Weekly Fixed Income Commentary: Treasury yields rise as Fed downplays larger rate hikes
Weekly fixed income update highlights
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Total returns were negative across the board, with convertibles, taxable munis and preferreds registering the worst performance.
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Agencies, MBS, investment grade corporates and ABS outperformed Treasuries.
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Municipal bond yields rose across the curve. New issue supply was muted at $5.1B, with outflows of -$2.6B. This week’s new issue supply ticks up to $12.6B ($3.9B taxable).
U.S. Treasury yields rose again despite last week’s Federal Reserve meeting, at which the central bank hiked rates by 50 basis points. Markets priced in a higher likelihood that the Fed will end up further behind the curve in taming inflation. Risk assets continued to weaken.
Watchlist
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10-year Treasury yields rose again, and we expect them to remain around this level this year.
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Spread sectors were weaker amid elevated uncertainty.
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Municipal bonds appear attractive vs. Treasuries.
Investment views
Accommodative interest rate policy remains a key market support. While investors continue to focus on more hawkish Fed policy, overall rates are likely to remain relatively low even after several rate hikes.
The underlying growth outlook is healthy, as consumers have strong balance sheets, businesses are reinvesting and Covid recedes. This should keep defaults low.
Treasury yields are likely to rise this year, but we don’t expect the 10-year Treasury yield to rise much above 3%.
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 appear particularly attractive. Essential service municipal bonds also look compelling.
Key risks
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The Russia/Ukraine conflict continues to escalate.
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Inflation fails to decline as expected, negatively affecting asset values.
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Policymakers remove accommodation too rapidly, undermining the global economic expansion.
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COVID-19 cases increase, or new variants emerge.
Investment grade corporate technicals remain a headwind
U.S. Treasury yields rose last week, despite an initial rally after the Federal Reserve hiked rates 50 basis points (bps) as expected on Wednesday. Ultimately, the 10-year yield ended 19 bps higher, while the 2-year yield rose only 2 bps. Chair Powell seemingly removed the possibility of a future 75 bps hike, causing the front-end of the curve to rally. However, by signaling an unwillingness to hike more aggressively, markets priced in a higher likelihood that the Fed will end up further behind the curve, requiring even higher rates in the future to tame inflation. Separately, the April jobs report showed another healthy pace of job creation, a modest deceleration in average hourly earnings growth and a deterioration in the labor force participation rate. Overall, the report signaled a continued tightening labor market.
Investment grade corporates sold off, returning -1.32% for the week, but outperforming similar-duration Treasuries by 17 bps. Macro volatility dominated attention, with the asset class rallying post-FOMC before retracing to end the week lower. Technicals continue to be a headwind, with another large outflow of $5.4 billion. Supply decelerated somewhat, with only $20 billion of new deals pricing.
High yield corporates also returned -1.19%, but underperformed similar-duration Treasuries by -69 bps. Earnings generally have been positive, but names are getting especially punished for bad earnings reports, e.g. in the home building, retail and food-related sectors. CCCs underperformed notably, returning -1.66%. Loans saw a similar dynamic, returning -0.58%, where lower-quality also underperformed. Crossover accounts have reportedly been selling loans, given their recent outperformance, to fund withdrawals. Data released last week show that high yield accounts’ allocations to loans fell by -71 bps in the second quarter, the largest quarterly decline on record, to 3.5%, likely setting up a more positive technical backdrop ahead.
Emerging markets also weakened, returning -1.27% and underperforming similar-duration Treasuries by -7 bps. The asset class had an outflow of -$2.5 billion, and trading volumes were somewhat muted. Central bank moves also remain in focus. Poland hiked rates by 75 bps, less than expected. The curve steepened, as the market priced in risks of higher future inflation. In contrast, the Czech Republic also hiked rates 75 bps, which was more than expected, and the sovereign curve flattened.
The municipal bond market sells off, but remains orderly
Municipal bond yields rose once again last week across the yield curve. Short-term rates were 5 bps cheaper and 30-year rates were 12 bps cheaper by week’s end.
Although the Fed raised rates last week, investors are looking for the Fed to present more aggressive wording and actions to show its commitment to curtailing inflation.
The municipal market remains solid. The May 1 coupon of $38 billion has yet to be completely reinvested, credit concerns are mild and yields are nearly 100% of Treasuries. Although munis continue to weaken, the market remains orderly. Institutional money managers are using the selloff to reposition portfolios according to mandates.
The state of North Carolina issued $300 million limited obligation bonds (rated Aa1/AA+). The deal was priced to sell and was well received, as tax-exempt municipals are attractive. For example, a 10-year bond with a 5% coupon came at a yield of 3.04% and closed the week at 3.12%. This tax-exempt offering is almost 100% of the taxable 10-year Treasury bond yield.
High yield municipal bond outflows continued last week. While U.S. Treasury bond yields rose after the Fed meeting, high yield municipal yields were less volatile and relatively outperformed. The rate volatility caused some muni deals near the end of the week to be postponed, but it was nonetheless a light week for new issuance. This week is expected to be more active, with at least 18 high yield deals. In another sign of strong credit quality, Puerto Rico reported robust sales tax receipts in March, strengthening many of its credits. Investors can now buy GO and COFINA bonds at a 5% tax-exempt yield.
Intermediate municipal yields are roughly 100% of Treasuries, which is extremely attractive on a relative basis.
In focus: The Fed signals urgency
Last week’s meeting delivered plenty of action but few surprises. With inflation stuck at multi-decade highs, the Fed will employ a dual strategy to normalize monetary policy: raising interest rates more rapidly while shrinking its balance sheet.
As expected, the Fed lifted its policy target range by 50 bps, to 0.75% - 1.00% — double the 25 bps increase in March and the largest such move at a single meeting since 2000. Another 50 bps boost is a near-certainty at the Fed’s next gathering in June, but Chair Jerome Powell dismissed talk of any 75 bps hikes, even as markets have begun to price in that possibility.
In addition, the Fed announced it would start reducing its $9 trillion balance sheet in June. This process, known as quantitative tightening (QT), involves unwinding the asset purchases the Fed made in response to the pandemic over the past two years by allowing maturing assets to roll off without replacement. The amount of QT is scheduled to equal up to $60 billion/month of U.S. Treasuries and $35 billion/month of agency mortgage-backed securities, phased in over a few months.
The Fed is in a tough spot. Striking the right balance between lowering inflation and keeping the U.S. economic expansion intact will challenge both its policy acumen and its rhetorical powers as it seeks to achieve a “soft landing” for the economy.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 06 May 2022.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 04 May 2022.
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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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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