Uncategorized
Choosing carry
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. This material does not constitute research.
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
Source: Bloomberg
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.
* * *
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.
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.
