Bonds | Treasury Yields Report: Interest rate cuts could make these bonds an attractive target

Joy Wiltermuth

Bonds issued by home builders are signaling a pretty upbeat tone for the U.S. economy, even as U.S. recession fears linger.
Wage growth has been on the rise while borrowing costs have fallen, with the average 30-year fixed-rate mortgage plunging this week to a three-year low of 3.55%, helping to partially offset the affordability crunch for would-be homeowners. That all should be music to the ears of home builders, which operate cyclical businesses and often rely heavily on debt to construct homes for future buyers.
“Last year, home builders were under considerable pressure because of rates and affordability, which go hand and hand,” said Matthew Kennedy, head of corporate credit at Angel Oak Capital Advisors, in an interview Friday.
“But with Powell pivoting and rates starting to come down,” Kennedy said, “that was an impetus of change.”
Federal Reserve Chair Jerome Powell kept rates steady for the first half of 2019, while vowing to keep a close eye on signs of a potentially slowing U.S. economy. But as the U.S.-China trade war marched on, the central bank in July opted for a quarter percentage point “mid-cycle adjustment” to help support household and business confidence.
In a July report, Moody’s Investors Service said it expects the home-building industry to be stable with 2% to 4% top-line growth over the next 12 to 18 months, but with stronger revenue growth at home builders with a focus on entry-level homes and lower prices.
“Public companies that showed positive growth of above 5% during the first calendar quarter were generally the ones weighted more heavily toward affordable offerings, including Meritage Homes MTH, +2.69%, LGI Homes Inc.  LGIH, +1.37% and Century Communities Inc. CCS, +0.21%, ” wrote Moody’s analysts led by Natalia Gluschuk.
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Kennedy said he preferred the bonds of builders with a focus on affordability that can attract millennials and others looking for a starter home, or the next step up.
The high risks associated with home builders often land them in the high-yield, or “junk-bond,” category of corporate debt because new homes can sit on the market unsold when sentiment shifts.Like stocks, high-yield bonds also can be vulnerable to bouts of volatility and market shocks.
Friday housing data came out weaker than expected, showing that new-home sales in July fell almost 13%, but with a key caveat that June had a “ridiculously large revision” higher of its sales figure.
Yet, on Friday, the closely-tracked ICE BofAML U.S. High Yield Homebuilders & Real Estate index closed at $101.76 per share and held its 8.78% gain year-to-date, or better than the 6.97% gain of the broader ICE BofAML U.S. High Yield index, according to FactSet.
“You wouldn’t think this would be defensive,” Kennedy said of home builder bonds. “It is just that right now the consumer is very strong, household formation is picking up and affordability is easing.”
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Stephen Percoco, founder of Lark Research, said that Friday’s lower new-home sales report was unlikely to lead to volumes falling below his 6% annual growth target. Sales of new U.S. homes were still 4.3% higher in July than a year ago.
“This year is continuing at a real solid pace, which as long as the economy doesn’t fall back dramatically, the momentum in housing should continue,” the former Salomon Brothers junk-bond analyst, told MarketWatch in an interview.
“But we have to be cautious, because when certain sectors of the economy start slipping, eventually that will affect the consumer and housing will follow.”
Major U.S. stock indexes ended lower on Friday, with the Dow Jones Industrial Average DJIA, -0.11%  losing more than 600 points amid an intensifying U.S.-China trade war. The S&P 500 index SPX, +0.19%  shed almost 76 points after President Trump called for American firms to seek alternatives to China after Beijing imposed retaliatory tariffs