INSIGHTS

On July 20, 2020

AAM Viewpoints – 2020 Mid-Year Fixed Income Review

Taxable Market

The first half of 2020 was a tale of two very different markets. The first quarter (Q1) was one for the record books as many of us looked forward to an end to the global lockdown and a return to normalcy. The impact of the coronavirus spreading around the globe was unprecedented and the results in equity and fixed income markets reflect the uncertainty we were – and still are – facing. Adding to the volatility, on March 9 oil prices had their biggest one-day drop since the Gulf War in 1991 when the price fell 25% as Saudi Arabia and Russia decided to increase oil production which pushed the price down 67% during the quarter.

The U.S. stock market fell into a bear market in just 22 days, the shortest time ever, while the peak-to-trough drop has typically taken 12 to 18 months. Highlighting the significance of these moves, the Volatility Index (VIX) closed at an all-time high on March 16. The 10-year Treasury Volatility Index (TYVIX) also moved into historic territory on March 19th as the 10-year and 30-year Treasury bond yields fell to all-time lows of 0.54% and 0.99% respectively. The shutdown of the economy and the ensuing flight to safety pushed Treasury returns over 8% as volatility spiked with the uncertainty of the impact of coronavirus spreading around the globe.

Q2 was a different story with virtually every asset class posting positive performance. One of the primary drivers for the rebound were actions from the Federal Reserve with the announcement of the Primary Market Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF) on March 23. Once the facilities were announced, bond prices moved up as concerns about companies’ ability to repay or refinance debt came down and corporate bond issuance boomed with year to date investment grade issuance topping $1.2 trillion, up 99% from the same period last year. The Q2 total of $730 billion was a new record and broke the previous record set in Q1 of $494 billion.

Although returns have been positive year to date, the swings have been astonishing as we look for a path through the economic downturn with the recent escalation of cases in the U.S. and anticipated impact on global GDP estimates. A rating agency predicted the record number of sovereign downgrades caused by the lockdown will, for the first time ever, leave more countries in the junk category than in the investment grade category. They estimate the lockdown will leave a global fiscal deficit of $9.7 trillion this year which is approximately 12% of global GDP and overall debt is expected to reach $76 trillion, which is 95% of global GDP. The agency has already taken 32 negative rating actions affecting 26 countries and has 117 sovereign grades on negative outlook.

It appears volatility is likely to remain high throughout the remainder of the year as we evaluate corporate earnings while the potential for surges in coronavirus cases remains. Additionally, unemployment is expected to improve but remain high by historical standards and let’s not forget about the upcoming election.

The most commonly referenced taxable fixed income index, the Bloomberg Barclays U.S. Aggregate Index, posted a gain of 6.14% year to date with the best performance in the index coming from the Treasury component which was up 8.71%. The Bloomberg Barclays U.S. Corporate Investment Grade Index was up 5.02% year to date, after posting a gain of 14.54% in 2019. The difference between Q1 and Q2 is also evident in Bloomberg Barclays U.S. High Yield Index which lost -12.68% in Q1 and gained 10.18% in Q2 with Energy losing -38.94% in Q1 and gaining 40.01% in the second quarter.

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

The 10-year Treasury started the year yielding 1.91%, as the three-month Treasury bill yield went negative at times. The 10-year yield closed out the first half of 2020 with a yield of 0.657%, down 125bps (basis points), after reaching an all-time closing low yield of 0.543% on March 9. With a trailing 12-month return of 10.45% we believe the asset class doesn’t offer a compelling value over the long term as yields remain near all-time lows. With the 10-year Treasury yielding 65bps you are earning a historically low 6.8bps of yield per unit of duration.

The prices of corporate bonds rebounded sharply as investment grade bonds with a triple-A rating have outperformed the most, up 9.62% year to date, largely driven by the longer duration nature of the triple-A tier and a flight to quality. Single-A bonds have outperformed triple-Bs, up 6.18% and 3.36% respectively.

Municipal Market

The Bloomberg Barclays Municipal Bond Index was down 0.63% in Q1 and posted a 2.72% gain in Q2 and is now up 4.45% over the trailing 12 months. The Municipal-to-Treasury ratio, a popular metric to measure relative value for tax-exempt debt, finished Q2 at 130% which was well above the 10-year average of 97% reflecting tax exempt municipals are cheap to Treasuries. 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 2020. 

Municipal bond issuance of nearly $200 billion year to date is 20% higher than $166.8 billion last year for the same period. According to Bloomberg, state and local governments are expected to issue only $11.2 billion in bonds over the next 30 days. This remains below the year-to-date average of $14.17 billion and in line with the 2019 30-day visible supply of $11.9 billion.

Source: AAM, The Bond Buyer

Demand for municipal assets dropped with $1.55 billion in outflows from mutual funds and exchange-traded funds (ETFs) in the first half of 2020. The Investment Company Institute (ICI) estimates $44.46 billion (vs. $51.9 billion in inflows in the first six months of 2019) have flowed out of municipal mutual funds and ETFs in March alone. Meanwhile, taxable bond mutual funds and ETFs have seen outflows of $67.2 billion versus $167.8 billion in inflows at this point in 2019.

Defaults

Moody’s reports the global trailing 12-month speculative default rate closed Q2 at 5.4%, a 10-year high, which was up from 4.8% at the end of May and up from 2.4% a year earlier. The expectation is for the global default rate to finish 2020 at 9.3%. The U.S. speculative default rate closed Q2 at 7.3% and was up from 6.4% in May and 3% a year ago. Moody’s forecasts the U.S. speculative grade default rate will finish 2020 at 12.2%, peaking at 12.4% early next year before declining to 10.5% in June 2021 (long-term average of 4.5%). These forecasts assume that the U.S. high-yield spread will tighten to below 500bps over the next four quarters while the U.S. unemployment rate will remain around 10% over the same period.

Credit Spreads

Spreads in U.S. Investment Grade continued to rally in June, with the IG index tighter by 26bps. Index spreads ended the month at 160bps and are 60bps wider year to date. Bonds at the front of the curve rallied the most in June, with 3-year tighter 33bps, and the belly of the curve tighter 35bps and the long-end 16bps.

The ICE Bank of America Merrill Lynch U.S. Corporate BBB Option Adjusted Spread (OAS) is 207bps over treasuries and the ICE Bank of America Merrill Lynch U.S. High Yield Option Adjusted Spread is 644bps (see chart below). As recently as March 23 the spreads were 488bps and 1087bps respectively. BBB spreads are 77bps wider year to date while HY spreads are 284bps wider this year after tightening since March.

Yield Curve

The spread between the 30-year U.S. Treasury yield and the 5-year U.S. Treasury yield rose from 69bps at the end of 2019 to 112bp on June 30. While the 30-year minus the 5-year curve is steeper by 42bps year to date, the 10-year minus 2-year is steeper by 15bps. The chart below shows reflects the steepening in 30s and 5s, 10s and 2s and 10s and 3-month Treasury bill.

Outlook

Interest rates around the globe remain low with approximately $13.385 trillion in global debt in negative territory at the end of Q2. The U.S. presidential election and uncertainty surrounding the virus spreading, as more states backtrack on re-opening plans, indicates the volatility will remain high for the remainder of the year. Assuming that is the case, you should be reviewing what you own and expect more corporate and municipal downgrades. The performance of the economy will depend on how individual states respond to an upsurge in cases and the impact on the public’s behavior.

This environment presents both opportunities and risks for fixed income investors. This is the time to understand where the risk lies in your fixed income portfolio. Hiring a professional management team with an experienced track record can help clients sleep better at night during this stage of the cycle. Active managers generally diversify portfolios across asset classes, sectors, maturities and tactically adjust duration as needed. Although there is no playbook for a global shutdown, if you believe the recession is coming to an end, we believe you should consider evaluating opportunities to bring in duration, understand risks associated with accommodative global central banks targeting inflation growth, review corporate and municipal exposure and stress test portfolios. This approach allows fixed income investors to stay invested in volatile markets and provides a potential ballast to equity exposure in your portfolio.

CRN: 2020-0713-8418 R