Franklin Templeton hosted the latest edition of its Megatrends Accelerate Webcast Series, an online event that brings together investment experts to share their diverse views on thematic and topical issues facing investors.
Moderated by Catherine Matthews, a global product specialist in London with Western Asset, panelists weighed in on this quarter’s theme, Navigating Rates and Risks: Will 2023 Be Bonds’ Comeback Year?The speakers covered the following topics:
- Banking sector uncertainty and the resulting flight to quality, which has the potential to bring about a sharp pull-back in lending while stoking recessionary fears,
- The outlook for interest rates and inflation along with the implications for corporate, emerging market and U.S. municipal bond issuers,
- Finding pockets of value in the global bond market today.
Bonds have traditionally been seen as a steady source of income for investors; however, fixed income was anything but predictable in 2022. With stubbornly high inflation, by early 2023, bond yields reached highs not seen in many years as central banks raised rates globally. With the tumultuous events in the banking sector over the last two weeks, government bonds have returned to their traditional benefit of providing diversification in a risk-off period with a decline in yields helping offset volatility in certain credit sectors. And this is all happening at the same time as the U.S. Federal Reserve’s (Fed) latest announcement.
Excerpts from the panelists’ comments are below. To view the event replay, click here.
Tracy Chen, Portfolio Manager at Brandywine Global, said:
Before the Covid pandemic, we were of the view that bond yields would be lower for longer. But in this more inflationary world, we are less constructive on bonds, especially on the long end.
In terms of valuations, last year saw the worst performance of the bond market in the past 200 years. This year, we think bond yields definitely look more attractive than at any time in the post-global financial crisis period.
We believed something would break even before this banking crisis happened. And now bonds are actually providing a safe haven and protection for investors’ portfolios. Our timeline for recession is pulled forward because of this banking stress. The Fed will be struggling, fighting inflation while also maintaining financial stability. But I think this should be a good year for the bond market.
Today’s banking stress is very unique compared to historical crises. This one is not driven by credit risk, it’s more driven by mismanagement of duration risk in the U.S., as well as some regulatory oversight and governance issues in Europe. But at the same time, hopefully this duration risk can be more easily solved if we give banks a backstop and liquidity. Of course, this will definitely drive bank balance sheet consolidation and, as a result, the banks will tighten their lending standards and we might have a credit crunch if it’s not managed well.
These banking developments have implications for securitized credit. Banks provide a lot of loans to the consumer sector and the mortgage sector. The agency mortgage-backed security (MBS) market is very deep. We have foreign buyers. We have insurance companies. We have money managers waiting to buy if the spread becomes cheap enough.
In non-agency residential MBS, you have very healthy underwriting. We see that 95% of borrowers have a loan-to-value ratio below 80, and the average mortgage rate that they locked in is a little over 3%. They have years of home price appreciation cushion.
With regard to commercial mortgage-backed securities (CMBS), there might be some stress because regional banks provide 80% of the lending to the commercial real estate market. There’s nowhere to hide in CMBS, not even agencies, as spreads widen.
In terms of consumer asset-backed securities (ABS), you have the least risk of forced liquidation because banks only own about 2% of the ABS market, and it’s perceived to be a safe haven due to its short duration. There are some good opportunities in the AAA tranches of subprime auto ABS, which have widened a lot. In terms of collateralized loan obligations (CLOs), you are going to see more distressed CCC rated loans and more downgrades. But, at the same time, AAA rated CLOs also widened close to 200 basis points.
Many emerging market (EM) countries were ahead of the curve this cycle, hiking rates early to fight inflation. And now with this deceleration and the growth outlook moderating, their central banks can focus on lowering interest rates this year. In addition, we have seen the peaking of the U.S. dollar and stronger growth out of China. All of these factors are leading to a Goldilocks situation for EM countries, especially those that can benefit from China’s reopening and recovery story, like Thailand and Malaysia. And then there are those that can benefit from near-shoring, like Vietnam and Mexico.
This means there are a lot of opportunities to invest in EM countries, especially local government bonds. They have been performing very well since October of last year, and they should continue to do well if the central banks cut interest rates.
Thinking about where I see the best opportunities in the global bond markets today, I think agency MBS offer a very attractive opportunity because they will be a good hedge in the case of a recession. The way I view them is they’re a cheaper version of Treasuries, meaning they have minimal credit risk and bountiful liquidity. I also like some AAA rated short duration ABS and CLOs and, potentially, CMBS to stay defensive. Seasoned investment grade-rated credit risk transfers (CRT) also look attractive.
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Jennifer Johnston, Director of Municipal Bond Research at Franklin Templeton Fixed Income, said:
We think municipal bonds could be a safe haven for a couple of reasons. Oftentimes muni bond income is tax free, which can provide additional benefits to investors. And the muni market in general is of far higher quality than the corporate bond market. We have significantly lower default rates and the ratings of the muni indices are even stronger when compared to the corporate bond market indices. We generally see stronger credit fundamentals in our market, and we do see some opportunities, particularly going out long, where munis are still relatively cheap versus Treasuries compared to where they’ve been in the past.
The troubles in the U.S. and European banking sectors have not had very much of an impact on the municipal market. The first concern when the crisis started was whether or not pension funds had exposure to any of the banks, either from a debt or equity perspective. We have seen some exposure, but generally these are very diversified investment vehicles, so we do not expect any long-term pressure on public sector pensions at this point.
The municipal market is extremely inefficient. When there are market dislocations like we are seeing now, it gives us an opportunity take advantage of that and find good value.
Finally, we are currently seeing a flight to quality supporting Treasuries. Munis don’t always move in lockstep with Treasuries – we tend to lag a little bit – but hopefully, over time, the flight to quality can benefit munis.
Banks own about 15% of the municipal market; they tend to own high grade, long duration bonds. For collateral purposes, the banks could see advantages to holding Treasuries and agency notes and selling the municipal bond components of the portfolio. That’s something we’re looking for – whether or not banks have to sell. I think the market is trying to prepare itself for that.
There definitely are positive and negatives to municipal credit quality when dealing with inflation. Governments experience inflation just like consumers do. When costs go up, it can erode operating margins, which can require budget adjustments. So there are definitely pressures from increasing costs. And of course the cost to borrow has also increased. The municipal market provides a significant amount of infrastructure for the U.S. It’s a capital-intensive sector and we are certainly watching as these entities now have higher borrowing costs. We think some of the pressure coming from higher borrowing costs is mitigated by some of the decisions made during the Covid recovery. Municipal entities benefited from federal aid and economic stimulus, which translated into surpluses. Some entities used part of their surplus to pre-pay debt and cash fund capital projects. This is helping to reduce the need to issue debt in this rate environment.
The other interesting impact we’ve seen from rising costs is on the labor side. When you connect that to the very tight labor markets that we’ve seen, it’s caused a lot of challenges. It’s impacting pretty much every sector but more so in the healthcare and senior living sectors. They’re paying more for their employees, which is putting pressure on margins. This can impact many areas of spending, particularly for state and local governments because, as wages go up, so do the entities’ required contributions into pension funds.
There is a positive aspect to inflation for municipal governments and many transit agencies; income taxes and sales taxes often make up a meaningful part of revenues. As wages go up, so do income taxes. As the cost of goods goes up, so do sales taxes. The strong budget performance across the past several years was driven by these revenue sources.
Through the end of 2022 and the beginning of fiscal 2023, we’ve seen really strong revenue performance in this space. We expect that to continue until consumers start to make different purchasing decisions because costs are higher or wage inflation starts to moderate. We are starting to see growth rates slow with expectations of further slowing into next fiscal year.
I see municipal bonds as currently being a great value. The fact that they generate tax-exempt income is certainly important for many investors. Right now, especially further out the curve, we are finding opportunities for good value.
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Annabel Rudebeck, Head of Non-U.S. Credit at Western Asset, said:
We have had some really dramatic moves in the global credit markets in recent days – a combination of technology, social media and lots of day traders. Also moving quickly, but over a longer timeframe, are the rate hikes – roughly 4% in a 12-month period – that did throw up some hidden pockets of stress.
But is this a full-blown banking crisis? No. The regulation that was put in place after the 2008 global financial crisis really was designed to provide much better strength on the capital side. And we’re not seeing weakness on the asset side. Deposit flight may be a bit of a risk for some parts of the sector, but that’s clearly something that the authorities are looking at. This presents a nice buying opportunity for credit and especially for some of the higher quality financial sector names.
The yields of around 5% in the corporate credit markets are very attractive compared to what we’d been seeing previously. Clearly with the moves that we’ve seen just in the past few days, there’s more of that yield coming from credit now than from government bonds. We think it’s a particularly attractive time to enter the global credit markets.
The 50-basis point increase from the European Central Bank last week was essentially pre-announced so we think it was necessary for them to push ahead. Had they not done so, we think the market would’ve panicked, thinking perhaps they knew something about the banking system that the rest of us didn’t.
They did two other things that were supportive as well. They talked about there being plenty of liquidity provision for the financial sector, and they also took away forward rate guidance, suggesting that the path from here on will be dependent on inflation data and market conditions.
As we think about what could affect inflation moving forward, we are seeing companies choosing to prioritize price over volume. This happens in sectors with high barriers to entry, typically duopolies or oligopolies. We see it in autos and beverages. In the case of leisure and travel companies, for example, we’re seeing premiumization – management teams focusing on higher margin, typically more expensive products.
Corporates may not be helping to beat down inflation in quite the way that one might expect. This has implication for corporate profits and earnings. There will be a point where the ability to push price over volume becomes more challenging. Presumably that would happen if we do see a big correction among higher-earning people.
Profit margins are elevated. I think we should be realistic and expect that they may need to correct a bit lower. We should be cautious in our outlooks, but it may be that big business continues to do reasonably well, particularly companies that have huge pricing power and that have managed their inventories well.
There are some sectors that are being impacted by the latest round of volatility. Financial companies are obviously in focus. We’ve got a very different story within the U.S. – the regionals compared to the big money center banks. Similarly in Europe there’s a difference between the higher rated, high quality Northern European banks and some of the weaker, smaller banks.
In terms of the best opportunities in the global bond markets today, we like the three- to five-year spot on the credit curve. It’s still got a healthy yield compared to the long end so that seems to be a sensible place to be in a world of economic and interest rate uncertainty, quite frankly. Financials also look very compelling, although they’re rallying pretty fast today in these choppy markets. Investors could dip into the high quality end of the high yield market as well because high yield fundamentals have stood up well. But we wouldn’t be looking out too far or taking too much risk. And clearly it’s important to keep portfolios diversified by credit issuer at this point in time.
