Weekly Fixed Income Commentary: Treasury yields rise on strong inflation data
Weekly fixed income update highlights
- Total returns came in negative across all fixed income sectors.
- A negative risk sentiment weighed on non-Treasury sectors, and credit spreads widened.
- Municipal bond yields sold off. New issue supply was muted at $5.3B, with outflows of -$2.1B. This week’s new issue supply is $3.4B.
U.S. Treasury yields jumped last week, led by a dramatic spike in short-term rates, pulling total returns into negative territory. A surprisingly strong CPI report pushed credit spreads wider. All eyes are on the U.S. Federal Reserve as it meets this week.
Watchlist
- 10-year Treasury yields rose, and we expect modest rate increases this year.
- Credit sectors delivered weak relative performance.
- Net-negative supply should provide some support to municipal bonds.
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
- The Russia/Ukraine conflict continues to escalate.
- Inflation fails to decline as expected, negatively affecting asset values.
- Policymakers remove accommodation too rapidly, undermining the global economic expansion.
- COVID-19 cases increase, or new variants emerge.
High yield corporates languish
Treasury yields rose last week led by a dramatic spike in short-term rates. Yields jumped on Friday after a stronger-than-expected consumer price report caused investors to increase expectations for Fed rate hikes. Market-based expectations for the year-end fed funds policy rate increased more than 32 bps on Friday, and now reflect a policy rate of nearly 3.25% by December 2022. Longer-maturity Treasury yields had already risen by Friday, as they followed European rates higher early in the week. The yield curve flattened, as the 2-year Treasury yield increased a remarkable 41 bps while the 10- and 30-year maturities rose 22 and 11 bps, respectively.
Investment grade corporates struggled as yields rose and spreads widened. Spreads were subdued early in the week, despite heavy new issuance of $30 billion compressed into the first half of the week. However, the tone softened into Friday’s CPI release. The sector’s total return was negative at -1.79%, and underperformed similar-duration Treasuries by -43 bps. Year-to-date issuance totals about $680 billion, and fund outflows continued for the 15th consecutive week.
High yield corporates languished under a general risk-off broader market tone as recession fears grew. Retail and food/beverage were the hardest hit sectors, as investors worked to reduce inflation-linked credits. High yield posted a negative weekly total return of -2.32% and lagged similar-duration Treasuries by more than -121 bps. The new issue market has picked up materially from May. About $2.35 billion priced last week, bringing the June total to $8 billion, compared to $4 billion for the month of May. The loan market also ended the week on a softer tone, with a modestly negative total return of -0.02%. In the first sizable new issue week since mid-April, five new deals priced totaling more than $8 billion.
Emerging markets bonds declined across the board. High yield bore the brunt of the pain, as spreads moved wider. The global EM index fell -1.74% for the week and underperformed similar-duration Treasuries by more than -36 bps. EM local markets were under pressure by the increase in core rates and U.S. dollar strength, which pushed yields much higher across most local markets.
Municipal bond yields should remain range bound
Municipal bond yields sold off by week’s end. Although short term rates remained unchanged, 30- year yields rose 29 bps by week’s end. The new issue calendar was muted, and dealers struggled to get deals done. Fund flows turned negative once again. This week’s new issue calendar will have to be priced cheap to pique investor interest.
Investors are again concerned that the Fed is behind the curve. The market continues to discount the Fed’s lack of resolve, so Treasury rates may continue to experience volatility.
The municipal bond sell off makes sense, given that Treasury yields rose so dramatically. However, tax-exempt bonds are no longer cheap relative to Treasuries. Thus, deals will need to be attractively priced to lure buyers. We believe municipal yields should remain range bound for the summer with less supply and money returning to the market via reinvestment.
The state of Maryland issued $262 million general obligation bonds (rated Aaa/AAA) on Wednesday. Large balances remained in the deal by the end of the day. The deal included 5% bonds due in 2033 that came at a yield of 2.63%, then traded later in the week at 2.72%. This deal reflects how interest rates in general continued to sell off all week.
High yield municipal bonds outperformed last week, with fixed income markets hyper focused on inflation and the Fed meeting. High yield municipal credit spreads contracted by 13 bps. Interest rate anxiety caused AAA-rated muni yields to increase 29 bps on the long-end of the curve, while high yield muni yields increased 15 bps on average. High yield flows were flat last week. We are tracking at least 14 new issue deals this week. Demand remains strong, bolstered by a surge of inflows on top of heavy June/July cash flows.
Tax-exempt municipal bonds are no longer cheap relative to Treasuries, so deals will need to be attractively priced to lure buyers.
In focus: Investment grade corporate issuance cools
After a solid start to the year, investment grade corporate issuance slowed in May.
Supply slightly exceeded 2021 year-to-date volume through April, as issuers pulled forward deals in anticipation of higher rates and more volatile Treasury rates and corporate spreads. Gross supply of $125 billion was expected in May, but volatility pared that total back to $90 billion, making it the quietest May since 2014. As a result, year-to-date supply through May has declined 6% versus 2021 levels.
The drop in supply has provided strong technical support for the investment grade corporate market. Market strength was previously met with a headwind of heavy supply, but that was not the case in May. As a result, investment grade corporates delivered the strongest relative performance of all taxable fixed income sectors.
Looking ahead, issuance is expected to slow through the remainder of June as companies enter earnings black-out periods. The slower pace will likely continue through the summer, when issuance calendars tend to be lighter. Issuance should pick up again in the fall, but we expect total gross supply to end the year lower than last year.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 10 Jun 2022.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 08 Jun 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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