Insights
How to Generate Returns in Today's Fixed-Income Markets
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MSIM Institute
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October 20, 2021
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How to Generate Returns in Today's Fixed-Income Markets
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October 20, 2021
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How to Generate Returns in Today's Fixed-Income Markets
How to Generate Returns in Today's Fixed-Income Markets |
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This Q&A comprises edited highlights of the above-named session with panelists John Baur, Co-Director of the Emerging Markets Team at Eaton Vance Management, Justin Bourgette, Director of Investment Strategy and Portfolio Manager on the High Yield Team at Eaton Vance Management, and Jack Cimarosa, Portfolio Manager on the High Yield Fixed Income Team at Morgan Stanley Investment Management. The panel was moderated by Katie Herr, Head of Fixed Income Product Strategy at Morgan Stanley Investment Management.
Katie Herr (moderator): Justin, following last year’s rally in credit markets, in which sectors do you see the greatest relative value opportunities globally?
Justin Bourgette: Risk premiums across almost all credit assets have compressed due to the global economic reopening, strong corporate cash flows and ultraloose monetary policy. Dispersion is extremely low, both across and within market sectors, but relative value opportunities can still be found. In terms of the core credit sectors, we favor loans over high-yield bonds. Yields are similar in both sectors, but floating-rate loans are, by design, better positioned to deliver in the event of rising rates in our opinion, which remains a distinct possibility. In most areas of high yield, valuations remain tight and we do not believe a surprise rate decline would provide significant potential for upside. That said, we do see value opportunities within select high-yield segments – specifically, in higher-rated U.S. bonds and in attractively priced European credits rated CCC and B.
Away from loans and high yield, we believe BB-rated and BBB-rated collateralized loan obligation (CLO) tranches remain compelling. CLOs, which have sustained limited losses through multiple cycles, offer an attractive liquidity premium in today’s low yield environment.
Katie: John, emerging markets comprise a large and diverse universe. Where are you seeing emerging markets debt (EMD) opportunities? For instance, are opportunities significantly different between the local- and hard-currency markets?
John Baur: Emerging markets are highly diverse, as you say, so opportunities really depend on the individual countries and sources of return, be that currencies, interest rates, sovereign or corporate spreads. There is a wide array of attractive investments across the whole of the EMD opportunity set.
That said, if we are speaking in broad terms, and addressing currencies, which investors frequently ask about, relative value is more appealing on the local side at present. With few exceptions, spreads appear tight to fair-valued in hard-currency EMD. In contrast, local currencies are trading at levels that we consider to be inexpensive compared to developed markets. Consider, too, that some EM central banks have already begun hiking rates ahead of their developed-market counterparts, which provides carry opportunities on the local-currency side.
Katie: Justin, how are you thinking about yields and current risks? Is there still room for compression or are we in more of a carry trade?
Justin: Yields can be analyzed with a simple building-blocks approach. At the base, we start with cash rates and term premiums to calculate risk-free rates (e.g., U.S. Treasury or German bund yield curves) and then add the credit spread. In doing this analysis, it’s clear that global risk-free rates remain very low today across the board. Among other things, that could reflect ultraloose monetary policy, demographic changes, secular stagnation or some combination thereof. For the income markets where we invest, we view low base rates as a risk; more precisely, we do not believe that compensation is adequate for today’s worsening inflation outlook.
Looking at credit spreads, we consider credit risk premiums to be fair to slightly expensive for this point in the cycle and for the given levels of market risks. Thus, while compensation for taking credit risk is available, on balance, we believe it will be more of a carry trade going forward.
Katie: Jack, do you agree? Are compression opportunities harder to find in high yield?
Jack Cimarosa: Yes, to a degree. As Justin points out, beta-driven returns appear behind us. Therefore, opportunities rely more on relative value and idiosyncratic bond and sector positioning. An example would be corporate M&A. Deal flow is trending up globally, which typically indicates aggressive LBO activity, a potential risk to high yield. However, cash-rich strategic buyers are also active dealmakers in this environment. As such, it follows that owning the bonds of smaller takeover targets that are acquired by these larger, higher-quality rivals would be good for creditors and for bond prices.
Second, upgrade candidates are an investment opportunity, in our view. In 2020, there was rightly much concern about how downgrades and fallen angels might impact high-yield markets. To less fanfare this year, roughly half of that fallen angel volume has been upgraded back to investment grade. For discerning investors, identifying upgrade candidates may also be an opportunity for earning alpha.
Katie: In the first half of 2021, high-yield spreads narrowed considerably, but that tightening eased in July and August, particularly in pandemic-exposed sectors. Do you see this as a buying opportunity? And if so, where is that opportunity?
Jack: Yes, we’ve viewed the widening spreads as a buying opportunity, particularly in the B-rated and CCC-rated buckets. The widening comes in response to the spread of the COVID-19 delta variant as well uncertainty related to U.S. Federal Reserve (Fed) monetary policy. In this environment, we think the extra carry available in these segments and lower duration exposure are positives that can be additive to high-yield returns. And while uncertainty remains, we see scope for spreads here to narrow, given the supportive macro environment, low incidence of default (circa 1% presently) and strong fundamentals.
In terms of the specific sectors, we think the reopening trade may drive spread compression in leisure and travel. Airlines, for example, have raised ample liquidity and air travel has proven to be relatively safe. Within the airline sector and further down the supply chain in terms of parts and servicing, we see some opportunities. We are less sure on some leisure areas, such as movie theater chains and cruise operators, which may suffer from more impaired business models into the longer term.
Katie: John, how have emerging markets fared during the pandemic? Has there been an upturn in defaults?
John: We've seen more defaults and restructurings over the past 18 months than at any comparable period in the past 20 years. At the beginning of the pandemic, we heard prominent experts warning about the forthcoming wave of defaults, highlighting concerns over the capacity of investors and legal systems to handle the upturn. Sovereign defaults did increase, but not by the level that experts anticipated. Meanwhile, workouts have been fairly orderly and consensual, given investors’ recognition of the unique challenges presented by COVID-19.
Over the next 18-24 months, we expect the relatively high rate of defaults to persist. Sri Lanka may be next. The country has reportedly approached the IMF to negotiate a relief deal. We would expect a restructuring of commercial credit to be part of that program, which has been well telegraphed to the markets.
Other emerging countries are also likely to run into trouble ahead, including those that are not currently viewed as default candidates by the market. Countries like Brazil, for instance, suffer from significant fiscal weakness and seem to lack the political pathway to restore health to public finances.
On a more general point, emerging markets have not matched their developed-market counterparts in rolling out vaccines, which has left EM countries more vulnerable from a health and economic perspectives. EM countries have lagged their developed peers in fighting the pandemic and as such, we expect to see a lagged rebound in emerging economies, starting later this year and into 2022.
Katie: Justin, as an asset allocator, what keeps you up at night?
Justin: Inflation. We view rising price pressures as the largest risk on the horizon because inflation will ultimately guide monetary policy. The market widely views inflation as transitory, which seems to be the case in certain sectors and can be tied specifically to economic reopening. What happens, however, if price growth is stickier than policymakers expect and they have to hit the brakes a little harder and sooner than expected? We don’t believe that this is priced into credit assets today, which we see as a risk, given how much policy has driven markets over the past year.
RISK CONSIDERATIONS
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Executive Director
High Yield Team
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Managing Director
Global Fixed Income Team
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Justin Bourgette
Director of Investment Strategy, Portfolio Manager
Eaton Vance Management |
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John Baur
Co-Director of Emerging Markets, Portfolio Manager
Eaton Vance Management |