Weekly Fixed Income Commentary

Treasury yields rise as markets watch the Fed

William (Bill) Martin
Taxable Fixed Income CIO,  TIAA Investments
John V. Miller, CFA
Head of Nuveen Municipals
Statue of hawk at the Fed
Highlights
  • High yield corporates delivered the best fixed income returns, followed by preferred securities and senior loans.
  • The municipal market sold off last week, amid increased supply and negative fund flows.
  • Emerging market bonds rallied, supported by improved market liquidity and strengthening currencies versus the dollar.

Shorter U.S. Treasury yields rose more than long rates last week, despite disappointing inflation data. The yield curve flattened as a result. Federal Reserve (Fed) officials reinforced the gradual path of rates hikes, as the market anticipates another 25 basis point increase on September 26.

Treasury yields rise despite disappointing inflation data

Treasury rates increased for all maturities last week despite disappointing consumer and producer price data.1 Most of the move, led by shorter maturities, occurred on Tuesday and Friday. Although last week’s inflation data was weaker than expected, several measures have reached multi-year highs. Short maturity yields increased more than long maturities, and the yield curve flattened.1 The yield difference between the 10-year Treasury and the 3-month T-bill now stands at about 86 basis points (bps).1

A risk-friendly market tone aided relative performance for non-Treasury sectors, but rising yields pulled down total returns.1 Credit-related sectors outperformed and all posted positive total returns for the week.1 High yield corporates delivered the best returns, followed by preferred securities, senior loans and investment grade corporates.1 High yield spreads tightened by 16 bps, and the sector solidly outperformed similar-duration Treasuries.1 Emerging markets built on the previous week’s outperformance with a positive total return.1 The global aggregate mustered a slightly positive total return based on strong performance in the European region.1

Fed officials broadly reinforced the current path of gradually rising rates last week. One notable speech indicated that, “…it appears reasonable to expect the shorter-run neutral rate to rise somewhat higher than the longer-run neutral rate.” This statement is consistent with the Fed’s economic projections showing the policy rate rising to about 3.4% in 2020 before declining to the longer-term neutral estimate of about 3%. The next Fed rate decision will be announced on September 26, and the market expects a hike of 25 bps.

Emerging markets built on the previous week’s outperformance.

 

Municipal bond market faces seasonal challenges

The municipal market sold off last week.1 New issue supply ticked up to $7 billion.2 The supply was absorbed, but some deals were cheapened upon final pricing. Fund flows were negative at -$136 million.3 The new issue calendar remains robust, with $6.7 billion expected this week.2

The municipal market faces seasonal challenges as we approach the end of the calendar year. These burdens include a building new issue calendar that is expected to remain robust; a supply/demand equation that slightly favors supply (major bond calls are complete for the year); and high grade intermediate municipal bonds that are expensive compared to Treasuries. This makes municipal holdings of many banks and insurance companies sale candidates for investors. Banks have sold $16 billion of holdings at substantial profits into the market in the first six months of this year.1

Sarasota Co. Public Hospital District, FL offered $350 million in revenue bonds (rated A1/NR/AA-).4 The bonds were priced somewhat aggressively for a selective market environment. Underwriters struggled to get the deal underwritten. Some bonds were trading in the secondary market at slightly cheaper levels from where the deal was underwritten.

High yield municipal bond fund flows totaled $160 million last week.3 Over longer performance periods, the yield component of return and benefit of credit spread compression may more than offset the negative impact of increasing interest rates when market technicals are supportive, as they are now. In the short term, when Treasury yields move rapidly, there simply isn’t enough time to accrue enough yield or trading volume for credit spreads to sufficiently offset the negative impact of rising rates. Therefore, short-term high yield municipal bond performance can be swayed by Treasury volatility. Over time, performance is increasingly influenced by yield and credit spreads.

High yield corporates and emerging markets lead

High yield corporate bonds rebounded.1 The asset class rallied from the previous week’s negative return and outperformed all other fixed income categories.1 Every high yield sector posted gains, led by retail and health care.1 Lower-quality bonds (CCCs) bested higher-rated issues (Bs and BBs)—a pattern that has held throughout much of 2018.1

Equities and commodities provided a favorable backdrop for high yield. Prices for U.S. stocks, oil and copper rose by more than 1% last week, creating a tailwind for high yield corporates.1 Limited supply also helped, as new issuance totaled just $4 billion across six deals.2

Investment grade corporates recorded a positive return, outperforming U.S. Treasuries and securitized sectors.1 The market tone was generally positive, although trading activity slowed and spreads for property and casualty insurers began to widen as Hurricane Florence approached the southeastern U.S. coastline late in the week.

Emerging market bonds were the second-best performers.1 Despite outflows of $1.1 billion, the emerging markets landscape was relatively calm last week.3 Liquidity improved, with decent two-way flows across markets in Brazil, Argentina and Turkey. Sovereign and corporate spreads narrowed considerably.

Every high yield sector posted gains, led by retail and health care.

 

Emerging market currencies gained against the U.S. dollar last week, with central bank meetings in developed and emerging markets producing divergent results. The European Central Bank and Bank of England held rates steady, while their counterparts in Turkey and Russia hiked rates.

In focus: Investment grade corporates are poised for positive return

The investment grade corporate sector is poised to deliver its first quarter of positive performance for 2018, for both total and excess returns.

This sector was challenged earlier this year by heavy issuance, coupled with reduced demand by overseas buyers. Reduced supply is the main driver of this positive quarter-to-date performance.

We expect issuance to continue declining for the remainder of 2018. Gross corporate issuance exceeded $850 billion year-to-date through August, and we expect issuance to total approximately $1.1 trillion to $1.2 trillion for all of 2018.2 This would represent a roughly 25% decrease in issuance from 2017 and the lightest year for issuance since 2011.

Overall, our outlook for the sector remains cautious. The decrease in supply should result in positive technical support, and we expect credit fundamentals to remain stable. However, technicals tend to be difficult to predict, and investors are growing concerned about increasing leverage due to low rates and tight credit spreads.

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1 Bloomberg L.P.
2 The Bond Buyer, 14 Sep 2018.
3 Lipper Fund Flows.
4 Market Insight, MMA Research, 12 Sep 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%.

A word 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.
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.
This information represents the opinion of Nuveen, LLC and its affiliates and is not intended to be a forecast of future events and or guarantee of any future result. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. There is no assurance that an investment will provide positive performance over any period of time.
The investment advisory services, strategies and expertise of TIAA Investments, a division of Nuveen, are provided by Teachers Advisors, LLC and TIAA-CREF Investment Management, LLC. Nuveen Asset Management, LLC and Symphony Asset Management LLC are registered investment advisers and affiliates of Nuveen, LLC.