Weekly Fixed Income Commentary: Treasury yields fall, awaiting a last Fed hike
Weekly fixed income update highlights
- Treasuries, agencies, investment grade and high yield corporates, MBS, taxable munis, emerging markets and senior loans all enjoyed positive total returns.
- Preferreds securities was the only major asset class with negative returns, though it still ended April with the best performance.
- Municipal bond yields remained essentially unchanged. New issue supply was $8.5B with outflows of -$92M. This week’s new issuance is expected to be $6.5B.
U.S. Treasury yields fell amid mixed U.S. economic data ahead of this week’s U.S. Federal Reserve meeting. We expect the Fed to raise interest rates by 25 basis points, in likely its final move of this tightening cycle.
- U.S. Treasury yields fell sharply.
- Spread assets gained, but generally lagged Treasuries.
- Increased seasonal supply should provide an attractive entry point for municipal bonds.
“Higher for longer” emerges as a theme, as the Fed battles to control inflation. Higher interest rates are likely to cause additional volatility.
The underlying growth outlook remains healthy, thanks to strong consumer balance sheets and solid levels of businesses investment. This combination should keep corporate defaults low.
Treasury yields are likely to fall this year, and we expect the 10-year Treasury yield to end 2023 around 3.25%.
We favor selectively taking on risk in this environment of attractive prices and yields. Credit selection is key as we search for bonds with favorable income and solid fundamentals.
- Inflation fails to moderate as expected, weighing on asset prices.
- Policymakers tighten too rapidly, undermining the global economic expansion.
- Geopolitical flare-ups: China, Russia, Turkey, Iran.
Investment grade inflows continue
U.S. Treasury yields fell sharply last week, with 10-year yields down -15 basis points (bps) to 3.43%. 2-year yields fell even more, dropping -18 bps. The moves came amid soft industrial survey data pointing to weaker U.S. economic growth ahead. However, the housing market appears to be rebounding, with home prices rising by the most in nine months and new home sales increasing the most in seven months. First quarter GDP data surprised to the downside, mainly due to a drawdown in inventories; actual underlying spending increased. Additionally, inflation data came in slightly hotter than expected. Overall, the U.S. economic outlook looks better than feared, but still highly uncertain. We expect the Fed to raise rates by 25 bps this week, in likely its final move of the tightening cycle. However, rates could move further if inflation and labor market data continue to surprise to the upside. Next week, we also get the April jobs report on Friday.
Investment grade corporates rebounded, returning 0.87% for the week, though they lagged similar-duration Treasuries by -15 bps. The market experienced its fifth straight weekly inflow, with $2 billion entering the asset class, while supply was in line with expectations at around $17 billion. For April overall, supply was -22% lower than expected, at $62.2 billion. In May, that is expected to change, with most banks penciling in around $135 billion of supply for the month. Preferred returns were poor after a recent strong run, returning -0.24% for the week but still 1.51% in April, the best major fixed income asset class.
High yield corporates rallied, returning 0.49% for the week, though they also underperformed similarduration Treasuries by -15 bps. Senior loans eked out a gain of 0.06%, despite the fall in rates and another outflow of -$717 million. High yield funds had inflows of $594 million. In both markets, earnings dominated attention and drove idiosyncratic price action. Overall, first quarter results have been better than expected.
Emerging markets returned 0.72% and lagged similar-duration Treasuries by -18 bps. In both corporate and sovereign markets, investment grade names outperformed high yield. Colombia was a notable laggard, with spreads widening 35 bps after President Petro shook up his cabinet and appointed a new finance minister. Across the EM asset class, outflows returned, with -$539 million exiting hard currency funds and -$94 million leaving local currency funds.
Municipal bonds should remain well bid
Municipal bond yields remained essentially unchanged last week. New issuance was generally well received, but some balances remained. Fund flows were negative yet again. This week’s new issue supply will need to be priced to sell to clear the market.
All eyes will be on the Fed this week, as it is expected to raise rates an additional 25 bps to the 5.00% – 5.25% range. The Fed maintains that hikes will continue until U.S. inflation declines to 2%. Most investors are pleased with the Fed’s progress and commitment. Thus, long-term rates are lower than the fed funds rate. We see a potential opportunity to lock in rates longer out on the curve, as these rates will not likely be this cheap by year’s end.
Municipal bonds should remain well bid. We are approaching historically large reinvestment months in May, June and July, with muted new issue supply.
The state of Wisconsin issued $495 million general obligation refunding bonds (rated Aa1/AA+). The deal included 5% coupon bonds due in 2033 that came at a yield of 2.57%. This yield is roughly 73% of the 10-year U.S. Treasury bond, rich by historical standards.
High yield municipal bond yields declined slightly last week, ending April only modestly higher compared to larger increases in high grade yields. High yield muni credit spreads tightened slightly on average, and even more so for short-duration high yield, suggesting the credit spread curve inversion is beginning to normalize. High yield municipal spreads ended the month at 256 bps for 20-year bonds versus 304 bps for 7-year bonds. The pace of outflows tapered by month-end. New issuance should be light this week, but soon the market will be fed with large reinvestment cash flows in June, July and August. May 1 cash flows will likely also have a positive impact on demand.
Earnings dominated attention and drove idiosyncratic price action in both the high yield corporate and senior loan markets.
In focus: Banks report encouraging earnings
Most banks have released first quarter earnings, which were of particular interest to credit markets in the wake of the March banking crisis. Overall, the results have been encouraging.
While deposits are lower across both the global systemically important banks (GSIBs) and regional banks, the decline was generally modest for most institutions, and banks remain well capitalized. First Republic Bank was an outlier, and was placed into FDIC receivership early Monday morning. JP Morgan has acquired the bank’s deposits, loans and securities, but will not assume the debt and preferred securities.
Bank earnings and profitability metrics were generally better than expected. However, net interest margins will likely be under pressure, particularly among regional banks that may have to pay up to retain and/or attract deposits.
Commercial real estate (CRE) exposure continues to be an area of focus, but we believe that stress within this space is more likely to be an earnings event. We don’t expect it to materially impact capital levels.
With the bank earnings season mostly in the rearview mirror, GSIBs have recently issued senior debt after a long, quiet period during the March banking crisis. New issuance has been well received with limited concessions.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 28 Apr 2023.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 26 Apr 2023.
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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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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