Weekly fixed income update highlights

• Treasuries, agencies, investment grade and high yield corporates, taxable munis, senior loans and emerging markets all had positive total returns.
• Municipal bond yields rose across the curve. New issue supply was $8.1B with outflows of -$534M. This week’s new issuance should be $3.5B.

U.S. Treasury yields rose again as U.S. economic growth remains strong and U.S. Federal Reserve Chair Powell delivered hawkish comments at the Jackson Hole conference. He emphasized that if economic growth remains strong, rates may need to increase further.

Watchlist

• 10-year U.S. Treasury yields were flat, but we anticipate modest declines over the course of 2023.
• Spread assets outperformed relative to Treasuries.
• Increased seasonal supply should provide an attractive entry point for municipal bonds.

Investment views

“Higher for longer” rates 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 business investment. This combination should keep corporate defaults low.

Treasury yields are likely to fall slightly this year, and we expect the 10-year Treasury yield to end 2023 around 3.35%.

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.

Emerging markets rally

U.S. Treasury yields rose last week, led by the front end. 10-year yields were essentially flat for the week, while 2-year yields rose 14 bps. Economic data were slightly weaker than expected, as the composite U.S. Purchasing Managers’ Index fell -1.6 pts in the preliminary August release. The move marked the third straight monthly decrease and the sharpest drop since last November. Nevertheless, a popular estimate of real-time economic growth from the Federal Reserve Bank of Atlanta moved even higher, to 5.9% quarter-over-quarter annualized growth for the third quarter. Separately, Fed Chair Powell leaned hawkish in his remarks at the Jackson Hole conference. He emphasized that if economic growth remains strong, rates may need to increase further. The market went from pricing around a 37% chance of another rate hike at the start of the week to a 62% chance on Friday after Powell spoke.

Investment grade corporates gained, rallying 0.61% for the week after four straight weeks of losses. The asset class outperformed similar-duration Treasuries by 41 bps. Issuance was very soft, at around $3.5 billion for the week, and this week’s calendar is expected to be equally light. However, activity is likely to pick up in September. Roughly $130 billion of new deals are expected to come to market, which would be about in-line with historical averages. Outflows from investment grade funds totaled -$984 million last week.

High yield corporates also advanced, returning 0.41% for the week and beating similar-duration Treasuries by 51 bps. Senior loans returned 0.27%. High yield funds saw elevated outflows of -$1.2 billion, while loan funds saw a marginal outflow of only -$42 million. The backdrop of strong economic growth and higher rates is supportive for both high yield and loans, thanks to their lower duration and elevated credit risk compared to core fixed income asset classes.

Emerging markets improved after recent underperformance, gaining 0.49% for the week and outpacing similar-duration Treasuries by 37 bps. The rally came despite continued sluggish growth data from China, where corporate profits were reported down -6.7% year-over-year in July. A survey of economists showed that consensus expectations for China’s full-year GDP growth have been marked down from 5.5% to 5.2% for this year.

Municipal bonds represent value

Municipal bond yields rose across the curve last week. Short-term rates ended the week 4 bps higher, while long-term yields rose 9 bps. Weekly new issuance was priced to sell and well received. Weekly fund flows were negative. This week’s new issue calendar is undersized heading into the U.S. Labor Day holiday.

Muni rates sold off because they are slightly rich to Treasuries. What’s driving that relationship? Not much municipal bond reinvestment money is left to put to work. Also, the new issue calendar is expected to heat up after Labor Day and should be outsized through the end of the year.

Muni yields may be challenged for the next few months, but we believe muni bonds still represent value. We would consider any outsized selloff a buying opportunity.

New York City Transitional Finance Authority (TFA) issued $1 billion in bonds (rated Aa1/AAA). The deal was priced to sell and so well received that underwriters lowered yields upon final pricing. For example, the 5% coupon 10-year bond was priced with a tax-exempt yield of 3.39%.

High yield municipal bond yields increased only 5 bps on average last week, continuing to cushion investors from more pronounced volatility in high grade munis and U.S. Treasuries. Even with the relative outperformance, investors remain attracted to higher yields. High yield munis saw inflows again last week. While the average yield of the Bloomberg High Yield Municipal Index stands at 5.93%, large inflows remain elusive for the asset class. As a result, total returns rely on excess yield premium and idiosyncratic credit selection. Deals are expected this week in sectors such as land-secured, charter schools, sales tax districts, higher education and health care.

Strong U.S. economic growth and higher rates support high yield corporates and senior loans.

In focus: Post-Covid municipal budgets remain resilient

As the summer wraps up and fall begins, many municipal governments will focus on budget and capital plans that will consider higher costs from inflation, waning federal funds and a slower U.S. economy.

Many state and local governments are planning for budget deficits, which means budgets will reflect lower revenues. For fiscal year 2024, state governments are expecting a 0.7% decline in stand-alone revenues, following double digit annual growth in collections in 2021 and 2022. Short-term Covid related federal funds will also be expiring.

Governments continue to have extraordinary financial flexibility, and fundamentals remain strong. They are prepared to balance budget deficits by reducing targeted expenditures. Average spending by states increased by an elevated 16.8% in 2022 due mostly to one-time Covid-related spending. States are estimating just a 2.5% increase in expenditures in FY24. Governments also have the flexibility to reduce other expenditures and increase revenues.

In addition, municipal governments’ rainy day funds, or savings/reserves, sit at historical highs. State governments are entering FY24 with $159 billion in rainy day funds, or more than double pre-pandemic levels, which offers significant budgetary flexibility.