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Weekly Fixed Income Commentary: Softer inflation data leave Treasury yields lower
Weekly fixed income update highlights
- Treasuries, agencies, MBS, investment grade and high yield corporates, preferreds, senior loans and emerging markets all had positive total returns.
- Municipal bond yields declined across the curve. New issue supply was $8.2B with outflows of -$136M. This week’s new issuance should be $9.1B.
U.S. Treasury yields fell on softer inflation data, helping fixed income to broadly gain. Markets continue to price in another U.S. Federal Reserve rate hike at the July meeting, in addition to a risk of another hike later this year.
Watchlist
- 10-year U.S. Treasury yields fell, and we anticipate further 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 businesses 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 3.25%.
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.
Loans benefit from the risk-on tone
U.S. Treasury yields fell sharply last week due to softer-than-expected inflation data. 10-year yields ended -23 basis points (bps) lower at 3.83%, while 2-year yields dropped -18 bps. The yield curve remained heavily inverted as a result. Markets continue to price in another Fed rate hike at the July meeting, plus a risk of another hike later this year. Apart from the inflation data, labor market data improved as initial jobless claims moderated, though inflation expectations moved higher. Overall, the incoming data remain consistent with a moderate slowing in the economy, not a rapid deterioration.
Investment grade corporates rallied strongly, gaining 1.60% for the week and outperforming similar-duration Treasuries by 11 bps. After hitting a year-to-date high in yields the prior week, the market snapped back robustly, with yields down -22 bps to 5.45% for the overall index. Issuance was somewhat light, with $11 billion of new supply. Banks underperformed modestly, and preferreds gained 0.65% but lagged similar-duration Treasuries by -46 bps.
High yield corporates also rallied, returning 1.60% and beating similar-duration Treasuries by 62 bps. Despite the fall in yields, loans benefited from the risk-on tone as well, returning 0.60% for the week. In both asset classes, lower-quality names outperformed, with CCC rated credits advancing 2.11% and 0.81% in high yield and loan space, respectively. Despite the rally, both markets continued to see outflows, of -$379 and -$137 million in bonds and loans, respectively.
Emerging markets continued to outperform, returning 1.77% and beating similar-duration Treasuries by 36 bps. Sovereign spreads tightened -4 bps, and high yield (-22 bps) outperformed versus investment grade (7 bps). Local markets benefited from the fall in U.S. rates and the associated fall in the dollar, which weakened -2.3% for the week. Outflows continued from hard-currency funds at -$199 million, but local funds returned to inflows at $76 million. Issuance was light across emerging markets, with only $3.6 billion of new supply coming to market.
The municipal bond market gains support from July reinvestment
Municipal bond yields declined across the curve last week. Short-term rates fell -7 bps and long-term rates declined -3 bps. It is no surprise that munis lagged the Treasury rally, as munis have been trading rich to Treasuries and continue to do so. New issue supply was well received but fund flows remained negative.
Fixed income markets in general have a good tone. Inflation has declined to 3%, and Fed officials indicate at least one more rate increase this year to get inflation down to their 2% target. Investors continue locking in long bond yields, as they think those rates will decline as early as the first part of 2024. Tax-exempt bonds also continue to be well bid due to more than $100 billion to be reinvested this summer. The 1 July reinvestment of $40 billion continues to support the market as it has not been completely deployed.
Denton Independent School District, TX, issued $949 million unlimited tax school building bonds (rated NR/AA, with bonds having the Permanent School Fund guarantee rated AAA). The deal was well received. For example, 5% coupon bonds due in 2053 came at a yield of 4.08% and traded in the secondary market at 3.88%.
The high yield municipal market is beginning to form a more solid rally with 1) a more stable rate environment 2) strong fund flows and 3) limited supply. After 10 years of banishment, the City of Detroit came to the market with a deal that was massively oversubscribed. Credit selection and deal allocations are delivering strong alpha.
Munis lagged the Treasury rally, as they have been trading rich to Treasuries and continue to do so.
In focus: Cooler times for the CPI
After hitting a multi-decade high of 9.1% (year-over-year) in June 2022, headline Consumer Price Index inflation has declined for 12 straight months. It registered 3.0% last month — the lowest since March 2021. Core inflation, which strips out food and energy costs, also moderated, to 4.8%. On a month-over-month basis, both headline and core CPI weighed in at just 0.2%.
Details of the CPI print were encouraging. Used car prices, which helped drive inflation higher early last year amid a shortage of computer chips necessary to build new vehicles, dipped 0.5%. For those taking to the skies, airline tickets dropped 8.1%. And although the broad food index edged up 0.1%, a basket measuring the cost of meat, poultry, fish and eggs dropped 0.4%. The shelter index, up 0.4% and accounting for about 70% of the increase in headline CPI, slowed from the recent pace of increases.
Investors cheered the inflation moderation. Both stocks and bonds rallied following the CPI release last Wednesday, as market pricing removed around 6 bps of expected hikes for this year. While we’re pleased that inflation appears less hot and sticky, we still expect the Fed to hike interest rates by 25 bps at its 26 July meeting and keep its options open thereafter. Several voting members lean hawkish. And, importantly, other central bankers, including Chair Jerome Powell, have vowed to bring inflation fully down to the Fed’s 2% target.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 14 Jul 2023.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 12 Jul 2023.
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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Important information on risk
Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. The value of convertible securities may decline in response to such factors as rising interest rates and fluctuations in the market price of the underlying securities. Senior loans are subject to loan settlement risk due to the lack of established settlement standards or remedies for failure to settle. These investments are subject to credit risk and potentially limited liquidity, as well as interest rate risk, currency risk, prepayment and extension risk, and inflation risk.
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