A discussion on China’s ability to deliver solid economic growth in the coming months in order to prevent a further global slowdown in 2019 and beyond.
> High yield rebounded strongly in 1Q19, underscoring commentary that the Federal Reserve’s (Fed) last rate hike was an ill-timed misread of myriad underlying data, which in turn led spooked investors in passively managed strategies to overreact. With increased liquidity and wider spreads, the U.S. high-yield bond market, as measured by the BofA Merrill Lynch High Yield Cash Pay Index, rose 7.4% during 1Q19.
> Defying its critics, the U.S. leveraged loan market, as measured by the Credit Suisse Leveraged Loan Index, showed returns of 3.78%, marking the strongest first quarter in a decade, according to Credit Suisse.
> While high yield flows during the quarter were positive, the pace of retail outflows in the loan sector slowed.
After ending three years of gradual tightening, the Federal Reserve pivoted and signaled a more accommodative policy stance that helped investment grade spread product achieve healthy gains in the first quarter, led by BBB corporate issues. But a synchronized global slowdown increased the probability of a global recession and rate cut later in the year.
Robust demand for investment grade municipal bonds was largely driven by the cap on state and local tax (SALT) deductions under tax reform. As the muni yield curve flattened, many investors, particularly in high tax states, bought bonds with longer maturities and lower credit ratings, which in turn provided the best muni returns in the quarter.
Only a few managers in certain asset classes have been able to outperform index-replicating strategies on a net basis.
Despite significant outflows in recent months, leveraged loans is still one of the best risk-adjusted asset classes since 1992.
> A flight to quality and a widening of spreads hurt investment grade spread product in the fourth quarter, and more volatility is likely in 2019 as global liquidity declines despite new dovishness by the Federal Reserve and moderately stimulative policies in China.
> Investment grade municipal bonds benefited from turmoil in equities markets in the fourth quarter, and higher quality issues outperformed. For the year, returns were modestly positive as supply declined and a shrinking market provided some price support.
> The high yield market experienced a difficult fourth quarter in an environment in which global economic growth appeared to be slowing. Issuance continued to shrink during the quarter and outflows from mutual funds totaled -$20.2 billion. Fundamentals remained healthy, however, and defaults were low by historical standards.
> Leveraged loans experienced a significant sell-off in the fourth quarter, nearly offsetting the positive performance of the year’s first three quarters. Loan issuance for the year amounted to the second-highest on record, but it dropped off sharply in the fourth quarter as demand from mutual funds turned negative. Demand from CLOs, however, remained strong.
> Rising interest rates dampened total returns in the investment grade-taxable market in the third quarter as the yield curve continued to flatten. Volatility has returned to global markets and is likely to remain, given tightening global liquidity conditions.
> The investment grade municipal bond market continued to feel the effects of the 2017 tax law, as the elimination of advance refundings reduced supply, and banks and insurance companies continued to reduce their holdings, primarily at the long end of the curve.
> The high yield market advanced 2.44% during the quarter, according to the ICE BofAML High Yield Index, with CCC-rated issues leading. Despite some outflows from mutual funds, technical factors, on balance, provided support to the market, as issuance declined during the quarter and the market continued to shrink.
> The leveraged loan market posted positive returns for the quarter, gaining 2.00% and building on the previous two quarters. It was the strongest quarterly performance for loans since fourth quarter 2016. Gains occurred across all sectors, with Retail and Metals & Mining leading the way, and Diversified Media and Utilities lagging. There were no new defaults this quarter, signaling a reduction in forward looking projections.
> Rising short-term rates dampened total returns in the investment grade-taxable market in the second quarter as the yield curve continued to flatten. A flatter curve does not mean that recession is imminent, though so-called “synchronized global growth” appears to be at an end.
> The tax-exempt municipal bond market continues to digest the effects of the new tax law as banks and insurance companies became active sellers, and the elimination of advance refundings resulted in diminished supply.
The high yield market eked out a positive return in the second quarter while issuance continued to decline and flows to mutual funds and ETFs remained negative. Defaults remained about even with last year, at 2.06%, while credit quality continued to improve.
The leveraged loan market posted a return of 0.78% for the quarter, continuing the trend of the first quarter. Issuance continued to be robust, hitting the second-highest level on record, and demand remained strong.
2018 Volatility Regime Change
The dominant themes in the second half of the year continued to be the lack of volatility (stock and bond volatility plumbed to record lows) and a loosening of financial conditions, which allowed the Federal Reserve (the Fed) to continue to raise the federal funds target.
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