Fixed Income Perspectives
ING Investment Management
By Christine Hurtsellers, Matt Toms, Mike Mata
November 27, 2012
Bond Market Outlook
Global Interest Rates: As long as economies remain weak, interest rates will be low and central banks will be accommodative.
Global Currencies: We remain bearish on the U.S. dollar, yen and euro, preferring to own EM currencies with better yields and more attractive valuations.
Corporates: Our medium-term outlook remains constructive, but spreads are likely to widen and be volatile near term due to weaker earnings guidance and the fiscal cliff.
High Yield: Spreads continue to offer attractive long-term compensation for default risk, though current yields and dollar prices limit upside.
Mortgages: Prepayment fears have spiked post-election, but mortgages should remain well supported by Fed buying activity.
Emerging Markets: Developed market rates will remain low near term, providing attractive yield advantages for EM bonds.
- A wise American once said “Life is hard; it’s harder if you’re stupid.” A good example is when your pals in Washington are so busy pushing their partisan agendas that they lose sight of what could happen to the American economic Thunderbird if it goes all Thelma and Louise over the fiscal cliff. With the latest elections in the books, it remains to be seen if a Democratic president and acrimonious Republican House can put on their thinking caps to devise a way to delicately pump the brakes of fiscal restraint. Accommodative monetary policy should provide sufficient maneuverability for prudent fiscal tightening, but the recent risk-off environment suggests market participants have not forgotten the brinksmanship that defined the 2011 debt-ceiling debacle.
- Meanwhile, October was more trick than treat for markets; risk aversion reigned supreme as Hurricane Sandy howled up the Eastern seaboard, while political uncertainty and lackluster earnings reports also weighed negatively on sentiment. The focus abroad has been on Spain and its recent sovereign downgrade; the question now seems to be when β not if β Spain will turn to the ECB-sponsored Outright Monetary Transactions program for support.
- While the euro zone has returned to recession and remains mired in fiscal uncertainty, the U.S. fiscal cliff is the market’s main concern. The bid for safe-haven assets should continue to be well-supported by the shaky outlook for U.S. fiscal stability, resulting in a generally flatter yield curve. However, in light of easing tail risks in Europe and China, growth and market performance have the potential to surprise to the upside β as do interest rates β should lawmakers reach a smart compromise to the fiscal cliff.
- We continue to favor U.S. and foreign corporate bonds, emerging market local and hard currency sovereigns, and residential and commercial mortgaged-backed securities β sectors that continue to provide yields in excess of long-term inflation expectations and that are benefiting from extremely accommodative monetary policy. As these safe-haven investments become scarcer β especially in the highest-quality segments of each asset class β investors should prioritize security selection as a source of risk-adjusted returns.
Global Interest Rates
- Deleveraging takes time, and policy rate tightening remains only a very distant threat. As long as weak economies provide a reasonable pretext for easy policy, central banks will keep interest rates low by continuing and if necessary expanding their QE programs. The Fed is likely to extend its Treasury purchases after Operation Twist expires at the end of the year, perhaps in a more balanced fashion across the curve.
- Our estimate of the fair value of the ten-year Treasury rate is 2.00β2.25%. Yields remain lower than growth and inflation would warrant, driven in part by safe-haven flows, political risks and central bank intervention. This is partly justified by low bond market volatility, but compensation per unit of interest rate risk is relatively low. Central bank activity has been fully discounted in many countries, and relief from acute political uncertainty is likely to provide upward pressure on rates if tail risks continue to abate.
- We remain bearish on the euro given the recessionary outlook for the region; however, we do favor European currencies β like the Polish zloty and Hungarian forint β that stand poised to rally with the euro while acting as relative safe havens should the euro come under pressure. We have become more bearish toward the U.S. dollar in recent months, and continue to add exposures to fundamentally attractive emerging market currencies in countries like Brazil and Mexico. Given the recent support for unrestrained monetary easing to counteract Japan’s deflationary pressures β which could severely impact Japan’s currency by impairing the long-term solvency of a government that has gross debts equivalent to more than 200% of GDP β the yen may have finally reached a tipping point.
High Yield Corporates
- While the high yield market continued to move higher in October, its pace slowed as equity market enthusiasm waned in line with a lackluster start to earnings season and political uncertainty in Washington. Balance sheets are healthy, limiting the risk of a near-term spike in defaults, but overall credit improvement may have ended as we have seen downgrades outnumber upgrades in recent months. Spreads continue to offer attractive compensation for default risk in the longer term, though the return to a sub-7% yield and near-record-high dollar prices limit upside from current levels.
Investment Grade Corporates
- Initial indications are that the third quarter reporting season will be similar to the second quarter’s, with earnings generally in line but revenues weak. Flat to negative profit growth is the near-term concern and could weigh on spreads. The financial industry continues to perform well; cyclical industries showed some life in October after a protracted period of underperformance, but concerns about the fiscal cliff may force a reversal. Our medium-term outlook remains constructive, but near-term spread direction is likely to be wider and more volatile until there is some clarity around a fiscal-cliff compromise.
- Agency MBS struggled to keep pace with Treasuries in the postelection rate rally, as the Obama victory has fueled speculation that government-sponsored refinancing programs could be expanded, leading to increased prepayment speeds. Even if HARP or other government programs gain traction, agency MBS will continue to be well supported by favorable supply/demand dynamics driven by the Fed’s QE3 program.
- Non-agency RMBS continue to benefit from the low interest rate environment and fundamental improvements in the U.S. housing sector. Credit standards remain stubbornly high, but even small increases in demand have been meaningful. While tighter compared to early-2012 levels, relatively wide credit spreads continue to attract yield-hungry investors.
- A refinancing boom in CMBS continues, fueled by QE3 and fortified by election results. With the bulk of the maturities coming due in 2015β17, we believe CMBS fundamentals are poised for a period of stability. Technical remain a key risk, however, as the refinance environment is influencing higher new-issuance volumes, potentially skewing an otherwise favorable supply/demand balance.
- Positive consumer payment behavior, assisted by the low-rate environment, continues to support ABS’s reputation as a safe haven. ABS will continue to offer high-quality, stable performance during periods of heightened risk aversion.
- The rate cut-driven stimulus cycle that has broadly defined emerging market central bank activity in 2012 is largely over. Debt dynamics and fundamentals remain favorable for EM countries, and yields are attractive at current levels relative to developed market sovereigns and corporate credit. With the decennial leadership change in China now underway, we think the country will be able to achieve relatively stable growth consistent with the government’s 7.5% target; private-sector strength in the U.S. will help China’s export channel contribute to that expansion.
ING U.S. Investment Management’s fixed income strategies cover a broad range of maturities, sectors and instruments, giving investors wide latitude to create a new portfolio structure or complement an existing one. We offer investment strategies across the yield curve and credit spectrum, as well as in specialized disciplines that focus on individual market sectors. We build portfolios one bond at a time, with a critical review of each security by experienced fixed income managers. As of June 30, 2012, ING U.S. Investment Management managed $127 billion in fixed income strategies in the United States
This commentary has been prepared by ING U.S. Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities.
Past performance is no guarantee of future results.
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