September 30, 2020
Fixed Income Newsletter: Quarterly Update
September 30, 2020
Fixed Income Newsletter: Quarterly Update
September 30, 2020
Markets pulled back in September as stimulus negotiations stalled while the COVID-19 outlook and election uncertainty added to concerns. For the third quarter however, economic growth rebounded, and MS Economics expects GDP to exceed pre-COVID levels as soon as Q2 2021, supporting a steeper yield curve and tighter credit spreads. We still see value in intermediate municipals and credit, and we find preferreds and high yield attractive for appropriate clients seeking higher income.
Elections Have Consequences (for Yields)
At a recent team meeting, we reflected upon the passing of Eddie Van Halen. A younger team member commented, “l googled him … guitar virtuoso … never heard of him.” I guess he never doodled “VH” on his notebook while daydreaming in grade school. When we discussed their most famous songs, we discovered they only had one #1 Billboard hit: the song “Jump” off of their “1984” album. The interesting thing about this song is that while it was written by a rock guitar God, it’s played with synthesizers and keyboards! The analog for today’s fixed income portfolio managers is that it might be the time to put down the axe and instead play piano for a little while.
In other words, the state of the economic cycle suggests appropriate fixed income investors may want to underweight duration and overweight credit. We’re partial to the view that the current set up is reminiscent of 2016, where after a growth scare (then Brexit) election results allowed for greater certainty, fiscal stimulus and higher bond yields. Today, while the “V”-shaped recovery continues, it’s notable that the 10 year Treasury ended September at 68bps, only a shade higher than March’s month end at 67bps.
For positioning, we think the tightening in credit spreads can continue and we agree with the view that the economic recovery should support a modestly steeper yield curve. However, we believe policymakers can help avoid a 2013-like “taper tantrum” scenario or even the 75bps 10 year move from 2016.
Regarding 2013, in hindsight, it was a messaging error from the Federal Reserve (Fed) where market participants extrapolated the tapering of quantitative easing into an entire rate hiking cycle, effectively bringing forward the tightening. With the Fed’s focus on financial conditions, their approach to the yield curve should be much more cautious this time around. Morgan Stanley’s Global Head of Macro Strategy, Matt Hornbach, in his weekly macro piece, “The Coiled Snake”, 10/19/20, has a year end 2020 10 year note target of .95 basis points and 2% on the 30 year for reference. 2021 targets sit at 1.20% and 2.05% for the 10 and 30 year, respectively.
The Fed has signaled short rates should remain lower for longer, but long term bond yields could move higher with growth and inflation expectations. Attractive valuations (wider credit spreads) in credit and municipals could offset the impact of rising rates in intermediate duration allocations.
The Fed’s new framework, known as average inflation targeting, coupled with a summary of economic projections (dot plot) at the lower bound through 2023, amount to the Fed jawboning the yield curve steeper. Core inflation, running under 2% currently, will be permitted to drift higher for a longer period before raising Fed Funds. However, on any disruptive move higher in Treasury rates, look for the Fed conversation to shift to Japanese-style yield curve caps, as it did over the summer according to Fed minutes, limiting the rates upside.
For all the uncertainty on stimulus and vaccine trials, economic data has improved, as evidenced by the Citi US Economic Surprise Index. The US economy should hit pre-COVID GDP levels by the second quarter of next year, according to Firm economists led by Chetan Ahya, Morgan Stanley’s Chief Economist and Global Head of Economics, in their piece, “A Sharper V”, 9/7/20. This strength should support continued recovery in credit and muni valuations, which is why we remain constructive on intermediate duration allocations as part of a diversified portfolio.
Rates can’t go much lower either. Following the weakest monthly jobs gain since the start of the recovery, the 10 year failed to rally. If media reported polls are correct, the widening lead for Biden, suggesting a lower likelihood of a contested election, may be putting some upward pressure on rates as well. For fiscal policy, increased spending is likely under either a Republican or Democratic president, although the timing may differ slightly. A Blue Sweep scenario could lead to a larger fiscal stimulus, further steepening the yield curve.
If Republicans can again defy the prognostications in this election cycle, policymakers may seize on momentum to produce a stimulus package quickly after the election. Otherwise Republicans may focus on the Supreme Court nomination at the expense of a stimulus deal ahead of the election, and may prevent a fiscal package before power changes to Democrats in January. In the meantime, any tightening in the polls, implying increased likelihood of a contested election, could offset this upward pressure in rates.
Municipals: Back to Business
With the summer months now a fading memory, we believe October and November are likely to be prime months for muni investors looking to put money to work. Although there will likely continue to be a considerable number of concerns regarding the current state of credit among COVID19-impacted issuers, the outcome of the presidential election and the size, timing and fate of any future CARES package, there are also a number of factors that we believe support municipal bond purchases at this time and through the fall.
Among these favorable factors are an already completed price roll back to pre-summer yield levels, a seasonal supply/ demand shift that favors better entry points, a steeper muni yield curve that can reward investors for venturing out (within reason), outsized relative value ratios versus USTs and, finally, the growing reality that federal tax rates for the majority of municipal bond buyers are unlikely to decline in a reelection scenario and may actually rise materially with a change of administration. Let’s examine further.
PRICE ROLL BACK: The intense rally of the summer gave back almost all of its price gains by September, went sideways (yields unchanged) for a month until weakness resumed in early October, completing a round trip that has brought yields up to pre-summer levels … so the ”V” is for return of value.
SEASONAL OPPORTUNITY: Redemptions (maturities, coupons and calls) in muni bondholder accounts throughout the street had the biggest month of the year in August and the smallest month was September,1 which we expect will be followed closely by October and November. Not surprisingly, muni mutual fund flows went negative in early October, breaking a 20-week trend of inflows. Meanwhile, historical muni issuance trends point to increased primary market supply through late-November … again, during some of the lowest redemption months of the year. Headlines in and around the presidential election could spur volatility and potentially favorable entry points.
STEEPER MUNI CURVE: “Location, location, location” While it’s no secret that short-end rates are rather low, the muni yield curve is steeper in the belly and beyond, so it potentially pays to venture out. Breaking the 30-year curve down into six individual 5-year segments, the largest yield pick-up (66 basis points) is in 5 to 10 year maturities, followed by 35 bps in the 10 to 15-year band, 21 bps in the 15 to 20-year range and 17 bps in 20 to 25-years. That said, 87% of available yield is captured in 5 through 25 year maturities along what is currently the steepest muni curve since February 2018.
RELATIVE VALUE DOES MATTER: “It’s All Relative” … and here’s why. The yield of 10-year AAA munis currently equal an outsized 125% of the yield of 10-year USTs. For context, the 40-year average is 84% and it was mid-70% range pre-COVID and during the 2010 Build America Bonds window.2 Using Morgan Stanley’s UST forecast of a 1.20% 10-year by this time next year and the current benchmark “AAA” muni yield of 0.95% and applying the long-term average relative value ratio of 84% suggesting minimal downside risk from current levels (though interim volatility may be greater). The logic is that an elevated 10-year UST yield would likely indicate a US economy substantially on the mend and impacts of COVID-19 having materially abated. Should that be the case, then the states that comprise the United States should also be on the mend, having similarly weathered the worst of the pandemic. This would further suggest that the sharply elevated relative value at hand today, should revert to the long-term average of 84% or, even lower into the mid-70% range should taxable muni issuance continue. That said, we consider todays 125% relative value ratio3 a “buffer” versus potentially rising interest rates. We remain constructive on high-quality tax-exempt munis.
Preferreds posted strong results in the third quarter, particularly in July, after Fed stress test results alleviated concerns for the financial sector and credit spreads tightened across fixed income. The broad measure of 25 par securities, P0P4, rose 5.89% in the quarter, including 4.83% in July, while investment grade $1000 par, CIPS, rose 4.38%, including 3.43% in July. The next catalyst for the sector will be third quarter results, where credit investors will closely scrutinize loan loss reserves and the outlook for provisions and the economy in general.
We remain constructive on preferreds as an asset class given valuations (wide credit spreads), which could provide some offset against rising rates. Preferreds trade with an OAS, the option adjusted spread over Treasuries, of approximately 300 basis points, or in line with historical averages, after trading as tight as 200bps in February. This rebound has lagged the move in senior spreads, which were approaching January values in late summer before some widening in September. We’re comfortable with average valuations given our fundamental views and yield opportunities elsewhere, but versus senior financial spreads, preferreds are as wide as we’ve seen in the past five years.
Year to date, high yield rated preferreds have underperformed IG ($1000 par market is about a 25/75 mix, based on HIPS and CIPS) by 6% as of 9/30, and we could see this begin to narrow, with better than expected 3Q results for regionals and consumer finance names potentially serving as a catalyst. 25 par has outperformed 1000 year to date, partially due to longer duration, and a steepening in the yield curve and/or equity weakness could begin to normalize this valuation gap, in our view.
A steeper yield curve scenario could force investors to reassess opportunities. Fixed to floating rate preferreds naturally mitigate this “extension risk” with coupons that reset after the call date off of a floating rate. Historically, most securities carried floating coupons tied to LIBOR, followed by SOFR beginning in 2019, and 5 and 10 year Treasury rates more recently. With 3m LIBOR at only 22bps and SOFR at 8bps, we’ve trimmed these securities in favor of the newer structure. Lower for longer for the Fed only makes LIBOR/ SOFR resets less attractive.
We found this summer’s new issues, based on 5 and 10 year reset, especially attractive. 5 year and 10 year CMT resets are a small part of the overall market, 25%, of CIPS, but we believe the market has been slow to assign a premium to this newer structure, which could outperform in a steepening rate environment.
Regarding the upcoming election results, qualified dividend income (QDI) could be impacted by proposed tax rate changes. QDI allows investors to pay the long term capital gains rate on dividends. A potential Biden proposal could have the same effect as eliminating QDI for most clients. In terms of market response however, we think this would more likely be negative for risky assets broadly, rather than preferreds specifically, as investors booked gains in high fliers ahead of tax changes.
We would also like to point out that QDI preferreds don’t tend to trade at “after tax parity” with non-QDI to begin with. The market is inefficient and this phenomenon is one of the factors supporting our relative value arguments versus comparable-yielding fixed income assets like high yield and loans. Our Non Resident Client preferred portfolio (non-QDI) currently carries a similar yield to worst as our $1000 preferred as another example.
Regarding corporate taxes, the financial sector pays one of the highest average rates, and on our estimate from MS research, raising the rate to 28% would lower EPS by a median 7%. Our policy team, led by Michael Zezas, thinks a 25% corporate rate is more likely, implying a 4% EPS impact to the financial sector. This could potentially impact equity valuations but less so for credit, in our view. It’s also important to note that changes are more likely part of a broader fiscal package that could stimulate growth, lowering risks for balance sheet deterioration, and potentially steepening the yield curve, both of which could more than offset the EPS impact from tax. We expect fiscal stimulus first, in January or February under a blue-sweep scenario, followed by corporate tax changes and possibly adjustments to capital gains tax as much as two years down the road, further limiting the impact to markets.
Credit spreads continued to rebound in the quarter but backed up slightly in September on stimulus concerns and COVID-19 uncertainty. Despite the rally, spreads are still off the tights of the year. We see value in BBBs relative to A and would buy the dip on a pick-up in volatility.
Attractive rates are incentivizing record investment grade supply in 2020 (up 60+% year to date) and corporations are issuing longer maturities and taking out shorter term and high coupon debt. At the short end, measured by the 1-3 year Bloomberg Barclays Corporate Index, net supply was negative in September, and we expect this recent trend in corporate activity to continue supporting the market. While the Fed remains a backstop, the pace of purchases has slowed down in recent weeks to 20m from 300m a day over the summer.
We welcomed the modest widening in credit spreads in the month, but the technical backdrop helped keep spreads contained, and for the quarter, the index produced a total return of 60bps. Historically high quality credit is more rates than credit sensitive, but with the Fed’s latest dot plot firmly at the lower bound through 2023, we believe rates duration diminishes in significance for our 1-3 year horizon. So in the context of a short corporate portfolio, duration becomes a mechanism to gear the portfolio to tightening spreads.
We maintain a small duration overweight as well as a BBB overweight in portfolios, which allows us to participate in the continued upside potential while avoiding more COVID-exposed industries. We want to make this distinction clear – Fed liquidity can lower the cost of capital but it won’t fix an insolvent business. COVID-19 has brought forward certain economic trends and the reckoning of many industries that were already in secular decline. We are proud that we avoided fallen angels in our portfolios and we don’t see the need to reach into more challenged industries with BBBs generally offering attractive relative pick up to A. Fallen angel downgrades have slowed from earlier in the year as well.
By sector, the top performer year to date in investment grade credit has been financials, followed by tech. At the other end, the energy sector has produced negative excess returns 10.31% while leisure has negative excess returns of 7.30% in the ICE BofAML U.S. Corporate Index (C0A0) Index. Financials outperformance is hardly the case in equities, which validates our view that issues for the sector are more income statement (net interest margin) than balance sheet centric (loan losses). The financials sector is built for recessions— the stress tests essentially mimic the financial crisis—and we’re comfortable maintaining this overweight, along with technology, health care and utilities. Energy is an underweight in portfolios as well as retail, leisure and hospitality.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks.
Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Municipal securities are subject to early redemption risk and sensitive to tax, legislative and political changes. Taxability Risk. Changes in tax laws or adverse determinations by the Internal Revenue Service (“IRS”) may make the income from some municipal obligations taxable. By investing in investment company securities, the portfolio is subject to the underlying risks of that investment company’s portfolio securities. In addition to the Portfolio’s fees and expenses, the Portfolio generally would bear its share of the investment company’s fees and expenses. Preferred securities are subject to interest rate risk and generally decreases in value if interest rates rise and increase in value if interest rates fall. High yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and liquidity risk.