Fixed Income Third Quarter Outlook

PGIM Fixed Income shares key insights about the bond market in the third quarter of 2018.

September 11, 2018

Each quarter, PGIM Fixed Income publishes an outlook describing their views on the economy, as well as their expectations for sectors within the bond markets. Here’s where they see value (and where they don’t) in the coming quarter.

Q2 Showers to Bring More Rain or Flowers?

The markets struggled in Q2 as the fears on the trade and political fronts that emerged early in the year were realized in the quarter to varying degrees, while the long shadow of quantitative tightening continued to stretch across the markets. The trade conflicts started getting awkward at the G20, but then became real as U.S. barbs were met with tit-for-tat measures that are at risk of intensifying as Q3 begins. The results from the Italian elections in Q1 transformed into a market nightmare in Q2 as renegade parties entered a coalition with a platform that appeared to jeopardize Italy’s finances and its relationship with Europe. Meanwhile, emerging market developments, including elections in Turkey and Mexico, raised concerns about the potential rise in policy heterodoxy.  

Over the first half of 2018, these concerns fueled a continued widening of spreads from the tights of Q1, which may have gotten a bit ahead of fundamentals. However, after months of widening, spread product may offer reasonably good value. Fundamental and political risks may still loom, but in many cases, these may be more than priced in.

At a glance - PGIM Fixed Income sector views as of as of June 30, 2018

Sector

Outlook

Rationale

Municipal Bonds

Positive

Favorable technicals in Q3 could lead to outperformance versus Treasuries.

Emerging Market Debt

Positive but selective

EM policymakers have responded credibly to the recent market volatility, and hard currency assets have historically performed well during Fed hiking cycles and global market shocks. Local rates also appear to have overshot in many instances and present select opportunities. While U.S. dollar (USD) strength could continue, focusing on Emerging Market Foreign Exchange (EMFX) relative value—rather than the direction of the USD—may be the prudent strategy in the short run.

Structured Products

Positive but selective

Long-term positive on structured products at the top-of-the-capital structure, especially Collateralized Loan Obligations (CLOs) and Commercial Mortgage Backed Securities (CMBS), although spreads could widen modestly in the short run before stabilizing. We remain content to earn carry at current spreads. Negative on conduit CMBS mezzanine tranches as credit quality is unimpressive. Increasingly looking at financing trades, rather than exposure to underlying assets, amid tight spreads and high leverage demand.

Global Leveraged Finance

Positive but selective

Neutral on U.S. high yield as solid fundamentals and favorable technicals appear to be nearly priced in. Slightly more constructive on U.S. leveraged loans compared to U.S. high yield over the next 12 months, primarily due to greater downside protection. Moderately positive on European leveraged finance based on expectations for spreads to tighten modestly in the short and medium term with support from solid fundamentals, earnings growth, and decent European macro conditions.

Developed Market Rates

Opportunistic

We’re maintaining tactical positioning across several developed rate markets as they appear to be trading in tight ranges. We’re also implementing some later-cycle trades, such as a “curve cap” in the U.S.

Agency MBS

Neutral

Neutral versus rates, while remaining underweight versus other spread products. Prefer up-in-coupon positioning in both 30- and 15-year sectors to maximize carry. Still holders of seasoned pools given better prepayment behavior and better convexity.

IG Corporate Debt

Cautious

Cautious given increased downside risks even with wider spread levels, favorable fundamentals, and earnings growth momentum. Still favor U.S. money center banks. U.S. tax reform remains supportive.

The full PGIM Fixed Income Market Outlook PDF opens in a new window is available for financial professionals.

Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Commercial mortgage-backed securities (CMBS) are a type of mortgage-backed security backed by commercial mortgages rather than residential mortgages. They are composed of a variety of loans, each of which represents different property sizes and locations. These loans are pooled and are broken into tranches of risk that are sold to investors. High yield bonds, known as junk bonds, are subject to a high level of credit and market risk. International bonds are bonds issued by foreign corporations or foreign government agencies. Emerging market bonds are local currency bonds issued by emerging market governments. Emerging market countries may have unstable governments and/or economies that are subject to sudden changes. These changes may be magnified by the countries’ emergent financial markets, resulting in significant volatility to investments in these countries. Investment-grade corporate bonds are bonds with a credit rating of AAA to BBB as rated by Standard & Poor’s, or Aaa to Baa as rated by Moody’s. Mortgages refer to mortgage-backed securities (MBS), which are composed of a variety of residential mortgage loans, each of which represents different property sizes and locations. These loans are pooled and are broken into tranches of risk that are sold to investors. Collateralized loan obligations (CLOs) are securities backed by a pool of debt, often low-rated corporate loans. Municipal bonds are tax-exempt bonds with a maturity of at least one year, including state and local general obligation, revenue, insured, and pre-refunded bonds. Unlike other investment vehicles, U.S. government securities and U.S. Treasury bills are backed by the full faith and credit of the U.S. government, are less volatile than equity investments, and provide a guaranteed return of principal at maturity. Asset allocation and diversification do not assure a profit or protect against loss in declining markets. Past performance is no guarantee of future results.

The views expressed herein are those of PGIM Fixed Income investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. Neither Prudential Financial, its affiliates, nor their licensed sales professionals render tax or legal advice. Clients should consult with their attorney, accountant, and/or tax professional for advice concerning their particular situation. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy.

This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. Clients seeking information regarding their particular investment needs should contact a financial professional.

PGIM Fixed Income is a unit of PGIM, Inc. (PGIM), a registered investment advisor. PGIM is a Prudential Financial company. © 2018 Prudential Financial, Inc. and its related entities. PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.

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This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation about managing or investing your retirement savings. Clients seeking information regarding their particular investment needs should contact a financial professional.

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