Report authors wrote that fiscal stimulus in the U.S. will probably be slow in coming or limited in duration. The underlying fundamentals that have been bullish for bonds still remain. PGIM thinks that global rates are likely to remain relatively stable or even drop a bit over the coming quarters. This applies to U.S. rates, but also global yield as well, which PGIM expects with compress against the 10 year Treasury. Falling rates does not imply a Fed move, it just means more demand for U.S. government bonds, pushing up bond prices, of course, and eating into yield.
Corporate tax reform, recently proposed by the White House, could provide a boost to the corporate sector later this year, PGIM analysts believe. In addition to lower corporate tax rates, the repatriation of up to $2 trillion of offshore profits may lead to reduced issuance, particularly in the technology and pharmaceutical sectors, and potential selling in short-maturity bonds. Limiting the deductibility of interest expense could also incentivize companies to reduce future borrowing in favor of equity financing.
PGIM is overweight BBB-rated, long-maturity U.S. corporate bonds given the steeper spread curve over the 10 year, and high pension funding contributions. The idea is that better yield in this space could lead to increased demand for longer-maturity bonds, flattening the curve out a bit, and give investors holding those bonds now some extra total return.
They are underweight A-and-higher rated corporate bonds due to “event risk”, such as a failure to redo the Affordable Care Act. Right now, their favorite industries for the second quarter include electric utilities, and, select pharmaceutical companies, which they did not disclose in the report.
On the muni-bond side, they like taxable municipals and riskier bonds with shorter-maturity dates.
“We think U.S. corporate bonds spreads tighten in the coming quarter,” report authors wrote, adding there was “little to no risk of a U.S. recession” and saw on-going investor demand, including foreign investors putting money to work here.
PGIM also likes emerging market bonds. But which ones? Dollar denominated or local currency?
Investors have pumped roughly $22.9 billion into emerging market bonds this year, according to PGIM, with about $15.2 billion going into dollar (or euro) bonds and $7.7 billion going into local currency bonds.
PGIM expects a “significant amount of cash flow to be reinvested into the asset class” in the second quarter.
Risks include U.S. trade policy like a NAFTA scrap, circulating around the Washington rumor mill yesterday, China’s credit bubble and commodity pricing impacts on the big natural resource giants that issue bonds.
Regarding the politics of populism in Europe, the momentum may be fading if Emmanuel Macron is elected president of France on May 7. Still, PGIM says that even on the back of lower oil prices and the Fed’s decision to hike rates in March, emerging markets are in a “sweet spot”.
Some broader trades for the aforementioned sections include the iShares JP Morgan USD Emerging Market Bond (EMB 115.26 -0.10 -0.09%) fund and the much smaller iShares Emerging Market Local Currency Bond (LEMB 47.60 -0.32 -0.67%) fund. The local currency bond ETF is up 6.8% this year as of Wednesday’s close, with EMB trailing by 300 basis points and the iShares 10-Year Treasury bond (IEF 107.55 +0.38 +0.35%) ETF up 1.5%, tracking the spread differential pretty close.
The Vanguard Long-Term Corporate Bond (VCLT 93.37 +0.06 +0.06%) is another way into the corporate bond space. It holds some non-U.S. debt however, priced in dollars. Its biggest holdings include GE Capital, Anheuser Busch InBev and Goldman Sachs. The fund rose 10.78% last year and is up 1.31% year-to-date.