Weekly Fixed Income Commentary: Treasury yields decline in a positive week for fixed income
Weekly fixed income update highlights
- All major fixed income segments rallied, led by investment grade corporates, taxable munis, and convertibles. High yield corporates, preferreds and structured assets posted positive returns.
- Municipal bond prices finished higher. New issue supply was $7.2 billion, with robust flows of $1.5 billion. This week’s new issue supply is expected to be only $4.8 billion.
- Emerging markets outperformed, helped by the slightly weakening dollar.
U.S. Treasury yields fell slightly and the broad fixed income market performed well last week. The economic calendar was light, with core PCE price inflation slightly beating expectations at 3.1% year-over-year. But the market mostly overlooked this data and inflation breakevens ended the week flat.
- Treasury yields fell last week, but we continue to anticipate further increases throughout 2021
- Spread assets were well-supported versus Treasuries, and strong growth should continue to support fundamentals moving forward
- Municipal bonds are unlikely to remain so rich
Zero/negative global interest rate policy remains a key market support. Attention remains on the eventual tapering of purchases, but we do not expect that to happen any time soon.
Unprecedented global fiscal stimulus should boost consumption and growth this year. First quarter GDP rose at a robust 6.4% pace.
Record supply of investment grade corporates has been followed by issuance from high yield, middle market loans and the broadly syndicated loan market. Taxable municipal supply continues to grow.
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 remain particularly attractive. Essential service municipal credits also look compelling.
- Inflation rising in a disorderly way, forcing premature policy tightening.
- Further complications with the COVID-19 vaccine rollout.
- Geopolitical flare-ups: China, Russia, Turkey, Iran.
- Policymakers become cautious or run out of stimulus capacity.
Major fixed income segments rally
U.S. Treasury yields declined modestly last week. The Treasury auctioned 2-, 5- and 7-year notes, which were met with strong demand. Investors were focused on the large increase in use of the Federal Reserve’s reverse repo facility, which saw a record $495.3 billion uptake. As asset purchases continue, and the Treasury also runs down its cash balance, the level of reserves in the system has risen. This has pushed short-end interest rates lower and ultimately incentivizes banks to use the Fed’s zero-yielding facility rather than lend out their funds at negative rates. This dynamic does not have implications for fixed income beyond the shortest-yielding instruments.
Investment grade corporates rose last week, returning 0.55%, with spreads narrowing to their lowest levels since 2007. The asset class outperformed similar-duration Treasuries by 23 basis points (bps). After posting the worst quarterly performance since 1980 in the first quarter, investment grade corporates have rallied for two consecutive months. Fund flows totaled $911 million, continuing a multi-month streak of positive demand, but that was the smallest weekly inflow of the year.
High yield corporates performed well, returning 0.35% after lagging earlier in the month. The asset class saw similar excess returns as the high grade market, posting 22 bps of outperformance versus similar-duration Treasuries. May saw total issuance of around $47 billion, the busiest May ever, with energy providing around half of that total. Senior loans saw continued strong performance as well, posting 0.17% total returns.
Emerging markets gained, returning 0.44% and outperforming similar-duration Treasuries by 9 bps. Yields fell across the board, following the move in Treasuries, and spreads generally narrowed. The asset class also received a boost from currency dynamics. Even though the headline dollar index traded flat for the week, an index of emerging markets currencies gained 0.6%, with the Brazilian real (2.7%), South African rand (1.4%) and Colombian peso (1.1%) leading gains. The Chinese yuan broke through the closely-watched 6.40 per dollar level, taking it to its strongest level since 2018, possibly clearing the way for further EM currency appreciation in the months to come.
High yield municipals see accelerated inflows
Municipal bond prices finished higher, while U.S. Treasury bonds remained range bound.
Technical factors dominate the news in the municipal bond market. Supply is expected to be limited over the summer, with 30-day new issue supply at only $6.7 billion. Yet demand should remain robust, as reinvestment money totals $122 billion from June 1 to August 1. Municipals should remain well bid through the summer as long as Treasuries remain range bound.
Washington Metropolitan Area Transit Authority issued $788 million revenue green bonds (rated Aa/AA) Bonds traded at a premium in the secondary market. For example, 5% coupons issued at a yield of 1.27% traded in the secondary market at 1.25%. Note that green bonds are certified to be friendly to the environment. This designation on municipal bond issues is becoming increasingly more popular as investors want to invest in a socially responsible way.
High yield municipal bond yields decreased by 9 bps las week on average, 3 bps more than AAA yields. Inflows continued to accelerate at $814 million. This marked the fourth highest weekly flow of 2021, but in any other year it would have easily set a record. As a result, more than 20 high yield municipal new deals were heavily oversubscribed. We expect much lighter new issuance this week, which puts even greater focus on secondary market supply and should keep downward pressure on credit spreads. Credit spreads are now at +200 bps. With the current momentum, the market appears poised to usher in a sub-200 bps credit spread environment.
High yield corporates saw their busiest month of May ever, with total issuance of around $47 billion.
In focus: Summer appears strong for munis
The municipal market heads into the summer on strong fundamental and technical footing. We believe this combination of factors should support performance over the next few months.
On the fundamental side, revenues have fared better than originally projected at the onset of the pandemic, and they continue to improve as stimulus dollars sent to state and local governments work their way through the system. Reopenings will likely provide an additional boost to municipal credits. Traffic is building on toll roads, hospitals are operating at normal capacity, hotel occupancy is improving, TSA passenger check-ins are increasing and capacity at tourist destinations is expanding.
From the technical side, the summer typically sees lighter new issuance, and we expect this year to be no different. At the same time, demand remains robust. Maturities and coupons are especially heavy in July and August, and investors are considering the probability of higher future tax rates. We expect this outsized demand to continue outpacing the light summer supply, ultimately supporting tax-exempt municipal market performance.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 28 May 2021.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 26 May 2021.
Municipal reinvestment: JPMorgan.
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 Barclays Municipal Index; high yield municipal: Bloomberg Barclays High Yield Municipal Index; short duration high yield municipal: S&P Short Duration Municipal Yield Index; taxable municipal: Bloomberg Barclays Taxable Municipal Bond Index; U.S. aggregate bond: Bloomberg Barclays U.S. Aggregate Bond Index; U.S. Treasury: Bloomberg Barclays U.S. Treasury Index; U.S. government related: Bloomberg Barclays U.S. Government-Related Index; U.S. corporate investment grade: Bloomberg Barclays U.S. Corporate Index; U.S. mortgage-backed securities; Bloomberg Barclays U.S. Mortgage-Backed Securities Index; U.S. commercial mortgage-backed securities: Bloomberg Barclays CMBS ERISA-Eligible Index; U.S. asset-backed securities: Bloomberg Barclays Asset-Backed Securities Index; preferred securities: ICE BofA U.S. All Capital Securities Index; high yield 2% issuer capped: Bloomberg Barclays High Yield 2% Issuer Capped Index; senior loans: Credit Suisse Leveraged Loan Index; global emerging markets: Bloomberg Barclays Emerging Market USD Aggregate Index; global aggregate: Bloomberg Barclays 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.
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