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A season for relative value

| June 28, 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.

Ah, summer. The days are warm, the drinks are cold and, more often than other times of the year, the other guys take their eye off the ball. It is the season for relative value. This may be more true in 2019 than in other years because of the fluid list of uncertainties—trade, growth, inflation, the Fed—driving elevated realized and implied market volatility. It is harder to follow it all from the beach, so there is opportunity in macro and opportunity in micro, too.

A number of opportunities come out of a yield curve inverted out to three years and upward sloping from there. It is a yield curve ripe for barbelled portfolios that pick up yield and convexity over bullet positions of the same duration. The very front end of the curve seems likely to rally if the Fed delivers any cut this year, and the back end could come down, too, with a barbell likely outperforming the current low yield point on the curve. The Treasury, agency, and corporate markets all offer versions of that trade, and so does MBS. As Brian Landy lays out elsewhere in week’s issue, the agency CMO market offers the equivalent of a barbell position with potential to outperform pass-throughs. It shows the expected advantages in carry and convexity.

The inverted curve has also shifted relative value in parts of the market with heavy participation from banks and other portfolios working for net interest income. High funding costs have dampened interest in spread assets in the 3- to 4-year part of the curve, and spreads in those parts of corporate debt and agency CMBS, among other markets, have widened. Mary Beth Fisher details the way a portfolio benchmarked to the 1- to 3-year agency or Treasury market could substitute agency CMBS of similar duration and pick up between 30 bp to 50 bp in annual return.

Low absolute rates have also affected MBS through rising prepayments, especially in new prime jumbo private MBS where speeds in May have already jumped to 50 CPR or higher. Investors in private MBS have a rising appreciation for more stable cash flows, and some of those cash flows may come from a surprising source: interest-only MBS backed by loans originated 10 years ago or more. Those IO show good value relative to comparable securities in the agency MBS market and could work well in portfolios trying to add carry without giving away too much carry.

Unusually heavy trading in CLOs in early June highlighted, among other things, the continued wide spreads in a niche of that market: junior ‘AAA’ classes. Subordination, duration, size, liquidity and downgrade risk push spreads on junior ‘AAA’ 30 bp or more wider than their senior counterparts. Over time, however, the wider spread compounds and leads to a growing return advantage for the junior ‘AAA.’ And since junior ‘AAA’ trade surprisingly close to ‘AA’ classes, the price impact of a downgrade is modest and actually falls over time. Nimble portfolios able to aggregate junior ‘AAA’ or leverage them could set themselves apart from peers. A brief on the case for junior appears elsewhere in this week’s issue.

As usual, names in investment grade corporate debt routinely get out of line and open gaps in relative value. Meredith Contente highlight The Walt Disney Company and Dan Bruzzo focuses on Brookfield Asset Management.

Make hay or returns when the sun shines.

* * *

The view in rates

Another week and the US 10-year yield remains between 2.0% and 2.1%. The G20 from June 28-29 becomes the market’s next reality show, with potential for volatility to drop immediately afterwards. But that looks unlikely to hold for long. Underlying cause of uncertainty remain in play. Look for volatility to continue with some temporary respite after the G20. Fundamental fair value for 10-year rates remains around 2.50%, but uncertainty around tariffs and their impact and the timing and magnitude of Fed action should keep rates from getting there.

 The view in spreads

Market expectations for Fed rate cuts should help spreads, especially in credit. Credit markets increasingly reflect confidence that the Fed will act to counter any economic weakness that would normally trigger weaker credit fundamentals and wider spreads. Market volatility should counteract some of the optimism. But the credit markets feel comfortable that the Fed will and can buffer risk from slowing growth.

The view in credit

Low rates should help corporate balance sheets deal with the high levels of debt accumulated since the 2008 crisis. Even before rates dropped this year, corporate credit on the margin looked like it was improving from its state last year. Various measures of leverage paint a mixed picture, but many are improving. Companies have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. Management has heard the concerns of debt investors. Households continue to look strong with low unemployment, rising home prices, and generally good performance in investment portfolios.

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