In testimony before the House Committee on Financial Services in mid-July, Federal Reserve Board chair Janet Yellen reiterated her oft-stated message that the central bank could raise rates this year provided the U.S. economy continues to strengthen. Despite her upbeat tone, however, Yellen declined to specify when the board would act, prompting many market observers to draw their own conclusions.
DoubleLine Capital co-founder and legendary bond investor Jeffrey Gundlach, a panelist at the 2015 Delivering Alpha conference sponsored by Institutional Investor and CNBC, which was held in New York the same day that Yellen testified, told the audience not to expect an increase before 2016. “When Yellen says she will raise rates if economic growth improves, people hear ‘she will raise rates.’ But that’s not what she said,” the CEO insisted.
However, Lee Brading, head of credit research at Wells Fargo Securities, says his team believes policymakers will issue a small hike in September. “I think many are in the camp of ‘let’s get this 25 basis point hike over with,’ but I believe the bigger issue will be the velocity at which there are follow-up hikes,” he says. That will depend on exogenous factors, such as China’s economic growth, Greece’s future in the euro zone and the price and supply of oil, adds Brading, who is based in Charlotte, North Carolina.
“Our forecast for the liftoff date is for December 2015,” counters Charles Himmelberg, head of global credit strategy at Goldman, Sachs & Co. in New York. “We think a September hike would have required a clearer signal at the June meeting, because we don’t think the Federal Open Market Committee wants to surprise on the hawkish side when they raise the funds rate for the first time in nine years.”
He does not rule out the possibility that the Fed could act sooner, though. “A hike in September could again become our baseline if we were to see much stronger-than-expected activity or inflation data over the next few months, a sharp easing of financial conditions or a combination of the two,” Himmelberg explains. “But we think a December liftoff date is both more likely and better policy.”
Until the Fed follows words with action, investors will continue to wonder what will happen and when — and many will look to the sell side for help in contextualizing each newly released market data point. The firm whose insights they hold in highest esteem is J.P. Morgan, which leads the All-America Fixed-Income Research Team for a sixth consecutive year. Of the 57 sectors that produce publishable results, J.P. Morgan analysts earn a place in 49 — one more than last year.
In second place for a fourth year running is Bank of America Merrill Lynch, whose total jumps by four, for a firm record of 45. Wells Fargo rises one rung to No. 3, even though its total is unchanged at 28. Its advance is propelled by losses at Barclays, which slips to fourth place after losing five spots, leaving it with 25. Goldman Sachs repeats at No. 5 despite the loss of four positions, reducing its total to 20.
Fourteen firms appear on this year’s roster. Click on the Leaders link in the navigation table at right to view the full list.
To see the top-ranked analysts and teams in each sector, click on the Best Analysts of the Year.
In late June another renowned financier, Carl Icahn, raised eyebrows by warning on Twitter that he believes the market is “extremely overheated — especially high-yield bonds.” Peter Acciavatti, who captains the J.P. Morgan group that claims an astonishing 13th straight victory in High-Yield Strategy, begs to differ.
“I don’t believe the outperformance of high-yield bonds has run its course,” he says. “With Treasury yields moving higher this year, high-yield bonds are easily outperforming other, more rate-sensitive asset classes, such as investment-grade bonds. With the Fed expected to raise rates later this year and next, I would expect high-yield bonds to continue to outperform against most fixed-income asset classes.”
Acciavatti brushes aside concerns that a rate increase will send markets into a tailspin similar to the one a couple years ago after Fed officials first mentioned ending quantitative easing. “We think the impact will be minor, with current market valuations looking attractive,” the New York–based strategist says. “In particular, today the market has a yield of 7 percent and a spread of 546 basis points — well above the 5 percent and 437 basis point levels the market had in early May 2013 heading into the ‘taper tantrum’. Further to this point, current spreads price in a default rate near 4 percent, which is well above the current rate of 1.7 percent, our year-end forecast of 1.5 percent and even our 3 percent forecast for the end of next year, when energy defaults likely pick up.”
Even so, he acknowledges that the sector could suffer collateral damage. “We still expect the market to see outflows from retail mutual funds as the high-yield asset class gets incorrectly lumped in with other, more rate-sensitive asset classes,” the crew chief advises. “This should lead to some temporary weakness but not much more.”
The team’s advice to investors? “With healthy credit conditions, low default rates and rising rates, we think fund managers should favor single-B-rated bonds and second lien loans over double-B-rated bonds,” Acciavatti says.
His colleague Eric Beinstein, who helms the squads in first place in Credit Derivatives (with Dominique Toublan) and Investment-Grade Strategy, makes the case that high-grade bonds, which have struggled this year, are poised to rally.
In recent months the difference between high yield and investment grade yields has narrowed, a phenomenon driven by trends in the energy sector as well as retail flows, Beinstein explains.
“Year-to-date energy spreads are tighter, as they had a strong sell-off in the fourth quarter,” he says. “This has contributed to the outperformance of high yield versus investment grade, as energy has a higher weight in the high-yield index.”
The strong dollar has hurt higher-quality issuers more than their riskier counterparts, the New York–based analyst adds, because the former rely more heavily on global sales, while the latter are more dependent on domestic revenue trends (excluding the energy sector.) “We believe that investment grade may outperform in the second half, as higher Treasury yields are more supportive of investment-grade spreads than high-yield,” Beinstein notes.
Himmelberg, of Goldman Sachs, holds a similar view. “Relative to investment grade, the high-yield market is more exposed to industries facing secular challenges. Specifically, metals and mining and offshore drillers together have a combined weight of roughly 6.5 percent of the total par value in the high-yield market,” he points out. “Second, we think that pressures from new-issue volumes this year have weighed more heavily on investment grade than high yield, and we expect this technical pressure to revert as new-issue volumes slow over the second half of the year. Our year-end forecasts imply that investment-grade spreads will retrace all of their 2014 widening and thus revisit their June tights, while high-yield spreads will recover less, implying investment-grade-to-high-yield spread decompression in the second half.”
Wells Fargo’s Brading, who repeats in second place in the Building sector, notes that for high yield to continue to outperform, “we would need to see a material rally from the energy and materials sectors, and current global economic conditions indicate that commodities prices are unlikely to strengthen in the near term. We appreciate high yield’s domestic focus and the relative cushion that the incremental spread component offers in a rising-rate environment; however, the current challenges facing the asset class and yield distribution make portfolio construction increasingly challenging.”
How can portfolio managers avail themselves of opportunities inherent is such a scenario? “We are recommending that investors position for a flatter [ten-year versus 30-year] investment-grade bond spread curve,” Beinstein responds. “The curve has already flattened by about 12 basis points from its peak in the first quarter, and we believe this will continue as long-end Treasury yields rise. Overall, we believe that spreads will likely tighten between now and the end of the year, given that yields and spreads are more attractive than they have been in a while, and the U.S. economy is doing well.”
Specifically, the J.P. Morgan analysts advise underweighting sectors where spreads are tight and M&A is active — aerospace and defense, consumer products, manufacturing and technology — and overweighting cable and satellite names, subordinated debt of large-cap bank holding companies and pipeline offerings, among others.
“We expect issuance to remain active for the remainder of the year, but somewhat slower than the pace in the first half,” Beinstein says. “This is being driven by M&A, companies raising funds to pay more to shareholders, and also the view by some corporate treasurers that bond yields will likely be higher in a year or two, so it is prudent to issue now. We expect full-year 2015 issuance to be about 15 percent above last year’s record amount of supply.”
Scott Marchakitus, Goldman Sachs’ director of credit research, says his firm recently revised its forecast for investment-grade issuance from $1.2 trillion to $1.3 trillion this year. This demand is “driven primarily by a significant increase in acquisition financing that has already taken place and the continuation of a strong funding pipeline,” he explains. “Although we just passed the $800 billion mark [as of July 14], we think M&A financing and a desire to enhance shareholder returns should keep new supply flowing through year end, albeit at a slightly slower pace than the first half of the year.”
Much of this new supply will be in the consumer products; financial services; health care; and technology, media and telecommunications industries, says Marchakitus, who is headquartered in New York.
The financial sector in particular will be making up for lost time. “Through the second quarter U.S. bank issuance was up 8 percent year over year versus 18 percent for the investment-grade market, so it’s arguably measured versus the record pace overall,” observes Wells Fargo’s James Strecker, who vaults from third place to claim his first appearance in the winner’s circle in Banks. However, with a Fed proposal on total loss-absorbing capacity, or TLAC — a capital-adequacy-ratio requirement included in Basel III — expected in early September, “bank issuance may experience less of its typical second-half slowdown this year,” he adds.
TLAC could lead to America’s biggest lenders taking on an additional $283 billion in senior debt, Strecker estimates.
That’s not necessarily cause for optimism for fixed-income investors, however. “If U.S. banks were not able to definitively outperform during the first half of 2015 despite being aided by supportive technical and fundamental tailwinds, the prospects are even less likely in the second half, as this positive backdrop is likely to change,” he contends.
Valuations remain stretched, the Charlotte-based analyst adds, and banks are susceptible to underperforming during bouts of volatility and weakness, because they are an efficient vehicle to bring down risk quickly, given the sector’s size and inherent liquidity. “As such, we remain comfortable with our market-weight allocation but reiterate that our bias is for spreads to widen,” he says. “Furthermore, we prefer short-dated debt given that performance has lagged out the curve amid the moves in Treasuries and given that TLAC issuance is likely to be longer dated.”
The 2015 All-America Fixed-Income Research Team reflects the opinions of more than 2,090 portfolio managers and buy-side analysts at some 540 institutions that oversee an estimated $9.6 trillion in U.S. fixed-income assets.
