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Investing Commentary published on September 14, 2018

August 2018 Market Commentary

Strategy and Outlook

  • U.S. Treasury Curve: We believe that the Fed will continue on its path toward rate normalization despite trade concerns and issues in emerging markets; however, a lower terminal Fed Funds rate target could impact the pace of tightening.
  • Tax-Exempt Municipal/Treasury Ratios: Tax-exempt municipal relative value has improved given the underperformance of municipals in August.
  • Municipal Market Technicals: Supply perked up in August, but year-to-date issuance still lags versus the same period last year.
  • Corporate Credit Quality: 2Q18 earnings came in strong, but share buybacks and debt-funded M&A remain a strain on credit fundamentals as leverage continues to be high.
  • Corporate Supply and Demand: Corporate supply slowed in August, but the market is bracing for high issuance in September. Foreign demand is strong, per TIC data.
  • Securitized Trends: Agency MBS underperformed in August on an excess return basis on an uptick in implied volatility early in the month. The ABS market has been steady this summer.

 

Monthly Recap

Market Review

An Education in Flattening

As the summer closes out and back to school season has come into focus, flattening in the U.S. Treasury curve is still on the syllabus for fixed income traders. U.S. Treasury yields fell in August primarily due to a flight to quality related to geopolitical risks (Turkey, emerging market (EM) currencies). Treasury yields closed the month between 5-11 basis points (bps) lower across the curve. The market continues to watch for potential yield curve inversion, as the 2s10s curve tightened significantly over the month to 22bps, 10bps flatter.

Still, upward pressure on Treasury rates remains in our view, given still-robust U.S. economic growth, improving labor markets, tightening from global central banks and the Fed’s balance sheet unwind. In addition, the strong consumer is supporting the U.S. economy, with data showing healthy consumer confidence for August and better-than-expected retail sales numbers for July. For the consumer, strong equity markets have driven capital gains, and higher savings rates have improved household net worth. On the economic front, core PCE rose 0.2 percent month-over-month in July, and increased 2 percent year-over-year. Both figures were in line with consensus estimates.

FOMC minutes for the July/August meeting revealed an upbeat tone, but also expressed stresses related to the Fed balance sheet and global trade. FOMC participants also noted that the Committee’s characterization of monetary policy as “accommodative” could be inappropriate “at some point fairly soon.” With the Fed’s balance sheet roll-off set to accelerate to $50 billion per month, the net U.S. monetary policy has moved slightly tighter. That said, the extra supply of Treasuries and mortgage-backed securities (MBS) due to the lack of Fed buying has been easily absorbed in the market (see The Fed’s Shrinking Balance Sheet and MBS Opportunities). Per market pricing, a hike at the September meeting is all but certain, while a hike in December is priced at just over a 65 percent chance.

In August overall, equities continued to rally despite some risk-off related to EM. Investment grade (IG) corporate spreads widened modestly, while IG muni yields were rangebound.

Municipal Market Review

Higher Ratios as Summer Ends

The Bloomberg Barclays Municipal Bond Index posted a positive total return of 0.26 percent, pushing year-to-date total returns to 0.25 percent. However, the Bloomberg Barclays Municipal Bond Index underperformed the Bloomberg Barclays U.S. Treasury Index, which closed the month up 0.77 percent.

Given the municipal underperformance versus Treasuries in August, municipal/Treasury ratios improved between roughly 4 and 5.5 ratios versus the recent lows in mid-to-late July. The most attractive part of the curve remains in the long end in our view, with the 30-year ratio closing August at 100 percent. The two-year ratio is still low on a historical basis.

Municipal bonds traded in a narrow range across the curve in August. Municipal yields rose between 5bps and 8bps in the 2- to 6-year range. The 10-year fell 1bp to 2.44 percent, while the 30-year rose 1bp to 3.02 percent. Heavier than expected long-dated supply contributed to the underperformance at the long end, as banks and insurance companies have been less supportive in that range. While the municipal curve has modestly flattened since the end of July, 2s10s and 2s30s have steadily steepened since the beginning of June, in stark contrast to the flattening of the Treasury curve.

Supply rebounded to $32.6 billion in August, which represents a 20 percent increase from July and one of the highest issuance months of 2018. We note that new-money issuance volume has increased significantly as a proportion of total issuance (Figure 2).

Despite the higher month-over-month supply figure, year-to-date issuance of $224.6 billion is still 15 percent lower than the same period in 2017.

August was another strong month for retail demand, as mutual funds posted inflows for four consecutive weeks through the end of August, per Lipper. Inflows were $212 million for the week ending August 29.

The credit team agrees that overall conditions remain benign, and credit quality for many states is marginally better than it was a year ago. Many budgets are balanced, but structural risks remain given narrow reserves and low pension funding contributions.

Corporate Market Review

Back to School, Back to Supply

The Bloomberg Barclays Corporate Index option-adjusted spread (OAS) widened 5bps to 114bps in August. Spreads widened largely due to expectations for a deluge of supply in September, trade concerns and negative credit news from Bayer AG (Glyphosate headlines) and Ford Motor Credit Co. (Moody’s downgrade).

In sector performance for August, REITs was a top performer, benefiting from low supply and the benign rate environment. Railroads fared worst primarily because it is a longer-duration sector, as the credit curve steepened in August. Crossover names fared best in July, while BBB names did worst. Shorter-maturity corporates had the best performance, while the long end lagged.

IG corporate credit remains supported by above-trend U.S. GDP growth (4.2 percent for 2Q18), tax reform that lowered corporate tax rates and benefited profitability, and ongoing strength in the U.S. consumer. For 2Q18, revenues for IG non-financial issuers grew 8.7 percent year-over-year—the fastest pace in 6 years. Ebitda grew 9.6 percent, per JP Morgan data.

That said, record-high debt leverage continues to strain credit fundamentals. Gross leverage remains elevated at 2.9 times, the highest level since the financial crisis (excluding commodities), per JP Morgan. The rise in M&A year-to-date, along with the continued prevalence of share buybacks has helped spur increased leverage and has contributed to a higher proportion of BBB-rated names in the Bloomberg Barclays Corporate Index versus the historical range.

High grade issuance totaled $92.5 billion in August, versus $108 billion in August 2017. In general, summer supply volumes came in weaker than last year’s pace. Year-to-date, supply has reached $887 billion, down 10 percent from the same period last year, per Bank of America Merrill Lynch. On the demand side, IG fund flows were robust in August; the month saw $9.1 billion driven by demand for short-duration bond funds, per EPFR Global. Year-to-date, inflows have reached $91.4 billion, which trails $231.5 billion of inflows in the same period last year.

Securitized Market Review

Implied Volatility Tests Agency MBS

Agency MBS underperformed in August on an excess return basis primarily due to an uptick in implied volatility early in the month.1 The Fed net takeout dropping to zero in the near-term, housing fundamentals and trade frictions are concerns. However, on the positive side, TIC data shows some preference for MBS over U.S. Treasuries from foreign investors. Domestic banks have resumed buying in 3Q18. We saw positive headlines on the uniform MBS front, with the IRS providing guidance that Freddie Mae exchanges will not be a taxable event (see What to Watch in Agency MBS: Our Top Five Themes for more information on the government-sponsored enterprise single-security initiative).

The asset-backed securities (ABS) market has been steady this summer, and August produced 9bps of excess returns.2 Technical volatility quieted, and fundamentals remain sound. We have seen significant issuance in subprime auto ABS in August, and there is improving credit performance in that space.

In credit cards, we continue to see normalization of fundamentals. However, the rate of growth of household debt has moderated over the last several quarters. We remain focused on the most prime sectors, where we believe credit risks are very low and structural protection is strong.

 

[1] Proxy used is the Bloomberg Barclays U.S. Aggregate Index.

[2] Proxy used is the Bloomberg Barclays U.S. Aggregate Index.

 

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