Weekly Fixed Income Commentary: Treasury yield curve steepens amid risk-friendly sentiment
Highlights
- Emerging markets enjoyed the strongest weekly returns, followed by preferred securities and high yield corporates.
- Municipal yields declined on the long end of the curve, with a strong rally on Friday.
- Investment grade corporates posted their first loss after five consecutive weekly gains.
10- and 30-year Treasury yields rose last week while shorter maturity rates fell, steepening the Treasury yield curve.1 These moves were likely driven by heavy corporate bond issuance and shifting estimates of future purchases of Treasuries. The Federal Reserve (Fed) offered no surprises at its April meeting, but recommitted to supporting smooth market functioning.
Treasury yield curve reverses recent flattening
10- and 30-year U.S. Treasury yields rose and shorter maturity rates fell last week, steepening the yield curve.1 A steeper curve with higher long rates typically reflects greater confidence toward future growth and inflation. However, amid astoundingly weak economic data, this steepening was likely driven by heavy corporate bond issuance and shifting estimates of future Treasury purchases by the Fed. The week ended on a soft note when aggressive trade rhetoric from the Trump administration fueled a risk-off market tone, but overall market movements reflected risk-friendly sentiment.
April’s recovery in risk assets culminated with positive returns for the month.1 All sectors outperformed similar-duration Treasuries last week, and only investment grade corporates endured a negative total return.1 Although investment grade corporate spreads tightened, the sector’s long duration dragged total returns into negative territory.1 Emerging markets enjoyed the strongest weekly returns, followed by preferred securities and high yield corporates.1 April was a positive month for risk assets, with all sectors producing higher total returns than Treasuries and outpacing similar-duration Treasuries.1 Despite a strong month, all sectors still lag Treasury returns for the year.1
The Fed’s meeting produced no surprises, but noted the considerable risks for the U.S. economy over the medium term. It reinforced its commitment to support smooth market functioning through liquidity enhancing facilities, and differentiated these programs from true monetary policy accommodation.
April was a strong month for risk assets, with all sectors outpacing similar-duration Treasuries.
Municipal market receives fundamental support
Municipal yields ended the week lower on the long end of the curve, with a strong rally on Friday.1 New issuance was $8.9 billion and fund flows were negative at -$1.3 billion.2,3 This week’s new issue supply is expected to be $5.8 billion ($1.9 billion taxable).2
The municipal market is recovering after Senate Majority Leader Mitch McConnell recently commented that some municipalities should consider bankruptcy. Counter arguments highlighted the support for municipalities during this crisis, including House Speaker Nancy Pelosi’s hopes that Congress would appropriate $500 billion to aid the states. Additionally, investors were cheered by prospects that the federal government will buy almost all municipal credits through its Municipal Liquidity Facilities program, initially funded at $500 billion. Finally, Fed Chairman Powell pledged that the Fed will keep interest rates low until the U.S. economy “is solidly on the road to recovery.”
Power Authority of New York issued $1.1 billion tax-exempt bonds (rated Aa1/AA).4 The deal came midweek, amid high uncertainty in the municipal market. However, by week’s end the 4% maturity due in 2055 (which came at a yield of 3.22%) traded in the secondary market at 2.92%.
The high yield municipal market is much more stable than it was in March, but headline risk and general uncertainty continues to put pressure on fund flows and market performance. The market has experienced a steady weakening of performance after the mini recovery rally in the first week of April, responding to expectations of Fed intervention in the municipal market, which has yet to materialize. Fund flows totaled -$790 million last week, as negative macro level headlines stirred fears in an environment already uncertain over the revenue impacts of the coronavirus shutdown on issuers.3 However, market pricing is not recognizing the security features in place, and comprehensive credit analysis considered more than just revenue impacts.
High yield corporates and EM debt rebound
Emerging markets (EM) debt was the week’s top performer.1 A rebound in oil prices, coupled with month-end positioning, helped the asset class end April on an upbeat note. Both sovereign and corporate EM segments benefited from narrowing spreads, although EM bond fund flows (-$1.46 billion) were negative for the second straight week.3 Some aggressive measures by EM central banks drove yield-curve flattening in select markets, notably Hungary and Mexico.
High yield corporate bonds swung into positive territory after the previous week’s decline.1 The week’s main theme was month-end positioning, as high yield indexes finished recalibrating to accommodate the recent influx of fallen angels. Spreads tightened by 31 bps, led by areas that had widened the most in March, such as energy and gaming/ leisure.1 Fund flows were positive at $743 million, extending a five-week stretch that totaled $19.6 billion – recouping the $19.2 billion of outflows from the prior five weeks.3
High yield corporate fund flows were positive at $743 million, extending a five-week stretch.
Investment grade corporates posted their first loss after five consecutive weekly gains.1 Spreads tightened overall, led by big moves in the energy sector, while pharmaceuticals, retailers and real estate investment trust (REIT) spreads were unchanged to a few basis points wider.1 Inflows continued for the third week in a row, coming in at $2.25 billion.3 New supply remained steady, with $80 billion brought to market by 33 issuers, skewed heavily toward non-financial sectors.2
In focus: The Fed recaps its massive monetary stimulus
Since early March, the Fed has cut interest rates to zero, relaunched virtually all of its emergency stimulus programs from the financial crisis and implemented several new ones. At its April meeting, the Fed provided an update on these efforts to keep the U.S. financial system and economy afloat amid the coronavirus pandemic.
In addition to maintaining its fed funds policy range at 0% to 0.25%, the Fed reinforced plans to continue its bazooka of large-scale asset-purchase programs and lending facilities.
The Fed added a new sentence to its policy statement, describing the public health crisis as posing risks to the economic outlook over the “medium term” – likely one to two years. This outlook hints strongly that the Fed believes it will still need to guide the economy when the country reopens, presumably over the next few months.
In his post-meeting press conference, Chair Jerome Powell indicated that interest rates would remain at or near zero “for a good while.” He also continued to emphasize that the Fed’s current role is to help keep financial markets functioning and minimize the economic damage. Powell also made clear that he believes expansive fiscal stimulus – not monetary policy – is the most effective way to fill the economic hole. And that hole is big: U.S. GDP contracted at a -4.8% annualized rate in the first quarter.
1 Bloomberg L.P
2 The Bond Buyer, 1 May 2020.
3 Lipper Fund Flows.
4 Market Insight, MMA Research, 29 Apr 2020.
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.
Bloomberg Barclays Municipal Index covers the USD-denominated tax-exempt bond market. Bloomberg Barclays High Yield Municipal Index covers the USD-denominated, below investment grade tax-exempt bond market. S&P Short Duration Municipal Yield Index tracks the municipal bond market with maturities from 1 to 12 years. Bloomberg Barclays Taxable Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term taxable bond market. Bloomberg Barclays U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market. Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury. Bloomberg Barclays U.S. Government-Related Index includes debt guaranteed, owned and sponsored by the U.S. government; it does not include debt directly issued by the U.S. government. Bloomberg Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable corporate bond market. Bloomberg Barclays U.S. Mortgage-Backed Securities Index is the MBS component of the U.S. Aggregate index and includes the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). Bloomberg Barclays CMBS ERISA-Eligible Index is the CMBS component of the U.S. Aggregate index and includes CMBS investment grade securities that are ERISA eligible under the underwriter’s exemption. Bloomberg Barclays Asset-Backed Securities Index is the ABS component of the U.S. Aggregate index and includes credit and charge cards, autos and utilities. ICE BofA Merrill Lynch U.S. All Capital Securities Index is a subset of the BofA Merrill Lynch U.S. Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities. Bloomberg Barclays High Yield 2% Issuer Capped Index measures the market of USD-denominated, non-investment grade bonds and limits each issue to 2% of the index. The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. Loans are added to the index if they qualify according to the following criteria: The highest Moody’s/S&P ratings are Ba1/BBB+, only funded term loans are included, and the tenor must be at least one year. Bloomberg Barclays Emerging Market USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. Bloomberg Barclays Global Aggregate Unhedged Index measures the performance of global bonds. It includes government, securitized and corporate sectors and does not hedge currency. One basis point equals .01%, or 100 basis points equal 1%.
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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