Fixed Income Asset Allocation

Transcription

1 Fixed Income Asset Allocation j a n n e y fixed income strat e g y While 2015 finished off with big spread widening in high yield, strong performance of our favorite sector, munis, overwhelmed losses in high yield. Introduction As we noted in 4Q 2015, the main driver of returns has shifted from interest rate moves to credit moves, which contributed to a negative return for credit sensitive sectors during the quarter. Janney s Moderate Fixed Income Asset Allocation posted a strong quarterly +1.1% return, easily beating Agg benchmark s negative return for 4Q for all of 2015, the Janney moderate allocation outperformed by +2.7%. In terms of duration, we recommend underweighting the 3 7 year part of the yield curve, a view first expressed in our Outlook 2016 note published at the beginning of December. We re still cautious on credit, especially high yield, as while there are pockets of opportunity, knock-on selling across the sector will likely pressure spreads for several months to come. Securitized sectors (RMBS/ABS/CMBS) continue to be a source of outperformance, as the incremental carry has exceeded the risk off selling. Moderate Allocation Outperformed Benchmark Over Last Twelve Months 0.90% 0.70% 0.50% 0.30% Bars indicate sources of over/underperformance of Moderate Allocation relative to the Aggregate bond markets Guy LeBas Chief Fixed Income Strategist glebas@janney.com See page 5 for important information regarding certifications, our ratings system as well as other disclaimers. 0.10% -0.10% -0.30% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% -1.00% Treasuries Agencies Mortgages IG Credit HY Credit ABS/CMBS Preferreds Munis Moderate Allocation Total Return Aggregate Bond Market Total Return 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q FI ASSET ALLOCATION PAGE % -3.00% Janney FISR Moderate FI Allocation Outperformed Aggregate by Cumulative +2.7% Over 12 Months Ended Dec -4.00% Source: Janney Fixed Income Strategy; Bloomberg

2 The credit cycle is still in its early phases, and while defaults will most likely be constrained to the commodities-sensitive names, spread widening will impact the entire sector. Current Worldview The fourth quarter of 2015 was an ugly one for the credit markets. While investment grade corporates managed to hold without too much spread widening, the higher quality sector nonetheless generated a negative total return. The real story, however, occurred in high yield credit. Continued low and falling energy (-18% on WTI crude on the quarter) and industrial metals (-8.3% on Bloomberg Commodities Industrial Metals sub-index) prices added to distress among commoditiessensitive high yield names. But unlike in prior quarters, the fundamental credit pressure spiraled more aggressively to other industries. The main mechanism was ETF outflows into a broadly illiquid market with limited dealer support. As ETFs and other funds faced outflows, they were forced to sell not only the problematic commodities-sensitive holdings, but also higher quality names in other industries as well. The net effect was a much broader high yield selloff in 4Q and a big underperformance of most other fixed income markets. Barely noticed against the high yield drama was a strong showing from the tax-exempt sector in the final three months of the calendar year. Muni to Treasury ratios compressed in the 10 year portion of the curve to as low as 87% at year end, down from 104% at the end of September. For a 10 year bond, that s the equivalent of 3.4% outperformance, while for the full tax-exempt sector, the +1.8% total return on the quarter trounced Treasuries -0.9% showing (and that s before accounting for the benefits of tax-exemption). The story with municipals is consistent with the historical experience heading into and during periods of Fed rate hikes, when muni to Treasury ratios have generally compressed. The mechanism here is likely more about supply expectations compressing, and demand increasing as private investors allocate away from credit with the turning credit cycle. When it comes to our Janney Fixed Income Asset Allocation s performance, the much stronger muni sector easily overwhelmed the much weaker high yield sector as a function of simple math the muni allocation at 30% accounted for more than four times the high yield allocation at 7%, leading to another quarter of strong performance for the allocation recommendations as a whole, and capping off a year in which Janney s Fixed Income Allocation beat the benchmark by fully +2.7%. Going forward, many of the themes that worked, relatively speaking, in 4Q 2015 are likely to persist. The high yield credit markets, and credit in general, appears to be in the early stages of a cyclical down turn. Credit cycles have a few phases, and we re in the first one, in which spreads widen as investors sell, but defaults are still few and far between. That initial phase typically lasts 6 12 months, after which defaults begin to rise (we expect defaults will be largely contained to energy and commodities-sensitive names). The high yield market bottom is typically found somewhere around the early to middle portion of the default phase, the exact point at which it s most painful to buy high yield. Given that said portion of the credit cycle is still some months into the future, we re recommending moderate and aggressive risk tolerance private client investors hold a smaller-thantypical portion of their portfolio in high yield. Similarly, munis performance record should persist, as we re in the early phases of the Fed rate hike cycle in which munis tend to outperform. Finally, while duration is unlikely to be as big a performance driver in the next year as is credit spreads and/or sector performance, we still recommend underweighting the 3 7 year portion of the yield curve. There s more about the thinking behind this recommendation in our Outlook 2016 presentation, however, the short version is as follows. While the long end of the yield curve is sensitive to the Fed s peak fed funds rate in the current cycle, the intermediate portion of the curve is more sensitive to the path the Fed takes to get to this peak. According to the FOMC s December statement and various accompanying policymaker comments, the primary contingency for this path is the short term evolution of PCE inflation. Still-low PCE means a slightly more gradual pace of rate hikes, while PCE gravitating back towards 2% more rapidly than markets expect could mean as many as six rate hikes in The last piece of the puzzle is that, statistically speaking, we as an economic society do not and cannot be confident in which way PCE inflation will trend in the short term. This uncertainty, not an outright negative opinion, is why we recommend avoiding the belly of the yield curve into this Fed rate hike cycle. FI ASSET ALLOCATION PAGE 2

3 Recommended Allocations Moderate (our core allocation; includes access to all fixed income asset classes with limitations on weightings reflective of an average risk tolerance) Treasuries (7%) Agencies (3%) Muni (IG 35%, HY 0%) MBS (10%) ABS/CMBS (15%) Preferreds (10%) Credit (IG 15%, HY 5%) We are increasing our muni portfolio weighting to its maximum, reflecting the strong historical experience of the sector during Fed rate hikes plus the ongoing value of the tax exemption. Aggressive (Expands limitations on asset class weightings, permitting more access to higher risk/higher return asset classes reflective of an above-average risk tolerance) Treasuries (5%) MBS (5%) Muni (IG 35%, HY 0%) ABS/CMBS (25%) Preferreds (5%) Credit (IG 15%, HY 10%) FI ASSET ALLOCATION PAGE 3

4 Conservative (Excludes access to below-investment grade and other higher risk/ higher return asset classes reflective of a below-average risk tolerance) Muni (IG 25%) Treasuries (12%) TIPS (6%) Agencies (20%) Credit (IG 17%) MBS (20%) Today s environment doesn t have any perfect corellaries, but the rate hikes plus early phases of credit deterioration have a good number of paralells. We believe in the power of backtesting investment strategies not as a tool to build them, but rather as a secondary confirmation that the strategy we ve built would have performed well in the environment for which it was designed. As noted in the Worldview section on page two, we re looking at a relatively stable, if historically low, interest rate environment on the long end of the curve, and rising short term rates. Couple that with a deteriorating credit environment, and the arguably best historical corollary is the period, which covers the peak of the tech bubble and a period in which the Fed hiked rates a handful of times. Unfortunately, fixed income performance data wasn t as granular in that timeframe, though we ve reconstructed sector performance for that year. Backtesting our fixed income allocation across a range of historical scenarios indicates that the portfolio performs as anticipated. With the greater allocation to illiquid assets than the benchmark, the allocation expectedly underperforms the broader bond markets in periods of liquidity stress, as denoted by the 2007 mini-credit crunch and the 2008 full blown Global Financial Crisis. Backtested Moderate Allocation Total Returns 10.00% 8.00% Moderate Allocation Returns Aggregate (Benchmark) 6.00% 4.00% 2.00% 0.00% -2.00% Liquidity Crisis Moderate Credit Detioration Source: Janney Fixed Income Strategy; Bloomberg Easy Credit Days Fed Rate Hikes FI ASSET ALLOCATION PAGE 4

5 Analyst Certification I, Guy LeBas, the Primarily Responsible Analyst for this report, hereby certifies that all of the views expressed in this report accurately reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. Definition of Outlooks Positive: Janney FIS believes there are apparent factors which point towards improving issuer or sector credit quality which may result in potential credit ratings upgrades Stable: Janney FIS believes there are factors which point towards stable issuer or sector credit quality which are unlikely to result in either potential credit ratings upgrades or downgrades. Cautious: Janney FIS believes there are factors which introduce the potential for declines in issuer or sector credit quality that may result in potential credit ratings downgrades. Negative: Janney FIS believes there are factors which point towards weakening in issuer credit quality that will likely result in credit ratings downgrades. Definition of Ratings Overweight: Janney FIS expects the target asset class or sector to outperform the comparable benchmark (below) in its asset class in terms of total return Marketweight: Janney FIS expects the target asset class or sector to perform in line with the comparable benchmark (below) in its asset class in terms of total return Underweight: Janney FIS expects the target asset class or sector to underperform the comparable benchmark (below) in its asset class in terms of total return Benchmarks Asset Classes: Janney FIS ratings for domestic fixed income asset classes including Treasuries, Agencies, Mortgages, Investment Grade Credit, High Yield Credit, and Municipals employ the Barclay s U.S. Aggregate Bond Market Index as a benchmark. Treasuries: Janney FIS ratings employ the Barclay s U.S. Treasury Index as a benchmark. Agencies: Janney FIS ratings employ the Barclay s U.S. Agency Index as a benchmark. Mortgages: Janney FIS ratings employ the Barclay s U.S. MBS Index as a benchmark. Investment Grade Credit: Janney FIS ratings employ the Barclay s U.S. Credit Index as a benchmark. High Yield Credit: Janney FIS ratings for employ Barclay s U.S. Corporate High Yield Index as a benchmark. Municipals: Janney FIS ratings employ the Barclay s Municipal Bond Index as a benchmark. Disclaimer Janney or its affiliates may from time to time have a proprietary position in the various debt obligations of the issuers mentioned in this publication. Unless otherwise noted, market data is from Bloomberg, Barclays, and Janney Fixed Income Strategy & Research (Janney FIS). This report is the intellectual property of Janney Montgomery Scott LLC (Janney) and may not be reproduced, distributed, or published by any person for any purpose without Janney s express prior written consent. This report has been prepared by Janney and is to be used for informational purposes only. In no event should it be construed as a solicitation or offer to purchase or sell a security. The information presented herein is taken from sources believed to be reliable, but is not guaranteed by Janney as to accuracy or completeness. Any issue named or rates mentioned are used for illustrative purposes only, and may not represent the specific features or securities available at a given time. Preliminary Official Statements, Final Official Statements, or Prospectuses for any new issues mentioned herein are available upon request. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, securities prices, market indexes, as well as operational or financial conditions of issuers or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. We have no obligation to tell you when opinions or information contained in Janney FIS publications change. Janney Fixed Income Strategy does not provide individually tailored investment advice and this document has been prepared without regard to the circumstances and objectives of those who receive it. The appropriateness of an investment or strategy will depend on an investor s circumstances and objectives. For investment advice specific to your individual situation, or for additional information on this or other topics, please contact your Janney Financial Consultant and/or your tax or legal advisor. FI ASSET ALLOCATION PAGE 5