Current yields and spreads are creating the perception that fixed income isn’t offering much value, but Western Asset Deputy CIO Michael Buchanan does see pockets of opportunity in several segments of the market.
- One of our highest conviction strategies right now is local emerging market debt (EMD). Local emerging market sovereign debt has been the best performing fixed-income asset class year-to-date, but curiously, their real yields continue to rise relative to developed market sovereign debt. This phenomenon can be attributed to elevated nominal yields and core inflation in emerging markets that is trending lower, perhaps benefiting from some of the same deflationary trends witnessed in developed markets. We think local EMD has the potential to outperform.
- Bank loans are also poised to perform. LIBOR is now above the “floor” rate embedded in most bank loans, so any increase in LIBOR will directly benefit the coupon of the underlying loan. Bank loan performance over the past year has been hindered by elevated repricings and refinancings. The pace of these repricings and refinancings is slowing, and we expect this trend to continue. As a result, there is less risk to investors that coupon levels will slip.
- AAA rated CLO tranches appear attractive. Granted, this is a smaller part of the market but it is one that we think offers quite a bit of spread given the safety and low volatility of the asset class versus other similarly rated debt. We are selectively expressing CLO AAA rated tranches in our client portfolios.
“Rising Star” Candidates
- Improving credit quality is notable within high yield. There’s been a reduction in CCC rated issuance (possibly due to regulation) and perhaps investor appetite to buy CCC rated bonds. On the flip side, BB issuance and BB participation in the overall market has gone up quite meaningfully, now comprising the largest part of the high-yield market.
- This shift in the credit profile of the market hasn’t really been absorbed or factored in by many market participants.
- More specifically, within this expanded universe of BB rated bonds, we see opportunity in certain BB credits that we feel have a strong likelihood of migrating to investment-grade within the next year to year and a half. We think this is a really nice risk/reward relationship given the incremental yield offered by BBs when compared with BBBs. Currently, this spread is almost a full percentage point. If one is accurate in terms of selecting the credits that can make that leap from BB to BBB, we maintain that there is a reasonable amount of spread tightening that can be captured.
- Based on our fundamental research, we see the opportunity in nearly one out of every five BBs, and are seeking to take advantage of these “rising star” candidates in our client portfolios.
Private Loan Sectors
- While traditional lenders have stepped away from some of the smaller opportunities in residential, commercial, and specialty finance lending, due to regulatory forces or capital constraints, Western Asset and others are stepping in to provide a financing solution. We think it’s a solution that currently offers a very attractive yield advantage versus the traditional syndicated loan markets.
- We like having the ability to use our strong voice during the underwriting process. We also have much more of an influence in terms of dictating pricing and we can emphasize high-quality borrowers.
- Finally, in an overall sector that appears not to offer a lot of compelling relative value (developed market sovereign debt), Italy appears to offer an attractive relative value opportunity. Growth in Italy is picking up and we’re seeing signs of fiscal improvement. We are taking advantage of the generous yield versus Germany and expect to witness compression between the two.