Quarterly Fixed Income Survey: September 2017

On the basis of this quarter’s results, it is clear that the dichotomy between what the credit market expects versus what the interest rate market expects, continues. We recommend that investors clip the coupon in credit, but maintain some dry powder for more opportunities ahead.

It’s been a year since we began surveying our third-party fund managers every quarter in order to give you access to their latest views. In September, we received answers from 218 investment managers from across the world. Leading bond and currency managers (highlighted by our research process) from 8 specialised areas were asked to consider valuations, expectations and outlooks for the coming months.1

Today, we’ve chosen to focus on the conclusions drawn for credit, interest rates, emerging market bonds, currencies, securitised bonds and municipal bonds.

Global credit markets outlook

Spreads expected to be range bound while US assets are most attractive

Global investment grade (IG) credit managers have tempered their expectations with only 25% of respondents expecting spread tightening (falling from 57% last quarter). The majority of respondents believe spreads are range bound. In high yield, we see a similar story with half of all managers seeing spreads as being range bound, and the rest being somewhat split between widening and tightening projections.

Between June-August 2017, high yield credit spreads tightened initially before widening and levelling out by the end of the period.2 Therefore, spreads have in fact been roughly flat since the last survey was performed in June, which implies that the change in sentiment is not necessarily the result of a market driven opportunity.

Meanwhile, managers across both global IG credit and leveraged credit believe that US high yield debt is the most attractive credit asset on a 12-month horizon.

Global interest rates outlook

US interest rates

Most managers expect two US interest rate rises over the next 12 months, down from three last quarter. Part of this decline comes from US inflation expectations falling, with the average now being 1.9%, down from last quarter’s 2.1%. Broadly, interest rate managers seem to be tired of the idea of a reflationary market. This is possibly due to weaker data this summer as well as a loss of confidence in the progress of tax reform.

US terminal rates

Survey respondents continue to reduce their expectations for the terminal funds rate by the US Federal Reserve (Fed). There is some dichotomy in views, with terminal rates anywhere from 1.76% to 2.75% (listed in quarter point increments) scoring equal votes – a total of 74% of those surveyed fell into this band.

Emerging markets outlook

Mexican peso is still the favourite

The Mexican peso is still a firm favourite despite the North American Free Trade Agreement (NAFTA) negotiations and 2018’s presidential elections. However, the favouritism has subsided somewhat with 21% of managers finding it the most attractive currency versus 44% of managers in our first survey for 2017.

Wide dispersion of favoured emerging market currencies

Over 80% of our survey respondents continue to believe that local emerging market debt is more attractive than hard currency emerging market (EM) debt on a one to three-year view. Local currency markets have done very well over the course of 2017 prior to the survey, suggesting that there may be less room for further appreciation this year. Anticipation of a shift towards more modest emerging market currency returns towards the year end helps to explain why optimism has reduced this quarter, with 24% believing EM foreign exchange (FX) will be a strong contributor against the US dollar versus 38% of participants believed so last quarter.

That being said, 88% of managers expect a neutral to positive impact from EM FX. Should that come to fruition, then the 6% yield on offer in the asset class (i.e. JP Morgan GBI-EM Global Diversified Index) is rather attractive versus other areas of fixed income. Hence why 71% of managers see a return of 6-12% over the next 12 months.

Emerging market inflation outlook

With 62% of respondents expecting lower EM inflation over the coming months, this has almost doubled following only 37% of participants with the same view last quarter. This same trend is visible in EM Local rates, where 59% of managers now think they are cheap, versus 42% last quarter.

Developed market currencies outlook

Euro, US dollar and sterling are the ones to watch

G10 currency managers have raised their expectations for the euro to US dollar exchange rate to somewhere between 1.16 and 1.25 (versus 1.11-1.15 last quarter). This is consistent with reductions in expectations for the US Federal Reserve on the interest rate side. In our view, a change here could create an opportunity to exploit.

Brexit is still weighing on sterling (GBP), however there has been a slight shift up in target for the sterling to US dollar exchange rate to between 1.25 and 1.30. This implies some weakening from here as GBP is 1.33 today.

Asset-backed securities outlook

Securitised managers are still broadly positive

The securitised asset market has been on an extended bull run since the global financial crisis of 2008/09. Given this, securitised managers are still broadly positive in their markets. However, 24% of managers expect loss-adjusted yields of non-agency mortgages to widen (versus only 6% of managers last quarter.) Overall, managers are more worried about the ability of commercial mortgage-backed securities (CMBS) structures to absorb losses at the BBB level, particularly in the 2012 and 2013 vintages where retail and mall risk is more prominent. More broadly, residential house prices are expected to rise 3-5% in the next 12 months.

Municipal bonds outlook

Municipal bonds look more positive

The overall outlook for municipal high yield assets has improved this quarter. 67% of managers expect municipal high yield to outperform corporate high yield, versus 60% last quarter. Our observation here is that managers are more bullish on credit risk in municipals, relative to their counterparts in the corporate credit space.

30-year AAA Municipal/Treasury yield ratio expectations

As 30-year AAA Municipal/Treasury yield ratios continue to come in, managers too have shifted their expectations. Last quarter, 100% of managers saw ratios in the 95-110% range. This quarter, 24% shifted into the 80-95% range. Interestingly, 78% of managers see no change to municipals as a result of changes to the tax code, believing Donald Trump has little incentive to strain the finances of cities and states.

Opportunities for savvy investors

As always, investors will need to stay nimble and responsive to evolving conditions in order to reap the best rewards against today’s market backdrop. In analysing the results from this survey with the view from our desk here at Russell Investments, the dichotomy between what the credit market expects and what the interest rate market expects, continues. For more about this, see our blog from June where we delved deeper into the lack of bond market consensus.

Interest rate market participants are anticipating minimal growth – a scenario which would normally be disastrous for credit. However, the outlook from credit market participants remains fairly constructive. Investors should consider maintaining some ‘dry powder’ (highly liquid, cash-like assets) on both the interest rate and credit front. Remember, the market is under no obligation to provide you with a return at any given point in time. For a broad global market Q4 outlook, see our strategists’ final instalment for 2017.

1 Global IG credit survey: 28 | EM local currency survey: 34 | EM hard currency survey: 33 | Municipal bonds market survey: 19 | Securitised survey: 21 | Global leveraged credit survey: 32 | Global rates survey: 27 | Currency survey: 19 |
2 Source: Bloomberg Barclays Global High Yield Credit Option Adjusted Spread, 04 October 2017.

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