Fixed Income 2019 Outlook

Matt Toms

Matt Toms, CFA

Chief Investment Officer, Fixed Income

Executive Summary

“Policymakers’ unprecedented response to the 2008 crisis acted to quell volatility—the unwind will exacerbate it.”

While our clients span across insurers, plan sponsors, consultants and financial advisors, the current environment presents a balancing act that is common to all: How can investors meet their need for current growth while being mindful of the risks ahead?

In this environment, navigating the path forward will require one focus above all: Positioning portfolios to avoid downside velocity.

In the outlook that follows, we provide an overview of the structural shifts responsible for today’s challenging market environment and three actionable insights to help navigate the path ahead:

  • Consumers over corporates
  • Capitalize on relative strength of the U.S.
  • Double down on security selection, expand the opportunity set

How we got here

Ten years removed from 2008, it is easy to forget how much of our current investment landscape has been shaped by central banks’ unprecedented response to the global financial crisis. Unusually muted market volatility and historically low yields for traditional fixed income instruments have characterized much of the last decade.

“It is no coincidence that the Fed’s $4.5 trillion balance sheet roughly equals the expansion of corporate credit since 2009.”

To combat this persistent headwind, many investors have expanded their investible universe, accelerating a trend that has been in place for several decades. Historically, the mechanism to deploy capital has been largely housed within the banking system. More recently, the mechanism to deploy capital has shifted to being largely intermediated in the public markets. Today, thanks in large part to the incredibly accommodative monetary policy of the last ten years, this mechanism is now further evolving. Indeed, since the financial crisis, the historic prominence of the bank channel has continued to be degraded by the growth of the market channel or intermediated credit channels, parts of which take on the ominous name “shadow banking system.”

Figure 1. A Decade of Easy Monetary Policy Fuels Corporate Credit Expansion

Figure 1. A Decade of Easy Monetary Policy Fuels Corporate Credit Expansion

Source: Barclays, Company Filings: Voya estimates, S&P, Prequin

It is no coincidence that the Fed’s $4.5 trillion balance sheet roughly equals the expansion of corporate credit since 2009 (Figure 1). As Figure 1 shows, much of the recent credit expansion has been in non-traditional categories. Senior loans and middle market debt, once esoteric, off-the-run asset classes, now constitute a larger portion of the credit market than unsecured high yield bonds. In the equity markets, the shift to nontraditional sources of capital has been even more pronounced over the last 25 years. In 1996, the number of U.S. publicly-listed companies was greater than 8,000. Today that number is only 4,300 and initial public offerings are currently at half their average rate from the 1980s and 1990s. Meanwhile, there is nearly $2 trillion in unallocated capital in the private equity pipelines.

What is driving the market’s growing preference for private capital? As we explore in the sections that follow, the answer to this question has broad implications for the global economic system.

But I want it now: The “Amazon experience” comes to a capital market near you

The world has lost its patience. Or perhaps more appropriately, technology has disrupted our relationship with waiting (enabling us to become the demanding little creatures we were all along). People expect convenience. People expect accessibility. And people expect immediate gratification. These new expectations do not simply apply to one category. Nearly all facets of society have been affected: Entertainment, transportation, travel, food, retail, and perhaps most importantly from an investment perspective, information.

“The world has lost its patience. Or perhaps more appropriately, technology has disrupted our relationship with waiting.”

A long-term investment mindset used to mean you thought beyond the quarter. Now “long-term oriented” seems to mean you think beyond next Tuesday. The public markets’ preference for information has moved from quarterly, to monthly, to daily, to hourly, to by the nanosecond. Coinciding with this trend is a growing emphasis on liquidity since the 2008 crisis and a regulatory framework that has made reporting and compliance an increasingly burdensome undertaking for publicly listed companies. Against this backdrop, a new private market “ecosystem” is evolving and reshaping the investment landscape. Private capital pools have expanded from the far, isolated borders of the investment spectrum to become a formidable perimeter surrounding what has traditionally been viewed as “core” allocations. As this private ecosystem continues to grow, one point that we believe will increase in relevance in the years to come is how private capital pools behave differently than banks. The growing preference for private capital does not come without consequences. There are risks and perhaps unintended outcomes that have broader implications for our economy and society.

“What are the broader risks as the world increasingly operates at two different speeds?”

Consider the recent liquidation of Toys R’ Us, which was accelerated after a private lender exercised its senior creditor rights to lock in its return on investment. In the media, this was portrayed as a decision between shutting down a company with ~33,000 employees versus achieving returns required by investors in hedge funds. To complicate matters, investors in hedge funds often include public pension plans that stand to gain from the investment, but lose from the resulting fall in employment and taxes in their jurisdiction. Additionally, while participants in pension plans theoretically benefit on the margin from these types of actions by hedge funds, the massive shift from DB to DC plans means that most people save for retirement through 401k plans, where investments like hedge funds, private equity and private debt are not broadly available.

In our view, this example is a microcosm for the nuances and risks of what is increasingly becoming a “2-speed world.”

Big picture: What happens when people and regulators have had enough?

I subscribe to the idea that the mission of finance is to optimize a society. Over the course of history, financial innovation has delivered great societal benefits but also exposed economies to the changing whims of regulators and markets. This tug of war—between financial innovation, economic prosperity and regulation—lays the foundation for the modern business cycle. New financial instruments take shape or gain favor, leverage increases, bubbles form, markets correct, and regulators react—sometimes too much and sometimes not enough.

Regulators respond to economic downturns with legislation. People respond with votes. Reaction to the most recent crisis ushered in a wave of populism across the globe, which has elevated geo-political risks and increased uncertainty among market participants. However, what we believe is perhaps even more concerning is how regulators might respond to future crises.

“When liquidity sensitivity is prioritized over intrinsic value, you run the risk of knowing the price of everything and the value of nothing.”

A fixed income investor’s primary job is to ask: What could go wrong? This is particularly true when it comes to understanding the unintended consequences of regulation. Following the 2008 crisis, investors and regulators emphasized liquidity. In line with the “I want it now” mindset, preferences for liquidity have fallen into the range of “by the nanosecond.” So what could go wrong with this approach? The problem is when you define what is liquid, you inherently define what is not. When this happens, the perception of illiquidity creates illiquidity. In this environment, any prescriptive liquidity analysis standard would effectively decide which movie theatres to yell “fire” within.

“A fixed income investor’s primary job is to ask: What could go wrong?”

For investors, any prescriptive approach to defining liquidity would only exacerbate the growing rift between public and private markets. In an increasingly bifurcated state, public markets could simply become a bastion of large mature companies as more capital flows into the private intermediated market space that is typically out of reach for the average investor. This backdrop has the potential to reinforce the trappings of a “two-speed world” and help fuel the uncertainty and geo-political risks associated with the growing wave of populism across the globe.

While regulators have thus far stopped short of a full-scale, prescriptive approach to defining liquidity in bond markets, how many crises away are we from regulators overreaching? Moving forward, this is a risk we will be paying particularly close attention to.

Avoiding downside velocity in 2019: Three areas of focus

So where are we now? The Fed is beginning to unwind its unprecedented response to the global financial crisis. Other central banks have been slower to act, raising questions about the tools they will have to combat the next downturn. In the U.S., although markets are beginning to balance back towards higher levels of securitized issuance, post-crisis debt build-ups have been disproportionately represented by the corporate bond markets, with a massive buildup in BBB-rated public debt. While we do not believe a downgrade cycle is imminent, risk is undoubtedly elevated. In this environment, security selection, which is always a vital component of portfolio construction, is more critical than ever.

Looking ahead to 2019, we believe there are three areas to focus on to avoid downside velocity.

Focus area #1: Consumers over Corporates

Figure 2. Mortgage debt cycle is still early versus corporate credit

Figure 2. Mortgage debt cycle is still early versus corporate credit

Source: Federal Reserve Bank of St. Louis, Federal Reserve Bank of New York, BLS and Voya Investment Management. Corporate Debt as represented by Federal Reserve Bank of St. Louis Non-Financial Corporate Credit Instruments through 01/31/18. Mortgage Debt as represented by Federal Reserve Bank of New York Survey of Household Debt & Credit through 03/31/18.

Driving forces: As the pace of corporate issuance resumed its higher trajectory following the crisis, the debt-to-GDP ratio of corporate debt has risen above its long-term average. Meanwhile, a very different picture is forming in the U.S. mortgage sector. While mortgage debt issuance has resumed growing in the post-crisis era, its debt-to-GDP ratio is instead falling. In addition, significant regulatory enhancements have affected Government Sponsored Enterprises, banks, broker-dealers, rating agencies, mortgage servicers and—perhaps most dramatically— mortgage lending standards. With conservative lending dynamics still in play, mortgage loans exhibit vastly superior credit characteristics, including less leverage, compared to those underwritten before the financial crisis.

Portfolio strategy: Looking ahead to 2019, we continue to favor securitized credit given the sector’s U.S. focused, consumer and housing/ real estate-centric risk drivers.

Focus area # 2: Double Down on Security Selection, Expand the Opportunity Set

Figure 3. What could go wrong? The loaded spring of long-duration BBB-rated corporate bonds

Figure 3. What could go wrong? The loaded spring of longduration BBB-rated corporate bonds

As of 09/30/2018. Source: Bloomberg Barclays. BBB as represented by the Bloomberg Barclays Baa Corporate Bond Index. High yield as represented by the Bloomberg Barclays High Yield Index.

Driving forces: On the surface, the sharp increase in BBB-rated debt seems concerning, particularly against a backdrop of higher net leverage and declining coverage ratios. While risk is present, we do not believe a downgrade cycle is imminent. Credit markets are being supported by strong corporate earnings, as positive revenue and EBITDA growth are helping offset higher net leverage and declining coverage ratios.

However, while there appears to be no clear and present danger, we do have longer-term concerns. The growth in BBBs has been as pronounced among longer duration bonds; i.e., bonds with a duration of 10+ years. Why does this matter? Historically, the high yield market has absorbed downgraded BBB debt, demand that helped stabilize credit markets and provide a buffer against market volatility. However, the high yield market is not a natural buyer base for longer duration bonds. Accordingly, we believe the existing glut of long dated BBB-rated bonds is a coiled spring. In the event of downgrade wave, the lack of demand for these long-dated bonds has the potential to exacerbate downside volatility.

Portfolio strategy: Security selection, security selection, security selection. Gaining exposure to corporate credit in the current environment requires a comprehensive understanding of the fundamentals of each individual issuer. In addition, by expanding the opportunity set, investors can gain corporate exposure through instruments that provide imbedded structural protections. For example, collateralized loan obligations (CLOs) provide over-collateralized exposure to senior secured loans, while investment grade private credit offers protective covenants, relatively attractive yields and issuer diversification.

Focus area # 3: Capitalize on the Relative Strength of the U.S

Driving forces: Extraordinary times called for extraordinary measures. Times are no longer extraordinary, but central banks have been very slow to respond. This expands downside risk into any new downturn.

While the Federal Reserve has been diligently raising rates, the ECB is still at a zero policy rate. Such an aggressive policy may increase the odds of achieving a 2% inflation target in 2019, but may also increase the odds of more lasting disinflationary pressures into any economic downturn, where monetary tools may have already been exhausted trying to achieve upside.

Meanwhile, the central bank actions of the developed world will likely continue exposing vulnerabilities in emerging markets. Differentiating between idiosyncratic and potentially systemic risk is critical. While individual countries such as South Africa, Turkey, Brazil and Argentina face idiosyncratic challenges, a strengthening U.S. dollar is creating downside pressure across the entire emerging market space.

Portfolio strategy: Prefer U.S.-centric assets, utilizing volatility as an opportunity to selectively add to emerging markets debt. Within EMD, we prefer hard currency sovereign risk, specifically to countries whose current accounts remain stable as we remain concerned with countries and EM corporates that are exposed to potential bouts of U.S. dollar funding pressure.

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