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AAM Viewpoints – Mid-Year Fixed Income Review

Taxable Market

The first half of 2017 provided 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 2.27% with slightly higher returns in the Investment Grade Corporate Space. The Bloomberg Barclays U.S. Corporate Investment Grade Index returned 3.8% year to date (YTD). Higher average coupon and greater interest rate sensitivity both helped the sector outperform U.S. Treasury and Agency issues during the same timeframe. Below investment grade fixed income experienced slightly lower returns in the second quarter resulting from early quarterly performance being offset by Energy sector weakness.

Source: AAM – Bloomberg Barclays Live | Past performance is not indicative of future results

U.S. Treasury markets continued their largely range-bound activity through the second quarter. With the 10-year yield in a range of 2.12% to 2.42%, the income component of return remains important to fixed income investors though additional returns during the second quarter can be attributed to marginally wider volatility. The 10-year U.S. Treasury yield rose from a 2.14% to 2.30% in the last four days of the quarter and remains well above the 1.37% posted last July after the Brexit vote. Since that day in July 2016, a 10-year U.S. Treasury with a 2% coupon has lost approximately 7.5% of its principal value. That’s almost four years of income.

Source: U.S. Department of the Treasury

Credit Spreads

Credit spreads are relatively tight at this time and we are in one of the narrowest ranges since 2008. The Bank of America Merrill Lynch U.S. Corporate BBB Option Adjusted Spread is only 146 basis points (bps) over treasuries and the Bank of America Merrill Lynch U.S. High Yield Option Adjusted Spread is only 377bps (see chart below). As recently as February 2016, the spreads were 301bps and 845 bps respectively. We do not expect continued spread tightening from these levels and continue to favor more credit-sensitive holdings in a flat to rising rate environment. We expect the income generated from higher coupons to drive fixed income returns in the current environment and this, along with benign default rates, have the potential to benefit lower investment grade holdings.

Municipal Market

The Bloomberg Barclays Municipal Bond Index was down in June, which was its first negative performance month since the post-election sell-off. On June 29 yields on 10-year AAA bonds rose 7 bps to 1.95%, the steepest one-day increase since December 15 as speculation that the world’s central banks will take a more aggressive tack toward raising interest rates. New issuance was underwhelming at just $36.8 billion in June (down 23% year over year). On July 1 a new fiscal year began for 46 states and 10 did not pass a budget on time. Although municipalities remain strong with minimal defaults, some states continue to struggle with expenditures outpacing revenues while other states struggle with political challenges.

Demand for municipal assets remain high as investors continue to add money to mutual funds and exchange traded funds (ETFs). The Investment Company Institute (ICI) estimates $16.9 billion have flowed into municipal mutual funds and ETFs in the first half of 2017. Meanwhile, taxable bond mutual funds and ETFs have seen inflows of $186.2 billion which already exceeds the $160 billion in 2016.

Yield Curve

The U.S. Treasury and Municipal curves flattened as yields rose during the second quarter as global central banks took a more hawkish tone. The spread between the 30-year U.S. Treasury yield and the 5-year U.S. Treasury yield dropped from 108bps on March 31 to 95bps on June 30. Since the yield curve is still positive, it seems the expansion still has some breathing room. When the curve inverts (shorter maturities have higher yields than longer maturities) is when to begin thinking about a recession. The last three times the yield curve inverted it did predict an upcoming recession. However, a flattening curve doesn’t mean it’s time to panic because after the curve inverted it was 14 months before the 1990-91 recession, nine months before the 2001 recession and 16 months before the downturn in 2008-09.

Outlook

As we enter the second half of the year, we continue to favor credit risk over duration risk. Income payments, rather than higher prices, will likely be a key driver in total returns if interest rates rise. Higher interest rates are coincident with periods of economic growth and we are witnessing increasing economic growth around the globe. Higher interest rates are also correlated to inflation. Although we have seen muted inflation data recently, global central banks are targeting higher inflation and we believe they will be successful at achieving their objective.

CRN: 2017-0710-6032R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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Effective, June 10, 2016, please note that Gene Peroni left Advisors Asset Management (AAM) to become President of Peroni Portfolio Advisors, Inc. Peroni Portfolio Advisors, Inc. ("PPA") is an investment advisor independent of AAM.