Fixed Income Outlook
What Used to be Unprecedented Could Become Conventional
In the second quarter of 2020, the US. fixed income markets recovered from the volatility in March. It appears the height of the recent move, the highest risk premiums, and widest credit spreads occurred on March 20th. As the Federal Reserve began massive liquidity injections and credit backstops, investors had enough confidence in the credit markets to provide stability. In addition to the Fed, Congress provided fiscal stimulus to help offset the unprecedented government- mandated shutdowns of most state economies due to the outbreak of the coronavirus.
It is important to remember the equity markets hit an all-time high on February 19, the economy was solid, and unemployment in virtually all demographic groups was at multi decade lows. The damage to the economy from coronavirus is almost beyond comprehension. The U.S. economy contracted 5.0% annualized in the first quarter, the first contraction since the fourth quarter of 2008. Over forty million Americans have filed for some type of employment assistance. Personal and business bankruptcies are expected to soar.
The initial reactions by state and local governments was to issue shelter in place orders, close most non-essential businesses, and ban any type of commercial or recreational gathering. The shutdown was effective, but at an enormous damage to the economy. Governments began reopening their economies as quickly as their health situation allowed. The reopenings have created a second wave of infections in the South and West, and governments are experimenting with various rules and regulations trying to limit the spread of the virus and that are expected to create the least amount of damage to their economies.
The credit markets snapped back from the declines of March, and outperformed government bonds in the second quarter. The two year U.S. Treasury note has traded around 0.20%. The ten year U.S. Treasury note has traded mostly between 0.60% and 0.80%. 1-10-year US Treasuries returned 0.42% in the first quarter. 1-10 year high grade corporate bonds, those rated A3/A- or better, returned 5.93%. 1-10-year investment grade corporate bonds, those rated Baa3/BBB- or higher, returned 7.88%. 1-10-year high yield bonds, those rated below Baa3/BBB-, returned 9.13%.
Going forward, the bond market will try to determine the level that the economy can grow and still allow economic activity to be slowed enough to slow the spread of the virus. The credit markets are expected to be stable with the massive Fed support solidly in place. The Fed has indicated that stimulus and support will stay as long as needed. Interest rates are not expected to rise dramatically, as the Fed is expected to be active in keeping them low to support the recovery. As the summer progresses, the November Presidential election will become another unknown to the outlook.
The second quarter was one of massive corporate debt supply. At quarter end, investment grade new supply had already crossed the $1 trillion mark, nearly double last year’s pace and almost matching the record supply of $1.3 trillion set back in 2017. Even with the extremely heavy supply calendar, demand for new issues has remained strong with almost every deal being several times oversubscribed. Expectations are for new supply to slow down in the second half of 2020 and should be in line with the numbers seen in the second half of last year.
After hitting their widest point in late March, credit spreads saw a dramatic recovery throughout the second quarter. The Fed helped stabilize the investment grade corporate credit market by creating a buying program, primarily in the one to five-year part of the curve. The gradual reopening of the economy throughout the second quarter also calmed market nerves, and by the end of June, credit spreads returned to the pre-shutdown levels of early March. After reaching a high of +373 basis on March 23, the Barclays Investment Grade Index closed out June at +150 basis points. A significant improvement, but still shy of the +90-100 basis point range seen at the beginning of 2020. Going forward, credit spreads should generally continue on the path to recovery, though a second Covid wave in the fall and a reclosure of the economy would put negative pressure on credits.
The high yield sector had its best quarter in a decade and saw returns of over 10%. Recovering commodities prices, especially in the oil market which pushed past the $40 per barrel mark, helped lift the Barclays High Yield Index to a close at +624 basis points on June 30 after reaching as high as +1100 basis points in late March. While the recovery in high yield bonds has been dramatic, spreads still remain at about double where they started the year.
The municipal bond market experienced a strong rally in the second quarter of 2020 as attractive yields brought investors into the asset class. Increased government intervention, strong investor demand for tax-free income, and limited new issue supply pushed municipal yields lower during the quarter.
Municipal bond yields followed the Treasury market lower in anticipation that the Federal Reserve will keep rates low for an extended period of time. The yield on the 10-year AAA General Obligation bonds hit its high for the quarter on April 2nd and finished the quarter 98 basis points lower at 0.85%. At the same time, the yield on the 5-year AAA General Obligation bond dropped 96 basis points to end the quarter at 0.45%. This decline in rates produced a quarterly return of 2.56% on the ICE BofAML 1-10 Year AAA-A Municipal Index and was the highest quarterly return since the third quarter of 2009.
The positive returns were driven by the Federal Reserve announcing the Municipal Liquidity Facility in April to help with the cash crunch facing State and Local Governments by buying short-term debt sold to cover revenue shortfalls caused by the pandemic. Also contributing to the decline in municipal yields was the limited new issue supply. Second quarter new issue supply, at $74.6 billion, was 6.5% lower than the same period in 2019. The limited new issue supply and steady investor demand contributed to lower yields and tighter spreads. The high-yield municipal sector also performed well as lower yields pushed investors to take on more risk.
As stability starts to return to the market, municipal credits are adjusting to new levels and assessing the impact of slowing tax revenues on municipal credits. High-grade credits have been in strong demand and spreads have compressed. The market is experiencing a bottom-up credit rally as investors take on more risk to achieve their yield targets. New issue supply is expected to remain lower than average. At the same time, increased demand from summer reinvestment coupled with positive flows into the asset class provides supportive technical for the next few months.
We look to position portfolios with a neutral duration while focusing on the 1 to 10-year part of the yield curve. We prefer high-grade municipal revenue credits rated AA-AAA with dedicated revenue streams as a hedge against a slower economy. High-grade State and Local General Obligation credits provide a strong foundation to portfolios while callable bonds could offer value for their higher yield and shorter duration. As we move closer to the November elections, the increased talk of potential higher taxes should increase investor demand for tax-free bonds. Any backup in rates should be viewed as an entry point for adding municipal bonds to a portfolio or a buying opportunity for existing holdings.
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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.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
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.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
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).