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Investing Podcast recorded on May 15, 2018

April 2018 Market Recap

Podcast Transcript

Hello this is Natalie Baker, vice president of marketing here at Breckinridge and welcome to the Breckinridge podcast. Today I'm joined by two members of our portfolio management team, Matt Buscone, and Khurram Gillani and we will be talking about some of the major market events from the month of April. So, Matt, it feels like we need to start with the item that grabbed the most headlines during April... the 10-year Treasury yield closing at over 3% for the first time since 2014.

Yeah, it certainly generated a lot of headlines in the fixed income world, and we did get one day where yields did close over 3% towards the end of April before rallying slightly lower in the month end. The jump higher in yields was due to concerns about the U.S. and China trade renegotiations, worries about a faster pace of Fed rate hikes, and economic data showing higher inflation, and still historically low unemployment.

What was some of the inflation data that helped to push yields higher?

So several of the readings on inflation have increased. The most important one was the core PCE deflator rising to 2.5% in the fourth quarter and that is showing a 2.6% annual increase of hourly wages in April. Also the recent rise in commodity prices, particularly oil, with that bouncing above $70 also led to increased inflation fears during April.

And how about the readings on economic growth?

So we did get the reading on the first quarter 2018 GDP growth and the numbers did show a little bit of growth slowing. It was 2.3% in the quarter which was down from 2.9% in the fourth quarter of 2017, and while business growth remained very strong, the slowdown on the consumer side was notable with consumption growth only growing by 1.1% and that was markedly down from 4% in the last quarter of 2017.

So would the lower reading on GDP cause the Fed to slow down their pace of rate hikes?

Pretty unlikely. The Fed probably would be too concerned given that first-quarter growth is underwhelmed in prior years only to bounce back in subsequent quarters, and in the background as we just mentioned earlier, we still have historically low unemployment and we are starting to see some wage pressure and that flowing into the inflation side, so I think the Fed is comfortable with their expectations for the future pace of rate hikes.

I see and while there wasn't a Fed meeting last month, the market remains focused on any Fed-speak and we did get a look at the minutes from the March meeting. Anything interesting to note?

Yes, so the market continues to digest the recent FOMC rate hike, and additional rate hikes remain a global focus. The minutes show there was consensus among the Fed’s policy makers that the economy would strengthen, and inflation would rise in the coming month and the committee did unanimously vote to raise the Fed funds to a target range of 1.5 to a 1.75 during the March meeting. There were some misgivings from a couple members who thought that waiting to see more evidence of inflation moving to the 2% target made sense, but it does feel like a slightly more hawkish bend is coming into the Fed, and while the economic outlook remained upbeat, members noted that the threat of a trade war would be a downside risk to the economy.

Well how does Breckenridge view the recent rise in rates?

So while we think rates may move modestly higher from here, we don't there will be a fourth rate hike in 2018 and we still think inflation remained below 3% and that there is the potential for some downside on the equity market from some of those aforementioned trade war concerns, we have seen an increase in volatility and there may potentially be some negative surprises in economic data and certainly some geopolitical issues that continue to pop up that all may help to keep a lid on the rise in Treasury yields. And anecdotally there does also seem to be a strong amount of pent-up demand that comes into the fixed income markets when the 10-year yield gets to that 3% level.

I see. Well given all the data and Fed news, what was the impact on the Treasury curve?

So Treasury yields were stable over the first two weeks of the month but rising concerns over higher inflation and the rise in the price of oil did cause Treasures to sell off and yields to rise in the latter half of the month. For the month, yields were higher by over 20 basis points from 2 to 10 years while the 30-year yield was higher by about 15 basis points, and the yield curve remains very flat with the spread between the 2-year and 10-year Treasury just less than 50 basis points.

What were the changes like for the municipal yield curve?

So municipal bonds underperformed in shorter data maturities say 2 to 3 years, outperformed from 5 to 15 years, and matched the Treasury performance on the long end. The short end in munis suffered from outflows and money market funds that pressured floating-rate bonds. That, in turn, caused yields to rise on shorter maturity bonds while the intermediate longer end of the curve outperform on a continued lack of new issue supply. Yields were higher by about 20 basis points in 2 to 3 years, 15 basis points in five years, and less than 10 basis points in 10 years and about 15 out in the long end part of the muni curve.

Well, we have mentioned the low levels of new issue in municipal supply on multiple occasions throughout the year. Do you have a supply update for us?

So after about a 30% drop in issuance during the first quarter of 2018, April supply did rebound to about $29 billion, a 14% increase from what we saw in March of this year but still marginally lower from what we saw in April of 2017. That did help the year-to-date supply figures little bit. We have now had $94 billion worth of issuance this year. That's down 23%. I think at its worst levels, new issue supply was running 30+ percent behind schedule. And after several weeks of outflows on the demand side, mutual funds did reverse course and posted $200 million worth of inflows in just the last week, pushing the year-to-date total to a positive $6.5 billion. And something to watch in the coming in the coming weeks and months is the maturity reinvestment coming back into the muni market during the May through August time period. That would be the sum of bonds that are maturing and coupon payments that may potentially come back into the muni market. It is approaching the levels that we saw last summer that were historically high, but we are entering this cycle was significantly less supply and lower ratios than we had last year, so that stronger technical may again prove to be a tailwind for muni performance over the summer.

Well, what about the overhang from secondary selling and dealer inventories? I know we have spoken about that in the past year.

Yeah, we have seen a little bit less pressure from that coming over the last few weeks or so. There has been a decrease in the amount of bid-wanted items and dealers have been able to reduce their inventory level somewhat, so there has been a little less pressure and sort of that shadow primary that we have talked about over the last couple weeks. It is something to keep an eye on, though, particularly if munis get more expensive than they have been. From a relative value standpoint as those ratios get lower on the muni side, you may see banks and other crossover buyers like insurance companies look to exit munis as they get more expensive and lean into more taxable assets given their lower tax rates now.

And speaking of relative value where did munis end up for the month?

So ratios closed April slightly cheaper in the 2- and 30-year ranges, with the 2-year at 75% and the 30-year at 100% with municipal outperformance in the 5- and 10-year range ratios tightened to 79% for fives, and 85% for the 10-year range. We continue to monitor that 10-year ratio as it gets close to 80% which is the estimated bank and insurance company break-even ratio.

In March we saw some positive returns from munis. I'm guessing with the rate movements that you mention above, that wasn't the case for April though.

Yeah that's correct, another down month for munis. The Bloomberg/Barclays Muni Index posted a negative total return of 36 basis points, bringing the year-to-date return to a -1.46%. The 1- to 10-year blend was down 28 basis points for the month and was lower by just under 1% at 0.98 basis points for the year. The long bond index which is comprised of bonds from 22 years and longer showed the worst returns for the month while the one-year index showed the least negative returns. Make sense given the rise that we saw longer. And for the month, lower quality bonds out-performed AAA rated bonds by close to 20 basis points.

Okay, well switching gears talk about fundamentals, do you have a quick update on the credit front?

So municipal credit conditions remain stable, however there continues to be some targeted concerns in areas like Illinois. While the state’s credit profile has improved modestly since last summer with the passage of the fiscal year 2018 budget and associated income tax increase, the primary drivers of the state fiscal distress remain unresolved. If the state cannot get a balanced budget complete by the July deadline, it remains at risk for a ratings downgraded to noninvestment grade, which may have ripple effects for other local Illinois credits. Additionally, the teacher strikes that got a lot of headlines in Arizona are also a risk to monitor. If the labor market tightens and education spending has not been restored to prerecession levels in many states, there may be pressure for other states to raise pay or benefits on the teacher side that may put additional stress on budgets that are still little bit strained this late in the economic cycle.

All right, well thanks, Matt.

Thank you.

So now moving over to the corporate side, Khurram, let's start out with performance for investment-grade corporates in April. How did they do compared to March?

Investment-grade corporate spread 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. Overall the corporate index tightened two basis points during the month to end the month at 108 basis points which is 23 basis points wider than year-to-date tights. April was the first month of cumulative spread tightening since January. Typically, as rates rise spreads tend to tighten. That relationship didn't hold in February and March, but it did return in April. The Bloomberg Barclays Corporate Index generated 4 basis points of excess returns during the month. Intermediate corporates tightened by three basis points during the month while long corporates widened by about the same amount. In that way intermediate corporates outperformed Treasuries generating 19 basis points of excess returns while long corporates generated -28 basis points of excess returns and hence underperformed Treasuries during the month.

Okay, so what were returns across the credit quality spectrum? Did lower quality outperform?

So in April, higher-quality single A’s and especially AA corporates outperformed lower quality BBB's. AA’s generated 12 basis points of excess returns while BBB's generated five basis points of excess returns, however year-to-date BBB's have outperformed higher-quality corporates.

Got it. Well, what sectors did better than others and any thoughts as to why?

Industrials outperformed financials in April due partly because of the underperformance in the REIT sector. Banks actually held-up fairly well. Spreads tighten four basis points there, while the REIT sector widened by nearly 5 basis points. The energy sector was the clear winner in April so sectors like refiners, independent energy, and integrateds outperformed all other sectors as WTI crude oil spot prices increased over 5% during the month and ended the month at a four-year high. The energy sector also reported very good earnings during Q1 which also helped spreads tighten. So, for example if you look at the integrated energy sector, companies such as Total and Shell. Their spreads tightened six basis points during the month and they generated 46 basis points of excess returns. Sectors such as tobacco, Pharma, paper and chemicals underperformed during the month due to a variety of reasons including worse than expected reported earnings and M&A.

So Matt discussed the muni curve in April. What happened to the corporate credit curve?

The credit curve steepened in April, so spreads in 1 to 3 years were nine tighter during the month. Spreads in 3- to 5-year were three tighter while spreads in 7- to 10-year were 1 to 2 basis points wider and spreads were unchanged in the 30-year. The threes/fives credit curve is trading at 21 basis points which is the highest level since mid-2016. Interestingly the spread curve flattening we saw earlier on this year has been almost completely reversed over the last several weeks. Given the rising rates and spread, the yield to worst on the corporate index has increased from 3.3% at the beginning of the year to a little over 3.9% at the end of the month. The yield to worst on the intermediate corporate index is currently 3.6% while the yield to worst on long corporates is nearly 4.6%.

So any thoughts on why the credit curve steepened during the month?

Yeah, so there’s a few reasons, the first being that the 30-year Treasury yield has not moved very much year to date, so if you look at year-to-date, the ten-year has increased over 50 basis points while the 30-year Treasury yield has inched up less than 40 basis points. So that partly explains some of the steepening that we saw in April. We've also seen more long issuance year-to-date. Notably in the first four months of 2018, $100 billion of non-financial bonds longer than 10 years have been issued or 23% of total issuance versus $64 billion in the first four months of 2017 or roughly 15% of total per J.P. Morgan data. Also due to repatriation of cash overseas we are seeing less short duration issuance. And lastly, I would say demand from foreign investors has declined due to higher effects of hedging costs. Hedging costs have risen to 2.8% per data from B of A versus less than 2% a year ago. This rise in cost is partly mitigated the higher all-in rates that have come about this year. So per Fed data, net foreign corporate bond purchases actually slowed in the fourth quarter of 2017 to $152 billion versus $432 billion in Q4 of 2016.

Okay, so let's talk about issuance. How is corporate supply this month?

Supply actually increased 35% versus April 2017. Financials made up a third of total issuance. After good earnings announcements banks such as Goldman, Citi, Morgan, and JP Morgan all issued paper. The largest deal of the month was General Mills, an eight-part deal totaling $6 billion to fund their acquisition of Blue-Buffalo. The deal priced fairly attractively, for example, the 10/17/23 maturity bonds priced at +115 OAS and recently traded 20 basis points tighter in the secondary market.

Okay so let's switch gears and talk about securitized products. Can you comment on recent Bloomberg news stories and other rumblings about rotations out of credit and into MBS?

Yes, so at Breckinridge, we still see value in high quality corporate bonds and will continue to allocate capital to the asset class across our government credit strategies. We also acknowledge that we are in the later stages of the credit cycle and so we do see value in adding securitized products is specifically agency MBS and consumer ABS such as credit cards and prime autos to a liquid diversified defensive portfolio. There are many merits to this rotation. On the liquidity side, agency MBS trades to a tune of over $200 billion a day compared to about $30 billion a day for investment grade corporate bonds according to data from Bloomberg. MBS also tend to outperform corporates in the higher volatility environment as you have seen this year. We also know that MBS is historically one of the least correlated asset classes with higher beta sectors of the market. On the ABS side, we like the collateralized bankruptcy remote structures that prime credit cards and autos afford. The deals we buy are short duration and delever over time which provide nice diversification to senior unsecured credit. Lastly both ABS and MBS sectors afford relatively attractive spreads in the current markets, so we believe we are not sacrificing yield but at the same time moving up in credit quality.

All right, thanks Khurram. For further info on the month of April please see our market commentary which is located on the Breckinridge website. We hope that you in the field of down this informative and we look forward to you joining us on our next podcast. Thank you.



DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.

Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.

Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.

Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.