Rates, Rallies & Risks
Falling interest rates, tightening credit spreads and continued investor demand drove strong returns for investment grade credit in 2019—particularly in U.S. corporates—and while a number of trends look supportive heading into 2020, question marks remain.
As always, all eyes have been on the Fed, which ended its mini easing cycle in October after three rate cuts—inspiring market confidence that fears of imminent economic recession were perhaps overblown. Rate markets responded accordingly with Treasury yields rising across maturities and the yield curve steepening—after inverting multiple times over the past year—further quieting fears that economic doom lay just beyond the horizon.
Investment grade rated corporate bonds—perhaps unsurprisingly—have benefited the most from this move to a more “risk-on” mentality, as well as from falling rates for most of 2019. The positive performance has, however, left us wondering if significant value still exists at current levels. With the Bloomberg Barclays U.S. Corporate Bond Index closing the year at a spread of 93 basis points (bps), spreads are not far off from their all-time tights, which notably were achieved when the index composition was both lower duration and higher credit quality. That said, flows into the asset class remain strong and the search for yield—especially from overseas investors into U.S. corporate credit—shows no signs of abating. Attractive FX costs serve as an accelerant to this.
U.S. Corporate Spreads Inch Near All-Time Tights
Source: Bloomberg Barclays. As of December 31, 2019.
Heading into 2020, some of the best investment grade rated opportunities appear to be outside of traditional corporate bond indexes. We see particular value, for instance, in investment grade rated CLOs, which offer investors the potential to earn a significant incremental credit spread, while also offering structural protections and diversification away from idiosyncratic credit risks. To put this into perspective, at the end of the year, BBB quality CLOs traded with a spread of 376 bps, well ahead of single-B quality high yield corporates, which traded with a spread of 324 bps. The ability to access the CLO market is not only a way of diversifying away from corporate risk, but also a way to capture attractive spread at an investment grade rating.
Similarly, asset-backed security (ABS) markets offer some of the most compelling value opportunities in the IG space today. The ABS investment universe continues to expand in depth and breadth, and we see opportunities in areas as diverse as student loans, whole business franchise and commercial aviation. The sector also provides a way to invest in the U.S. consumer—which remains on solid ground amid strong employment and rising wages, and continues to be the driving force buoying the economy. But it does so in a way that—similar to CLOs—offers incremental spread and diversification away from idiosyncratic credit risk, which is particularly valuable late in the economic and credit cycles. It’s also worth noting that heavy new ABS issuance in 2019 resulted in spreads pushing wider for various consumer sectors, despite firm underlying fundamentals—which we believe presents a very compelling entry point for new allocations in 2020.
What the Fed does in 2020 will surely be among the biggest drivers for corporate credit markets. All signs are that the easing is done—at least for now—but with the Fed’s balance sheet expanding substantially, some market participants question if what we’re really seeing is QE4, by another name. Additionally, questions about the repo market’s “plumbing” loom large after liquidity scares in 2019. Whether the Fed has truly provided a solution by injecting liquidity at year-end, or simply a Band-Aid, is an uncertainty that needs resolution, or another technical risk flare-up could be slated for 2020.
Finally, as we look ahead in 2020, we see no shortage of risks—valuations (as previously discussed) and geopolitics (U.S. elections, trade wars, Middle East tensions, Brexit, etc.) chief among them. But if the past offers any help in picking credits or managing allocations across investment grade rated asset classes, we can be reasonably confident that the coming onslaught of geopolitical headlines will result in overreactions, and therefore value opportunities. The key is to recognize them when they emerge, and be nimble enough to capitalize upon them. And, as discussed, some of the best opportunities will very likely be outside of traditional bond indexes.