Markets recovered in September after the risk-off tone in August as trade rhetoric softened and economic data bounced back.
- U.S. Treasury rates rose across the curve over the month, with the 3- to 7-year yields rising the most.
- After a 30 percent drop in issuance during 1Q18, April municipal supply rebounded to $29 billion.
- Municipal bonds underperformed Treasury bonds in shorter-dated maturities, outperformed from 5 to 15 years and matched the Treasury performance on the long end.
- In corporates, short-duration bonds performed better, as investors were attracted by higher yields and continued to seek alternatives for short paper.
A Rainy Run
In the 2018 Boston Marathon, more than 25,000 determined runners trudged through brutal conditions that included blustery winds, heavy rains and near-freezing temperatures.1 The investment grade (IG) space combatted its own set of difficult conditions in April, as IG corporates and municipals weathered higher U.S. Treasury yields, rising hedging costs for foreign investors and unfavorable technicals.
In the May Fed meeting, the FOMC held pat, after increasing the Fed Funds rate to a range of 1.5 percent to 1.75 percent in the March meeting. The Fed said the inflation target is “symmetric,” which implies that the Fed is willing to allow inflation to overshoot its 2 percent target. Nonetheless, the market is pricing in two additional hikes in 2018 as nearly certain, and a third hike in December at 50 percent probability. The expected rate hikes come on the back of 2.3 percent GDP growth in 1Q18 and manufacturing PMI of 57.3 for April, down from 59.3 for March.
In April, the 10-year U.S. Treasury bond closed above 3 percent for the first time since January 2014, before a modest rally into month end. The jump higher was due to concerns about the China/U.S. trade negotiations, worries about Fed rate hikes and data showing higher inflation, and still-low unemployment. Readings on inflation have increased with the core PCE deflator rising to 2.5 percent in the first quarter, and with average hourly earnings seeing a 2.7 percent annual increase in March. The recent rise in commodity prices, particularly oil (Figure 1), also led to increased inflation fears during April.
Rates rose across the curve over the month, with the 3- to 7-year yields rising the most, and the 30-year bond yield rising the least. The yield curve remains very flat, with the spread between 2-year and 10-year maturities at less than 50 basis points (bps). FOMC moves remain a major global market focus, and the overall direction of the U.S. market seems highly dependent on “Fedspeak.”
In April, IG corporate and municipal bonds had negative total return. IG corporate bonds had a negligible excess return (0.04 percent) and underperformed equities, which posted a small positive return, and high yield corporates, which saw total return of 0.65 percent and excess return of 1.21 percent.2
Municipal Market Review
The Bloomberg Barclays Municipal Index posted a negative total return of 0.36 percent, bringing the year-to-date total return to -1.46 percent. Yields were higher by over 20bps in 2- to 3-year bonds, 15bps in 5-year bonds, less than 10bps in 10-year bonds and close to 15bps in 30-year bonds. The Bloomberg Barclays Municipal Bond: Long Bond (22+) Index had the worst returns, while the Bloomberg Barclays Municipal Bond: 1 Year (1-2) showed the least negative returns. Lower-quality bonds outperformed AAA-rated bonds by close to 20bps.
Municipal bonds underperformed Treasury bonds in shorter-dated maturities (2 to 3 years), outperformed from 5 to 15 years and matched the Treasury performance on the long end. The short end suffered from outflows in money market funds that pressured floating-rate bonds, which caused yields to rise on short-maturity municipals. Meanwhile, intermediate maturities outperformed due to a continued lack of new issue supply. The 10-year AAA ratio got close to a low of 80 percent near the end of month. That level bears watching, as it may trigger more selling from banks, insurance companies or other non-traditional municipal investors.
After a 30 percent drop in issuance during 1Q18, April supply rebounded to $29 billion, which was a 14 percent increase from the prior month and a 4 percent decline from April 2017. Year-to-date supply stands at $94 billion, a 23 percent decline versus the same period last year. After several weeks of outflows, mutual funds reversed course and posted over $200 million inflows for the week ending April 25. This pushed year-to-date total inflows to $6.5 billion.
Looking forward, technicals are supportive. Maturity reinvestment from May through August is approaching the high levels seen last summer, but we are entering this cycle with significantly less supply and lower ratios.
Municipal credit conditions remain stable; however, there continues to be targeted concerns in areas with credit stress, such as Illinois. If the state cannot get a balanced budget completed by the July deadline, it remains at risk for a ratings downgrade to non-investment grade, which may have ripple effects to local IL credits.
Corporate Market Review
Squall of Supply
In April, the Bloomberg Barclays U.S. Corporate Index had total return of -0.93 percent and excess return of 0.04 percent. The option-adjusted spread was about flat, closing at 108bps. Spreads were rangebound throughout the month.
IG corporate spreads started April off strong despite equity volatility and macro concerns. However, as supply rose strongly in the second half of the month (post earnings restrictions) and demand weakened, spreads retraced their tightening. High-grade new issue supply totaled $123.5 billion in April - the highest monthly April supply on record.3 This compares with supply of $124.8 billion in March and $84.5 billion in April 2017.
Short-duration bonds performed better, as investors were attracted by higher yields and continued to seek alternatives for short paper. By contrast, long-duration bonds fared worst, as they bore the brunt of elevated supply and rate volatility. Notably, in the first four months of 2018, $100 billion of non-financial market bonds longer than 10 years have been issued versus $64 billion in the first four months of 2017, or roughly 15 percent of the total (Figure 2).4
The hefty supply was met with softer demand. Long-term IG bond mutual funds reported slightly negative net inflows in April, and $34 billion year-to-date, as compared to $38 billion for the same period last year. Part of the slowdown is due to higher hedging costs for foreign investors. Hedging costs have risen to 2.8 percent, per BAML, versus less than 2 percent a year ago.5 This rise in costs is partly mitigated by the higher all-in rates that have come about this year.
The best-performing sectors included Energy, Consumer Cyclicals and Finance companies. Energy got a boost from higher crude oil prices, while Consumer Cyclicals benefited from strong earnings - particularly, strong results from Amazon.com. The worst performers were Tobacco, Sovereigns, Pharmaceuticals, Paper and Chemicals. Altria Group led underperformance in the Tobacco sector. Crossover bonds fared best, while BBBs had the worst showing.
Securitized Market Review
Running into LIBOR Concerns
For ABS, April saw continued focus on the widening LIBOR/OIS spread which is a proxy for funding pressures in the system. LIBOR represents unsecured borrowing rates between banks and the OIS leg represents collateralized borrowing rates (repo). This has the effect of widening swap spreads. As a result, ABS Treasury option-adjusted spreads rose, and are now at more attractive levels. ABS Treasury OAS rose from low 30s to mid-40s at quarter end, but partly reversed in April. Nominal spreads versus benchmark spreads have remained in a tight range year-to-date.
ABS technicals remain solid, contributing to year-to-date outperformance. ABS supply is up to $85 billion so far this year, or 5 percent higher versus the same period in 2017. The higher supply has been met with strong demand.
In MBS, April was steady given underwhelming supply, with April net supply running about $40 billion lower year-over-year. Mortgages remain one of the most-negatively correlated asset classes with higher-beta sectors of the market. However, the roll-off from the Fed’s balance sheet is gaining pace and Banks (normally a large buyer) have been noticeably absent in the sector, which has had a negative impact.
Going forward, higher home prices could impact affordability, which could then impact supply. Sales of existing homes increased by 1.1 percent to 5.6 million SAAR month-over-month in March, but still declined 1.2 percent versus a year ago.6
Strategy and Outlook
Treasuries Clock in at 3 Percent
Breckinridge’s Investment Committee notes solid labor data and the rise in core PCE, which have bolstered the Fed’s case for rate hikes. While business growth remained strong, the slowdown on the consumer side was notable, with consumption growing by only 1.1 percent, down from 4 percent last quarter. Despite the slowdown, the Fed should not be too concerned given that first-quarter growth has underwhelmed in prior years only to bounce back in subsequent quarters, and we still have price inflation and wage growth rising.
That said, in our view the transition from “quantitative easing” to “quantitative tightening” will eventually impact market performance and could delay a third rate hike in 2019. Additionally, we are closely following trade war concerns, potential negative surprises in economic data and geopolitical issues that may create headwinds for markets in the future.
We continue to expect a parallel shift in the curve. Following a jump in the 10-year Treasury yield to levels above 3 percent in April, we are monitoring further upward pressure on Treasury yields from the Fed’s unwind (lowering demand long-end Treasury bonds), the Fed’s rate hike cycle (increasing short-end rates) and the Treasury auction size (increasing supply).
Given rate volatility, markets that react strongly to Fed announcements and various risks to credit, we remain duration-neutral in our Tax Efficient and Government Credit strategies relative to their benchmarks. With the credit cycle in its later stages, our high-quality bias in credit and sector allocation remained unchanged in both Tax Efficient and Government Credit portfolios.
 Boston Athletic Association, as of May 4, 2018.
 Bloomberg Barclays, as of April 30, 2018.
 Bank of America Merrill Lynch, as of May 1, 2018.
 JP Morgan, as of May 3, 2018.
 Bank of America Merrill Lynch, as of April 30, 2018. Hedging costs calculated as annualized three-month dollar hedging costs for EUR investors.
 National Association of Realtors, as of April 23, 2018.
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