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In the second quarter, long-term rates fell to multiyear lows, lifting returns for high-duration, or more interest-rate sensitive, asset classes. With that said, we continue to see an environment especially attractive for high yield bonds and, to a lesser extent, leveraged loans. With corporate default levels low by historical standards, spreads still wide of early 2018 levels, and core interest rates at their current low levels, we see the return premium offered by the credit markets as an appealing option for income-starved investors.

Relative performance over the past three months was largely dictated by the level of interest rate sensitivity, as the 10-year U.S. Treasury yield fell approximately 50 bps over the course of Q2. Investment grade corporate bonds, with a duration over seven years, were the top performers, while floating rate loans lagged their fixed rate cohorts. While outperforming in Q2, core fixed income has been further pushed into a corner by declining interest rates. The Barclays Agg, a proxy for core fixed income, is becoming more and more reliant on price appreciation to boost returns as the index now yields just 2.50%.

We continue to view credit as attractive given the higher level of income, with a preference for high yield bonds over loans. With falling rates making it more difficult to find income, high yield bonds yield over 6%, with the possibility of spread compression to drive price gains. Corporate fundamentals, which ultimately drive the attractiveness of credit, continue to be fairly benign. High yield bond and loan default rates are currently 1.46% and 1.30%, respectively, both low by historical standards.

The path of rates has also driven a reversal in leveraged credit flows, as a flattening yield curve has altered investor preference. Investors have exchanged LIBOR-based floating rate loans for fixed rate high yield bonds. We see both as attractive, as spreads are still wide of early 2018 levels and corporate fundamentals remain solid. In the second half of 2019, we will be watching for signs of a business downturn that could impact the credit backdrop.

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