The Big Idea
A little déjà vu
Steven Abrahams | January 8, 2021
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.
Last year closed with a strong showing in credit and losses in rates, and that should create a little déjà vu for investors even in the first week of the New Year. The November 3 elections raised expectations for fiscal stimulus and then Washington actually delivered. And effective vaccines for Covid-19 suddenly cleared a path to some kind of normal economic activity, although delivery so far has been far from effective. Democratic capture of the Senate this week has put things in motion again. Spread assets continue to hold a big advantage over rates, although narrowing spreads mean security selection will likely play a much bigger role.
A strong finish in credit
Prospects for fiscal stimulus and pandemic renormalization last quarter helped bear steepen the yield curve and tighten spreads. High yield corporate debt printed annualized total returns of more than 25% (Exhibit 1). Leveraged loans and investment grade corporate debt delivered between 13% and 16%. Private CMBS printed nearly 6%. ABS, agency MBS and agency CMBS delivered annualized returns in the low single digits. Treasury debt lost more than 3%.
Exhibit 1: In 4Q2020, returns on credit again beat rates
Returns in credit more than covered the realized risk. Leveraged loans delivered 7.77% in annualized returns for risking a 1% annualized swing in those returns (Exhibit 2). High yield corporate debt delivered 6.58% for each unit of risk. Assets with more balanced exposure to credit and interest rates—investment grade ABS, investment grade private CMBS, investment grade corporate debt—delivered between roughly 3% and 4% for each unit of risk. Sectors with limited credit exposure and healthy rate exposure—agency MBS, agency CMBS and Treasury debt—delivered the lowest returns for each unit of risk.
Exhibit 2: The 4Q2020 ratio of return-to-risk also highlights credit
The results reflected the quarter’s steepening yield curve and tightening spreads and the different mix of rate and spread exposure across the asset classes. Leveraged loans and high yield debt and other assets with relatively low duration dodged the worst effects of rising rates while seeing the most significant tightening in spreads (Exhibit 3). Treasuries took the worst of the rise in rates, and other asset classes fell in between.
Exhibit 3: The yield curve bear steepened and spreads tightened in 4Q2020
A volatile interplay between rates, spreads and asset risk exposures
The interplay between rates and spreads and the embedded risk exposures across assets had played out all year long. The first quarter saw a sharp drop in rates and widening in spreads as pandemic started shutting down economies worldwide. Treasury debt in the first quarter produced annualized gains of nearly 34%, for instance, while high yield debt and leveraged loans printed annualized losses of more than 55% (Exhibit 4).
Exhibit 4: In 1Q2020, pandemic led rates to far outperform credit
The second quarter brought the full effect of Fed intervention into play as the Fed held target rates at nearly zero, launched QE in Treasury and agency debt and rolled out a slew of other programs to support lending to broker/dealers, corporations, states and municipalities, small and medium businesses and foreign central banks, among others. The CARES Act also put an estimated $2 trillion of stimulus into the economy. Rates barely moved, but spreads tightened sharply. Credit recovered a large part of its earlier losses with leveraged loans showing annualized returns of 46% and high yield showing 43% while agency MBS and Treasury debt overed slightly above 0%.
Exhibit 5: In 2Q2020, Fed action and the CARES Act brought credit roaring back
The third quarter saw the impact of Fed programs and the CARES Act continue, and credit again outperformed. High yield and leveraged loans led the way with agency MBS and Treasury debt trailing and other asset classes in between (Exhibit 6). The biggest difference between the second and third quarters was much lower volatility as the year went on. Returns in every asset class fell in a steadily narrower range. The pattern of returns in the third quarter almost mirrored the pattern in the last quarter.
Exhibit 6: In 3Q2020, Fed policy and the CARES Act kept lifting credit
Lessons learned from a year of asset returns
Asset performance over the last year argues that spread assets will likely continue outperforming rates as long as Fed policy, fiscal stimulus and pandemic renormalization continue. Bear steepening in the yield curve looks likely to leaves losses in rates exposures, especially exposures to the longer part of the yield curve. Credit stands to continue tightening to historic levels.
Despite the prospects for credit, it probably will not repeat the relative performance it showed after the first quarter of last year. The credit markets have already priced in a lot of bullish news. There is still room for upside from new fiscal spending on pandemic relief, infrastructure and other programs. There is also room for upside surprises to the economy from strong consumer balance sheets and pent-up demand for travel, dining, leisure and entertainment. But current spreads make it almost impossible for spreads to cover the same ground they covered between March and December.
Security selection should become much more important in adding to portfolio returns. For example, owning private debt, holding the public debt of companies likely to get acquired, identifying classes of structured credit where the borrower or even the servicer creates a cash flow advantage, finding underpriced prepayment stories—all of these should make bigger marginal contributions to portfolio return.
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The view in rates
The Treasury yield curve has finished its most recent session with 2s10s at 98 bp and 5s30s at 139 bp, both high marks over the last 12 months. The steepening largely reflects rising inflation expectations. The spread between 10-year notes and TIPS shows inflation expectations at 208 bp, also the high point for the year, with real yields showing significant weakness and hovering just above -100 bp. Inflation expectations reflect a real difference in circumstances compared to the Fed’s 2008 and later efforts to revive inflation: this time around, fiscal policy is fully engaged. Federal spending will soak up resources and force the private sector to compete. Heavy Treasury supply is adding steady pressure. Implied interest rate volatility remains low, helped by high levels of market liquidity and a Fed pledged to keep rates low and QE running until it sees “substantial progress” toward economic recovery.
The view in spreads
Spreads in many asset categories are near or at historic tights with room to tighten further. Tremendous net Treasury supply is creating a surplus of the riskless benchmark while QE absorbs MBS, the relatively riskless spread asset, at least regarding credit. Beyond the influence of net Treasury supply, fiscal stimulus, pandemic recovery and Fed policy should also keep spreads steadily tighter through 2021. Weaker credits should outperform stronger credits, with high yield topping investment grade debt and both topping safe assets such as agency MBS and Treasury debt. Consumer credit should outperform corporate credit.
The view in credit
Consumers in aggregate are coming out of 2020 with a $5 trillion gain in net worth. Aggregate savings are up, home values are up and investment portfolios are up. Consumers have not added much debt. Although there is an underlying distribution of haves and have nots, the aggregate consumer balance sheet is strong. Corporate balance sheets have taken on substantial amounts of debt and will need earnings to rebound for either debt-to-EBITDA or EBITDA-to-interest-expense to drop back to better levels. Credit in the next few months could see some volatility as Covid begins forcing shutdown of some economic activity and distribution of vaccines potentially hits some logistical potholes. But distribution and vaccine uptake through next year should put a floor on fundamental risk with businesses and households most affected by pandemic—personal services, restaurants, leisure and entertainment, travel and hotels—bouncing back the most.