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Treasury yields decline on softer economic data
Weekly fixed income update highlights
- Total returns were positive across almost all major fixed income asset classes.
- High yield corporates had negative total returns, after a strong start to the year.
- Municipal bond yields declined further. New issue supply increased to $7.9B with inflows of $1.5B. This week’s new issuance should be $5.5B.
U.S. Treasury yields fell across the curve last week. U.S. economic data was in focus, with producer prices moderating more than expected, lending confidence to the consensus narrative that the U.S. Federal Reserve will soon end its interest rate hiking cycle.
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- U.S. Treasury yields fell across the curve.
- Spread assets appreciated.
- Net-negative supply should provide some support to municipal bonds.
The end to U.S. central bank tightening appears near, as we expect Fed rate hikes to cease early this year. The overall level of rates is likely to remain historically low.
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 fall this year, and we expect the 10-year Treasury yield to end the year around 3.25%.
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.
- Inflation fails to moderate as expected, negatively affecting asset values.
- Policymakers remove accommodation too rapidly, undermining the global economic expansion.
- Geopolitical flare-ups: China, Russia, Turkey, Iran.
- Covid cases increase, or new variants emerge.
High yield corporate returns soften slightly
U.S. Treasury yields fell again, with 10-year yields down -2 basis points (bps) to touch a fresh 4-month low. Two-year yields fell -6 bps. Macroeconomic data were in focus, with producer prices moderating more than expected, lending more confidence to the growing consensus that the U.S. Federal Reserve will soon end its interest rate hiking cycle. However, other economic data pointed to a sharper slowdown in activity, with retail sales and industrial production both disappointing to the downside.
Investment grade corporates traded close to flat, as a strong start to the week faded after the weaker macroeconomic data. The asset class returned 0.09% for the week, lagging Treasuries by around 1 bps. Investment grade corporate fund inflows totaled $3.8 billion, while the new issue market calmed somewhat after a frenetic start to the year. Only five issuers came to the market with less than $15 billion of supply, well below expectations for around $25 billion. That led deals to be comfortably oversubscribed, offering just 5.7 bps of concession on average.
High yield corporates softened after a strong start to the year, returning -0.31% and underperforming similar-duration Treasuries by -52 bps. The new issue market picked up, with almost $7 billion of new supply hitting the market. Demand was more tempered, and one deal was pulled due to lack of interest. Loans returned 0.37%, the asset class’s sixth consecutive weekly gain.
Emerging markets outperformed substantially, returning 0.81% and beating similar-duration Treasuries by 67 bps. Within both sovereign and corporate spaces, high yield outperformed investment grade. Inflows into hard-currency funds accelerated further, with $1.9 billion entering the asset class for the week, the biggest weekly inflow since June 2021.
Municipal bonds enjoy second consecutive week of inflows
The municipal bond yield curve rallied again last week, along with the Treasury curve. Weekly new issue supply was well received and fund flows were positive for the second consecutive week.
Economic data continue to show that inflation is weakening, yet the Fed maintains it will raise rates to a terminal rate of around 5%. Ironically, this has led to a solid tone for fixed income markets. Some feel fixed income is in a win-win situation. If inflation persists, the Fed will likely stick to its guns and ultimately win the battle with a 5% rate, making it hard to finance further expansion. However, if the economy continues to slow, the Fed will need to stop raising rates, in which case longer-term bonds should rally. Tax-exempt bonds continue to remain well bid. Supply remains muted with an abundant amount of money seeking to be invested.
The Louisiana Public Facilities Authority (for Tulane University) issued $162 million revenue bonds (rated A1/A+). It was well received. For example, 5% coupon bonds due in 2033 came at a yield of 2.69%. The underwriter quoted a premium bid for any maturity once the bonds were free to trade.
High yield municipal bonds outperformed again last week, as yields decreased and credit spreads tightened on average. Fund inflows were solid last week at $823 million, bringing the two-week total to more than $1.7 billion. SIFMA (short-term money market rate) has reset at 1.86%, a strong affirmation of the return of liquidity to the market. New issue supply this week should again be very light, and we expect the secondary market to be well bid.
Investment grade corporate fund inflows totaled $3.8 billion, while the new issue market calmed somewhat after a frenetic start to the year.
In focus: Odds of U.S. recession grow
With last week’s softer economic data, concern about a possible U.S. recession this year is increasing. Consensus places the odds at around 65%. Whether a recession actually occurs will definitely affect fixed income valuations. The question is especially thorny in the current environment, because different indicators are sending different signals.
Our recession probability models reflect this uncertainty. For example, a model based on the Treasury yield curve suggests around 60% odds of recession, close to consensus. Our models based on leading economic indicators and surveys of bank lending conditions point to higher odds, around 75%. Measures based on the labor market, where the incoming data have been strong, point to much lower risk, around 25%.
Ultimately, we believe a holistic view is best. Surveying the performance of our models over the last 70 years, it is very rare for all indicators to simultaneously signal high recession risks. Some degree of noise is inevitable. That said, when the average implied recession odds across all of our models is above 50%, as it currently is, a recession has occurred every time.
We believe the odds of a recession look elevated for 2023. We think the depth of a recession would be mild by historical standards, and there should be scope for fixed income investors to selectively and opportunistically add exposure to core sectors, which will likely perform well in the type of mild slowdown that we expect.
Issuance: The Bond Buyer, 20 Jan 2022.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 18 Jan 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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