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Weekly Fixed Income Commentary: Risk-off sentiment drives Treasury yields lower
Highlights
- Only taxable municipals and commercial mortgage-backed securities outperformed Treasuries.
- Municipal bond prices closed stronger, and high yield municipals are showing signs of strength.
- Emerging markets debt posted gains for the sixth week in a row.
U.S. Treasury yields declined last week, led by longer maturities. Risk sentiment deteriorated, with investors concerned about a potential no-deal Brexit, rising coronavirus cases and waning prospects for additional U.S. fiscal stimulus. This week’s Federal Reserve (Fed) meeting is not expected to result in any policy shifts, but the Fed could extend the maturity of its Treasury purchases.
Brexit concerns drive U.S. Treasury yields lower
Risk sentiment deteriorated last week and Treasury yields declined, led by longer maturities. Concerns rose that the United Kingdom would leave the European Union without first securing a trade deal. And the market tone was further eroded by rising coronavirus cases and waning optimism over additional U.S. fiscal stimulus. As a result, yields on all Treasury maturities closed the week lower. Long maturities fell the most, but the 2-year Treasury yield approached its all-time low on Friday after experiencing its largest single day move in more than a month. There was $118 billion in Treasury coupon supply made available in three auctions. The auction results largely supported a flattening yield curve, with a soft 3-year auction and a well-supported 30-year auction.
The risk-averse market sentiment weighed on non-Treasury sectors. Only taxable municipals and commercial mortgage-backed securities outperformed Treasuries. However, falling yields supported positive total returns for all sectors. Mortgage-backed securities suffered the lowest weekly return, but investment grade corporates endured the worst performance versus similar-duration Treasuries. Investment grade corporate spreads widened, offsetting a significant portion of the positive returns produced by the sector’s longer duration.
We don’t expect this week’s Fed meeting to include any material policy shift announcements. However, there is speculation that the Fed could extend the maturity of its Treasury purchases to support the markets through near-term economic risks posed by rising virus cases.
We will soon enter one of the strongest periods of technical strength for munis in any calendar year.
High yield municipals show signs of strength
Municipal bond prices closed stronger last week. New issue supply of $8.6 billion was well received. Fund flows were positive at $992 million. This week’s new issue supply is expected to be $7.7 billion ($2.3 billion taxable).
High grade municipal prices have been grinding richer since the summer, spurred by government policies. The Fed lowered short-term rates to zero and the federal government injected trillions of dollars into the U.S. economy in response to the coronavirus crisis. Congress is now considering another stimulus package.
We continue to believe that interest rates should remain lower for longer as the economy recovers from the pandemic. However, we see some headwinds for high grade municipals in 2021. Specifically, new issue supply could reach an all-time high of $500 billion as America begins rebuilding aging infrastructure. However, we do not believe outsized supply would overwhelm the market, as municipals investors will view this as a buying opportunity.
New York Transportation Development Corporation issued $628 million bonds for a terminal project at JFK Airport (rated Baa1/ NR). The deal was well received. The 20-year bond with a 4% coupon was issued originally at a 2.06% yield, but traded in the secondary market at 1.98%. This once again shows the market’s continued optimism that people will someday travel by plane again in earnest.
The high yield municipal market is showing several signs of strength. Flows accelerated to $365 million last week. PRASA successfully refunded its 2008 debt with a limited public offering. Brightline FL successfully placed $950 million of completion bonds for phase two. We will soon enter one of the strongest periods of technical strength in any calendar year, giving the market a strong tailwind. After lagging for several months behind other risk assets, we expect high yield municipals to continue outperforming, although careful credit selection remains critically important.
Emerging markets debt and U.S. investment grade credit finish ahead of high yield
Emerging markets (EM) debt posted gains for the sixth week in a row. Despite continued fund inflows (+$2.9 billion), the bid for EM risk slowed as investors searched for a catalyst to justify further spread tightening. Uncertainty about a near-term U.S. fiscal relief package and the increased chance of a no-deal Brexit also crimped enthusiasm last week, and there were pockets of profit taking in higher-quality, lower-spread names. Within EM, corporate credit outperformed sovereign bonds.
Investment grade corporate bonds returned to positive territory last week following the prior week’s moderate loss. The overall tone was muted, with 5 basis points (bps) of spread widening and middle-of-the-pack returns. In the primary market, 14 issuers priced more than $20 billion in new investment grade supply. This week will likely be the last opportunity for any new issuance in 2020, given the likely expected slowdown in activity ahead of the holidays.
Within emerging markets, corporate credit outperformed sovereign bonds.
High yield corporates delivered a positive return and maintained their lead over other fixed income categories for the fourth quarter — a period in which the asset class has experienced only one negative week. Last week’s gain, however, was the smallest for high yield since late October. Spreads widened by 7 bps, and fund flows were essentially flat. Lower-quality (CCC rated) issues continued to outperform their B and BB counterparts even in the face of tempered investor demand for risk.
In focus: Muni market is well-positioned for 2021
The municipal market is entering 2021 on a strong note. High grade valuations have returned to pre-pandemic levels, and high yield is trending in a favorable direction. We believe this leaves room for spreads to contract in the first half of next year.
Fundamental strength will depend on how long the economy takes to recover from the pandemic. The next few months will be challenging, but we expect more normalcy by the second half of the year. Defaults may show a small uptick, but not a huge shift in the overall security of the asset class. We believe performance will be based on credit and technicals, with a bit of politics, rather than purely interest rates.
Technicals appear solid going into the first quarter. Gross supply should continue at or near record levels, most of it taxable. The net supply is likely to be relatively modest, as tax-exempt bonds are called away and replaced with taxables. Meanwhile, we expect strong demand to continue.
Next year, we anticipate rising interest rates, but spreads could be narrowing, which could benefit total returns. Interest rates could rise if that happens, but municipals have shown they can perform well in such an environment.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 11 Dec 2020.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 09 Dec 2020.
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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