The risks, macro factors and opportunities behind Western's outlook for the year ahead.
While 2019 was marked by continual anxiety—about Brexit, US-China trade, Fed actions, a potential US recession, and political and social unrest around the world—it’s ultimately shaping up to be an incredible year for fixed-income investors.
2019 in Review
- Despite a fair amount of general market pessimism early in the year, we believed global growth would prove to be resilient.
- We thought the much-hyped threat of recession in the US was unwarranted, and as the year wore on the narrative of impending doom faded.
- We viewed the Federal Reserve (Fed) as being too hawkish after raising rates in late 2018. Its stance changed and resulted in three 25 basis point cuts in 2019.
- Our long-held belief that inflation would remain low, both in the US and globally, lent further support to our expectation that central bank accommodation would continue.
- Given our view that fundamentals remained solid at the start of 2019, we identified the weakness seen in December 2018 as making valuations even more compelling and positioned our portfolios accordingly.
- The general investment strategy we pursued over the year was to overweight spread product, complemented with duration.
2020 Macro Drivers
- We believe slow, steady global growth will be likely throughout 2020.
- Manufacturing data appears to be stabilizing, further supporting our view for global growth.
- We think it’s unlikely that growth rates will rise above expectations, given that it took 10 years of accommodative policy to get only to where we are today with cumulative growth below what was seen during previous recoveries.
2020 Investment Risks
- We expect to see greater market volatility overall, driven by uncertainty surrounding trade, social unrest and politics.
- US political risk will likely increase with the presidential election in 2020; our informal poll during the webcast had 72% predicting that Republicans will retain the White House.
- There are also fears that the economy could be running too hot, which could eventually cause rates to rise. However, we don’t think this is the most likely scenario, especially given the secular headwinds of deteriorating demographics and rising sovereign debt loads.
- We anticipate that idiosyncratic risks will rise as spreads are tighter and opportunities may become harder to identify. But, Western Asset has a very large, global platform to help us take advantage of a more challenging market.
2020 Investment Opportunities
- High-yield: Overall, high-yield looks attractive, but not across the board. We think there will be attractive opportunities in CCC high-yield, but only on an issue-by-issue basis.
- Bank loans: Given their underperformance in 2019, we think bank loans will benefit from the fundamental strength seen in corporate credit. Western Asset is especially well positioned to benefit from primary issuance, given our ability to influence issue terms.
- CLOs: We think in general CLOs are currently very cheap. BBB CLOs on average have traded about 80%-85% of the high-yield market. BB CLOs are also above normal ranges, offering approximately 200% of the yield found in high-yield. We don’t think this opportunity will last much longer.
- Structured products: We expect record issuance in 2020, and we like the opportunities we see both in residential and commercial issues as well as in credit risk transfer notes (CRTs). Here also we can influence the structuring of deals, including the collateral and call structures.
- EM: We remain very constructive on EM and like that its leverage is fairly low. We continue to favor the opportunities we see in local currency-denominated EM.
- Western Asset has a strong voice with regard to how primary issue deals are structured. But, there are times when the secondary market is more appealing. We are able to remain agile and can be responsive to the relative value of the primary market when that value is skewed in our favor.
- The current market environment is fairly unique and does not resemble another time in recent investing memory, with strong fundamentals continuing to favor markets. We’re 10 years into an economic recovery, but not yet seeing widespread indicators of credit excess. As a result, we see continued runway in the credit cycle.
"Brexit" is a shorthand term referring to the UK vote to exit the European Union.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
A basis point is one one-hundredth (1/100, or 0.01) of one percentage point.
Spread product refers to taxable bonds that are not Treasury securities and include securities such as agency securities, asset-backed securities, corporate bonds, high-yield bonds and mortgage-backed securities.
Duration measures the sensitivity of price (the value of principal) of a fixed-income investment to a change in interest rates. The higher the duration number, the more sensitive a fixed-income investment will be to interest rate changes.
An investment-grade rating (AAA, AA, A, BBB for example) is one that indicates that a municipal or corporate bond has a relatively low risk of default. Bonds with below investment-grade ratings (BB, B, CCC for example) are considered low credit quality and have a higher risk of default.
A BBB rating is the lowest investment-grade rating; it reflects an opinion that the issuer has the current capacity to meet its debt obligations but faces more solvency risk than A-, AA- or AAA-rated issues.
A collateralized loan obligations (CLO) is a security backed by a pool of debt, often low-rated corporate loans. To fund the purchase of new debt, the CLO manager sells stakes in the CLO to outside investors in a structure called tranches. Each tranche is a piece of the CLO, and it dictates who will be paid out first when the underlying loan payments are made.
Structured credit investments include collateralized bond obligations (CBOs), collateralized debt obligations (CDOs), syndicated loans and synthetic financial instruments. A CBO is understood to be of investment grade, but is backed with the use of a pool of below-investment-grade bonds. CDOs are a kind of asset-backed security, holding a pool of collateralized debt, such as mortgages and auto loans, that may be subdivided into various tranches representing different levels of risk. A syndicated loan is a loan offered by a group of lenders (called a syndicate) who work together to provide funds for a single borrower. Synthetic financial instruments are artificially created investment vehicles or instruments intended to meet requirements not met by existing, conventional instruments. They are designed to reduce risk, increase diversification or offer a higher return. A synthetic floating rate instrument can be produced by combining a fixed-rate bond and an interest rate swap. Or an asset with the same risks and rewards as the underlying share can be created by the purchase of a call option and the simultaneous sale of a put option on the same share.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.