This analyst blog is part of our coverage of the 2018 Morningstar Investment Conference.
Investors in both investment-grade and high-yield corporate bonds were rewarded in 2016 and 2017, but 2018 has been a rougher ride. The Federal Reserve is hiking interest rates, and the yield on the 10-year U.S. Treasury is up close to half a percentage point since the beginning of the year. Meanwhile, the economy has enjoyed solid growth, company fundamentals remain relatively strong, and credit spreads look thin relative to history. This has led to a unique, challenging environment for many fixed-income investors.
Morningstar's Sarah Bush was joined by three experienced corporate bond-pickers at the Morningstar Investment Conference: Loomis Sayles' Elaine Stokes, PIMCO's Mohit Mittal, and Western Asset's Ryan Brist. The panelists discussed the state of the corporate bond market, how the firms were positioning their funds, and the potential impact of the growth of the BBB and bank loan markets.
Brist said Western Asset is more conservatively positioned today than it has been at any other time since the 2008 financial crisis. Their caution is driven primarily by the tight valuations in the corporate bond market, and they are generally positive on the fundamental and technical factors affecting the market.
Mittal said some of the recent weakness in bond prices has been the market adjusting to the ongoing removal of the Federal Reserve from the market, which will effectively increase the supply of bonds.
Stokes echoed that sentiment and mentioned that Loomis has been building a barbell into certain portfolios, holding a high level of cash that is offset by a slug of high-yield bonds. She noted that late in a credit cycle both high-yield and convertible bonds do well, but they offset the risk of those positions by holding a lot of cash.
All three managers are finding value in a handful of sectors, particularly energy and financials, that they believe are still in the recovery stages of their respective sell-offs (financials in 2008, energy in 2014-15) so they should hold up better during the next sell-off.
All three were also in agreement about the concerns they have in the market, specifically the growth of the BBB market and in covenant-light bank loans. They noted that all of the current lending is taking place in the lowest quality parts of the market, and that any future recession could have a significant negative impact on the corporate bond and bank loan markets. In particular, Brist said bank loan investors should expect lower recovery rates than the historical average. But all three were also positive about the opportunities for bond-picking that such an environment might lead to.