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Fixed-Income Insights

We look at the fixed income market and explore different sectors where investors may find value.

 

In Brief

  • We believe the flattening yield curve does not indicate an imminent U.S. recession, as underlying fundamentals, and other economic signals, remain strong.
  • Leverage in the U.S. financial system has not been concentrated in a dangerous way. Rather, the primary driver of the expansion in debt has been the U.S. Treasury.
  • Risk assets such as high yield may help to balance the growing amount of interest rate risk, as do short duration and floating rate strategies.

 

While last month’s inverted three-month/10-year U.S. Treasury curve sparked fears about a near-term recession in the U.S., we’ve evaluated several factors that point to the contrary. As I noted previously, the yield curve is an imperfect signal, and we haven’t seen any signs of a downturn from other key economic indicators. In fact, the bond market environment currently offers some unique opportunities for investors.

Re-defining the Value of Cash
Before we begin to explore the potential opportunities, let’s first explore how a shift in the value of cash affects the market. We tend to focus primarily on U.S. Federal Reserve (Fed) monetary policy and its potential impact on the U.S. economy. But of course, the benchmark fed funds rate also has a direct impact on markets, beyond signaling and reassuring investors. Re-pricing the value of cash, as illustrated in Chart 1, has implications for every other asset class.

How has this played out in recent years? In 2018, markets had to re-think expected compensation from investments, as the multi-year rise in overnight interest rates reached a critical point. The selloff in early 2018 was directly correlated to fears about rising rates; we saw it happen again in October, as fears of too-aggressive Fed tightening were the initial catalyst for the broader selloff in risk assets. Downward revisions in corporate earnings expectations and softening economic data combined with fears of a Fed overshoot to make many investors start to think a U.S. recession was imminent.

 

Chart 1. How Have Changes in Short Rates Influenced Stocks and 10-Year Treasuries?
Yields on indicated investments, March 29, 2009-March 29, 2019

Source: Bloomberg. As of 03/29/2019.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

So how did re-pricing of the value of cash, and the residual impact on all other asset classes, help spark a rebound in the first quarter of the year? As we can see in Chart 1, the relationship between expected returns on major asset classes versus cash has shifted dramatically, following a prolonged period of a stable differential. While this shifting relationship had already threatened to shift investor interest toward shorter term alternatives, and away from equity and debt markets, fears of continued hiking in 2019 amplified this dynamic.  When the market reevaluated the Fed’s likely next step, it prompted a re-pricing away from the expected 3.0% overnight rate toward a continuation of the status quo as the Fed indicated it would hold off on rate hikes in 2019. This, coupled with waning concerns about China trade conflicts, prompted a comeback in investor confidence.

A Flattening Yield Curve Does Not Mean a Recession
Can this market momentum continue? Some investors are skeptical. But we think there’s little reason to believe that a flattening yield curve means we’re nearing the end of this economic cycle, or that a recession is near. In fact, if we factor in favorable underlying U.S. financial conditions, the already low odds of an imminent U.S. recession move even lower.

Take a look at Chart 2, which examines the strength of the recession signal from only the yield curve (on a 12-month lag), versus a combination of that curve signal plus the signal from the Chicago Fed’s National Financial Conditions Index (NFCI). We can see that the yield curve signal, taken in isolation, is far more likely to give false recession signals, and has indeed been rising again recently.  However, the combined indicators carry positive implications for continued U.S. growth.

 

Chart 2. Favorable U.S. Financial Conditions Appear to Reduce Odds of U.S. Recession
Recession probability of the U.S. Treasury curve (three-month/10-year) with and without adjustment for underlying U.S. financial conditions, January 1975–March 2019

Source: Bloomberg and Lord Abbett as of 03/31/2019. For illustrative purposes only. The Chicago Fed’s NFCI is an update produced weekly that takes a closer look at money markets, debt and equity markets, plus traditional and “shadow banking" systems.

 

This chart examines the strength of the recession signal from only the yield curve (on a 12-month lag), versus a combination of that curve signal plus the signal from the Chicago Fed’s National Financial Conditions Index (NFCI). We can see that the yield curve signal, taken in isolation, is far more likely to give false recession signals, and has indeed been rising again recently. However, the combined indicators are showing positive signals for continued U.S. growth.

Leverage in the System Primarily Concentrated in U.S. Treasury Debt
In past financial cycles, the U.S. government has tended to increase spending during recessions, and dial back expenditures during periods of recovery. Today, we’re seeing the opposite, as U.S. government borrowing has reached record levels during a period of economic expansion (see the first panel in Chart 3). While some investors opt for a 10-year Treasury bond as a supposed safe-haven investment in their portfolio, compensation for holding this type of investment has never been lower, as shown in the second panel of Chart 3.

 

Chart 3. Even as U.S. Government Borrowing Hits Record Highs, Term Premium Is at Historic Lows
Historical and projected U.S. government debt and budget deficit, January 2001–January 2021 (3a); 10-year U.S. Treasury term premium, June 30, 1961–March 22, 2019 (3b)

3a.


Source: International Monetary Fund, Bloomberg, Federal Reserve Bank of New York, and Lord Abbett. Actual debt data as of 12/31/2018.

3b.

 

Source: International Monetary Fund, Bloomberg, Federal Reserve Bank of New York and Lord Abbett as of 03/31/2019. Estimated 10 year Treasury Term Risk Premium shows difference between actual and estimated risk-neutral yield on a 10-year U.S. Treasury bond.
See https://www.newyorkfed.org/research/data_indicators/term_premia.html for details. For illustrative purposes only.

 

While we still see value on the short end of the curve, we think there are better opportunities than the 10-year Treasury note. One area we think is worth considering is credit, for reasons we'll explore below.

High Yield and Other Fixed Income Assets
After underperforming during the broad market pullback in December 2018, high yield came back to post its best quarter on record in the first quarter of 2019. And since we do not believe the decade-long U.S. economic expansion is close to ending, we think there is still attractive value in the sector. We would note that default expectations are low (based on data compiled by J.P. Morgan) and fundamentals are solid. While it’s not for everyone, high yield does offer some relative value for investors, in our view.  Yield spreads versus Treasuries are still well above the lowest levels of the current economic cycle, and are still relatively wide given default expectations.  Moreover, the credit quality of the benchmark ICE BofAML U.S. High Yield Constrained Index has improved substantially over the past decade.

 

Chart 4. U.S. High Yield Valuations Appear Attractive Even With Tighter Than Average Spreads
U.S. high yield spread, U.S. trailing 12-month high yield default rate, and U.S. default rate forecast, February 29, 2000–February 28, 2020

Source: Moody’s and Bloomberg. Actual data through 02/28/2019.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Forecasts are based on current market conditions and are subject to change.

 

We’re also taking a closer look at investment-grade corporate debt. While there is more investment-grade debt outstanding there than there was before the 2008–09 financial crisis, there is also quite a bit more equity value, or enterprise value, from the issuing companies to go along with that growth in debt. However, many large corporations have added leverage and have thus seen their debt downgraded to BBB, lowering the quality of the investment grade corporate universe, even as the high yield universe has improved in quality. Low borrowing costs, plus strong profit margins and earnings, are leading companies in the BBB category to take on more leverage, as shown in Chart 5.

 

Chart 5. Triple-B Companies Now Account for Nearly Half of Investment-Grade Corporate Bonds
Rating composition of the investment-grade corporate bond market as of the indicated dates

Source: Bloomberg, ICE BofAML US Corporate Index, Credit Suisse, Lord Abbett. As of 01/31/2019. For illustrative purposes only.  Does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

As financial conditions are making it easier to borrow money, we’re seeing that quality companies with the balance sheet flexibility and incentive to take on some debt are doing so. And, as with other quality companies that follow this path and downgrade from, say, single-A to double-B, they can remove this leverage in the event of financial stress, in our view.

Summing Up
In looking at the benchmark 10-year U.S. Treasury note, we think there is better value available in other segments of the fixed income market. Given current market and economic conditions, we believe that the fixed income strategies we’ve discussed here, offering more yield and more income than U.S. government bonds, don’t require investors to take on a significant amount of additional risk for incremental returns. For those considering shorter maturities, as the front of the yield curve appears fairly valued, we think short duration and floating rate securities present appealing opportunities.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

A bond yield is the amount of return an investor will realize on a bond. Though several types of bond yields can be calculated, nominal yield is the most common. This is calculated by dividing the amount of interest paid by the face value. Yield to maturity is the rate of return anticipated on a bond if held until it matures.

Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices.

Fed funds are overnight borrowings between banks and other entities to maintain their bank reserves at the U.S. Federal Reserve (Fed). Banks keep reserves at Fed banks to meet their reserve requirements and to clear financial transactions.

The National Financial Conditions Index (NFCI) is a weekly update produced by the Chicago Federal Reserve that provides information on U.S. financial conditions in money markets, debt and equity markets, as well as traditional and “shadow” banking systems.

Term premium is a gauge of the level of risk inherent in holding a longer-term bond versus a series of shorter-term securities. It represents the estimated risk embedded in a longer-maturity bond that is determined by the difference between the actual yield and the “risk neutral” yield (represented by rolling a series of shorter-term securities extending to the same maturity at current rate expectations).

Yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. One such comparison involves the two-year and 10-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee. Statements concerning financial market trends are based on current market trends, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. All investments involve risks, including the loss of principal invested.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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