admin | January 25, 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.
Although both MBS and corporate debt should continue to tighten to the Treasury curve, corporate debt looks like it has a little more room to run. That’s only because corporate debt saw more damage in 2018, especially late in the year, and offers more carry now. The appetite for carry only looks likely to grow as the Fed stands to weighs its next move through March and possibly into June.
Exhibit 1: Corporates may close some ground to MBS as the Fed weighs its next move
The Fed has repeatedly told the market since early January that it will wait for substantially more information before making its next move, and that continues to encourage the carry trade. The government shutdown may have cut off the flow of timely public information, but that’s unlikely to change things. The Fed looks unlikely to move before March and possibly before June. If so, carry should drive portfolio returns as the Fed waits.
Corporate debt offers more carry than MBS for now, and arguably enough to outweigh the loss of liquidity. But corporate debt still looks vulnerable if the economy slows through 2019, so there likely a limit to how much the market will close the spread gap. More than $278 billion of corporate bonds slipped from ‘A’ to ‘BBB’ last year, driving outstanding ‘BBB’ debt to $3.35 trillion. With new ‘BBB’ issuance, total outstanding ‘BBB’ rose by $400 billion. The historically high balance of ‘BBB’ may be just as sound as similarly rated debt in the past, but it magnifies the potential impact of any economic slowdown.
MBS has its own challenges with steady net supply, the flow of MBS out of the Fed and a likely change in bank liquidity regulations that stands to reduce demand from that large group of buyers. MBS quality has also slowly eroded as the Fed has stepped out of the TBA market, and TBA financing rates have been poor. All of this could ultimately limit MBS performance.
For the first half of the year, corporates may outperform MBS. But it would be surprising if it lasted much longer than that.
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The view in rates
The rates market has drifted to the low end of its likely range for at least the next six months. Rates on 10-year notes have slowly drifted above minimum fair value of 2.75% and should slowly drift closer to 3.00%. Absent a clear signal from the Fed, the slope of the curve should remain steady, too. If the Fed eventually signals more hikes in 2019, the curve should flatten with shorter yields rising and longer yields remaining. If the Fed rolls through June without a sign of 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
Carry may not be king, but it certainly has received a promotion so far in 2019. A stable Fed should keep encouraging carry trades. Portfolios buying corporate debt should focus on names that show organic growth or use free cash flow or asset sales to pay down debt should perform the best. Agency MBS should also tighten but underperform corporates.
The view in credit fundamentals
Corporate credit fundamentals remain vulnerable, but only if slower economic growth creates problems. 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.
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