Weekly Fixed Income Commentary: Treasury yields drift higher despite soft consumer data
Highlights
- High yield corporates posted the best weekly return among U.S. non-municipal sectors, followed by senior loans and preferreds.
- Municipal yields continued to grind lower last week, with high grade municipal-to-Treasury yields looking unusually rich.
- The global aggregate index delivered a solidly positive total return, as both the European and Asian markets outperformed U.S. markets.
U.S. Treasury yields ended last week higher, led by longer maturities. Yields declined early in the week, due to dovish Fed comments and weaker than expected consumer price data. However, Thursday’s soft 30-year Treasury auction reversed the momentum and yields began to climb, more than offsetting declines.
Treasury yields drift higher
U.S. Treasury yields finished higher last week, led by the 10-year maturity range. Interest rates declined to begin the week, with longer maturities falling the most. Strong 3- and 10-year auctions helped drive rates down, supported by dovish Fed comments and weaker-than-expected consumer price data. The 2-year Treasury yield touched a record low yield in overnight trading on Wednesday night. However, a soft 30-year Treasury auction on Thursday reversed the momentum and yields began to climb. The largest rate movements occurred later in the week, as long Treasury yields led the move higher and more than offset earlier declines. The 30-year Treasury yield closed the week above 2% for the first time since February 2020, and the 10-year yield also saw the highest level since before the pandemic.
Most taxable sectors posted positive total returns and outperformed the lagging Treasury market. Across U.S. sectors, high yield corporates once again outperformed and posted the highest weekly return among non-municipal sectors. Senior loans and preferreds also enjoyed positive returns and strong performance. Only mortgage-backed securities underperformed Treasuries, due to elevated prepayment speeds. All sectors have outperformed similar-duration Treasuries so far this year. The global aggregate index delivered a solidly positive total return last week, as both the European and Asian markets outperformed U.S. markets.
The 30-year Treasury yield closed the week above 2% for the first time since February 2020.
Municipal bonds should maintain their value
Municipal yields continued to grind lower last week. New issue supply of $7.2 billion was readily absorbed. Fund flows continued to be solid at $2.6 billion. This week’s new issue supply is expected to total $5.2 billion.
High grade municipal bonds appear rich versus Treasuries. A typical 10-year high grade tax-exempt bond yields 0.69% versus 1.2% for the 10-year Treasury. That makes a yield ratio of 58%, compared to the long-term average in the mid-80% range. However, investors are comfortable with these rich ratios in the current environment. The Fed has in essence bailed out U.S. municipalities, pledging them $350 billion. Also, taxes may eventually rise under the Biden administration, making tax-exempt municipal bonds even more attractive. Finally, there just aren’t enough tax-exempt bonds to meet demand, as they are being replaced by taxable bonds that refund tax-exempt debt. We believe municipal bonds should maintain their value as long as current conditions prevail.
New York City Industrial Development Agency issued $507 million refunding bonds for the New York Mets (Queens Baseball Stadium Project, rated Baa2/BBB-). The deal was very well received, with $8 billion in orders. Investors are banking on the idea that the U.S. will one day be back to attending baseball games in person.
High yield municipal bond yields and credit spreads continue to tighten, with yields decreasing 11 basis points (bps) last week, 7 bps more than AAA-rated municipals. High yield inflows continued, with investors adding another $832 million last week. Some of the best performing bonds in February have more economically sensitive credits like student housing, convention centers and sales tax bonds. In addition, both sales tax and property tax bonds for American Dream have rallied meaningfully in the last two weeks.
More than half of high yield corporates now yield less than 4%
High yield corporate bonds continued their winning ways. The asset class has recorded gains in 14 of 15 weeks since early November. Last week’s performance was similar across all quality tiers, and overall spreads tightened by 10 basis points (bps). The extended rally has driven the average yield on high yield corporates steadily downward, to a record-low close of 3.96% at midweek. Corporate earnings and new issuance were in focus, with nearly $15 billion in deals coming to market, in line with January’s torrid pace. Fund flows (-$228 million), however, reversed the previous week’s positive momentum.
Investment grade corporates posted a negative result for the fourth consecutive week and five of the last six. Total returns were hindered by rising long-term U.S. Treasury yields. Among sectors, energy outperformed, benefiting from a 5% jump in oil prices. Secondary trading volumes were light, and inflows (+$2.7 billion) slowed from the prior week’s four-month high. The primary market was quieter, with $11.8 billion in new debt.
The average yield on high yield corporates hit a record-low close of 3.96% at midweek.
Emerging markets (EM) debt realized a small loss after rising for three weeks in a row. Appetite for EM risk remained intact, with EM bond funds attracting $3 billion of inflows. New supply failed to keep up with demand, especially in emerging Asia, where a lack of new sovereign issuance amid early Lunar New Year celebrations kept many investors sidelined.
In focus: Surge in muni bond demand overwhelms supply
Investors continue to pour money into the municipal bond market, as the usual January effect has extended into February.
The asset class has seen inflows in 38 of the past 39 weeks, for a year-to-date total of $24 billion overall, $4.5 billion in high yield municipals.
While investor appetite grows, the amount of municipal debt outstanding has been effectively flat for the past 10 years, and a decreasing portion is tax-exempt. Taxable new issuance totaled just 7% of the market in 2015, exploding to 31% in 2020. We expect taxable issuance to total around 35% for 2021.
Why the increase in taxable issuance? The Tax Cuts and Jobs Act eliminated advance refunding of tax-exempt bonds by issuing new tax-exempt bonds. As a result, issuers adopted programs selling taxable bonds to advance refund existing bonds. As long as advanced refunding deals continue to offer present value savings, issuers will continue issuing in the taxable market.
In this environment, access to new issue deals, as well as in-depth credit research, becomes critically important.
Going forward, we expect investors to be increasingly focused on the potential for rising tax rates, which should continue to boost demand for municipal bonds.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 12 Feb 2021.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 10 Feb 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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