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Weekly Fixed Income Commentary: Treasury yields rise further on positive employment report
Weekly fixed income update highlights
- Treasuries, taxable munis, MBS, CMBS, ABS, preferreds, investment grade and high yield corporates, and emerging markets all weakened in total return terms.
- High yield, ABS and emerging markets all outperformed in excess returns terms.
- Municipal bond yields declined. New issue supply was $10B, with flows of -$2.9B. This week’s new issue supply is $5.7B.
U.S. Treasury yields rose after positive economic data and another round of hawkish central bank meetings across developed markets. Spread assets were weaker after recent strong gains.
Watchlist
- 10-year Treasury yields rose last week, and we anticipate increases in the quarters ahead.
- Spread assets were weaker after recent strong gains.
- Municipal bonds are moving closer to fair value.
Investment views
Zero/negative global interest rate policy remains a key market support. While investors continue to focus on more hawkish Fed policy, overall rates are likely to remain low.
Unprecedented global fiscal stimulus should continue to boost consumption and growth.
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 bonds also look compelling.
Key risks
- Inflation rises in a disorderly way, negatively affecting asset values.
- Policymakers remove accommodation too rapidly, undermining the global economic expansion.
- Further complications with the Covid vaccine rollout, as well as new variants.
- Geopolitical flare-ups: China, Russia, Turkey, Iran.
Sizeable senior loan inflows continue
U.S. Treasury yields rose again, with the 10-year yield ending 14 basis points (bps) higher for the week. Most of the move was driven by higher real yields, which rose 19 bps, as inflation breakevens declined -5 bps. The January jobs report vastly exceeded expectations, showing a gain of 467,000 jobs in January, plus another 709,000 in net revisions to the prior two months. The labor force participation rate rose to 62.2% and average hourly earnings rose 5.7% year-over-year. Overall, the data suggested that the labor market is tighter than previously realized.
Investment grade corporates weakened again, returning -1.20% and underperforming similar-duration Treasuries by -16 bps. All-in yields reached a fresh 22-month high at 2.93%. Flows were light, with markets in Asia still mostly closed for the Lunar New Year holiday. New issue activity picked up, with 11 issuers bringing $20 billion of new supply. Overall, the primary calendar was 2.4x oversubscribed and came with concessions of around 2.5 bps, up from the year-to-date average of 2.2 bps.
High yield corporates outperformed. While still registering a negative total return of -0.30% for the week, the asset class outperformed similar-duration Treasuries by 22 bps. That came despite another sizeable outflow of -$4 billion, making the last four weeks the largest such stretch of outflows since August 2014. Loans gained 0.07%, with continued sizeable inflows of $1.3 billion. CLO warehouses remain active as well, further boosting demand. That said, there was emerging evidence of crossover accounts pivoting away from loans and into bonds, given the recent sharp underperformance by the latter.
Emerging markets also outperformed, beating similar-duration Treasuries by 48 bps, though the asset class posted a -0.47% total return for the week. Attention was dominated by hawkish policy meetings at the Bank of England (BoE) and European Central Bank (ECB). The BoE hiked rates 25 bps, and four of the nine committee members surprisingly voted for an even larger 50 bps hike. The UK sovereign curve bear flattened sharply, with 2-year yields up 29 bps and 10-year yields up 17 bps. In Europe, the ECB refrained from changing policy immediately, but signaled higher odds of rate hikes later this year. The market has now priced more than 50 bps of hikes this year. European curves also bear flattened, with 2- and 10-year bund yields up 36 and 25 bps, respectively.
Light municipal bond new supply will need to be priced to sell
Municipal bond yields closed last week lower, although they sold off slightly on Friday due to the outsized jobs report. Municipal bond yields are relatively attractive versus taxable Treasury yields, so munis should remain well bid if Treasuries remain range bound. Municipal bond fund flows were negative for the third consecutive week. Light new issue supply this week will need to be priced to sell to pique investor interest.
The Fed will most likely begin to raise short-term rates beginning in March, after Friday’s surprisingly strong jobs number. Many investors expect five rate hikes by year end. In terms of interest rates, the 10-year Treasury yield is the highest since December 2020. It is up to the Fed to show that inflation is under control. If so, rates should remain range bound.
Broward County, Florida, issued $199 million water and sewer utility revenue bonds (rated Aa1/AA). The deal was priced to sell, and some bonds broke to premiums from where they were issued. For example, the deal contained 4% coupon bonds due in 2047 issued at a yield of 2.26%. Those same bonds traded in the secondary market 5 basis points lower at 2.21%.
High yield municipal bond yields remain lower month-to-date on average, due to stronger demand after January’s adjustments. Despite outflows, bonds are being firmly bid and tax loss swapping remains active. The new issue calendar remains light, with less than 10 high yield municipal deals expected this week. The market continues to focus on the execution of the Puerto Rico GO restructuring and bond exchange, which involves a massive cash injection into the market. Investors are watching how PROMESA and Puerto Rico will engage on PREPA’s restructuring.
Municipal bond yields remain relatively attractive versus taxable Treasury yields.
In focus: The Fed preps for lift off
While the timing of U.S. monetary policy changes remains uncertain, the Fed has clearly laid out the anticipated sequence of events. Chair Powell discussed the intended path for policy adjustments at his last press conference, as the Fed “moves steadily away from highly accommodative policies.”
The Fed will begin by finishing asset purchases, known as tapering. It will reduce assets purchases every month until it is only reinvesting maturing bonds to maintain the current balance sheet level. The taper is set to end in March.
Next comes the initial interest rate increase, referred to as lifting off. Although it is not a set policy rule, all rate hikes since 2000 have been 25 basis point (bps), which is the cadence we expect moving forward.
The third step would involve additional rate increases as appropriate. These hikes will come prior to beginning the fourth and final step. Beyond these hikes, adjustments will be ongoing, as the Fed views changing the target rate for fed funds as its primary means of adjusting monetary policy.
Finally, the Fed will allow the balance sheet to shrink, via run off, by no longer reinvesting portfolio payments. Based on Powell’s comments last month, the process is likely to start no sooner than June. The Fed expects balance sheet reduction to “run in the background” until it achieves the desired size.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 04 Feb 2022.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 02 Feb 2022.
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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A word 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.
Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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