AAM Viewpoints – 2021 mid-year fixed income review
As the 2nd quarter (Q2) of 2021 came to an end, it’s estimated that 54% of Americans had at least one COVID-19 vaccine dose and we witnessed a robust economic reopening and higher inflation. The focus now seems to be on what the fixed income market might be telling us and the potential impact of the COVID-19 delta variant. Could the recent rally in Treasuries be technically driven by pension fund rebalancing, transitory inflation, short covering, or the lack of supply? One could argue any of these points so let’s start by looking back at the first half of 2021 which was a tale of two different markets.
During Q1 virtually all fixed income assets – except for high yield – were negative. The Bloomberg Barclays U.S. Aggregate Index (AGG) had its fourth worst quarter in history with a loss of 3.37%. Corporates were down 4.60% and Treasuries were down 4.25%. Q2, on the other hand, was the opposite with most asset classes posting positive returns as the AGG posted a 1.84% return led by Corporates at 3.55% and Treasuries up 1.75%, as many of the potential factors above came into play. Although we had robust growth in Q1 with GDP at 6.40% and expectations for Q2 are near 9.0%, concerns that this cycle may have already peaked, and the economy won’t do as well the rest of this year and next, are putting pressure on long-term rates. Despite a possible peak, we expect growth through the rest of this year will be strong when compared with pre-pandemic levels.
Source: AAM, Bloomberg Barclays Live data | Past performance is not indicative of future results.
The 10-year Treasury started the year yielding 0.916%, which was 100bps (basis points) lower than where it started 2020. The 10-year yield closed out the first half of 2021 with a yield of 1.469%, up 55bps. With a trailing 12-month return of -0.33% we continue to believe the asset class doesn’t offer a compelling value over the long term as yields remain at historically low levels. With the 10-year Treasury yielding 1.469% investors are earning only 16bps of yield per unit of duration.
The Treasury market was active in June with the curve flattening as yields in the 2-3-year bonds were 11-17bps higher while 30-year yields dropped 20bps. Meanwhile, as shown below, the real yield on the 10-year Treasury remains negative and finished June at -0.87%.
Global credit markets recently faced one of the worst weeks of the year after the selloff in risk assets. U.S. high-grade corporate bond yield premiums hit a 16-year low at the end of June.
In Q2 ICE Bank of America Merrill Lynch U.S. Corporate Bonds had total returns of 3.59% in maturities 7-10-year range and 2.14% in the 5-7-year range. However, the year-to-date returns remain negative at -1.36% and -0.46% respectively.
In Q2 the ICE BofA ML U.S. Corporate BBB Index returned 3.73% but has lost 0.38% on the year while A-rated bonds came in at 3.36 % in Q2 and lost 1.71% this year. The U.S. Corporate AA Index also lost 1.75% thus far in 2021 even after returning 3.74% in the quarter. As lower rated bonds have performed better this year, it’s important to select appropriate credits that offer relative value to their peers rather than blindly reaching for yield.
The Bloomberg Barclays Municipal Bond Index was down 0.35% in Q1 and posted a 1.42% gain in Q2 and is now up 4.17% over the trailing 12 months. The Municipal-to-Treasury ratio, a popular metric to measure relative value for tax-exempt debt, finished Q2 at 68% which was well below the 10-year average of 97% reflecting tax-exempt Municipals are expensive to Treasuries. Duration was rewarded in June as short-maturity yields ended June mostly higher while yields at the long end of the curve were slightly lower. The 1-3-year index was down slightly for the month.
Municipal funds recorded 17 consecutive weeks of inflow after adding $832 million in cash during the last week of June. Municipal exchange-traded funds (ETFs) also have had inflows of $5.8 billion in Q2 and $11 billion this year according to Bloomberg.
Municipal bond issuance of $223.6 billion year-to-date is 6.3% higher than $210.4 billion last year for the same period. This compares to the six-month average $195.6B from 2012-2021 ($192.4 billion from 2012-2020).
Source: AAM, The Bond Buyer data
The mountain of distressed debt outstanding which reached almost $1 trillion at the height of the pandemic has sunk to about $60 billion, according to Bloomberg. Bankruptcy court was also slow for corporations. The first half of 2021 saw the fewest large bankruptcies in the U.S. since 2018, according to data compiled by Bloomberg.
Moody’s reports the global trailing 12-month speculative default rate closed Q2 at 4.0% which was down from 4.9% at the end of May after peaking at 6.8% in December 2020. The expectation is for the global default rate to finish 2021 at 1.7%. The U.S. speculative default rate closed Q2 at 4.1% and was up from 5.5% in May and 7.3% a year ago. Moody’s forecasts the U.S. speculative grade default rate will finish 2021 at 1.6%. Well below the long-term average of 4.5%.
Source: AAM, Moody’s data
Spreads in U.S. Investment Grade (IG) continued to tighten in June as the IG index now sits at historically tight levels. IG Index spreads ended the month at 86bps and are 17bps tighter year-to-date. Longer-dated bonds rallied the most in June, with 7-10-year maturities tighter 8bps for the month and 17bps tighter year-to-date.
The ICE BofA ML U.S. Corporate BBB Option Adjusted Spread (OAS) is 107bps over Treasuries and the ICE BofA ML U.S. High Yield OAS is 304bps (see chart below). Both of which are roughly half where they were this time last year. As recently as June 2020 the spreads were 207bps and 644bps respectively. BBB spreads are 23bps tighter year-to-date while HY spreads are 82bps tighter this year.
The spread between the 30-year U.S. Treasury yield and the 5-year U.S. Treasury yield flattened from 128bps at the end of 2020 to 119bps on June 30. While the 30-year minus the 5-year curve is flatter by 9bps year-to-date, the 10-year minus 2-year is steeper by 42bps. The chart below shows reflects the steepening in 30s and 5s, 10s and 2s and 10s and 3-month Treasuries during the pandemic and the flattening this year.
The discussion of tapering will likely gather steam by the middle of Q3 and key topics of focus in the coming quarter will be inflation, the progress toward tax increases and potential impacts on growth and yields. Adding to the challenges in Q3 will be the concerns related to new variants around the globe. All of this continues to support the view that curve steepening should resume in Q3, but the pace is likely to be hampered compared to Q1.
The bond market also might have gotten ahead of itself on the reflation trade, since a hot U.S. economy doesn’t mean higher inflation is guaranteed. Also, long-term rates are down across many parts of the globe with approximately $13.393 trillion in global debt in negative territory at the end of Q2. This may be signaling concern that the pandemic may intensify again as the COVID-19 delta variant gains traction and vaccinations in much of the world are progressing slowly. The delta variant is now thought to be the dominant strain of the virus in the U.S.
Any improvement in the labor market remains important as we move past the large fiscal boosts in 2020 and 2021. We expected a good June jobs report and we got a good report. The weekly jobless claims data reached a new cycle low at 368,000 the last week of June along with surging job openings indicating continued strength. U.S. job openings rose to a record high in May, underscoring persistent hiring difficulties and reflecting more vacancies in the health care, education and hospitality industries. The number of available positions climbed to 9.21 million during the month from a downwardly revised 9.19 million in April according to the Labor Department’s Job Openings and Labor Turnover Survey. The number of people who voluntarily left their jobs decreased to a still high 3.6 million in May, as the quits rate dropped to 2.5%. The total number of vacancies exceeded hires by 3.28 million in May, the highest on records to 2000.
Regarding tapering, the Fed minutes revealed there was some discussion about reducing mortgage-backed security (MBS) purchases faster than Treasuries, but there was no consensus. The minutes didn’t show any heightened concern about inflation as policymakers expect pressures to ease after the transitory effects, mostly from supply-chain issues and the onetime reopening of the economy, begin to fade. The minutes did reveal some Fed officials commented on the link between low interest rates and the strength of the housing market. This could be a factor in the debate about MBS purchases but also could have some policymakers favoring an earlier rise in interest rates.
This environment presents both opportunities and risks for fixed income investors. We believe this is the time to understand where the risk lies in your fixed income portfolio. A professional management team with an experienced track record can help clients sleep at night during this stage of the cycle. Active managers will diversify portfolios across asset classes, sectors, maturities and tactically adjust duration as needed.
CRN: 2021-0708-9298 R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.