Fixed Income Outlook  |  Q1 2020

Sector views

Fixed Income Team

Sector views

Trends in mortgage market

We continue to have a generally favorable outlook for mortgage credit. We think the underlying fundamentals for commercial real estate appear stable, supported by a strong employment backdrop, interest rates that remain historically low, and a positive U.S. economic environment. When the Fed shifted back to a more accommodative monetary policy stance early in 2019, the U.S. housing market responded positively. Against the backdrop of mortgage rates that are low by historical standards, we think home price growth suggests the economy is likely to expand at a steady, moderate pace.

We continue to find better relative value in CMBX versus cash bonds. We think the negative sentiment toward the retail industry — though well deserved — overstates the risk of the index. We think the index offers sufficient protection, even at the BBB-rated level. In our view, mall operators may be able to stabilize their revenues by repurposing properties, thereby mitigating or delaying losses.

Within cash commercial mortgage-backed securities (CMBS), we have been focusing on mezzanine tranches rated A and BBB- that were issued between 2011 and 2014. Securities in this market category offered a significant yield premium over many other areas. We have been avoiding mezzanine securities issued in 2015 or later.

Rally in corporate debt

The investment-grade corporate credit class rallied in November, following the October rate cut by the Fed and optimism about the phase-one trade deal with China. For corporate credit, we continue to like the BBB-rated market segment. For several years debt issuance increased as corporations financed mergers and acquisitions. Now, we're beginning to see BBB issuers reduce debt.

High-yield bonds fairly valued

We continue to have a generally positive outlook for high-yield credit. We think the fundamentals underlying U.S. issuers are skewed slightly positive, buoyed by favorable corporate earnings. High-yield bonds rose 2.89% for the fourth quarter, as measured by the JPMorgan Developed High Yield Index, with most of the advance occurring in December. From a sector perspective, cohorts that underperformed in 2019 — such as lower-rated issuers in energy and other sectors — could continue to rebound if economic growth remains steady and stocks advance.

Looking at defaults, when distressed exchanges are included in calculating the U.S. high-yield default rate, the figure was 2.86% as of December 31. Despite an increase from the end of 2018, the default rate remains low from a historical perspective. The long-term average default rate for high yield is 3.44%, based on annual default rates dating back to 1980.

We think the market's supply-and-demand backdrop is supportive given moderate net new issuance and strong flows into high-yield mutual funds and exchange-traded funds. From a valuation standpoint, high-yield spreads look fairly valued to us in light of underlying fundamental strength and a favorable technical environment. Despite these positives, risks to our outlook include price volatility in oil and other commodities, policy missteps by global central banks, and heightened geopolitical tension.

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