CONTRIBUTORS
Robert O. Abad
The global central bank rate-cutting cycle is in full swing, with the European Central Bank, Swiss National Bank, Sweden’s Riksbank and the Bank of Canada all reducing interest rates in recent weeks. The Bank of England is expected to join in later this fall. Meanwhile, US growth and inflation data are trending as we anticipated (i.e., moderate growth, abating inflation), which should enable the US Federal Reserve (Fed) to cut rates at least once before year-end. Emerging market (EM) central banks, waiting for the Fed’s first move, will likely follow suit. Given this backdrop, we believe investors should revisit the global credit landscape, where the income and total return potential looks especially attractive in a lower interest rate environment. While opportunities may not be out in the open, a careful examination of global credit—in essence, shaking the trees—may be able to identify hidden pockets of value for investors.
Exhibit 1: The Impact of a 1% Rise or Fall in Interest Rates
Source: JPMorgan. As of June 30, 2024. US Aggregate is represented by the Bloomberg US Aggregate Index; IG Corporates is represented by the Bloomberg US Corporates Index; US High Yield is represented by the Bloomberg US Corporate High Yield Index; Leveraged Loans are represented by the J.P. Morgan Leveraged Loan Index; MBS are represented by the Bloomberg US Aggregate Securitized – MBS Index; ABS are represented by the J.P. Morgan ABS Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Our multi-asset credit (MAC) investment team currently favors a diversified mix of high-yielding, high-quality fixed-income credit, which is consistent with Western Asset’s outlook for a soft-landing scenario in the US. Here are the sectors we're focused on:
High yield corporate credit
High-yield (HY) corporate fundamentals appear to remain sound midway through 2024. Leverage profiles and interest coverage ratios support the asset class, providing further runway for this credit cycle. Market technicals have created ongoing tailwinds with both retail and institutional inflows into high-yield credit and limited net new-issue supply via the primary calendar, keeping spreads tight (+313 basis points) and yields around 8%. We remain confident in the income-generation narrative for this opportunity set, favoring cyclicals, financials, energy and potential rising stars. Our focus is on upcoming new issuance at appropriate concessions in the higher quality segment of high-yield credit.
Bank loans and CLO tranches
The loan market continues to grind tighter due to record demand imbalances, with significant collateralized loan obligation (CLO) issuance against a limited new-issue loan calendar. Bank loan yields above 9% remain attractive, offering limited duration and potential outperformance during periods of rate volatility. We continue to favor high-quality loan borrowers and more defensive sectors at this stage of the cycle. CLO debt has experienced significant tightening and outperformance this year, thanks to its floating-rate nature and attractive yields. We expect this performance trend is likely to persist through the rest of the year. For broad market investment portfolios, we prefer higher-quality CLO AAA tranches, while for more total return-focused investors, we favor BBB and select BB opportunities.
Structured credit
This sector offers high-quality yields across most asset classes, and spreads are likely to continue tightening without a hard-landing scenario. Excess returns across structured product sectors range from 1% to 12% year-to-date (YTD), yet still appear cheap on a relative value basis compared to most credit sectors.
In the residential mortgage-backed securities (RMBS) space, housing affordability remains strained, but home prices are rising due to limited supply meeting pent-up demand. While sales and starts activity will be tied to interest rates, credit performance currently shows no signs of strain. Mortgage lenders are seeking tools to improve affordability. Subordinated tranches of credit risk transfer (CRT) securities have been among the best performers in the credit market over the past 12 months, as investors benefited from the following market low.
The commercial MBS (CMBS) market has reopened with YTD issuance volume on pace with the 2013-2020 annual average. While some AAA bonds now merely appear to be priced at fair value, spreads remain wide across mezzanine and subordinate tranches, and secondary markets offer a variety of total return opportunities. CMBS is one of the few active commercial real estate (CRE) financing markets, with capital being deployed to take advantage of the cyclical opportunity to lend at the best terms seen in more than a decade.
In the asset-backed securities (ABS) space, consumer fundamentals remain strong and stress has been manageable. We are still cautious of credit deterioration and favor higher-quality consumer sectors, established sponsors and sectors with positive tailwinds. Off-the-run sectors and issuers can provide attractive risk/reward opportunities, while bank selling may result in opportunities in the form of risk transfer or outright portfolio sales in the auto sector.
Investment grade (IG) corporate credit
US IG credit spreads hit new multi-year lows of +80 basis points in May, driven by a continued influx of capital into IG. Persistent all-in yield buyers have bolstered technical strength, effortlessly absorbing the record new-issue calendar. Q1 earnings revealed that IG fundamentals are still robust, with corporate management teams maintaining balance sheet discipline and defensive strategies. While valuations are stretched compared to historical averages and warrant caution, we are focusing on moving up in quality as spread compression persists.
Emerging market (EM) debt
We see value in specific segments of EM debt, reflecting strong YTD returns but acknowledging the potential for increased volatility stemming from the upcoming US elections and shifts toward protectionist trade policies. Looking ahead, we anticipate the remainder of 2024 to be a carry-type environment for EM credit given strong absolute yields but comparatively tight spreads. Our focus remains on frontier market sovereigns and primary issuances from HY companies, which both offer attractive valuations and potential returns relative to the broader market. We’re also constructive on select EM local markets, such as Mexico, which offer high nominal yields. EM corporates, which continue to benefit from lower interest-rate sensitivity and strong balance sheets, can be an attractive allocation for ratings-sensitive investors given the spread pickup to US IG credit.
In closing
In recent months, global credit markets have shown impressive resilience despite challenges like volatility with US Treasuries, surprising economic data and global political uncertainties. Looking ahead to the second half of the year, the upcoming US presidential election could add more uncertainty to the mix. However, developed market central banks have finally started cutting rates after much anticipation, a trend likely to continue amid the ongoing global economic slowdown and subdued inflation. While some investors remain cautious about potential spread widening and are prepared to pivot toward riskier assets in a market selloff, we believe it’s time to “shake the trees” in an effort to capitalize on compelling opportunities in today’s market.
Exhibit 2: Comparison of Returns Across Fixed-Income Sectors
Source: Bloomberg, JPMorgan, Morningstar LSTA. As of June 28, 2024. All sectors shown are yield-to-worst except for Municipals, which is based on the tax-equivalent yield-to-worst assuming a top-income tax bracket rate of 37% plus a Medicare tax rate of 3.8%; and Leveraged Loans, which is yield-to-maturity. Euro IG is represented by the Bloomberg Euro Aggregate Bond Index; US Treasury is represented by the Bloomberg US Treasury Index; ABS is represented by the Bloomberg Asset-Backed Securities Index; MBS is represented by the Bloomberg US Mortgage Backed Securities Index; Non-Agency CMBS is represented by the J.P. Morgan Non-Agency CMBS Index; IG Corp is represented by the Bloomberg US Corporate Bond Index; Muni is represented by the Bloomberg Municipal Bond Index; Euro HY is represented by the Bloomberg Pan-European High Yield Index; Non-Agency RMBS is represented by the J.P. Morgan Non-Agency RMBS Index; EM Corp is represented by the J.P. Morgan CEMBI Broad Diversified Index; Leveraged loans are represented by the Morningstar LSTA Leveraged Loan Index; EMD USD is represented by the J.P. Morgan EMBI Global Diversified Index; US HY is represented by the Bloomberg US Corporate High Yield Index; EM Local is represented by the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified Index. Yield-to-worst is the lowest possible yield that can be received on a bond apart from the company defaulting. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Definitions:
One basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
A collateralized loan obligations (CLO) is a security backed by a pool of debt, often low-rated corporate loans.
An Asset-Backed Security (ABS) is a financial security backed by a loan, lease or receivables against assets other than real estate and mortgage-backed securities.
Residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS) are forms of asset-backed securities, holding pools of residential or commercial mortgages (respectively) used as collateral for the securities.
Subordinated bonds refer to debt, which in the case of default will not get paid out until after the senior debtholders are paid in full.
Pioneered by Freddie Mac in 2013, credit risk transfer (CRT) programs structure mortgage credit risk into securities and (re)insurance offerings, transferring credit risk exposure from US taxpayers to private capital.
"AAA" and "AA" (high credit quality) and "A" and "BBB" (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ("BB," "B," "CCC," etc.) are considered low credit quality, and are commonly referred to as "junk bonds."
An off-the-run security is older than the most recent issue of a periodically issued security and trade at a discount to on the run securities.
Carry refers to a bond market tactic where you borrow and pay interest in order to buy something else that has higher interest
The Bloomberg US ABS Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.
The Bloomberg US Corporate Bond Index measures the performance of the investment-grade, fixed-rate, taxable corporate bond market. It includes US dollar-denominated securities publicly issued by US and non-U.S. industrial, utility and financial issuers.
The Bloomberg US Treasury Index measures the performance of US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with at least one year until final maturity.
The Bloomberg US Mortgage-Backed Securities (MBS) Index tracks the performance of fixed-rate agency mortgage-backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). Effective June 1, 2017, hybrid adjustable-rate mortgages were removed from the index.
The Bloomberg US Corporate High Yield Index measures the performance of the US dollar-denominated, high-yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, S&P and Fitch Ba1/BB+/BB+ or below). Bonds from issuers with an emerging markets (EM) country of risk, based on Bloomberg EM country definition, are excluded.
The Bloomberg Municipal Bond Index is a market value-weighted index of tax-exempt, investment-grade municipal bonds with maturities of one year or more.
The Bloomberg Euro Aggregate Bond Index includes fixed-rate, investment-grade Euro denominated bonds. Inclusion is based on the currency of the issue, and not the domicile of the issuer. The principal sectors in the index are the Treasury, corporate, government-related and securitized.
The Bloomberg Pan-European High Yield Index measures the market of non-investment grade, fixed-rate corporate bonds denominated in the following currencies: euro, pounds sterling, Danish krone, Norwegian krone, Swedish krona, and Swiss franc. Inclusion is based on the currency of issue, and not the domicile of the issuer. The index excludes emerging market debt.
The J.P. Morgan Non-Agency CMBS Index measures the market of non-Agency commercial mortgage-backed securities deals, reflecting the outstanding debt in the market.
The J.P. Morgan Non-Agency RMBS Credit Index tracks a combination of sector and vintage level jumbo, CRT (credit risk transfers), and legacy RMBS, reflecting the outstanding debt in the market.
The J.P. Morgan Leveraged Loan Index is designed to mirror the investable universe of U.S. dollar institutional leveraged loans, including U.S. and international borrowers
The J.P. Morgan ABS Index captures 70 per cent of the size of the US ABS market and utilizes a market-value weighted methodology.
The J.P. Morgan Corporate Emerging Market Bond Index (CEMBI) Broad Diversified Index is an unmanaged index of USD-denominated emerging market corporate bonds.
The J.P. Morgan EMBI Global Diversified Index (EMBIGD) tracks liquid, US Dollar emerging market fixed and floating-rate debt instruments issued by sovereign and quasi-sovereign entities.
The J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM) Global Diversified Index is an unmanaged, market-capitalization weighted, total-return index tracking the traded market for US-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
The Morningstar LSTA US Leveraged Loan Index is a market-value weighted index designed to measure the performance of the US leveraged loan market based upon market weightings, spreads and interest payments.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
Asset-backed, mortgage-backed or mortgage-related securities are subject to prepayment and extension risks.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.