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Weekly Fixed Income Commentary: Treasury yields rise as inflation surprises continue
Weekly fixed income update highlights
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Core fixed income broadly had negative returns amid the rise in rates, including Treasuries, agencies, MBS, investment grade and high yield corporates, taxable munis, convertibles and leveraged loans.
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Municipal bond yields remained essentially unchanged. New issue supply remained light at $4.1B, with outflows of -$2.2B. This week’s new issue supply ticks up to $8.2B.
U.S. Treasury yields rose further last week. Inflation surprised to the upside again, driving interest rates higher and pressuring fixed income returns. Spread assets weakened amid elevated volatility.
Watchlist
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10-year Treasury yields moved higher last week.
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Spread assets weakened amid elevated volatility.
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Net-negative supply should provide some support to municipal bonds.
Investment views
Accommodative interest rate policy remains a key market support. While investors continue to focus on more hawkish Fed policy, overall rates are likely to remain relatively low even after several rate hikes.
The underlying growth outlook remains healthy, as consumers have strong balance sheets, businesses are reinvesting and Covid recedes. This should keep defaults low.
Treasury yields are likely to rise this year, but the pace of long-term increases should remain relatively modest.
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
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Inflation fails to moderate as expected, negatively affecting asset values.
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Policymakers remove accommodation too rapidly, undermining the global economic expansion.
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The Russia/Ukraine conflict continues to escalate.
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Covid-19 cases increase, or new variants emerge.
Investment grade corporate spreads reach the widest of 2022
U.S. Treasury yields rose again last week, after the September CPI report showed another surprisingly high inflation rate. That should almost guarantee another 75 basis points (bps) rate hike at the U.S. Federal Reserve’s policy meeting next month and increases the odds for additional outsized rate hikes over the next few quarters. Two-year Treasury yields rose 19 bps, while 10-year yields rose a more modest, but still significant, 14 bps.
Investment grade corporates weakened as well, returning -1.62% for the week and lagging similar-duration Treasuries by -72 bps. Spreads touched 165 bps mid-week, their widest levels of the year. Meanwhile, yields on the IG market overall ended the week at 5.97%, a new 13-year high. Market technicals remain unsupportive, with another -$6.7 billion leaving the asset class. On the supply side, only one deal priced, and it was met with tepid demand at only 2.0x oversubscribed. That likely signals elevated concessions for this week, when $15 billion to $20 billion of new supply is expected to price.
High yield corporates sold off, returning -1.11% for the week and underperforming similar-duration Treasuries by -61 bps. Loans outperformed on a relative basis, returning -0.26%. Both markets saw further outflows, of -$713 million and -$1.1 billion for bonds and loans, respectively. The new issue market was slightly more active than in investment grade markets, but demand was similarly muted. Only four deals priced in high yield and one in loans, and they generally struggled to price and ultimately widened.
Emerging markets suffered from another large outflow and returned -1.69% for the week, underperforming Treasuries by -94 bps. Higher U.S. inflation, additional rate hikes and a stronger dollar have been a major drag on the asset class this year and that trend continued last week. Emerging markets funds saw another large outflow of -$2.3 billion, though that was the second consecutive weekly deceleration. The primary market was completely silent across both sovereigns and corporates, and overall issuance is now running -50% year-over-year.
Individual investors support the municipal bond market
Municipal bond yields decoupled from the Treasury market last week, ending basically unchanged. The municipal new issue calendar remained light and negative fund flows continued for the tenth consecutive week. This week’s new issue supply will need to be priced to sell to pique investor interest.
Fed rate increases should persist (for now). The 10-year Treasury yield reached 4% last week, which is still inverted relative to short-term yields. This suggests that investors believe the Fed will continue to raise short-term rates. Many expect the Fed will be successful by the second quarter of 2023, when long-term rates should rally.
Muni bonds also remain resilient. While mutual funds have seen redemptions, individual investors have supported the market with heavy interest, as they can buy bonds with a tax-exempt 4% yield. Institutional investors also continue to rework their portfolios. We expect continued volatility through the rest of 2022, but we believe trends are suggesting a better year in 2023.
The New Jersey Turnpike Authority issued $700 million turnpike revenue bonds (rated A1/AA-). The deal was well received, and some bonds traded at a premium in the secondary market. For example, 5.25% bonds due in 2052 came at a yield of 4.44%. and later traded 4 basis points richer at 4.40%.
High yield municipal bond yields rose last week, but outperformed on a relative basis. Yields are finding resistance higher as investors are attracted by the highest levels in years. Secondary trade volume is robust, as mutual fund selling is being met by strong demand from other buyers. Fund outflows persist but appear to be slowing. New issue volume remains constrained.
Investment grade corporate yields ended last week at 5.97% overall, which was a new 13-year high.
In focus: Inflation surprises to the upside
The U.S. September CPI report showed another big monthly price increase, with the headline measure rising 0.4% and the core measure up 0.6% from August. Overall, inflation is proving to be more durable than most analysts and policymakers expected, with negative implications for fixed income markets.
Under the surface, shelter inflation continues to accelerate. That component makes up almost one-third of the CPI basket, and is running at an annualized rate of more than 9%. Other services sectors are also seeing elevated pressures, as the tight labor market feeds through to higher prices. On the other hand, goods prices are moderating as supply chains normalize, and commodity prices are broadly off their peaks of earlier this year. We remain concerned about the near-term trajectory, but still think that inflation will moderate back to the 3% range by the end of next year.
Unfortunately for fixed income markets, that may be too late to give the Fed much comfort at the next few meetings. We expect another 75 bps hike in early November, followed by another 50bps hike in December and two 25 bps hikes in early 2023. Higher policy rates should weigh on fixed income returns and begin to drag more materially on economic growth. As a result, we favor an up-in-quality bias within asset classes.
Performance: Bloomberg L.P.
Issuance: The Bond Buyer, 14 Oct 2022.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 12 Oct 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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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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