Weekly Fixed Income Commentary: Treasury yields resume declines on weaker economic data
Weekly fixed income update highlights
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Treasuries, agencies, MBS, ABS, taxable munis, investment grade and high yield corporates, preferreds, emerging markets and leveraged loans all had positive total returns.
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Most spread assets, including MBS, investment grade and high yield corporates, preferreds and emerging markets had negative excess returns.
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Municipal bond yields declined across the curve. New issue supply was $6.1B with outflows of -$92M. This week’s new issuance is expected to be $5.9B.
U.S. Treasury yields declined last week amid softer U.S. economic data. Manufacturing and services surveys came in weaker than expected and the March jobs mostly met expectations.
Watchlist
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U.S. Treasury yields resumed their declines.
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Spread assets underperformed amid softer economic data.
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Increased seasonal supply should provide an attractive entry point for municipal bonds.
Investment views
“Higher for longer” emerges 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 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
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Inflation fails to moderate as expected, weighing on asset prices.
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Policymakers tighten too rapidly, undermining the global economic expansion.
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Geopolitical flare-ups: China, Russia, Turkey, Iran.
Investment grade corporates enjoy favorable technicals
U.S. Treasury yields resumed their declines last week, with the 10-year yield ending -8 basis points (bps) lower at 3.40%, touching its lowest level since September. The 2-year yield fell more modestly, down -4 bps for the week. Economic data was mostly weaker, with the manufacturing and services surveys from ISM both declining more than expected. The ISM manufacturing index fell to 46.3, a new post-Covid low, while the services gauge fell to 51.2. Levels below 50 indicate a contraction in activity. Meanwhile, the March jobs report mostly met expectations, with the U.S. economy adding 236,000 new jobs for the month. Average hourly earnings were also in-line with expectations, moderating to 4.2% year-on-year, their slowest rate of increase since mid-2021.
Investment grade corporates gained last week, thanks to the rally in rates, returning 0.45%. However, the asset class underperformed similar-duration Treasuries by -17 bps. Accordingly, overall yield levels fell -6 bps, but spreads widened 2 bps. The technical backdrop was favorable, as the asset class snapped a streak of three consecutive weekly outflows with a $1.8 billion inflow. The new issue market was quiet amid the holidays, with only $9 billion pricing versus expectations for around $15 billion.
High yield corporates eked out a positive return, gaining 0.09% but lagging similar-duration Treasuries by -28 bps. The asset class experienced an elevated inflow of $3.8 billion, the first since early March and the biggest single-week inflow in 23 weeks. Senior loan funds had their eleventh straight weekly outflow, with -$592 million exiting the asset class. The loan market still managed to return 0.34% for the week, however.
Emerging markets also rallied, returning 0.27% for the week. The asset class underperformed similarduration Treasuries by -30 bps. Sovereign bonds from Ukraine were downgraded by S&P to CCC, after the government announced a plan to restructure external debt by next year. Central banks in Israel and New Zealand hiked rates, the latter by more than expected, but other central banks held rates steady, including in India, Australia and Poland. The potential for less aggressive rate hikes, combined with the dollar’s -0.40% deprecation for the week, helped the asset class.
Municipal bond yields reach their lowest point since March 2022
The Municipal bond yield curve rallied last. New issue supply was very well received, while outflows continued. This week’s new issue calendar should also be well received.
The U.S. Federal Reserve has been focused on fighting inflation T and containing the recent banking crisis. The banking situation appears to be contained for now, so the Fed’s focus can return to inflation. Treasuries sold off slightly on Friday’s strong employment report, but should remain well bid as the Fed continues to show its commitment to controlling inflation.
Municipal bond yields have rallied to their lowest point since March 2022. Fixed income in general remains stable and many investors are interested in the tax-exempt income offered by municipal bonds. Yet muni supply remains muted. We expect munis in general to remain well bid.
The state of California issued $2.5 billion general obligation bonds (rated Aa2/AA-). The deal was well received and underwriters were able to lower yields across the curve. Longer bonds increased 15 bps upon final pricing. The deal broke to a premium in the secondary market, with many maturities trading 10 bps higher.
High yield municipals participated in step with Treasury bonds and investment grade municipals as yields rallied last week. Spreads remained at virtually the same level from the week before. Fund flows were positive for the second consecutive week at $149 million, as investors are gaining confidence in fixed income and longer duration. Supply remains light, which should support the market. Eyes will be on inflation data this week, which could cause market volatility to increase.
High yield corporates experienced their biggest single-week inflow in 23 weeks.
In focus: High yield munis enjoy a recovery rally
The high yield municipal bond market produced a positive total return in the first quarter, despite rate volatility and banking sector concerns.
High yield muni bond yields have lagged the more aggressive rally in high grades, despite positive inflows for high yield muni bond funds and negative flows for high grade funds. Credit spreads have widened as a result.
We believe investors should consider emphasizing credit risk over duration risk in this environment. Short-duration high yield credit spread inversion remains pronounced and offers attractive relative value for investors who are duration sensitive or seeking optimal risk-adjusted yields.
We expect the high yield municipal market recovery rally to continue now that interest rates appear to be stabilizing. A large amount of liquidity should be available as the market regains its 2022 outflows. We typically see technicals strengthen in June, July and August. And the persistent lower supply environment means we are less likely to experience the typical supply pressures in the fall.
Market convexity currently favors the investor, and market yields offer reliable and lasting income opportunities without taking on the reinvestment risk of shorter duration taxable fixed income.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 07 Apr 2023.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 05 Apr 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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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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