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In my recent blog on the impact of tax reform, I explained why I believe the new tax law should be extremely supportive of the US 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 US (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 Dec. 26, US 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 yieldbonds may represent a sweet spot in the market. First, many US 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.
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, US demand for new homes has rebounded. I believe some BB-rated homebuilders could potentially be upgraded to investment grade.
Invesco Core Plus Bond Fund
Invesco Core Plus Bond Fund is designed to find opportunities across a variety of fixed income sectors. The strategy invests in a core allocation of 80% investment grade bonds and complements that with a 20% allocation to other areas of the market where we see growth potential. The examples above illustrate areas we are closely watching for opportunities. With tax reform creating a potentially positive environment for US investment grade bonds, and growing opportunities in other areas of the market, the Invesco Core Plus Bond team is bullish on the outlook for 2018.
1 Source: Bloomberg, L.P., “Oil rises from 3-year high after US stockpiles seen plunging,” Grant Smith, Jan. 10, 2018.
2 Source: Bloomberg, L.P.; examples include Domino’s Pizza, Inc., Dunkin Donuts, Jimmy John’s Sandwiches and The Wendy’s Company, data as of Jan. 31, 2018. As of Dec. 31, 2017, these issues represented 0.23%, 0.75%, 0.59% and 0.47% of Invesco Core Plus Fund assets, respectively.
3 Source: Invesco Ltd., sector examples include energy, building materials, homebuilders, construction, home furnishings and leisure travel.
4 Source: Invesco Ltd.
Blog header image: Frank L Junior/Shutterstock.com
Franchise fees are periodic payments (either fixed or variable in size) that are made by a franchise operator to the franchise parent company.
Securitization is the process of pooling one or more contractual debt instruments and selling their related cash flows to third party investors as securities.
Asset-backed securities are notes backed by financial assets, such as credit card receivables, auto loans and home equity loans.
Past performance is not a guarantee of future results.
Securities and holdings mentioned are for educational purposes only and are not buy or sell recommendations.
Most master limited partnerships (MLPs) operate in the energy sector and are subject to the risks generally applicable to companies in that sector, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk. MLPs are also subject to the risk that regulatory or legislative changes could eliminate the tax benefits enjoyed by MLPs, which could have a negative impact on the after-tax income available for distribution by the MLPs and/or the value of the portfolio’s investments.
Although the characteristics of MLPs closely resemble a traditional limited partnership, a major difference is that MLPs may trade on a public exchange or in the over-the-counter market. Although this provides a certain amount of liquidity, MLP interests may be less liquid and subject to more abrupt or erratic price movements than conventional publicly traded securities. The risks of investing in an MLP are similar to those of investing in a partnership and include more flexible governance structures, which could result in less protection for investors than investments in a corporation. MLPs are generally considered interest-rate-sensitive investments. During periods of interest rate volatility, these investments may not provide attractive returns.
Most senior loans are made to corporations with below-investment grade credit ratings and are subject to significant credit, valuation and liquidity risk. The value of the collateral securing a loan may not be sufficient to cover the amount owed, may be found invalid or may be used to pay other outstanding obligations of the borrower under applicable law. There is also the risk that the collateral may be difficult to liquidate, or that a majority of the collateral may be illiquid.
Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply-and-demand for energy resources. Short-term volatility in energy prices may cause share price fluctuations.
Energy infrastructure MLPs are subject to a variety of industry-specific risk factors that may adversely affect their business or operations, including those due to commodity production, volumes, commodity prices, weather conditions, terrorist attacks, etc. They are also subject to significant federal, state and local government regulation.
Mortgage- and asset-backed securities are subject to prepayment or call risk, which is the risk that the borrower’s payments may be received earlier or later than expected due to changes in prepayment rates on underlying loans. Securities may be prepaid at a price less than the original purchase value.
Junk bonds involve a greater risk of default or price changes due to changes in the issuer’s credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods.
Fixed income investments are subject to credit risk of the issuer and the effects of changing interest rates.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Invesco Core Plus Bond Fund risks:
The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Derivatives may be more volatile and less liquid than traditional investments and are subject to market, interest rate, credit, leverage, counterparty and management risks. An investment in a derivative could lose more than the cash amount invested.
The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the fund.
Matt Brill, CFA
Senior Portfolio Manager
Matt Brill is a Senior Portfolio Manager for Invesco Fixed Income. He is responsible for implementing investment grade credit strategies across the fixed income platform.
Prior to joining Invesco in 2013, Mr. Brill was a portfolio manager and vice president at ING Investment Management, where he specialized in investment grade credit and commercial mortgage-backed securities. Prior to that he was a portfolio analyst at Wells Real Estate Funds. He entered the industry in 2002.
Mr. Brill earned a BA degree in economics at Washington and Lee University. He is a Chartered Financial Analyst® (CFA) charterholder.