City National Rochdale remains positive on taxable fixed income assets based upon our economic outlook, current credit valuations, a modestly higher interest rate outlook, and the steepness of the yield curve. We look to position suitable taxable portfolios to be overweight credit, barbell portfolio maturities, while staying relatively duration-neutral to respective benchmarks overall. We expect fixed income total returns in the year ahead to broadly track coupon income.
Rising Rates on the Horizon
In April’s World Economic Outlook the International Monetary Fund (IMF) forecasted 2015 global growth of 3.5%. This growth rate is reflective of positive momentum in advanced economies, and uneven growth among emerging and developing economies.
In early June the IMF projected that 2015 U.S. Real GDP will grow at a 2.5% year-over-year rate (which is in line with City National Rochdale’s U.S. GDP forecast of between 2.5% to 3.0%). The IMF’s 2.5% projection is in line with its 2014 projection of 2.4%, but is a significant downgrade from its April 2015 forecast of 3.1%. The IMF attributed the revised growth outlook to “unfavorable weather, a sharp contraction in oil sector investment, the West Coast port strike, and the effects of the stronger dollar. These developments represent a temporary drag, but not a long-lasting brake on growth. A solid labor market, accommodative financial conditions, and cheaper oil should support a more dynamic path for the remainder of the year.”
Within this 3.5% global growth context we continue to see relatively subdued global inflation expectations while long term bond yields remain near all-time lows. Low government bond yields in the Eurozone and Japan continue to be supportive of U.S. interest rates. Low global interest rates provide a hedge against a dramatic backup in U.S. interest rates as non-USD investors are able to find greater value in U.S. Treasuries than in local market government bonds. Simply put, although we expect interest rates to increase over the coming year, we do not expect runaway domestic inflation and a dramatic rise in U.S. interest rates.
Fixed income investors have been trained to a have an almost Pavlovian response to higher interest rates. While a significant jump in interest rates does correlate to negative returns, higher interest rates are not necessarily the evil people often fear. Fixed income markets are expecting the Federal Reserve to raise rates in the latter half of this year with a bias towards the fourth quarter. This modest uptick in interest rates could negatively impact the market value of some fixed income assets. However, coupon payments and near term bond maturities are then reinvested at higher market rates. At City National Rochdale, we are constructing portfolios to take advantage of this potential opportunity while also seeking to benefit from the relative steepness of the Treasury and Credit yield curves.
Over the past several weeks, financial media has drawn more and more attention to liquidity risks within fixed income markets. These articles are centered on the fact that new and increased bank regulations have forced market-making banks to reduce their inventory available for trading. These articles propose that if fixed income investors sell en masse, the reduction in inventory held at the major broker dealers may result in heightened volatility and price discovery dislocating from true fundamental value. Although we do see this as a risk, we expect the reduction in dealer inventories to be much more of an issue for investors looking to execute large trades (100MM+). Historically these trades were relatively easy to execute in a short time frame. Going forward, we expect players transacting in this size to break up the trade into smaller blocks in order to make them easier for the market to digest. This is indeed inefficient, but by no means catastrophic. If fixed income markets experience heightened volatility as a result, we view this more as an opportunity than a long term risk. At City National Rochdale, we continue to manage portfolios with liquidity in mind. When managing portfolios, we are mindful of each security’s issuance size, structure, credit quality, and minimum trading increment. In addition, taxable strategies include U.S. Treasury and U.S. Agency allocations, where appropriate, to further bolster portfolio liquidity as well as dampen price volatility.
Supply and Demand Dynamics
By the end of May, the investment grade corporate bond market had absorbed over $580Bn of bonds brought to market in 2015. At this pace we are set to see nearly $1.4Tn of gross issuance for the year, which will surpass last year’s total of $1.04Tn. This flood of supply is understandable, as companies are looking to lock in relatively inexpensive financing before rates are expected to rise. Strong demand and the abundance of supply has kept credit spreads relatively stable to slightly wider. Mergers and acquisition (M&A) related supply has been particularly heavy in the pharmaceutical, energy, and technology sectors. These sectors account for nearly 36% of the total YTD issuance. Looking forward, we expect credit spreads to tighten and the pace of new supply to slow as interest rates are expected to creep up.
Corporate credit quality has improved immensely over the past several years. Corporations have been able to refinance higher coupons and more costly debt for new, low-cost financing, while keeping more cash on the balance sheet. We believe this position of current credit strength is also one of the largest sources of risk. With the domestic economic picture looking relatively positive and the expectation for below average default rates, we expect to see additional debt-financed M&A deals, stock buybacks, and rising stock dividends. These actions are a negative to issuer credit quality and may result in credit rating downgrades.
Due to heightened M&A risks and the current bias of shareholder rewards over bondholders’ protections, we favor the financial sector over the industrial sector.
The merits and economic impact of increased bank regulation will likely be debated for some time. However, we do know that from a credit quality perspective, banks are now much stronger than pre- crisis. Average Tangible Common Equity Ratios of 9% are at the highest level since World War II, and asset quality continues to be robust with low levels of non-performing assets and charge-offs. Moreover, financials, and more specifically banks, are operationally geared to benefit from higher interest rates. Banks have been struggling to grow net interest margins (the net interest generated from assets relative to the amount paid on deposits). As many loans are tied to LIBOR or Prime lending rates, even a 25 basis point increase in the Federal Funds Rate should have a direct positive impact on banks’ underlying earnings power.
More importantly, the ability of banks to re-lever themselves, pay out increased dividends, and engage in large scale M&A has been greatly diminished by the passing of Dodd-Frank and the use of the Federal Reserve’s Annual Supervisory Capital Assessment Program and Comprehensive Capital Analysis Reviews. This should serve to support the credit ratings of bank debt.
Leverage among S&P 500 companies has fallen to lows not seen since 1988 on a debt-to-equity basis, while revenue growth has been fairly flat year-over-year. These attributes leave industrial credit quality vulnerable to managements’ desire to manufacture stock price performance via increased dividends and buybacks. These actions, as well as M&A risks mentioned earlier, result in our neutral recommendation on the sector.
However, we see opportunities in the industrial sector. Security selection will be of primary importance. Within this sector we favor corporations that have just recently completed a major M&A deal and no longer pose the same downgrade and price risk. In addition, we favor lower-rated issuers that do not have room to add more leverage, and still remain investment grade.
Increased risks in selected industries are expected to push default rates higher. With that in mind, defaults are expected to remain below the 4.7% average default rate we have seen since 1996. The global speculative grade default rate in May was 2.4%, according to Moody’s, which forecasts a year-end default rate of 2.7%.
The price declines we have witnessed across the commodity complex are expected to result in an uptick in defaults. Smaller players in the energy and metals and mining industries are particularly at risk. In light of depressed margins, relatively few assets to monetize, and a lack of scale, these industries suffer from an increased potential of being unable to generate sufficient cash flow to fund ongoing operations. As one could expect, the lion’s share of defaults will likely come from the high yield space, while investment grade credits continue to slog through the downturn in commodity prices.
With rising rates on the horizon and easy access to capital beginning to diminish, credit markets have started to differentiate risks on a more granular level. As Warren Buffett famously said, “Only when the tide goes out do you discover who’s been swimming naked.” Coming out of the financial crisis, passive fixed income products benefited from a broad market multi-year rally. Going forward, we expect active duration management, security selection, and quality credit research to outperform passive products. We continue to find value in corporations with strong fundamentals who have recently announced major M&A deals, and whose credit risk is mispriced by the market.
|Investment and Insurance Products:
• Are Not insured by the FDIC or any other federal government agency
• Are Not deposits of or guaranteed by a Bank or any Bank Affiliate
• May Lose Value
Average Tangible Common Equity Ratios: A measure of a company’s capital, which is used to evaluate a financial institution’s ability to deal with potential losses. Tangible common equity (TCE) is calculated by subtracting intangible assets, goodwill and preferred equity from the company’s book value.
Federal Reserve’s Annual Supervisory Capital Assessment Program (SCAP): This is commonly referred to as the bank stress test. The Federal Reserve and Thrift Supervisors annually determine if the subjected financial institutions hold sufficient capital to withstand two macroeconomic stressed scenarios.
Comprehensive Capital Analysis Reviews (CCAR): The Federal Reserve evaluates a Bank Holding Companies (BHC) capital adequacy, capital adequacy process, and its planned capital distributions, such as dividend payments and common stock repurchases. As part of CCAR, the Federal Reserve evaluates whether BHCs have sufficient capital to continue operations throughout times of economic and financial market stress and whether they have robust, forward-looking capital planning processes that account for their unique risks. The Federal Reserve may object to a BHC’s capital plan based on either quantitative or qualitative grounds. If the Federal Reserve objects to a BHC’s capital plan, the BHC may not make any capital distribution unless the Federal Reserve indicates in writing that it does not object to the distribution.
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.
Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.
Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.
There are inherent risks with fixed income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. When interest rates rise, bond prices fall.
Investments in below-investment-grade debt securities and unrated securities of similar credit quality, commonly known as “junk bonds” or “high-yield securities,” may be subject to increased interest, credit, and liquidity risks.
Restricted and illiquid securities may fall in price because of an inability to sell the securities when desired.
Investing in restricted securities may subject the portfolio to higher costs and liquidity risk. Investing in international markets carries risks such as currency fluctuation, regulatory risks, economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money.
Diversification may not protect against market loss or risk.
Investing involves risk, including the potential loss of principal. Past performance is no guarantee of future results.