Are We There Yet?
2019 was a very good year for investors. Surprisingly, both offensive and defensive sectors did well, which is a marked about-face compared with 2018. We believe this is mostly due to a central bank shift to policy easing, especially in the U.S., coupled with a relatively steady economy. The excess liquidity created by the Federal Reserve’s (Fed’s) easier monetary stance did not find its way into increased capital investment but rather seeped into asset prices, lifting many to record highs. Interestingly, in U.S. high yield (HY), there seemed to be a flight to quality, as BBs performed best, while in U.S. investment grade (IG) there was a reach for yield, with the BBBs gaining the most ground.
It was not long ago that worry about the bubble-like expansion in the size of the BBB sector and a possible rise in defaults wreaking havoc on the high yield market were the prevalent views. John Sheehan from our IG team published a rebuttal to those fears earlier last year, and market worry about the BBBs has since receded. The question now is what strategies make sense for investors today? Do we continue to ride the liquidity fueled rise in asset prices, hoping to correctly time a graceful exit, or should we assume a more defensive stance and wait for a more propitious re-entry point?
The U.S. High Yield Index1 returned over 14%, while the investment grade U.S. Corporate & Government Index returned nearly 10%. This is highly unusual as rates generally fall when the economy is weakening and bond spreads are widening. Yields fell last year while spreads tightened meaningfully. Digging a bit deeper we find that the best performers, as mentioned above, were the BBB and BB sectors. The BBB U.S. Corporate Index started the year at 4.69% yield-to-worst (YTW) and tightened 150 basis points (bps) to 3.19% YTW by year end. The BB U.S. High Yield Index tightened by 240 bps from 6.25% to 3.85% YTW. The spread between the two is now very thin, meaning that either BBBs have more to rally or BBs are at risk of pulling back (or both). In any event, we do not expect further tightening of spreads like we saw in 2019, and since we are starting 2020 with lower nominal yields, that portion of returns will be lower. The latest round of Fed easing seemed to be an “insurance” policy aimed at preventing the economy from dipping into recession, rather than the more typical injection of liquidity following the bursting of some asset bubble, as in 2000 and 2008. We can argue that it may not yet have been necessary, but the fact remains that they have used up some valuable ammo that will be needed when recessionary forces do return.
The HY market as a whole now yields 5.33%, having begun 2019 at 7.89%. The IG bond market yields 2.25%, down from 3.27%. How much lower can those yields realistically go from here? For an extreme comparison from the land of zero interest rates, the Euro High Yield Index dropped from a 4.73% YTW on January 1st to 2.62% on December 31st. This compares to the Euro Broad Market Index, which rallied from a 0.77% yield to a mere 0.24% YTW at year end. Theoretically, rates in the U.S. could go to the zero bound, but as my colleague Eddy Vataru argued in our recent publication, “Negative Rates in the U.S.? We Don’t Think So,” we believe that structural differences in our markets will likely prevent that from happening. Also, if our economy were to weaken enough to warrant zero rates here, it is very likely that HY spreads would widen dramatically.
The market seems to be largely ignoring any individual company stress points, and one could argue it is priced to near perfection. At the end of December, only 5% of the HY market was defined as distressed (yield spreads over 1000 bps). In December of 2008, it was over 80%! We’re not saying that we will return to that level, but rather that the market is pulled a bit taut today and that it would not be unusual for there to be some reversion to more normal spreads and to see more differentiation between issuers. We are seeing the beginnings of that now as the lower quality bonds (CCCs and below) have noticeably lagged the market during the 2019 flight to quality. As the economy continues to stabilize and even strengthen a bit, and the uncertainty around the trade conflict recedes, we could see some narrowing of spreads between the lowest and highest rated non-investment grade cohorts.
The economy has remained on its low growth trajectory, albeit picking up a bit of strength lately, and we do not expect much change from that pattern for the foreseeable future. It will ebb and flow around a low growth, low inflation axis and the markets will react to factors beyond the economic realm at times. In the U.S., 2020 is an election year. We do not know whether or not the markets will continue to climb that wall of uncertainty, but it will be a year filled with drama to be sure. In the U.K., it seems they are closing in on a long-awaited separation from the European Union, despite what some fear could create more uncertainty regarding their borders with Scotland and Ireland. In Europe we have a new head of the central bank, who, as in the U.S., is not an economist by training, which of course worries many economists. We do not expect to see major policy shifts there, but there seems to be more open dialogue about the effectiveness of their negative interest rate policy (NIRP).
One thing we will be watching closely is Sweden’s exit from negative rates. On December 19th, the Riksbank, the oldest central bank in the world and one of the pioneers in experimenting with negative rates, raised its policy rate from -0.25% back to 0.00%. While a very modest first step, they expect inflation to approach 2% in 2020 and feel negative rates are no longer appropriate. While they warned not to expect further hikes, we are hopeful this is the first step towards interest rate normalization in the Eurozone. Critics of NIRP seem to be getting louder as some feel that the reversal rate (the rate at which further cuts harm economic growth) has been reached. We agree.
We were cautious coming into 2019 and were clearly premature. Historically we have gravitated towards the most attractive parts of the market but in what we view as the least risky way to participate. With the front end of the markets slightly inverted a year ago, we decided that the safest areas were at the front end of the curve. By design, we left some money on the table, but we didn’t expect to see such a powerful rally in longer dated bonds and risk assets. Now, with the curve normalized (steeper), and rates only having bounced a little off their lows, where do we find value? We believe that stretching for quality at this point may have diminishing returns given the low absolute interest rate levels and prefer to search for overlooked credits that may play catch-up in 2020 as economic prospects brighten. We saw some lift to these type of companies’ bonds in December and believe it will continue in 2020. It will come as no surprise to many of you that we are still favoring the shorter end of the duration spectrum, as moves like the Riksbank could be followed by other central banks, which could cause some interest rate volatility. Duration in the bond market is near historic highs, and we would rather not increase duration exposure at this time.
Since we are closing the books on the 2010s and entering the 2020s we’d like to reflect on the past decade and muse about the next. The last decade has been fairly good, with the average annual return for the S&P 500 of 13.6%. Government, IG corporate and HY bonds returned 3.2%, 5.6% and 7.5% annually for the same period. For the prior ten years 2000-2009, the returns for the S&P, Government, IG Corporate and HY were: -0.9%, 6.1%, 6.6% and 6.5%. Tailwinds from declining interest rates will probably be de-minimus and economic growth will likely be somewhat slower. What should investors expect for the next ten years and how should we think about positioning for what could be a lower return environment? While we don’t know what the future may bring, the longer this liquidity fueled asset price bull market continues, the more extended valuations become. With low interest rates, modest economic growth and smaller benefits from globalization it is possible that we could be facing lower returns in both risk assets and interest-sensitive sovereign debt. We believe that a prudent, risk-aware approach focused on absolute returns with an eye towards preserving assets in down markets is preferred.
These are interesting times. Each cycle is different from the last, but rational behavior usually emerges following periods in which investors justify why the spiking prices are different this time or, as former Fed chairman Alan Greenspan famously called it, “irrational exuberance.” Investors commonly perceive that markets have become risky only after prices have already declined. Rarely do they correctly identify those risks in advance. It is our job, however, to be vigilant in identifying those risks early, and consequently, we continue to focus on delivering strong risk-adjusted returns and remaining deliberate in our process, preferring to wait for fatter pitches before raising our risk profile.
We thank you for your continued confidence and welcome any questions or comments you may have.
Carl Kaufman, Bradley Kane, Craig Manchuck
Earnings growth is not a measure of a fund’s future performance. Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
It is not possible to invest directly in an index.
No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.
The Federal Funds Rate is the rate at which depository institutions (banks) lend reserve balances to other banks on an overnight basis.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance.
The ICE BofA U.S. High Yield (HY) Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market.
ICE BofA BBB U. S. Corporate Index tracks the performance of U.S. dollar denominated corporate debt rated BBB/Baa that is publicly issued in the U.S. domestic market.
ICE BofA BB U.S. High Yield Index is a subset of ICE BofA U.S. High Yield Index including all securities rated BB/Ba.
The ICE BofA U.S. Corporate & Government Index tracks the performance of U.S. dollar denominated investment grade debt publicly issued in the U.S. domestic market, including U.S. Treasury, U.S. agency, foreign government, supranational and corporate securities.
ICE BofA Euro High Yield Index tracks the performance of EUR denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets.
ICE BofA Euro Broad Market Index tracks the performance of EUR denominated investment grade debt publicly issued in the eurobond or Euro member domestic markets, including euro-sovereign, quasi-government, corporate, securitized and collateralized securities.
A basis point is a unit that is equal to 1/100th of 1%.
The yield to worst (YTW) is the lowest potential yield that can be received on a bond, assuming there is no default.
Ratings are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘D’, which is the lowest grade. Moody’s ratings are expressed as letters and numbers ranging from ‘Aaa’, which is the highest grade, to ‘C’, which is the lowest grade. A Standard and Poor’s rating of BBB- or higher is considered investment grade. A Moody’s rating of Baa3 or higher is considered investment grade. A Standard and Poor’s rating below BBB- is considered non- investment grade. A Moody’s rating below Baa3 is considered non-investment grade. If an issue is rated by both agencies, the lower rating is used to determine the sector. Fund breakdown by credit ratings are based on Standard and Poor’s ratings. Not Rated Securities consists of securities not rated by either agency, including common stocks, if any.
Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.
1 Unless otherwise indicated, all indices are ICE Bank of America.