Weekly Fixed Income Commentary

Treasury yield curve flattens as the Fed watches inflation

William (Bill) Martin
Taxable Fixed Income CIO,  TIAA Investments
John V. Miller, CFA
Head of Nuveen Municipals
Weekly Fixed Income Commentary Image
Highlights
  • The investment grade corporate sector posted a solid total return for the third consecutive week.
  • High yield municipal bond yields fell last week.
  • High yield corporates gained for the week, despite a modest retreat in oil prices.

Intermediate and long U.S. Treasury yields ended last week nearly unchanged. Shorter yields rose and the yield curve continued to flatten as Federal Reserve (Fed) officials suggested that inflation may be allowed to run higher than its 2% target. The market believes the Fed is now more likely to continue raising interest rates.

U.S. treasury yield curve continues to flatten

A risk-friendly tone propelled Treasury rates to make a big move higher early last week.1 From that point, intermediate and longer maturity yields drifted lower throughout the week, offsetting most of the earlier increase to end nearly unchanged.1 Shorter maturity yields continued trending higher, supported by a weak 3-year Treasury auction and Fed comments about not being at its inflation goal.1 As a result, the yield curve flattened considerably.1 The difference between the 10- and 7-year Treasury yields dropped below 3 basis points (bps). This section of the yield curve has historically been among the first to invert.1

The investment grade corporate sector continued to recover, posting a solid total return for the third consecutive week.1 High yield joined the recovery and bounced back from last week’s underperformance to lead all domestic sectors.1 As has been the trend this year, the lower quality high yield credits delivered the strongest performance.1 Globally, emerging markets continued to recover, while the Global Aggregate Index was dragged down by soft returns in the Asian-Pacific region.1

Fed officials commented last week that the central bank would likely be comfortable letting inflation run above its 2% target and that simply touching the target was insufficient. The market interpreted this as increasing the likelihood that the Fed would continue tightening policy and raising rates. Market-based probabilities now indicate nearly 90% certainty of a 25 bps rate increase in September. We believe the Fed will continue along its path of gradual increases, but the September hike is likely to be the final increase in 2018.

The difference between the 10- and 7-year Treasury yields dropped below 3 bps.

 

Municipal bond demand remains strong

The municipal market was quiet last week but had a firm tone.1 New issue supply totaled $8.2 billion and was well received.2 Weekly fund flows returned to a positive $651 million.3 This week’s new issue calendar is large at $9.2 billion, but the market should absorb it easily.2

Although the outsized July 1 coupon money remains to be invested, municipal bonds are expensive versus their taxable government counterparts.1 As a result, dealers are receptive to pricing that will help continually turn over their inventories. New issuance continues to be well received.

Two notable issuers represent the current municipal market dynamics. Demand for municipal bonds in high tax states (especially California and New York) has become incredibly strong.

The Trustees of the California State University sold $495 million system wide revenue bonds (rated Aa2/AA-).4 Yields were so low, the short end of the deal was priced at yields lower than AAA municipals. This is very uncommon. Separately, in one day, The Dormitory Authority State of New York (DASNY) sold sales tax revenue bonds in five different issues totaling $1.8 billion.4 Short bonds were also yielding less than the AAA scale, and the long end was aggressively priced. The need for tax-exempt bonds remains strong.

High yield municipal bond yields decreased last week, while yields for long U.S. Treasuries and AAA municipals were unchanged to slightly higher.1 As a result, credit spreads contracted another 5 bps and fund flows totaled $313 million.1,3 High yield municipal new issuance is expected to be roughly $400 million this week, with nearly half of that coming in the senior living sector.2

Investment grade corporates continue their recent rebound

Investment grade corporate bonds outperformed most U.S. taxable fixed income sectors and the broad U.S. Aggregate Index last week.1 Over the past three weeks, corporates have returned 1.3%, helping them recoup a portion of the losses endured in the second quarter and year to date.1

New issuance in the investment grade corporate space has declined from June’s levels, contributing to the sector’s recent rally.2 Dealer expectations call for an increase in new-issue volume this week. Investment grade spreads narrowed last week after hovering near the year’s high of +123 bps.1

High yield corporates performed well in spite of last week’s modest retreat in oil prices, which have been trending upward since mid-June.1

New high yield issuance was light.2 A small number of deals totaling approximately $2.45 billion were priced last week, while demand for cash bonds remained solid.2 High yield fund flows were positive, led by exchange-traded funds.3

Investment grade corporates realized gains for the third consecutive week.

 

Emerging markets (EM) rallied to lead all taxable sectors, despite the escalating U.S./ China trade dispute.1 EM spreads generally tightened, and fund flows were positive for the first time in 12 weeks.11,3 Sovereign and corporate bonds performed best, while local-currency EM debt posted only a slight gain as the strong U.S. dollar remained a headwind.1

In focus: Corporate bond performance diverges

Investment grade corporates underperformed high yield in the second quarter, returning -0.98% and 1.03%, respectively. As we are now clearly in the latter half of the credit cycle, this divergence is somewhat counterintuitive.

Investment grade spreads were pressured throughout the second quarter by weaker overseas demand and rising yields. Spreads widened by +14 bps in the second quarter, for a total of +30 bps year to date. The sector’s 2018 total return of -3.27% is the lowest in domestic fixed income.

We have grown more cautious in our outlook for investment grade credit. We believe credit fundamentals will likely remain stable. However, concerns related to trade tensions, rising rates and increased leverage warrant a more defensive approach.

High yield corporate spreads widened +9 bps for the quarter and +20 bps for the year. Nevertheless, the sector posted a positive total return for both periods, making it the best performing taxable fixed income sector year to date.

Lower-quality high yield has outperformed, with CCC-rated spreads tightening by -61 bps during the quarter. This quality segment returned +3.27% versus -1.77% for BB-rated credits year to date.

Valuations, rather than fundamentals, may pose the bigger challenge for high yield going forward. Given trade policy uncertainty, we believe it is reasonable to focus on higher quality bonds in the sector.

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1 Bloomberg L.P.
2 The Bond Buyer, 13 Jul 2018.
3 Lipper Fund Flows.
4 Market Insight, MMA Research, 11 Jul 2018.

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. The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. Loans are added to the index if they qualify according to the following criteria: The highest Moody’s/S&P ratings are Ba1/BBB+, only funded term loans are included, and the tenor must be at least one year. 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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A word on risk
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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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