January 2022 US Fixed Income

TEST2 Migration: Harvesting higher yields in today’s bond markets

• Seth Meyer, CFA Portfolio Manager
• John Kerschner, CFA Head of US Securitised Products | Portfolio Manager

January 2022 US Fixed Income

TEST2 Migration: Harvesting higher yields in today’s bond markets

• Seth Meyer, CFA Portfolio Manager
• John Kerschner, CFA Head of US Securitised Products | Portfolio Manager

Head of U.S. Securitized Products John Kerschner and Portfolio Manager Seth Meyer discuss the opportunities available in bond markets, despite rising interest rates.

Key Takeaways

• Bond yields are rising because the market thinks economic growth will be strong.
• Strong economic growth is positive for many individual companies and securities across the securitized and high-yield markets.
• We believe there are numerous opportunities to harvest higher yields with lower durations.

Rising interest rates raise justifiable concerns about the future returns of bond portfolios. But it is important to not let fear of higher rates dragging on returns keep investors from capitalizing on the potential opportunities in the current environment. Bond yields are rising because the market thinks economic growth will be strong, and the expectation that the Federal Reserve (Fed) will ultimately have to raise interest rates to cool the economy. But the degree of growth in the meantime could be substantial. The to-date fiscal stimulus in response to the COVID-19 pandemic is around 25% of U.S. gross domestic product (GDP)¹. We haven’t seen fiscal support like that since World War II. The median projection for 2021 growth in the U.S. is currently 5.7%, higher than any year since 1984 when annual growth was 7.3% (Figure 1).

Figure 1: U.S. annual GDP growth and 2021 median forecast

A rapidly growing economy may fan the fears of inflation, but it is also a significant positive for many individual companies and securities. Indeed, in the past six months, corporate credit and securitized bond markets have rallied broadly as investors (literally) bought into the idea that maybe the worst of the COVID-19 crisis was behind us. But we have generally observed that as spreads tighten, the correlation between industries and sectors tends to decline and the dispersion of future performance tends to rise. In our view, the opportunities have shifted from timing the direction of an entire asset class to more careful industry, company and security selection. The key question being, which industries and companies are most likely to benefit from a rebounding economy?

Opportunities for yield exist

CMBS in a changing world

Each recovery is different. COVID-19 accelerated many transitions in the U.S. economy, including the shift to a more digital economy, which has sparked some surprisingly niche opportunities. The rise of e-commerce enabled a fast-tracking of remote work capabilities, cloud services, and on-demand grocery and goods delivery. As online ordering has gained popularity, the call for speedy delivery has grown. This is driving increasing demand for industrial space – particularly warehousing – close to large urban areas, builders are scrambling to add it, and the commercial mortgage-backed securities (CMBS) market is funding it. Mortgage-backed securities (MBS) are fixed income investments secured (or ‘backed’) by a collection of mortgages. Investors receive periodic payments derived from the underlying mortgages, similar to coupons. CMBS are backed by mortgages on commercial properties rather than residential real estate. Similarly, we are seeing a rise in demand for biomedical office space. Occupancy rates for these spaces are likely to stay high because it is a niche industry that – unlike many other sectors of the economy – does not lend itself to working from home. (It is rather difficult to do cutting-edge biomedical research from your spare bedroom.) Likewise, it is not easy to retrofit existing industrial spaces to suit medical research – the requirements are too specific, with highly regulated health and safety requirements. Current occupancy rates of biomedical facilities are near 100% and rents are high per square foot, and CMBS is funding new facilities. Finally, multi-family homes fall within the commercial mortgage sector, and demand for housing remains strong. Multi-family mortgages performed well relative to expectations throughout the COVID crisis, and successive stimulus payments have helped. Ultimately, demand exceeds supply for homes in the U.S., and the more affordable multi-family home sector is no exception.

Investing in the U.S. consumer

Despite the historic recession, consumer bankruptcies and auto delinquencies are both near all-time lows. Home price appreciation and used car sale values are near all-time highs. Aggregate consumer savings have surged, with over $2 trillion in excess savings accumulated since the pandemic hit. This environment creates, in our view, attractive risk-adjusted return opportunities in consumer-related sectors, such as asset-backed securities (ABS) which are ‘backed’ with assets such as car loans or credit card debt. Market-placed lending (MPL) securities – which consist primarily of direct-to-consumer loans – have grown, taking share from the credit card market. In our view, the trend towards MPL is likely to accelerate, and may well be the future of unsecured consumer lending. Like many newer markets, this provides opportunities for experienced investors to identify attractive pools of loans offering higher yields and/or lower credit risk than similarly rated counterparts in the ABS market. Credit-Risk Transfers (CRTs) are another opportunity where performance is more directly tied to the outlook for the consumer. When the U.S. housing Agencies (such as Fannie Mae or Freddie Mac) issue mortgages, they issue MBS securities, which are guaranteed by the issuing agency, and CRTs, which transfer the credit risk of the mortgage to the buyer. Having a positive outlook on CRTs is predicated on having a positive view on the creditworthiness of homeowners. In addition to the already mentioned strengths of the aggregate consumer, there is more demand for homes as a result of COVID-19 and a shortage of supply. While mortgage rates have risen in recent months, they are still relatively low, and home price appreciation was strong in 2020 at near 10%². We expect home price appreciation will remain positive, significantly mitigating foreclosure risk. Meanwhile, we see numerous consumer- and business-related opportunities within the ABS market. For example, air travel has been picking up, with leisure demand particularly robust³. With the vaccine distribution moving faster than many expected, we think pent-up demand for travel will see bookings rise further and we foresee a sharp rebound in airline travel in the quarters ahead. This travel includes the even more niche sectors such as cargo plane leases and business jets – both investable via the ABS market. Sometimes the opportunities are more technical in nature. Take securities backed by timeshares (vacation homes that are purchased for limited use). Many of these securities were considered part of the hospitality sector and were thus assumed to have a cloudy outlook. However, in our view, Americans’ desire for a holiday hasn’t diminished, and it is generally a higher-quality borrower that opts to purchase a timeshare. The list goes on: Technology ABS backed by cell towers, fiber-optic cable and data centers are all more likely to see increased demand as the digitization of the economy progresses. It takes time to identify viable prospects and evaluate the specific credits, but, in our view, there is no shortage of opportunities.

CLOs that float, as rates rise

Collateralized loan obligations (CLOs) are made up of floating-rate bank loans (also known as leveraged loans) issued to corporations that normally have a below investment-grade credit rating. But when the loans are pooled into portfolios, the offerings to investors range across the rating spectrum, including AAA. Yields at the AAA level are high compared to similarly rated corporate bonds and other securitized AAA assets. And the “credit curve” in CLOs is currently quite steep: The amount of additional yield paid for securities with lower credit ratings is increasingly higher as credit-quality diminishes. The result is yield spreads that are increasingly attractive relative to similarly rated corporate bonds, as can be seen in Figure 2.

Figure 2: 2-year average yield spreads of CLOs and corporate bonds

Like many other corporate and securitized markets, the projected losses in leveraged loans (the building blocks of CLOs) have been trending lower as economic forecasts have trended higher. CLOs deserve a closer look in a low yield, rising rate environment.

Monetary stimulus supports high-yield corporates

Monetary stimulus has been as historic as the fiscal stimulus provided since the pandemic began. Not only did the Fed lower policy rates to zero, it also bought bonds directly in the open market, including – for the first time – high-yield bonds. The aim was clear and twofold: to ensure companies could access funding, and to lower companies’ funding costs to buttress their profitability. Such was the signaling strength of the Fed, that the corporate bond-buying programs were only lightly tapped, with market participants eagerly supporting new issues, allowing the Fed to cease further purchases at the end of 2020. While broader monetary accommodation must end at some point, it is difficult to argue against the mathematics of low default rates in short-maturity securities given the current support. Unsurprisingly, the forecast default rate has fallen. During the height of the COVID-19 induced uncertainty, defaults were predicted to be as high as 15% this year. In reality, the default rate over the past 12 months – both in the U.S. and globally – was in the single digits, and declining⁴. In our view, the Fed’s generous accommodation will last until it is no longer needed. We do not believe the Fed engaged in the most massive balance sheet expansion since World War II only to pull the plug too soon. While high-yield bonds are rated below investment grade and thus carry more risk, we think we are in the part of the recovery cycle where lower-credit quality securities returns are probably more skewed to positive than at other times. And with current yields in the Bloomberg Barclays U.S. High Yield Index near 4.4%, the absolute income is nearly two times the yield of the Bloomberg Barclays U.S. Corporate Bond Index (currently at 2.3%) and nearing three times the yield of the Bloomberg Barclays U.S. Aggregate Bond Index (currently at 1.6%)⁵. While the high-yield asset class has more duration (a measure of its sensitivity to changes in interest rates) than many of the securitized sectors we have discussed, it is low relative to investment-grade corporate bonds. High yield also has the highest correlation to U.S. equities among the major bond markets. As such, high yield can be thought of as an attractive hybrid asset in a diversified portfolio, providing returns more in line with the direction of equities, while also offering a relatively high income. Our more positive outlook on the asset class as a whole does not discount the attractive risk-adjusted return opportunities within particular sectors, and companies. CCC rated securities have outperformed (up 4.9%) the rest of the high-yield market year-to-date⁶ as the market reprices the higher, but more rapidly diminishing, default risk in the lowest-rated securities. Understanding divergences between the rating sub-sectors of the market can provide active managers opportunities to add value. The same is true at the sector level, where themes like rising e-commerce or a strong consumer can also be applied.

You can’t always get what you want. But if you try sometime, well you just might find you get what you need.” – The Rolling Stones

Balancing yield and duration

We believe interest rates are likely to rise in the quarters ahead as the recovering economy forces them to levels more appropriately aligned with “normal” economic growth. This poses risks to bond portfolios. But if an individual bond’s duration is a risk in a rising rate cycle, the key question in our view is, are you being sufficiently compensated for that risk? Broad corporate credit benchmarks such as the Bloomberg Barclays U.S. Corporate Bond Index have rallied significantly in recent quarters, and currently yield 2.3% with a duration of 8.4 years⁷. With 8.4 years of duration, the index would – assuming spreads stay unchanged – fall 8.4% if the comparable-maturity Treasury bond yield were to rise a further 1.0% in the next year. With a yield of 2.3%, investors would lose a net 6.1%⁸. The benchmark’s duration risk should not be underestimated. But not all bond portfolios need to be constructed the same as the benchmark. First, an individual investor’s goals and risk tolerance are key factors in finding the right balance of duration and income. Second, we do not believe that rising rates mean “bonds” (generally) are inappropriate in a diversified portfolio. On the contrary, we believe there are numerous opportunities to harvest higher yields with lower durations. And because the path to higher rates is unclear and surprises happen, owning some duration is prudent. In our view, adjusting and actively managing the balance of income and duration will be the key to total returns in 2021. Investors can also opt to take on additional credit risk and lower correlation to interest rates by extending into the high-yield market. Or they could diversify their exposure into securitized products where yields often exceed those paid for corporate bonds, the durations are lower and – as in the case of CLOs and many CMBS – the coupons are floating rate, offering a natural hedge against potentially rising interest rates. Sector selection is only part of the process, however. Ultimately, we believe the value in active bond asset management comes from security analysis within sectors that are identified as offering attractive risk/reward. Characteristics of individual securities can vary widely, and it is the role of the manager to pick securities and combine them into a portfolio that meets the yield and risk targets investors seek. Don’t give up on bonds. Instead, find a manager that understands your goals and has the ability to harvest opportunities that help you realize them. ¹ International Monetary Fund, as of 11 March 2021. ² Bloomberg, as of 29 March 2021. ³ Bank of America, as of 29 March 2021. ⁴ Source: Moody’s, US speculative-grade trailing 12 month default rate, global speculative-grade trailing 12 month default rate, at 28 February 2021. ⁵ Source: Bloomberg, as of 22 March 2021. ⁶ Bank of America, as of 24 March 2021. ⁷ Bloomberg, as of 22 March 2021. ⁸ Janus Henderson, as of 22 March 2021.

Featured Funds

JMUIX

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JMUDX

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Glossary Expand Asset-backed Security (ABS): A financial security which is ‘backed’ with assets such as loans, credit card debts or leases. They give investors the opportunity to invest in a wide variety of income-generating assets. Basis point: A Basis point is 1/100^th of 1%. 1 bp = 0.01%, 100 bps = 1%. Bloomberg Barclays U.S. High Yield Index: The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the US dollar-denominated, high yield, fixed-rate corporate bond market. Bloomberg Barclays U.S. Corporate Bond Index: The Bloomberg Barclays U.S. Corporate Bond Index measures the US dollar-denominated fixed-rate corporate bond market. Bloomberg Barclays U.S. Aggregate Bond Index: The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market. Collateralized Loan Obligations (CLOs): Debt securities issued in different tranches, with varying degrees of risk, and backed by an underlying portfolio consisting primarily of below investment grade corporate loans. Commercial Mortgage-Backed Security (CMBS): These are fixed income investment products backed by mortgages on commercial properties rather than residential real estate. Correlation: How far the price movements of two variables (e.g., equity or fund returns) match each other in their direction. If variables have a correlation of +1, then they move in the same direction. If they have a correlation of -1, they move in opposite directions. A figure near zero suggests a weak or non-existent relationship between the two variables. Credit ratings: A score assigned to a borrower, based on their creditworthiness. It may apply to a government or company, or to one of their individual debts or financial obligations. An entity issuing investment-grade bonds would typically have a higher credit rating than one issuing high-yield bonds. The rating is usually given by credit rating agencies, such as Standard & Poor’s or Fitch, which use standardized scores such as ‘AAA’ (a high credit rating) or ‘B-‘ (a low credit rating). Moody’s, another well-known credit rating agency, uses a slightly different format with Aaa (a high credit rating) and B3 (a low credit rating). Credit Risk Transfer Securities (CRT): Pioneered by Freddie Mac in 2013, Credit Risk Transfer programs structure mortgage credit risk into securities and insurance offerings, allowing the transfer of mortgage credit risk exposure to investors. Duration: A fixed income security or portfolio’s sensitivity to a change in interest rates, measured in terms of the weighted average of all the security/portfolio’s remaining cash flows (both coupons and principal). It is expressed as a number of years. The larger the figure, the more sensitive it is to a movement in interest rates. ‘Going short duration’ refers to reducing the average duration of a portfolio. Alternatively, ‘going long duration’ refers to extending a portfolio’s average duration. Fiscal stimulus: Fiscal policy is government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank. Fiscal expansion (or ‘stimulus’) refers to an increase in government spending and/or a reduction in taxes. Floating rate loans/leveraged loans: These are typically loans arranged by banks on behalf of businesses and sold to investors. They are called floating rate because the regular coupon paid to investors adjusts in response to changes in interest rates. The loans are senior within the borrowing firm’s capital structure, which means they are among the first to be paid back in the event the company defaults. High yield: A bond that has a lower credit rating than an investment grade bond. Sometimes known as a sub-investment grade bond. These bonds carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher coupon to compensate for the additional risk. Inflation: The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation. Investment grade: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments. The higher quality of these bonds is reflected in their higher credit ratings when compared with bonds thought to have a higher risk of default, such as high-yield bonds. Market-place Lending (MPL): Marketplace lending is a nonbank lending industry that uses innovative financial technology (fintech) to make loans to consumers and small businesses. Monetary stimulus: Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Securitized: Securitized products are fixed income securities that pool financial assets together to create new securities that can be marketed and sold to investors. Spread: The difference in the yield of a corporate bond over that of an equivalent government bond. Yields: The level of income on a security, typically expressed as a percentage rate. For equities, a common measure is the dividend yield, which divides recent dividend payments for each share by the share price. For a bond, this is calculated as the coupon payment divided by the current bond price. Yield spread: A measure of how much additional yield an issuer offers over comparable “risk-free” U.S. Treasuries. In general, widening spreads indicate deteriorating creditworthiness of corporate borrowers, tightening spreads are a sign of improving creditworthiness.

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