Credit markets are supported by a bright near-term economic outlook, but fixed-income investors should exercise caution in tight market conditions
Guggenheim Investments, the global asset management and investment advisory business of Guggenheim Partners, today provided its First Quarter 2018 Fixed-Income Outlook, “Walking the Risk Tightrope.”
The report reflects the investment management team’s view that the current environment represents “an unfortunate asymmetry of risk.” With bonds in most sectors trading above par, yields historically low, and spreads near or below pre-crisis levels, the best a fixed-income investor can reasonably expect is to earn the coupon, while principal is at risk from an active Federal Reserve (Fed), the looming increase in Treasury supply, geopolitical risk, and credit deterioration.
“Bull markets do not die of old age, but as they grow older they become more vulnerable to shocks as companies and households get overextended,” said Scott Minerd, Global CIO and Chairman of Investments. “Monetary policy tightens to curtail overheating economic activity, and so ends the business cycle. Our Macroeconomic and Investment Research Group analyzed the late-cycle behavior of several key economic and market indicators, and concluded that the current expansion will end as soon as late 2019.”
Current conditions could persist for some time—economic growth is accelerating, monetary policy is not overly restrictive, and optimism is high—but history has shown that with a recession approximately two years away, the time for caution is approaching.
With this quarter’s outlook, we also release timely and relevant video commentary from Portfolio Manager Adam Bloch, and Brian Smedley, Head of the Macroeconomic and Investment Research Group.
Among the highlights in the 32-page report and video:
- We have reduced our allocation to corporate bonds—including investment grade, high yield, and preferreds—to the lowest level since the financial crisis, given the low absolute spreads across these sectors.
- Spreads in collateralized loan obligations (CLOs), asset-backed securities (ABS), Agency commercial mortgage-backed securities (CMBS), and non-Agency residential mortgage-backed securities (RMBS) remain attractive relative to corporate bonds.
- We see unemployment ultimately falling to 3.5 percent, and expect that a tight labor market will nudge wage growth higher, causing inflation to rise. Given these factors, we expect the Fed to raise rates four times in 2018.
- Analyzing the effects of the new tax plan is a focus across sector teams. The reduction in the corporate tax rate from 35 percent to 21 percent is expected to help boost cash flow primarily for smaller, domestically focused companies. Higher-levered industries and companies will be negatively affected by the new limit on deductibility of interest expense above 30 percent of earnings before interest, taxes, depreciation, and amortization. In municipals, the cap on state and local tax deductions may prompt more migration from high-tax states to low-tax states, which would have negative credit consequences for certain issuers.
- We expect 2018 will see further loosening of credit standards in bank loans. Covenant-lite loans now represent around three-fourths of outstanding loans, a phenomenon we would categorize as late-cycle behavior.
- The Treasury’s recent refunding announcement reflects an increase in the government’s need to borrow. The looming increase in supply, particularly in bills and two-year and three-year maturities, combined with four rate hikes, will result in disproportionate pressure on the front-end yields and support further bear flattening of the yield curve.