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AAM Viewpoints – 2018 Mid-Year Fixed Income Review

Taxable Market

The first half of 2018 provided negative returns across fixed income asset classes with one exception – high yield. The most commonly referenced taxable fixed income index, the Bloomberg Barclays U.S. Aggregate Index, posted a loss of 1.62% with the worst performance in the investment grade corporate space. The Bloomberg Barclays U.S. Corporate Investment Grade Index is down 3.27% year-to-date (which is the worst semi-annual return since 2013) as a duration-driven selloff and spread widening led to a loss. This comes as no surprise as the Corporate component of the Aggregate Index has a duration of 7.26 and an average coupon of 3.96%. Below investment grade fixed income experienced positive returns in the first half of the year driven by strength in the energy sector in Q2 as the Bloomberg Barclays U.S. High Yield Index gained 16 basis-points (bps) with the Energy component returning 1.46% as WTI (West Texas Intermediate) crude finished the quarter at $74.15 per barrel.

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

U.S. Treasury markets began 2018 with the 10-year yield at 2.40% which rose 71 bps to a high as 3.11% by 5/17/2018. The income component of return remains important to fixed income investors though additional returns during the second quarter can also be attributed to marginally wider volatility. The 10-year U.S. Treasury yield remains well above the 1.37% posted in July 2016 after the Brexit vote. Since that day, the 10-year U.S. Treasury with a 1.625%% coupon has lost approximately 10% of its principal value. That’s six years of income.

 

Credit Spreads

Credit spreads are tight as we remain in one of the narrowest ranges since 2008. The ICE Bank of America Merrill Lynch U.S. Corporate BBB Option Adjusted Spread is only 163 bps over Treasuries and the ICE Bank of America Merrill Lynch U.S. High Yield (HY) Option Adjusted Spread is only 371 bps (see chart below). As recently as February of 2016 the spreads were 301 bps and 845 bps respectively. BBB spreads are 35 bps wider year-to-date while HY spreads are 13 bps wider this year and we would expect this widening trend to continue for the remainder of 2018 as the income generated from higher coupons should drive fixed income returns in this environment.

 

Municipal Market

A degree of uncertainty has clouded the municipal bond market in the first half of 2018, largely a result of provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) enacted in the closing days of 2017. Various provisions underlie declines in both supply and demand. The Bloomberg Barclays Municipal Bond Index was down 1.11% in Q1 (the first quarterly loss since the election in Q4 2016), but posted a 0.87% return in Q2 and is now down only 25 bps year-to-date.

Municipal bond issuance reached $30 billion for the third straight month, as the market prepares for what is expected to be a slow summer. At the half way point of 2018, volume stands at $161.05 billion (19.8% lower than $200.99 billion at this point last year). According to Bloomberg, state and local governments are expected to issue $30.2B in municipal bonds in the next month.

Source: The Bond Buyer

Demand for municipal assets remains as investors continue to add money to mutual funds and exchange-traded funds (ETFs). The Investment Company Institute (ICI) estimates $13.5 billion (vs. $16.9 billion in the first half of 2017) have flowed into municipal mutual funds and ETFs in the first half of 2018. Meanwhile, taxable bond mutual funds and ETFs have seen inflows of $113.1 billion which trails the $186.2 billion at this point in 2017.

 

Yield Curve

The U.S. Treasury curve flattened as short-term yields rose during the first half of 2018. The spread between the 30-year U.S. Treasury yield and the 5-year U.S. Treasury yield dropped from 41 bps on March 31 to 25 bps on June 30. Although the curve is flatter by 70 bps since June 2017, the slope remains positive and we feel this indicates that the expansion still has some breathing room. Investors should respect the yield curve but not panic when the curve inverts (shorter maturities have higher yields than longer maturities). 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 go to cash 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.

Investors also tend to focus on the spread between the 10-year U.S. Treasury and the 2-year U.S. Treasury. 10-year yields reflect both growth and the inflation outlooks while the short end is tied to market expectations and Fed policy. The chart below shows the recent flattening for both 30s and 5s and 10s and 2s.

 

Outlook

We see a sustained global and U.S. economic expansion. Solid growth and a return of mild inflation expectations have kept the Fed on track with potentially two more rate hikes this year. It’s unlikely the Fed will cut the expansion short with its steady interest rate increases and balance sheet reduction. The U.S. Treasury curve is flatter than it has been in more than a decade, raising the possibility of a yield curve inversion, but even if it inverts this sign is typically 18-24 months ahead of a recession. Note that the recent trend is in line with prior tightening cycles. The current non-inverted slope of the curve remains consistent with economic expansion.

Although we believe the current cycle will extend through at least 2019, we are entering 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. As the economic cycle progresses, fixed income investors may benefit from the tightening in Fed policy. With short-term rates likely rising more than long-term rates, there is less of a need to stretch for yield than during the era of easy money.

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 has the potential to allow the fixed income investors to stay invested in volatile markets and provides a ballast to equity exposure in your portfolio.

 

CRN: 2018-0702-6742 R

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.