Uncategorized
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. This material does not constitute research.
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.
* * *
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.
This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.
Important Disclaimers
Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.
In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.
The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.
This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.
In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.
Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.
Important disclaimers for clients in the EU and UK
This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).
The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.
This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.
This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.
This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.
