Weekly Fixed Income Commentary: Treasury yields decline over growth concerns
Weekly fixed income update highlights
- Total returns were positive for Treasuries, agencies, MBS, CMBS, ABS, taxable munis and investment grade corporates.
- Returns were negative for higher-risk asset classes, including high yield corporates, convertibles, preferreds and loans.
- Municipal bond yields rose slightly across the curve. New issue supply was $12.6B, with outflows of -$2.4B. This week’s new issue supply is manageable at $8.1B.
U.S. Treasury yields declined for the first time in six weeks. The move boosted total returns across fixed income markets, though spreads generally widened.
- 10-year Treasury yields declined, but we expect them to move modestly higher this year.
- Spread sectors were weaker amid elevated uncertainty.
- 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.
Investment grade corporates snap sell off streak
U.S. Treasury yields declined sharply last week, with the 10-year yield dropping -21 bps to 2.92%. The move came despite another upside surprise to U.S. consumer price inflation, which showed a 0.6% month-over-month core price increase in April. However, inflation is now decelerating year-over-year. Headline prices rose 8.3% versus a year ago, down from 8.5% in March. The market is now pivoting from worries about inflation to concerns about growth. Two-year yields fell -15 bps, flattening the curve, as the market removed around 11 bps of expected Fed rate hikes for this calendar year.
Investment grade corporates benefited from the rally in Treasuries, gaining 0.60% for the week and snapping a streak of five straight weekly selloffs. Yields for the index fell -8 bps, but spreads widened 7 bps, causing the asset class to underperform similar-duration Treasuries by -52 bps. The asset class benefited from a slower growth in supply, which is now running lower than year-ago levels, after approximately $21 billion priced for the week. For May, the market has seen around $40 billion of new supply, significantly less than the $65 billion expected through the first two weeks of the month. Concessions remain elevated at around 13 bps, as the market continues struggling to digest new issuance.
High yield corporates underperformed, returning -1.21% last week and underperforming similar-duration Treasuries by -192 bps. Spreads widened 50 bps, the biggest move since June 2020, marking significant decompression versus investment grade corporates. Within high yield, the same dynamic dominated, with BBs widening 30 bps compared to CCCs at 102 bps. Higher-quality segments tend to be longer-duration, so they benefited more from the rally in Treasuries. Loans also weakened, returning -1.63%, for their worst week since March 2020.
Emerging markets weakened slightly, returning -0.36% and underperforming similar-duration Treasuries by -138 bps. Under the surface, the asset class exhibited the same decompression dynamics as other fixed income markets, with high yield spreads widening 58 bps versus a more modest move of 6 bps for investment grade. Core European markets rallied alongside Treasuries, with 10-year German bund yields down -18 bps. Periphery spreads tightened somewhat after widening over the last several weeks.
Municipal bonds offer value versus Treasuries
Municipal bond yields sold off slightly last week across the curve, mainly due to outsized new issue supply and mutual fund redemptions. Short-term rates rose 4 bps and 30-year rates rose 15 bps.
The 10-year U.S. Treasury bond recently hit a four-year high of 3.13 %, but closed the week at 2.92%. Fed Chair Powell has suggested several more 50 bps rate hikes this year, and investors believe the Fed may be getting a better handle on inflation.
Heavy outflows continued across all municipal bond funds. But munis still offer value, with municipal-to-Treasury yield ratios nearing 110%. Credit quality remains strong, but substantial credit spread dispersion opportunities exist due to liquidity pressure. For those with a long-term fundamental view and cash on hand, this may be an attractive entry point for municipal credit risk. Outsized reinvestment money is expected in the next few months that should keep municipal bonds well bid – $44 billion on June 1 and $48 billion on July 1.
Dormitory State of New York (DASNY) issued $820 million Northwell Health Obligated Group revenue bonds (rated A3/A-). Demand for higher yielding tax-exempt bonds continues, and some bonds traded at a premium in the secondary market. For example, a 30-year bond with a 4.25% coupon came at a yield of 4.81%, then traded in the secondary market at 4.75%.
High yield corporate spreads widened 50 bps, the biggest move since June 2020.
In focus: Asset classes differ on odds of recession
Inflation is decelerating year-over-year for the first time since last summer, Treasuries rallied and lower-quality spreads widened further. As a result, attention seems to be pivoting away from inflation and toward recession.
With elevated volatility across markets, asset classes are signaling different risks of recession. We use models that convert current asset prices into ISM-equivalent growth readings. They presently indicate that equities discount an ISM of around 49, credit spreads around 53 and Treasuries around 63. For context, the current ISM manufacturing survey sits at 55.4, a very healthy level. Put differently, equities are implying a roughly 75% chance of a significant growth slowdown, while credit spreads imply only a 26% chance. Treasury yields, which have been rising and steepening lately, signal a near-zero chance of a sharp slowdown.
Clearly, these divergent signals cannot all be correct. Our base case remains for healthy growth this year and next, making current risk asset valuations appear increasingly attractive. High yield spreads, which currently imply a modest slowdown in economic growth, also price in a forward default rate of around 4.5%. The recent default rate has been sub-1%, and even after the recession in 2020 it peaked at 6.3%.
Even if the economy slows and defaults pick up, we believe current valuations are pricing in a more severe outcome and will likely generate positive total returns moving forward.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 13 May 2022.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 11 May 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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