Western Asset Expects Central Bank Unwinding of Accomodation to be "Unexciting"
Uncertainty Has Created Potential Opportunities in High Yield, Emerging Market Local Currencies, and Structured Bank Loans
October 16, 2017
In a webcast focused on finding value in today’s global fixed income markets, Western Asset Management Deputy CIO Michael C. Buchanan made the case that low yields and tight bond spreads as the Fed unwinds its balance sheet have left many investors “needlessly anxious.”
Most market watchers point to successful actions of the U.S. Federal Reserve, Bank of Japan and European Central Bank for underpinning the low yields and tight spreads in today’s markets. As that support is gradually withdrawn, Mr. Buchanan said that those who believe the current condition is solely attributable to central bank accommodation will be needlessly anxious that opportunities will be few as the Fed and others begin unwinding their balance sheets.
“There are two additional factors, which are also important,” Mr. Buchanan observed. “First is that today’s slow, steady, economic growth – with persistently low inflation – is an ideal condition for bond investors, and the reason we have seen lower government yields. Secondly, strong corporate health, with low default rates, is why spreads have been tighter than normal. Investors should focus on those two facts as the central banks begin to reverse their processes.”
“There are still opportunities in fixed income,” Mr. Buchanan advocated. “That’s not very apparent when you just look at the overall fixed-income market metrics, but we are finding pockets of opportunity and taking advantage of those opportunities for our clients.” He highlighted select high-yield bonds, emerging market local currency bonds, and structured and bank loans.
“Fed Chair Janet Yellen has said this process should be like ‘watching paint dry.’ It will be the exact opposite of the aggressive, bold moves the Fed made when they began accommodation. This unwind process is tricky, clearly one the market is very focused on. It will require an approach that integrates active feedback from the market, but success is doable and likely."
“Yields are low and spreads are tight, so perhaps the value has really been extracted from fixed-income,” Mr. Buchanan noted. “But within certain markets, we are finding opportunities that we’re very excited about. And I think a lot of these opportunities are not really obvious.”
Mr. Buchanan began his discussion of potential investor opportunities with high yield.
“High yield in isolation is not a table-pounding investment right now,” he explained. “The market is reasonable, we think the market is fair, but we see segments that we are very, very excited about. With less CCC issuance, BB issuance and participation in the overall market has gone up quite meaningfully. It is now the largest part of the high-yield market. Some of the increase in BBs has come from fallen angels, no doubt: lots of energy, metals and mining companies.”
“There’s an interesting opportunity, not in those sectors per se, but in BB credits that have a very strong likelihood for the ‘fallen angels’ to migrate back to investment-grade. This is not a home run trade but a really nice risk/reward relationship. If you are accurate in selecting credits that can leap from BB to BBB, there’s a reasonable amount of spread tightening you can capture.”
“Our research team is very excited about this opportunity. They have scrubbed the universe of BBs and found an extraordinarily high number of these credits, in BB-land, that over the next year to year-and-a-half have a high degree of likelihood to make it to investment-grade. By our bottom-up measure, it’s almost one out of every five BBs. We are taking advantage of these ‘rising star candidates’ in client portfolios, hoping to capture the upgrades to investment-grade.”
He turned next to bank loans, one of the worst performing fixed income categories year-to-date.
“That is poised to change,” Mr. Buchanan said. “Most bank loans are now above their LIBOR floor, meaning they will participate one-to-one in increases in LIBOR, and performance can begin to shift. Bank loans also have gone through an unprecedented period of repricing where, essentially, coupons were lowered by the companies. That happens typically when there is quite a bit of demand for loans, and when a significant universe of the loan market trades above par. We think this wave of repricings is going to continue to trend lower.”
“There also seems to be quite a bit of conviction that interest rates are not going anywhere. Although we are not worried about materially higher rates, we think you will see improvement, some increase in rates over time, particularly at the short end. That will benefit bank loans.”
A smaller part of the market, Mr. Buchanan honed in on AAA-rated collateralized loan obligations (CLOs).
“It offers quite a bit of spread given the level of safety and low volatility of this asset class,” he said. “These are very, very secure structures. You would have to see a meaningful impairment to the overall deal, approximately 30 percent or more, to witness any impairment in CLO AAA-rated tranches. For historical backdrop, that has never happened: no AAA CLO tranche has been impaired. Furthermore, market forces have required more equity to go into these deals.”
“It is a small part of the market, but one where we think there is reasonable opportunity. And selectively we are expressing CLO AAA-rated tranches in our client portfolios.”
One of Western Asset’s highest conviction strategies right now is local emerging market debt.
“The story is one of real yield,” Mr. Buchanan said. “This is really surprising because probably the best performing fixed-income asset class year-to-date has been local emerging market sovereign debt. The index we follow is up a little over 16 percent year-to-date – a tremendous performer. That may lead investors to think, ‘Maybe there’s no opportunity there.’ Yet real yields continue to go higher, creating a more compelling case for local emerging market debt.”
“That’s happening because core inflation in emerging markets is trending lower. The market perhaps has not completely appreciated that. You could see benefits, in emerging market inflation, influenced by the same factors that have influenced developed market inflation. This could be the beginning of an exciting trend for emerging market local currency debt. The overall yield levels are still very high. Again, we are taking advantage of it for our client portfolios.”
On the structured product side, Western Asset sees opportunity in the private loan sector.
“Traditional lenders have stepped away from some of the smaller opportunities on the residential side, commercial side, specialty finance side, due to regulatory forces and capital constraints,” Mr. Buchanan said. “We and others are stepping in to provide financing solutions. It offers a very attractive yield advantage, versus the traditional syndicated loan markets. What we also like is the ability to have real influence on underwriting standards, and influence in dictating pricing.”
“We can really emphasize high quality borrowers. We can be very choosy.”
“The trade-off is you get less liquidity, but the real benefits you get are better, more enhanced collateral and better pricing overall.”
 JPMorgan Emerging Markets Bond Index (“EMBI Global”)
Scrutinizing Sectors: Finding Value in Fixed Income Today
About Michael C. Buchanan CFA
The Deputy Chief Investment Officer of Western Asset Management Co., Mike Buchanan is a specialist in high yield, having headed the Global Credit team. Prior to joining the firm in 2005, Mr. Buchanan served as Managing Director and Head of U.S. Credit Products at Credit Suisse Asset Management, and as Executive Vice President and Portfolio Manager at Janus Capital Management. He also worked at BlackRock Financial Management as a managing director and portfolio manager, and at Conseco Capital Management as a vice president and portfolio manager. A Certified Financial Analyst, Mr. Buchanan earned his B.A. from Brown University.
About Western Asset Management
Western Asset Management is one of the world's leading fixed-income managers with $428.8 billion in assets under management as of June 30, 2017. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. From offices in Pasadena, Hong Kong, London, Melbourne, New York, São Paulo, Singapore, Tokyo and Dubai, the company provides long-term, value-oriented investment services for a wide variety of global clients, across an equally wide variety of mandates. To learn more about Western Asset Management, please visit www.westernasset.com.
About Legg Mason, Inc,
Legg Mason, Inc. is a global asset management firm, with $754 billion in assets under management as of September 30, 2017. The company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).
Fixed-income securities involve interest rate, credit, inflation, and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed-income securities falls. High yield bonds are subject to greater price volatility, illiquidity, and possibility of default. International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Asset-backed, mortgage-backed or mortgage-related securities are subject to prepayment and extension risks. Tapering of the Federal Reserve Board's quantitative easing program and a general rise in interest rates may lead to increased portfolio volatility.
Credit Quality is a measurement of a bond issuer's ability to pay interest on the bond in a timely manner; it informs investors of an investment’s credit worthiness, or risk of default. The credit quality ratings provided by ratings agencies such as Standard and Poor’s (S&P), Moody’s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details. High yield, or below-investment grade bonds are those with a credit quality rating of BB or below.
LIBOR (Intercontinental Exchange London Interbank Offered Rate) is a benchmark rate that some of the world’s leading banks charge each other for short-term loans.
The JPMorgan Emerging Markets Bond Index (“EMBI Global”) tracks total returns for U.S. dollar-denominated debt instruments issued by emerging market sovereign and quasi-sovereign entities: Brady bonds, loans, Eurobonds and local market instruments. Investors cannot invest directly in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.
An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
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