Fixed Income Outlook

Range Bound?


The fixed income markets were relatively stable in the third quarter of 2020. After the initial shock and volatile reaction of the market in the first quarter, the Fed programs and fiscal stimulus enacted in the spring calmed the credit markets. Interest rates were stable in the third quarter with the benchmark ten-year Treasury note closing as low as 0.51% in August and as high as 0.76%. The average closing yield for the quarter was 0.65%, with the market closing between 0.60% and 0.70% most of the months of August and September.

The credit markets, backed by the liquidity and open market purchases of the Federal Reserve continued to stabilize and outperform US Treasuries. 1-10- year high grade corporate bonds rated A3/A- and higher had a total return in the third quarter of 0.99% vs. the 1-10 US Treasury total return of 0.19%. 1-10- year investment grade corporate bonds rated Baa3/BBB- and higher had a total return of 1.49%. 1-10-year high yield bonds, those rated below investment grade, had a total return of 4.55%. It was encouraging to see the credit markets snap back quickly after the volatility of the first quarter. 

Fed Chairman Powell indicated over the summer that the Fed will continue to support the markets as much as possible and that in his opinion more fiscal stimulus is needed to bolster the recovery. The Fed also outlined a new philosophy that they intend to allow inflation to trend above the Fed’s target for a period of time, to bring the average inflation rate up to the target. The Fed also indicated short term interest rates would probably remain at zero until possibly 2023.

For the remainder of 2020 the markets will focus on the continuing effects of the coronavirus pandemic, the attempts by Congress to pass additional fiscal stimulus after the elections, and the pace of the recovery in the employment markets. It would be prudent to assume that 10-year interest rates continue to close under 1.00% for the remainder of the year, and with the Fed backstopping the market, that credit risk spreads continue to be tame.

quarter end active treasury curves chart


Credit Markets

While the third quarter of 2020 continued to see strong supply, only September could crack the top ten heaviest supply months of all-time. This is after seeing four of the first six months of 2020 do the same, including the top three heaviest supply months ever. We did see 2020 surpass 2017 as the heaviest supply year ever over the summer and we still have a handful of months remaining in the year. At the end of September, new supply volume reached $1.54 trillion, which is about 67 percent ahead of last year’s pace. Even with all the record supply hitting the market, demand has kept up and is actually higher than in 2019. New deals have been 4 times oversubscribed versus 3.2 times in 2019 causing spreads on the new deals to tighten by over 25 basis points between the initial price talk and where the  deals actually released. In 2019, the spread compression was just below 20 basis points.


asset class returns chart


Credit spreads in the secondary market generally tightened in the first part of July before settling into a pretty narrow range for the remainder of the third quarter. After rallying during the first couple of weeks of July from +147bps to +129bps, the Barclays Investment Grade US Corporate Index hovered between +125bps and +135bps before slipping slightly wider in late September in sympathy with the weakness in equities. The index hit +140bps before finishing the quarter at +136bps. With expectations for new supply to slow dramatically in the fourth quarter, credit spreads should gradually tighten with the lighter supply as we head towards year-end. Watch for a possible second outbreak of Covid or uncertainty in the outcome of the elections to potentially create some volatility in the credit market.

The high yield sector followed a similar path in credit spreads throughout the third quarter. It appears the third quarter will end with a negative return of over 1%, the weakest return since March, though spreads do appear to be trending tighter. Record supply has also been felt in the high yield market with companies taking advantage of overall absolute yields being the lowest ever for the sector. High yield tends to follow a little more closely to the equity market, as well as commodities, so events that negatively impact those sectors could show up in high yield spreads as well.


Municipal Market

The municipal bond market posted positive returns in the third quarter of 2020 as investors continue to be attracted to the asset class. Steady investor demand for tax-free income, attractive relative value, and an accommodative Federal Reserve kept yield volatility low during the quarter. 

Municipal bond yields were range bound for much of the third quarter. The yield on the 10-year AAA General Obligation bonds hit its low for the quarter on August 10th but finished the quarter 31bps higher at 0.84%. At the same time, the yield on 5-year AAA General Obligation bonds rose just 11 basis points to end the quarter at 0.29%. While rates did move slightly higher during the third quarter the municipal market was able to post a positive quarterly return of 0.83% for the ICE BofA 1-10 Year AAA-A Municipal Securities Index. The positive returns were driven by steady investor demand as investors continue to be attracted to municipal bonds not only for tax-free income but for the attractive relative value. With Municipal/Treasury ratios above 100% crossover buyers were attracted to the municipal market for the absolute yield value. Also helping to keep rates in check was the Federal Reserve announcing that rates would probably remain low through 2023 setting up the lower for longer scenario. 

The Municipal Lending Facility (MLF), that was put into place under the CARES Act, will remain available through December 31, 2020. The MLF was establish to help provide State and Local Governments with additional liquidity by buying short-term debt to cover any revenue shortfalls caused by the pandemic. As of the 3rd quarter, only two municipalities, the State of Illinois and New York Metropolitan Transportation Authority, have accessed the program. At the same time, municipalities have not had any trouble issuing debt as new issue supply was 4% higher than the same time last year. Issuers brought new money tax-free deals along with taxable refunding deals to market taking advantage of the low rate environment.


As a form of normalcy starts to return to the market, municipal credits continue assess the impact of slowing tax revenues. High-Grade credits have been in strong demand and spreads have compressed. The market is experiencing a bottom-up credit rally as investors are starting to take on more risk to achieve their yield targets. New issue supply is expected to remain steady as issuers finish up financings for 2020. We look to position portfolios with a slightly short to neutral duration while focusing on the 1 to 10-year part of the yield curve as the economic numbers start to improve. We prefer High-Grade municipal revenue credits rated AA-AAA with dedicated revenue streams. 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. Increased talk of potential higher taxes due to the November election results could 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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Other Sources: Bloomberg;;; 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).