Things are much different now than they were expected to be one year ago. This time last year, the Fed was expected to increase short term interest rate by 0.25% up to three more times. Fed Chair Jerome Powell’s overly hawkish comments at a December press conference caused bond yields to rise and the equity markets to tank. 10-year note yields peaked on November 8th at 3.23% before dropping to 2.69% at year end.
As the calendar turned, the U.S. economy did not turn out to be as strong as expected. Moreover, the uncertainty created by the Trump Administration on trade with many of our trading partners came front and center. The Federal Reserve reversed from their expected course and yields in the bond market have responded in kind. On September 3rd, the yield on the 10-year note set a year-to-date low of 1.46%. For most of the second half of 2019, the 10-year note traded in a range between 1.50% and 1.75%. The yield curve, as measured by the 10-year – 2-year yield spread, briefly inverted in August and September but is currently positive by around 0.10%.
While many factors can influence bond yields, the two primary drivers of yields in the fourth quarter are expected to be trade negotiations with China and the effect of international yields and foreign central bank policy. A high level delegation from China met with the Trump administration in Washington in mid-October for trade negotiations, however, little progress was made. Both the equity and bond markets will continue fixate on any future news on the status of the trade war. As foreign central banks have begun trying to stimulate their sluggish economies, overseas bond yields have traded below zero, making US yields look attractive to foreign buyers, further pushing U.S. rates lower.
Throw in Fed policy and the inflation outlook, and yield forecasting should be as perilous as ever. The market expects the Fed to continue to lower interest rates and stimulate the economy. Inflation has been contained and continues to trade below the Fed’s 2.00% target. Any signs of increased inflation, or lack of Fed easings, could cause interest rates to rise, as could signs of renewed growth.
After some volatility early in the third quarter, investment grade credits settled into a trading range that lasted through quarter end. After widening in June, corporates spreads rallied in July, tightening significantly. However, credits widened again in August as lingering trade woes and signs of a slowing economy put a damper on the market. Since then we have seen credit spreads spend the rest of the third quarter in a range of around +115 to +125 on the Barclay’s Investment Grade Index.
Markets, starved for new supply, readily absorbed the boost in September supply including the heaviest corporate new issuance week ever of around $75 billion. Looking ahead, supply should be relatively light as issuance slows heading into year end. We could see some new deals come to market through around mid-November, but then the spigot should shut off until the calendar rolls to 2020.
Credit spreads widened in 4Q18 but a repeat performance is not expected again this year. Tame inflation and a dovish Fed should keep Treasury yields low in the fourth quarter. As such, investors are likely to search for yield elsewhere in the market. The combination of low Treasury yields and lighter corporate new supply should put a cap on any potential widening of spreads.
There are, however, some risks affecting corporate notes that are primarily broader headline issues that need to be watched as we head into year-end. Brexit could see a conclusion at the end of October and will be something to keep an eye on. The ongoing trade battle between the US and China also seems to have a lot of push and pull on the market with each passing headline. Longer term attention should also be paid to the political arena as we are heading into an election year, not to mention potential volatility of the ongoing impeachment proceedings.
The high yield sector saw a much more volatile quarter as both a weaker domestic equity market and a slide in oil prices kept the sector on its toes and produced swings of nearly 100 basis points in spreads. The high yield sector takes much of its cue from the energy sector since a significant amount of names in the high yield index are pegged to commodities. Going forward, keep an eye on oil prices and the equity market for direction in the high yield sector.
The municipal market posted positive returns for the third quarter even as volatility increased. Municipal yields trended lower on weaker than expected economic data, easing monetary policy, and the continued trade issues with China. At the same time, an increase in new issue municipal supply added some upward pressure on yields, but that pressure was partially offset by steady investor demand.
The yield on municipal bonds followed the Treasury market lower in anticipation that the economy is starting to slow and the Fed will continue to cut rates. 10-year AAA General Obligation bonds hit their high for the quarter in July but finished the quarter 22 basis points lower at 1.42%. At the same time, the yield on 5-year AAA General Obligation bonds dropped only 8 basis points to end the quarter at 1.23%, creating a much flatter yield curve. This decline in rates produced a quarterly return of 0.71% on the ICE BofAML 1-10 Year AAA-A Municipal Index and a year-to- date return of 4.31% - the best return since 2011.
The municipal market did experience its first negative monthly return of the year in September. A sharp sell-off in the Treasury market while the municipal market was experiencing higher than average new issue supply added upward pressure to municipal yields. The sell-off was short lived as investors used the backup as a buying opportunity, pushing yields lower across the curve. Third quarter new issue supply, at $80.4 billion, was 12% higher than the second quarter as issuers took advantage of low rates to issue debt. Offsetting the increase in supply was steady investor demand with Lipper reporting 39 consecutive weeks of positive inflows into tax-free mutual funds.
The themes that have contributed to the firmer municipal market during the first three quarters of 2019 should remain in place for the rest of the year. Negative net supply should help keep credit spreads tight and hold the market in a narrow trading range well into the fourth quarter. Demand should remain strong as tax adjusted municipal yields remain attractive to high net worth individuals seeking tax-free income. Bonds from high tax states, due to the elimination of state and local tax deductions (SALT), continue to be in demand and trade at tight spreads versus the AAA General Obligation scale. New issue supply is expected to remain higher than average going into the fourth quarter, possibly limiting price performance.
We continue to position portfolios with a neutral or slightly longer duration while focusing on the 5 to 10-year part of the yield curve. We also prefer high-grade municipal credits with dedicated revenue streams as a hedge against a slower economy. Callable bonds could offer value for their higher yield and shorter duration. Any back up in rates should be viewed as an entry point or a buying opportunity.
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Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
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Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).