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Bond CIO report card: how six key sectors are shaping up

Neuberger Berman bond veteran reveals what to back and what to avoid across several asset classes.

Bonds in an evolving environment

Brad Tank, CIO of fixed income at Neuberger Berman, is preparing for a fast-changing world for fixed income investors. With central banks seeking to normalise policy against the backdrop of low yields, Tank and the company’s fixed income investment committee are keen to unearth areas of the market still proving attractive. Here Tank outlines how he expects six key sub-sectors to fare over the near term.

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Global rates and inflation – volatility looms

Tank said that after a brief pause in the third quarter, the slow unwinding of global central bank accommodation should soon resume. However, he added that realised inflation continues to disappoint and challenges remain for bond buyers.

‘US inflation data perked up in August after a string of disappointments, and we expect a modest acceleration during the fourth quarter and into early 2018, as the dollar weakness that has persisted throughout 2017 is expected to boost inflation by 0.5% versus trend over the next few quarters,’ he said.

Tank added that dollar weakness is also expected to lift corporate profits and help prolong the current business cycle. Overall, he said, central bank policy efforts could lead to a volatility spike if – or indeed when – the Fed disappoints the market with the pace of its rate hikes.

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Credit – caution is key

As with inflation and rates expectations, Tank said central bank influence is dominating credit discussions. ‘A decline in liquidity – via increased benchmark policy rates, reduced asset purchases and smaller balance sheets – could increase spread volatility, which generally has been lacking for more than a year.

‘Ultimately, however, a potential turn in the economic cycle remains the key risk to credit spreads. Without any imbalances to disrupt the economy, growth should remain low but persistent and the credit cycle should continue.’

Tank highlighted that despite recent widening, spreads between euro- and sterling-denominated credit remain near historic highs. Meanwhile, credit fundamentals have improved, but Brexit could make UK issuers less attractive.

‘At current spread levels, we remain relatively defensive on European credit. However, there continue to be some interesting security-selection ideas, particularly in corporate hybrids, which we believe are significantly undervalued relative to other European credit opportunities.’

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Securitised assets – hurricane headaches

Tank again highlighted the role of the central banks, noting that agency MBS are still awaiting the advent of Fed balance-sheet reduction. He said initial tapering would not be disruptive to the mortgage market, but would probably cause a modest widening in MBS spreads.

Looking at near-term events, Tank highlighted how the major hurricanes hitting the US could impact mortgage debt, with ‘catastrophic losses’ becoming likely. ‘While CMBS spreads were fairly stable through the third quarter, they too were impacted by Harvey and Irma, as investors remain concerned about the effect on commercial real estate values in the afflicted areas.’

Elsewhere, Tank said legacy non-agency RMBS continue to be extremely well bid, while sourcing bonds has become increasingly difficult as the market continues to shrink. However, ABS demand remained strong as the Libor curve continued to trade at elevated levels to the short part of the Treasury yield curve – an area that Tank said generally presents good relative value.

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HY & leveraged loans – on the up

Tank said recent improvements in the US market make for a constructive scenario for HY bonds and senior floating rate loans, which have historically performed well during rising-rate environments.

‘We continue to believe that the high yield market is compensating investors for default risk. We think defaults peaked in 2016 and could remain below 2% in both 2017 and 2018 as revenue and leverage ratios improve,’ Tank said.

While volatility has failed to emerge in the non-investment grade space, Tank said there is still potential for a spike over the balance of the year given ongoing policy uncertainty in the US, various geopolitical flashpoints and the possibility that the improvement in global economic growth could wane.

Meanwhile, Tank said senior loan performance year-to-date has come in at the low end of expectations, as Libor increases have not been enough to offset spread compression in the new issues which resulted from refinancings in the high-demand environment.

‘However, the loan market also appears to be compensating investors for default risk, and the asset class remains a low-volatility, low-risk way to gain exposure to the non-investment grade space,’ he said. ‘We believe European high yield securities are likely to provide coupon-driven returns for the remainder of 2017.’

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EMD – local heroes

‘The post-US election rebound in emerging markets assets has continued, and we remain positive on emerging markets debt going forward,’ Tank said. ‘Economic growth in emerging markets surprised to the upside in the first half of the year, and we expect it to remain strong.’

Tank said external vulnerabilities for these economies remain at multi-year lows, and several countries, having adjusted to lower commodity prices, are now in a position to rebuild FX reserves and ease monetary policy. ‘We continue to see improving fundamentals in core countries like Brazil, Russia and Indonesia, and believe strong global growth should support exports going forward.’

Tank said valuations remain reasonably attractive, while real yields in local currency debt remain high and currencies look undervalued. ‘In local currency, we prefer duration in countries with higher yields, avoiding the lower-yielding proxies of the developed world.

‘In EM FX, we’re overweight across regions but mostly favour currencies in Europe. In hard currency markets, our high-conviction country biases include the improving stories of Argentina and Ukraine, attractively valued opportunities in Azerbaijan, Mexico and Indonesia, and select frontier prospects, including Ivory Coast, El Salvador and Nigeria.’

Tank said the key risks to EMD stem from China and the developed markets, as China’s economic activity is expected to slow towards the end of the year as policymakers pull back some degree of monetary stimulus.

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Munis – revival gathering steam

Tank said sentiment toward the muni market has improved in 2017 after the bonds sold off broadly following the US presidential election, with fund flows sharply positive across investment grade and high yield.

‘Munis have exhibited strong relative performance this year, driven by technical factors. Demand has increased as fears have waned that tax reform would reduce the appeal of munis. Supply, meanwhile, has failed to keep up with last year’s record pace thanks to a decline in refunding activity.'

Tank added that the technical backdrop remains supportive as we head towards the end of the year, even as high fixed costs and sluggish early-year economic growth made for a challenging budgetary season. That said, both investment grade and high yield muni bonds are more fully valued at this point.

Again referencing the US hurricanes, Tank said natural disasters pose liquidity risks to the muni bond market. ‘Although they can create significant headline risk and suppress economic activity initially, natural disasters are often followed by a period of above-average growth, as federal money flows in and rebuilding efforts take hold.’

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