Highlights

  • Expect modest near-term rise in interest rates
  • Gradually increase exposure to government bonds as interest rates rise
  • Corporate fundamentals remain strong with pockets of event risk

Executive Summary

The taxable bond market posted positive total returns in 2015 with the Barclays U.S. Aggregate Index generating a 0.55% return. Treasuries and securitized assets led the way with returns of 0.84% and 1.47%, respectively, while broad corporates returned -0.68%.  Last year’s returns fell well short of the 5.97% earned by the Barclays U.S. Aggregate in 2014.

The corporate high-yield market posted disappointing returns of -4.47% (Barclays U.S. Corporate High-Yield Index), as the broad downturn in commodity prices put energy, metal, and mining issuers under significant stress. These sectors posted returns of -23.55% and -23.69%, respectively, for the year.

According to the Barclays indices, high-yield municipal bonds returned 1.81%. Improving economic conditions typically benefit high-yield municipal bonds, and for investors with appropriate risk tolerance, the asset class may provide an opportunity. 

Taxable bond performance is typically derived from four key factors – rate movements, supply/demand dynamics, curve placement, and credit selection. 2016 contributions to performance will largely mirror last year’s. In our view, stabilization of commodity prices and continued positive global growth should serve as a catalyst for improved 2016 performance.

We have liftoff…or do we?

After nearly seven years, bond market participants had become accustomed to the Federal Reserve’s zero interest rate policy. Now that the Federal Reserve raised interest rates in December, as expected, interest rate risk management takes on increased importance.

It is particularly noteworthy that although the Federal Reserve increased the fed funds target rate from 0.25% to 0.50% on December 17 (from 0.00% to 0.25%) the market absorbed the rate hike with ease.

The day prior to the rate move, the slope of the U.S. Treasury 2-year to 10-year curve (the yield on the 10-year Treasury minus the yield on the 2-year Treasury) was 129 bps. At year-end, the slope of the 2-year to 10-year curve was 122 bps. This reduction in slope (or flattening of the yield curve), was a result of the 2-year Treasury gaining nearly seven basis points in yield, while the 10-year Treasury remained stable.

This relatively benign curve movement is a testament to the ability of the Federal Reserve to effectively communicate the rate move and market participants’ aptitude in pricing in monetary policy.

It is important to emphasize that this rate move, although a significant symbolic move, is not as important as the path of future rate hikes. According to the Federal Reserve’s most recent Summary of Economic Projections, it expects to raise rates four times this year by nearly 100 bps. Most market participants believe this is too much too soon. City National Rochdale agrees and expects two additional rate hikes during the year.

The slight uptick in short-term interest rates may negatively impact the market value of some fixed income assets. However, coupon payments and near-term bond maturities will then be able to be reinvested at higher market rates. At City National Rochdale, we are constructing portfolios to take advantage of this opportunity while also benefiting from the relative steepness of credit yield curves.

Subpar growth, but growth nonetheless

The outlook for global growth has deteriorated markedly as the collapse in commodity prices materially affects growth prospects for emerging market economies and those heavily tied to exporting oil. As one would expect, the International Monetary Fund recently downgraded its global growth projection from 3.6% to 3.4%, with just 1.8% GDP growth expected for advanced economies.

Although City National Rochdale sees tough times ahead for some emerging market economies, we continue to expect positive U.S. growth. Despite an economic drag stemming from negative net exports and subpar capital spending (primarily due to the cut-backs in investment from the energy sector) the U.S. consumer remains resilient. Gains in housing and continued government spending bolster our expectation for 2.25% to 2.75% U.S. GDP growth for 2016.

In concurrence with our expectation for continued U.S. GDP growth, we expect to see a slight rise in inflation. Core inflation (personal consumption expenditures [PCE], excluding food and energy prices) has remained relatively low for nearly a year. Over the past year we have seen continued improvement in the labor force, specifically in the unemployment rate dropping to 5% and signs of wage growth. Both of these factors should push core inflation modestly higher.

Although City National Rochdale expects 2016 to be a year of heightened asset price volatility, we do not expect runaway domestic inflation or a dramatic rise in U.S. interest rates.

Supply and Demand Dynamics

By the end of 2015, the investment-grade corporate bond market had absorbed nearly a record $1.2Tn of new issuance. This issuance was primarily used to lock in relatively inexpensive financing, fund dividend payments, stock buybacks, and fund mergers and acquisitions (M&A). M&A related supply had been particularly heavy in the pharmaceutical, healthcare, and technology sectors. This heavy amount of issuance and M&A activity was partially responsible for the widening of credit spreads throughout the year.

The new year is expected to bring more of the same. Despite the uptick in interest rates, corporate financing costs remain relatively attractive, as corporate yields remain relatively low on a historical basis.

Investment Grade Bond Yields

Moreover, we continue to expect corporations to turn to M&A to generate growth while volatile equity markets and shareholder activism persist. We expect the combination of these factors to result in relatively stable tightening credit spreads in aggregate while company-specific risks will increase.

“Thank you sir, may I have another?”

Last year served as a turning point in corporate credit quality. On a debt/earnings before interest, taxes, depreciation, and amortization (EBITDA) basis, U.S. investment-grade corporate issuers weakened from the recent peak to levels last seen in the early 2000s.

City National Rochdale expects 2016 to yield better results as the domestic economy is looking relatively positive, default rates are expected to remain below the long-term average, and the current level of credit spreads provide satisfactory compensation relative to our assessed risk. These positive attributes are counterbalanced by the collapse in commodity prices, an aging credit cycle, and the continued bias toward manufacturing equity returns via debt-funded dividends, stock buybacks, and M&A.

As such, current valuations point toward a buying opportunity for sectors with continued fundamental strength, lower levels of event risk, and a domestic focus. For the second year in a row, City National Rochdale prefers financials to industrials in aggregate, while opportunistically increasing our exposure to government bonds as interest rates gradually rise. Government bond allocations continue to serve as a source of principal protection and stability within core bond strategies.

  • Financials: The merits and economic impact of increased bank regulation will be debated for some time. However, from a credit quality perspective, banks are now much stronger than pre-crisis. Bank Tier 1 Capital Ratios (a measure of a bank’s capital adequacy) remain near peak levels of 11% (as of Q3 2015).

    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). Since many loans are tied to LIBOR or Prime Lending Rates, the recent 25 basis point increase in the fed funds rate will have a direct positive impact on banks’ underlying earnings power. Banks have historically increased lending rates at a faster pace than they increase the amount they pay on deposits (deposit rates are upward sticky).​

    More importantly, banks are in an earlier stage in the credit cycle when compared to other industries. 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, the use of the Federal Reserve’s Annual Supervisory Capital Assessment Program, and Comprehensive Capital Analysis Reviews.
     
  • Industrials: Coming into 2015, leverage among S&P 500 companies had fallen to lows not seen since 1988, while revenue growth had been fairly flat year over year. These attributes left industrial credit quality vulnerable to managements’ desire to drive stock price performance via increased dividends, stock buybacks, and material releveraging via M&A (as mentioned earlier).

These managerial trends are expected to continue in 2016. Energy- and commodity-related corporations have seen their credit strength deteriorate significantly in sympathy with the downturn in commodity prices. At the same time non-energy/commodity-related corporations have announced, but not yet funded, nearly $1.3Tn of M&A deals.

These factors present active managers with the opportunity to outperform as 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. Fundamentally, we look for management that is committed to remaining investment grade.

Default Rates

Default rates serve as an important gauge of the health of corporate credit markets, as well as the state of the overall economy. Last year marked the peak in corporate credit quality as revenue growth slowed, cash flow margins contracted, and leverage picked up modestly. Increased risks in selected sectors are expected to push default rates higher, but remain below the 4.8% average default rate we have seen since 1999. The global speculative grade default rate in December was 3.4%, according to Moody’s, which forecasts a 2016 year-end default rate of 3.9%.

Default Rates

The price declines we have witnessed across the commodity complex are expected to result in an uptick in defaults. Smaller players in the energy, 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 cyclical downturn in commodity prices.

City National Rochdale’s exposure to these sectors is concentrated in high-quality names that are market leaders and have significant financial flexibility.

Opportunities

City National Rochdale views core fixed income as an investor’s security blanket and wealth preserver. As such, we continue to search for opportunities that are prosaic, as this will be a year where avoiding credit landmines will reap the best reward.

Coming out of the financial crisis, passive fixed-income products benefited from a broad 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 and safety in the financial sector. In addition, corporations with strong fundamentals that have recently announced or funded major M&A deals, and that have mispriced credit risk, will be particularly attractive.

Conclusion

City National Rochdale remains positive on taxable fixed- income assets based upon our economic outlook, current credit valuations, and modestly higher interest rate outlook. We look to position taxable portfolios to be slightly overweight credit and barbell portfolio maturities, while staying relatively duration-neutral to respective benchmarks. We expect fixed-income total returns in the year ahead to broadly track coupon income.

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Index Definitions

Barclays U.S. Aggregate Index comprises U.S. government, mortgage-backed, asset-backed, and corporate fixed income securities with maturities of one year or more.

Barclays U.S. Corporate High Yield Index covers the U.S.-dollar denominated, non-investment grade, fixed rate, taxable corporate bond market and includes securities with ratings by Moody’s, Fitch and S&P of Ba1/BB+/BB+ or below.

The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

Barclays U.S. Corporate Investment Grade Index measures the performance of investment grade corporate bonds.

Important Disclosures

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.

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.