Gregory S. KaplanDirector of Fixed Income, Managing Director | Mar. 23, 2020

Fixed Income Credit Market Update

Indiscriminate selling and impaired liquidity have led to broader HY markets pricing in an expectation of defaults as high as 50% in some sectors. Timing the bottom is very difficult, but for patient investors, a well-diversified risk managed approach can lower this risk while earning a very high level of income.

Dislocations and bouts of illiquidity happen in this market periodically. With an appropriate approach to credit risk, investors can benefit by riding through the volatility and deploying new capital opportunistically.

Similar to HY, indiscriminate selling has led valuations to fall below fair value. In addition, support from the Fed in a variety of forms has started forming a bottom in this sector.

The retail investor base in municipals has led to a deeper discount to fair value than even corporate bonds.

Key Highlights

High Yield Credit Markets:

Key point: Indiscriminate selling and impaired liquidity have led to broader HY markets pricing in an expectation of defaults as high as 50% in some sectors. Timing the bottom is very difficult, but for patient investors, a well-diversified risk managed approach can lower this risk while earning a very high level of income.

CNR view: For income-oriented investors, the high cash flow provides a buffer to price volatility (which should be expected). With yields over 10%, investors are being well compensated for our expectation of default risk and should consider adding exposure gradually.

High Yield Municipal Bonds:

Key point: Dislocations and bouts of illiquidity happen in this market periodically. With an appropriate approach to credit risk, investors can benefit by riding through the volatility and deploying new capital opportunistically.

CNR View: While uncertainty remains high, the recent dislocation is an opportunity to increase tax-sensitive income for investors. While still early, we envision an opportunity to add capital in the months to come.

Investment Grade Corporate Bonds:

Key point: Similar to HY, indiscriminate selling has led valuations to fall below fair value. In addition, support from the Fed in a variety of forms has started forming a bottom in this sector.

CNR View: For high quality corporate bond allocations meant to be an anchor in a portfolio over the long term, this is beginning to look like a good entry point for investors.

Investment Grade Municipal Bonds:

Key point: The retail investor base in municipals has led to a deeper discount to fair value than even corporate bonds.

CNR View: While we expect credit stress to build, high quality resilient issuers have been penalized similar to others and provide a nice buying opportunity for the appropriate investor.

Overview

Credit markets have reacted strongly to the events and uncertainty over the past month surrounding the spread of COVID-19 and the oil price war started by Russia and Saudi Arabia. While Treasury bond yields are sharply lower YTD as investors have sought this safe haven, other bond sectors are sharply higher in yield (lower in price). The extreme uncertainty has made the repricing of risk volatile and uncertain, and this is likely to continue near term. Very low oil prices have negatively impacted the energy sector, a large part of the corporate high yield market. Further, structural changes in the credit markets post-GFC (great financial crisis) have added fuel to already impaired liquidity conditions across all but the government bond markets. While markets tend to overshoot, and opportunities are emerging, we are being defensive until more clarity emerges.

On 3/23/20, the Fed rolled out a significant expansion of monetary liquidity tools to stabilize the credit markets. These measures were large and targeted to key stress points. Among them, support has been provided to the corporate credit, agency mortgage and public finance (municipal) markets. A very important part of these measures includes the Primary Market Corporate Credit Facility (PMCCF) for new issue corporate bonds and loans and the Secondary Market Corporate Credit Facility (SMCCF), both of which are already relieving the acute liquidity stress seen in the market (easily seen in corporate bond ETFs and the credit default swap market). Unfortunately, these tools do not address the high yield markets.

High Yield (HY) credit markets:

Credit markets are historically a strong reflection of what is expected by global investors over the near to medium term. The higher yielding subset of this will reflect this to a larger degree and often faster. The moves by the Federal Reserve (and other notable moves by global central banks) were not directed to the high yield space, and spreads continue to widen. Liquidity conditions remain extremely impaired in all markets, emerging markets as well as developed markets. This suggests that, for now, investors should bide their time. Only those desperate for liquidity should contemplate any action until trading conditions have normalized.

The broader leveraged loan market, to name one, is currently pricing around $85 or 85% of par, which is substantially above the long term average and would imply the greatest loss in the history of the market. In the table below, historical return experience in the years following the Bloomberg Barclays Corporate High Yield index exceeding 10% yield-to-worst is encouraging for long term investors.

S&P Global Ratings expects US corporate high yield default rates to reach 10% over the next 12 months, more than triple the 3.1% rate at the end of last year. The energy sector will likely carry much of this burden, representing roughly 15% of the Bloomberg Barclays Corporate High Yield Index.

Importantly, a default does not mean a full loss for that position; recovery rates can be meaningful. Leveraged loans, for example, are typically collateralized by hard assets and have a historical recovery rate of 77%. While recovery rates will likely be lower this time, rates are compensating investors for this scenario in our opinion and will likely result in positive forward returns.

For historical perspective, an investor committing to domestic high yield corporates during the dark days of November 2009, after Lehman Brothers failed and the Fed rolled out similar crisis measures as today, would have made money by staying with the strategy (first table below). If we assume an even worse scenario with record breaking defaults of 20% that slowly recover to “only” a 2008 scenario, investors grow their initial investment by early 2021 (second table below). While this period will no doubt look different as uncertainty continues, selling at the trough guarantees loss of principal and limits recovery potential if reentry is ill timed.

High Yield Municipal Bonds

High yield municipals have largely dealt with the same two broad issues discussed above, a repricing of risk and poor liquidity. Fund flows out of HY municipal bond funds (which represent about 40% of the market) have accelerated, forcing some players to sell what they must. Nuveen’s high yield municipal mutual fund made news last week by selling $700 million in high yield muni bonds into an unreceptive market to meet redemptions. Retail flight and illiquidity have led the Bloomberg HY municipal bond index down over 15% year-to-date. In prior crises, distressed buyers were waiting in the wings to step in and buy at the bottom. While we have seen some nibbling, their absence so far suggests we have further to go. The graph below shows the sharper rise in yields for corporate high yield, while municipal high yield is only back to the longer-term average.

Investors who were prepared for the late stage of the 11 year expansion needed diligence and patience to avoid reaching for yield. The benefit is they are being rewarded by better downside protection through the current environment. A great example of this distinction can be seen in the $800 million deal sold in 2017 to finance the American Dream mall in northern New Jersey. Retail funds had snapped up this deal at the time due to the need to put cash to work in a general reach-foryield environment. The 7% coupon 2050 maturity bonds are down over 23% in value in the past 3 weeks alone and face more downside if bearish 2Q’20 GDP forecasts come to pass (chart below).

Looking forward, we are cautious on credit, most notably the senior living sector. A key benefit to our strategy has been to own “seasoned” projects that are in full operation and providing cash flow. We see the highest default risk in projects that are still under development (e.g., a new senior living facility that is still leasing space). We also recognize that the asset class is meant to provide investors with a high level of tax-free income. By controlling credit risk, the current market decline presents an opportunity to carefully increase the income stream. While we expect default rates in the market to increase, perhaps even sharply, we expect our strong quality bias to continue to protect us on the downside while we anticipate a better entry point.

Investment Grade Corporate Bonds

Investment grade credit markets have experienced unprecedented volatility over the past two weeks, as the spread of COVID-19 triggered some of the largest credit fund outflows on record. As investors fled risk markets, 10y Treasury yields fell more than 100 basis points (1 percentage point), reaching an all-time low of 54bps on March 9. The rush to cash-like instruments has driven T-Bill yields below zero for maturities out to October 2020. The move has been precipitous and disorderly as corporate bond liquidity became impaired and sellers became “price-takers.” The end result has been a widening in credit spreads not seen since the Great Financial Crisis. Even US Government Agency debentures, which are explicitly backed by the government, underperformed Treasuries, further highlighting the irrationality and lack of liquidity present in credit markets.

We believe we are approaching a bottoming process in the credit markets, particularly given the Fed’s announcement of “unlimited QE,” which includes purchases of corporate and municipal bonds, as well as commercial paper, in both the primary and secondary markets. In addition, they will set up two credit facilities to fund corporations, and establish programs to bolster liquidity to money market funds and asset-backed securities. Their goal is to help support all facets of the market and ultimately avoid a larger global credit crisis. We expect Congress to pass its large fiscal stimulus package shortly, which will likely drive risk markets to act more rationally as stability and liquidity recover. Recession seems a certainty in the near term; however, the fixed income team has been diligently working to increase the creditworthiness of its holdings over the past two years. As a result, CNR holds significantly less triple-B rated exposure than most benchmarks and is underweight to potential problem sectors like Energy, Retail, Autos and Airlines (see table below). Ultimately, there will be a lag between the implementation and impact of these new programs from both the Fed and Congress, but they should drive a significant retracement in spreads in the coming weeks, particularly if we gain insight into the spread and death rate of this disease, or if experimental treatments yield promising results.

Opportunities do exist and we are looking to capitalize on them as markets stabilize. Crossover trades into municipal markets, for example, have been especially interesting. Pre-refunded municipal bonds (fully collateralized by government bonds) with nominal yields near 3% have been very attractive, and we have been active in this area since last week for both corporate bond and municipal bond clients.

It is important to note that with the majority of capital market assets trading at severely dislocated valuations, CNR did not deviate from our time tested investment process. While fully recognizing the anchor role of core fixed income in most portfolios, CNR is looking to add value in the near term by actively buying relatively cheap assets while keeping the overall risk profile of client portfolios in line with the needs of our clients over the long term.

Investment Grade Municipal Bonds

The municipal bond market has broadly tracked the corporate bond market down through the crisis so far but worse. The 10-yr Bloomberg AAA municipal index yield bottomed on March 9 at 0.81% coinciding with lows for corporate and US Treasury bonds. Since then, however, the 10-yr municipal yield has risen more than 2 percentage points to 2.84%. This is 50 basis points more than corporate bonds while the 10-year treasury was unchanged. This significant underperformance for municipals reflects the two key things mentioned above, the uncertain repricing of credit risk in the face of the looming recession and the poor liquidity conditions in the market. Refinitiv Lipper reported last week that the 1-week outflow from weekly-reporting investment grade bond funds was $35.6 billion, surpassing the prior record of $7.3 billion by almost fivefold. The moves made by the Fed included an expansion of their money market facility into the municipal Variable Rate Demand Note (VRDN) market. This market has been dislocated, offering yields over 9% in some instances, adding extra funding costs on municipalities.

As often unfolds in times of crises, investors sell “what they can” first, followed by what they must. With almost 90% of our holdings rated double-A or higher, we are in the enviable position of having few credits of concern. We estimate that the municipal market is in inning 4 of this process. The repricing of risk is also midstream as the path to recovery is a function of numerous variables that are very difficult to predict at this stage. In the meantime, deterioration of liquidity conditions creates an opportunity for discerning investors. We are currently seeing pre-refunded (usually backed by US government securities) and other very high quality bonds offering attractive yields of 2-3% in 1-3 year maturities.

To demonstrate the dislocation: We measure relative value by the yield ratio to the matching Treasury note. Using the 3-yr Bloomberg muni/treasury ratio index as a proxy, after averaging 92% for the past decade, this ratio now sits at 388% (graph below). The table below shows historical total return performance is attractive over the months following such a dislocation. Longer duration high-grade bonds are also starting to look interesting, but we are not buyers quite yet.

Key Points

Indiscriminate selling and impaired liquidity have led to broader HY markets pricing in an expectation of defaults as high as 50% in some sectors. Timing the bottom is very difficult, but for patient investors, a well-diversified risk managed approach can lower this risk while earning a very high level of income.

Dislocations and bouts of illiquidity happen in this market periodically. With an appropriate approach to credit risk, investors can benefit by riding through the volatility and deploying new capital opportunistically.

Similar to HY, indiscriminate selling has led valuations to fall below fair value. In addition, support from the Fed in a variety of forms has started forming a bottom in this sector.

The retail investor base in municipals has led to a deeper discount to fair value than even corporate bonds.

Index Definitions

The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded (Bloomberg Ticker: LF98TRUU)

Bloomberg 10-Year AAA Municipal Yield. The curve is the baseline curve for BVAL tax-exempt munis. It is populated with high quality US municipal bonds with an average rating of AAA from Moody's and S&P. The yield curve is built using non-parametric fit of market data obtained from the Municipal Securities Rulemaking Board. Bloomberg Ticker: BVMB10T

Bloomberg High Yield Municipal Bond Index is an unmanaged index considered representative of non-investment-grade bonds.

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.

This material is available to advisory and sub-advised clients of City National Rochdale, LLC, a Registered Investment Advisor and a wholly-owned subsidiary of City National Bank.

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.

An asset allocation program cannot guarantee profits. Loss of principal is possible.

There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.

Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

The material contains forward-looking statements regarding intent, beliefs, or current expectations which are used for informational purposes only. Readers are cautioned that such forward-looking statements are not a guarantee of future performance, involve risks and uncertainties, and actual results may differ materially from those statements as a result of various factors. The views expressed are also subject to change based on market and other conditions. Furthermore, the opinions expressed do not constitute investment advice or recommendation.

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