Chief Investment Officer at Western Asset Management Co.
The second half of the year should see very strong growth in global gross domestic product (GDP) as the world economy reopens. However, investors should be cautious about presuming a higher secular trend rate of growth or inflation based on these short-term cyclical boosts.
With manufacturing and homebuilding already having fully recovered, but with supply chain and hiring obstacles emerging, it seems that realized U.S. growth will fall short of the expectations that seem to be built into market pricing given how sharply term yields have risen in recent months.
Given this backdrop, investors might want to consider positioning portfolios to withstand further market volatility, yet have them remain flexible enough to capture value opportunities as they appear. Below is a summary of where we see value in U.S. fixed-income markets.
Investment-Grade Corporate Credit
We are optimistic on credit fundamentals and reassured that companies will maintain conservative balance sheet management. While favorable technicals endure, valuations have already returned to pre-Covid levels for many sectors. We are maintaining overweights to banking, select reopening industries and rising-star candidates where allowed.
High-Yield Corporate Credit
U.S. high yield spreads were 50 basis points (bps) tighter in the first quarter of 2021 despite the rise in Treasury rates. We saw record new issuance, heavily focused on refinancings, with a slight pickup in mergers and acquisitions; we expect this trend to continue. Issue selection and asset class allocation remain the key drivers for our portfolios. We will look to add selectively (away from leveraged buyout issuance) for total return/spread compression, given current valuations.
Bank Loans
In the bank loan market, we see $25 billion of visible repayments for quarter-end, which should help with a fairly heavy forward calendar. We expect net collateralized loan obligation (CLO) issuance to rise once the wave of refinancings clears, which, when coupled with continued retail flows into loans, should keep loan demand steady and hopefully put a floor on any softness in the secondary markets. We believe outperformance will come primarily from significant interest carry, avoiding problem credits and owning select names with more meaningful impact from Covid where fundamentals and liquidity remain intact and there is still real price convexity in the credit.
Collateralized Loan Obligations
We expect CLO primary issuance to remain heavy but also to be met with renewed demand post quarter-end. The broader loan market default rate is trending at 2% while the universe of loans held in CLOs is running a default rate of less than 50 bps. Any additional widening in the CLO market should be viewed as an opportunity to add attractive yield. We retain our view that AAAs will continue to perform well in either a bearish or bullish scenario. We expect supply to remain heavy, which will lead to opportunities to add lower-rated CLOs at attractive levels in the coming months.
Mortgage and Consumer Credit
Agency Mortgage-Backed Securities (MBS)
We are neutral on agency MBS at current valuations and due to expectations of continued support from Federal Reserve purchases over the near term. We favor TBA in production coupons and specified pools in higher coupons.
Non-Agency Residential MBS
U.S. home prices have been supported by historically low mortgage rates, a dismal lack of supply on the market, tight lending conditions and a rebirth of household formations, which continue to support further home price appreciation and fundamentals for credit investors. We are positive on credit risk transfers from government-sponsored entities Freddie Mac and Fannie Mae as well as legacy non-agency RMBS/new-issue re-performing loan deals.
Non-Agency Commercial MBS
While the commercial sector remains further behind in terms of recovery, momentum is also building in this sector. In the near term, we remain cautious as it is uncertain how long it will take for commercial real estate markets to fully recover from the negative impacts of the pandemic. We expect the fundamental outlook to be uneven across property types and markets as the impact of COVID-19 varies on each property type and geography. We are positive on short-duration, well-structured single-borrower securitizations and loans. We remain selective and prefer bonds that can better withstand a period of reduced operating income and forbearance and provide good risk/reward potential.
Asset-Backed Securities (ABS)
We are cautious on consumer fundamentals and watchful of credit performance on consumer ABS sectors due to the impact of the pandemic on the economy and the uncertain pace of recovery. We favor well-protected senior ABS classes from high-quality sectors with low Covid disruption impact.
Municipals
Within the most recent $1.9 trillion American Rescue Plan Act relief package, state and local municipalities received $350 billion of direct aid to address revenue shortfalls associated with the pandemic. We believe that while some entities will receive more federal aid than needed, the stimulus package will be particularly supportive of lower-grade municipalities, providing liquidity that will lengthen the runway for these entities to address longer-term structural challenges. As the policy focus shifts to infrastructure, supply technicals will be in focus amid possibilities for a return of a taxable municipal infrastructure program.
We continue to favor lower investment-grade revenue sectors that should continue to benefit from an economic recovery. However, we are cognizant of relative rich valuations, thus we are maintaining an above average liquidity position to maintain flexibility to navigate near-term market fluctuations associated with an extended tax season or near-term interest rate volatility.
Ken Leech is Chief Investment Officer at Western Asset Management Co., an independent specialist investment manager of Franklin Templeton. His predictions are not intended to be relied upon as a forecast of actual future events or performance or investment advice.
Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
Past performance is no guarantee of future returns.
©2021 Legg Mason Investor Services, LLC, member FINRA, SIPC. Western Asset Management Company, LLC, and Legg Mason Investor Services, LLC are wholly-owned subsidiaries of Franklin Resources, Inc.
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