Weekly Fixed Income Commentary: Treasury yields remain steady in a quiet week
Highlights
- Preferred securities enjoyed the strongest returns, closely followed by senior loans.
- Municipal bonds traded sideways, but closed with a strong tone.
- Investment grade corporate bonds fared slightly better than their high yield counterparts.
U.S. Treasury yields fell slightly during in a holiday-shortened week. The biggest movement came on Tuesday, with a just over 3 basis points (bps) increase in the 10-year maturity, after stronger-than-expected data from China. The Federal Reserve (Fed) is still not committed to a specific path for interest rates, and the market is not expecting a hike in 2019.
Treasury rates fall slightly in a short, quiet week
U.S. Treasury rates were little changed last week, with yields on all maturities falling slightly.1 The most noteworthy development was a batch of stronger-than-expected economic data out of China prior to Wednesday’s session. However, even the much-watched Chinese data had little impact on U.S. Treasuries. The largest movement occurred when rates rose just over 3 basis points (bps) on Tuesday, led by the 10-year maturity.1 All maturities finished within 2 bps of where they began the holiday-shortened week, with the 30-year moving the most.1
All taxable sectors showed modestly positive total returns, except mortgage-backed securities and global aggregate.1 Preferred securities enjoyed the strongest returns, closely followed by senior loans.1 Not all risk sectors performed well, as high yield corporates underperformed similar-duration Treasuries and posted a lower total return.1 In non-U.S. markets, the prior week’s performance reversed and emerging markets outperformed developed regions.1 Negative returns in both Europe and Asia dragged down the global aggregate sector performance, and it suffered the lowest return across all fixed income.1
A Fed official commented that an additional rate increase was still possible this year. While there is no consensus about hiking rates, it does indicate that the Fed is not committed to a specific path of interest rate policy. Market-based measures are less balanced and currently reflect a 45% chance of a rate cut in 2019 with a 0% probability of a hike.
Unbalanced supply and demand tips the scale in favor of municipal bond performance.
Municipal market supply and demand imbalance continues
Municipal bonds traded sideways during the holiday-shortened week, but closed with a strong tone.1 New issue supply was just under $3 billion due to the holiday, and was readily absorbed.2 Weekly fund flows were positive for the 15th consecutive week at $421 million.3 This week’s new issue supply is expected to be only $5.3 billion and should be readily absorbed.2
The supply and demand equation continues to be the story in the municipal bond market. First quarter new issue supply was only $75 billion.2 Net supply was essentially zero, however, considering that approximately an equal amount of bonds matured or were called in the same time period.4 Yet the demand for tax-exempt income continues: First quarter fund flows were the strongest since 2009, collecting $27.9 billion.3 Unbalanced supply and demand tips the scale in favor of municipal bond performance. And the Fed continues to appear comfortable about the level of interest rates. We expect the trend to continue to favor tax-exempt bonds for the foreseeable future.
Cleveland Clinic Heath System Obligated Group issued $500 million of hospital revenue bonds (rated Aa2/AA).5 Cleveland Clinic is a world-renowned hospital group, and the deal was well received. Bonds were trading in the secondary market at a premium to where the deal sold in the primary market.
High yield municipal fund flows continued last week at a strong $350 million, bringing the year-to-date total to nearly $6 billion.3 The supply constraint continues, and the holiday muted supply even further. In this environment, a $612 million non-rated deal for Hunt Refining, a deal that required substantial independent credit research, was more than 10 times oversubscribed.4
Modest spread widening tempers high yield gains
The strong rally in high yield corporates slowed last week.1 Spreads widened for the first time in five weeks, and the asset class eked out a positive return after gaining more than 1% in the first half of April and north of 7% in the first quarter.1 High yield has delivered positive results for six weeks in a row and in 14 of the past 16.1
Dealer inventories have shrunk, amid strong demand for high yield, exacerbating spread tightening. Last week’s modest widening may be a sign of fatigue, in line with our view that the degree of recent spread compression is not sustainable. Historically, late spring and early summer are seasonally volatile for high yield, even in otherwise bullish years.
Investment grade corporate bonds fared slightly better than their high yield counterparts.1 Spreads were flat and total returns were in the middle of the pack among taxable fixed income sectors.1 Demand for BBB rated corporate credit (the lowest tier of investment grade quality) has surged, evidenced by sharply narrower spreads between BBB and BB securities (the top rating for high yield bonds).
High yield delivered positive results for six weeks in a row and 14 of the past 16.
U.S. dollar-denominated emerging markets (EM) debt outperformed both high yield and investment grade U.S. credit.1 Local currency EM returns lagged as the U.S. dollar strengthened.
In focus: Leverage differs among high yield issuers
Concerns over high yield market weakness seemed to be abating during the first quarter, as credit spreads tightened and performance rebounded. But the growing gap in debt ratios highlights the importance of security selection as the economic cycle continues to age.
Leverage levels for non-financial high yield issuers are generally flat-to-down since peaking in early 2016. However, by breaking the market down by credit rating, we see a growing disparity.
Higher quality issuers appear to be improving their balance sheets and, we believe, better positioning themselves for slower growth in the future.
Among lower-quality issuers (B and CCC), overall leverage has remained steady since early 2016. However, the bottom quartile of most indebted companies are nearly 40% more highly leveraged than they were in 2016.6 At the same time, the least-levered companies in this group reduced net debt ratios by nearly the same amount over that period.
In a market where debt levels are rising among the most highly leveraged companies, we believe fundamental security selection becomes more important to achieving investment goals.
Leverage is defined as net debt to EBITDA (earnings before interest, tax, depreciation and amortization).
1 Bloomberg L.P.
2 The Bond Buyer, 18 Apr 2019.
3 Lipper Fund Flows.
4 Long-term Bond Sales, Bond Buyer; Loop Capital, 14 Jan 2019.
5 Market Insight, MMA Research, 17 Apr 2019
6 U.S. HY: Leverage Metrics Across Sectors, Tiers, CreditSights, 4 Apr 2019.
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 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 ofthe 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%.