High-Yield
Highlights The backdrop for global high-yield corporates remains positive, and a rebound in global GDP and earnings will help ease leverage and interest coverage concerns. With improving global growth taking over the reins from central bank liquidity as the primary driver of high-yield returns, we have decided to reassess the sources of value using some of our key indicators for junk bonds in the US and Europe. The US and euro area appear fairly evenly matched on our valuation metrics but euro area high-yield still offers good value on an absolute basis. We are therefore increasing our recommended allocation to overweight, matching our similar stance for US high-yield. Within the euro area, stay up in quality, favoring Ba-rated credit. Retail and consumer products are attractive bounce-back sectors as Europe emerges from lockdowns later this year. Feature Chart of the WeekCentral Bank Liquidity Has Driven High Yield Outperformance The past year has been excellent for global high-yield corporate bonds. Unprecedented monetary and fiscal stimulus in response to the COVID-19 economic shock and market rout helped rapidly lower credit spreads in the final three quarters of 2020. As the vaccine rollout picked up pace and the reopening trade began to dominate earlier this year, high-yield corporates continued to perform well despite defaults hitting a post-2008 high (Chart of the Week). An improving outlook for the global economy is highly supportive for lower-rated corporate debt from a fundamental perspective, even if that same pickup in growth will put pressure on policymakers to dial back monetary accommodation. Already, growth in major central bank balance sheets – a reliable leading indicator of high yield outperformance – is slowing, with corporate spreads approaching historically tight levels. Thus, we feel it is timely to assess valuation metrics in the largest high-yield markets of the US and Europe – and the implications for regional high-yield allocations - as economic growth takes over the reins from central bank liquidity as the primary driver of spread product performance. A Cyclical Reduction In Corporate Credit Risk In its recently published Global Financial Stability Report,1 the IMF noted that the COVID-19 shock has pushed up global nonfinancial corporate leverage, measured as debt relative to GDP, to historical highs (Chart 2). Some of that rise is due to companies ramping up debt issuance over the past year in response to supportive monetary policy and favorable financial market conditions. Yet according to the IMF, about half of the rise in global corporate debt-to-GDP ratios from Q4/2019 to Q3/2020 was attributable to sharply lower output. Now, with economic growth set to stage a strong rebound this year – the IMF is forecasting global real GDP growth of 6.0% in 2021 and 4.4% in 2022 - a rising denominator should result in corporate debt-to-GDP ratios stabilizing or even falling over the next couple of years. This will help maintain a positive backdrop for corporate spread product, even if central banks like the Fed turn less dovish later this year, as we expect Corporate interest coverage, using the Refinitiv Datastream bottom-up aggregates of individual company data, paints a similar cyclical picture (Chart 3). The absolute level of coverage ratios fell sharply in 2020, accelerating pre-pandemic downtrends that had already been in place in both the US and Europe. Since Q4/2019, however, interest expense actually fell very slightly in the US, meaning that of the 1.5 point fall in the interest coverage ratio, 1.3 points can be attributed to declining corporate earnings over that period. The picture was also lopsided in the euro area, with 2.5 points of the 2.8 point decline in interest coverage over that same period attributable to falling profits. Chart 2Rising Leverage Is Not Just A Debt Story Chart 3Falling Earnings Are Responsible For The Decline In Interest Coverage Rapid improvements in economic growth momentum, fueled by reopening economies and increased fiscal stimulus (especially in the US), should lead to a cyclical rebound interest coverage ratios in both the US and Europe in 2021 and 2022. Bottom Line: The backdrop for global high yield corporates remains positive, and a rebound in global GDP and earnings will help ease leverage and interest coverage concerns. A Trans-Atlantic Comparison Of High-Yield Bond Valuations Chart 4Our Relative Overweight On US HY Has Been A Success Since March of last year, we have maintained a recommended overweight stance on US high-yield versus European equivalents (Chart 4). That was originally a relative central bank play with the Fed including US high-yield in its corporate bond buying program, in contrast to the ECB that was only buying investment grade debt. Our relative regional allocation on high-yield corporates has worked out well, with the US outperforming the euro area by 3.9 percentage points (in excess return terms versus duration-matched government debt) since the pandemic peak in credit spreads last March. Today, with high-yield spreads back near historical tight levels and the momentum of excess returns starting to peak, a forward-looking reevaluation of our US versus Europe high-yield recommendation along value grounds is in order. To conduct our reassessment of value, we look at five key areas: default-adjusted spreads; 12-month breakeven spreads; volatility-adjusted spreads; credit quality curves; and, lastly, the relative carry offered by high-yield corporates in currency-hedged and unhedged terms. Default-Adjusted Spreads As discussed earlier in the report, fiscal and monetary support have helped stave off the worst for high-yield corporates on both sides of the Atlantic, with default rates spiking far less than the amount implied by the collapse in year-over-year GDP growth (Chart 5). Forecasts for 2021 are sanguine—Moody’s expects the trailing 12-month high yield default rate to reach 4.2% in the US and 2.6% in the euro area in 2021, in line with the IMF’s sharp upward revision to growth forecasts for both regions. The outlook for default-adjusted spreads, which look at the index option-adjusted spread (OAS) net of realized default losses, is much more positive in the euro area however, given that they have a much more attractive “starting point”. The realized default-adjusted spread in the euro area was already inching into positive territory last year, as opposed to the deeply negative spread in the US (Chart 6). This alone makes it much more likely that euro area high-yield will deliver a positive return net of default losses. Chart 5The Default Picture Is Expected To Improve Chart 6Euro Area Spreads Are More Attractive On A Default-Adjusted Basis In addition, the potential range for default-adjusted spreads (combining default rates and recovery rates, see the shaded boxes in the chart) is much narrower in the euro area given the lower post-crisis volatility in default rates in that region, making outcomes in the euro area far less uncertain than in the US. Volatility-Adjusted Spreads Chart 7Falling US Spreads Have Overshot The Level Implied By Equity Volatility Another way to evaluate the attractiveness of the level of spreads, and how much further they could fall, is to compare them to standard macro volatility gauges like the US VIX and the European VSTOXX indices. Credit spreads and equity volatility are highly correlated, as both are measures of investor uncertainty that rise during risk-off episodes and vice versa. The ratio of corporate credit spreads to equity volatility, therefore, can signal if spreads appear stretched relative to the broader risk backdrop. The global rally in riskier credit has helped push down volatility-adjusted spreads for both regions, making them expensive relative to the historic mean (Chart 7). However, the divergence between volatility and high-yield spreads is much more pronounced in the US, where the volatility-adjusted spread, currently at all-time lows and 1.8 standard deviations below the mean, appears much less attractive. In contrast, while the euro area measure is still within one standard deviation of the mean and has room to fall further, as it did in 2007. 12-Month Breakeven Spreads To look at valuations in high yield corporates relative to history, we turn to our 12-month breakeven spread metrics. These measure how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus a duration-matched position in government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. On this basis, there seems to be a bit more value in US high-yield spreads, with the 12-month breakeven at the 32nd percentile compared to the 18th percentile ranking for European high-yield. Both markets are not cheap on this metric, though, with the lion’s share of cyclical spread compression having already been realized (Chart 8). This additional value in the US is concentrated in the lower-quality tiers, with B-rated US HY looking most attractive (Chart 9). Chart 8US And Euro Area High-Yield Breakeven Spreads Chart 9All Credit Tier Breakeven Valuations Are In the Bottom Half Relative To History Credit Quality Curves To further inform our decision on value across credit tiers in the US and Europe, we look at credit quality curves, which measure the incremental spread pick-up earned from moving down to lower credit tiers. For example, we look at the spread differential between B-rated and Ba-rated high-yield bonds within the US or Europe. When making the comparisons, we adjust the spreads to account for duration differences between credit tier sub-indices and the overall regional high-yield index. This adjusts for slightly lower index durations as we move down in quality.2 Our colleagues at BCA Research US Bond Strategy have pointed out that the spread pickup earned from moving out of US Baa-rated bonds into Ba-rated bonds is elevated compared to typical historical levels.3 Credit quality curves in the euro area tell a similar story (Chart 10). The spread pickup from moving into Ba-rated credit is slightly higher in the euro area on a cross-country basis while there is a more attractive pickup in the US from moving further down in quality. Chart 10US & European HY Credit Quality Curves Chart 11Euro Area Caa-Rated Spreads Have Room To Fall To Pre-COVID Lows As quality curves have compressed across the board, we can also use the pre-COVID lows in these series as an anchor for how much more narrowing we could see (Chart 11). On that basis, there seems to be a bit more value left in the top two tiers of US high yield while there is more juice left in the euro area Caa-rated minus B-rated spread. The Caa-B spread differential is now quite expensive for the US, sitting -140bps below its pre-COVID low, a reflection of yield-chasing behavior by risk-seeking investors in an easy monetary policy environment. As the Fed begins to take its foot off the monetary accelerator within the next 6-12 months, as we expect, this credit tier is also most vulnerable to a repricing of default risk. Index Yield-To-Maturity Chart 12Junk Index Yields At All Time Lows The hunt for yield by fixed income investors has driven down the index yield on lower-quality credit to all-time lows in both the US and euro area (Chart 12). This dynamic has played out at a time when falling interest rate differentials between the two regions have cut down the cost of hedging US dollar (USD) exposures into euros (or, alternatively, reduced the gain from hedging euro exposures into USD). Importantly, this reduction in the gains/losses from currency hedging allows for a more honest assessment of the relative attractiveness of yields on lower-rated corporates in the US and Europe, reflecting compensation for taking credit risk rather than currency risk. With the backdrop for spread product looking positive, it is worth considering the simple carry over a twelve-month period for holding high-yield debt, in both USD-hedged and unhedged terms (Chart 13). For the overall index and the Ba-rated tier, the US dominates completely, with investors in the euro area better off holding US credit even after paying the currency hedging cost. This dynamic is flipped at the B- and Caa-rated tiers, with euro area credit appearing dominant. Chart 13US Ba-Rated Debt Is Dominant On A Carry Basis An Additional Point On High-Yield Sectors Sector composition will also be an important driver of high-yield returns going forward. In the April 2021 Global Financial Stability report, the IMF noted that global high-yield defaults in 2020 were concentrated in sectors most affected by the pandemic. On a relative basis, the US high-yield index appears more heavily weighted towards those sectors – a picture that becomes even more focused if Energy, which is the largest industry group in US high-yield, is considered as a pandemic-stricken industry (Chart 14). However, the euro area does have a slightly larger tilt towards the hard-hit Retail sector. Chart 14Oil And Gas Was Hardest-Hit In 2020 An important implication is that the sectors that suffered the most in 2020 are also the ones most poised for a snapback this year as economies reopen and growth recovers. One way to approach this from a relative valuation perspective is to look at the relative industry-level cross-country spreads between the US and Europe, compared to the change in global defaults by sector from 2019 to 2020 (Chart 15). Chart 15Sectors That Saw Rising Defaults In 2020 Are Poised For A Rebound Sectors that saw a moderate-to-high number of defaults last year, such as Retail and Consumer products, offer higher spreads in the euro area. These will also be the sectors to benefit the most from a consumption rebound as Europe exits lockdowns. On the other hand, US spreads are more attractive than European spreads for the Media and Transportation sectors that saw a big increase in defaults in 2020. Importantly, while the US Energy sector also looks more relatively attractive on that basis, much of a post-COVID recovery has already been priced in, with US high-yield energy spreads below pre-pandemic lows. Investment Conclusions Having looked at our suite of valuation metrics, euro area and US high-yield appear quite evenly matched. On a default and volatility-adjusted basis, spreads in the euro area appear to offer more value while US high-yield largely wins out on a breakeven spread and carry basis. Thus, the case for favoring US high-yield over European equivalents is no longer as compelling as it has been for much of the past twelve months. We are therefore taking profits on our long-held recommended overweight stance on US high-yield versus European high-yield. We are implementing this change by upgrading our strategic euro area high yield allocation to overweight (4 out of 5), which matches our similar overweight recommended tilt for US high-yield (see table on page 15). Within our model bond portfolio, we are “funding” that upgrade by reducing the size of our recommended overweight exposure to core European sovereign debt in Germany and France (see the model bond portfolio tables on pages 13-14). On the margin, this decision also positions us favorably with regards to the consumption driven H2/2021 recovery in euro area economies highlighted by our colleagues at BCA Research European Investment Strategy.4 Within European credit, we recommend staying up in quality, favoring the Ba-rated tier as lower quality tranches do not offer adequate compensation for the increased credit risk. Bottom Line: Rebounding global growth will help maintain a favorable backdrop for global high yield credit. The US and euro area look evenly matched on our valuation metrics, but there is still good value on offer in the euro area on an absolute basis. Increase allocations to euro area high-yield, favoring the Ba-rated credit tier and Retail and Consumer Products industries, in particular. Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1https://www.imf.org/en/Publications/GFSR/Issues/2021/04/06/global-financial-stability-report-april-2021 2 Please see BCA Research US Bond Strategy Report, "Ba- Rated Bonds Look Best", dated February 9, 2021, available at usbs.bcaresearch.com. 3 Note that this adjustment is made to facilitate more accurate comparisons within the credit tiers of the high-yield universe. No such adjustment is made to the Baa-rated credit spread, which is higher-quality investment grade and therefore not part of the high-yield universe. 4 Please see BCA Research European Investment Strategy Special Report, "A Temporary Decoupling", dated April 5, 2021, available at eis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
Highlights Duration: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to beat expectations. Corporates: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense. Inflation & TIPS: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners. Expect Some Pushback From The Fed The continuing bond market selloff will be the top item on the agenda at this week’s FOMC meeting. Meeting participants will debate whether the sharp rise in long-maturity bond yields represents a threat to the economic recovery and Chair Powell will no doubt be peppered with questions on the topic at his post-meeting press conference, as he was when he sat down with a Wall Street Journal reporter two weeks ago.1 But for our part, we’ll be focused more on the front-end of the yield curve this week. Specifically, we’ll be looking to see whether the Fed revises up its funds rate forecasts by enough to justify current market pricing or whether it uses its forecasts to push back against the bond bears. The market’s fed funds rate expectations have moved a lot since the Fed last published its own forecasts in December (Chart 1on page 1). In December, the market was priced for fed funds liftoff in December 2023 and then only one more 25 basis point rate hike through the end of 2024. Now, the market is looking for liftoff in January 2023, followed by two more rate hikes before the end of that year. Chart 1Market Priced For 3 Rate Hikes Before The End Of 2023 As for the Fed, at last December’s meeting only 5 out of 17 FOMC participants anticipated raising rates before the end of 2023. It’s logical to expect the Fed to increase its rate expectations this week as the economic outlook is much brighter than it was at the time of the December FOMC meeting. Back in December, we still didn’t know whether the Democrats would win control of the Senate, enabling passage of President Biden’s $1.9 trillion stimulus bill. Doubts also remained about how quickly COVID vaccination would occur. Chart 2The Data Can't Disappoint The Fed will probably respond to these pro-growth developments by revising up its interest rate expectations, but we doubt that these revisions will bridge all of the gap with the market. Employment and inflation both remain far from where the Fed would like them to be, and the Fed will want to send the message that its policy stance remains highly accommodative. We could see the Fed’s median fed funds rate forecast shifting to call for one rate hike by the end of 2023, but not the three currently priced into the yield curve. In this scenario, the Fed’s pushback could prompt some near-term downside in bond yields. The question is how long the Fed’s messaging will impact the market in the current environment of surging economic growth. The Economic Surprise Index shows that the economic data can’t even manage to disappoint expectations, a development that usually coincides with rising yields (Chart 2). Bottom Line: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to surpass expectations. We maintain below-benchmark portfolio duration and we will continue to use our Checklist (see last week’s report)2 to determine an appropriate time to increase duration. The Spread Buffer In Corporate Credit Treasury yields troughed last August, and since then returns have been hard to come by in the US bond market. This is not too surprising. Fixed income is hardly the ideal asset class for a reflationary economic environment. However, there are steps a bond portfolio manager can take to maximize profits in an economic environment that is characterized by (i) rapid economic growth, (ii) rising inflation expectations and (iii) monetary policy that remains accommodative. Specifically, bond investors should minimize their exposure to interest rate risk (i.e. duration) and maximize exposure to credit risk. That is, shy away from long duration assets with little-to-no credit spread and favor shorter duration assets where the credit spread makes up a large proportion of the yield. This sort of strategy has worked well since the August trough in Treasury yields. The Investment Grade Corporate Bond Index – an index with relatively long duration and a small credit spread – is down 4.08% since August 4th (Chart 3). Notably the worst returns have come from the highest rated credit tiers where the credit spread makes up a smaller proportion of the yield. Notice that Aaa-rated Corporates have lost 9% while Baa-rated bonds are only down 2.52% (Table 1). In contrast, total returns from the High-Yield Index – an index with lower duration where the credit spread makes up a much larger proportion of the yield – have held up nicely. The overall index has returned 6.65% since August 4th with the lowest credit tiers once again performing best. Chart 3Move Down In ##br##Quality Table 1Corporate Bond Returns Since The Aug. 4 2020 Trough In Treasury Yields Performance for both the Investment Grade and High-Yield indexes improves if we look at excess returns relative to a duration-matched position in Treasury securities. That is, if we hedge out the interest rate risk and focus purely on spread movements. Though even here, we find that the lowest rated credits with the widest spreads deliver the best returns. If we assume that this reflationary economic environment persists for the next 12 months, can we expect the same low rate risk/high credit risk strategy to succeed? One way to investigate this question is to look at the 12-month breakeven yields and spreads for different segments of the corporate bond market (Table 2). The 12-month breakeven yield is the yield increase that the index can tolerate over the next 12 months before it delivers negative total returns. Similarly, the 12-month breakeven spread is the spread widening that an index can tolerate over the next 12 months before it delivers negative excess returns (where excess returns are measured versus a duration-matched position in Treasury securities). Table 2Corporate Bond 12-Month Breakeven Yields And Spreads The overall Investment Grade Corporate Index, for example, has an average maturity of 12 years and a 12-month breakeven yield of 27 bps. This means that, if we assume that the investment grade corporate bond spread holds steady, then the odds of the index delivering negative total returns over the next 12 months are the same as the odds of a 12-year Treasury yield rising by more than 27 bps. An assumption of flat investment grade corporate bond spreads seems reasonable given that spreads are already historically tight (Chart 4). Moving down in quality within investment grade helps a bit, the Baa credit tier has a 12-month breakeven yield of 30 bps compared to a 12-month breakeven yield of 21 bps for the Aa credit tier. A similar benefit is observed if we look at the 12-month breakeven spread: 14 bps for Baa and only 6 bps for Aa. However, the real improvement comes when we move out of investment grade entirely and into high-yield. To calculate fair breakeven yields and spreads for high-yield bonds we need to incorporate default loss expectations. The current macro environment of strong growth and accommodative monetary policy should lead to relatively low default losses. That being the case, we assume a base case of a 2.5% default rate and 40% recovery rate for the next 12 months. Using this assumption, we calculate a 12-month breakeven yield of 75 bps for the High-Yield Index and a 12-month breakeven spread of 46 bps. This represents a significant extra buffer compared to what is offered by even the lowest investment grade credit tier. Not only that, but the 75 bps 12-month breakeven yield from the High-Yield Index looks even better when we consider that high-yield spreads are not as overvalued relative to history as investment grade spreads, and have more room to tighten as the economic recovery progresses (Chart 5). Chart 4Investment Grade Valuation Chart 5High-Yield Valuation Table 2 also presents two other default loss scenarios, and it shows that we need fairly pessimistic default loss expectations to make high-yield breakeven yields and spreads comparable to what is offered by investment grade bonds. Even if we assume a 4.5% default rate and 30% recovery rate for the next 12 months, we still get a 32 bps breakeven yield from the High-Yield Index, comparable to what we get from the Baa credit tier. Bottom Line: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense. Inflation & The Inverted TIPS Curve Chart 6Inflation Will Peak In April February’s Consumer Price Index was released last week, and it showed that core CPI managed only a 0.1% increase on the month. This caught some off guard given that “rising inflation” has become a popular market narrative during the past few months. Our view is that core inflation will rise significantly between now and the end of the year, and that 12-month core PCE inflation will end the year close to the Fed’s 2% target. We arrive at this view for three reasons. First, base effects will lead to a large jump in 12-month inflation measures in March and April. Chart 6 illustrates the paths for both 12-month core PCE and core CPI assuming modest 0.15% monthly gains between now and the end of the year. Because the severely negative inflation prints from last March and April are about to fall out of the rolling 12-month sample, 12-month core inflation is on the cusp of rising to levels considerably above the Fed’s target. This means that after 12-month inflation peaks in April, the question will be how much it declines during the remainder of the year. One reason why we think it might not fall that dramatically is that bottlenecks are already emerging in both the goods and services sectors, and prices will come under upward pressure as the economy re-opens and consumers are encouraged to deploy some of the excess savings they’ve built up during the pandemic. Producer prices are currently surging, as are survey responses about price pressures from the NFIB Small Business Survey and the ISM Manufacturing and Non-Manufacturing Surveys (Chart 7). Finally, shelter is the largest component of core inflation (accounting for almost 40% of core CPI). It would be difficult for overall core inflation to rise significantly without at least some participation from shelter. With that in mind, we now see evidence that shelter inflation will soon put in a trough (Chart 8). Chart 7Price Pressures Are Building Chart 8Shelter Inflation About To Bottom The permanent unemployment rate and Apartment Market Tightness Index are both tightly correlated with shelter inflation. The permanent unemployment rate has stopped climbing and will move lower during the next few months as increased vaccination rates allow for more of the economy to re-open (Chart 8, panel 2). The Apartment Market Tightness Index is also well off its lows, and it will soon jump above the 50 line, joining the Sales Volume Index (Chart 8, panel 3). Consumers are also increasingly seeing signs of rental inflation. A question from the New York Fed’s Survey of Consumer Expectations showed a very sharp increase in expected rents in February (Chart 8, bottom panel). Chart 9Stay Long TIPS As for TIPS strategy, we are hesitant to back away from our overweight TIPS/underweight nominal Treasuries position with inflation on the cusp of a such a significant move higher, especially with the 5-year/5-year forward TIPS breakeven inflation rate still below where the Fed would like it to be (Chart 9). We are also not yet willing to exit the inflation curve flattening and real yield curve steepening positions that we have been recommending since last April, even though the 5/10 TIPS breakeven inflation slope has become inverted (Chart 9, bottom panel).3 With the Fed targeting an overshoot of its 2% inflation target, an inverted inflation curve is more natural than a positively sloped one. This is because the Fed will be trying to hit its inflation target from above, rather than from below. Further, the short-end of the inflation curve is more sensitive to the actual inflation data than the long-end. This means that the curve could flatten even more as inflation rises in the coming months. Bottom Line: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the implications of what Powell said in this interview please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Duration: Long-maturity Treasury yields are closing in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Ba Versus Baa Corporates: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes. Labor Market: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022. Feature Chart 1Uptrend Intact Bond yields moved higher last week, maintaining their post-August uptrend despite a brief lull in the second half of January (Chart 1). The 30-year yield even touched 1.97%, its highest level since last February. Given the sharp up-move, the first section of this week’s report considers whether bond yields look stretched. More broadly, we discuss several factors that will help us decide when to increase portfolio duration. How Much Higher Can Yields Rise? We have maintained a recommended below-benchmark duration stance since October and have been targeting a range of 2% to 2.25% for the 5-year/5-year forward Treasury yield.1 That target range is based on median estimates of the long-run equilibrium fed funds rate from the New York Fed’s surveys of market participants and primary dealers (Chart 2). The rationale is that in an environment of global economic recovery where the Fed is expected to eventually lift the funds rate back to equilibrium, long-dated forward yields should reflect expectations of that long-run equilibrium. At present, the 5-year/5-year forward Treasury yield is 1.97% meaning that there is between 3 bps and 28 bps of upside before our target is met. Chart 2Almost At Target A 5-year/5-year forward Treasury yield between 2% and 2.25% would not automatically trigger an increase in our recommended portfolio duration, but it would mean that further increases in yields would need to be justified by upward revisions to survey estimates of the long-run equilibrium fed funds rate. In a similar vein, the 5-year/5-year forward TIPS breakeven inflation rate has risen considerably in recent months, but at 2.15%, it remains below the 2.3% to 2.5% range that the Fed would consider “well anchored” (Chart 2, bottom panel). In other words, there is still some running room for reflationary economic outcomes to be priced into bond yields. Cyclical Growth Indicators Treasury yields may be encroaching on the lower bounds of our target ranges, but cyclical economic indicators suggest further increases ahead. The CRB Raw Industrials / Gold ratio remains in a solid uptrend, and encouragingly, it is being driven by a surging CRB index and not just a falling gold price (Chart 3). Separately, the outperformance of cyclical equity sectors over defensives has moderated in recent weeks, but not yet by enough to warrant reversing our duration call (Chart 3, bottom panel). Chart 3Cyclical Bond Indicators Value Indicators Chart 4Bond Valuation Indicators While cyclical indicators point to further bond weakness ahead, a couple valuation measures show yields starting to look stretched. Two survey-derived estimates of the 10-year zero-coupon term premium have moved up sharply. The estimate derived from the New York Fed’s Survey of Market Participants has jumped into positive territory and the estimate derived from the Survey of Primary Dealers is close behind (Chart 4). These surveys ask respondents to estimate what they think the fed funds rate will average over the next ten years. By comparing the median survey response to the current spot 10-year Treasury yield we get a measure of how much term premium the median investor expects to earn. These term premium estimates have typically been negative during the past few years, though they did rise to about +50 bps before Treasury yields peaked in 2018. In other words, a positive term premium estimate, on its own, is no reason to extend duration. All it tells us is that if the median investor is correct about the future path of the fed funds rate, then there is more money to be made at the long-end of the curve than in cash. This doesn’t rule out investors revising their funds rate expectations higher, or the term premium becoming even more stretched. Another related bond valuation indicator is the difference between the market’s expected path for the fed funds rate and the path projected by the FOMC (Chart 4, bottom panel). Here we see that, for the first time since 2014, the market is priced for a faster pace of tightening over the next two years than the median FOMC participant anticipates. Again, this is not a decisive signal to buy bonds. The FOMC could revise its funds rate projections higher when it meets next month. However, the longer that market pricing remains more hawkish than the Fed, the stronger the case to increase duration becomes. The Dollar Chart 5Dollar Still Supports Higher Yields Finally, we should note that the trade-weighted dollar appreciated last week as bond yields rose (Chart 5). A stronger dollar certainly supports the case for extending duration, the only question is whether the dollar has strengthened enough to dent US economic growth and pull US yields back down. Our sense is that we haven’t reached that breaking point yet, but we could if US real yields continue to rise relative to real yields in the rest of the world (Chart 5, panels 2 & 3). We think of the relationship between US bond yields and the dollar as a feedback loop. A weaker dollar supports economic reflation, which eventually sends yields higher. However, once higher US yields de-couple too far from yields in the rest of the world, the dollar appreciates. A stronger dollar impairs the economic outlook and sends US yields back down, the dollar then depreciates and the cycle repeats. At present, we appear to be in the stage of the feedback loop where US yields are rising relative to the rest of the world, putting upward pressure on the dollar. However, we don’t think the dollar is yet strong enough to prevent US yields from climbing. Dollar bullish sentiment, for example, remains below 50% suggesting that most investors remain dollar bears. A sub-50 reading on this index also tends to coincide with rising US Treasury yields (Chart 5, bottom panel). A move above 50 in the dollar sentiment index would be another signal that the bond bear market is becoming stretched. Bottom Line: Long-maturity Treasury yields are closing-in on our intermediate-term targets. On balance, cyclical and valuation indicators continue to support an outlook for higher yields, but a few are sending warning signs that the bearish bond move is due for a correction. We maintain our recommended below-benchmark 6-12 month duration stance for now, but are keeping a close eye on the indicators shown in this report. Comparing Baa- And Ba-Rated Corporate Bonds Chart 6The Ba Index OAS Is Unusually High We have previously written that the macro environment is extremely positive for credit risk and we recommend moving down in quality within corporate bonds. We have also pointed out that the incremental spread pick-up earned from moving out of Baa-rated bonds and into Ba-rated bonds is elevated compared to typical historical levels. As such, the Ba-rated credit tier looks like the sweet spot for corporate bond allocation from a risk/reward perspective.2 In this week’s report we delve a little deeper into the relative valuation between Baa- and Ba-rated bonds. First, we note the difference between the average option-adjusted spread (OAS) of the Ba index and the average OAS of the Baa index. The Ba index OAS is 126 bps above the Baa index OAS, a level that looks high compared to recent years (Chart 6). One problem with this simple comparison of index OAS is that the average duration of the Ba index is much lower than the average duration of the Baa index (Chart 6, bottom panel). However, after doing our best to match the duration between the two indexes, we still find that Ba offers an attractive yield advantage, particularly compared to levels seen in 2017 and 2018 (Chart 6, panel 2). Going back to our simple OAS differential, we conducted a small study looking at calendar year excess returns between 1989 and 2020. Our results show that the differential between the Default-Adjusted Ba OAS and the Baa OAS does a good job predicting relative excess returns between the two sectors (Table 1).3 The Default-Adjusted Ba OAS is the Ba index OAS at the beginning of the calendar year minus realized Ba default losses that occurred during the year in question. We also use the Baa index OAS from the beginning of the year, but don’t make any adjustments for Baa default losses. Table 1Annual Excess Return Differential & Relative Spreads: Ba Corporates Over Baa Corporates Our results show that Ba excess returns outpaced Baa excess returns in every calendar year for which the Adjusted Ba/Baa OAS differential exceeds 100 bps. The raw Ba/Baa OAS differential is currently 126 bps. This means that we should be very confident that Ba-rated bonds will outperform Baa-rated bonds in 2021, as long as Ba default losses come in below 0.26%. This seems likely. For context, Ba default losses came in at 0.09% in 2020, despite the 12-month default rate spiking to almost 9%. Fallen Angels Another interesting issue to consider when looking at the intersection between the Baa and Ba credit tiers is the presence of fallen angels – bonds that were initially rated investment grade but have been downgraded to junk. The 2020 default cycle coincided with a huge spike in ratings downgrades and the number of outstanding fallen angels jumped dramatically (Chart 7). Not only that, but fallen angels also performed exceptionally well in 2020. Fallen angels outperformed duration-matched Treasuries by 800 bps in 2020 compared to 431 bps for the Ba-rated index, -10 bps for the Baa-rated index and -13 bps for the B-rated index (Chart 7, bottom panel). All that outperformance has compressed fallen angel valuations a lot. The incremental spread pick-up in fallen angels over duration-matched Baa-rated bonds is 201 bps, about one standard deviation below its post-2010 average (Chart 8). Fallen angels look even worse compared to the Ba index, offering only a 30 bps spread advantage (Chart 8, panel 2). Chart 7Fallen Angels Dominated In 2020 Chart 8Fallen Angels No Longer Look Cheap Bottom Line: From a risk-adjusted perspective, the Ba credit tier still looks like the sweet spot for positioning within corporate bonds. Fallen Angels have performed exceptionally, but no longer look cheap compared to the Baa and Ba corporate indexes. Labor Market Update Chart 9Employment Growth Has Slowed Last week’s January employment report was a disappointment with nonfarm payrolls growing only 49k after having contracted by 227k in December (Chart 9). Two weeks ago, we calculated the average monthly nonfarm payroll growth that will be required for the unemployment rate to reach 4.5% by certain future dates.4 In our view, an unemployment rate of 4.5% would meet the Fed’s definition of maximum employment, making it an important pre-condition for monetary tightening. Revising our calculations to incorporate January’s report, a 4.5% unemployment rate by the end of 2021 still looks like a long shot. Nonfarm payroll growth would have to average between +328k and +705k per month to meet that target, depending on the path of the participation rate (Table 2). That said, we still view a 4.5% unemployment rate by the end of 2022 as achievable. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% ##br##By The Given Date Yes, even that will require average monthly payroll growth of between +210k and +411k, but we are likely to see a re-opening of certain shuttered sectors – Leisure & Hospitality, for example – during that timeframe. When it occurs, this re-opening will lead to a surge in employment growth that will push average monthly payroll growth dramatically higher. Notice that almost 40% of the 9.9 million drop in overall employment since February 2020 has come from the Leisure & Hospitality sector (Chart 10). Chart 10Waiting For The Post-COVID Snapback Bottom Line: If the current pace of monthly employment growth is maintained, it will be a very long time before the economy reaches full employment. Vaccine effectiveness and distribution rate are the two most important factors that will determine employment growth going forward. We are optimistic that we will see a 4.5% unemployment rate sometime in 2022. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Excess returns are calculated relative to duration-matched Treasury securities in all cases. 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Chart 1Inflation Indicators Hook Up There’s no doubt that inflationary pressures are building in the US economy. The latest piece of evidence is January’s ISM Manufacturing PMI which saw the Prices Paid component jump above 80 for the first time since 2011 (Chart 1). Large fiscal stimulus is clearly leading to bottlenecks in certain industries that were not negatively impacted by the pandemic, and this could cause consumer price inflation to rise during the next few months. However, the Fed will not view a spike in inflation as sustainable unless it is accompanied by a labor market that is close to maximum employment. The Fed estimates that “maximum employment” corresponds to an unemployment rate of 3.5% to 4.5%, and we calculate that average monthly payroll growth of about +500k is required to reach that target by the end of the year. The bottom line is that rising inflation will not lead to Fed tightening this year. We continue to expect liftoff in late-2022 or the first half of 2023. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 3 basis points in January. The index option-adjusted spread widened 1 bp on the month, leaving it 4 bps above its pre-COVID low. As discussed in last week’s report, the combination of above-trend economic growth and accommodative monetary policy means that the runway for spread product outperformance remains long.1 However, given that investment grade corporate bond spreads are extremely tight, investors should look to other spread products when possible. One valuation measure, the investment grade corporate index’s 12-month breakeven spread – with the index re-weighted to maintain a constant credit rating distribution over time – is down to its 4th percentile (Chart 2). This means that the breakeven spread has only been tighter 4% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 4% of the time (panel 3). While we don’t anticipate material underperformance versus Treasuries, we see better value outside of the investment grade corporate space. Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration (see page 9). We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration (see page 8). Finally, the supportive macro environment means that we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors pick up the additional spread offered by high-yield corporates, particularly the Ba credit tier where spreads remain wide compared to average historical levels (see page 6). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 62 basis points in January. The average index option-adjusted spread widened 2 bps on the month, leaving it 47 bps above its pre-COVID low. Ba-rated credits outperformed duration-matched Treasuries by 50 bps on the month, besting B-rated bonds which outperformed by only 33 bps. The Caa-rated credit tier delivered 157 bps of outperformance versus duration-matched Treasuries. We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is merely in line with historical averages.2 Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only six defaults occurred in December, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, have also fallen dramatically (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in January. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened sharply in January, despite a continued rapid pace of refinancing activity (Chart 4). The option-adjusted spread adjusted downward in January and it now sits at 25 bps (panel 3). This is considerably below the 61 bps offered by Aa-rated corporate bonds and the 45 bps offered by Agency CMBS. It is only slightly above the 20 bps offered by Aaa-rated consumer ABS. The primary mortgage spread has tightened dramatically during the past few months (bottom panel), a key reason why refinancing activity has been so strong despite the back-up in Treasury yields. With the mortgage spread now closer to typical levels, it stands to reason that further increases in Treasury yields will be matched by higher mortgage rates. As such, mortgage refinancing activity could be close to its peak. While a drop in refinancing activity would be a reason to get more bullish on MBS, we aren’t yet ready to pull that trigger. The gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2), and we could still see spreads adjust higher. Last year’s spike in the mortgage delinquency rate is alarming (panel 4), but it will have little impact on MBS returns. The increase was driven by household take-up of forbearance granted by the federal government. Our US Investment Strategy service recently showed that a considerable majority of households will remain current on their loans once the forbearance period expires, causing the delinquency rate to fall back down.3 Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 24 basis points in January (Chart 5). Sovereign debt and Foreign Agencies underperformed duration-equivalent Treasuries by 21 bps and 7 bps, respectively, in January. Local Authority bonds outperformed the Treasury benchmark by 140 bps while Domestic Agency bonds and Supranationals outperformed by 15 bps and 7 bps, respectively. Last week’s report contains a detailed look at valuation for USD-denominated EM Sovereigns.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage versus US corporates for all credit tiers except Ba. We recommend that investors take advantage of this spread pick-up by favoring investment grade EM Sovereigns over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space. Ba-rated high-yield US corporates offer a spread advantage over EM Sovereigns and the extra spread available in B-rated and lower EMs comes from distressed credits in Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 108 basis points in January (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 6). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (bottom panel). Revenue bonds in the 8-12 year and 6-8 year maturity buckets offer an after-tax yield pick-up versus Credit for investors with effective tax rates above 3% and 16%, respectively. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 21% and 33%, respectively. All in all, municipal bond value has deteriorated markedly in recent months and we downgraded our recommended allocation from “maximum overweight” to “overweight” in last week’s report. However, investors should still prefer municipal bonds over investment grade corporate bonds with the same credit rating and duration. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in January. The 2/10 Treasury slope steepened 20 bps to 100 bps. The 5/30 Treasury slope steepened 13 bps to 142 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and stimulative fiscal policy will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on a duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 143 basis points in January. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 14 bps and 1 bp on the month. They currently sit at 2.15% and 2.06%, respectively. Core CPI rose 0.09% in December, causing the year-over-year rate to dip from 1.65% to 1.61%. Meanwhile, 12-month trimmed mean CPI ticked up from 2.09% to 2.10%, widening the gap between trimmed mean and core (Chart 8). We expect 12-month core inflation to jump during the next few months, narrowing the gap between core and trimmed mean. As such, we remain overweight TIPS versus nominal Treasuries, even though the 10-year TIPS breakeven inflation rate looks expensive on our Adaptive Expectations Model (panel 2).5 We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 17 basis points in January. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps in January, while non-Aaa issues outperformed by 48 bps (Chart 9). The stimulus from the CARES act led to a significant increase in household income when individual checks were mailed out last April. Since then, households have used this stimulus to build up a considerable buffer of excess savings (panel 4). The large stock of household savings means that the collateral quality of consumer ABS is very high, and this situation won’t change any time soon with even more fiscal stimulus on the way. Investors should remain overweight consumer ABS and take advantage of strong collateral performance by moving down in credit quality. The Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 does not alter our recommendation. Spreads are already well below the borrowing cost that was offered by TALF, and these tight spread levels are justified by strong household balance sheets. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 75 basis points in January. Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in January, while non-Aaa issues outperformed by 185 bps (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted. Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 28 basis points in January. The average index spread tightened 4 bps on the month to reach 45 bps (bottom panel). Though Agency CMBS spreads have completely recovered back to their pre-COVID lows, they still look attractive compared to other similarly risky spread products. This is especially true when you consider the Fed’s continued pledge to purchase as much Agency CMBS as “needed to sustain smooth market functioning”. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of January 29TH, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of January 29TH, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 86 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 86 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of January 29th, 2021) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, January 2021”, dated January 25, 2021, available at usis.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021, available at usbs.bcaresearch.com 5 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation
Highlights Fed: We will use the monthly US employment data to track progress toward the first Fed rate hike. At present, our base case outlook calls liftoff in late-2022 or the first half of 2023. Investors should maintain below-benchmark portfolio duration. Corporate Bonds: The macro environment is supportive for spread product returns, but there are better opportunities than in investment grade corporate bonds. We prefer high-yield over investment grade within the US corporate space, particularly the Ba credit tier. Munis: Muni value has deteriorated markedly, but the sector still looks attractive compared to investment grade corporate bonds. EM Sovereigns: We recommend owning investment grade USD-denominated EM Sovereign bonds instead of investment grade US corporates. Within high-yield, US corporates still offer a better opportunity than EM Sovereigns. Using Employment Data To Time Fed Liftoff The current debate raging in fixed income circles revolves around whether large-scale fiscal stimulus will cause inflation to flare this year, possibly leading to a much earlier fed funds liftoff date than is currently priced into the yield curve (Chart 1). Chart 1Fed Liftoff Priced For July 2023 Last week’s report discussed our outlook for inflation in 2021.1 In short, our base case calls for 12-month PCE inflation to peak above the Fed’s 2% target in April but to then fall back below 2% by the end of the year. However, there is a compelling case to be made that inflation could rise more quickly. Table 1A Checklist For Liftoff Last week, our Global Investment Strategy service pointed out that the combined effect of December’s fiscal stimulus deal and President Biden’s newly proposed American Rescue Plan would inject an average of $300 billion per month into the economy through the end of September.2 The Congressional Budget Office estimates that the monthly output gap – the difference between what the economy is capable of producing and what it is actually producing – is currently $80 billion. In that environment, it’s not hard to see how excess demand could lead to price increases in certain sectors. Chart 2How Far From "Maximum Employment"? Of course, for bond investors what matters is not just the path of inflation but how the Fed responds. If rising inflation prompts the Fed to lift rates before July 2023 – the liftoff date currently priced into the market – then bonds will sell off. If liftoff occurs later, then yields will fall. This makes timing the liftoff date critical, and fortunately, the Fed has given us three explicit criteria that must be met before liftoff will occur (Table 1). This week’s report focuses, not on inflation, but on the condition related to “maximum employment.” Our sense is that if the Fed does not think the economy is at “maximum employment” it will ignore modest overshoots of its 2% inflation target on the view that the large amount of labor market slack will eventually cause inflationary pressures to wane. We define “maximum employment” as an unemployment rate of 4.5%, consistent with the upper-bound of the Fed’s most recent range of NAIRU estimates (Chart 2). Using that assumption, and an assumption for the path of the labor force participation rate (Chart 2, bottom panel), we can calculate the average monthly payroll gains that must occur for the unemployment rate to hit the 4.5% target by specific future dates. Our results are shown in Table 2. We use four different scenarios for the labor force participation rate. The lowest estimate assumes that the participation rate remains at its current level. The highest estimate assumes that it re-converges to its pre-COVID level at the same time as the unemployment rate hits 4.5%. The two middle estimates assume smaller increases of 1% and 0.5%, respectively. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% Over The Given Horizon We expect the participation rate to rise as the economy recovers and people are drawn back into the labor force, but some workers have likely been permanently displaced by the pandemic and a full convergence back to pre-COVID levels may not occur until well after the unemployment rate reaches 4.5%, if at all. With that in mind, the “Convergence To Pre-COVID” scenario probably overstates the monthly payroll gains necessary to hit full employment and the “Stays At 61.5%” scenario almost certainly understates them. If we focus on the two middle scenarios, we see that average monthly payroll gains of between 472k and 572k are required for the unemployment rate to hit 4.5% by the end of this year. This range falls to 346k - 413k if we push the liftoff date out until mid-2022 and to 283k – 334k if we move out until the end of 2022. At first blush, these numbers look unattainable. Between 2010 and 2019, average monthly payroll growth averaged a mere +97k. But, given the downturn that just occurred, employment growth will likely be much stronger going forward. Our research into past economic cycles has found that the two main determinants of average monthly employment growth during the first year following a recession are: The drawdown in employment that occurred during the recession (a larger drawdown correlates with greater payroll growth in the first 12 months of recovery) Real GDP growth during the first 12 months of recovery Chart 3 shows the correlation between the peak-to-trough decline in nonfarm payrolls during the past eight US recessions and the average monthly payroll gains seen during the first 12 months of economic recovery. The correlation is quite linear except for the 2008 recession where the peak-to-trough decline in payrolls was 8.7 million but the bounce-back was incredibly weak. Chart 4 explains why the 2008 recession looks like such an outlier in Chart 3. Real GDP growth during the first 12 months of recovery coming out of the 2008 recession was very low, only 2.6%. Chart 3Large Payroll Drawdowns Tend To Be Followed By Strong Gains… Chart 4…And Occur Alongside Strong Economic Recovery Thinking about the current recovery from the COVID recession. Nonfarm payrolls fell by about 22 million from peak to trough in 2020. This is literally off the charts (looking at Chart 3), about 2.5 times the job loss seen in 2008. Then, the Fed’s most recent median estimate for real GDP growth in 2021 is a robust 4.2%, and this estimate was made before Democrats took control of the Senate and proposed a massive new stimulus bill. Considering both the large drawdown in employment and the outlook for rapid GDP growth in 2021, average monthly payroll gains should be quite strong this year. A return to a 4.5% unemployment rate by the end of 2021 is probably a long shot, but we can easily envision average monthly payroll gains on the order of 300k to 400k per month, enough to prompt Fed tightening by late-2022 or the first half of 2023. Whatever transpires, we will monitor monthly payroll growth in the coming months and use this analysis to continuously reassess our liftoff expectations. For the time being, investors should keep portfolio duration low. Alternatives To Investment Grade Corporates Another conclusion that falls out of the above analysis is that the runway for spread product outperformance remains long. With Fed tightening unlikely until late-2022 or the first half of 2023, monetary conditions will remain accommodative for some time. This will drive a continued search for yield, supporting the outperformance of spread product relative to Treasuries. But despite the supportive macro environment, bond investors face a problem that the most popular US spread sector – investment grade corporate bonds – looks very expensive. The average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is only 2 bps above its pre-COVID low, and the spread on Baa-rated bonds is exactly equal to its pre-COVID low. Aa- and A-rated bonds appear somewhat cheaper (Chart 5). The valuation picture is even bleaker after adjusting the index to ensure a constant average credit rating and average duration over time. The 12-month breakeven spread for the credit rating-adjusted corporate index has only been tighter 3% of the time since 1995 (Chart 6). Chart 5IG Spreads Are Tight... Chart 6...Especially After Adjusting For Risk The remainder of this report discusses potential alternatives to investment grade corporate bonds. Specifically, we’re looking for spread products that will benefit from the same macro environment as investment grade corporates, but where investors can pick up some additional risk-adjusted value. Candidate #1: Junk Bonds Chart 7Ba-Rated Corporates Are Cheap One obvious thing investors might consider is a move down the quality spectrum into high-yield bonds. This move comes with greater credit risk, but we believe the incremental spread pick-up provides more than fair additional compensation. The Bloomberg Barclays High-Yield index’s average option-adjusted spread is still 33 bps above its pre-COVID low, and the spread pick-up in the Ba credit tier relative to the Baa credit tier looks particularly compelling (Chart 7). The supportive macro environment makes us less worried about taking additional credit risk in a portfolio, and we recommend that investors pick up the additional spread offered in the high-yield space. The elevated incremental spread pick-up in Ba bonds makes that credit tier look like the best risk-adjusted opportunity. Candidate #2: Tax-Exempt Municipal Bonds Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 8). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (Chart 9), the same goes for Revenue bonds with 8-12 year maturities. Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate of 10% or higher. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 14% and 26%, respectively. Chart 8Muni / Treasury Yield Ratios Chart 9Munis Still Attractive Versus Corporates All in all, municipal bond value has deteriorated markedly in recent months and we therefore downgrade our recommended allocation slightly from “maximum overweight” (5 out of 5) to “overweight” (4 out of 5). Investors should still prefer tax-exempt municipal bonds relative to investment grade corporate bonds with the same credit rating and duration. Candidate #3: USD-Denominated Emerging Market Sovereigns For all of last year we advised investors to favor investment grade corporate bonds over USD-denominated EM Sovereigns of equivalent credit rating and duration. This positioning worked out well. Since the March 23rd peak in credit spreads, the A3/Baa1-rated EM Sovereign index has only outperformed the duration-matched A-rated US Credit index by 159 bps while it has underperformed the Baa-rated US Credit index by 571 bps (Chart 10). In the high-yield space, the B1/B2-rated EM Sovereign index has significantly underperformed both the Ba and B-rated US junk bond indexes. Chart 10EM Sovereigns Underperformed US Corporates In 2020 But now, after nine months of poor relative performance, value is starting to look more compelling in the EM Sovereign space. Chart 11 shows that EM Sovereigns offer a yield pick-up versus duration-matched US corporate bonds for all credit tiers except Ba. At the country level, the yield advantage in the A and Aa credit tiers is attributable to opportunities in Qatar, UAE and Saudi Arabia (Chart 12). In the Baa credit tier, investors should look for opportunities in Mexico, Russia and Colombia, while avoiding the Philippines. Chart 11USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Credit Rating Chart 12USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Country All in all, investors should shift some allocation away from investment grade corporates and into USD-denominated EM Sovereigns with equivalent duration and credit rating, focusing on the countries that offer a yield pick-up. Turning to high-yield, we would rather own junk-rated US corporate bonds than junk-rated EM Sovereigns. US corporates offer a yield pick-up over EM Sovereigns in the Ba credit tier, and the sky-high spreads offered by B and Caa-rated EMs are due to overly risky opportunities in Turkey and Argentina. We don’t see these countries benefiting from the supportive US macro environment in the same way as US corporate credit, and therefore recommend overweighting US corporate junk bonds over EM Sovereign junk bonds. Bottom Line: Investors should continue to overweight spread product versus Treasuries in US fixed income portfolios but should look for opportunities outside of investment grade corporate bonds. We recommend owning municipal bonds and USD-denominated EM Sovereign bonds in place of investment grade US corporate bonds with the same credit rating and duration. We also recommend taking additional credit risk in US junk bonds, particularly in the Ba credit tier. Investors should prefer US junk bonds over junk-rated EM Sovereigns. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Trust The Fed’s Forward Guidance”, dated January 19, 2021, available at usbs.bcaresearch.com 2 Please see Global Investment Strategy Weekly Report, “Stagflation In A Few Months?”, dated January 22, 2021, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Rates: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Municipal Bonds: Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. Economy: December’s employment report showed the first monthly contraction in nonfarm payrolls since April. However, this negative headline reflects the transitory impact of the latest COVID wave. It does not signal renewed weakness in the pace of economic recovery. Feature A Politically Driven Bond Rout In a Special Report last October, we argued that the bond market was vulnerable in a scenario where the November 3rd election resulted in the Democratic party winning the House, Senate and White House.1 It took some time, but after Democrats won both of Georgia’s Senate seats in last week’s special election, we are finally seeing the impact on the bond market. Nominal Treasury Yields First, the 10-year nominal Treasury yield moved above 1% for the first time since March. It currently sits at 1.13% (Chart 1). Meanwhile, the front-end of the Treasury curve held steady as the Fed continued to signal that liftoff is unlikely to occur within the next two years. The result has been a persistent steepening of the nominal curve (Chart 1, bottom panel). The 10-year nominal Treasury yield moved above 1% for the first time since March. We are positioned for a bear-steepening of the nominal Treasury curve, but the speed of this most recent move raises the question of how much further the bond sell-off can run. As we wrote in our year-end Special Report, we see yields continuing to rise until the 5-year/5-year forward Treasury yield reaches levels consistent with survey estimates of the long-run equilibrium fed funds rate (Chart 2).2 This would be in line with where yields peaked during the prior two global growth recoveries (2013/14 and 2017/18). At present, survey responses put our target for the 5-year/5-year forward Treasury yield at roughly 2% to 2.25%, still 18 to 43 bps above current levels. Chart 1Nominal Curve Bear-Steepening Chart 2How Much Upside For Yields? The prospect of greater fiscal stimulus under a Democratic government doesn’t necessarily translate into a higher ceiling for Treasury yields, but it does increase the speed with which yields will reach our target. All in all, we remain positioned for a bear-steepening of the nominal Treasury curve but will re-consider this stance if the 5-year/5-year forward yield reaches a range of 2% to 2.25%. Inflation Compensation Chart 3Stay Overweight TIPS For Now The recent 20 bps jump in the 10-year nominal Treasury yield was driven by a 15 bps increase in the 10-year TIPS yield and a 5 bps increase in the 10-year TIPS breakeven inflation rate. Notably, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates have both pushed above 2% and are sitting at 2.08% and 2.06%, respectively. While these long-maturity TIPS breakevens have recovered nicely, the Fed won’t be tempted to adopt a more hawkish policy stance until they reach a range of 2.3 – 2.5 percent, a range that has been consistent with “well-anchored” inflation expectations in the past (Chart 3).. While TIPS breakeven inflation rates aren’t yet high enough to worry the Fed, they are starting to look elevated compared to actual inflation. At 2.08%, the 10-year TIPS breakeven inflation rate is 27 bps above the fair value reading from our Adaptive Expectations Model (Chart 3, panel 3).3 Given this expensive valuation, we are currently looking for an opportunity to tactically reduce our allocation to TIPS. We expect that opportunity will come when the 12-month core and trimmed mean inflation rates re-converge (Chart 3, bottom panel). The low level of core CPI inflation relative to the trimmed mean suggests that inflation has near-term upside as some downtrodden sectors that are excluded from the trimmed mean recover from the pandemic. But inflation will moderate once that “snapback phase” is over, and we should get an opportunity to reduce our TIPS allocation.4 Along with an overweight allocation to TIPS versus nominal Treasuries, we also recommend owning inflation curve flatteners. The inflation curve tends to flatten when the cost of inflation protection rises, and this has indeed been the case during the past few weeks (Chart 4). It will make sense to exit this flattener when we tactically reduce our TIPS allocation, but this will only be a temporary move. In the long run, the inflation curve will eventually invert and then remain in negative territory for an extended period. This is the result of the Fed’s plan to engineer an overshoot of its 2% inflation target. If the Fed is successful, it means that it will be attacking its inflation target from above for the first time since the 1980s. In such an environment, it makes sense for the inflation curve to be inverted. Chart 4Inflation Curve Flattening Real Yield Curve Chart 5Real Curve Steepening Our final rates curve recommendation is a real yield curve steepener. This position has also performed well during the recent bond rout, as a 14 bps increase in the 10-year real yield occurred alongside a 13 bps drop in the 2-year real yield (Chart 5). As with our other rates positions, we are inclined to stay the course. A 2/10 real yield curve steepener can be thought of as the combination of a 2/10 nominal curve steepener and a 2/10 inflation curve flattener. During the recent bond sell-off, the 2/10 real curve has steepened by 27 bps, split between 17 bps of nominal curve steepening and 10 bps of inflation curve flattening. We will likely maintain our real yield curve steepener as a core portfolio position even if we eventually close our inflation curve flattener. Gradual progress toward fed funds liftoff and the resulting steepening of the nominal curve should be sufficient to steepen the real yield curve, even if inflation takes a pause. Corporate Credit Chart 6Move Down In Quality Corporate spreads have reacted well to the news of a Democratic sweep, even though it means that a corporate tax hike is coming in 2021. All else equal, the one-time hit to profits from a tax hike is negative for corporate balance sheets, but this is a minor consideration when the macro back-drop remains so positive for spread product. The combination of above-trend economic growth and highly accommodative monetary policy will encourage investors to keep adding credit risk, and the average investment grade and high-yield index spreads have still not quite recovered to their pre-COVID tights (Chart 6). We continue to view the Ba credit tier as the most attractive from a risk/reward perspective, as the incremental spread pick-up in Ba compared to Baa is elevated compared to what we’ve seen in recent years (Chart 6, panel 3). Bottom Line: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Fiscal Policy In 2021 Chart 7Organic Household Income Has Recovered Our US Political Strategy service debuted last week with a report that considers the outlook for fiscal policy in 2021 given that Democrats now have control of the House, Senate and White House.5 In short, the Democrats now have complete control of the government but their majorities in the House and Senate are thin. This means that the most radical parts of the Democratic agenda, like the Green New Deal, will be hard to pass. However, the Democrats will be able to deliver two reconciliation bills in 2021. The first bill could come soon and will likely focus on additional COVID relief and social support, such as $2000 checks to individuals instead of $600 ones. After that, the Democrats will focus on expanding and entrenching the Affordable Care Act (Obamacare). They will partially repeal the Trump tax cuts to help finance these priorities. On the issue of COVID relief, we are no longer concerned about the US economy receiving enough stimulus to avoid a double-dip recession. We had previously estimated that a further $600 billion to $1 trillion of income support for households would be required to support consumer spending at reasonable levels.6 This estimate now looks too high because non-CARES act household income has recovered much more quickly than we had anticipated. Non-CARES act household income is already back to pre-COVID levels (Chart 7). In our prior research, we assumed this wouldn’t happen until July 2021. In any event, another round of $2000 checks will provide more than enough income support to sustain a recovery in consumer spending. A Democratic sweep suggests big fiscal thrust in 2021 and less contraction in 2022. More generally, our US Political Strategy team has estimated the medium-term path for the US deficit under a “Democratic Status Quo” scenario that assumes another round of $2000 checks and that the remaining $2.5 trillion of the proposed HEROES Act will be enacted. It also considers a “Democratic High” scenario that adds Joe Biden’s $5.6 trillion policy agenda on top of the Democratic Status Quo (Chart 8). Biden will not achieve all of his agenda, so the reality will lie somewhere between the Democratic Status Quo and Democratic High scenarios. In either case, we will see considerably more fiscal thrust compared to the Republican Status Quo and Baseline scenarios. Chart 8Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 Municipal Bonds The prospect of federal government aid for challenged state & local governments is a crucial issue for municipal bond investors. Fortunately, the Democratic party’s HEROES act contains more than $1 trillion of aid to state & local governments and this will likely form the basis of the next COVID relief package. On top of that, further support for household incomes will also help support state & local tax revenues that are already recovering (Chart 9). Chart 9State & Local Austerity Will Continue That said, we are likely still in for a considerable period of state & local austerity given the large budget gaps that have opened during the past nine months. However, the expectation of help from the federal government makes us even more confident that state & local governments will muddle through without a spate of muni downgrades or defaults. We maintain our “maximum overweight” recommendation for tax-exempt municipal bonds, though valuation is turning more expensive by the day. Muni yield spreads versus Treasuries are contracting, particularly at the long end of the curve (Chart 10A) and valuations appear more expensive if we look at yield ratios instead of spreads (Chart 10B). In both cases, value looks better at the front end of the curve than at the long end. Chart 10AMuni / Treasury Yield Ratios Chart 10BMuni / Treasury Yield Ratios Bottom Line: The new Democratic government will deliver more than enough income support to sustain the recovery in consumer spending. Aid for state & local governments is also forthcoming and it will help sustain municipal bond outperformance versus both Treasuries and investment grade corporates. Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. December Payrolls Only A Temporary Setback At first blush, last week’s December employment report looks disastrous. Nonfarm payrolls fell by 140 thousand, the first monthly contraction since April. The contraction looks especially worrying when you consider that payrolls remain almost 10 million below pre-COVID levels and should be rising quickly at this stage of the economic recovery (Chart 11). Chart 11Payrolls Contracted In December Chart 12Permanent Unemployment Fell In December The grim headline numbers, however, severely overstate the magnitude of the problem. Rather than implying underlying economic weakness, the drop in payrolls reflects the transitory impact of the pandemic’s latest violent wave. December’s job losses came from the Leisure and Hospitality sector (-498k), the sector most impacted by the virus. Job gains remained solid elsewhere in the economy (+358k). The unemployment rate held flat at 6.7% in December, but encouragingly, this stable number masks both an increase in the number of temporarily unemployed (or furloughed) workers and a drop in the number of permanently unemployed workers (Chart 12). Those furloughed workers will return to work once the virus is better contained. Meanwhile, the drop in the number of permanently unemployed suggests that the economic recovery is taking hold. It will only gain momentum as the COVID vaccine is rolled out and additional fiscal stimulus is delivered in 2021. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 4 For more details on inflation’s “snapback phase” please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 5 Please see US Political Strategy Weekly Report, “Buy Reflation Plays On Georgia’s Blue Sweep”, dated January 6, 2021, available at usps.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Chart 12020 Returns After a tumultuous start to the year, corporate bonds rallied in 2020 H2, managing to eke out small annual gains versus Treasuries. Specifically, investment grade corporates outperformed duration-equivalent Treasuries by 4 basis points in 2020 and high-yield outperformed by 185 bps (Chart 1). Treasuries, for their part, bested cash by 7% on the year but returns have been trending down since August. As we look forward to 2021, the economic cycle is in what we call a sweet spot for spread product returns. Economic growth is above trend, but inflation is low and monetary conditions are highly accommodative. This macro back-drop will lead to positive spread product returns versus Treasuries and a moderate bear-steepening of the Treasury curve in 2021. However, stretched valuations for investment grade corporates mean that investors must be selective within spread product. We think the Ba credit tier offers the best risk-adjusted opportunity in the corporate bond space, and also recommend favoring tax-exempt municipal bonds over equivalent-quality investment grade corporates. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-matched Treasury index by 79 basis points in December and by 4 bps in 2020. The investment grade corporate index eked out a small gain relative to the duration-matched Treasury index in 2020. Corporates underperformed Treasuries by 18% from the beginning of the year until March 23, the day that the Fed stopped the bleeding in credit markets by unveiling its suite of emergency lending facilities. With the Fed’s backstops in place, the corporate index went on to outperform Treasuries by 22% between March 23 and the end of the year (Appendix A). As we noted in our 2021 Key Views Special Report, the corporate bond index option-adjusted spread is not quite back to its pre-COVID low.1 However, valuation is close to all-time expensive after adjusting for changes in the index’s average credit rating and duration. The 12-month breakeven spread for the Bloomberg Barclays Corporate Index (adjusted to keep the average credit rating constant) has only been tighter 4% of the time since 1995 (Chart 2). The same figure for the Baa-rated credit tier is 5%. As noted, the macro environment of above-trend growth and accommodative Fed policy is very positive for spread product returns. However, better value exists outside of the investment grade corporate space. In particular, we advise investors to look at Ba-rated high-yield corporates and tax-exempt municipal bonds. High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 190 basis points in December and by 185 basis points in 2020. Ba-rated junk bonds outperformed duration-matched Treasuries by 431 bps in 2020, while B-rated and Caa-rated bonds lagged by 13 bps and 238 bps, respectively. Since the March 23 peak in spreads, Ba-rated bonds outperformed Treasuries by 33%, B-rated bonds outperformed by 30% and Caa-rated bonds outperformed by 36% (Appendix A). We view Ba-rated junk bonds as the sweet spot within the corporate credit space. The sector is relatively insulated from default risk and yet still offers a sizeable spread pick-up over investment grade corporates (Chart 3). We noted in our 2021 Key Views Special Report that the additional spread earned from moving down in quality below Ba is in line with historical averages.2 Assuming a 25% recovery rate on defaulted debt and a minimum required risk premium of 150 bps, we calculate that the junk index is priced for a default rate of 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only seven defaults occurred in November, down from a peak of 22 in July. Job cut announcements, an excellent indicator of the default rate, are also falling rapidly (bottom panel). Overall, we see room for spread compression across all junk credit tiers in 2021 but believe that Ba-rated bonds offer the best opportunity in risk-adjusted terms. Table 3ACorporate Sector Relative Valuation And Recommended Allocation*Table 3BCorporate Sector Risk Vs. Reward* MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 22 basis points in December but underperformed by 17 bps in 2020. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 10 bps on the month to reach 61 bps (Chart 4). This is higher than the 58 bps offered by Aa-rated corporate bonds, the 49 bps offered by Agency CMBS and the 24 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we continue to view the elevated primary mortgage spread as a material risk for MBS investors. The elevated spread suggests that mortgage rates need not rise alongside Treasury yields in the near-term, meaning that mortgage refinancings can continue at their current rapid pace (panel 3). Our view is that expected prepayment losses embedded in MBS spreads (aka the option cost) are too low relative to this pace of refinancing. Last year’s spike in the mortgage delinquency rate was driven by households that were granted forbearance by the federal government’s CARES act (panel 4). The risk for MBS holders is that these households will not be able to resume their regular mortgage payments when the forbearance period ends this spring. While the situation bears close monitoring, our sense is that excess savings built up during the past nine months will be sufficient to prevent a surge of bankruptcies when the forbearance period ends. The recent stimulus package provides households with even more assistance. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 62 basis points in December but underperformed by 161 bps in 2020. Sovereign debt outperformed duration-equivalent Treasuries by 176 bps in December but underperformed by 98 bps in 2020. Foreign Agencies outperformed the Treasury benchmark by 7 bps in December but underperformed by 640 bps in 2020. Local Authority debt outperformed Treasuries by 146 bps in December but underperformed by 86 bps in 2020. Domestic Agency bonds outperformed by 14 bps in December but underperformed by 9 bps in 2020. Supranationals outperformed by 2 bps in December and by 3 bps in 2020. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, 2020’s dollar weakness was mostly relative to other Developed Market currencies (Chart 5). Value has improved somewhat for EM Sovereigns during the past few weeks, but the index continues to offer less spread than the Baa-rated US Credit index (panel 4). At the country level, Turkey, Colombia, Mexico, Russia, South Africa and Indonesia are the only countries that offer a spread pick-up relative to duration and quality-matched US corporates. Of those, only Mexico looks attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 56 basis points in December but underperformed by 286 bps in 2020 (before adjusting for the tax advantage). We upgraded municipal bonds to “maximum overweight” in our recent 2021 Key Views Special Report.3 Attractive valuations are the main reason for this move. First, spreads between Aaa-rated municipal bonds and equivalent-maturity Treasuries are elevated compared to history across the entire yield curve (Chart 6). Second, municipal bonds look even more attractive relative to duration and quality-matched credit. The Bloomberg Barclays Revenue Bond index offers a greater yield than the quality-matched Credit index across the entire maturity spectrum (before adjusting for the tax advantage). The same is true for the Bloomberg Barclays General Obligation index beyond the 12-year maturity point (panel 3). While the failure to include state & local government aid in the recent relief bill is a big blow to municipal budgets that are already stretched, we think municipal bond spreads offer more-than-adequate compensation for default/downgrade risk. State & local governments are already engaging in austerity measures that will help protect bondholders (bottom panel) and State Rainy Day Fund balances were at all-time highs heading into the COVID downturn. Both of these things should help stave off a wave of municipal downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in December. The 2/10 Treasury slope steepened 13 bps to 81 bps. The 5/30 Treasury slope steepened 7 bps to 129 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and the recently passed fiscal relief bill will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 141 basis points in December and by 117 bps in 2020. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 22 bps and 18 bps on the month. They currently sit at 2.01% and 2.07%, respectively. Core CPI rose 0.22% in November, pushing the year-over-year rate from 1.63% to 1.65%. Meanwhile, 12-month trimmed mean CPI fell from 2.22% to 2.09%, narrowing the gap between trimmed mean and core (Chart 8). We anticipate further narrowing in 2021 Q1 and therefore expect core CPI to print relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven inflation rate looks somewhat elevated on our Adaptive Expectations Model (panel 2).4 Inflation pressures may moderate once the core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure in the first half of this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields to come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in December and by 98 bps in 2020. Aaa-rated ABS outperformed the Treasury benchmark by 12 bps in December and by 81 bps in 2020. Non-Aaa ABS outperformed by 33 bps in December and by 207 bps in 2020 (Chart 9). On paper, the Treasury department’s decision to let the Term Asset-Backed Loan Facility (TALF) expire at the end of 2020 is quite negative for ABS. However, as we explained in a recent report, we don’t anticipate a material impact on spreads.5 For one thing, Aaa ABS spreads are already well below the borrowing cost offered by TALF. But more importantly, consumer credit quality is strong. As we first explained last June, the stimulus received from the CARES act led to a significant increase in disposable income and a jump in the savings rate (panel 4).6 Faced with an income boost and few spending opportunities, many households paid down consumer debt. Given the recently passed additional fiscal support and the substantial savings that have already accrued, we see household balance sheets as being in a good place. As such, we advise moving down-in-quality to pick up extra spread in non-Aaa ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 113 basis points in December but underperformed by 57 bps in 2020. Aaa Non-Agency CMBS outperformed Treasuries by 58 bps in December and by 56 bps in 2020. Non-Aaa Non-Agency CMBS outperformed Treasuries by 277 bps in December but underperformed by 360 bps in 2020 (Chart 10). We continue to recommend an overweight allocation to Aaa-rated Non-Agency CMBS and an underweight allocation to non-Aaa CMBS. Even with the expiry of TALF, Aaa CMBS spreads are already well below the cost of borrowing through TALF and thus will not be negatively impacted.7 Meanwhile, the structurally challenging environment for commercial real estate could lead to problems for lower-rated CMBS (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 50 basis points in December and by 105 bps in 2020. The average index spread tightened 7 bps in December to reach 49 bps (bottom panel). At its September meeting, the Fed decided to slow its pace of Agency CMBS purchases. It is no longer looking to increase its Agency CMBS holdings, but rather, will only purchase what is “needed to sustain smooth market functioning”. This is nonetheless a backstop of the market, and it does not change our overweight recommendation. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of December 31ST, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of December 31ST, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 85 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 85 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of December 31ST, 2020) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 4 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation