Market Views: Fixed Income
Outlook 2016: US Multi-Sector Fixed Income
The market appears confident that Federal Reserve rate hikes will be gradual in 2016, and we believe this could be storing up some shocks for the new year.
- Market expectations for the future path of US interest rates are extremely benign by historical standards.
- Corporate bond markets have endured a challenging 2015 and certain areas now offer compelling value.
- Municipal bonds have had a very robust year and may struggle to carry this momentum into the new year.
Putting a price on a Fed hike
At the time of writing this outlook, the Federal Reserve (Fed) is finally on the cusp of increasing interest rates, but despite the anticipation, market expectations for the future path of rates are extremely benign by historical standards.
This complacency could sow the seeds of an interesting year in 2016 with plenty of potential for surprises. However, we also believe that there are a number of opportunities.
Credit markets have tested investors over the last year. US corporate bond yield spreads have continued to widen, and the slightest disappointment on individual names has been met with intense reactions.
Record breaking issuance, declining liquidity and deteriorating fundamentals have all contributed to a challenging market.
However, valuations have become more attractive and reflect much of the bad news already.
Conversely, the US municipal bond market has been a bastion of strength and stability recently, but looking ahead to 2016, it is hard to see it maintaining such strong relative performance.
It’s not about the first Fed move; but the second, third, fourth and beyond.
Many commentators have spent time focusing on the timing of the Fed ‘lift off’ but probably not enough on the trajectory of rates thereafter.
It is perhaps natural that after such a prolonged period of ‘zero’ interest rates - and multiple rounds of quantitative easing around the world - that the first major bank to tighten policy would get such focus.
What really matters is what happens next. The current expectation - of just two 25 basis point (bps) hikes in 2016 - is much more benign than any recent rate hiking cycle.
It predicts that the Fed’s dovish approach will continue even as it raises rates, and is coupled with fears that the slowdown in the rest of the world will persist.
Making exact forecasts on either the Fed funds rate or 10-year Treasury yields is a fruitless task.
Nevertheless, it does feel that market expectations are one sided.
After years of excessively positive outlooks, the market has been beaten down; resigned to an extension of low growth with low inflation.
Having been wrong for so many years, one could almost argue the consensus view is no view at all.
Given where we are, any negative economic surprise could delay further rate hikes, but we believe it is unlikely to reverse or cancel the Fed’s hiking cycle altogether.
On the other hand, any positive surprises to global or domestic growth – and yes, it is possible - could result in a more material impact on markets, as rate hikes are brought forward and the expectation of the terminal rate moves above 2%.
Inflation could also present a surprise to the market, which is currently pricing in significantly below-trend inflation for the next ten years.
Are corporate bonds cheap enough?
Our strongest held conviction remains the compelling value of US investment grade corporate bonds.
Credit (ie. corporate bond) spreads have moved wider over the last 18 months in the face of record issuance, deteriorating fundamentals and declining liquidity.
Current valuations in BBB-rated issuers have moved to levels consistent with previous recessions and, at longer maturities, are near 25-year lows.
Since the summer we have slowly increased our exposure to credit and expect to do so as we head into 2016.
One of the key elements of that decision has been the time horizon we are taking. In this market, credit spreads could go 25 bps in either direction over the next three months, but as a team we feel confident that taking credit risk could be rewarding over a 12-month horizon.
The balance of positioning is crucial in this environment. While we have reasonable exposure to corporate credit risk, we have enough high quality assets to enable us to react to any surprises that create investment opportunities.
We favour investment-grade financial and broadly diversified industrial credits, including some higher quality energy issuers which are at what we consider to be very attractive valuations.
It is our view that the financial sector will continue to benefit from a more supportive regulatory backdrop and is more immune from the merger (M&A) risk, which is affecting many industrial sub-sectors.
How will municipal bonds react to a move from the Fed?
There have been two material dislocations in municipals in the last five years.
The most recent was two years ago, when ‘taper tantrum’ fears sent longer dated municipals to the cheapest levels seen in decades.
Municipal bond yields rose rapidly, spreads between rating grades widened and liquidity evaporated.
How times have changed. As we approach Fed ‘lift off’ the opposite has occurred.
Municipals have delivered strong outperformance relative to other bond markets, despite a plethora of idiosyncratic noise ranging from the collapse of commodity prices to the well-publicized fiscal malaise in Puerto Rico.
As we look forward to next year, expectations of negative net supply should support the market.
We believe that municipals are fully priced while corporate bonds are more undervalued.
Is liquidity going to come back?
No; at least not any time soon. However, if investors have a longer-term time horizon, we think they can demand an attractive ‘liquidity premium’.
As portfolio managers and investors we just have to come to terms with the new liquidity environment and manage accordingly.
2016 : A year of firsts
It will be the first series of rate hikes since 2006. It will also be the first time the Fed raises short-term rates with a $4.5 trillion balance sheet and the first time they raise interest rates with real economic growth running below 2.5%.
There will certainly be many significant decisions to be made and we anticipate 2016 will be another year for capitalizing on market dislocations.
We think that could be good news for those investors with a longer-term time horizon, as valuations in some areas currently look quite compelling.