Fixed Income Outlook
Weathering a Storm
The U.S. bond market had a wild ride in the first quarter of 2020. The yield on the 10-year U. S. Treasury note began the year at 1.92% and corporate credit spreads were near all-time tights. At the time, the U.S. economy was showing solid growth, and the labor market remained strong. On February 19th, corporate credit spreads hit all-time lows in tandem with the U.S. equity market notching an all-time high. Shortly after, it became apparent the coronavirus, also known as Covid-19, would be a much bigger problem than initially thought. As a result, both the equity and credit markets began selling off. In the middle of the virus concerns, Saudi Arabia and Russia began a production war that crushed the price of crude oil and hit lower rated energy companies hard.
In two highly unusual moves, the Federal Reserve lowered the overnight lending rate to 0.00%, the first time it had been at that level since the 2008 financial crisis. As the situation worsened, the Fed began implementing several more of the programs used in the 2008 financial crisis to keep adequate liquidity in the markets. The yield on the 10-year note hit a record low of 0.54% on March 9th. The Fed’s programs including their guarantees and backstops, stabilized the credit market, which began recovering on March 20th.
During the first two months of the year, investment grade credit spreads remained relatively steady at around +100 basis points. As Covid-19 concerns escalated and shelter in place orders were mandated by municipalities and employers, spreads began to dramatically widen as many revenue and company solvency concerns began to creep into the market. On March 20th, investment grade credit spreads ballooned nearly a fourfold to +373 basis points. Within a week however, we finished the quarter at +272 basis points as a result of credit support from the fiscal and monetary policies implemented.
Investment grade new supply languished for much of the first quarter as supply ran well behind the pace set over the past few years. This all changed in the final two weeks of the quarter as each week saw record issuance of over $109 billion each as companies tapped into the credit market to help fund through the times ahead. These new deals were priced cheaply in the market and were well received. There were anywhere from four to as much as twelve times as many orders for each deal priced. This, in turn, saw deals tighten 25 to 50 basis points, or even larger, in response to the heightened demand of these deals as they came.
The landscape of the credit market has changed significantly since the pandemic was declared. Globally, the debt of approximately 37 companies was downgraded to high yield. Of these, 17 were domestic companies. The high yield bond market followed much of the same pattern as investment grade throughout the quarter. The high yield index slid from about +350 basis points to +1100 basis points at the widest point in March. Since the announcement of Fed policy to purchase investment grade and high-yield bonds, the high yield sector has recovered to around +900 basis points.
However, the bounce back remains muted on the back of a soft commodities sector, primarily oil, as well as the general risk aversion seen by investors currently. With OPEC, Russia, and Saudi Arabia recently agreeing on a production cut deal, we have seen some further stabilization in the space.
These are certainly unchartered waters for the markets. The government-mandated shutdown of the economy is without precedent and makes the future virtually impossible to model. Movements in the fixed income market will be largely tied to the length of the shutdown and the speed of recovery of the post-virus economy. In light of the” by any means necessary” policy shown by the government, the credit market should remain generally stable and spreads should continue to stabilize, if not tighten, going forward. Any signs of progress on the medical front in developing treatments or vaccinations will probably be met with a further rebound in credit.
The municipal bond market started the quarter with strong buying as investors continued to seek tax-free income. Heavy investor demand and limited new issue supply pushed the yield on 10-year AAA General Obligation bonds to an all-time low of 0.73% on March 9th. As the Covid-19 virus fears started to roil the markets, municipal bond fund managers were caught in a liquidity squeeze as investors pulled money from the markets.
On March 20th, fund managers, faced with billions in redemptions, began to overwhelm the market with selling, which pushed the yield on the 1-10-year AAA General Obligation to a 12-month high of 2.79%. Municipal credit spreads also gapped wider as the market was under pressure. However, the sell-off did not last long as investors were quick to snap up bonds at the higher yield levels. This rush of buying pushed yields back down to finish the month at 1.33%. The roller coaster moves in rates produced a monthly return of -1.94% on the ICE BofAML 1-10 Year AAA-A Municipal Index and a year-to-date return of -0.32% - the first negative quarterly return since 2018.
As the market has begun to stabilize, municipal credits are adjusting to new levels and assessing the impact of slowing tax revenues. High-grade credits have held up well and the spread has narrowed. However, the high-yield municipal market, while off the lows, is still trying to find its footing. The Bloomberg Barclays Municipal High Yield Index returned -6.88% for the quarter and -11.00% for the month of March.
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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.
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).