Weekly Fixed Income Commentary: Strong economic data boost Treasury yields
Weekly fixed income update highlights
- Total returns were negative for all taxable fixed income sectors, except senior loans.
- A positive risk sentiment largely supported non-Treasury sectors, which delivered strong relative performance.
- Municipal bond yields declined dramatically. New issue supply was $4.9B, with inflows of $1.2B. This week’s new issue supply is $5.9B.
U.S. Treasury yields rose last week, reversing recent declines and dragging down total returns. Stronger economic data supported forecasts for a more aggressive U.S. Federal Reserve tightening cycle. The month of May was stronger for fixed income in general.
- 10-year Treasury yields rose, and we expect modest rate increases this year.
- Non-Treasury sectors delivered strong relative performance.
- Municipal bonds appear attractive vs. Treasuries.
Accommodative interest rate policy remains a key market support. While investors continue to focus on more hawkish Fed policy, overall rates are likely to remain relatively low even after several rate hikes.
The underlying growth outlook is healthy, as consumers have strong balance sheets, businesses are reinvesting and Covid recedes. This should keep defaults low.
Treasury yields are likely to rise this year, but we don’t expect the 10-year Treasury yield to rise much above 3%.
We favor a risk-on stance, focused on credits with durable free cash flow and solid balance sheets across a wide range of sectors. Mid-quality rating segments appear particularly attractive. Essential service municipal bonds also look compelling.
- The Russia/Ukraine conflict continues to escalate.
- Inflation fails to decline as expected, negatively affecting asset values.
- Policymakers remove accommodation too rapidly, undermining the global economic expansion.
- COVID-19 cases increase, or new variants emerge.
Senior loans show positive performance
U.S. Treasury yields rose last week, led by the 5-year maturity range. Rates reversed their recent declines, as stronger economic data supported forecasts for a more aggressive Fed tightening cycle. However, the jump in yields was not enough to offset the previous three weeks of declines. Maturities of 10 years and shorter ended lower for the month of May. This helped the Treasury sector deliver its first positive monthly total return since November.
Investment grade corporates benefited from an overall constructive tone, but rising yields dragged on total returns. The sector posted a weekly return of -0.85%, but outperformed similar-duration Treasuries by 31 basis points (bps). Despite last week’s decline, the sector produced its first positive month of the year in May, posting a total return of 0.93% and handily outpacing similar-duration Treasuries. Investors still appear to prefer higher-quality credits. Liquidity remains a challenge outside of new issuance, which was considerably lighter than expected in May.
High yield corporates followed investment grade, posting a negative total return of -0.34% last week and outperforming similar-duration Treasuries by 39 bps. Within high yield, bonds with longer duration and higher quality underperformed, while lower-quality CCC rated credits outperformed. High yield finished May with a modestly positive total return of 0.23% after jumping more than 3% in the final week, one of the strongest weeks in the last decade. Senior loans were the only sector showing a positive total return last week at 0.70%. However, the sector did not participate in the strong May monthly performance. It was one of the few sectors that declined during the month, at -2.51%.
Emerging markets similarly endured negative total returns of -0.43% for the week, but handily outperformed similar-duration Treasuries by 62 bps. Strong relative performance expanded beyond sovereign issues into high yield corporate bonds as well. Spreads in EM sovereigns tightened by 19 bps, offsetting a large portion of the rise in base yields. For May, the emerging markets sector fell slightly at -0.02% and underperformed similar-duration Treasuries by -38 bps.
Municipal bonds finish May with a positive return
Municipal bond yields declined dramatically last week. Short-term yields ended 10 bps lower and 30-year yields dropped 5 bps. Inflows totaled $1.2 billion, snapping 15 consecutive weeks of outflows, due to investor support following recent gains and outperformance relative to taxable bonds.
Municipal bonds have rallied 50 bps since their worst levels only a few weeks ago. Performance was so strong the final week of May that municipal bonds posted a positive return of 1.49% for the month. We expect this trend to continue for several reasons. Treasury yields appear range bound, and municipal bonds are relatively cheap versus Treasuries and on an absolute basis. Finally, and most important, supply and demand is expected to show a negative imbalance of -$33 billion for the summer. Reinvestment money is historically outsized during summer months, while new issuance is typically undersized.
Tampa, Florida, issued $298 million wastewater revenue bonds (rated Aaa/AAA). The deal was well received. For example, 5% coupon bonds with a 12-year maturity were priced with a yield of 2.60%.
High yield municipals also continued stabilizing last week, but the pace of performance leveled off after a rapid turnaround. Some high beta bonds are giving back some performance, as short-term trading accounts appear to be taking profits and bonds are transferring back into mutual fund ownership. Some bonds are up 40%+ since the turnaround on 18 May, so this is healthy for the market. Most of the market is still playing catch up, with average high yield municipal spreads roughly 25 bps wider since the turnaround. Summer is expected to produce significant net negative supply, fueled by heavy reinvestment, providing a strong technical backdrop to fuel a continued recovery and a fundamental realignment of relative valuations.
Municipal market inflows totaled $1.2 billion, snapping 15 consecutive weeks of outflows.
In focus: Muni bonds: an attractive entry point
Favorable bond valuations and higher yields, combined with strong credit fundamentals, are offering an attractive opportunity for municipal bonds.
Yields for 10-year AAA municipal bonds have more than doubled from one year ago, and it appears that U.S. Treasury yields may be settling into a new range. As such, municipal-to-Treasury ratios have risen sharply, with 30-year ratios reaching as high as 110%. Elevated ratios are often short-lived, but can offer compelling relative and absolute value. We have seen that rebound recently, with ratios now at approximately 90%. Municipal yields also dropped by almost 40 bps on average in May, suggesting that this window may be closing.
Credit fundamentals remain strong, with positive economic growth boosting tax revenues for municipalities to all-time highs. Rainy day funds and pension funding are at the healthiest levels in decades. High yield credit spreads have widened some after tightening significantly since the pandemic, after outflows created liquidity needs.
While there have been net outflows from municipal bonds funds, ETFs and a few state mutual funds have seen inflows since the beginning of the year. Inflows were a positive $1.2 billion last week, suggesting that investors are recognizing the opportunity.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 03 Jun 2022.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 01 Jun 2022.
Any reference to credit ratings refers to the highest rating given by one of the following national rating agencies: S&P, Moody’s or Fitch. Credit ratings are subject to change. AAA, AA, A and BBB are investment grade ratings; BB, B, CCC, CC, C and D are below-investment grade ratings.
Representative indexes: municipal: Bloomberg Municipal Index; high yield municipal: Bloomberg High Yield Municipal Index; short duration high yield municipal: S&P Short Duration Municipal Yield Index; taxable municipal: Bloomberg Taxable Municipal Bond Index; U.S. aggregate bond: Bloomberg U.S. Aggregate Bond Index; U.S. Treasury: Bloomberg U.S. Treasury Index; U.S. government related: Bloomberg U.S. Government-Related Index; U.S. corporate investment grade: Bloomberg U.S. Corporate Index; U.S. mortgage-backed securities; Bloomberg U.S. Mortgage-Backed Securities Index; U.S. commercial mortgage-backed securities: Bloomberg CMBS ERISA-Eligible Index; U.S. asset-backed securities: Bloomberg Asset-Backed Securities Index; preferred securities: ICE BofA U.S. All Capital Securities Index; high yield 2% issuer capped: Bloomberg High Yield 2% Issuer Capped Index; senior loans: Credit Suisse Leveraged Loan Index; global emerging markets: Bloomberg Emerging Market USD Aggregate Index; global aggregate: Bloomberg Global Aggregate Unhedged Index.
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A word on risk
Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. The value of convertible securities may decline in response to such factors as rising interest rates and fluctuations in the market price of the underlying securities. Senior loans are subject to loan settlement risk due to the lack of established settlement standards or remedies for failure to settle. These investments are subject to credit risk and potentially limited liquidity, as well as interest rate risk, currency risk, prepayment and extension risk, and inflation risk.
Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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