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Hawkish Fedspeak boosts Treasury yields
Weekly fixed income update highlights
- Total returns were positive for high yield corporates, emerging markets, loans, preferreds and convertibles.
- Total returns were negative for Treasuries, agencies, investment grade corporates, taxable munis, MBS, CMBS and ABS.
- Municipal bond yields rose slightly. New issue supply was $4.1B, with inflows of $1.1B. This week’s new issue supply should be $6.6B.
U.S. Treasury yields rose, led by shorter maturities. Hawkish commentary from U.S. Federal Reserve officials and strong economic data are causing expectations for future interest rates to move higher.
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- 10-year Treasury yields rose; we expect them to remain volatile and move modestly higher this year.
- Spread assets benefited from the improved economic growth outlook.
- Net-negative supply should provide some support to municipal bonds.
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 we don’t expect the 10-year Treasury yield to rise much above 3.00%.
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.
- The Russia/Ukraine conflict continues to escalate.
- COVID-19 cases increase, or new variants emerge.
Investment grade corporate new issuance remains active
Treasury yields increased last week, with the 10-year yield rising 18 basis points (bps). Two-year yields rose even more, up 34 bps. The sharp moves partially reversed July’s strong rally, which was the biggest monthly drop in 10-year yields since spring 2020. The market had been incorporating expectations of a shallower Fed hiking cycle and a return to rate cuts in early 2023, but several Fed officials pushed back against that dynamic in speeches and interviews, causing expectations for future rates to move higher. Additionally, economic data was very strong. The July employment report showed a net gain of 528,000 new jobs and another acceleration in wages, which further exacerbated the move higher in rates.
Investment grade corporates weakened, in line with Treasuries, though spreads narrowed. The asset class returned -0.89% for the week, but outperformed similar-duration Treasuries by 5 bps. After the strong jobs report on Friday, yield surged higher on lower growth fears and higher expectations for Fed tightening. The primary market remained very active, with high-rated tech names dominating attention. Meta ($10 billion new issuance), Intel ($6 bn), and Apple ($5.5bn) led the way, with overall supply at $62 billion, roughly double the expected pace. New issue concessions remain wide at 11.6 bps.
High yield corporates continued to outperform, returning 0.66% for the week and beating similar-duration Treasuries by 157 bps. After touching 583 bps in early July, high yield spreads have now tightened -155 bps to trade at around 428 bps. The rally partially reflects technical dynamics, with the new issue calendar relatively dry and retail inflows continuing. Another $2.93 billion entered the asset class last week. Meanwhile, senior loans returned 0.76%, helped by both higher rates and the firmer economic outlook.
Emerging markets outperformed as well, gaining 0.37% but outpacing similar-duration Treasuries by 140 bps. Though the asset class weakened at the start of the week, with hawkish Fedspeak pushing the dollar higher, it rebounded through Friday. Industrial metals prices, which have been pressured lately on recession fears, bounced back late in the week, helped by the better economic data. Separately, the Bank of England hiked rates by 50 bps, contributing to the selloff in global rates.
High yield municipal inflows continue
Muni yields rose slightly last week across the curve. Short-term rates increased 9 bps and long-term rates rose 2 bps.
Many investors believe the majority of inflation pressures are behind us, despite tough talk by several Fed officials after the last Fed rate hike. That may mean future Fed hikes will be lower than many currently fear. We agree that inflation fears should begin to cool, meaning Treasury bonds will likely remain well bid for the foreseeable future. Municipal bonds should also remain well bid as a supply/demand imbalance continues. Supply should remain light through Labor Day in the U.S., yet billions of dollars of reinvestment money remains to be redeployed. We believe munis also represent fair value at these levels.
The Georgia Ports Authority issued $757 million revenue bonds (rated Aa2/AA). The deal included 5% bonds due in 2042 priced at a yield of 3.24%. Those bonds traded in the secondary market at a yield of 3.33%. This reflects the selloff in fixed income due to the strong employment report published Friday morning.
High yield municipals enjoyed their fourth consecutive week of inflows at $860 million. High yield muni yields remained essentially unchanged, but key liquidity benchmarks like Puerto Rico and tobacco continued to grind tighter. The index returned 4% in July, while the tobacco sector returned 8.68%. Since the restructuring on 15 March, Puerto Rico general obligations bonds have returned -2.0%, very close to high yield muni index average returns. We are tracking at least 14 new issue deals this week, not counting deals that remain in day-to-day status from previous weeks.
Muni bonds should remain well bid as a supply/demand imbalance continues.
In focus: Corporate credit offers relative value
Valuations for the high yield corporate and senior loan markets have increased materially over the last several weeks. Spreads have tightened due to strong earnings, light new issuance, retail demand for high yield and institutional support for loans.
The risk and return tradeoff for corporate credit continues to look attractive relative to equities. But we encourage investors to be patient, as volatility in spreads and interest rates could persist given the uncertain economy.
While the loans and high yield markets generally move directionally with equities, they are currently trading at a material discount to par.
For investors looking for defensive equity exposure, credit may be worth considering. Going forward, we expect corporate credit to offer less potential downside risk compared to stocks, while also generating attractive current income. For floating-rate loans, that level of income could also rise if the Fed continues to raise rates while focusing on taming inflation. As many of these assets begin to migrate back to par, we believe they remain compelling investment opportunities.
Issuance: The Bond Buyer, 05 Aug 2022.
Fund flows: Lipper.
New deals: Market Insight, MMA Research, 03 Aug 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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Important information 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.
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