Weekly Fixed Income Commentary

Focus on strengthening economy keeps 10-year Treasury yield above 3%

Weekly Fixed Income Commentary Image
Highlights
  • Taxable fixed income returns were negative, with most sectors underperforming similar-duration Treasuries.
  • Municipal credit spreads continue to contract due to a supply/demand imbalance and strong credit fundamentals.
  • Investment grade and high yield corporate bonds stumbled amid rising interest rates.

Improving retail sales and productivity data, as well as leading indicators, point to ongoing solid U.S. economic growth. As a result, the U.S. dollar is strengthening and 10-year U.S. Treasury yields remained above 3% for the entire trading week. The bond market stumbled in response, and the market has repriced expectations for Federal Reserve (Fed) rate hikes through 2019.

10-year U.S. Treasury yield remains above 3% all week

The 10-year Treasury yield closed above 3% every day last week for the first time since 2011.1 There was no specific catalyst, but the largest jump occurred after Tuesday’s retail sales report.1 While April sales were as expected, the previous month’s sales were revised higher. Longer maturities led the rate increase.1 By the close of business Thursday, 10- and 30-year Treasury yields had risen more than 14 basis points for the week.1 Fiscal concerns in Italy caused global yields to retreat on Friday.

Taxable fixed income returns were negative across the board last week and most sectors underperformed similar-duration Treasuries.1 Although spreads were unchanged, the investment grade corporate sector was dragged down by its long duration and posted the lowest total return for any domestic sector.1 There was no clear risk-off market sentiment last week, but concerns regarding emerging markets weighed on that sector. Global emerging markets have struggled in April and May, and have significantly lagged U.S. Treasuries. The Global Aggregate Index produced the lowest overall total return last week as both Europe and Asia were significantly negative.1

This week’s release of the May Fed meeting minutes may provide insight into the Fed’s reference to a symmetric inflation objective, concerns about a potential inverted yield curve and use of forward policy guidance. We expect Treasury yields to drift modestly higher as the Fed continues to gradually increase policy rates. We believe stable inflation and continued strength in the labor markets will support the Fed’s ongoing tightening of monetary policy, which should not derail U.S. growth.

High yield municipal credit spreads have potential for further compression.

 

Further municipal credit spread compression is likely

The municipal market sold off last week.1 New issue supply was outsized at $10.1 billion, and some new deals broke to cheaper levels by the end of the week.2 Fund flows were positive at $207 million.3 This week’s new issue supply is expected to be $6.5 billion and should be well received.2 The new issue calendar should be very light this summer.2

Fixed income yields rose in general last week.1 Investors see the U.S. economy improving, which would require higher interest rates. Municipal bonds are not immune, although light supply and solid demand have provided support. While municipal supply remains thin, municipals are expensive versus U.S. Treasuries and buyers are not eager to invest cash.1

The Chicago Board of Education issued $561 million unlimited tax general obligation refunding bonds (rated NR/B; some maturities insured by Assured Guaranty rated AA).4 The deal was so well received that the issuer doubled the size of the original offering and lowered yields. This demonstrates the municipal market’s appetite for high yield tax-exempt bonds.

Municipal credit spreads continue to contract due to a supply/demand imbalance and strong credit fundamentals.1 Spreads remain roughly 100 basis points higher than the all-time lows reached in 1997 and 2007, suggesting there is plenty of room for further compression.1

High yield municipal fund inflows totaled $416 million last week, with $636 million of the $1.7 billion year to date total coming in the last two weeks.3 New issue supply is expected to be light this week.2 Investors will increasingly need to lean on the secondary market and their market access to find bonds. Credit research remains highly critical in this environment.

High yield municipals remain attractive based on long-term averages for credit spreads and the potential for further compression.

Corporate bonds struggle in the face of rising Treasury yields

Investment grade and high yield corporate bonds stumbled amid rising interest rates last week.1 Both 2- and 10-year U.S. Treasury yields hit multi-year highs.1 Investment grade spreads held firm, however, despite a series of unsettling geopolitical headlines and robust primary supply.1

New issuance of $32 billion was in line with expectations last week.2 This week, $25 billion to $30 billion of deals are anticipated.2 Demand for investment grade debt was strong, with a fresh source of interest emerging from Asian insurers looking to buy 7-10 year paper.3

High yield spreads widened slightly.1 Last week’s $540 million in redemptions—mostly from actively managed accounts—brought the year-to-date total to more than $15 billion.3 On a sector basis, only broadcasting, diversified media and retail posted positive returns for the week.1 From a quality perspective, CCCs barely eked out a gain but still outperformed Bs and the more interest rate sensitive BBs.1

CCCs barely eked out a gain, but still outperformed Bs and BBs.

Emerging market debt also lost ground, hurt by unstable trading conditions and continued dollar strength.1 New issuance slowed significantly in this challenging environment.2 Outflows for both hard and local currency funds were modest.3

In focus: Declining supply affects preferred securities

Reduced supply has been an important dynamic of the preferred securities market, as issuance has declined in recent years. A main reason for the decrease is that banks no longer need to raise additional capital.

In the past, banks proactively issued common stock and preferred securities to meet regulatory capital requirements. As asset bases declined, U.S. banks found themselves with more preferred securities outstanding than needed to meet requirements.

Declining issuance has continued in 2018, as U.S. banks call outstanding preferred securities. April and May saw significant call activity in the $25 par market, with more than $9 billion in calls being announced. These calls included deals that have been callable since 2013 and 2015, but are just now being redeemed.

As a result, the $25 par preferred market has experienced negative net issuance of approximately $12.7 billion in 2018 through May 4.5

Preferred securities market valuations still favor $1000 par value securities. The U.S. $25 par market has an average option-adjust spread (OAS) of -36 basis points as of 30 Apr, compared to the $1000 par denomination with an OAS of +209 basis points.6

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Income-Oriented Investing Understanding $25 par value preferred securities
1 Bloomberg L.P.
2 The Bond Buyer, 16 May 2018.
3 Lipper Fund Flows.
4 Market Insight, MMA Research, 18 May 2018.
5 Morgan Stanley
6 Based on the ICE BofA Merrill Lynch U.S. All Capital Securities Index.
Any reference to municipal 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.
Bloomberg Barclays Municipal Index covers the USD-denominated tax-exempt bond market. Bloomberg Barclays High Yield Municipal Index covers the USD-denominated, below investment grade tax-exempt bond market. S&P Short Duration Municipal Yield Index tracks the municipal bond market with maturities from 1 to 12 years. Bloomberg Barclays U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market. Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury. Bloomberg Barclays U.S. Government-Related Index includes debt guaranteed, owned and sponsored by the U.S. government; it does not include debt directly issued by the U.S. government. Bloomberg Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable corporate bond market. Bloomberg Barclays U.S. Mortgage-Backed Securities Index is the MBS component of the U.S. Aggregate index and includes the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). Bloomberg Barclays CMBS ERISA-Eligible Index is the CMBS component of the U.S. Aggregate index and includes CMBS investment grade securities that are ERISA eligible under the underwriter’s exemption. Bloomberg Barclays Asset-Backed Securities Index is the ABS component of the U.S. Aggregate index and includes credit and charge cards, autos and utilities. ICE BofA Merrill Lynch U.S. All Capital Securities Index is a subset of the BofA Merrill Lynch U.S. Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities. Bloomberg Barclays High Yield 2% Issuer Capped Index measures the market of USD-denominated, non-investment grade bonds and limits each issue to 2% of the index. Bloomberg Barclays Emerging Market USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. Bloomberg Barclays Global Aggregate Unhedged Index measures the performance of global bonds. It includes government, securitized and corporate sectors and does not hedge currency. One basis point equals .01%, or 100 basis points equal 1%.
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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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