Weekly fixed income update highlights

• Treasuries, MBS, ABS, and investment grade and high yield corporates all had negative returns.

• Emerging markets, preferred securities and senior loans gained.

• Municipal bond yields remained essentially unchanged. New issue supply was $7.7B with outflows of -$102M. This week’s new issuance is expected to be $8.5B.

U.S. Treasury yields rose despite improved U.S. inflation data, as expectations for more persistent inflation picked up. Both headline and core prices rose at the lowest rates since 2021. However, survey data showed a worrying increase in consumer inflation expectations.

Watchlist

• U.S. Treasury yields rose slightly.

• Spread assets were mixed, despite the rise in rates.

• Increased seasonal supply should provide an attractive entry point for municipal bonds.

Investment views

“Higher for longer” remains 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.

Key risks

• 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.

Inflows continue for investment grade corporate bonds

U.S. Treasury yields moved higher again last week, despite positive U.S. inflation data that showed a further slowdown in price pressures. Headline inflation moderated to 4.9% year-over-year, while core prices rose 5.5%. Both were the lowest rates of increases since 2021. However, survey data released on Friday showed a worrying increase in consumer inflation expectations, with the 5- to 10-year expectation rising to match a 12-year high of 3.2%. That caused Treasury yields to ultimately end higher for the week, with the 10-year yield closing up 3 basis points (bps) at 3.47% and the two-year yield rising 7 bps.

Investment grade corporates weakened alongside the rise in rates, returning -0.18% for the week but still outperforming similar-duration Treasuries by 4 bps. Regional banks continued to be pressured, with spreads widening another 15 to 100 bps; larger money center banks were flat. The asset class experienced an inflow of $2.7 billion, extending the current streak of inflows to seven weeks. Supply was relatively heavy, with $35 billion of new issuance, and demand for those deals was strong. New issue concessions averaged only around 7 bps. Another $35 billion of issuance is expected this week.

High yield corporates were mixed, returning -0.05% but beating similar-duration Treasuries by 6 bps. The asset class is still down for the month (-63 bps excess return) but up for the year (108 bps). Loan funds returned 0.02% and are now up 4.0% for the year. New issue supply has continued to pick up, with $3.1 billion and $5.0 billion of issuance across bond and loan spaces, respectively. In a possible sign of improved health, more deals are financing leveraged buyouts and merger/acquisition activity, rather than just refinancing.

Emerging markets gained, returning 0.08% and outpacing similar-duration Treasuries by 26 bps. The rally came despite a -$737 million outflow from hard currency funds. Local funds had robust inflows of $375 million, though the local market asset class returned -0.58% as the dollar gained late in the week after the high inflation expectation data. Focus for the EM asset class is now on elections in Turkey and, to a lesser extent, Thailand, where opposition parties may make electoral gains.

Muni bond investors enjoy higher yields as the Fed battles inflation 

Municipal bond yields remained range bound last week. Fund flows were negative for the thirteenth consecutive week. However, municipal bond money market funds saw inflows of $1.9 billion, as investors capitalized on outsized short-term yields. This week’s new issue supply must be priced to sell to pique investor demand.

The Fed continues its battle against inflation, but the inverted Treasury yield curve suggests that investors believe the U.S. Federal Reserve will prevail. In the meantime, muni bond yields have risen significantly since the depths of the pandemic. 1-year rates hit a low of 0.05% in April of 2021 and now sit almost 300 basis points higher at 2.97%. Similarly, the 10-year muni yield of 0.58% in August 2020 has risen 173 basis points to 2.31%. We expect rates to remain range bound as we enter the summer months, and munis should remain well bid. Historically high reinvestment money remains available, and it appears the new issue calendar will remain muted (versus 2022) for the year.

Dormitory Authority State of New York issued $1.08 billion school districts bonds (rated Aa3/NR). Underwriters struggled with the deal, and balances remained when it was finalized. The deal included 5% coupon bonds due in 2033 that came at a yield of 2.62%. This yield is approximately 76% of the 10-year Treasury bond yield.

High yield municipals saw positive fund flows last week, with demand firming just in time for the seasonal summer technical strength. U.S. Steel brought one of the largest high yield municipal new issue deals last week, and it was several times oversubscribed. Little new issuance is expected this week. The diligence of high yield muni investors will be tested, as access to supply is becoming increasingly valuable.

Municipal bond money market funds saw inflows of $1.9 billion, as investors capitalized on outsized short-term yields.

In focus: Municipal tailwinds expected in the summer 

Municipal markets historically see net negative supply during the summer months, and this year’s forecast is expected to be meaningful.

We are approaching historically large reinvestment months in May, June and July, when most municipal bonds mature and pay coupons. While not all money gets reinvested, most investors put a significant portion back into the municipal market. As such, there is a considerable increase in demand during these months.

At the same time, issuance is marking its slowest rate in five years, with supply about $100 billion below forecast. Low issuance plus seasonal demand should exacerbate this net negative supply dynamic, with projections at -$76 billion in June, July and August¹.

Meanwhile, credit fundamentals remain strong. Municipalities have record levels of tax collections and cash on hand. Credit upgrades have been outpacing downgrades by nearly 3 to 1 based on full year 2022 data.

We believe this technical tailwind, combined with more supportive Fed policy, should lead to positive performance in the municipal market moving forward.