Gregory S. KaplanDirector of Fixed Income, Managing Director | Mar. 7, 2019

2019 Fixed Income Outlook: From Volatility, Opportunity Emerges

Expect the Fed to raise its benchmark interest rate once in 2019.

The 10-year Treasury yield will likely rise, but remain within a range of 2.75%-3.25%.

Investor demand and stable credit conditions should support favorable tax-adjusted municipal performance.

Short duration securities are now offering yields above the inflation rate, providing a real return on lower-risk capital.

Volatility has created compelling opportunities within higher-yielding taxable fixed income sub-sectors.

The U.S. economy performed well in 2018, but growth is expected to slow towards the post-financial crisis trend rate of 2.2% in 2019. In spite of this deceleration, we believe the risk of recession is low. Supporting this view, the Federal Reserve has recently shifted to a more accommodative tone, providing a tailwind to the overall risk environment, including alternative fixed income strategies. Our initially unpopular call last summer for the Fed to pause in 2019 now seems prescient as the Fed and the market consensus have moved our way. We only expect one additional Fed hike in 2019. Also, the 10-year Treasury yield should end the year within a range of 2.75%-3.25%.

In the months leading to the change in the Fed’s tone in January, the market experienced tremendous volatility ,driving stock prices and other risk-assets down. This volatility created attractive valuations across fixed income risk-assets, improving the total return backdrop for senior bank loans, collateralized loan obligations, and emerging market (EM) debt. We expect these higher-yielding sectors to lead fixed income returns in 2019, although prospects for volatility remain heightened.

We also see continued opportunities in liquidity management and municipal bonds. The higher Fed funds rate has led to increased cash returns solidly over the inflation rate of 2%, and actively managed liquidity remains a very attractive option for risk-averse investors. The tax-exempt municipal bond market is poised to deliver favorable tax-adjusted returns this year too, with investor demand healthy and a relatively benign credit environment expected to support valuations. Overall, we see a decent year ahead for fixed income balanced against the slowing global economy, shifting central bank sentiments and the unsettled political environment.

MUNICIPAL MARKET

The bond price recovery during the final months of 2018 was a remarkable reversal to what had appeared to be a weak performance for investment grade (IG) municipals, which were on target to deliver negative total returns for the year. Fed policy actions coupled with strengthened economic activity boosted equity market valuations and eroded the appeal of fixed income securities. Consequently, nominal municipal yields rose as much as 55bps to 85bps across the curve. However, the pivot to a “risk-off” bias in November as concerns surfaced over the pace of rate hikes and whether an accelerated tightening campaign would dampen the expansion resulted in a sharp decline in yields by the end of December. Municipal bonds improved to settle into modestly positive territory, with the Bloomberg Barclays Municipal Bond Index posting a 1.3% total return in 2018, the fifth successive year of positive performance for the asset class. The firming of the market, in conjunction with tight supply and mutual fund flows, led relative, tax-adjusted, municipal total returns to eclipse all other fixed income asset classes. Notably, high yield (HY) municipals were top-grade as income accrual, and enhanced recovery prospects on Puerto Rico bonds led to outperformance.

January was in full “effect” for municipals as the seasonally favorable performance period did not disappoint to start the New Year. Despite the expectation that rate volatility will persist, an imbalance between available bonds and cash to spend is likely to continue providing essential price support in the coming months, with periodic bouts of illiquidity but also opportunities. Our base case for 2019 calls for rates to rise gradually, but we cannot rule out unexpected moves beyond initial estimates. It is important to note that slowly increasing yields do not necessarily detract from performance as income accrual (carry) could more than offset the associated price decline. The relative steepness of the municipal yield curve still offers attractive entry points to buy longer maturities, where valuations are more generous than those provided by shorter-term tenors that have experienced strong investor preference (see Figure 1).



Our view that Fed rate hikes will pause over the near-term is accretive to continued economic growth. This action leads us to position our duration (maturity sensitivity) targets slightly short of our benchmarks, but with an eye towards the second half of the year where policy actions may change our thinking. In our view, supply and demand dynamics coupled with our expectations for yield curve normalization lead us to believe municipal bonds will deliver another year of positive total returns. City National Rochdale forecasts tax-adjusted total returns of 3.0%-5.5% for IG bonds and 7%-8% for HY municipal bonds this year. Additionally, municipal bond performance may also find support given our expectations of no further legislative actions that would dilute the value of the tax exemption.

We expect primary market supply to rise moderately from the $340 billion issued last year, but net negative issuance should support demand as bond retirements, and other cash flows overwhelm investor appetite. In our view, the absence of advanced refunding ability will continue to limit overall issuance. With the recent change in Congressional control (House advantage to Democrats), we acknowledge infrastructure deficiency will be a talking point among legislative leaders. However, achieving consensus over a viable funding framework will be a difficult task. State and local governments should marginally increase new money bonds for replacement or modernization projects. We see an increased desire among issuers to address a growing backlog of infrastructure needs, but taxpayer resistance to approving broad bond authorizations will likely limit activity.

The Tax Cuts and Jobs Act (TCJA), which took effect in 2018, and which lowered corporate and individual tax rates, resulted in traditionally longer-maturity buyers, like banks and Property and Casualty (P&C) insurers, re-examining their municipal bond exposure. According to Federal Reserve Data, through Q4 2018, banks reduced their holdings of municipal bonds while P&C insurers modestly added. While changes in investment psychology will evolve, we see institutional demand stabilizing in 2019, with the narrative driven by relative value and the need for high-quality assets within their overall allocation.

Mutual fund flows, a key indicator of retail demand, have returned to positive in the opening weeks of 2019 after an extended period of redemptions toward the end of last year. For high-tax states such as California and New York, we expect demand for their municipal bonds to remain strong as investors seek tax-efficiency strategies to circumvent the impact of the SALT deduction limitation. The excess demand for bonds issued in high-tax states, while helpful to performance, could mask potential credit weakness among some issuers, particularly in the current environment where spreads are compressed within IG and HY. Investment grade and high yield municipal credit conditions should demonstrate stability for the majority of issuers in 2019, but we are cautious on a few fronts.

Sharpening the Focus on Municipal Credit Trends

After several quarters of robust tax collection growth, the impact of the TCJA (in particular, states most affected by the cap on the SALT deduction) is beginning to show up in revenue reports. For example, NYS projected it would take in $6.2 billion in personal income tax payments during December 2018 and January 2019, but received just $3.9 billion (versus $8.6 billion collected during the same period last FY).

Reconciling the course of organic growth against one-time fiscal disruption is difficult, and it may result in mid-course budget corrections for the current year and revisions to spending plans next year (FY 2020). That said, tax reform implications and the anticipated moderation in economic activity could lead to the reemergence of budgetary challenges for some state and local governments in the latter part of the year, but the solid reserve build-up of many issuers should enable them to weather operating variability.

We expect unfunded pension liabilities to remain a popular discussion this year. Most states exceeded their investment targets over the past two fiscal years, which begins in July for the majority of plans. In FY 2017, the average funded ratio for state pension plans approximated 70%. Despite better-than-assumed returns, a combination of demographic headwinds and assumption changes worked to counterbalance excess performance. Risk mitigation strategies, like discount rate reduction, is likely to evolve (see Figure 2).



Based on preliminary return data for FY 2018, the roll-forward of FY 2017 actuarial valuations should lead to relative stability for the year, in some plans an improvement, but the ongoing impact of actuarial adjustments is likely to limit the upside. In our view, the uptick in market volatility and lower-than-average returns earned to date in FY 2018-2019 could suppress any gains achieved if plan performance doesn’t improve over the next few months. For those states with the weakest plans, like Illinois, New Jersey, or Connecticut, losing ground on funding would further diminish their already mediocre credit quality.

Select states and individual local governments, such as Chicago, have entertained creative financing solutions to bolster contributions to their pension plans. Examples include pension obligation bonds and asset transfers or monetization, which we view with skepticism. The implementation of new Other Post Employment Benefit (OPEB) standards will likely lead some issuers to consider similar tactics, especially as these liabilities surface on their balance sheets in the FY 2018 financial statements. Retirement benefits funding is a longer-term concern subject to high variability, but with the risk of disrupting shorter-term budgetary demands. Despite a multi-year trend of most governments gradually implementing reforms, we still place considerable weight on retirement obligation analysis in our security selection process.

Our portfolio managers continue to view revenue bond sectors as attractive opportunities within an overall allocation. Picking sector winners and losers is critical at this stage of the cycle, particularly in observance of mixed trends developing within the space. For example, within private higher education, a divergence in quality has occurred over the past few years. According to S&P, in 2018 there were twenty downgrades and only two upgrades, a similar pattern observed in 2017. Institutions are focused on cost structure as net tuition revenues fail to keep pace with expense growth. In our view, brand value and student demand are critical differentiators within the sector, and we continue to favor larger, selective institutions with pricing power and in-demand programs, like STEM. In transportation, positive trends over the past several years, like increased utilization and transaction revenue, have bolstered the credit profiles of many airport and toll road issuers.

While growth among these issuers is normalizing, we are still finding value in those credits located in vibrant regions with strong longer-term prospects, where the service area characteristics support demand. The heightened political risk of general obligation bonds in recent years has crystallized our cautious view of this group of issuers. We have become highly selective, and are adding exposure to credits with strong economic fundamentals and demonstrated stewardship over their finances and operations.

Investors have questioned whether the municipal credit cycle is nearing its peak. An important caveat to municipal credit cycles is that there is no universal entry and exit. The fiscal condition of a particular issuer at any point in the cycle will hinge on its ability to manage the acquisition and use of limited resources, which is affected by politics, policy, and legal framework. For these reasons, our municipal research process does not change throughout a business cycle, and we continually reaffirm our view of credit through routine surveillance.

TAXABLE MARKET

Tightening monetary policy and credit market fluctuations challenged taxable fixed income in 2018, but even with the elevated levels of volatility, the asset class demonstrated resiliency. Declining bond prices and early-year losses subsided as concerns over global growth shifted investor sentiment, leading 10-year Treasury yields to end the year relatively unchanged (up 18 bps). Core fixed income recovered to earn investors a positive return, while the sell-off in opportunistic fixed income improved valuations and performance estimates.

To start the year, the tone of the market is more optimistic, with strong “out-of-the-gate” performance across our fixed income platform. Despite the likely deceleration in corporate earnings growth to a modest range of 2%-8% (from the more than 20% increase last year due to the one-time TCJA adjustment), and softening economic performance, the U.S. continues to expand, which should support prices this year. City National Rochdale forecasts total returns of 3%-5% for core taxable fixed income and 5.5%-6.5% for opportunistic fixed income in 2019.

The credit environment remains stable, with improved investment grade corporate balance sheets. Within core fixed income strategies, we continue to favor credit over government exposure, and financials over industrials and utilities. We continue to monitor the implications of tariffs, wage inflation, and geopolitics, as these forces could lead to profit margin compression. Also, the BBB-rated corporate bond market is roughly $2.5 trillion and growing, which could pressure borrowing costs, but while we are cautious, it is too early to be a concern. A key measure of indebtedness is a company’s net debt compared to its earnings before interest, taxes, depreciation, and amortization (EBITDA). This metric is only slightly above the levels observed in A-rated companies. Juxtaposing current IG corporate yields against those recorded in 2007, they remain an average of 200 bps lower today. The lower yields mean companies have locked in cheaper debt financing costs over the longer-term that alleviate their debt burden to more manageable levels, which supports capital expenditures and growth of the economy (see Figure 3).

Conversely, we are closely watching companies that financed stock buybacks and dividends through debt issuances. But counterbalancing this troubling trend is the 12% drop in corporate bond supply in 2018 (as rates increased) and further declines of 7% are estimated this year. We believe the reduced market supply has contributed significantly to the market rally year-to-date. As a result, additional return potential for lower quality IG credit remains low, and we are taking advantage of the favorable market momentum and stronger relative liquidity to upgrade the quality of our portfolios. In our view, investors can gain adequate risk compensation, reduced interest rate exposure, and enhanced income generation by complementing corporate allocations with opportunistic fixed income strategies.

Rising short-term rates have increased the comparative advantage of floating rate notes (FRNs), and we believe, contrary to current market pricing, an additional Fed hike in 2019 will further enhance their value-add, particularly within the short-end of the barbell structure for our strategies. We are also seeking opportunities to decrease the volatility of our core fixed income portfolios by adding taxable municipals. Historically, these securities have offered similar yields versus their corporate brethren, yet are higher in credit quality and possess a different investor base, which creates a lower correlation within our overall portfolio allocation.

We are maintaining our portfolio posture expecting higher shorter-term interest rates, hence our recommended allocation to liquidity management strategies, which returned over 2% last year. Based on our Fed policy outlook, we expect total returns in taxable liquidity management to exceed 2.5% in 2019 with the potential to approach 2.75% by year-end. While cash will help insulate investors from volatility, it is an appropriate time to look at attractive parts of the yield curve. Investment in longer-dated maturities does not automatically imply lower returns in a rising rate environment since these tenors do not necessarily move in tandem with the Fed. From the time when the tightening cycle began, the total return of Treasury tenors beyond ten years has outpaced the 1-3 and 7-10 year buckets, posting a 15% cumulative gain since 2015. Our current portfolio tilt towards a barbell structure continues to benefit from rising short-term rates and range-bound longer-term rates.

We believe core fixed income should remain a part of balanced asset allocation, but our highest conviction taxable fixed income sector in 2019 is short-duration EM debt. EM debt struggled in 2018 as Fed policy and falling energy prices combined to pressure the U.S. dollar higher, forcing fifteen EM countries to raise interest rates to defend their currencies. These events, coupled with volatile political situations in Turkey, Argentina, and Venezuela permeated headlines, causing widespread stress across the market and created pockets of value for discerning investors. Short-duration, high-conviction, EM bond yields are close to 7% with a corresponding duration of half a year, significantly reducing interest rate risk relative to longer-dated bonds. The sector also has a relatively low correlation with core domestic fixed income, and it serves as an excellent diversifier against U.S. corporate bonds. A longer-than-expected Fed pause may influence the U.S. dollar lower, creating a tailwind to the sector, and we believe the potential risk-adjusted return is attractive (see Figure 4).



U.S. Bank Loans are also exhibiting attractive dynamics and, despite general market concern, offer competitive yield and diversification in a balanced portfolio. In December 2018, senior bank loans experienced significant outflows, which pushed yields over 7% and returns have lagged other HY sectors so far in 2019. Despite the move lower, we do not view the weakness in the fourth quarter of 2018 as a sign of deteriorating credit quality. In some cases, market fundamentals are improving, and the sector default rate as of February is 1.4%, a seventeen month low for the asset class and a full percentage point below the 3-year high of 2.4%. Moreover, the EBITDA-to-interest expense ratio, a commonly used gauge of debt affordability, is rising (a positive).

Historically, U.S. bank loans are more defensive than U.S. HY bonds. Between 1990 and 2017, U.S. bank loans averaged recovery rates of 70% due to their secured position and seniority in the capital structure, while unsecured U.S. HY bonds averaged recovery rates of 43% over the same period. Currently, the yield spread between U.S. HY and U.S. bank loans is a mere 60 bps, the lowest level since 2014, suggesting relative outperformance for bank loans moving forward. We also view leveraged loan exposure through CLOs as an appropriate investment for sophisticated investors seeking additional diversification and income potential over a long time horizon.

In conclusion, in spite of slowing growth, we do not believe global economic conditions will turn negative based on our holistic view of the environment. Exogenous factors could pose downside risk, but their resolution can also provide a tailwind to growth and asset returns. We diversify our risk exposures while seeking enhanced income opportunities in what remains a low-interest rate market. Security selection is paramount to our credit and portfolio management process, which carefully assesses compensated risk and return potential. Late cycle dynamics will favor opportunistic fixed income, and our active core fixed income mandates are positioned to benefit from our expectation that the Fed will resume its tightening cycle later this year.

Key Points

Expect the Fed to raise its benchmark interest rate once in 2019.

The 10-year Treasury yield will likely rise, but remain within a range of 2.75%-3.25%.

Investor demand and stable credit conditions should support favorable tax-adjusted municipal performance.

Short duration securities are now offering yields above the inflation rate, providing a real return on lower-risk capital.

Volatility has created compelling opportunities within higher-yielding taxable fixed income sub-sectors.

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. This risk is heightened with investments in longer duration fixed-income securities and during periods when prevailing interest rates are low or negative.

Investments in below-investment-grade debt securities, which are usually called “high-yield” or “junk bonds,” are typically in weaker financial health, and such securities can be harder to value and sell, and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) ,and taxable gains are also possible.

Investments in the municipal securities of a particular state or territory may be subject to the risk that changes in the economic conditions of that state or territory will negatively impact performance. These events may include severe financial difficulties and continued budget deficits, economic or political policy changes, tax base erosion, state constitutional limits on tax increases, and changes in the credit ratings.

All investing is subject to risk, including the possible loss of the money you invest.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

Diversification does not ensure a profit or protect against a loss in a declining market.

Past performance is no guarantee of future performance.

Investment management services provided by City National Bank through its wholly owned subsidiary City National Rochdale, LLC, a registered investment advisor.

Index Definitions

Bloomberg Barclays U.S. Municipal High Yield Index: measures the non-investment grade and non-rated USD-denominated, fixed-rate, tax-exempt bond market within the 50 United States and four other qualifying regions (Washington DC, Puerto Rico, Guam, and the Virgin Islands). The Index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

The Bloomberg Barclays Municipal Bond Index is considered representative of the broad market for investment grade, tax-exempt bonds with a maturity of at least one year.

Bloomberg Barclays U.S. Corporate High Yield Index: measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

The Bloomberg Barclays Emerging Markets Hard Currency Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers.

The S&P/LSTA U.S. Leveraged Loan 100 Index is designed to reflect the performance of the largest facilities in the leveraged loan market.

Bloomberg Barclays Intermediate U.S. Corporate Index: measures the performance of U.S. corporate bonds that have a maturity of greater than or equal to 1 year and less than 10 years. The Index is a component of the Barclays U.S. Corporate Index and includes investment grade, fixed-rate, taxable, USD-denominated debt with $250 million or more par outstanding, issued by U.S. and non-U.S. industrial, utility, and financial institutions

. The Bloomberg Barclays US Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

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