Where's the Value in Fixed Income?

Central banks' normalizing monetary policies, synchronized global growth for the first time in a decade, and an overhaul for the US tax system are all part of a colorful backdrop for fixed income investing in 2018.

Views on the investment environment, valuations and yield opportunities for short-duration securities, municipal bonds, and multisector fixed income are shared by three portfolio managers.

Our Panel Responses

Christopher T. Harms
Christopher T. Harms

Vice President and Portfolio Manager Loomis, Sayles & Company

As we head into 2018, we believe we are in the late expansion phase of the credit cycle in the United States. This means that corporations’ growth is slowing down and leverage is increasing. Additionally, we expect the Federal Reserve (Fed) will continue on its path of tightening monetary conditions in a gradual and measured way. The Fed began balance sheet reductions in October and has signaled three rate hikes are in store for 2018, most of which will come from the front end (short-term rates) of the yield curve.

Flattening yield curve
Flattening of the yield curve (when there is little difference between short-term and long-term rates for bonds of the same credit quality) has already had an effect on the bond market since Sept. 30th. A flattening or reversing yield curve is often seen as a precursor to a recession. However, we are not of that belief, and think that there are a lot of technicals going on in the market right now, especially in the US treasury market with short-term bill issuance high and inflation under control at around 2%.

US treasuries have been finding some demand from two schools of investors. One school is investors who don’t believe inflation is a problem and have been buying long-term treasuries. For example, liability-matched pension funds appear to be going long in duration, around 15 years. The other area of demand has been in the two-year duration space, all the way out to the five-year. Overall, we are less concerned with risk in the short-end as we move into 2018, and really look at the 10- to 30-year range as the area of caution.

With that backdrop, we believe yields of US governments in the short end of the curve (1- to 5-year durations) are still not offering much value at 1.5% to 2%. We are finding more value in asset-backed securities, as well as Triple A quality corporate bonds with short durations. 2018 should also be a year to focus on security selection opportunities, buying new issues with concessions and secondary bonds that can offer favorable risk-return profiles.

Policy shifts at the Fed?
In February, new Fed Chair Jerome Powell is set to replace Janet Yellen. We don’t expect there to be any big surprises or any major shifts in policy under Powell. However, there could be as many as five Fed governor seats that will become vacant and need to be filled in 2018.

The Fed has done a good job communicating to the market what its moves would be to deleverage its balance sheet thus far. This has been especially helpful within the mortgage-backed securities market. That said, we currently believe valuations in commercial mortgage-backed securities (CMBS) are fair. However, we think many parts of the mortgage-backed market appear overvalued and do not adequately compensate for prepayment risk. At this phase, we are focused on securities with limited prepayment risk.
Christopher T. Harms, is a Vice President and Portfolio Manager at Loomis, Sayles & Company.

Christopher Harms is a Vice President and Portfolio Manager for Loomis, Sayles & Company. He serves as a portfolio manager in the fixed-income group and as co-head of the relative return team. He also co-manages the Loomis Sayles Core, Intermediate Duration and Short Duration strategies. Mr. Harms has over 36 years of investment industry experience. Prior to joining Loomis Sayles in 2010, he was a senior vice president and managing director of an investment management team at CapitalSource Bank. He has also served as managing director and senior fixed-income portfolio manager at Mackay Shields.

Mr. Harms holds a BSBA from Villanova University and an MBA from Drexel University.

James Grabovac
James Grabovac, CFA®

Managing Director and Investment Strategist McDonnell Investment Management, LLC

Supportive US fundamentals
Economic fundamentals continue to occupy solid ground as investors approach 2018 with the added twist of evolving tax legislation now winding its way through Congress. The US economic recovery and subsequent expansion will reach the 8½ year mark at the end of 2017, and we expect a continuation of growth over the medium-term horizon.

The US labor market continues to experience gains in employment, although wage growth remains remarkably tepid, particularly in light of the mature stage of the economic cycle and generally low level of unemployment. Inflation remains well contained and continues to hover below the Federal Reserve target of 2% despite a recovery in energy markets over the past year.

Interest rates
Against this backdrop, interest rate markets have been remarkably stable, confined within a tight range of only 60 basis points throughout 2017. The feature characteristics of the US fixed income markets have been flattening yield curves and quality spread (the difference in yield between non-Treasury and Treasury securities of similar maturity) compression. Investor behavior has largely focused on adding income by reaching for yield both by adding longer-maturity exposure as well as buying lower-quality holdings.

The rising tide has tightened quality and sector spreads across markets and has been accompanied by buoyant equity markets and extremely low levels of market volatility. We expect this narrative may continue to be operative unless and until either a correction of significance occurs in risk markets, or the Fed steps on the brake pedal more vigorously than investors anticipate.

Fed in transition
The Federal Reserve is currently undergoing an unprecedented transition with the nomination of new Fed Chair Jerome Powell and the ultimate appointment by the President of as many as five new Fed governors after Fed Chair Yellen steps down in February. The unusual degree of turnover is largely the result of retirements as the seven governor positions were originally created with staggered tenures to help avoid the potential politicization of the Board. In addition to retirements, however, two positions have been vacant as Congress has refused to approve nominees from the President of an opposing party. It is likely that the full Board will eventually be constituted as that obstacle is no longer in place.

The Fed has been the most effective driver of economic policy since the Great Recession as Congress largely abdicated its policy role after its initial response to the economic downturn. Fed initiation of the zero-lower bound interest rate policy, in conjunction with its Large-Scale Asset Purchase program, was instrumental in paving the road to economic recovery. Investors should expect, but not necessarily assume, that a newly constituted Board will operate as effectively in the event of the next downturn. We remain hopeful that the administration will be cognizant of the vital role assumed by the Federal Reserve as it considers candidates for nomination to the most important central bank in the world economy.

Municipal bond market year in review
Rate markets spent most of the past year recovering from the sharp, but ultimately short-lived, sell-off they underwent during the 4th quarter of 2016. The US municipal market registered strong relative performance as it outperformed the US Treasury market across most of the yield curve. Limited new issue supply characterized much of the year, although a late quarter onslaught of issuance was brought about by the passage of companion tax bills in Congress, both of which seek to restrict tax-exempt municipal issuance. Municipal market performance mirrored returns in the corporate market with lower quality, longer-maturity segments of the market registering the strongest relative returns. Demand was steady, if not robust, as reflected in consistent US mutual fund inflows throughout most of the year as well as a modest expansion of institutional holdings by commercial bank and insurance company portfolios. Valuations versus Treasuries tightened, but remained attractive in comparison to longer-term historical averages.

Tax reform could mean change for muni market
The final tax reform legislation is expected to have significant impact on municipal market issuance. The new law will prohibit state and local issuers from refinancing outstanding debt with tax-exempt issuance, via the process known as Advance Refunding. The amount of this type of issuance varies depending upon several factors, including the general level of municipal and Treasury rates, but it can represent more than a quarter of total annual issuance during periods of extensive refinancing activity.

Private activity bonds (PABs), which were proposed to be eliminated in the House version of the tax reform bill, were saved in the final legislation. PABs make up a large portion of the municipal market and include issuers involved in healthcare, housing, airports, water and sewer facilities and redevelopment projects, among others. Industry analysts estimated that as much as 20% to 40% of municipal new issue financing would no longer qualify for tax-exempt treatment if the Advance Refunding and PABs provisions were enforced. The inclusion of either provisions places the tax legislation at odds with the stated administration goal of creating a large infrastructure investment program as an important piece of its legislative agenda.

Prior to President Trump’s signing of the Tax Cuts and Jobs Act into law on December 22, issuers had been rushing to market before year-end to qualify for tax-exempt treatment. We anticipate a sharp drop-off in supply at the beginning of 2018 in any eventuality.

What’s ahead for muni bonds?
Despite the new tax legislation, we anticipate relatively benign conditions for municipal investors heading into 2018. Our outlook is centered around expectations of continued economic growth, stable inflation and reduced supply of tax-exempt issuance.

As mentioned, we expect a reduction of municipal and corporate issuance over the period ahead. We would expect a diminution, but not elimination, of demand from institutions subject to the lowered corporate tax rate; but anticipate a strengthening of demand from individual investors, particularly in high-tax states, as the potential elimination of the deductibility of state and local taxes amplifies demand as investors seek to generate income exempt from federal and state taxation.

Finally, aside from the potential impact of changes in the tax code, we believe that fundamental issuer credit quality across the broad municipal market continues to improve as the economic expansion lengthens. While individual fiscally stressed issuers still face significant challenges, we expect most issuers will be able to adapt to a changing landscape with flexibility and creativity as they continue to provide the critical essential services that serve as the backbone of our economy.
James Grabovac, CFA®, is a Managing Director and Investment Strategist at McDonnell Investment Management, LLC.

James Grabovac is Managing Director and Investment Strategist at McDonnell Investment Management, LLC. In this role, he is responsible for executing tax-exempt investment strategies for the firm’s client portfolios, focusing on institutional client portfolios and subadvised mutual funds. Mr. Grabovac has over 30 years of investment industry experience.

Prior to joining McDonnell, Mr. Grabovac was an independent futures trader. He also managed tax-exempt mutual funds at Invesco Funds Group in Denver, and managed a high-yield municipal bond fund for Stein Roe & Farnham in Chicago. Mr. Grabovac also worked extensively with Stein Roe & Farnham’s insurance company clients.

Mr. Grabovac has an MBA in finance from the University of Michigan and a BA in economics from Lawrence University. He holds the Chartered Financial Analyst® designation and is a member of the CFA Institute as well as the CFA Society of Chicago.  

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Matthew J. Eagan
Matthew J. Eagan, CFA®

Vice President and Portfolio Manager Loomis, Sayles & Company

Our outlook calls for stable economic growth and an uptick in inflation. US and global growth are steadily improving, and US inflation indicators are below Federal Reserve (Fed) and consensus expectations.

We do see the Fed walking a tightrope. They want to continue to normalize monetary policy as quickly as they can. They have been getting support from the US economy which certainly seems like it is normalizing. We think the Fed will most likely implement three interest rate hikes in 2018. But really, the deciding factor will be how much inflation heats up. As mentioned, the economy appears to be humming right now, especially when you look at the Purchasing Manager Index.

We believe steady economic growth is also supporting risk assets, and continue to like opportunities in corporate bonds. While spreads (the difference in yield between non-Treasury and Treasury securities of similar maturity) have tightened significantly and the risk premiums for the investment-grade and high-yield markets are lower with increasing downside risks, we see further upside potential given the outlook for earnings growth and the low probability of defaults or economic recession.

High-yield advantage
Valuations appear fair, and with a growing economy we expect lower default rates in the high-yield sector. We think global demand for US high-yield credit should remain, due largely to attractive relative yields. When you’re looking at an investment-grade bond, spreads are so tight that the dominant risk factor is the term-structure risk (the risk to Treasury and interest rates). So overall, in the corporate space, we find high yield the most attractive – where defaults are declining, profits are rising, and the fundamentals look pretty good.

By the way, I would also say that the debt buildup and issuance we’ve seen in the third and fourth quarters of 2017 has been more dominant in the investment-grade space than high yield. In fact, we haven’t really seen a lot of issuance in the last three years in high yields.

Currency calls
The US dollar was weak versus a lot of reserve currencies, particularly the euro, in 2017. But we think the euro is overshot to a certain degree. In 2018, we think the US dollar will strengthen versus the euro.

The weaker US dollar fueled currency rallies in many emerging and developed markets. Emerging markets also benefited from the search for yield, positive risk sentiment and improving fundamentals. We believe some value remains in local-currency emerging debt and are being selective in our security selection while focusing on attractive real yields.

Overall, investment themes we believe make sense for fixed income investing in 2018 are broadening diversification, generating income, lowering duration and reducing overall interest rate sensitivity.
Matthew J. Eagan, CFA®, is a Vice President and Portfolio Manager at Loomis, Sayles & Company.

Matthew Eagan is a Vice President of Loomis, Sayles & Company and a Portfolio Manager for the Loomis Sayles fixed-income group. He manages institutional and mutual fund portfolios, and is a co-portfolio manager of the firm's flagship fund. He has over 26 years of investment industry experience as a portfolio manager and fixed-income analyst.

Mr. Eagan started his investment career in 1989 and joined Loomis Sayles in 1997 as a fixed-income research analyst for the multisector fixed-income team. Previously, he worked for Liberty Mutual Insurance Company as a senior fixed-income analyst and for BancBoston Financial Company as a senior credit analyst.

Mr. Eagan received his BA from Northeastern University and his MBA from Boston University. He is a CFA® charterholder.