This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, in a specially commissioned piece for Morningstar's US Investing Week, MacKay Shields LLC, fixed income manager for Nordea, explains how yield spreads will provide a cushion against rising rates.
US investment grade and high yield markets have experienced a considerable degree of volatility in recent months – largely in response to non-economic developments.
Among other things, the US was on the brink of a military strike in Syria and there was continued turmoil in Washington as various factions debated the budget, the continuing resolution and the debt ceiling.
After much political wrangling, President Obama signed a bill to raise the debt ceiling and avert - or at least postpone - default. The resolution bill will fund the government until mid-January and the debt ceiling is suspended until February 7, at which time it will be reset. Treasury may have additional leeway to fund itself for a few months past the February deadline.
Thus, with the budget and debt ceiling debates likely tabled until early 2014, market participants turned their attention back to the topic of tapering, which has been a major headline since May.
We believe the Fed never actually committed to tapering, it simply tried to convey that tapering was a possibility should economic conditions warrant such a move. However, many market participants have complained that the Fed’s recent communication has been confusing. With few signals from policymakers on the timing of a reduction in asset purchases, Fed policy is somewhat unpredictable at this juncture. Supported by recent payroll data that disappointed expectations, surveys now suggest that consensus is building around a move in the New Year, most likely in March.
In the meantime, global financial markets continue to experience very strong liquidity with the Fed and the Bank of Japan both maintaining record levels of quantitative easing. This environment is highly supportive of risk assets.
Both US investment grade and high yield markets have recently seen spreads tighten over comparable duration US Treasuries. Assuming a gradual rise in rates, spread tightening is expected to somewhat exceed any near-term rise in Treasury rates.
In fact, yield spreads should provide a greater cushion against rising rates than is typically the case at this point in the cycle, resulting in a longer period of price stability. Additionally, we believe the default rate will remain within the range of 2%. At this time, there is no sector that gives us serious cause for concern.
We believe the US will continue to make progress on the path to sustainable growth as fiscal conditions ease and monetary policy remains highly accommodative. We maintain a favourable outlook for high yield and believe there is room for further spread tightening.
Corporate fundamentals remain solid, as balance sheets generally remain healthy and companies have refinanced near-term maturities at favourable rates, although leverage has begun to tick up in recent quarters. Technicals, which had been a headwind during the summer months, have become more supportive.
