By Rom Badilla, CFA
There are many headwinds that could plague markets and keep investors awake at night in the weeks and months ahead. The European Debt Crisis, the Fiscal Cliff, weakening corporate earnings and the muddle through U.S. economy are reasons that could create volatility and uncertainty around the market place. Such scenarios could lead to a selloff in risk assets like credit and equities and into safe-haven securities like the dollar and U.S. Treasuries.
Contrary to these risks, the Fed’s recent initiative to expand their balance sheet via Quantitative Easing is generally supportive of corporate bonds and equities due to better financial conditions. As we had talked about, the Fed’s purchases of Mortgage Backed Securities and the subsequent richening of the asset class via declining spreads or the incremental yield over Treasuries, should lead investors to sell their holdings and look to other sectors for yield. Sectors like Corporates, High Yield, Commercial Mortgage Backed Securities (CMBS) all stand to outperform as investors reach for better returns.
JP Morgan provided an interesting analysis on which sectors within a particular asset class might be expected to outperform the most during the latter stages of a spread tightening period. In their latest U.S. Fixed Income Markets Weekly, JP Morgan provided the following analysis:
In Exhibit 5, we present the average profile of spread narrowing over two significant narrowing cycles, late 2002-2004, and 2009-2010. As the table shows, higher-rated sectors tend to tighten earlier, with AA spreads, for example, seeing 69% of total tightening in the first half of the period. Lower-rated sectors tend to tighten later, suggesting that we should see credit quality curves flatten as the rally matures.
Having said this and if history is a guide, spreads in Investment Grade Corporates which are rated AAA through BBB-, should tighten in the early phases. As yields compress near U.S. Treasuries, investors look to other risky asset classes such as High Yield which are rated BB+ through CCC-, for additional returns. So, if an investor missed the early stages of outperformance by the corporate bond market, this analysis reveals that that outperformance has momentum via lower credits which in turn leads to a flattening of the credit yield curve.
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