City National Rochdale remains positive on 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 portfolios to be over-weight credit, barbell portfolio maturities, while staying short to neutral duration relative to respective benchmarks. We expect fixed income total returns in the year ahead to broadly track portfolio yield.
City National Rochdale expects U.S. GDP to expand 2.5% to 3% for 2015. A strengthening labor market, accommodative financial conditions, and cheaper oil all support a more dynamic path for the rest of the year. Low government bond yields in advanced economies continue to be supportive of U.S. Treasury prices. We expect interest rates to rise over the coming year, but do not expect runaway domestic inflation or a dramatic rise in U.S. rates.
Fixed income markets expect the Fed to begin raising short-term rates later this year (see chart), but at a slower pace than previously forecasted. At City National Rochdale, we are positioning portfolios to take advantage of this reinvestment opportunity, while also benefiting from the relative steepness of the Treasury, municipal, and credit yield curves.
Liquidity Concerns: Recent media reports have focused on liquidity risks within fixed income markets, noting that tighter bank regulations have forced market makers to reduce inventory available for trading. These articles cite concerns that if fixed income investors sell en masse, reduced inventories will result in heightened volatility. If this does occur, we would view it more as an opportunity than a long-term risk.
Supply and Demand Dynamics: The investment grade corporate bond market may see nearly $1.4 trillion of gross issuance in 2015, surpassing last year’s total of $1 trillion. Corporations are continually looking to lock in relatively inexpensive financing before rates rise. Strong demand and the abundance of supply have kept credit spreads relatively stable. Looking forward, we expect credit spreads to tighten and the pace of new supply to slow as interest rates creep up.
Corporate Credit: Corporate credit quality has improved in recent years. Corporations have refinanced higher coupon debt for new, low-cost financing, while keeping more cash on hand. 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 mergers and acquisition (M&A) deals, stock buybacks, and rising stock dividends. Due to M&A risks and the current bias of shareholder rewards over bondholders’ protections, we favor the financial sector over the industrial sector.
Municipals: Municipals are largely following the direction of the taxable fixed income markets, but have been in a weak technical period due to heavy new issue supply. As a result, we have seen muted volatility and some decent buying opportunities. Shorter maturities are seeing the most demand, with the best value found in 5% coupons in the 15- to 20-year part of the curve. Other focal points include Puerto Rico, Chicago, the California drought, and the disparate pension circumstances across the nation. We are targeting duration slightly short versus our benchmarks while shifting back to a higher-quality bias. We are also increasing liquidity in portfolios, at the margin, to take advantage of potential volatility as we near Fed lift-off .
Opportunities: 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. Since the financial crisis, passive fixed income strategies have benefited from a broad market rally. Going forward, we expect active duration management, security selection, and quality credit research to outperform passive strategies.
City National Rochdale, LLC is a Registered Investment Advisor and wholly owned subsidiary of City National Bank.
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