Truce and carry

admin | January 18, 2019

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Fed and the markets look increasingly like they’ve struck a truce. The Fed promises to listen to the market and not simply march ahead to its own beat. The market promises to rethink its concerns about Fed policy snuffing out economic growth. It’s a convenient arrangement. The Fed gets back some control over financial conditions. The market gets back some confidence in taking risk. The combination promises to leave markets much more stable this year than they were last. That raises the issue of adding carry as a source of return.

Almost all fixed income spread sectors remain wider than they have been in nearly two years or more. Investment grade and high yield corporate debt look wide. Leveraged loans and CLOs look wide. Private and agency CMBS and private MBS look wide, too. The only sector that dodged a large part of the widening late last year was agency MBS. Credit widened on concerns that the Fed could tip the economy into recession, but MBS, after widening initially with credit, tightened as a safe haven from credit and on the possibility that the Fed in a recession might start reinvesting in MBS.

Credit backed by US households looks like a good place to start adding carry. With median household income at a record high of $61,000, household net worth at a record high of $98 trillion and household debt service as a share of disposable income at a record low of 9.8%, the average household balance sheet is strong. The list of interesting assets should include new ‘AA’, ‘A’ and ‘BBB’ prime jumbo MBS, where structure adds prepayment protection and where both structure and collateral add credit protection. Agency CMBS, which are backed by mortgages on apartment buildings, also look wide and attractive. Agency CMO floaters continue to trade at wide spreads with limited risk of going wider.

In corporate credit, ‘AAA’, ‘AA’ and ‘A’ CLOs trade wide to their investment grade corporate benchmarks and offer good opportunities to pick up relative value across both managers and structures. CLO manager portfolio performance has varied widely since September, with 3-month total returns varying between +2.04% and -3.49%, and deal structure has become more leveraged with the drop in loan prices. The market doesn’t seem to have priced in all the differences either in performance or leverage. In investment grade corporate debt, names with a credible record of paying down debt or otherwise reducing leverage look like the best values.

The ‘BBB’ corporate market still looks like a clear underweight. Average leverage in ‘BBB’ names continues to run above historic norms, and even with the truce between the Fed and the market, economic growth looks almost certain to slow through 2019 and put steady pressure on those balance sheets.

It still looks prudent to tread cautiously in selling liquidity to pick up carry. The economy looks most likely to slow through 2019 to a lower but steady pace, but the market may extrapolate from slow growth right into recession. The market consequently stands to see a few bouts of widening until GDP growth clearly stops declining and levels out. Keep a healthy liquidity reserve.

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The view in rates

Rates on 10-year notes have slowly drifted above minimum fair value of 2.75% and should slowly drift closer to 3.00%. The slope of the curve will continue to depend heavily on signals from the Fed. If the Fed signals more hikes in 2019, the curve should flatten with shorter yields rising and longer yields remaining. If the Fed signals no more hikes, that could steepen the curve as concerns about recession ease. The Fed shows its next set of dots in March, so between now and then data and speeches should drive rates. For now, the delicate balance between Fed policy and potential growth dominates all other rates concerns—tariffs, government shutdowns and others included.

The view in spreads

Spreads across almost all risk sectors have tightened for the last two weeks. Investors anecdotally are putting money to work that had been sidelined by the volatility in the final quarter of last year. That should only go so far, especially in corporate credit. Slower growth poses risk to the nearly $3 trillion in ‘BBB’ credit, especially the most highly leveraged names. Names that show organic growth or use free cash flow or asset sales to pay down debt should perform the best. Wider spreads in corporate credit should put pressure on other spread assets, although consumer debt should show less volatility. Agency MBS should perform the best as concern about recession increases the chances the Fed might start reinvesting portfolio principal.

The view in credit fundamentals

The upcoming corporate earnings season should provide the first look at results in the last quarter of 2018 and the outlook for 2019. Consensus forecasts for real GDP suggest real growth slows through 2019 toward a 2.0% pace in 2020. ‘BBB’ corporate balance sheets may have trouble managing debt service if slowing growth puts pressure on revenues. Management may need to trim equity buybacks and reduce debt. Households, however, look strong. Unemployment should fall through 2019 even as growth slows. Strong net worth and manageable debt service should help households, too.