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Investing Podcast recorded on February 12, 2019

From the Desk - January Recap 2019


Muni Recap

Welcome to the Breckinridge market update. I'm Eric Haase, a portfolio manager and I'm joined by Sara Chanda, a fellow portfolio manager. So we've had a strong start to the year in 2019 in the fixed income markets and it's really been a continuation of what we saw in 2018, or at least in the last quarter of the year. So this month, we'd like to discuss the strong returns that we've seen in the muni market, positioning and how it impacts relative value.

That's right. So looking at positive performance over the course of 2018, actually fixed income munis were one of the best performing sectors. Looking at the broad index as an indicator, it was up just about 1.3% and the agg was actually flat for the year, and that trend has actually continued into 2019. Looking at the broad index right now for the month of January, it's up about 76 basis points or so. We've had three consecutive months of positive performance and over the last three months, the broad index has been up just over about 3% on a cumulative basis.

So one thing we'd like to point out is we've had very strong returns but it's important to remember that periods of returns like this are not necessarily the norm in the high-quality fixed income space. We had a huge flight to quality in the fourth quarter that drove rates a lot lower, so really what that does is it affects your capital appreciation part of your total return equation. So it's not the income-based returns we would expect and we could see some reversion in the future if rates do back up. So one thing we think about is how do we prepare for situations like this? Our Investment Committee determines duration targets, curve positioning, and credit and sector allocation, and they consistently monitor macrotrends as well as market-specific factors in order to make these determinations.

That's right, and so some of the things we think about, kind of the reaction we'd have when we see dislocations in the market, we really need to reassess our current opinions and determine if modifications really need to be made with our current strategies. And despite the recent volatility that we've seen, we've actually made no change to our base case for Fed funds and we do expect still one mid-year hike in 2019. You may ask why that is. Our outlook really balances strong data that we've been seeing on the GDP side above trend growth there, low unemployment contained inflation but with some macro-challenges as headwinds. That may include China, European elections, trade tensions, and political gridlock, just to name a few, but we do ultimately think that strong GDP and labor markets will keep the Fed on target to hike, albeit at a slower pace.

So overall, across our strategies, we're essentially duration neutral.

That's right, so right now we really don't have a strong conviction to move off of that at this juncture. So again continuing with the neutral bias on the duration side.

At Breckinridge, we continue to have a diversified maturity structure and a higher-quality bias.

Right, and I'd say right now, that's probably a good thing given the fact they we're still in the late stages of the credit cycle. Spreads have remained very tight and really, as a result of that, we are really selling into some of the strength that we've seen in the market, taking advantage of really upgrading our credit quality across the portfolios.

So when the Investment Committee gets together, one of the factors they look at and one of the metrics would be yields and ratios. So, the ratio is how we compare a AAA municipal bond yield to the similar maturity U.S. Treasury yield, and that just gives us some relative value between the tax exempt and the taxable markets. Right now, ratios are pretty low.

Actually, that's right. Ratios in the 10-year spot fell below 80%, which is actually a multi-year low and at this juncture, we have actually opted to stand pat and not really shorten our duration at all because we do think that ratios will remain at the lower end of the range over time really due to the fact that investors that seek tax-exempt income will continue to do so, really into 2019 in light of tax reform.

So essentially, the way we view it is that in the part of the curve that we're primarily focused on, where we invest our capital, ratios should be range-bound but we could see, the long end ratios could see some pressure in the future due to some supply dynamics, right?

That's right, so the last couple of years, really supply's been driven by refunding deals in the market. That's actually shifted now because in light of tax reform, advanced refunding deals are no longer allowed. So now new money issuance is actually taking hold and really driving supply and, as a result of that, that tends to be bonds that are dated on the longer part of the market. We have had a strong buyer base in the form of banks but again, with tax reform and their rates dropping lower, they are more net sellers now.

And another thing that the Investment Committee looks at is just credit spreads in general. So you look at where we are in the past 10 or so years. Spreads are the tightest that they've been, so you think about the AA portion of the curve where, again, where we spend a lot of money and put a lot of capital toward, that spread's gone from around 13 basis points to the AAA municipal scale to 6. So we've tightened by 7 basis points and that's also worked its way down to the BBB or lower credit portion of the market, where that's gone from around 117 basis points in spread to 76, so tightening significantly from where we were.

But credit spreads could widen and several factors we would consider would be, being in the late stages of the credit cycle, we see some fundamentals weaken over time and again, as we mentioned earlier with supply dynamics, we've talked about, you know, in the past, infrastructure spending whether that may actually come to light or not, that could obviously impact spreads as well.

So on the ratio front again, we've had a large rally over the last three months and in that period of time, we've seen that 5-year ratio drop down from 77% to 73%. So ultimately what that means is that tax exempt municipal bonds are now less attractive relative to taxables. In the taxable world, we look at Treasuries and taxable munis as opportunities to cross over in our portfolios.

Right, and just for folks in the field, just as a definition of taxable municipals, they're really just municipal bonds which are generally issued to finance a project or activity that really does not provide a major benefit to the public. Therefore the federal government doesn't allow their income to be tax-exempt and what they represent is about, you know, 10% of the overall municipal market. We do buy them in our taxable strategies as part of our overall asset allocation and also as crossover opportunities in our tax efficient strategies.

The taxable munis in general, they are government securities more on the local side than on the Federal side like a U.S. Treasury so we like them because of a few reasons. One particularly is that they provide more spread than a Treasury. So right now, if you're looking at the 3-year part of the curve, you're able to pick up an additional, we'll call it 30 to 35 basis points by buying a AA-rated taxable muni relative to a AAA-rated Treasury. Additionally, these are the same names that our analysts cover on the tax-exempt side so we are able to leverage all the work that we're doing there in order to find opportunities in that market.

They really do have similar risk drivers as the tax-exempt munis that we look at, and really, for our taxable product, they are less correlated to other asset classes that we're purchasing so it does provide a nice counterbalance.

We hope folks in the field found this information informative and if you have any questions or comments, we'd love to hear from you at Thanks.

Corporate Recap

Welcome to the Breckinridge podcast, I'm John Bastoni, one of the traders here Breckinridge. Today, I'm pleased to be joined by Khurram Gillani, one of our fixed income portfolio managers and today we are going to start with corporates. We have a few themes to hit on today, the first one being performance. So corporates and spread products, in general, had a tough month in December. I'm curious if you can elaborate how the month of January played out?

Sure. So IG corporate bonds bounced back pretty strongly after a shellacking that they took in December and Q4 in general. The rally in January actually undid most of all the losses taken in all of Q4 2018. Some bonds that were trading 50 to 80 basis points wider during Q4 actually moved 50 to 80 basis points tighter in just a few short weeks this month.

So it sounds like spreads tightened about 25 basis points during the month, if I'm looking at the index correctly. I'm curious how that translated on an excess return basis.

That's right. IG spreads, like you mentioned, tightened 25 basis points during the month. So the Barclay's Index, which began the year at +153 option adjusted spread ended the month at +128 option adjusted spread. So, corporates outperformed Treasuries pretty handedly during the month. Corporates actually had the best month in terms of excess returns since January of 2009. To put some numbers on it, corporates reported 183 basis points of excess return and total returns of 235 basis points during the month.

So what specifically were some of the drivers of the great performance we saw over the month?

Well, it was a very risk-on month in the equity market, and that supported credit spreads and that was partially due to the announcement by the Fed in the second week, that they are going to likely take a pause in interest rate hikes for the remainder of the year. Also, earnings, especially bank earnings, came in very strong and they indicated that financial conditions are still supportive over an overall healthy U.S. economy. And then lastly, I would say supply also acted as a tailwind this month. Supply was fairly robust, it was, per the index, $148 billion for the monthly, but that was actually $15 to $20 billion lower than the market anticipated for the entire month, so I think that was another tailwind that likely led to tighter IG corporate spreads during the month. As a result, new issue concessions in the primary market went from double digits at the beginning of the month which was a continuation of what we saw in December to flat and negative by the third and fourth week of the month.

This sounds like the recipe for, you know, longer corporate outperforming some of the shorter tenors. Did that hold true this month?

Yes, it did. That's exactly right. So as a whole, the corporate credit curve parallel-shifted downward and long corporates, which significantly underperformed last year, outperformed in terms of total and excess returns even though the spread change of a corporate maturing in 10+ years was about the same as the spread change of a corporate maturing between one and three years. To put some numbers on that, corporates maturing greater than 10 years in the index saw spread tightening of about 24 basis points but they had 293 basis points of excess returns, whereas short corporates, say one to three-year corporates saw spread tightening by 23 basis points but they only posted about 47 basis points of positive excess returns.

So just continuing along this theme of the higher beta sectors doing better, it looks like oil was up $7 per barrel over the month, so over $50 a barrel. So I would assume that energy sectors, specifically some of the BBB rated segments did better than others this month.

That's right. So all major sectors posted positive excess returns during the month and yes, the energy sector was a clear outperformer. So pretty much every subsector, independent energy, oil field services, refining, midstream, generated the largest excess returns during the month and that was because oil was up about 19% month over month.

And what specifically happened at the rating level? I assume some of those sectors are BBB rated which helped drive returns of that rating bucket.

Yeah, given the risk-on month, usually we tend to see BBBs outperform in a risk-on environment and that was the case as well in January. So at the rating level, BBBs tightened more than the overall market. They posted over 200 basis points of positive excess returns. A and AA spreads underperformed BBB spreads, but they still ended up posting fairly healthy positive excess returns during the month.

Great. And usually we wrap up the credit sector with any credit-specific stories of note in the month. It sounds like Bristol-Myers Squibb was in the headlines this past month. I was wondering if you can elaborate on the story there.

Yeah, definitely. So the first week of the month, Bristol-Myers announced that they entered into a definitive agreement to acquire Celgene in a cash and stock transaction, valuing the equity at $74 billion. So Bristol-Myers Squibb is planning to come to the market sometime this year, they haven't announced when, to issue a good chunk of debt, guessing between $32 and $35 billion of debt. They're going to issue some time later this year to fund the cash portion of that transaction. So we expect gross leverage to go from where it is currently, which is about 1.3 times to about 4 times so it's definitely a significant leveraging event for Bristol-Myers. It's definitely the biggest acquisition admitted they've made in their 132-year history. So their 10-year bonds were initially 40 to 50 basis points wider right after the announcement. Those have come back about 20 basis points from peak widening, but they are definitely still wider. Celgene bonds, just the opposite, since they are the target. Their bonds are 50 to 60 basis points tighter and they're a lower rated company, so they will likely get upgraded by the rating agencies.

Great, thank you.

So let's turn to the securitized market. So John, can you give us a market recap of what happened this month with securitized, focusing on MBS in particular?

Yeah, so as we mentioned earlier in the podcast, I mean, January was a very strong month for all spread products and the securitized sector certainly benefited from that as well. You know, after we trailed into the risk-off interest rate rally at the end of 2018, mortgage-backed securities, the current coupon nominal spread versus Treasuries tightened about 5 basis points in January which translated into about 32 basis points of excess returns versus Treasuries. This was the best month we have seen since September 2017.

So John, what were some factors that led to the strong performance in the MBS sector? We hear a lot about the January effect. Did that have something to do with it?

There was really a confluence of factors that really helped mortgages last month. Usually the sector experiences some sort of January effect, where once the large banks are done with their window-dressing for year-end, they usually come in and size and support the sector and buy a fair amount of mortgage-backed securities. Secondly, one of the largest mortgage REITs raised equity which almost exclusively gets deployed into agency mortgage-backed securities, so that certainly helped the sector. And lastly, we're in the slow seasonal part of the year from a homebuying and turnover perspective. Ultimately, that translates into lower MBS supply which is welcomed by the market given the imbalance between the supply and demand picture that we have discussed a few times on this podcast.

And then quickly on credit card and auto ABS. Do those continue to perform well like they did in 2018?

Yeah, the prime consumer segment of the asset-backed segment continues to perform very well and it seems like what's felt like every month over the past year or so, we continue to see positive excess returns. January was no different, we saw 16 basis points of excess returns versus Treasuries last month.

Great. So we have also seen a few headlines that have come out lately about our government-sponsored entity reforms, specifically releasing Fannie and Freddie from the government's control. Can you elaborate on that, and did that the impact spreads, in your opinion at all?

So Fannie and Freddie, as we all know, have been a conservatorship since the financial crisis in 2008, but lately there's been some rumors about some potential changes to that, and this really all started with the acting FHFA director. The FHFA is the regulator of Fannie and Freddie. The gentleman's name is Joe Otting who took over in January for director Mel Watt, and he made statements recently that a plan would be released within a few weeks that was rumored to be around allowing the GSEs, Fannie and Freddie, to build capital and ultimately be released back into the public domain. Now, FHFA does have the power to allow the GSEs to build capital without involving Congress, but congressional support would be needed to fill out some of the details on the rest of this alleged plan, specifically whether or not Fannie and Freddie mortgage-backed securities would have an explicit government guarantee or not. The other interesting tidbit of this is that Director Otting is the acting director right now, while we wait for the White House's official nominee, Dr. Mark Calabria, to be confirmed at some point later this year. So it struck the market as very unusual that an acting director would be making these types of comments. Since then, the White House has backtracked these comments, saying they would ultimately work with Congress on a very detailed plan which would obviously take a lot longer especially as you come up on election season, so as it stands right now, these are rumors without any details and any implication on the market would be really just speculative at this point.

So it seems like there is a lot of uncertainty. Who knows if they're actually going to go through with this alleged plan to allow Fannie and Freddie to be in the public domain. The market is just not clear on anything.

Yeah, I mean I would say, if anything, the fact that they're talking about it leads me to believe that some plan will be released, but, you know, like anything, the devil's in the details.

Okay great, John. Thanks for those comments. Thanks, everyone, for listening out there. Join us next month for our next podcast. Thank you.


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