Weekly Fixed Income Commentary: Despite soft labor data, Treasury yields rise
Weekly fixed income update highlights
- High yield corporates, mortgage-backed securities, convertibles, preferred securities, senior loans and emerging markets rallied.
- Treasuries, investment grade corporates and taxable municipals weakened amid the rise in yields.
- Municipal bond yields remained unchanged. New issue supply was $5.2B, with flows of $1.0B. This week’s new issue supply should be $5.2B ($1B taxable).
Jobs numbers were somewhat weaker than expected, but U.S. Treasury yields rose and the yield curve steepened. The economic expansion continues and the Federal Reserve remains on track to begin tapering later this year.
Watchlist
- Treasury yields rose last week, and we continue to anticipate higher rates into year end
- Spread assets performed well, as economic growth continued
- Municipal bonds are unlikely to remain so rich
Investment views
Zero/negative global interest rate policy remains a key market support. Investors continue to focus on the eventual tapering of purchases, which we expect to happen this year.
Unprecedented global fiscal stimulus should boost consumption and growth this year, with second quarter GDP growth approaching 10%.
Record supply of investment grade corporates has been followed by high levels of issuance from high yield, middle market loans and the broadly syndicated loan market. Taxable municipal supply also continues to grow.
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 credits also look compelling.
Key risks
- Policymakers become cautious and remove accommodation too early.
- Inflation rising in a disorderly way, forcing premature policy tightening.
- Further complications with the COVID-19 vaccine rollout and the Delta variant.
- Geopolitical flare-ups: China, Russia, Turkey, Iran.
High yield corporates show robust performance
U.S. Treasury yields rose again last week, despite somewhat softer labor market data. 10-year Treasury yields rose 2 basis points (bps) and the yield curve steepened. The August labor report showed a gain of only 235,000 jobs, much weaker than the 733,000 expected. That said, the unemployment rate fell -0.2 percentage points to a new post-COVID low of 5.2%. Wage growth was also surprisingly strong, at 0.6% month-over-month. Separately, the ISM manufacturing survey for August surprisingly rose 0.4 percentage points (pt)to 59.9, compared to expectations for a -1.0 pt drop. Taken together, economic activity seemingly continued to expand in August, though supply constraints in the labor market continue to bite. We will be much more focused on the September and October jobs reports, which will reflect hiring after most schools reopen and expanded unemployment benefits expire across the U.S.
Investment grade corporates weakened slightly last week, returning -0.08%, but outperforming similar-duration Treasuries by 8 bps. Primary market activity was slow, with only $3.75 billion of new issuance pricing. Issuance should heat up, with $40 to $45 billion expected this week and $130 to $140 billion expected for September. Investment grade corporate spreads have widened 8 bps from their lows at the end of June, but remain historically low, leading corporates to seize the opportunity to issue new securities and refinance existing liabilities.
High yield corporates showed strong gains, generating 0.41% of total returns for the week, with all of that gain (41 bps) representing outperformance versus similar-duration Treasuries. Senior loans also rallied, gaining 0.19% for the week. As in the high grade market, both the high yield and leveraged loan markets are set to see robust issuance in September. Expectations are around $40 to $50 billion of new issuance this month for both asset classes.
Emerging markets notched another gain last week, returning 0.20% for their fifth consecutive weekly gain. That represented 27 bps of outperformance versus similar-duration Treasuries. The asset class has been supported by the weaker dollar, which depreciated another -0.7% last week to touch its weakest level in a month, and by the rally in commodity prices. Front-month WTI oil prices gained another 0.8%, after rallying over 10% the prior week.
Municipal yields remain low on an absolute basis
Municipal bond prices were unchanged in a quiet week due to the Labor Day holiday in the U.S.
The disappointing employment report pushed talk of Federal Reserve (Fed) tapering of easy monetary policy further into the future. The Fed will require solid evidence that the economy is in full recovery from COVID-19 before it begins tapering. Thus, as we have been saying for quite some time, we expect interest rates to remain lower for longer.
Tax-exempt municipal interest rates may see slight upward pressure. The new issue calendar often builds toward the end of the year and deals may need to be cheapened. Also, municipal yields remain low on an absolute basis. However, a tremendous amount of cash remains on the sidelines. We continue to view any potential short-term increase in tax-exempt rates would as a buying opportunity.
The New York City Transitional Finance Authority (TFA) issued $950 million revenue bonds (rated Aa1/AAA). The deal was well received and underwriters were able to increase price on some maturities. The underwriter was quoting a bid of 2 bps richer on most maturities from where the deal came.
The high yield municipal market is snapping back to attention after the holiday. We are tracking at least 15 deals this week, including a gargantuan $500 million senior living project deal. Since mid-July, yields for both high yield municipals and U.S. Treasuries have remained range bound, while AAA-rated municipal yields have risen 20 bps. The softness in high grade munis has given investors opportunities to invest cash that has accumulated through the summer. This trend has not diminished high yield inflows, which continued at $396 million last week.
The municipal new issue calendar often builds near the end of the year and deals may need to be cheapened.
In focus: Municipal credit proves resilient
State and local tax governments proved to be surprisingly resilient during the pandemic. This was quite unexpected last spring when most governments projected steep revenue losses and crafted budgets in an environment of significant uncertainty.
Substantial federal monetary and fiscal support helped stabilize the fiscal health of state and local governments. For the first quarter of 2021, total state and local tax revenues were up 10.4%, compared to the first quarter of 2020. Sales tax collections have steadily improved over the past three quarters after modest declines in early 2020.
Property taxes, which account for about half of local government revenues, have remained remarkably stable. States did not see the huge losses in income taxes that many expected, as most jobs lost were concentrated in lower-wage sectors. The U.S. labor market lost 22.4 million jobs due to COVID-19, and most projections do not expect total employment to recover to pre-pandemic levels until sometime next year.
Moody’s revised its outlook for local governments to stable from negative and upgraded Illinois from Baa3 to Baa2. New York, New Jersey and Louisiana have garnered positive outlooks. S&P maintains negative outlooks on only 6% of rated credits, down from 8% a year ago.
While overall credit conditions have improved, the specifics are more nuanced for credits with structurally imbalanced budgets. Monitoring how stimulus funding is deployed will ensure that spending doesn’t create future budgetary cliffs.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 03 Sep 2021.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 01 Sep 2021.
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 Barclays Municipal Index; high yield municipal: Bloomberg Barclays High Yield Municipal Index; short duration high yield municipal: S&P Short Duration Municipal Yield Index; taxable municipal: Bloomberg Barclays Taxable Municipal Bond Index; U.S. aggregate bond: Bloomberg Barclays U.S. Aggregate Bond Index; U.S. Treasury: Bloomberg Barclays U.S. Treasury Index; U.S. government related: Bloomberg Barclays U.S. Government-Related Index; U.S. corporate investment grade: Bloomberg Barclays U.S. Corporate Index; U.S. mortgage-backed securities; Bloomberg Barclays U.S. Mortgage-Backed Securities Index; U.S. commercial mortgage-backed securities: Bloomberg Barclays CMBS ERISA-Eligible Index; U.S. asset-backed securities: Bloomberg Barclays Asset-Backed Securities Index; preferred securities: ICE BofA U.S. All Capital Securities Index; high yield 2% issuer capped: Bloomberg Barclays High Yield 2% Issuer Capped Index; senior loans: Credit Suisse Leveraged Loan Index; global emerging markets: Bloomberg Barclays Emerging Market USD Aggregate Index; global aggregate: Bloomberg Barclays Global Aggregate Unhedged Index.
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