A quick glance at the conditions affecting the bond market paint a rather uncertain picture.
The Federal Reserve sees no reason to raise interest rates (or lower them). Several measures of inflation are pegged at the Fed’s target, segments of unemployment are at historic lows, and the US economy is expected to grow around 2.5% in 2019.
At its March FOMC meeting, the Federal Reserve did an about-face from the interest rate path outlined at the December 19, 2018 FOMC meeting. The Fed went from three interest rate hikes and an “autopilot” reduction of its balance sheet to zero hikes in 2019 and ending its balance sheet reduction this fall. While no interest rate hikes bode well for the bond market, the change in Fed policy suggests that the Fed is no longer concerned that the economy is going to overheat anytime soon.
Looking forward, the expected change in Fed policy should narrow the path of interest rates in 2019. During the current cycle of interest rate increases that began in 2015, the highest yield that has been reached on the 10-year Treasury note was 3.23% on November 18, 2018, while the lowest yield on the 10-year note since 2017 was 2.37% at the end of March this year. With the Fed on the sideline, it is hard to believe that 10-year yields can break out of its current range. Seeing the 10-year trade the entire year between 2.35% and 2.75% would not be surprising. Rather than absolute interest rates, the shape of the yield curve could be more interesting. The yield spread between 10 year notes and 2 year notes is currently under +0.20%. If the markets are convinced economic growth is going to slow, this spread could go negative once again.
Investment-grade corporates started off the first quarter of 2019 at their widest spreads of the past couple of years. Much of that widening came in the last few weeks of 2018 but was quickly reversed during the month of January. Spreads continued to slowly grind tighter throughout the rest of the first quarter. One of the primary reasons spreads pushed wider at the end 2018 was concern over the record amount of outstanding corporate debt – approximately $5.3 trillion in investment grade corporate debt – while facing the potential of a global market slowdown. The large amount of outstanding debt is highlighted by the fact that half of that debt - approximately $2.5 trillion – is BBB rated. This is a significant jump from prior years, when BBB debt only accounted for 35% of total debt outstanding in 2006 and 28% in 1997. This is cause for concern because a downturn in the economy could be met with large amounts of the investment grade market being downgraded and flooding the much smaller high yield market, which stands at only $1.3 trillion currently. There could be huge price declines in the high yield market while it struggles to absorb the influx of debt.
There are plenty of bright spots that have caused investment grade credits to rebound. After years of increasing record issuance during the low Treasury yield and tight credit spread environment, supply is showing a slowing trend for a second straight year. Two of the companies with the largest amount of outstanding BBB-rated debt, AT&T and General Electric, are committed to paying down their debt load. Perhaps more importantly, the Federal Reserve looks to have halted further Fed tightening in order to keep the economy moving forward. The ensuing rally in Treasuries of about fifty basis points should mean overall yields could remain lower for the foreseeable future. That combined with tightening credit spreads should keep borrowing costs low.
Also, even though credit spreads have tightened significantly so far this year (Barclay’s IG Index is around +120, versus +157 at the beginning of the year), we are still a long way from historic tights (+75), so we can sit in a range around this area, or even continue to drift tighter for an extended period of time without external forces driving spreads one direction or the other.
Looking over at the high yield sector, the big rally in the credit market definitely carried over as high yield bonds had their best first quarter since 2003. The rally in high yield has been driven by a strong commodities market as well as yield grab by investors. Slowing new supply is also driving spreads tighter as new issuance in the first quarter fell to its lowest levels in three years. Three quarters of new supply was refinancing of existing debt.
Concerns going forward, of course, revolve around a slowing economy and its impact on the overall size of the high yield sector as well as a softening in the commodities sector where many high yield credits reside. Similar to investment grade corporates, the factors above should keep high yield debt on firmer footing in the near term with bonds continuing to trade in the current range.
The positive momentum the municipal market experienced late in 2018 continued into the first quarter of 2019. The diminishing chance of further Federal Reserve rate hikes, increased investor demand for tax-free income, and limited new-issue supply pushed municipal yields lower during the quarter.
The yield on 10-year AAA General Obligation bonds hit its year-to-date high on January 1st at 2.28% and finished the quarter 42 basis points lower at 1.86%. At the same time, 5-year AAA General Obligation bonds peaked at 1.94% and ended the quarter at 1.57%.
This decline in rates has produced a year-to-date return on the ICE BofAML 1-10 Year AAA-A Municipal Index of 2.04%, representing the best first quarter return since 2001 and surpassing all of 2018’s gain.
Also contributing to the decline in municipal yields was the limited new issue supply. While first quarter new issue supply, $65.5 billion, was higher than the same period in 2018, it is still below historical averages, thus, creating increased demand for bonds and tighter spreads. This aided in municipal yields declining at a faster pace than Treasury yields and pushing the municipal/ treasury ratio to expensive levels. At the end of the quarter, the 5-year ratio was at 70% and the 10-year ratio was at 77% compared to the 12-month averages of 73% and 83%.
Several factors that contributed to the firmer municipal market in the first quarter of 2019 could remain in place for the rest of the year. While dealers are expecting a slight increase in new issue supply for 2019, the elimination of municipal refinancing is keeping annual supply levels below historical averages. At the same time, investor demand for municipal debt continues to be steady. Similarly, higher redemption activity has created a negative net supply environment leading to tighter municipal credit spreads.
Municipal bonds remain appealing to many high-net worth investors for their low volatility and steady tax-free cash flow. Bonds from states with high state income taxes continue to be in demand and trade at tight spreads versus the AAA General Obligation scale. A lower, but positive GDP forecast, along with a more dovish tone from the Federal Reserve has been positive for bonds and could provide rate stability in the short run.
If the economy has more legs than is being priced in the market, rates could push higher. However, any backup in rates could be viewed as an entry point or buying opportunity. We continue to position portfolios with a neutral duration to 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.
BBVA is the trade name for BBVA USA, Member FDIC, and a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.
This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
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International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
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.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
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.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
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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).