Sector views from our portfolio managers
Investment grade corporate bonds
As we entered 2019, risk assets were heavily oversold and valuations appeared attractive resulting from the “risk-off” sentiment that was prevalent late in 2018. However, an improving macroeconomic environment, a more dovish stance from the Federal Reserve (Fed), and expected progress on U.S. and China trade have supported a relatively dramatic rebound in asset values across the board.
In the near term, we don’t expect further spread tightening in the investment grade corporate sector, as credit spreads have reached our near-term forecasts. However, fundamentals are generally healthy, and we expect supply to drop in the coming year, supporting yields for investment grade corporate bonds. Strategically, we continue to prefer the financial sector over non-financials given their strong capital positions relative to event risk, such as M&A activity. Tactically, we see value in banks, telecommunications, higher-quality energy and autos, but have a less favorable view on most other industries in the sector.
We think the market’s concerns over BBB-rated concentration risk is overblown, and we are not overly concerned about “fallen angel” risk. Many corporate issuers that have increased debt levels for mergers and acquisition (M&A) activity have indicated plans to reduce that debt. In the event of an economic slowdown, these issuers have many levers to pull to avoid a downgrade to high yield, such as cutting dividends, reducing capital spending, and curtailing share buybacks. We think investors should be more vigilant about managing exposures to single-A issuers that may risk dropping to BBB for the sake of M&A transactions or other shareholder-friendly initiatives.
What is a “fallen angel” bond?
A fallen angel is a bond that was issued with an investment-grade rating (BBB or higher) but has since been downgraded to below investment grade due to the weakening financial condition of the issuer.
Fallen angels can include corporate, municipal or sovereign issuers. Initial ratings and subsequent downgrades are assigned by one or more nationally recognized statistical rating organizations such as Standard & Poor’s, Fitch or Moody’s Investors Service. Our analysts assign our own proprietary credit ratings to make decisions internally.
The preferred and contingent capital (CoCo) sector offers strong fundamentals and technicals. Banks — representing the largest industry within the sector at 69% — were wildly profitable in 2018 and passed the most rigorous set of stress tests to date with flying colors, demonstrating that current capital levels are sufficient.2 Furthermore, in a strong vote of confidence regarding the underlying strength and capital levels of the banking sector, the Fed allowed banks to meaningfully increase dividends and share buyback programs. Net supply was negative in the U.S. preferred market, and banks were redeeming more preferred paper than they were issuing.
Nevertheless, these strong fundamentals and technicals couldn’t overcome investor outflows of $5.9 billion (12% of the mutual fund category) in 2018, which significantly hurt performance.3 Almost all of the outflows were in the fourth quarter, initially sparked by a general risk-off sentiment when the sector under-performed the broad fixed income market, but greatly exacerbated by tax loss harvesting later in the quarter. All in, spreads in the sector widened over 200 basis points during the fourth quarter of 2018. Although positive flows of $350 million have returned to the category in 2019, there is much more to come in our opinion, and spreads have tightened by over 100 basis points.4
We see opportunity in the current market environment for a variety of reasons. We believe the fundamentals of the bank sector should remain strong for the rest of the year, and net new issue supply will remain negligible. Furthermore, we think preferred securities offer additional characteristics that make them especially attractive at this stage of the credit cycle, including:
- Diversified issuer base: The bank and insurance issuers that dominate the preferred market are uncommon borrowers in the high yield and leveraged loan markets, which diversifies investors’ sources of income and risk.
- Higher quality: Many preferred securities are actually higher quality than their credit ratings suggest. Often, BB- or BBB-rated issues are A-rated or higher at the senior debt level, as shown in Figure 4. For example, 76% of preferred issuers have ratings of A or better, despite a market weight of 60% BBB and 33% below investment grade at the security level. Furthermore, banks and insurance companies operate in highly regulated industries, which may offer additional protection for investors in preferred securities.
Emerging markets corporate debt
We think emerging markets corporate valuations are attractive compared to investment grade corporates in the U.S., Europe and Japan as well as U.S. high yield corporate bonds.
Emerging markets are a large and growing share of the global economy, and are projected to grow faster than developed markets, making them an important contributor to the world’s economy. According to the International Monetary Fund (IMF), emerging markets are expected to contribute an estimated 60% to global gross domestic product (GDP) in 2019, up from 37% in 1990.5
Our outlook for emerging markets corporate debt is based on the complexity and nuance of the sector. The universe of U.S. dollar-denominated emerging markets corporate debt comprises both traditional corporate issuers and those that are defined as “quasi-sovereign,” meaning a government owns 50% or more of a company’s equity and/or voting rights.
Compared with emerging markets sovereign debt (bonds issued directly by a government), we favor emerging markets corporate debt given that it has provided strong risk-adjusted returns and tends to be higher quality. We approach emerging markets investing with a healthy appreciation that what happens with agencies or large corporations/financial institutions can have significant implications to government financing and vice versa.
Currently, some of our highest-conviction views are:
- Turkey: We believe banks’ non-performing loans are under pressure, but valuations are still attractive. Our cautious approach has us favoring the large private banks with bigger capital buffers, many of which have foreign or large sponsorship from the private sector.
- Argentina: High interest rates, higher-than-expected inflation and political risks continue to dominate. While corporate bonds have a better track record than sovereign debt in terms of default, they are not immune to a selloff. We will be closely watching elections in the second half of 2019.
- Mexico: Concerns remain in Mexico due to uncertainty surrounding the country’s state-owned petroleum company and the amount of government support that will be provided. Furthermore, worries over growth prospects for the country and the potential for a deterioration in credit lead us to take a more cautious approach.
A word on China
No discussion of emerging markets would be complete without commenting on China. There is very little U.S. dollar-denominated sovereign debt outstanding from China. Within the dollar-denominated quasi-sovereign sector, we see little differentiation and think that valuations look unattractive given the sizable government presence in the economy. While we don’t foresee a hard landing, we always need to be mindful of China as the biggest global macro risk given its relevance to global trade and commodity markets.
Tactically, we have found interesting opportunities in the China high yield corporate space, but are mindful to be price-sensitive and not to chase a rallying market. China defaults will be rising and garner headlines, but this is expected and should be contained to the local investor base and smaller non-systemic issuers.
High yield corporate bonds
We believe the high yield corporate bond market currently offers attractive value for investors, despite recent spread volatility and uncertainty around interest rates. We don’t see high yield as overvalued, and our current fundamental outlook for defaults remains benign. Additionally, the strong year-to-date performance within high yield has been driven more by changes in interest rates and overall risk appetite than by shifts in underlying credit quality, which may present some future opportunities for our intensive credit research process.
We think investors should focus on identifying those companies with strong cash-flow that are properly capitalized for the volatility in their businesses and positioned to navigate different economic cycles. While we don’t anticipate an imminent recession, we think investors should prepare for future economic uncertainty by de-emphasizing the lowest-quality tier of the high yield sector, bonds rated CCC and below.
We are not expecting to see a mass migration of fallen angels into the high yield market. It is important to note that the size of the BBB market is not a good proxy for companies that will become fallen angels. In general, BBB borrowers are very large companies with many levers to pull to prevent getting downgraded, not the least of which is reducing dividends and share buybacks.
The leveraged loan market has experienced tremendous growth over the past several years. We view this growth as being driven by demands from investors looking for floating-rate exposure to offset rising rate/duration concerns, yield-seekers driving new collateralize loan obligations (CLOs) issuance, and corporate issuers opportunistically favoring loans due to their flexibility and attractive borrowing costs given this aggregate demand. The combination of market growth and investors’ perceptions that we are in a late stage of the credit cycle has created concern from the media, market strategists, regulators and even Fed committee members. However, we find this angst, and the volatility that has ensued, to be misplaced. In fact, it has created attractive long-term risk-adjusted opportunities for investors, and we remain constructive on the sector given our rigorous research process.
However, the Fed’s recent announcement that it will pause on rate hikes for 2019 removed a near-term tailwind for loans and, as a result, many individual fixed income investors and yield-seekers now seem to be less interested in floating-rate exposure. At the same time, the Fed’s policy pivot removed our key downside risk: We no longer see the risk of the Fed raising rates too quickly and accelerating an end to the credit cycle.
A by-product of the strong demand for leveraged loans and the “blurring” interest between high yield bonds and leveraged loans has been the significant growth of covenant-lite (cove-lite) issuance, which has been a long-term, secular trend. Cove-lite loans now represent roughly 80% of the loan market and as much as 87% of new issuance in 2018, which has caused investor concern and been a subject of debate in the market.6 However, it’s important to note that “covenant-lite” does not mean “covenant-free.” Cove-lite loans do indeed have covenants, but instead of traditional maintenance-based tests, the covenants are based on certain events. Additionally, it is important to point out that part of the reason for the rise in cove-lite loans is due to the fact that larger, higher-quality and more-established companies have been entering the market, and lenders/investors naturally demand fewer covenants from these types of borrowers.
We have been paying close attention to the cove-lite trend and factor it into our investment assessments. We expect loan recoveries to be lower in the next credit downturn compared to historical experiences. Compared to a covenant-heavy structure, the cove-lite nature likely will push out the actual event of default due to less onerous or restrictive tests. We think the cove-lite trend is noteworthy, but some of the key warning signs of the pre-financial crisis era are not particularly alarming right now, as indicated in Figure 6.
Loan covenants: a closer look
A loan covenant is a condition in a loan or bond issue that requires the borrower to fulfill certain conditions, forbids the borrower from undertaking certain actions, or which possibly restricts certain activities to circumstances when other conditions are met.
Covenant-lite loans are a type of financing that is issued with fewer restrictions on the borrower, but fewer protections for the lender.
Loans with traditional covenants require the borrower to perform certain financial maintenance tests at regular intervals, usually quarterly. Covenant-lite loans may be subject to incurrence tests, which do not occur at specified intervals, but may be triggered by a specific event.
Ultimately, we believe that the best offense in the leveraged loan market is strong research. We doubt that the cove-lite trend will end any time soon. Our deep and experienced research team identifies loans, cove-lite or not, that are well-positioned to repay investors and potentially drive strong returns. We tend to focus on companies that generate solid free cash flow through a business cycle, favoring more predictable industries and higher-quality sectors. Furthermore, we size our exposures to cyclical and more-volatile sectors conservatively. Areas of chief concern for us relate to borrowers with very aggressive and loose credit agreements, generous and sizeable expenses added back to earnings before interest, tax, depreciation and amortization (EBITDA), and aggressive leveraged buyout (LBO) capital structures with stretched debt levels, and/or structures with no or limited junior debt cushion.
And while we acknowledge the near-term risks within this asset class, we believe loans remain an important strategic allocation for most investors. The following section on portfolio construction describes how our Solutions team considers incorporating loans into diversified portfolios.