In my recent blog on the impact of the tax reform, I explained why I believe the new tax law should be extremely supportive of the U.S. investment grade (IG) bond market, including provisions that could lead to reduced supply. Looking beyond IG, the news appears to look good for other fixed income sectors as well.
Opportunities in MLP hybrids
Master limited partnerships (MLPs) are, simply put, partnerships that are publicly traded on a national stock exchange. Most of them operate in the energy sector. After an extended period of equity underperformance, MLPs have recently begun issuing “hybrid” securities, which we find attractive in the current environment: Rating agencies can assign equity credit of 50% or more to these securities (depending on the security’s structure and the issuer’s credit rating). These issues typically pay a fixed coupon for five to 10 years before converting to a floating rate if not called. MLPs may not want to raise money via the sale of public equity units when prices are depressed, and tax reform has generally raised the cost of traditional debt issuance, so hybrids potentially offer these midstream companies (i) lower cost financing when compared to issuing new equity and (ii) enhanced ratings due to the equity credit mentioned above. At the same time, investors may have the opportunity to receive a higher yield than what may be available through senior debt.
The (still unloved) energy sector
Perhaps helped by the wintry weather over much of the U.S. (and low inventories), energy prices finally seem to have found some footing. For example, West Texas Intermediate has jumped about 10% in the past month and now exceeds $64 per barrel – near its three-year high.1 We believe there is still value in energy-related issues and are most enthusiastic about MLP pipeline operators within the space. While difficult to forecast, we think oil prices could soon stabilize and remain range-bound. Balance sheets of energy companies have also improved significantly over the past 18 months, increasing their ability to service debt, even with oil prices below $40.
Whole business securitizations
Recently, we have observed a new trend with companies that had previously raised funds via the high yield or unrated market. Rather than issue a junk bond and pay a higher coupon and associated fees, certain companies (restaurants in particular) are choosing to independently securitize their cash-generating revenue streams including franchise fees. This process may provide the company with the ability to issue bonds at lower rates or create investment grade bonds when they had not been able to previously. This type of asset-backed security is known as a “whole business” securitization. While this type of security is complex and is less liquid than a typical debt structure, we find these attractive because investors in these securities own the rights to a slice of a potentially valuable asset (like the franchise fees). We expect more of these deals in 2018.
Beaten-down retail companies offer opportunity
The recent holiday season was the best in years for retailers; many entered the period with low inventories and a leaner cost structure. According to a Mastercard SpendingPulse report released on December 26, U.S. retail spending was up 4.9% in 2017 compared to the previous year. Because we have not yet hit the equilibrium point on ecommerce versus brick and mortar, there may be more adjustments within the industry. However, we believe the fears of Amazon putting everyone out of business have been overblown. We see opportunities in beaten-down retail issues that have a dominant brand and market share.
Potential opportunity in high yield
There are three reasons why I believe BB-rated high yield bonds may represent a sweet spot in the market. First, many U.S. pension plans and insurers are restricted to investment grade bonds. With these large players shut out of the high yield market, demand for these instruments is reduced, which makes market prices far more reasonable. This increases the pool of possible investments and gives our research staff the opportunity to hunt for the most attractive issues available. Second, the ongoing economic recovery is improving corporate balance sheets, and we continue to see many sectors rebounding with the broader economy. In the high yield space, we see many higher quality bonds with the potential to be upgraded to investment grade within the next year. In such an event, these bonds could earn a considerable return from both appreciation and the higher coupon.2
Last, many of the sectors that took the brunt of credit downgrades during the recession have seen their fortunes improve.3 For example, homebuilders were severely downgraded.4 Since that time, U.S. demand for new homes has rebounded. I believe some BB-rated homebuilders could potentially be upgraded to investment grade.
Invesco Global Bond Fund
Invesco Global Bond Fund is designed to find opportunities across a variety of fixed income sectors. The strategy invests in a core, minimum allocation of 75% investment grade bonds and complements that with up to a 25% allocation to other areas of the market where we see growth potential. The examples above illustrate areas we are closely watching for opportunities. With U.S. tax reform creating a potentially positive environment for investment grade bonds, and growing opportunities in other areas of the market, the Invesco Global Bond team is bullish on the outlook for 2018.
