Fixed Income Outlook
The “Good Place” Economy
After both the October and December Federal Open Market Committee meetings, Fed Chair Jerome Powell insisted the economy is in a “good place” signaling that the central bank is likely to remain on hold throughout 2020. With moderate economic growth and a pause in monetary policy, yields in the US Treasury market are expected to trade in a fairly tight range throughout 2020. The 10 year US Treasury yield closed 2019 at 1.92%, and appears to be content to trade in a 1.75% to 2.00% band in the first quarter. However, the potential for market volatility is ever present as we enter into a presidential election year.
In the fourth quarter, investment grade credit spreads continued to tighten, finishing the year at levels not seen since early 2018. For the year, credit spreads tightened 61 basis points as a result of solid fundamentals and light supply. The tightening in spreads trimmed nearly a third off of the Barclay’s Investment Grade Index taking it from +157 to +96 on December 31st. As a result of tightening spreads, investment grade corporate bonds rallied up 1.11% for the quarter and 10.20% in 2019.
New issue supply was down a little less than 5% in 2019 at a volume of over $1.1 trillion. However, expectations are for a solid start to new supply for 2020, which should be fairly well absorbed by strong investor demand. As a result, credit spreads should be able to trade in a relatively tight band, which should lend support to investment grade credit in 2020.
There are, however, some downside risks that could possibly impact the corporate market going forward. Headlines regarding the 2020 presidential election and the ongoing impeachment proceedings could cause substantial volatility in the market. Meanwhile, across the pond Britain’s divorce from the European Union could also have an impact on corporate rates.
The high yield sector also rallied in 2019 – the strongest performance since 2016. For the year, the Barclay’s High Yield Index returned 14.25%. Solid fundamentals and low default rates led to a grind lower in spreads, even though new supply in 2019 was significantly higher than in 2018. Looking forward, it would be difficult for the high yield sector to have similar results in 2020. However, if the status quo remains, high yield may be able to stay in this range. The sector tends to follow equities, so anything that significantly disrupts stocks or the commodity market could have an impact on high yield performance. Due to the tightness in spreads and the correlation with energy prices, we continue to monitor the high yield space.
The municipal market posted positive returns for the fourth quarter and the year due to accommodative monetary policy along with consistent demand for tax-exempt. Lower interest rates and narrower credit spreads contributed to returns exceeding expectations for the year. The 10-year AAA General Obligation bonds ended the quarter with a yield of 1.48% after hitting a high of 1.59% during the quarter. At the same time, the yield on 5-year AAA General Obligation bonds dropped 14 basis points to end the quarter at 1.14% creating a slightly steeper yield curve. This move in rates produced a quarterly return of 0.73% on the ICE BofAML 1-10 Year AAA-A Municipal Index. For the year, the index returned 5.08% - the best yearly return since 2011.
Fourth quarter new issue supply was 29% higher than a year earlier at $100.4 billion as issuers took advantage of low rates to issue and refinance debt. Off-setting the increase in supply was steady investor demand from individuals and mutual funds. A clear indication of consistent demand is Lipper, which has reported 51 consecutive weeks of positive inflows into tax-free mutual funds.
The conditions that set the tone for the municipal market in 2019 are expected to stay intact for 2020. Negative net supply should help keep credit spreads tight and hold the market in a narrow trading range into the first quarter. Investors are expected to continue capital allocations into municipals as tax adjusted municipal yields remain attractive to high net worth individuals seeking tax-free income. In particular, 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 first 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 moderating 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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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).