Weekly Fixed Income Commentary: Treasury yields rise, anticipating a Fed pause
Weekly fixed income update highlights
- Treasuries, agencies, investment grade and high yield corporates, taxable munis, preferreds and emerging markets all had negative total returns.
- Municipal bond yields increased. New issue supply was $12.3 billion and outflows totaled -$297M. This week’s new issuance is estimated at $9.5B.
The U.S. Treasury yield curve steepened as the U.S. Federal Reserve indicates a pause at the November meeting. The market has essentially priced out any chance of a November hike and is pricing in only a 20% likelihood of a December rate increase.
Watchlist
- The 10-year U.S. Treasury yield rose, but we anticipate modest declines in overall rates during the rest of 2023.
- Spread assets, except senior loans, underperformed versus Treasuries.
- Increased seasonal supply should provide an attractive entry point for municipal bonds.
Investment views
“Higher for longer” rates remains as a theme, as central banks battle 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 business investment. This combination should keep corporate defaults low.
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.
Key risks
- Inflation fails to moderate as expected, weighing on asset prices.
- Policymakers tighten too rapidly, undermining the global economic expansion.
- Geopolitical flare-ups intensify: China, Russia, Turkey, Iran and Israel.
Senior loans eke out a positive return
U.S. Treasury yields rose and the yield curve steepened last week. The front-end of the curve was mostly anchored, with the 2-year yield increasing 2 basis points (bps). 10- and 30-year yields rose the most, increasing 30 and 32 bps, respectively. The steepening was driven by the reversal of last week’s flight-toquality trade, strength of economic data and comments by Fed Chair Jerome Powell suggesting no rate hike at the November meeting. Several Fed members acknowledged that recent increases in longer-term interest rates should result in the tightening of financial conditions, negating the need for a near-term hike. The market has essentially priced out any chance of a November hike and is pricing in only a 20% likelihood of a December rate increase.
Investment grade corporates declined by -2.06% for the week. The asset class underperformed similar-duration Treasuries by -37 bps. Spreads widened by 6 bps and the index yield-to-worst rose to 6.37%. Last week’s new issuance totaled $25.5 billion, led by financials as they exited earnings season. Deals were about 3.2 times over-subscribed, on average, with narrow new issue concessions. Outflows returned at -$2.2 billion, driven entirely by mutual funds.
High yield corporates also declined, returning -1.17% for the week and underperforming similar-duration Treasuries by -62 bps. However, senior loans eked out a 0.02% positive return, making it the only asset class to post a positive total return last week. The high yield new issuance calendar was subdued, with high yield and senior loan issuance of $4 billion and $3 billion, respectively. High yield and senior loan outflows totaled -$1.9 billion and -$26 million, respectively.
Emerging markets declined, returning -1.22% last week but outperforming similar-duration Treasuries by 28 bps. Spreads compressed across hard currency sovereigns and corporates, with the investment grade components outperforming high yield. The new issue market was marginally weak and led by corporates, with just over $9.5 billion pricing. Emerging markets bond funds saw outflows of -$1.9 billion, driven by hard currency funds. Exchange-traded fund outflows eased marginally to -$627 million.
Municipal bond yields appear attractive
Municipal bond yields rose last week. New issue supply was priced to sell and fund flows were negative once again. This week’s new issue supply will need to be priced at very cheap levels for deals to clear the market.
The increase in yields is understandable. Muni new issue supply continues to be outsized. Traders are reluctant to stock many bonds because so many sponsors are executing billions of dollars of tax-loss swaps daily. While this choppy market should continue through the rest of the year, we believe investors should maintain exposure to tax-exempt bonds. Yields are 4% on the short end, nearly 5% in the intermediate range and up to 6% on the long end. The taxable-equivalent yields look even more attractive. And investors may continue to book tax losses where practical.
The Commonwealth of Massachusetts issued more than $1 billion of bonds in four tranches (rated Aa1/AA+). Bonds traded at a discount in the secondary market. For example, 10-year bonds priced with a 5% coupon came at a yield of 3.53%. Those bonds traded later at 3.64%, reflecting the general fixed selloff as the week progressed.
High yield municipal bond funds reported outflows of -$190 million last week, as the average yield for the Bloomberg High Yield Municipal Bond index increased 20 bps to 6.41%. We are tracking 10 high yield muni new issue deals this week totaling $1.7 billion, headlined by Chicago Board of Education and NY LaGuardia Delta. The secondary market remains well bid.
While the choppy muni bond market should continue, we believe investors should maintain exposure to tax-exempt bonds.
In focus: The 10-year Treasury yield defies gravity
After soaring 50 bps in September, the 10-year U.S. Treasury yield has jumped another 33 bps in October, to 4.92%, en route to its highest level since 2007.
Similar outsized moves took place in 2022, when inflation was rising sharply and the Fed was hiking rates. But inflation has cooled since then, and the Fed is proceeding cautiously. What’s behind the recent ascent?
U.S. economic data continues to top forecasts. Although households have exhausted nearly all of their pandemic savings, retail sales rose for the sixth straight month in September, fueled by increasing real wages (i.e., after inflation). And initial jobless claims, a proxy for layoffs, fell to a nine-month low last week, signaling further strength in the job market.
Also, a wave of long-term Treasury issuance has hit the market to fund an ever-growing federal deficit amid waning demand for Treasuries from the Fed, other central banks and foreign governments. All told, investors are now expecting a higher-for-longer interest rate environment.
Although headlines are sounding the alarm about the surging 10-year yield, we believe the security currently offers good value. It should provide sufficient income to outpace inflation. And if the economy and inflation slow as we expect, the 10-year yield should fall, boosting its price and offering the potential for capital appreciation.
Taxable equivalent yield represents the yield that must be earned on a fully taxable investment to equal the yield on a municipal investment on an after-tax basis.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 20 Oct 2023.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 18 Oct 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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