Gregory S. KaplanDirector of Fixed Income, Managing Director | Feb. 12, 2020

2020 Fixed Income Outlook: A New Decade, Continued Opportunities

The Fed is on hold for now, but don’t rule out additional rate cuts by year-end.

Interest rates likely to remain rangebound for the year.

We expect fixed income investors to earn their coupons in 2020.

Opportunistic fixed income expected to outperform core, with security and sector selection paramount.

Municipal and Corporate bonds continue to benefit from strong demand, which should support prices at least over the near term.

Last year was a pivotal period for markets and policy. An abundance of caution over domestic and global affairs, such as U.S. and China trade negotiations and Brexit, manifested into Fed intervention and a dovish swing toward supportive measures. The benchmark rate was lowered three times, and the Fed has been acting aggressively to counteract the recent disruption in the overnight lending markets through renewed asset purchases on the balance sheet. Consequently, the Treasury curve inversion retreated, and lower nominal yields and spread compression propelled strong performance across fixed income asset classes.

As we begin a new decade, investor sentiment is more optimistic than it was several months ago. Near-term recession risk abated with stable yet moderating U.S. economic fundamentals, which should lead to a trend-line GDP growth of roughly 2% this year. Following an “easy” Fed policy bias for most of 2019, City National Rochdale expects a stable rate environment for now, with further easing on the table if the economy underperforms; this should anchor short-to-intermediate rates, while longer-term tenors are likely to reflect shifting inflationary expectations. Throughout the recovery, the Fed’s preferred inflation gauge has consistently failed to meet the central bank’s 2% symmetrical target. While Middle East tensions and resultant higher oil prices and renewed trade uncertainty could elevate specific inflationary metrics, the secular forces that have muted upward price pressure are intact. However, we would reassess our view should risks tilt toward sustained higher U.S. inflation.

The prospect of lower GDP growth and our expectation for range-bound 10-year U.S. Treasury yields of between 1.5% and 2% will remain supportive of the credit environment in 2020 and will likely reward investors taking intelligent risks. Fixed income investors should not fear duration (bond sensitivity to interest rates) and should embrace opportunities during market dislocation where yields rise while maintaining exposure to “quality” credit risk. Risk-taking this year requires careful and diligent security selection, particularly as the starting points for nominal yields and credit spreads are significantly lower than a year ago.

Within opportunistic sectors, CCC-rated U.S. high yield (HY) performance trailed BB- and B-rated credit cohorts during 2019 as late-cycle stress advanced. Despite our view of global economic conditions and Central Bank policy, tail risks, such as geopolitical disruptions, could lead to spreads widening out to their historical averages. However, volatility may create opportunity as valuations move away from fundamentals, but could also challenge returns. As such, we are de-emphasizing the U.S. HY and loan market in favor of the better-quality tiers of mezzanine collateralized loan obligations (CLOs). Mezzanine CLOs currently offer a higher relative yield to the broader loan market. Further, we are forecasting that a constructive technical backdrop will continue to support prices. Within this space, we see the loan market in Europe having a better risk/return profile and being more attractive with less influence by the retail market and greater transparency on underlying issuer balance sheets.

In our view, investment grade (IG) corporate bonds offer tactical opportunities on the shorter end of the maturity spectrum, with a preference for select financials over industrials. Within the municipal market, we expect strong demand for both tax-exempt and taxable securities to persist at least through the first half of 2020. Technical underpinnings, coupled with a generally stable credit outlook, should deliver positive returns. That said, earning your “coupon” with relatively little price contribution, but higher volatility, will likely drive total returns in 2020.

THEMES FOR THE YEAR

#1

Fixed income asset class returns will moderate from the exceptional performance achieved last year, with investors likely to earn their “coupon” in 2020. Following the steep drop in Treasury rates in 2019, where the 10-year yield declined by roughly 80 basis points (bps), the opportunity for price appreciation in 2020 is formidable. Despite our belief that bouts of interest rate volatility will likely surface in the coming months, we expect the “income” portion of total return will drive the performance calculus. We project low single-digit gains in core and IG tax-exempt fixed income, while high yield and opportunistic asset classes should deliver mid-single-digit returns this year.

#2

Our expectations for economic growth and Central Bank policy lead us to believe pockets of excess yield available within global opportunistic fixed income should produce relative outperformance against investment grade credit in 2020. Last year, U.S. HY credit earned more than 14%, led by the BB cohort, which is roughly half of the index and returned nearly 16%, well above the approximate 9% performance of CCC-rated bonds. Leveraged loans, CLOs, and global credit underperformed on a relative basis, but still achieved total returns above historical averages. Despite continued investor demand and supportive fundamentals, we reduced our near-term returns expectations for U.S. leveraged loans and high yield bonds as compressed spreads (and lower gross yields) currently limit their upside potential, but view European loans as a better alternative in the year ahead with a more constructive technical backdrop and less correlation to U.S. markets.

Both CLOs, particularly BB-tier mezzanine tranches (YE 2019 more than 650 bps spread to LIBOR) and emerging market corporate debt (YE 2019 more than 6% yield-to-worst), should deliver above-market income accrual this year as yields remain attractive for both segments. Moreover, emerging market credit should balance the lower return potential of U.S. HY and leveraged loans given their resilient quality as a result of active deleveraging and low historical default rates. If markets become disjointed and opportunities emerge, or our projections shift, we expect to take advantage of yield differentials offered by the various fixed income asset classes and reposition our portfolios accordingly. Nevertheless, we continue to have a positive view of opportunistic fixed income and expect favorable performance this year (see Figure 1).

#3

Investment grade corporate bonds have a narrow margin of safety to absorb downside economic risks as credit spreads hover near the low point of the cycle. During 2019, the option-adjusted spread of the IG index declined to roughly 90 bps as fundamentals, such as corporate earnings, and a dovish Fed provided a tailwind to valuations. However, we acknowledge sector-specific risks are rising (e.g., waning auto sales or oil price volatility). Should idiosyncratic risks converge with an economy that falls short of expectations, IG corporate spreads could reprice and widen from prevailing levels. In this context, we currently favor select financial institutions over industrials from a credit and relative value perspective, with potential short-term tactical opportunities.

Financial institutions benefit from stricter regulatory oversight, with better access to liquidity, and their balance sheets are reasonably well positioned, as evidenced by healthy capital ratios. Our bias is toward the largest capitalization financial institutions, such as money center banks, and away from consumer finance companies and other non-bank financials. Moreover, financials are less exposed to event risk, such as large-scale M&A, which has impacted industrials more so in recent years, as some of these issuers increased their leverage. Notwithstanding our sector preference, within the industrials space, however, we continue to emphasize those issuers with prudent debt management programs and conservative financial controls and policies, as well as substantial resource flexibility.

#4

The absolute size of the global debt market has increased dramatically over the past 10 years to roughly $11 trillion, which could be a source of trouble ahead. The proportionate size of the U.S. corporate BBB tier now accounts for more than 50% of all U.S. IG credit, whereas 20 years ago, it was just 30% of the IG market. Favorably, low interest rates throughout much of the recovery have kept key leverage metrics in check (e.g., debt-to-EBITDA) and interest coverage relatively stable. Overall, despite much larger nominal debt, the actual burden is not materially different than historical averages. However, late-cycle factors have begun to affect the lowest rungs of the U.S. corporate credit market (i.e., CCC bonds), where defaults increased in 2019, albeit off their cyclical low, but we continue to watch for stress signals within the entire corporate sector. A misstep in the global economy, or widening of issuer risk premiums, could impact the credit markets and cause rating downgrades to accelerate, particularly within the BBB tier. If many BBB issuers fall into speculative grade, then forced liquidation by institutional investors of these holdings could lead to adverse price movement in IG portfolios.

However, we currently have no immediate concerns, and BBB issuer rating trends are stable, with 2019 notching a record low downgrade share of just 0.3%, in contrast to A-rated bonds, which experienced more elevated activity. The durability of BBB bonds may reflect the willingness of those issuers to take actions to prevent transitioning to a “speculative grade” status, which generally results in a significant increase in borrowing costs. These actions include the suspension of buybacks and dividend hikes, extending the average maturity of debt outstanding as well as the sale of “non-core” assets to refocus their business operations. Furthermore, BBB-rated companies have seen an approximate 4% increase in operating margins since 2007, which adds to the cohort’s ability to service existing debt. That said, we continue to carefully monitor cash flow generation (and its growth in proportion to debt) given the decelerating macro backdrop and potential for rating volatility.

#5

Taxable municipal bonds continue to “check the box” for a variety of stakeholders, and we expect the recent surge in issuance to continue this year. In 2019, municipal bond supply increased more than 20% year-over-year to approximately $420B. The sharp rise in bond issuance is mainly due to taxable municipal volume, however, which reached $70B, or roughly 17% of gross supply, exceeding the post-crisis average of less than 10% (2011-2018). The spike in taxable municipal sales reflects a confluence of factors that provide several benefits to market participants. Under provisions of the Tax Cuts and Jobs Act (TCJA) of 2017, municipalities may no longer issue tax-exempt bonds to advance refund outstanding tax-exempt obligations. With low nominal Treasury yields (and curve structure dynamics), the refunding math continues to make sense for those issuers taking advantage of taxable municipals to execute cost-saving transactions. With renewed interest from foreign buyers and institutional investors, taxable municipal bonds offer attractive relative value opportunities versus traditional corporate and global sovereign bonds, with added diversification and favorable quality characteristics (i.e., the default rate of municipal bonds is lower than global corporates). Within our taxable strategies, we continue to take advantage of yield spreads and attractive risk/ reward opportunities relative to corporate bonds (see Figure 2).

#6

Strong municipal market technicals show no signs of fading and should support bond prices at least over the near-term, but tight valuations require investors to be flexible in portfolio construction. The 2019 outperformance was attributable primarily to two dynamics: excess cash chasing fewer available bonds (net negative supply) and lower nominal yields. To put this in perspective, Lipper reported record inflows of nearly $94B last year, which comfortably surpassed the previous high water mark of $79B in 2009. Year-to-date, bond mutual funds and ETFs continue to attract substantial capital additions. The consistency of flows underscores the desire for investors to optimize their tax burden under federal tax reform (impact of the limit on SALT deductions) while seeking the safety of the asset class.

Consequently, the benchmark municipal rates curve declined appreciably from a year ago, credit spreads narrowed, and valuations are historically expensive when comparing the yields between municipal bonds and comparable taxable securities. There is little indication, if any, of investor resistance to these currently rich valuations. We expect to assess relative value trades across the various fixed income asset classes given the more positively sloping curves and the potential crossover opportunities, like taxable municipal bonds or corporates, that could add to portfolio net after-tax returns (see Figure 3).

#7

Evolving investment grade municipal credit trends pose longer-term concerns, but the sector is mostly stable in the near-term, with many issuers well positioned in 2020. We expect a relatively benign credit environment this year with more muted economic growth likely supportive of adequate quality, despite differences in regional forces that may influence the trajectory for some state and local governmental issuers. Favorably, many municipalities have repaired their balance sheets and maintain sufficient levels of reserves to counter the next downturn (see Figure 4). We expect overall rating stability to persist (agency upgrade/downgrade ratios trending positively), and risk premiums to remain relatively narrow, but any unforeseen credit event could result in volatility, which may open up opportunities to re-align portfolios. We continue to favor various revenue bond sectors over tax-backed obligations but are cautious in our security selection within health care and higher education.

Unfunded pension liabilities are a perennial talking point within municipal credit, and the risks of rising budgetary costs associated with pension contributions and mediocre funding adequacy have not decreased. While we don’t expect this year to generate acute pension stress for public plans, we continue to monitor funding commitment and ongoing reform initiatives, especially given the elevated levels of financial market risk within most systems. The favorable financial market returns achieved in FY 2019 will help support stable pension liabilities for most plans in the near-term. We also continue to monitor climate change and cyber risk, which have garnered increased attention in recent years. Market participants have sharpened their focus on the principles of environmental, social, and governance (ESG) risks. We understand the potential impact on local tax bases or municipal enterprises from these risks and account for them in our analytical framework and research process. We have not yet observed a direct linkage between public finance rating actions and climate and cyber risks to date, but the layering of ESG considerations into the assessment process could lead to rating changes in the future.

#8

“Stick to your knitting” in high yield municipal bonds as some weakness in issuer and sector quality is surfacing at a time when valuations are relatively expensive. The narrative for high yield municipal bonds is similar to its investment grade counterpart, with investor demand and an ongoing, albeit slowing, economic expansion supportive of prices. An important measure of relative value is the incremental yield that can be attained on high yield investments versus investment grade municipal bonds. The current differential sits at roughly 220 bps, which is lower than 12 months ago, and below its long-run average, according to Bloomberg Barclays data. Higher valuations could remain for some time, especially given our outlook on the U.S. economy this year. The risk of a redemption cycle from either a surprise credit event or a rise in interest rates, which may cause valuations to widen from existing levels, is not currently our base case. While the fundamental backdrop of the high yield municipal market is mostly stable, we continue to monitor default and impairment activity, which increased last year.

According to Municipal Market Analytics (MMA), first-time issuer defaults increased more than 25% in 2019 (to 52 issuers) from the cyclical low of 41 in 2018. Recent default activity, along with associated impairment data, suggests the market may witness increased default experience over the near-to medium-term. Some projects financed in past years have fallen short of operational and cash flow expectations, especially for those with highly speculative business models (e.g., a plant that converts plastic waste into fuel) or questionable real estate investments. But, we do not currently foresee acute stresses in the high yield market that could materially alter our view of performance this year. However, if high yield municipal bond demand recedes and/or periods of illiquidity develop whereby valuations become cheaper, these events could lead to attractive buying opportunities within the space. Continued focus on security and sector selection is crucial in the current late-cycle recovery so as to avoid unnecessary risks that could impact portfolio performance.

Key Points

The Fed is on hold for now, but don’t rule out additional rate cuts by year-end.

Interest rates likely to remain rangebound for the year.

We expect fixed income investors to earn their coupons in 2020.

Opportunistic fixed income expected to outperform core, with security and sector selection paramount.

Municipal and Corporate bonds continue to benefit from strong demand, which should support prices at least over the near term.

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.

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