Weekly fixed income update highlights

• Treasuries, MBS and ABS had positive total returns.

• Investment grade and high yield corporates, preferreds, senior loans and emerging markets all weakened.

• Municipal bond yields remained essentially unchanged. New issue supply was $6.3B with outflows of -$846M. This week’s new issuance is expected to be $7.9B.

U.S. Treasury yields rose after the U.S. Federal Reserve hiked interest rates for what should be the final time of this tightening cycle. U.S. economic data were mostly positive, including a strong employment report and improving manufacturing data.

Watchlist

• U.S. Treasury yields rose slightly.

• Spread assets weakened on continued banking sector stress.

• 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.

High yield corporates hit a technical headwind

U.S. Treasury yields rose last week and the curve steepened. The 10-year yield rose 2 basis points (bps), while the 2-year yield fell -9 bps. The Fed raised interest rates by 25 bps as expected and signaled that it is likely finished hiking for now. U.S. economic data were mostly positive, with the unemployment rate falling back to 3.4% in the latest jobs report. The ISM manufacturing survey rose 0.8 pts as well, though it remained in contractionary territory at 47.1.

Investment grade corporates weakened, returning -0.59% for the week and lagging similar-duration Treasuries by -58 bps. Spreads widened 10 bps, their worst performance since mid-March at the peak of the banking stress. Spread levels for the index reached 146 bps, also the highest since they peaked in mid-March around 163 bps. Financials led the weakness, with small regional bank bonds falling -10 to -30 points in price. Larger regional spreads were 30 to 50 bps wider, and money center banks were 20 bps wider. Given the banking weakness, preferred securities sold off, returning -3.29% for the weak and underperforming similar-duration Treasuries by -346 bps. Despite the negative price action, investment grade funds had inflows of $3.4 billion.

High yield corporates declined, returning -0.38% for the week and lagging similar-duration Treasuries by -69 bps. Unlike the investment grade market, high yield was affected by a technical headwind of -$1.6 billion in outflows for the week. Loan funds saw outflows of -$374 million, with the asset class returning -0.11%. Both markets had relatively large issuance, with $5.7 billion in the high yield market and $4.9 billion in loans. Both were largely dominated by refinancing deals.

Emerging markets outperformed other risk assets but still ended lower, returning -0.02% for the week to underperform similar-duration Treasuries by -12 bps. Hard currency sovereign spreads widened 3 bps, with high yield outperforming slightly as Tunisia and Argentina both rallied 1.5 pts in price. Outflows eased, but continued, with -$146 million exiting hard currency funds.

Municipals look to benefit from positive technicals

Municipal bond yields were essentially unchanged last week. This is positive news in the face of another Fed rate hike and a strong U.S. employment report. New issuance was priced to sell and well received. Municipal bond mutual funds have shown outflows for 12 consecutive weeks, but it should be noted that exchange-traded funds have experienced positive flows for the year. This week’s new issue supply should be well received.

Many investors are concerned that the strength of U.S. employment will lead to continued inflation. However, the Fed maintains its resolve to continue fighting until inflation declines to the Fed’s target rate of 2%.

Fixed income in general remains well bid as investors believe the Fed will bring inflation under control. Municipal bonds also remain well bid. Heavy reinvestment money is coming due throughout the summer and new issuance is expected to remain muted throughout 2023.

Energy Northwest (state of Washington) issued $509 million electric revenue bonds (rated Aa2/AA-). The deal included 5% coupon bonds due in 2038 that came at a yield of 3.23%. Those bonds traded in the secondary market at 3.10%.

High yield municipal bond yields declined on average last week, and credit spreads tightened slightly as a result. The inversion of the high yield municipal credit spread curve is slowly normalizing. The pace of outflows continues to taper, and soon the market will be fed with large reinvestment cash flows in June, July and August. Rate volatility has been stabilizing, and this is allowing high yield munis to produce positive total returns with greater consistency. Performance should be supported with the Fed seemingly on pause and a summer of technical strength.

Municipal bond reinvestment money is soon coming due, and new issuance should remain muted throughout 2023.

In focus: Will the Fed shelve its hiking boots?

As expected, the U.S. Federal Reserve raised interest rates by 25 bps last week, taking the target range for its policy rate to 5.00%-5.25%.

In its policy statement, the Fed signaled an imminent end to this aggressive tightening cycle that began in March 2022. It no longer “anticipates that some additional policy firming may be appropriate,” instead saying that it will “closely monitor incoming information.”

During his post-meeting press conference, however, Chair Jerome Powell leaned slightly hawkish. While noting that the Fed is “prepared to do more” if needed and will assess incoming data on a meeting-bymeeting basis, Powell also implied that more rate hikes may be warranted if inflation remains persistently high and banks don’t tighten lending standards as anticipated.

Markets ignored Powell’s message, continuing to price in nearly three full rate cuts over the balance of 2023, with zero additional hikes from current levels. When asked about the disconnect between Fed rhetoric and market pricing, Powell stated that, based on the Fed’s projections, rate cuts aren’t appropriate.

In our view, the Fed is done tightening for now. We expect the central bank to keep policy rates unchanged for the next several meetings, with a small chance of cuts in the fourth quarter.