INSIGHTS

On July 22, 2019

AAM Viewpoints – 2019 Mid-Year Fixed Income Review

Taxable Market

The first half of 2019 produced positive returns across fixed income asset classes. The most commonly referenced taxable fixed income index, the Bloomberg Barclays U.S. Aggregate Index, posted a gain of 6.11% year-to-date with the best performance in the index coming from the investment grade corporate component. The Bloomberg Barclays U.S. Corporate Investment Grade Index was up 9.85% year-to-date, after posting a loss of 2.51% in 2018, as a duration-driven rally and spread tightening led to the gains. Below investment grade fixed income also experienced positive returns in the first half of the year driven by strength in the financial sector as the Bloomberg Barclays U.S. High Yield Index gained 9.94% with the financial component returning 11.37%.

U.S. Treasury markets began 2019 with the 10-year yield at 2.68% and then fell 70 bps (basis points) to a closing low of 1.98% on June 25. The income component of return remains important to fixed income investors though additional returns during the second quarter can also be attributed to interest rate volatility. The 10-year U.S. Treasury yield remains well above the 1.37% posted in July 2016 after the Brexit vote. Although the Treasury rally that started late last year produced 5% of price appreciation, since 2016 the 10-year U.S. Treasury with a 1.625%% coupon is still down 3.31% in value (approximately two years of income).

Municipal Market

The Bloomberg Barclays Municipal Bond Index was up 2.9% in Q1 (1^st quarter) and posted a 2.14% return in Q2 (2^nd quarter) and is now up 6.71% over the trailing 12 months. Municipal-to-Treasury ratios are a popular metric to measure relative value for tax-exempt debt and have widened since Q1 2019 but are still well below their 10-year averages. Despite the mounting uncertainties over the U.S. and global economies, tax-exempt debt looks poised to continue delivering positive returns into the second half of 2019.

Municipal bond issuance reached $166.8 billion year-to-date which is slightly higher than the $161.05 billion at this point last year. According to Bloomberg, state and local governments are expected to issue only $2.2 billion in bonds over the next 30 days. This is well below the 200-day moving average of $7.6 billion.

Source: AAM – The Bond Buyer

Demand for municipal assets remains high as investors continued to add money to mutual funds and exchange-traded funds (ETFs) for the past 25 consecutive weeks. The Investment Company Institute (ICI) estimates $51.9 billion (vs. $13.5 billion in the first six months of 2018) have flowed into municipal mutual funds and ETFs in the first half of 2019. Although Municipal ETF inflows are significantly less than mutual funds, they have taken in about $4.2 billion this year which marks the best start to a year on record and puts them on pace for the biggest annual influx since ETFs began investing in municipal bonds in 2007. Meanwhile, taxable bond mutual funds and ETFs have seen inflows of $167.8 billion which exceeds the $113.1 billion at this point in 2018.

Defaults

Moody’s reports the global trailing 12-month speculative default rate closed Q2 at 2.3% which was up from 2.1% at the end of Q1 and down from 2.9% in Q2 2018. The expectation is for the global default rate to finish 2019 at 2.4% and climb to 2.6% by the end of 2020. The U.S. speculative default rate closed Q2 at 3% and was up from 2.6% in the first quarter, but down from 3.6% in Q2 2018. Moody’s forecasts that the speculative grade default rate will finish 2019 at 3.2% based on the assumption that capital markets will remain open to speculative grade companies to refinance their debt over the next 12 months.

Credit Spreads

Credit spreads have tightened after a move wider at the end of 2018. The ICE Bank of America Merrill Lynch U.S. Corporate BBB Option Adjusted Spread is only 156 bps over treasuries and the ICE Bank of America Merrill Lynch U.S. High Yield (HY) Option Adjusted Spread is only 407 bps (see chart below). As recently as February of 2016 the spreads were 303 bps and 887 bps respectively. BBB spreads are 45 bps tighter year-to-date while HY spreads are 126 bps tighter this year.

Yield Curve

The U.S. Treasury curve steepened in Q2 as expectations of a Fed rate cut increased. The spread between the 30-year U.S. Treasury yield and the 5-year U.S. Treasury yield rose from 50 bps at the end of 2018 to 76 bps on June 30^th. Although the 30-year minus 5-year curve is steeper by 43 bps since June of 2018, the 10-year minus 2-year remains the same at 25 bps. In the short end of the curve we currently have an inversion (shorter maturities have higher yields than longer maturities) with the 3-month Treasury yield at 2.06%, the 2-year at 1.75%, the 3-year at 1.70% and the 5-year at 1.76%. The first inversion occurred on 3/22/19 when the three-month Treasury yield moved higher than the 10-year Treasury. The chart below shows reflects the steepening in both 30s and 5s and 10s and 2s.

Outlook

Interest rates around the globe are lower with nearly $13 trillion in global sovereign debt in negative territory as central banks maintain accommodative monetary policy. This makes U.S. Treasuries look attractive to foreign investors. Expectations here in the United States are for the Fed to cut rates later this month. If the Fed cuts rates 25 bps, we would expect limited volatility, as expectations for a cut are near 100%. We would likely see the yield curve return to a positive slope with short-term rates moving down and long-term rates holding or moving down slightly. If the Fed postpones a cut, we anticipate increased volatility because that would be a surprise the market does not anticipate. Only the 10-year minus 3-month Fed Funds yield curve is inverted at this time while the more common curves, 10-year minus 2-year and 30-year minus 5-year, remain positively pitched and have been steepening. This steepening would indicate a sustained U.S. economic expansion.

Although we believe the current cycle will extend through late 2020, we are in the late stage of this business cycle. The late-cycle phase presents both opportunities and risks for fixed income investors and is often a time of rising volatility. This is the time to know what you own and understand where the risk lies in your fixed income portfolio. Hiring a professional management team with an experienced track record can help clients sleep at night during this stage of the cycle. Active managers will diversify portfolios across asset classes, sectors, maturities and tactically adjust duration as needed. Our playbook is telling us to evaluate opportunities to bring in duration, tighten credit quality, beware of tight spreads, increase exposure to Treasuries and Agencies, review Corporate exposure, and stress test portfolios. This approach allows the fixed income investors to stay invested in volatile markets and provides a ballast to equity exposure in your portfolio.