loans and see opportunities in BBB-rated debt. We have a
utilize multiple financial levers during periods of difficult operating positive outlook for European bank credit spreads, especially
conditions. Most important, we have recently watched several subordinated bonds. As a significant laggard, CLOs could snap
large BBB companies respond to challenging operating results with back as new issuance trends slow.
aggressive actions for the benefit of bondholders:
Positive on U.S. Mortgage Credit
– Anheuser-Busch InBev cut its dividend and continues to Improvement to affordability metrics and better matching of
consider asset sales in order to reduce its debt load. supply and demand of new homes bolsters the outlook for
securitized mortgage securities and private mortgage lending.
– General Electric slashed its dividend and announced a number
Relative value has largely shifted from the legacy distressed
of divestitures, buying time as it stabilizes core operations.
credit market to the Credit Risk Transfer (CRT) market.
– Kraft Heinz more recently announced a significant dividend cut.
Cautious on Longer-Duration Government Debt
It is also exploring asset sales in order to strengthen its balance
We prefer to be underweight exposure to long-maturity
sheet and maintain investment grade ratings. These actions clearly
government bonds in Europe and the U.S., but will monitor
benefited bondholders to the detriment of shareholders as the
the markets to take advantage of volatility, which is likely to
stock price subsequently declined by over 30%.
re-emerge as a function of expectations of central bank policy.
The increase in leverage since the financial crisis is real and we will We are also underweight the U.S. dollar and the euro.
surely see a number of fallen angels during the next downturn.
Overweight Emerging Market Debt
However, as we have recently observed, not all BBB credits are the
While yields and spreads in emerging market sovereigns and
same. A thorough understanding of each individual credit and their
credits have recovered from multiyear highs, they continue
ability to defend their ratings can uncover some great investment
to provide attractive excess risk premia relative to developed
opportunities.
market credits. We believe emerging market growth may have
bottomed and started improving, helped by policy reactions in
these countries and changes in developed markets. Early leading
indicators reveal potential “green shoots.”
Selective on Investment Grade Credit and Municipals
Following weakness in December, some parts of the credit
markets have recovered to the extent that seems to front-end
load return. We are opportunistically trimming these securities,
for example 10-year municipal bonds, which seem rich.
Certainly, some optimism is warranted as we expect some trade
policy normalization and recognize the importance of valuing
individual issues rather than asset classes.10 FIXED INCOME INVESTMENT OUTLOOK 2Q2019
Market Views
Next 12 Months UNDERWEIGHT NEUTRAL OVERWEIGHT
+ ++
GOVERNMENT BOND MARKETS VIEWS
United States
United Kingdom
Germany
France
Italy
Spain
Japan
Canada
New Zealand
Australia
U.S. TIPS
INVESTMENT GRADE SECTOR VIEWS
U.S. Agencies
U.S. Agency MBS
U.S. CMBS
U.S. ABS
U.S. Mortgage Credit
U.S. Credit
Europe Credit
U.K. Credit
Hybrid Financial Capital
Municipals
HIGH YIELD & EMERGING MARKETS VIEWS
U.S. Full-Market High Yield
U.S. Short-Duration High Yield
Pan-Euro High Yield
Floating-Rate Loans
CLO
EM Hard-Currency Sovereigns
EM Hard-Currency Corporates
EM Hard-Currency Short Duration
EM Local-Currency Sovereigns
CURRENCY VIEWS*
U.S. Dollar
Euro
Pound
Yen
Swiss Franc
Australian Dollar
Swedish Krona
Norwegian Krone
Canadian Dollar
Mexican Peso
Brazilian Real
Chinese Yuan
Russian Ruble
Turkish Lira
Views expressed herein are generally those of the Neuberger Berman Fixed Income Investment Strategy Committee and do not reflect the views of the firm as a
whole. Neuberger Berman advisors and portfolio managers may make recommendations or take positions contrary to the views expressed. Nothing herein constitutes
a prediction or projection of future events or future market behavior. Due to a variety of factors actual events or market behavior may differ significantly from any
views expressed. See additional disclosures at the end of this material which are an important part of this presentation.
*Currency views are based on spot rates, including carry.2Q2019 FIXED INCOME INVESTMENT OUTLOOK 11
Market Outlook Given the current flatness of the yield curve in the U.S. both in absolute
terms and relative to other sovereign debt, we remain modestly
We continue to see value in most credit markets and remain defensively cautious on long duration as we look for opportunities to take
positioned on interest rates. Detail on individual sectors is provided in advantage of price swings tied to expectations on monetary policy.
the table on page 10 and the text below.
U.S. TIPS: Modest Overweight
We continue to like TIPS relative to nominal Treasuries, but less so on
Global Interest Rates and Inflation an absolute basis since real yields have dropped and come closer to
U.S. Government Bonds: Modest Underweight our forecast of equilibrium fair value.
The rate of expansion in economic activity peaked during the summer
European Government Debt: Mixed
of 2018 and will likely continue to decelerate into 2019. The Institute
Adjustments to our European government debt views reflect incremental
for Supply Management (ISM) manufacturing index was at 61 in
caution on macroeconomic challenges. Over the last couple of months,
August 2018 and has since fallen to 54 while the ISM New Orders
European economies have decelerated more than previously expected
index dropped from 65 to 56.
and shown signs of an industrial recession. As a result, we have reduced
Still, despite the deceleration of growth in the second half of 2018, the our underweight exposure to longer-duration bonds.
U.S. economy continues to expand at or close to trends. We continue
In a couple of years, following a prolonged period of negative rates, we
to expect the economy to continue growing around 2%, tied to the
expect rate normalization.
following expectations:
Within Europe, we are more constructive on semi-core (France and
•
FOMC’s newly discovered patience with respect to future actions
Belgium) and the euro periphery (Ireland, Spain and Italy). EU elections
in monetary policy generates a range-bound market in rates and
in the spring could bring added volatility to European markets as a
stable expectations for monetary policy.
barometer of populist sentiment.
• Ten-year
Treasuries trade in the 2.25% – 3.25% range for the next
few quarters. In the U.K., Brexit represents an ongoing saga. Clouds of uncertainty
• The
will continue to hang over the Bank of England. We are neutral overall
yield curve steepens modestly, especially at the front end of the
toward duration in U.K, expecting a range between 1% and 1.6% over
curve.
the next 12 months.
In our view, the calibration of monetary policy for the rest of 2019
Canadian Government Debt: Modest Underweight
will involve tapering Quantitative Tightening rather than rate cuts. An
In Canada, housing is showing signs of slowing. The Bank of Canada is
extended pause in rate hikes by the Fed should eliminate the need for
more cautious overall and has relaxed its previous hiking bias. We remain
stealth tightening inherent in QT.
neutral duration despite flatness of the yield curve. We prefer to hold
Core inflation measures remain sticky since commodities and oil prices provincial debt over government bonds due to attractive spread levels.
have gravitated away from the panic levels of December 2018. The
Australian Government Debt: Neutral
Fed will likely remain on hold for 2019 as it reassesses progress on
With a slowdown in Australian inflation, real rates seem relatively high.
the inflation front and evolves its policy framework. A more structural
Uncertainty on China trade remains. Over the last six months, growth has
shift in breakeven inflation rates and repricing of term premia is also
slowed to its weakest pace since the financial crisis, culminating in the
possible in the case of average inflation targeting by the FOMC.
Reserve Bank of Australia also moving to a neutral monetary policy bias,
and the market is pricing in at least one rate cut over the next 12 months.12 FIXED INCOME INVESTMENT OUTLOOK 2Q2019
Securitized Assets Mortgage-backed Credit (MBS Credit): Modest Overweight
Strong underlying house price appreciation data and housing
U.S. Agency Mortgage-backed Securities (MBS): Neutral affordability measures continue to support the credit risk transfer
We took advantage of a temporary widening of spreads in the (CRT) market and our overweight position on MBS Credit.
fourth quarter of 2018 to increase our exposure to MBS. During
the subsequent period of significant tightening, we lightened our • CRT value: Relative value has largely shifted from the legacy
positions, moving back to a neutral position. distressed credit market to the Credit Risk Transfer (CRT) market.
•
Attention to quality: We are seeing some degradation in the
• Potential for further tightening: We think that the flatness of
the curve is keeping the banks from becoming significant buyers of collateral quality and structural quality of recently issued CRT deals,
MBS, but this could drive spreads even tighter if the curve steepens which we have largely been avoiding.
on the margin, as we expect.
• Attractive characteristics: From a money manager’s perspective,
we believe that Agency MBS are still attractive to hold in portfolios
due to their spread, liquidity, quality and currently muted prepayment
Investment Grade Credit
sensitivity. U.S. Credit: Modest Overweight
Europe Credit: Modest Overweight
Commercial Mortgage-backed Securities (CMBS): Modest
Based on the expectation in the U.S. and across developed economies for
Overweight
economic growth to slow but remain comfortably positive in aggregate,
In the fourth quarter and early in the first quarter, CMBS spreads moved
investment grade credit appears to be fairly valued at this point:
wider primarily due to new issue supply rather than fundamental
quality concerns. We used this opening to add to our CMBS exposure. • Manageable risks: This soft landing outcome will allow most
companies to continue to manage their debt profiles in an
• Selective exposure: We were particularly active in new-issue last
investment grade framework. We only expect to see significant
cash flow (LCF) bonds, as well as seasoned AA parts of the capital
downgrade risk at companies with challenged business models.
structure.
• Renewed demand: The more accommodative monetary policy
•
Less idiosyncratic risk: We continue to endorse the idea that
from global central banks should allow for better technical dynamics
CMBS has added appeal due to its low exposure to idiosyncratic
throughout credit. While demand is not expected to be as strong as
risk relative to other credit markets and its more attractive spreads
it was in 2016 and 2017, the Federal Reserve’s pause on rate hikes
relative to corporate credit.
for an extended period will encourage yield-seeking investors to
Asset-back Securities (ABS): Modest Overweight return to the credit space.
We believe ABS remain attractive relative to Treasuries, although • Steady supply: With supply continuing to generally track 2018
swap spreads have tightened fairly significantly since fourth quarter levels, appetite remains among issuers to proactively execute
widening, which caused us to reduce our overweight position. liability management transactions that extend the duration of the
credit universe. Modest M&A volumes should also help to maintain
• High-quality short duration: These assets trade off of Libor. consistent issuing patterns.
• Consumer-linked: The ABS market is supported by strengthening • Tighter spreads: While credit fundamentals should remain
consumer balance sheets. supportive and technical factors are in good shape, valuations are
now more challenging. Spreads across all currencies have been
tightening during 2019, and have generally reached levels where
the upside is more limited.2Q2019 FIXED INCOME INVESTMENT OUTLOOK 13
The biggest risks to investment grade credit today are an earlier- High Yield Credit and Leveraged Loans
than-expected return by the Fed to rate hikes, a surprise outcome in
trade policy and a worse-than-expected outcome to Brexit. We do not U.S. Full-Market High Yield: Neutral
believe any of these risks are priced into current spreads. U.S. Short-Duration High Yield: Modest Overweight
The U.S.-based high yield market returned 6.57% through the end of
February, consistent with other risk assets. (The S&P 500 rose +11.16%
over the same period.) The high yield market has benefited from:
Municipal Bonds • Dovish Fed policy
Municipals: Modest Underweight
• Positiveinflows of $10.2 billion, which partially reversed outflows of
Within the Municipal space, we favor short-term maturities, floating rate
$43.1 billion in 2018 outflows
bonds and extending long maturities from 10 to 12 years, as follows:
• Expectations for a positive outcome on U.S. – China trade
• Valuation full in parts of municipal markets: High-grade one-
to 10-year tax-exempt municipal bonds seem fairly to fully valued The last twelve-month (LTM) default rate for high yield as of February
due to strong fund flows and moderate supply growth year-to- end declined 70 bps to 1.11% when the $16 billion iHeart default
date. Moreover, the five-year and 10-year parts of the curve seem of February 2018 fell out of the calculation replaced by the $44.8
particularly rich on a historical basis. billion Windstream default in February 2019. We expect the 2019 high
yield default rate to remain near 2%, well below the historic average
• Technical support: Although 2019 supply should increase from
default rate of 3.5%.
anemic 2018 levels, the technical backdrop is favorable in light of
less market concern about rising rates and the potential for stronger Leveraged Loans: Modest Overweight
fund flows. While loans have rebounded from the fourth quarter sell-off and have
• Favorable economy: The economic backdrop is still favorable, performed well through February (up over 4%), they have lagged the
although a downshift in growth and a slowing housing market U.S. rally in high yield and equities. Still, we see some reasons to be
could create some budgetary headwinds relative to 2018. constructive on loans:
•
Investment grade opportunities: Investment grade taxable • Discipline: Retail outflows and weaker CLO demand over the last
municipal bonds offer competitive option-adjusted spreads relative three months has brought some discipline back to the loan market.
to investment grade corporates and should also benefit from strong While loan structures are hardly investor-friendly, they are becoming
technical factors. less issuer-friendly than they were during the first nine months of
2018.
• High yield stability: The backdrop for municipal high yield bonds
is favorable as a sidelined Fed should benefit carry investing and •
Relatively low defaults: According to data from Leveraged
lessen the likelihood of fund outflows due to rising rates. Commentary & Data (LCD), the default rate of the leveraged loan
index will fall to just 0.88% when two large defaults roll out of the
Currently the 10-year AAA muni-to-Treasury ratio is 77%, which is calculation in March 2019. Save no fresh defaults, that would be the
below the historical range of 80% – 100% and the lowest reading lowest rate in almost seven years.
since 2010. Our current view is that the richness in 10-year municipal
bonds is an anomaly driven by a perfect storm of factors: strong fund
flows, programmatic buying from ladder strategies, tepid new supply
and lower concern about rate risk. We would have to see this ratio
hold in the face of several straight weeks of strong new issue supply
and more rate volatility before believing that some kind of paradigm
shift has occurred.14 FIXED INCOME INVESTMENT OUTLOOK 2Q2019
Emerging Market Debt Foreign Exchange
Compensation potential remains ample both in hard currency and While labor market and inflation data remain robust across the
local currency emerging market debt given the magnitude of the major economies, other indicators of economic activity have shown
correction last year. pronounced signs of slowing. The current dynamics of economic
activity and central bank policy have led to:
Emerging Market Hard-Currency Sovereigns: Modest
Overweight •
Lower FX volatility: Implied volatility has declined to levels last
Emerging Market Hard-Currency Corporates and seen in 2014 following a dovish turn by many central banks. With
Short-Duration: Neutral uncertain medium- and long-term dynamics, FX volatility is likely to
While yields and spreads in emerging market sovereigns and credits increase going forward.
have recovered from multiyear highs, they continue to provide • Carry-seeking behavior: As estimates of future spot volatility
attractive excess risk premia relative to developed market credits:
falls, the attractiveness of currencies with higher yields tends to
•
Reversal of outflows: Partly supported by a better liquidity increase.
outlook, emerging market debt has seen a reversal of the outflows
In the event of a breakout from the current environment, exchange
that dominated in 2018. Inflows have largely targeted hard currency
rates would be the primary mechanism for restoring equilibrium, which
strategies.
could present opportunities for a relative value currency strategy.
• Technical support: In hard currency space, net new issuance in
U.S. Dollar: Modest Underweight
both sovereign and corporate credits will also likely be lower in
We are modestly underweight the U.S. dollar. The Federal Reserve
2019 than in recent years.
took a more dovish stance following recent asset-price-led tightening
• Moderating return: Our return expectations for the balance in financial conditions, which has reduced the dollar’s interest rate
of 2019 are now more moderate considering the strong market differential to other major currencies.
recovery experienced early this year.
One imminent factor is the large U.S. debt issuance due in the second
Emerging Market Local-Currency: Modest Overweight half of 2019, reflecting a large quantity of existing debt maturing and
We see value in local currency debt, as well: the need to fund recent fiscal deficits. Because the U.S. requires foreign
funding, and there is no reason to expect an increase in demand for
• Undervalued currencies: Emerging market currencies continue U.S. debt, such a large increase in supply should trigger either higher
to be largely undervalued and provide positive and above-average U.S. yields or U.S. dollar depreciation.
real yields.
Additionally, in the event of an agreement between U.S. and China on
• Technical support: Technical factors remain largely supportive trade, we would expect the U.S. dollar to reverse some of its recent
given extensive redemptions and risk reduction across emerging strength.
markets in 2018.
Euro: Modest Underweight
• News flow sensitivity: Local currency emerging market debt risks We are modestly underweight the euro. In the eurozone, the
performing better than expected if economic news improves; for Purchasing Managers’ Index (PMI), which reflects the economic
example, if China shows signs of recovery in the third quarter. health for manufacturing and service sectors, has stabilized, albeit
at low levels.
Sluggish growth in China and potential U.S. tariffs on European cars
have weighed on the external sector. Still, despite recent deceleration,
economic growth is expected to be at or above trend for 2019.2Q2019 FIXED INCOME INVESTMENT OUTLOOK 15 ECB monetary policy remains accommodative reflecting continuingly weak inflationary pressures. In the spring, European parliamentary elections and Spanish elections may again cause concerns about the stability of the eurozone. Norwegian Krone and Swedish Krona: Modest Overweight These two Nordic currencies are undervalued from a long-term fundamental perspective. Both central banks are in hiking cycles, so there is room for these currencies to appreciate significantly. This is especially true for Sweden where the evidence suggests that negative real and nominal rates have led to significant capital outflows from the country.
16 FIXED INCOME INVESTMENT OUTLOOK 2Q2019 This material is provided for informational purposes only and nothing Investments in hedge funds and private equity are speculative and involve herein constitutes investment legal accounting or tax advice or a a higher degree of risk than more traditional investments. Investments in recommendation to buy sell or hold a security. This material is general in hedge funds and private equity are intended for sophisticated investors nature and is not directed to any category of investors and should not only. Indexes are unmanaged and are not available for direct investment. be regarded as individualized a recommendation investment advice or a Past performance is no guarantee of future results. suggestion to engage in or refrain from any investment-related course The views expressed herein are those of the Neuberger Berman Fixed In- of action. Neuberger Berman is not providing this material in a fiduciary come Investment Strategy Committee. Their views do not constitute a pre- capacity and has a financial interest in the sale of its products and services. diction or projection of future events or future market behavior. This materi- Neuberger Berman as well as its employees does not provide tax or legal al may include estimates, outlooks, projections and other “forward-looking advice. You should consult your accountant tax adviser and/or attorney for statements.” Due to a variety of factors, actual events or market behavior advice concerning your particular circumstances. Information is obtained may differ significantly from any views expressed. This material is being is- from sources deemed reliable but there is no representation or warranty as sued on a limited basis through various global subsidiaries and affiliates of to its accuracy completeness or reliability. All information is current as of the Neuberger Berman Group LLC. Please visit www.nb.com/ disclosure-glob- date of this material and is subject to change without notice. Any views or al-communications for the specific entities and jurisdictional limitations opinions expressed may not reflect those of the firm as a whole. Neuberger and restrictions. The “Neuberger Berman” name and logo are registered Berman products and services may not be available in all jurisdictions or to service marks of Neuberger Berman Group LLC. all client types. Investing entails risks including possible loss of principal.
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