Dovish Central Banks Extend Cycle, Higher Corporate Credit Allocation May Be Warranted
Portfolio Manager Mayur Saigal discusses the fixed income landscape and why a higher allocation to corporate credit may be warranted today versus 2018.
- The dovish tone struck by central banks in 2019 is reminiscent of 2011 and 2012, when the Federal Reserve’s (Fed) and the European Central Bank’s (ECB) focus on pledging to do what it takes helped to dampen volatility and reduce both credit risk and term premiums.
- The most significant difference is the starting levels of corporate credit spreads, which are close to their long-term average levels and will likely be range-bound from here.
- Despite the range-bound environment, we believe central bank actions have extended the credit cycle and possibly warrant a higher allocation to credit today as compared to late 2018, but selectivity is required.
Mayur Saigal: Before we touch upon the 2019 outlook, I think it is important to understand where we were last year and how we got here. So 2018 was an interesting year, because earnings were almost up 20% year over year on the heels of the tax reform. You had labor markets that were solid. You had the economy on a very good footing and yet all asset classes had negative returns. So the question really is what happened, when everything was going great with such an amazing economic backdrop, how did all these returns be negative and why was volatility so elevated? Well, I think that the tipping point was in October of last year where [Chairman Jerome] Powell indicated that the Fed was further away from the neutral point. Essentially what that meant was the path of hikes for the Fed would be at a faster pace than what fed fund futures were implying. They did reverse course earlier this year. In January of 2019, the Fed said that they would be pausing the rate hikes. They subsequently also said they would be flexible with their balance sheet, both the composition as well as the size if the economy warranted. So that has been a massive pivot back from October levels that really spooked markets. Since then we have seen also other central banks go on the same path of a dovish tone.
This regime change that we have seen in 2019 is not too different than what we saw in 2011 and 2012, where the Fed and the ECB were focused on forward guidance and they were focused on pledging to do what it takes. That had dampened volatility. That had reduced the credit risk premiums and term premiums, which is not too different than what we have seen in 2019. I think what is really different is the starting level of spreads. Back then when the Fed and all of the central banks were dovish, spread levels were at good levels to provide double-digit returns. Today the spreads within the investment-grade space and the high-yield space are close to the average levels and so there is not much of an opportunity to provide the same kind of return profile. Carry is the name of the game in this environment until the cycle turns.
The supply landscape is going to help the range-bound argument for investment-grade spreads and high-yield spreads. And the shift there is happening for a number of reasons. One, if you look at global yields, if you look at sovereign yields in Germany and in Japan, they are close to zero. Also, the Fed pause has contained the cost of hedging for foreign investors that are looking to invest in investment-grade markets here in the U.S. Combined with that, if you look at the investment-grade market itself, net supply for this year is expected to be negative, down 20%. So that is a technical tailwind that will be supportive of a range-bound environment in corporate spreads.
It is still a good opportunity to add more credit in this range-bound environment and be selective of what names or what sectors that can benefit on a risk-adjusted basis.
The cycle has been extended with what central banks have done. And that warrants a higher allocation to credit today as compared to last October and November where the central bank put was not there.
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Fixed income securities are subject to interest rate, inflation, credit and default risk. As interest rates rise, bond prices usually fall, and vice versa. High-yield bonds, or “junk” bonds, involve a greater risk of default and price volatility. Foreign securities, including sovereign debt, are subject to currency fluctuations, political and economic uncertainty, increased volatility and lower liquidity, all of which are magnified in emerging markets.
Credit Spread is the difference in yield between securities with similar maturity but different credit quality.
Carry is the return of holding a bond to maturity by earning yield versus holding cash.
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