Banking uncertainty weighs heavily on bond markets

Weekly fixed income update highlights

• Total returns were positive for Treasuries, investment grade corporates, taxable munis, MBS, ABS and emerging markets.
• In contrast, preferreds, convertibles, high yield corporates, and senior loans had negative total returns.
• Municipal bond yields declined. New issue supply was $6.8B with outflows of -$461M. This week’s new issuance is undersized at $3.3B.

U.S. Treasury yields continued to fall steeply amid heightened economic and financial uncertainty. We expect the U.S. Federal Reserve to hike rates by 25 basis points this week, though the longerterm outlook is much less clear than it was just one week ago.

Watchlist

• U.S. Treasury yields decreased across the curve.
• Spread assets sold off in the wake of banking sector uncertainty.
• Increased seasonal supply should provide an attractive entry point for municipal bonds.

Investment views

“Higher for longer” emerges as a theme, as the Fed battles to control inflation. Higher interest rates are likely to cause additional volatility.

The underlying growth outlook remains healthy, thanks to strong consumer balance sheets and solid levels of businesses investment. This combination should keep corporate defaults low.

Treasury yields are likely to fall this year, and we expect the 10-year Treasury yield to end 2023 around 3.25%.

We favor selectively taking on risk, in this environment of attractive prices and yields. Credit selection is key as we search for bonds with favorable income and characteristics.

Key risks

• Inflation fails to moderate as expected, weighing on asset prices.
• Policymakers tighten too rapidly, undermining the global economic expansion.
• Geopolitical flare-ups: China, Russia, Turkey, Iran.

Corporate bond market sees zero new issuance  

U.S. Treasury yields fell sharply as uncertainty and risk aversion both accelerated last week. The 10- year Treasury yield fell -27 bps, while the 2-year yield fell -75 bps. That marked the biggest weekly front-end rally since 1987. In addition to the large directional moves, intraday volatility remains high. The 2-year yield has moved up or down by at least 20 bps in each of the last seven sessions, the longest streak on record going back to 1976. We continue to expect the Fed to hike rates by 25 bps at this week’s policy meeting, though the longer-term outlook is much less clear than it was just one week ago.

Investment grade corporates gained last week, helped by the huge rally in Treasuries, returning 0.76%. Excess returns were negative, at -89 bps. Even relatively safe, highly rated corporates were shunned by investors, leading to spread widening. The asset class saw an outflow of -$3.8 billion, snapping a streak of 10 straight weekly inflows. At the same time, the new issue market completely dried up, with zero new deals coming to market. That was the first non-holiday week of zero issuance since February 2020, at the start of the Covid crisis.

High yield corporates weakened, returning -0.42% for the week. Similar to the prior week, the rally in rates helped total returns, but did not fully offset the impact of wider credit spreads. The asset class underperformed similar-duration Treasuries by -89 bps. High yield assets experienced a strong decompression trend. BB-rated corporates returned 0.18%, while CCCs fell -2.05%. As in investment grade, the new issue market was completely closed and fund flows were negative. Around -$1.4 billion left high yield corporate funds and -$1.6 billion exited loan funds. Senior loans returned -1.04% for the week, its biggest weekly selloff since September. 

Emerging markets eked out a positive return of 0.12% for the week, though the asset class lagged similar-duration Treasuries by -156 bps. Most of the weakness was concentrated in lower-rated segments. Within sovereigns, investment grade spreads rose 7 bps, versus high yield’s 78 bps widening. As in other markets, the new issue market was completely closed amid the volatility and outflows picked up, with -$1.3 billion leaving the asset class, the largest outflow of the year.

Municipal credit remains strong amid banking turmoil

Municipal bond yields declined last week, following the Treasury curve flight-to-quality rally. Muni yields declined -30 basis points on the short end and only -6 basis points on the long end. Weekly new issue supply was well received, while fund flows were negative. This week’s undersized new issue supply should be well received.

Markets in general remain volatile due to banking sector concerns. Some investors believe banks may be forced to sell municipal holdings and use the cash to shore up their balance sheets. At this time, we see no credit issues appearing in municipals as an asset class. Banks would be selling to raise liquidity to meet customers’ withdrawal demands. With excess cash on the sidelines waiting to be invested, we would see any municipal sell off as a potential buying opportunity.

NYC Transitional Finance Authority (TFA)  issued $950 million tax-secured bonds (rated Aa1/ AAA). The deal included 4% coupon bonds due in 2051 yielding 4.45%. Those bonds traded in the secondary market at a yield of 4.40%.

Municipal bond yields were significantly less volatile than Treasury yields last week, and high yield municipal yields were even less volatile. As high yield muni inflows resume and market liquidity normalizes, the typical low correlation to rate volatility is also returning. High yield municipal yields decreased by just 2 bps last week on average, making their relative value more attractive compared to much larger decreases for high grade muni bonds and Treasuries. Some higher risk areas of the market like Puerto Rico and tobacco showed greater volatility, but rebounded by end of the week. Net inflows totaled $300 million. New issuance this week is very light, with less than six high yield municipal deals pricing.

The 2-year Treasury yield has moved up or down by at least 20 bps in each of the last seven sessions.

In focus: Banks enter the Fed’s calculus 

Until very recently, the Fed had set its sights on taming inflation. But suddenly the health of the banking system entered the equation, complicating matters for the central bank.

Following the shuttering of Silicon Valley Bank on 10 March and Signature Bank two days later, Chair Jerome Powell and his colleagues now must consider the potential economic fallout of bank sector turmoil. Investors “voted” by shunning risk assets in favor of safe-haven securities like U.S. Treasuries, despite the Fed’s opening of a new lending facility to provide extra funding for banks to meet future deposit withdrawals.

These events make this week’s Fed meeting the most up-in-the-air gathering in recent memory, with reasonable cases for an interest rate hike, a pause or even a cut. The market is pricing in around a 60% chance of a 25 bps hike and a 40% chance of a pause.

There’s been no word from policymakers, as they’re in the blackout period preceding every Fed gathering, prohibiting them from speaking publicly. In our view, the lack of additional bank runs, coupled with the muted reaction to the European Central Bank’s 50 bps rate increase on 16 March, gives the Fed a window to tighten further, most likely by 25 bps.