Why Is The ECB Not Raising Interest Rates Faster?

Municipal Bonds outperformed most other Fixed Income segments in 2022 but also saw record outflows. Will that change in 2023?

The Asset-Backed Securities (ABS) market contains many different types of securities backed by different assets. So to understand the outlook for asset-backed securities, investors need to look at examples of how these asset pools will perform in 2023. The latest research from ABS investment managers inside RFPnetworks suggests that the outlook for Asset-Backed Securities in 2023 will be mixed. Some ABS segments may do well. Whereas some ABS segments may face headwinds.

Examples of Asset-Backed Securities with a positive outlook

In general ABS investment managers seem comfortable taking short duration consumer related ABS exposure. Despite immediate recessionary pressures, labour markets remain tight, wage inflation is the norm, and the consumer finances are in much better shape than the pre-GFC period. This is leading to strong demand for pools of assets that are exposed to both student loans and car loans.

Examples of Asset-Backed Securities where the outlook is mixed

Commercial Mortgage Backed Securities (CMBS) are at the longer end of the ABS duration timeline. Investing in these specific asset-backed securities requires expertise and selectivity. The circle of covid, working and shopping from home has 'irreversibly' impacted the demand for office and retail real estate. This makes the risks and returns on these pools of long duration assets less predictable. There are exceptions which can accessed via Single-Asset Single-Borrower deals (SASB), which is why highly active managers are getting all the calls from investors today.

What is clear is that investors will continue to be interested in asset-backed Securities in 2023. But not just for yield and the strong covenants that bind deal originators. The outlook is also being driven by many other factors that solve issues within Fixed Income portfolios that bonds are unable to solve.

High Yield Bonds were a relative winner in 2022 in a year that saw every fixed income segment except cash deliver negative total returns. The question investors are asking now is whether spreads will widen further in 2023.

Current yields in both the U.S. and Europe are touching high single digits. Well above 10 year averages. High yield is delivering high yield. Which also means that being a corporate treasurer of a high yield rated corporate in 2023 will not be easy.

Refinancing the short duration liabilities characteristic of the high yield market will be very sensitive to the outlook for growth and inflation. Whilst margin preservation and expansion was possible during the covid period, in a recessionary environment, passing through higher input and labour costs to consumers will be tougher.

But these smart high yield corporate treasurers know this. Many have taken pre-emptive action by reducing balance sheet leverage and increased interest coverage to levels not seen since the early 2010's.

But whilst the fundamentals on average across high yield may look decent, investment managers and rating agencies are expecting default rates to rise, albeit from a low levels historically. Despite the current discounted bond prices.

So whilst there is a likelihood of spread widening, the magnitude will be sensitive to the depth and length of the recession, and the monetary policy response. Which in turn raises an even more important question for investors: Where in the rating tables - from CCC to BB - should there high yield investment manager be focused in 2023.

Looking at the latest fixed income asset allocation outlooks, European Investment Grade Credit is frequently overweight. But for very specific reasons. This is leading asset manager selectors to spend more time uncovering more managers that can tap into the latest alpha soruces. Here's what they are discussing.

It has not gone unnoticed by the some of smartest sales people we talk to, that both the buyers of businesses (Private Equity firms) and Buildings (Real Estate Investors) are now buying loans and CMBS respectively. The thinking goes like this:

Own the company and it's assets. Or own the senior secured financing of that company for a more certain double digit return, with low leverage, that is in line with fund targets.

For CMBS the story is similar, but potentially even more compelling. With interest rates still rising and property valuations falling in many major cities, yields on the mortgages behind these buildings are higher today. A phenomena that may remain for as long as rent and property valuations face continued downward pressures.

High Yield is currently being researched intensely. Versus Global Government Bonds or Investment Grade Credit the yield on High Yield Bonds is high. But that investment argument is too simple. Here's what potential High Yield Bond investors are researching:

Are High Yield Bond Markets Cheap?

‍To answer this question, investors are comparing views on default rates, recovery rates to calculate their expected loss versus the current spread. Only then can they decide whether high yield bond markets are cheap, or not cheap enough. This exercise is also being performed for U.S., Europe and Emerging Market High Yield Bonds. What is interesting is that expected default rates vary widely across high yield bond investment managers.

What Is the Expected High Yield Bond Default Rate?

‍The variation in expected high yield bond default rates is being driven by two factors: Firstly, investment managers views inside RFPnetworks differ widely on the global economic outlook -  growth, interest rates and inflation forecasts. The resultant assumed economic base cases cover a wide range of scenarios. From a shallow recession to prolonged stagflation. And this varies again on a global and regional level (U.S. versus Europe versus Emerging Market economic outlooks).

The second related issue is whether the relatively strong fundamentals can be sustained. Corporate EBITDA is under pressure from rising rates, a strong dollar, rising input costs (e.g. tight labour markets) and the prospect of renewed supply chain constraints as Chinas buckles down on COVID again. So whilst EBITDA estimates have been revised down, the question is whether this is the start of some serial correlation. We've had the first downward revisions, but may be not the last.

Are Short Duration High Yield Bonds The Best Option Today?

‍The research in this area is getting interesting. Investors are focussing on three characteristics of the short duration high yield bond market: Firstly, they are comparing yield levels on short duration bonds products to the broader high yield and investment grade bond market. And given the wide variation in economic outlooks across investment managers, they are analysing how short duration bonds perform in rising flat and falling rate scenarios. And then looking at the risk adjusted returns of short duration bonds versus the broader high yield market.

Short Duration Bond may look relatively attractive. But before a decision to invest gets a sign-off, a lot of research is happening behind the scenes with potential high yield investors. And only then does the real research begin. How do you  find the best high yield investment manager for the current market environment and the diverse future economic scenarios that can happen.

EMD research inside RFPnetworks therefore tends to receive a relatively large proportion of our daily traffic. And currently, there seems to be a lot of interest in Hard Currency EMD. Which is interesting given there is a lot of information to digest from the YTD Sep 2022 numbers.

There is a lot of new information to digest on EMD Bond Markets.

The default allocation to EMD tends towards local currency bonds. The market is larger than hard currency bonds, more liquid, and of higher quality. But are you getting paid for your risk today, and if so, where is the outperformance of local currency bonds coming from?

With 10 year treasury yields breaking 4% for the first time since 2007, and EM Sovereign Bond prices falling to levels not seen in 20 years, investors are taking another look at EM bond markets. The fixed income feed inside RFPnetworks was dominated last week by new papers dissecting the universe: The risks, the drivers of performance, and the outlook for EM Fixed Income markets versus developed markets.

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CLO Equity is often is often perceived as a bull market product. When the world is awash with liquidity, the ability of corporates to refinance their loans is easier and the subsequent cashflows can cascade down the waterfall to the CLO equity holders. But if your base case is a recession - tighter credit markets - why would you invest in CLO equity?

There are many reasons to consider CLO Equity ahead of a recession. In fact, those that did before the global financial crisis and the COVID pandemic earned approximately 400 basis points excess return above the long term average across CLO Equity vintages going back to 2002.

The trick is to find active CLO managers that can re-invest cashflows into higher yielding loans as prices fall, with strong covenants and limited default risk. Sounds simple, but it is not. It's about finding right active CLO manager, especially ahead of a recession. Investment Manager selectors that do the research, will work out who these managers are. And that is what they are doing inside RFPnetworks.

High Yield Bonds have outperformed loans over the past months. But also over the much longer term. And whilst loans and private credit may be the coolest asset class in town, investors are sobering up to a world in which plain vanilla investments and liquidity have old school attractions.

U.S. Taxable Municipal Bonds have been on the watchlist of European Investors for most of this year. For non-US investors they have many appealing characteristics that differentiate from traditional government and corporate bonds. And for some segments of the market, for example Insurance Companies, they are checking more and more boxes.

What's been interesting is how U.S. Taxable Municipal Bonds are now getting noticed. What we see are institutions searching our fixed income feed for terms such as credit quality, low correlation, default rates, yield-to-worst and infrastructure bonds. Our search engine algorithms are returning U.S. Taxable Municipal Bond research. And the subsequent click rates are high.

Muni research is getting a lot of traffic.

How do Senior AAA European ABS impact the liquidity, safety, and yield of a cash portfolio over a 6-12 month horizon?

2021 saw record new issuance across the ESG Fixed Income market. In contrast, 1Q22 saw a change in that trend. New issuance recorded it's first quarter-on-quarter drop, down approximately 80% versus 4Q21 and 15% versus the 1Q21. But that may be about to change, especially in Europe.

The EU is now faced with a dichotomy: On the one hand, there is a refocus on Energy Security following the Russia's use of Gas and Oil supply as a bargaining chip to reduce the EU's involvement in Ukraine. And at the same time,  to meet EU demand for energy, several countries are u-turning on the reduction or resistance to coal-powered plants or nuclear power. The Netherlands and Poland are but two examples.

The political narrative points to the immediate imperative. A bitter pill to swallow for many that can only be digested with the promise of a longer term, greener alternative.

Despite the recent dip in ESG Bond issuance, asset managers are expecting a new impetus for Green Financing in 2022. Which for investors creates new opportunities to accelerate their net-zero portfolio ambitions.

At the end of May, US Retail investors came back to the US leveraged loan market following three previous weeks of net outflows. And whilst this is not necessarily a buy signal to other investors, it marked the climb to a spike last week in Loan research activity in our feeds, by European Institutional Investors. But their interest was not US leveraged loans. It was European leveraged loans.

With Municipal Bonds trading at attractive valuations, higher yields versus treasuries, together with strong credit fundamentals, renewed dialogue between Professional Investors and Municipal Bond investment managers is taking place.

The relative value of Municipals versus Corporate Bonds in a rising rate environment is now high on the research agenda of many professional investors.

The long-term risk-adjusted relative performance of European Loans versus U.S. loans, U.S. and European high yield bonds, has got institutions interested.

Together with Traditional Bonds issued by ESG leaders, today Green Bonds are gathering interest from institutional investors & investment advisors. They are one of a range of instruments that can help shift portfolios to net-zero and reward climate change mitigation and social betterment.

But there are issues that need to be addressed in the evaluation of issuers and green bonds.

Following 39 of the 40 negative 12-month rolling periods for the Bloomberg Municipal Bond Index, subsequent 12-month returns were not only positive, they were abnormally strong, with an average of 14.70%.

Emerging Market Debt, like the entire fixed income asset class, has had a tough start to 2022.

Even hard currency bonds, as represented by the JP Morgan EMBI Global Diversified Index, have seen YTD returns not experienced since 1995. With 1Q22 completing four consecutive negative quarters - an occurrence which has only happened 3 times since 1993.

The good news is twofold.

Given the widening in corporate credit-risk spreads since February, consumer-focused ABS is gaining the interest of professional investors.

Given a backdrop of strong labour markets, nominal wages, and solid household balance sheets, there is clearly support for consumer-related segments of the ABS market, such as auto loans.

The unknown risks are how inflation and rising rates will impact future absolute levels of delinquency.

Only three times in history has High Yield delivered 4 consecutive months of negative monthly returns. That's what's happened in 2022

Will May numbers set a new record?

Despite a traumatic April for Investment Grade Credit, investors are focused on the decade high yields the asset class now offers. Levels that are now comparable to that of High Yield at the start of 2022. But what story do the fundamentals tell?

Like CCC securities in the corporate high yield space, distressed Emerging Market Sovereign debt is often an overlooked segment of the asset class. But possibly for the wrong reasons.

The first quarter of 2022 was a tough time for fixed income credit investors with Global Investment Grade Corporates, High Yield and Convertible bonds all delivering negative performance averaging around -6%.

The question now is whether convertible bonds offer better prospects than investment grade or high yield bonds looking forward.

As an asset class, most institutional investors find it difficult to find a slot in their portfolio for these hybrid securities. That may be about to change.

Whilst Loan Issuance for 1Q22 in both the US & Europe was strong, levels were less than 1Q21. But those stats don't tell the whole story.

In Mar 2022 in Europe, there was zero syndicated loan issuance.

The question now is where will loan investors turn?

Fixed income investors are facing two cold fronts: A trifecta of tightening liquidity, slowing growth and high inflation; and sharply rising sovereign, investment grade and high yield bond yields. There has been nowhere to hide in traditional fixed income. The question being discussed with asset managers now is, what should we do?

Following a fall of 5% in 1Q22, Agency Mortgage Backed Securities posted a quarterly performance that was worse than the taper tantrum of 2013, and more that twice as bad the next worst quarters in 1987 and 1994.

Interestingly, Agency MBS spreads have trended higher higher as the risk of mortgage prepayment has actually trended lower.

Professional Investors are therefore asking whether agency MBS can earn them yields that are relatively attractive for the asset class on a historical basis, but also compared to alternatives within the high quality fixed income space.

Whilst many companies have been able to pass on input inflation to consumers, the question is how much pricing power still remains?

And more importantly, does their product demand curve exhibit sufficient inelasticity to sustain profitability and keep balance sheets strong.

The answer varies across industries, with potential credit rating downgrade risk potentially on the horizon.

Alternative Credit is taking centre stage in professional investors fixed income portfolios.

But what types of alternative credit are getting the most interest from professional investors? The opportunities are wide and varied, as are the risks.

Since 2000, there have only been 14 negative quarterly returns for the CLO and Loans asset class. The impact of the Russia-Ukraine crisis on the loan markets, has resulted in 1Q22 being one of those quarters.

However, the negative quarter was one of the smallest compared to what happened during the Global Financial Crisis of 2007/8, the European Sovereign Debt Crisis of 2011, or the China Trade War of 2018.

The question now on investors minds, is what can they expect from loans and CLOs for the remainder of 2022.

High Yield Bonds had a tough first quarter in 2022 as investors computed the impact of 3 interconnected factors on the asset class.

March was a 'nowhere to hide' month for fixed income investors. As government bond yields rose to pre-pandemic levels. And spreads on both European and US High Yield widened over the entire first quarter. Raising the question, does an unconstrained fixed income approach make sense in the current market environment?

With markets expecting increasing central bank hawkishness, should Fixed Income investors turn to Bank Loans?

For investors with Global EMD asset managers, the question of shifting to a more regional approach to the asset class is starting to gain attention.

How will the yield curve develop and what is the thinking behind the walls of Central Banks?

What is the probability that Russia will default after 25 May 2022? And Russian Corporates will continue to pay their external debt? And a restructuring of Ukraine external debt can be avoided?

Surging inflation is causing a headache for Fixed Income Investors in 2022. Which short term bonds soothe the pain in their portfolio?

And if so, are U.S. high yield investors at risk of being over-leveraged at the end of the longest economic cycles in history?