Fixed Income Investment Outlook Q3 2018: Back To Front

Our Fixed Income Investment Strategy Committee examines the short-duration debt instruments that can help investors take advantage of rising rates on the front end of the U.S. Treasury curve.

After years in which ZIRP meant zip for investors beyond principal protection, the front end of the U.S. yield curve is once again offering the ability to generate a reasonable rate of return as the Federal Reserve continues to normalize its monetary policy. By layering on some credit risk through a variety of short-duration debt instruments, investors may be able to boost their return potential with limited additional volatility and without taking on significant exposure to rising interest rates. And while non-dollar investors seem to be getting squeezed out of this particular trade by high currency hedging costs, there are other ways they potentially can capitalize on the opportunities in short-duration assets.

For the first time since global central banks' response to the financial crisis unleashed years of interest rate cuts, zero or negative interest rate policies, and quantitative easing measures that left the world awash with liquidity, the short end of the U.S. yield curve appears attractive on an inflation-adjusted basis. While this trend hasn't gone unnoticed, there are still attractive opportunities to be had among short-duration instruments for U.S. dollar investors, especially those willing to take on a little credit risk. (Note that while non-dollar investors may not see the immediate appeal of these strategies given the current expense of currency-hedging, this obstacle can be mitigated.)

A slow but steady stream of Federal Funds rate increases has pushed policy-sensitive short-term U.S. Treasury yields to levels not seen in a decade. While a 2.5% interest rate on a two-year Treasury might not seem like that big of a deal after the very strong performance of risky assets throughout the post-crisis cycle, the ability to again earn both positive nominal and real rates of return on the short end of the U.S. market represents a significant milestone. This is true not only for the income investors can generate, but also for the impact it likely will have on relative value across financial assets going forward. For years, Wall Street has favored stocks and other risky assets due in part to the lack of remunerative options in other lower-risk investments-colloquially dubbed the "Tina" effect, as in "there is no alternative." Now there are alternatives, however, and this optionality represents a headwind for risky assets; if a potential 4-5% return can be achieved on the front end of the fixed income market with limited risk, many investors may opt for the relative certainty of that position rather than maintaining or increasing their allocations to riskier financial assets.

Further incenting investors to stay short, the U.S. yield curve has continued to flatten year to date; as shown in Figure 1, the spread between the yields offered on 10-year and 2-year U.S. Treasuries has dipped below 40 basis points, a tightness not seen since before the financial crisis. This comes even as the 10-year Treasury drifted through the 3% level for the first time since January 2014.

Figure 1. The U.S. Yield Curve Has Flattened to Pre-Crisis Levels
10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
Source: Federal Reserve Bank of St. Louis.

Gradually rising interest rates in the U.S. are likely to remain a central theme in the markets. The 25-basis point hike in the Federal Funds rate following the Fed's June meeting was the seventh such increase since the central bank began its tightening cycle in December 2015 and brought the upper bound of the Fed's target rate to 2%. Recent Fed rhetoric shows little indication that the central bank is interested in accelerating the pace of its hikes despite improved economic and inflation expectations.

In fact, the Fed appears willing to tolerate inflation above its 2% target for a "temporary period" as part of its objective of "symmetric inflation." As the Fed grapples with the "neutral" level of interest rates that neither stimulates nor curbs economic growth, its efforts are complicated by a need to reconcile the economic tailwinds of tax cuts and increased government spending with the potential headwinds of tariffs and other trade tensions. While minutes from the May Fed meeting telegraphed the June hike, they also noted that continuing on this path of rate hikes could bring its target rate "at or above their estimates of its longer-run normal level before too long." This is consistent with our thesis that the Fed is likely to become even more measured and two-way in its policy approach as its terminal rate nears, especially given markets' reaction to tighter liquidity conditions thus far in 2018. In stark contrast with 2017's sanguine environment, the ongoing removal of liquidity from the system this year has contributed to the emergence of such key market dynamics as choppy equity markets, widening credit spreads and a stronger dollar. We expect these volatile conditions to become even more pronounced in the second half of the year as the Fed's balance sheet reductions increase and the European Central Bank likely ends its bond-purchase program.

Volatility may be further increased by global risks, which in general appear to have heightened in recent months. After a relatively uneventful 2017, European politics have pushed their way back to the fore, most notably in Italy, where fractious attempts to form a government caused some remarkable market moves in late May. Emerging markets - Turkey and Argentina in particular - have been impacted by the renewed strength of the U.S. dollar, and elections in Mexico in July could introduce more uncertainty to these economies. After seeming to fade somewhat, trade tensions are back with a vengeance as President Trump announced restrictive tariffs against allies and rivals alike, eliciting retaliatory moves along with general consternation among governments and businesses.

Short Duration: A Compelling Risk-Return Tradeoff

Though attractive yields are possible with short-maturity Treasury securities, we're inclined to go a little further down the quality spectrum in pursuit of modestly higher income levels. In addition to less sensitivity to rising interest rates, short-duration assets typically offer investors less volatility and shallower drawdowns than similar longer-duration debt. As we discuss below there are a number of lower-duration, credit-sensitive investment options that may be well suited to the current environment, particularly when deployed as part of a diversified portfolio.

Figure 2. An Array of Short-Duration Opportunities
As of May 31, 2018
Source: Short-Duration High Yield = BofA Merrill Lynch 1-5 Year BB U.S. High Yield Index; Short-Duration EMD = 50% JPMorgan EMBI Global Diversified 1-3 Year Index / 50% JPMorgan CEMBI Broad 1-3 Year Index; Short-Duration IG Credit = BofA Merrill Lynch 1-3 Year U.S. Treasury Year; Senior Floating-Rate Loans = S&P/LSTA Leverage Loan Index.

Note: Data above represent yield to worst for all asset classes except for senior floating rate loans, which are represented by yield to maturity.

Short-duration high yield. Net supply in the high yield market has been in decline for the past few years, and the pool has continued to shrink thus far in 2018. This trend is somewhat curious given that high yield bonds tended to be among the best performing asset classes during previous periods of rising rates. Interest rate hikes - including those we are now experiencing - typically occur when economic growth is robust, suggesting an environment in which both profits and thus the ability of issuers to service their debt are on the upswing. Given a mature but still-kicking economic cycle, the credit prospects for high yield issuers are favorable.

While the high yield market already is less rate sensitive than investment grade corporates given the shorter maturities and higher coupons of junk bonds, focusing on short-duration high yield bonds can reduce interest rate risk even further while sacrificing only a limited amount of potential return. Short-duration high yield can serve as higher-quality, lower-volatility approach to non-investment grade exposure, likely trailing the broader high yield market slightly during rallies but outperforming when spreads widen. They can also complement senior floating-rate loan holdings, offering greater total return potential given their fixed interest rates and call protection.

At the index level, short-duration high yield currently has a yield to worst of 5.2%, which is attractive in an environment of continued positive economic growth.

Short-duration emerging markets debt. After a year of outsized returns in 2017 and a strong start to 2018, emerging markets assets and currencies soon found themselves negatively impacted by higher U.S. interest rates, the strengthening U.S. dollar, rising oil prices and negative domestic developments in several key countries. While these dynamics had limited impact earlier in the year, those emerging market issuers with weaker funding profiles - notably, Turkey and Argentina - soon found their markets under pressure.

We don't think the emerging markets' recent difficulties foretell an extended period of financial turbulence - such as the "taper tantrum" in 2013 - 14 or the commodity collapse of 2014 - 16 - though spreads have widened materially. Though contagion fears are not unreasonable, emerging markets as a whole are in far better fundamental condition now, and we think the consolidation of cyclical improvements in many of the larger emerging economies is likely to provide a buffer against external headwinds. Corporate fundamentals, too, continue to improve as issuers decrease leverage and generate higher margins and better profitability. It's interesting to us that, despite the capital that has poured into the emerging markets in recent years, many investors fail to recognize the significant fundamental improvements that have occurred in these countries and the resiliency that they've developed as a result.

Cycles within cycles are nothing new in the emerging debt markets, and we remain constructive on the space for the intermediate to long term, treating the recent pullback as a buying opportunity - especially in places like Argentina. The short end, in particular, appears very attractive at current levels. By targeting emerging markets debt instruments with limited duration, investors can take advantage of the attractive spreads offered by these issues relative to developed markets while shielding themselves somewhat from the impact of rising U.S. interest rates. Meanwhile, a focus on hard-currency issues can alleviate investor concerns about local-currency volatility.

Short-duration investment grade credit. The short end of the U.S. investment grade credit market offers the potential for better risk-adjusted returns when compared to longer-duration bonds of similar quality. Things got a bit messy in the first quarter, owing largely to the implications of the tax-reform bill signed into law at the end of 2017. The spread to Treasuries among corporate bonds with maturities between one and three years widened sharply in February and March on fears that changes to the tax treatment of international profits would spark widespread repatriation of assets held outside the U.S. - and with it the widespread selling of the short-duration investment grade corporates in which a good portion of this cash is invested. These fears have failed to materialize, however, and the market appears to have accepted that a concentrated wave of liquidation is unlikely. As a result, buyers have returned to the short end of the market over the past month or two, with now-wider spreads offering a more attractive re-entry point into a space where fundamentals continue to be strong.

We also recognize that in addition to a relatively flat interest rate curve, credit curves are also relatively flat, as shown in Figure 3. Concurrent with this renewed interest in short-term paper has been modestly reduced interest in long assets as the yield curve continued to flatten; issuance has shifted to debt in the three- to five-year range in response to this change in investor demand. We'd expect this trend to continue until and unless the yield curve steepens.

Figure 3. Investment Grade Credit Curve Also Has Flattened
30-Year HQM Corporate Bond Spot Rate minus 5-Year HQM Corporate Bond Spot Rate
Source: U.S. Department of the Treasury, Federal Reserve Bank of St. Louis.

Senior floating-rate loans. Bank loans have been a magnet for capital for several years, as investors concerned about rising interest rates increasingly recognized the unique combination of relatively high yield potential and low duration offered by these securities. Though typically issued with maturities in excess of five years, senior loans have coupons that reset every 30, 90 or 180 days based on the prevailing Libor rate, resulting in minimal duration and thus minimal sensitivity to changes in interest rates. And while loans carry not-insubstantial credit risk-the average rating of the U.S. senior loan index is B+-their senior status in the borrower's capital structure means holders of this paper are the first to be paid back in the event of default. Moreover, loans traditionally have come with contractual agreements such as covenants and Libor floors that serve as additional investor protections.

The popularity of loans among investors has reshaped the character of the high yield bond market, as would-be public debt issuers in many cases have instead turned to banks for their financing needs. The U.S. senior loan market has doubled since 2010 and now exceeds $1 trillion outstanding; the high yield bond market, in comparison, has grown only about 30% over this period to total $1.1 trillion. While it may seem like senior floating-rate loans are a no-brainer in a rising-rate environment, there are signs that the senior loan market may prove a victim of its own success as the business cycle winds down.

Investors want loans and the capital markets want to accommodate them, but getting to the intersection of supply and demand has resulted in a persistent - though not yet alarming - degradation in credit quality. Leverage has increased. Standard and Poor's reports that the U.S. market's debt-to-EBITDA ratio hit a 14-year high around 5.0x earlier this year; while interest coverage still looks good, it is likely to decline as continued Fed hikes raise borrowing costs. Underwriting standards have declined, as is typical late in the cycle, and we are seeing an increasing number of loans with 0% or no Libor floors along with record-level issuance of covenant-lite loans, often extended to companies with more speculative and aggressive business models. The increased emphasis on loans for corporate financing has resulted in more top-heavy capital structures for borrowers, leaving fewer subordinated lenders to absorb losses before they hit senior debt holders. While this limited buffer tends not to be much of an issue when times are good-at around 1.8%, the default rate on loans is running below its 10-year average-it likely will translate into default rates that are higher and recovery rates that are lower than historically realized once the credit cycle turns.

Perhaps most concerning for investors is that yields on senior loans haven't been keeping pace with increases in Libor rates for some time; for example, while the three-month Libor rate has risen more than 60 basis points in 2018, the average loan coupon is up only about half that. Again, this phenomenon can be traced back to the popularity of the instruments, as healthy demand has enabled borrowers to refinance outstanding loans at more friendly terms, suppressing yields. For example, borrowers have been calling their outstanding loans and negotiating new contracts at lower credit spreads over Libor, which, given constrained supply, lenders tend to accept rather than risk losing out on their allocation. Borrowers also are refinancing to take advantage of the recent widening in the difference between one-month and three-month U.S. Libor rates, currently at more than 30 basis points compared to the 5-10 basis point range seen post-crisis. Though three-month Libor historically has been the reference rate of choice for most borrowers, they are free to choose their loan tenor and now are finding the cost savings inherent in the one-month rate worth the additional administrative burden of rolling loans every 30 days instead of 90. In addition, this Libor arbitrage may make CLO origination more difficult, impairing the demand from the largest buyers of loans. We expect the widening in the one-month/three-month Libor spread, shown above, to persist as Fed normalization continues.

The 2% return on senior floating-rate loans year to date through the end of May makes it one of the few segments of the fixed income market to have delivered positive returns thus far in 2018. As described above, however, risks to the asset class are gathering, suggesting caution is warranted despite the appeal of its floating-rate structure in a rising-rate environment.

Figure 4. Spread between One-Month and Three-Month Libor Has Widened Source: ICE Benchmark Administration, Federal Reserve Board of St. Louis.


Other Opportunities in Short-Duration Fixed Income

Municipal VRDOs and FRNs

Investors looking for short-duration exposure to municipal issuers have two main floating-rate options: variable-rate demand obligations and floating-rate notes, each of which can be issued as tax-exempt or taxable debt.

For investors that prefer or demand a stable net asset value, municipal variable-rate demand obligations (VRDOs) are the product of choice in the cash management space. VRDOs are long-term debt securities that feature a coupon rate that resets periodically-typically daily or weekly-based on the weekly SIFMA Municipal Swap Index. The VRDO structure also includes a "put" option that enables an investor to tender the securities at par plus accrued interest at any time with a specified period of notice. This put feature makes these securities eligible for purchase by money market funds under SEC Rule 2a-7 despite their long nominal maturities, and it also ensures that VRDOs trade at par regardless of credit and/or interest rate volatility. The put feature is made possible thanks to liquidity support provided either by a financial institution (either through an unconditional letter of credit or a conditional standby purchase agreement) or by the issuer itself (self-liquidity).

Looking around the rest of the fixed income complex, floating-rate bank loans are an asset class that seems tailor-made for a rising-rate environment, especially one in which cash flows and earnings remain supportive of corporate credit. That said, the supply side continues to present a challenge to loan investors, as the limited amount of M&A activity has reduced the pipeline of new bank loans to the market and has driven credit spreads tighter as a result. The supply/demand imbalance also is manifesting in the secondary market, as we're seeing companies reprice their loans for a spread pickup of as little as 25 bps.

Like VRDOs, municipal floating-rates notes (FRNs) tend to have longer maturities but limited duration given a floating rate that resets-generally weekly-based on the SIFMA Municipal Swap Index or one-month Libor. In contrast with VRDOs, however, municipal FRNs have neither liquidity support provisions nor a flexible put option, and they are priced mark-to-market. FRNs offer traditional taxable investors a compelling option-adjusted spread and low correlation to other sectors of the fixed income markets, along with higher credit quality and lower historical defaults versus 10-year U.S. corporates.

Tax-exempt VRDO yields have hovered between 1.05% and 1.80% over the past few months; assuming a 21% corporate tax rate, the taxable-equivalent yield for that trading range jumps to 1.33 - 2.28%. We currently are finding attractive opportunities in VRDOs with spreads 10-50 basis points over SIFMA. Given a wide range of maturity dates and credit qualities for FRNs, broad metrics can be difficult to pinpoint; to offer an example, however, we've been focused on structures with maturities inside five years that offer Libor spreads north of 80 basis points.

Corporate Floaters

We think investment grade corporate floating-rate notes are an attractive sector for short-duration investors. Perhaps less well-known than senior floating-rate bank loans, corporate floaters are issued by investment grade corporations and pay a variable coupon linked to a reference rate-typically three-month Libor-plus a fixed spread. Unlike the bank loan market, however, investment grade corporate floaters typically are not callable. These floaters allow investors to capture higher coupons and returns as Libor rises, with limited interest rate sensitivity.

After ending 2016 at 1.00% and 2017 at 1.69%, three-month Libor has increased to 2.32% as of the end of May, a level not seen since 2008. As you can see below the spread of the Bloomberg Barclays U.S. Dollar Floating Rate Note Corporates Index has been in a fairly narrow range over this period. In fact, the spread has compressed, suggesting the rising yields in the investment grade corporate floating-rate market have been driven by increased Libor levels.

Figure 6. Rising Libor Has Created Opportunities in Corporate Floaters
Bloomberg Barclays U.S. Dollar Floating Rate Note Corporates Index
Source: Barclays Capital.


What about Non-U.S. Investors?

Whether or not investors outside the U.S. find the aforementioned investment opportunities compelling will hinge largely on currency-hedging costs. Buying bonds outside their home domicile creates a foreign currency exposure that most investors will hedge using the forwards market, incurring a cost equal to the difference between the interest rates for the bond's currency and the investor's currency at the point on the forward curve at which the contract expires. With the Fed well into a tightening cycle while most other central banks remain on hold at very low levels, hedging costs have risen sharply and in many cases prohibitively; for example, the cost of hedging dollar-denominated assets into euros (using 12-month-forward rates) recently topped 3% for the first time. Subtract this 3% from the potential 4-5% yield on a short-duration portfolio that we mentioned earlier, and the return prospects for the foreign investor are much less compelling. However, there are a few options available to non-dollar investors.

First, non-dollar investors can work around this problem through a dynamic approach to currency hedging. A skilled active currency manager can dynamically adjust the hedged exposure between 0% and 100%, making opportunistic decisions based on fundamental views, the currencies' relative values and the cost of hedging. The outcome of this process can substantially enhance the return and mitigate the negative impact of hedging costs.

Second, the non-dollar investor could avoid the FX issue altogether by allocating to attractive short-dated credit opportunities in their home market. For European investors, one such example is the corporate hybrids market (though similar pockets of opportunity can be uncovered in many other regions). Mostly issued by high-quality European companies and denominated in euros, corporate hybrids are debt capital that also has some characteristics of equity and rank below all other forms of debt in an issuer's capital structure. For investors, the hybrid universe offers access to investment grade names with return potential commensurate with the high yield market. Though hybrids are either extremely long-dated or perpetual in maturity, issuers are overwhelmingly incented to call the securities on their first call date, usually five or 10 years post-issuance, and they are priced accordingly; as of May 31 the hybrid market's effective duration was around 5.2 years while its yield to worst was near 3.0%. We believe the growth in this $180 billion market is poised to continue, supported by a pickup in M&A activity on the Continent along with issuer refinancing needs.

Third, optimal short-duration portfolios for non-dollar investors may adopt a more barbelled approach to asset allocation. By combining riskier dollar short-duration holdings on a currency-hedged basis - such as in hard-currency emerging markets debt or short-duration high yield - with more conservative exposures to domestic markets, a non-dollar investor can construct a more attractive overall portfolio.

Finally, it's important for non-dollar investors to recognize that while currency-hedging costs currently are expensive due to the divergence of monetary policies across regions, they change over time. If policy tightening transitions away from the Fed and toward other global central banks, as we expect it will, dollar-hedging costs likely would decline, providing non-dollar investors a window of opportunity to access dollar short-duration assets at attractive levels.

It's also worth noting that while the dollar's recent strength, depicted in Figure 5, appears likely to stay intact in the near term, we believe its longer-term trend is downward given its valuation on a purchasing power parity basis and the negative sentiment associated with the country's twin deficits. That said, the recent rally in the greenback was not unexpected, as negative longer-term dynamics combined with changes to central bank balance sheets and mounting U.S. political risk drove the currency to oversold levels earlier this year even as interest rate differentials widened dramatically in favor of the dollar.

Figure 5. An Oversold Dollar Has Rebounded in Recent Weeks
Trade-Weighted U.S. Dollar Index: Major Currencies; March 1973 = 100
Source: Federal Reserve Bank of St. Louis.

Market Outlook

The front end of the U.S. yield curve looks attractive on an inflation-adjusted basis, offering investors the opportunity to again earn both positive nominal and real rates of return for the first time post-crisis. U.S. Treasury inflation-protected securities, meanwhile, remain our favorite play in the inflation markets given price pressures skewed to the upside in the American economy. U.S. agencies and ABS are our preferred investments among securitized assets. We're neutral to slightly negative on investment grade credit sectors globally. Given upbeat issuer fundamentals and its traditional strength in rising-rate environments, U.S. short-duration high yield currently appears to be the most attractive segment of the non-investment grade space. Emerging markets debt has struggled in recent months, but we believe the selloff has resulted in an improved value proposition across the complex given a supportive macroeconomic backdrop and solid country and corporate fundamentals. We have a constructive view on Scandinavian currencies in general and the Norwegian krone and Swedish krona in particular, as we believe the central banks of both countries look biased toward tighter monetary policy.

Government Bond Markets*

The front end of the U.S. yield curve is offering a reasonable rate of return for the first time post-crisis.

Global Rates and Inflation

While markets for the most part shook off central bank tightening efforts in 2017, it has been a much different story this year: credit spreads have widened, equities have traded sideways and the dollar has rallied. U.S. Treasury rate valuations normalized during the first half of 2018, as suggested by the term structure of the one-year forward yield curve relative to the Fed Funds rate equilibrium. After June's 25-basis point hike brought the upper bound of the Fed Funds rate to 2.0%, any additional Fed hikes at this point would tighten monetary conditions substantially. Offering the opportunity for real returns for the first time in a decade, the front end of the U.S. yield curve looks attractive in this environment. U.S. Treasury inflation-protected securities remain our most preferred inflation market play, as investors are underallocated to these linkers even as U.S. inflation risk is skewed to the upside. That said, it's worth noting that liquidity in TIPS can be tricky during the summer months, given higher realized volatility across many spread asset classes during the season.

In Europe, spreads between riskier peripheral sovereign credits and perceived safe havens like Germany widened sharply in recent weeks, as political turmoil re-emerged after a mostly quiet 2017. Italy's struggle to form a government in the months since its March general elections failed to produce a clear winner came to a head at the end of May, as the nomination of a euro-skeptic economic minister threatened to unravel the coalition between the Lega party and Five-Star Movement. Spreads on Italian paper widened to multi-year highs in response to fears that another election was on tap for the country. Spreads also increased in other heavily indebted peripheral economies like Portugal and Spain, the latter of which was facing its own political difficulties with the ousting of its scandal-plagued prime minister. We think these selloffs were overdone, presenting a potential investment opportunity; indeed, sentiment toward these beleaguered rate markets has improved already, as Italy appears to have dodged the need for another election in the near term while Spain's transition to new leadership has been uneventful thus far.

Ongoing normalization in rates and global central bank balance sheets will continue to test many crowded, popular trades and do so in volatile fashion. Carry trades will need to be re-evaluated in the context of the ever-changing investment landscape; among them, carry trades in the front end of yield curve in EU periphery (especially attractive for hedged investors), long carry in emerging markets (both hard and local currency) and long carry in the U.S. via steepening trades. Although fundamentals dominate over the long run, in the short term we continue to be aware of the evolving dynamics that support demand for high-quality government bonds.

Investment Grade Sector*

Short U.S. IG credit offers the potential for better risk-adjusted returns than longer-duration bonds of similar quality.

Securitized Assets

We remain modestly negative on agency MBS spreads over the near term, as the Fed's gradual approach to balance sheet reduction should help the market absorb the additional supply. Spread widening could become more pronounced in the latter half of 2018 as Fed reinvestments in agency MBS conclude, though the current low refinanceability of today's mortgage market should prevent widening from becoming drastic.

CMBS spreads widened in the second quarter, presenting some opportunities to add exposure to the space. AA and A segments of the capital structure, in particular, appear attractive relative to corporate bonds, though such issues can be difficult to source. The appeal of CMBS is bolstered further by its low exposure to the idiosyncratic risk faced by other asset classes, making it something of a safe-haven investment.

Although swap spreads tightened during the quarter, ABS offer attractive spreads to Treasuries, particularly on the short end of the curve. Going forward, we expect these high-quality short-duration assets linked to Libor will continue to be supported by strengthening consumer balance sheets.

A significant portion of the legacy RMBS market is exposed to structural interest rate caps, which is becoming an issue given the considerable increase in U.S. dollar Libor rates year to date; issue selection will be key to success in this market. Relative value in the space has shifted from the legacy distressed market to the credit-risk transfer (CRT) market, which continues to see support from robust underlying housing fundamentals.


U.S. investment grade corporate fundamentals remain solid in aggregate, as historically high levels of leverage are being offset by the extended economic cycle and improved cash flows that resulted from corporate tax reform. Corporate spreads have widened year to date, as risk premiums have been reintroduced into the credit markets; this is appropriate given monetary policy normalization that is ongoing in the U.S. and expected to take root in other major economies over the next year. Increased leverage and changing business dynamics are typical late-cycle phenomena that suggest investments in formerly "defensive" sectors like pharmaceuticals, food and beverage and consumer products should be examined more cautiously. In contrast, banking and energy are earlier in their respective business cycles and are the preferred credit exposures at this time.

We remain cautious on European credit based on tight valuations, the continued withdrawal of ECB stimulus and rising political risk. We have been defensively positioned, with little exposure to subordinated financials or to peripheral eurozone names, though we will look to add risk selectively as volatility reveals attractive opportunities. One area of the corporate market that continues to offer value is hybrid debt, particularly certain U.K. utility hybrid bonds that have been oversold on Brexit risk. We would note that the cross-currency swap situation currently makes it extremely favorable for U.S. investors to buy euro assets-and unfavorable for euro-based investors to buy dollar-denominated paper.

Municipal Bonds

Last year's tax-reform bill, which included the elimination of tax-exempt advance refundings, has had a positive impact on muni bond market technicals. Supply is down around 20% year to date, and the size of the market could shrink by $50 billion over the summer as maturities and coupons outweigh expected new-issue supply; this should support the relative performance of munis over the next few months. With the top personal tax rate still around the 40% mark, demand from individual investors has been and is likely to remain strong, particularly from investors in high-tax states like New York and California given the tax bill's $10,000 cap on state and local tax (SALT) deductions. In contrast, property & casualty insurers and banks have pulled back from the market given the impact of the new 21% corporate tax rate on the relative value of munis and corporate debt.

Municipal fundamentals are generally stable, as solid economic growth and continued strength in the housing market have been supportive of tax collections. Fixed costs related to pension obligations remain an overhang on credits in certain states, including Illinois, New Jersey and Kentucky, to name a few. Speaking of Illinois, the state was an unexpected source of relief this year, as lawmakers and the governor agreed to a spending plan ahead of deadline for the first time in three years. We remain watchful here in the late innings of state budget season, however, as it always has the potential to inspire volatility in the markets.

High Yield & Emerging Markets Debt*

Short-duration high yield can serve as higher-quality, lower-volatility approach to non-investment grade exposure.

High Yield and Leveraged Loans

Though slightly negative on an absolute basis, the U.S. high yield market has beaten most other fixed income asset classes in the rising-rate environment of 2018, led by the significant outperformance of lowerrated issues; the market's spread is more or less unchanged. We expect defaults among non-investment grade issuers to remain below the historical average, running at about 2% over the next 12 months. The credit quality of the high yield market remains stable, driven by the robust operating performance of underlying issuers; revenue and EBITDA growth have improved as leverage has plateaued, and refinancing activity has significantly reduced the amount of bonds maturing in the near term. Performance may be susceptible to a variety of factors going forward, including uncertainty around trade policy, shifting regulations and potential changes to leveraged-lending guidelines and their enforcement; meanwhile, technology-driven disruption remains a key risk to certain industries within the high yield space. Market technicals have been balanced, with retail outflows offset by lower new issuance and continued demand from non-U.S. investors. Volatility finally has picked up, largely driven by expectations of higher inflation and interest rates in the U.S. along with possible regulatory changes. All in, we expect U.S. high yield spreads to be range-bound going forward, as constructive issuer fundamentals and positive U.S. GDP growth will be offset by an increase in market volatility.

The relative performance of senior loans has been strong in 2018 as well, and it is one of the few fixed income asset classes to have generated a positive year-to-date return. As with high yield issues, loan market defaults should continue to trend at a below-average rate around 2%, supported by strong operating performance among borrowers. Risks are gathering, however. As non-investment grade companies increasingly turn to loans instead of bonds for their corporate financing needs, the resulting top-heavy capital structures leave fewer subordinated lenders to absorb potential losses before they hit senior debt holders. Leverage has increased, while covenant protections have weakened. Three-month Libor has moved sharply higher during 2018, and its spread to one-month Libor has widened considerably; in response, many borrowers have refinanced at the lower one-month rate, suppressing yields.

European high yield should deliver stable, coupon-driven returns in what we expect will be an increasingly volatile global environment. The European high yield market offers a much higher proportion of BB rated bonds (72%) and much less CCC paper (4%) relative to other developed high yield markets, and exposure to commodity issuers remains very low at 5%. The eurozone rate outlook is likely to remain more accommodative than that in the U.S.; with inflation persisting below target despite improving dynamics and stronger economic activity, the ECB seems unlikely to hike its policy rate in 2018. Meanwhile, current hedging costs make European high yield issues attractive to U.S. and Asian investors looking to diversify their existing non-investment grade holdings. All in all, we expect the demand for European high yield paper to remain strong in 2018.

Emerging Markets Debt

It's been a difficult few months for the emerging markets, as the impact of U.S. dollar strength and a 3% 10-year Treasury yield finally hit these economies, after a delay. Though the casualties in the emerging world were widespread, Turkey and Argentina suffered the most, as investors grew increasingly concerned about these countries' vulnerable external debt positions. The selloff in emerging markets currency and debt was so harsh that it began to resemble 2013's taper tantrum-unwarranted, in our view, given the significant improvements that have transpired since then in emerging market fundamentals, global economic growth and the terms of trade.

The significant spread widening in emerging markets hard-currency sovereigns year to date contrasts markedly with flattish U.S. high yield spreads, improving the relative value proposition of the former. In the emerging corporates space, valuations remain tight relative both to historical levels and to emerging sovereigns, though they have become more attractive vis à vis U.S. credits following the recent selloff, especially in the short end of the curve. Corporate fundamentals are expected to remain on the upswing, with decreasing leverage and higher margins and profitability. Despite strong net issuance year to date, technical factors are likely to remain overall neutral for emerging corporates due to relatively light positioning from crossover and dedicated accounts as well as supportive flows in the corporate and hard-currency space.

Benign local inflation dynamics have protected local rates from the upward pressure triggered by falling currencies and wider spreads. Local rates did lose relative value due to higher rates in the U.S. along with tightening financial conditions and the risks of rising developed market inflation. While visibility in emerging markets FX appears limited given the sensitivity of currencies to the various risks facing these economies, positioning and valuations have become more favorable.

Despite the recent troubles, the global macroeconomic backdrop remains supportive of emerging markets debt for the coming year, as these economies are well positioned to benefit from higher commodity prices, an increase in developed market capital expenditures, better liquidity locally as FX reserves are rebuilt, and the tailwind of still-easy global financial conditions. While leading indicators of global growth weakened in the first quarter, primarily driven by soft data in Europe, we don't see this as a trend, and we expect emerging market growth data to remain resilient. Risks persist, however, notably in geopolitics. After walking away from the Iran nuclear accord supported by its allies, the U.S. seems insistent on provoking the European Union and China into a trade war; meanwhile, additional sanctions against Russia remain on the table.


We are bullish on Scandinavian currencies in general and the Swedish krona in particular.

U.S. dollar: While the dollar has spiked against a range of developed and emerging market currencies since mid-April, driven in part by short covering, the lack of clear-cut fundamental support for the rally suggests that momentum is likely to wane. Expanding twin deficits (i.e., budget and current account deficits) and ongoing political instability in the U.S. should temper the dollar's strength even as short-term yield differentials and upside economic surprises remain supportive. The unwinding of long euro and emerging markets FX positions is likely over following the dollar's sharp ascent. Though dollar short covering has come a long way as economic growth and Fed policy expectations are increasingly priced in, market participants are still modestly short the currency. Net net, we expect the dollar will consolidate and settle into a trading range against the euro, with the lower bound around 1.15, while intervention by emerging market central banks trying to defend their currency should promote stability there. Given tensions around trade and tariffs, particularly after June's contentious G7 meeting, price action is likely to be volatile across currencies.

Euro: The European economy has benefited from the synchronized global expansion. And while PMIs have turned sharply lower of late, forward-looking indicators imply above-trend growth will continue in 2018 even as the euro's prolonged strength previous to the recent dollar rally has sapped European industry of some of its competitiveness. Inflation, too, has surprised to the downside recently, and ECB policy should continue to be accommodative, though a likely improvement in economic momentum should lay the groundwork for the central bank to remove extreme stimulus measures. While the dollar rally in the second quarter inspired the unwind of many long euro positions, the market is still long the euro and may see a short-term bounce as the dollar consolidates its gains. Though rhetoric from the new Italian leadership suggests it is not as market unfriendly as investors had feared, the country will continue to be a source of volatility as markets weigh the potential for irresponsible government spending despite a large debt-to-GDP ratio, an action we consider unlikely.

Yen: While purchasing power parity and real exchange rates point to an undervalued yen, wide yield differentials against the currency in both nominal and real terms, which are exacerbated by the BOJ's yield curve policy, temper expectations going forward. Solid economic growth and mounting inflationary pressures have translated into tentative signals that the BOJ may be preparing markets for the start of policy normalization. Of course, these improvements in the inflation outlook are relative; inflation remains well short of the BOJ's target and it's expected to stay that way at least through 2020. Further, the currency's fundamentals have not gone unnoticed by the market; it has been the best-performing major currency year to date, and market participants continue to be long yen. While the yen continues to be a safe haven during periods of risk aversion, a re-emergence of risk-on sentiment could lead to a selloff.

Pound: Having depreciated significantly since the Brexit referendum, the pound continues to appear undervalued on a purchasing power parity basis, a position bolstered by a late-2017 rate hike that improved yield differentials. That said, strong conviction in the pound is a challenge given ongoing Brexit negotiations; while a recently struck transition agreement between the EU and U.K. represents a positive step forward, political uncertainty likely will flare up periodically as negotiators hammer out the details. Further, it doesn't appear as if a "hard" Brexit is being priced into the pound at all, and such an outcome-or even a "medium-hard" Brexit-likely would lead to a selloff in the currency. The late June summit may revive headline risk and attendant market volatility, suggesting the pound is best played tactically at this point.

Swiss Franc: The Swiss franc remains one of the most expensive major currencies in the world. Given the expectations that recent eurozone's economic weakness is temporary, safe-haven positions in the franc should continue to be unwound; however, uncertain political situations in Italy and Spain could spark risk aversion and renewed safe-haven flows. The franc is one of the world's most attractive funding currencies, and the Swiss National Bank is unlikely to let any rapid appreciation in the currency threaten this status, especially given the country's low levels of inflation.

Swedish krona: We are bullish on Scandinavian currencies in general and the Swedish krona in particular, especially following its depreciation in late 2017 and first half 2018. Offering a more attractive valuation than the euro, the krona represents a high-octane trade on ECB policy, as we expect the Riksbank to begin a rate-hike cycle in conjunction with the end of the ECB's quantitative easing program. Backed by positive economic growth prospects that are buoyed in part by a resurgent eurozone, Sweden's inflation dynamics are supportive of tighter policy, even if they are somewhat volatile around the central bank's target. While less liquid than the euro, the krona tends to benefit from safe-haven flows in times of risk aversion.

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