Good Yield Hunting: Risks and Opportunities in Global Fixed Income Q1 2021

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  • 40 mins 57 secs
Pilar Gomez-Bravo, CFA, Director of Fixed Income - Europe and David Cole, CFA, Fixed Income Portfolio Manager discuss the landscape of Fixed Income in Q1 2021.

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MFS Investment Management

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Linda Nockler:

Hi everyone. I'm Linda Nockler from the Investment Solutions Group. I'd like to welcome you to this presentation on the key macro and market dynamics in global fixed income at present. Our intention is to provide a brief overview of the fixed income sectors covered in the quarterly insights guide, which also reflects our fixed-income capabilities. With so much happening in the world, we know clients are eager to hear our perspectives on the macro environment, as well as the rates in credit markets. The fixed income IPM is presenting today are Rob Hall, Mike Adams, Katrina Uzon and Owen Murfin. Rob will kick off with a discussion of the key macro themes, including the recovering growth and the numerous challenges and uncertainties related to the outlook for the global economy. Following the macro segment, we'll review global credit, structured debt, munis, EMD, and lastly comment on asset allocation by examining relative value across the global fixed income universe. I'll hand over to Rob now.

Rob Hall:

Well, thanks very much Linda. The global economy is clearly now in recovery and the wall of money from monetary and fiscal stimulus that we talked about last quarter is still a key support to that recovery. Central banks are committed to keeping monetary policy very easy and they won't risk the recovery by tightening too soon. The global outlook for more fiscal stimulus is a little less certain, but at least in the United States, the political climate should mean that there's more on the way. What's really changed over the last quarter is that the wall of money has been joined by the powerful, additional catalyst of vaccine roll-outs. We've included a slide in this quarter's presentation that illustrates the number and timing of vaccines becoming available. And we're suggesting that this offers a roadmap for recovery. And as a result, the expectation is that economic activity will be fairly strong in the year ahead, and that it should gain momentum as the year progresses.

Rob Hall:

Now that said, there are still a number of COVID related challenges to growth. The admittedly milder lockdowns that have accompanied the more recent waves of the virus has still dampened the path of recovery. The emergence of new virus strains could limit the efficacy of the vaccines being introduced. And it's unknown when the speed of vaccine distribution will catch up with official plans. One thing to keep in mind here is that the market is currently priced for perfect execution on vaccines. The potential obstacles to reaching herd immunity sometime in the not too distant future are generally not reflected in asset valuations. It's also important to note that this remains a very uneven recovery. It's uneven geographically with China and other parts of Asia clearly with a better footing than either Europe or the US and it's also uneven across economic sectors. With the recovery and services lagging recovery and manufacturing. This relationship is illustrated in a slide in the presentation showing personal consumption expenditures, as well as where consumers are using their credit cards and where they're not.

Rob Hall:

Now, it's not uncommon for us to get questions from investors worrying about whether this wall of money is going to drive inflation higher. And our answer to that question would be, "Not yet but don't ignore the risk of higher inflation sometime on the horizon". Inflation doesn't tend to get much traction when an economy is working off an output gap. And while the output gap created by this recession doesn't seem likely to be as large as that left behind by the global financial crisis, it will still be substantial and that should keep inflation at bay in the year ahead and perhaps beyond that. But there is a risk that all the liquidity created by the stimulus could eventually become inflationary. And that's part of the reason why inflation breakevens have been rising. Inflation breakevens, as you may know, are that portion of sovereign yields that compensates investors for expected inflation.

Rob Hall:

And they're rising faster in the US than elsewhere, partly because they're also being driven by the uncertainty created by the Fed's recent move to average inflation targeting, which means that they now have a higher tolerance for inflation above the 2% target. The term I'm hearing in our team meetings to describe the new policy regime is that it's a game changer for how to think about breakeven inflation in the US. Inflation compensation is part of what's baked into interest rates, but what's the bigger picture? The market is not pricing in any expectation of a move in the Fed funds rate for a long time to come. So the one place where we are seeing upward pressure on US rates is in longer maturity bonds. And that rise in rates at the long end of the curve is what we would refer to as a bear steepener and it looks like that steepening isn't over yet.

Rob Hall:

Again, it's inflationary expectations that are leading the push higher in rates. Real yields are still very low, solidly negative in fact. And that's important to keep in monetary conditions accommodative and in supporting debt sustainability over the longer term. I'll add here that we think it's important to think globally when thinking about interest rate and currency exposure and portfolios. And there are a number of relatively attractive opportunities outside the US. In fact, on the currency side we're expecting the dollar could weaken further versus a range of currencies given better growth elsewhere, and the relative aggressiveness of monetary and fiscal policy in the US. Let's turn our attention now from rates and currencies to spreads, as I turn things over to Mike Adams to update you on global credit. Mike, over to you.

Michael Adams:

Thanks, Rob. And hi everyone. I'll talk about investment grade and high yield corporates in this section. And in both of those asset classes, indications of stress decreased considerably through the second half of 2020 and on into the start of the new year. Recall that through the middle part of 2020, companies had taken on significant amounts of debt to build liquidity to make up for cash flow shortfalls resulting from the lockdowns. Our concern was that the economy may not rebound quickly or strongly enough to allow companies to service and to begin to pay down elevated debt levels resulting in a re-acceleration of downgrades. A better than expected economy and the ability of companies to adapt have been supportive of fundamentals and indications of stress reflect the more positive state.

Michael Adams:

In this chart, we show ratings actions for investment grade companies over periods of past crises. The period of 2020 shows a rapid downward adjustment, but then stability. The re-acceleration and downgrades has not happened. Similarly, in high yield, the distressed ratio can be looked at as a measure of stress applied by the market. And on this chart, the distress ratio in the blue line has fallen sharply and to low levels indicating the market does not have broad based concerns about the high yield market. Distress ratios tend to front run movements and defaults. So we should expect to see high yield default rates follow levels of distressed lower over the coming quarters.

Michael Adams:

So what has driven these benign views of corporate credit risk? One reason is it appears the deterioration of fundamentals has peaked. Leverage is starting to decrease. Levels of cash are still high, and companies are in general undertaking bond holder friendly actions. The vast majority of bond proceeds are going to refinancing, recapitalization and general corporate purposes while use for M&A is at a multi-year low. Maturities have also been pushed out. The average tenor of new issues was 12.6 years in 2020. Up from the previous record of 11.8 years in 2019. We would caution, however, that overall levels of debt are still extraordinarily high and continued economic improvement is necessary to avoid another wave of downgrades or defaults.

Michael Adams:

In addition to positive fundamentals, I should mention the powerful technicals that also underpin current valuations. Net new issue supply will be down likely around 50% this year versus 2020. And central banks, notably the ECB remain active pushing investors into yieldier parts of the market and supporting an ongoing bid for corporate credit. A lot of this better outlook is reflected in valuations. This should be a market that strongly favors selection rather than beta positioning. As we look at investment grade spreads distributed into ranges comparing year end 2020 to pre COVID levels, you can see that spreads ended the year about where they started. However, in breaking down the highest spread bucket into its industry components, we find areas in consumer cyclicals and in financials that may have been temporarily slowed by the pandemic but have a healthy, longer term prospects.

Michael Adams:

So to summarize the market is looking through some near term challenges and anticipating ongoing improvement in fundamentals coupled with supportive technicals and valuations largely reflect the positive view. Still, there are pockets of value where businesses with solid long-term prospects continue to offer opportunity. I'll turn it back over to Rob to talk about structured.

Rob Hall:

Well thanks Mike. Similar to the story for most other segments of the spread markets, spreads of ABS, CMBS, CLOs and agency MBS continued to compress into the last quarter of last year. And as a result, we're entering 2021 with spreads across most of structured debt trading at or through where we started last year. The massive valuation opportunity that opened up last March has closed. And it's largely the consequence of strong technicals driven by solid demand and limited supply. So in terms of positioning, we're still focused on staying near the top of the payment waterfall in the highest quality tranches where credit support is strong. But we're also paying very close attention to the composition of underlying collateral pools. We still like structured debt and we view it as a dependable source of high quality cash flows for portfolios but we acknowledge that there's a mix of good news and bad news from a fundamental perspective as we look across the sector very broadly.

Rob Hall:

So let's take a look at an example of each and we'll start with asset backed securities that are backed by consumer receivables, like credit cards. So far, the story since the beginning of the pandemic has been pretty favorable. Despite the big increase in unemployment, there really hasn't been any notable increase in delinquencies, even for subprime borrowers. The fiscal stimulus has been doing its job. It's been keeping consumers afloat, but it's also worth noting that the US consumer entered the 2020 recession, much better positioned than in 2007. Both from a leverage and a debt service coverage perspective. And this has resulted in far better consumer loan performance than during the global financial crisis.

Rob Hall:

But turning our attention to the CMBS sector. You may recall that in last quarters video, we looked at commercial real estate delinquencies by property type. Noting that delinquencies were rising markedly in COVID exposed sectors like retail and hotel, while other property types were holding up very well. And those delinquencies are now starting to flow through to rise in foreclosures. And that's what we're highlighting in a new chart that we've added to the insights guide. This is still a story that's in its early days, but it signals that the owners of at least some hotel and retail properties have decided that their equity is gone and they're handing back the keys to the lenders. The situation's been exacerbated by new loan originations for hotel and retail properties that are significantly lower since March of last year.

Rob Hall:

So what's the takeaway here? With less financing available to would be buyers, valuations of distressed properties are poised to take a significant hit. And we think the magnitude in some cases could surprise the market. And that's the message that the structured team has been sharing with our colleagues on the other investment teams across the firm, especially the financial services team. Because fire sale prices on foreclosed hotels and malls could wind up having a negative impact on banks and REITs balance sheets. And this is a great example of collaboration across investment teams at MFS. It really underscores the importance of truly understanding the fundamentals of what you own. Let's go back to Mike now for his thoughts on the state of the muni market.

Michael Adams:

Thanks Rob, as we've talked about in recent updates, the rally and municipal bonds has lagged that of corporate credit. Munis had received less generous levels of policy support and the timing of assistance took longer compared to the corporate market. However, fundamental improvement and the Democrats taking control of the Senate in January fueled a strong rally and munis through year end and into January 2021. This chart shows the relationship of upgrades to downgrades in the municipal bond market. Downgrades peaked in the second quarter and the relationship improved somewhat in the third quarter. The improvement captures municipal fundamentals avoiding worst case projections and tax revenues coming in at levels much better than anticipated. We would caution [offer 00:15:36] that stresses remain over the near term and ultimate recovery will be based on a continuation towards a normalization of the economy.

Michael Adams:

We still see value in munis, particularly in the crossover quality tiers. This chart shows muni yields, less investment grade muni yields. High-yield munis had sold off dramatically more than investment grade and have offered good value since April last year. The relationship is at a longer term average, however, still well off pre COVID levels. Some constituent changes in the high yield index before 2018 likely make the more recent three-year period, a better comparison. So we think there's still some room for compression of high yield towards investment grade in 2021. At the sector level, some dispersion remains and we continue to see opportunity in sectors like hospitals that were temporarily impacted by COVID but with favorable secular outlooks. Turning into technicals, and again like in corporates, issuance from munis will be down substantially in 2021 versus 2020. And inflows into the asset class last year were among the highest in history. Supply overall will be down year over year, but mainly lower in the tax exempt space.

Michael Adams:

The taxable muni supply will stay elevated at around $180 billion this year. Taking a look at this chart on the left-hand side of the page, you can see how taxable muni issuance has taken a meaningful share of overall muni issuance in 2020. Expect similar in 2021. As I think you all know taxable munis offer compelling opportunity for non US investors, a yield and a quality advantage over corporates. And on the right side of the page, as global high-quality sovereign yields have fallen, non US institutions have become larger holders of the asset class. We think taxable munis, with this heavier supply, high quality and relative yield advantage are among the more compelling opportunities in global fixed income. And Owen will take a deeper look at this in the asset allocation. But for now, let me turn it over to Katrina to talk about emerging markets.

Katrina Uzon:

Our outlook for emerging markets is reasonably favorable. Emerging markets finished the year on a very strong note, driven by the improvement in a number of external risk factors. The Fed and ECB continue to be very supportive, the passing of the EU budget and the recovery fund, agreement of the Brexit. And then finally the stimulus that was approved in the US. However, we expect the emerging markets recovery, particularly that of the high yield economies to potentially be less robust than a developed market recovery in 2021. Partially because we expect a delayed period for vaccinations compared to developed markets. And less fiscal and monetary space to continue to ease their policies. If you look at the pre-orders of COVID-19 vaccines across both developed markets and emerging market countries on this chart, you can see developed markets pre-orders far exceed population size in many of the major developed economies, but significantly lagged some of the densely populated emerging market economies.

Katrina Uzon:

We do think emerging market answered this crisis in a relatively well fundamental standing and what are able to respond with large fiscal stimulus. We see on this chart on the x-axis, significant deterioration in fiscal balances over the year in the emerging markets, and even more so on the developed market side. As a result, government debt to GDP, which is on the y-axis rose across both asset classes. It will be important to see how the governments will handle the fiscal adjustment that is needed in order to level off and eventually bring down the debt to GDP level. So country differentiation continues to play a large role. The good thing for emerging markets is that the basic balance is in surplus. So the majority of emerging market economies are not dependent on external financing in order to support their growth.

Katrina Uzon:

If you look at the short term as a percent of their currency reserves, it's also very manageable and that's providing a very good financial buffer to emerging markets. Valuations have tightened in, but remain fair to cheap to USIG and US high yield. And that drove significant inflows into the asset class. We finished 2020 on a very strong note with over $20 billion of inflows from investors searching for yield, which you can see on this chart. So the demand has been strong starting around July last year, but so has been the supply. 2020 setting new annual record and issuance driven primarily by investment grade sovereigns. While, the current investment environment is very conducive to risk assets generally, we believe the majority of good news on the investment grade part of emerging markets have largely been priced in. As a result, we've reduced exposure in a number of investment grade countries with negative idiosyncratic developments like Chile and Peru, for example, where frustrations around the lack of social services and income on the quality have caused a lot of volatility in bond prices.

Katrina Uzon:

We've reduced exposure in China and Russia that faced heightened sanctions risk. We've also reduced exposure to a number of investment grade countries where the fundamentals are decent, but where valuations from our perspective no longer compensate us for the risk factors like Qatar and Indonesia, for example. Instead, we added exposure to riskier assets with positive idiosyncratic developments and where we do think we're being compensated for the risks like Kenya and Ivory Coast. We have also been adding exposure to emerging market currencies based on attractive valuations and weak dollar. One of our larger currency adds was in Turkish lira, for example, following the recent change of the economic team. That offers a perspective change from misguided and unsustainable policies to a more orthodox approach that is focused on macro stability.

Owen Murfin:

Thanks Katrina. And so finally then taking all of these themes collectively, I wanted to explain how we're applying them specifically in asset allocation across our portfolios. So maybe starting then with develop market, so corporate debt. So we've talked about how the rally can be justified through things like the vaccine discoveries and the very strong technicals that Mike alluded to. But at this point we feel there's very limited [inaudible 00:22:53] for further directional spread rallies. And in fact, if we look at this chart here, you can see we're entering the year with spreads around a hundred basis points. Not only is that considerably tighter than the wides of 2020, it's also way through where you'd expect it to be for recessionary levels as well as the 20 year average. And what is also concerning us is that breakevens are statistically very low. So breakevens effectively are how much spreads or yields can widen over a 12 month period before you eradicate the carry from that particular asset class.

Owen Murfin:

But the fact that these are so low means the total returns will definitely be diminished relative to 2020. And we could even have periods of negative total returns in credit products, and this could deter retail enthusiasm particularly compared to the previous year. So we really have no strong directional beta view on corporate bond spreads. Preferring, as Mike said to focus on dispersion within the asset class security selection. We're very happy to buy cyclical sectors where we paid for that cyclicality, but we're looking to avoid very low quality bonds or those sectors like high yield energy, which are structurally challenged.

Owen Murfin:

So as we actually have a less enthusiastic view to these uninspiring valuations in corporates, we're also then looking for other high quality alternatives to get income from. And Rob mentioned some interest in areas and structured product, but I also just wanted to highlight what Mike was mentioned in terms of taxable municipals. So if we look at this following chart, what this shows is the yield relationship between taxable munis and the various investment grade credit markets. On the right-hand side, that looks at the recent history and you can see that during the COVID crisis, the heart of it, US corporate yields were actually higher than taxable munis. But the subsequent rally has now meant yields away underneath that of taxable munis. So the valuations in taxable munis do look attractive here, and that's not the only thing in their favor. Mike talked about how the Democrat victory is very favorable for the asset class, but [inaudible 00:25:09] also lower FX hedging costs should improve the attractiveness of the asset class to non US institutional investors.

Owen Murfin:

Another area they wanted to focus on was the periphery. And on the following slide, we show the longterm rally and spreads in periphery governments relative to Germany. Now, this has been a key source of alpha for many of our portfolios. Not just in 2020, but even before that. We've had a good call on peripheries. But despite the unwavering support of the ECB and ongoing extension in the pandemic emergency purchase program, it's hard to argue that valuations are nothing but really quite expensive now. And there's been a lot of publicity recently, how more risky periphery markets such as Portugal now have negative yields in ten-year maturities. So we really see peripheries now as a source of potentially funds in the future and are looking to take profits. We're also looking for remove some of the more illiquid periphery countries, such as Cyprus in favor of other countries, such as Italy.

Owen Murfin:

Now, as we look to take down risk in corporate bonds and periphery, that naturally leads us with some ability to look for other sectors. And we feel that one of the major beneficiaries of these flows will be towards the emerging markets. And the following chart shows that there is still a compelling pickup in terms of yield from moving between US investment grade and hard currency EM. If you strip out the Gulf countries and Venezuela, this pickup is just under 300 basis points. So we feel that this is pretty generous. Now Katrina has highlighted some of the challenges to BM, but we certainly feel that the risks have been reduced, particularly post the US election.

Owen Murfin:

And then finally, when it comes to EMFX, we like to look at this as a separate asset class. And what this chart here shows is despite the recent rally in EMFX, it has really had a fairly poor run. And it's hard to argue that EMFX valuations are expensive, particularly given the poor run they've had over many years. They've also lagged a rally and other risky parts of fixed income. So we do like the idea, as Katrina said of taking a basket of EM currencies, particularly against the dollar. So some examples could be for instance, the [engine repair 00:27:40] or the Turkish lira. So with that, I'll hand back to Linda to conclude.

Linda Nockler:

To close, I'd like to summarize a few of the key points made today. Firstly, on growth. The prognosis for growth is positive in 2021, but we need to be cognizant of the challenges, including the potential for longer-term economic scarring and the risks associated with achieving herd immunity. Secondly, the markets are priced for perfection, propped up by very significant fiscal and monetary stimulus. Will this Goldilocks scenario continue is the question? Thirdly, there will be winners and losers. Growth is uneven. Recovery and goods is likely to remain more robust than the rebound in services as social distancing persists. Certain industries are poised to out perform while others struggle. Active security selection allows managers like ourselves to select potential winners and generate alpha. More important than ever in the low for longer world we live in. Finally, I'd like to thank the IPMs who participated in this discussion. Please reach out to them with questions or meeting requests. Rob, Mike, Katrina and Owen, thank you very much for your insights and engagement with the field.