Weekly Fixed Income Commentary: Treasury yields decline; markets await the Fed
Highlights
- Higher risk areas enjoyed the strongest returns, led by emerging markets and high yield corporates.
- Municipal bonds traded sideways, in line with U.S. Treasuries.
- The global aggregate sector outperformed the U.S., supported by strong returns in Europe.
U.S. Treasury rates declined modestly last week, led by 10-year maturities and followed by 5- and 2- year yields. Markets focused on deteriorating Brexit negotiations and mixed U.S. economic data. Markets expect no policy changes when the U.S. Federal Reserve (Fed) meets this week.
Treasury rates fall modestly
Treasury yields finished last week slightly lower for all maturities except the 30-year, which remained unchanged.1 After several shifts, Treasury yields closed Thursday nearly unchanged for the week.1 Friday’s move determined the week’s change, with a modest decline in rates.1 The 10-year Treasury led the way lower, followed by 5- and 2-year maturities.1 Additional supply of long Treasuries and weak demand supported 30-year Treasury yields, which did not fall in line with shorter maturities.1 Markets focused on the evolving Brexit negotiations and U.S. economic data. U.S. data showed resilient consumer and economic growth, but dominant themes included softer manufacturing and production, along with continued disappointing price readings.
Risk sentiment was positive last week, although it was not accompanied by rising Treasury yields as is usually the case. All fixed income sectors posted positive total returns for the week and outperformed similar-duration Treasuries.1 The higher risk areas enjoyed the strongest returns, led by emerging markets and high yield corporates.1 Preferred securities added to their market-leading 2019 performance, experiencing positive total returns in 10 of 11 weeks this year.1 The global aggregate sector outperformed the U.S., with strong returns in Europe overwhelming soft performance in Asia.1
Markets are not expecting a rate increase at this week’s Fed meeting. In fact, investors anticipate the Fed’s forecast will reflect fewer additional future hikes. Current market-based measures actually indicate more than a 30% probability of a rate cut in 2019. We believe this outlook is too aggressive and do not project a Fed rate cut, barring a significant deterioration in U.S. economic data.
Last week marked the eighth week of substantial and positive municipal bond fund flows.
The municipal market needs more supply
Municipal bonds traded sideways last week, in line with U.S. Treasuries, with both markets ending the week with firm tones.1 New issue supply totaled $6.3 billion and was readily absorbed.2 Fund flows were positive yet again, at $1.6 billion.3 This week’s supply is expected to be a meager $3.6 billion and should be readily absorbed.2
The municipal bond market continues to be driven by recent records in supply and demand. New issue supply is nearly 50% lower so far in 2019 than in 2013 through 2017. 2018 was an outlier, as the year began with overhang of $60+ billion issued in December 2017.4 Demand continues to be strong, with last week marking the eighth week of substantial and positive fund flows. The municipal market simply needs more supply to meet demand. Demand comes partially from individual tax payers feeling the effect of reduced deductions for state and local taxes (SALT) as they file their income taxes.
Lower Colorado River Authority, Texas issued $393 million transmission contract revenue bonds.5 Strong demand allowed underwriters to increase the par amount of the deal by $22 million bonds and lower yields by 3 to 7 basis points upon final pricing.
High yield municipal bond yields decreased in line with AAA-rated municipals last week.1 We believe credit spreads would likely tighten further if trading volume were sufficient to allow competition to price in actual demand for credit risk. High yield municipal fund flows totaled $387 million last week, building on already historically strong technical strength.3 In this market, access to supply is highly valuable and highly discriminatory.
Corporate credit and EM debt extend 2019 gains
High yield corporate bonds bounced back from a negative week.1 The asset class was among the top performers in the taxable space, bolstered by strong inflows, favorable equity market sentiment and light overall new issuance. High yield spreads narrowed, and more than $1 billion entered the space.1,2 There was little difference in returns across quality tiers, as BB, B and CCC rated securities performed essentially in lockstep.1
Investment grade corporates delivered positive returns for the ninth time in the past 11 weeks, and now lead all taxable sectors for the month of March.1 Investment grade fund flows exceeded $2 billion for the third consecutive week, indicating there is plenty of cash available to put to work.3 Spreads tightened modestly despite heavier-than-expected new supply ($28 billion from 19 issuers).1,2
BB, B and CCC rated securities performed essentially in lockstep.
Emerging markets (EM) improved on their already solid 2019 performance.1 Sovereign, corporate and local currency returns were supported as global growth concerns dissipated and the U.S. dollar weakened against nearly all EM currencies. Gains were led by the Argentine peso (+3%), reflecting central bank measures introduced to fight stubbornly high inflation in that country. EM bond funds denominated in hard currencies experienced their tenth straight week of inflows.
In focus: Preferred securities: looking up in 2019
Preferred securities have outperformed all other fixed income asset classes so far in 2019, after declining dramatically in the fourth quarter of 2018 and ending last year down -4.5%.1
We think outflows were the primary culprit last year, despite supportive supply and solid fundamentals. Banks, the sector’s biggest issuer, had generated back-to-back quarters of strong earnings and passed stress tests more stringent than during the financial crisis. From a supply standpoint, the U.S. preferred market shrank by about $8 billion last year. At the same time, by some measures the sector experienced the largest outflows on record in the fourth quarter.
Preferred performance has turned around in 2019, thanks to strong inflows and tightening credit spreads. We believe the rally still has legs.
Valuations remain attractive and technicals may provide a tailwind. Supply should remain light, as banks will likely need to raise little, if any, capital this year. As a result, supply could stay flat or even shrink, while demand remains robust.
Yields remain attractive, and we believe potential for price return remains. Although the sector returned -4.5% last year, the price return was -9.9% while income contributed +5.4%. In 2019, prices have recouped only a portion of that decline, returning 6.5%.1
1 Bloomberg L.P.
2 The Bond Buyer, 15 Mar 2019.
3 Lipper Fund Flows.
4 MMA Strategist, 11 Mar 2019.
5 Market Insight, MMA Research, 13 Mar 2019.