New MMF rules impact various types of MMF investors and cause a range of issues to arise for investors using MMFs as a short-term solution.
STRATEGY AND OUTLOOK
- U.S. Treasury Curve: In early December, the front end of the Treasury curve inverted for the first time in over a decade; the current flat Treasury curve could slow the Fed’s pace of normalization.
- Tax-Exempt Municipal/Treasury Ratios: Short-end ratios moved higher over the month, mainly due to municipals lagging the powerful rally in Treasuries. Weakness in bank demand continues to place upward pressure on long-end ratios.
- Municipal Market Technicals: Municipal mutual funds continued to experience outflows through the first three weeks of December, making 12 consecutive weeks of outflows; however, funds registered an inflow during the last week of the year.
- Corporate Credit Quality: With continued high leverage, rising financing costs and slower global growth, 2019 will likely be a challenging environment for corporates.
- Corporate Supply and Demand: Following solid supply throughout the year, monthly issuance dropped to a paltry $9 billion in December.
- Securitized Trends: In asset-backed securities (ABS), normalizing fundamentals in credit cards and headlines in subprime autos are potential challenges.
Skittish Equity Market Permeates IG
Concerns highlighted last month, such as trade/tariff negotiations, a potential continued government shutdown, marginally fewer global inflation pressures, and a possible slowdown in U.S. and global growth continued in December. After reaching as high as $76 a barrel in October, oil dropped more than 40 percent to end the year at $45. Moreover, Brexit and a slowdown in China continued to weigh on markets.
These macro challenges culminated in an exceptionally volatile equity market over Christmas week with the Dow Jones dropping 3 percent in one day. This was followed by the biggest one-day point gain on record – a 5 percent return – marking the largest one-day percentage gain since March 2009. For the year, equities marked the worst performance in a decade with the Dow and the S&P 500 indices down roughly 6 percent.
Over the month, the FOMC raised the federal funds rate another 25 basis points (bps) to a range of 2.25 percent to 2.50 percent. Additionally, the Committee revised the dot plot to reflect two hikes in 2019 versus three previously, while the market is expecting less than one hike for the year. This is partly due to macro challenges that could slow the Fed’s pace of tightening.
Despite the hike, U.S. Treasury yields finished considerably lower over the month, dropping roughly 30bps across the curve, partly due to risk-off sentiment in the markets. The 10-year Treasury started the month just below 3 percent and rallied to 2.68 percent. For the year, 2-year bonds rose more than 60bps, while 5-year and longer were higher by about 30bps. The 2s10s curve closed out at 20bps, unchanged over the month and more than 30bps tighter on the year. The flattening of the curve may also hinder the Fed’s path toward normalization.
Given the heightened focus on rate hikes and the risk-off tone that permeated both bond and equity markets in 2018, investment grade (IG) corporates posted the worst year of total returns since 2008.1 On the other hand, municipal bond returns were one of the few asset classes globally to generate positive returns for the year, benefiting from the stable environment for credit quality. The Bloomberg Barclays Municipal Index posted positive total returns, while equities, IG corporates and high yield corporates had negative performance. Municipal total returns were higher than those of Treasury, Government-Related and Securitized indices for the year.
Municipal Market Review
Positive Returns for 2018
Municipals rallied over the month, with the 5- to 10-year range dropping the most in yield – down more than 20bps.2 The 10-year AAA closed out at 2.32 percent, about 30bps higher year-to-date. For the month, the 2s10s curve flattened, finishing at 52bps; however, the curve is 6bps steeper than it was at the start of 2018.
The municipal market finished the year on a very strong note with the 15- to 20-year indices performing best in December. Higher-quality bonds (AAA-, AA- and A-rated bonds) outperformed BBB-rated bonds, while on the sector side hospital, housing and special tax were the best performers of the month. The Bloomberg Barclays Municipal Bond Index returned 1.28 percent for the full year 2018.
Short-end ratios moved higher over the month due mainly to municipals lagging the powerful rally in Treasuries. The 2- and 3-year ratios were higher by two and three points, respectively. The 5-year was flat, and the 10- and the 30-year were lower by one.
New issue supply for the month came in at just $22 billion, down markedly from the record $69.8 billion that came in December of 2017 prior to tax reform taking effect. December’s supply was the third-lowest level of monthly issuance for the year. Full-year new issuance totaled $339 billion, down 24 percent from 2017. As Figure 2 illustrates, the steep decline in refunding issuance (-61 percent) was only partially offset by a rise in new money issuance (16 percent). The first and fourth quarters showed the steepest year-over-year declines in issuance.
Municipal mutual funds continued to experience outflows through the first three weeks of December, which made for 12 straight weeks of outflows. However, funds registered an inflow during the last week of the year. The outflow cycle wasn’t particularly large and had minimal impact on the market. Outflows for the year totaled $1.3 billion. There was a heavy volume of bid-wanted activity during the month, with bid lists averaging close to $1.5 billion daily. This ‘shadow’ primary supply was present at various periods this year, which helped offset the lower primary issuance.
Heading into 2019, the credit environment looks stable. State and local tax collections were up 7 percent year-over-year through 3Q18.3 The uptick in revenue reflects strong economic and financial market performance in the 12-24 months leading up to 3Q18; one-time expansions of the income and sales tax bases post-tax reform; and the June 2018 Wayfair decision from the Supreme Court (see June 2018 Market Commentary). The default rate in 2018 was the lowest since the Great Recession.
Corporate Market Review
Risk-Off Sentiment Breeds Underperformance
Due to overall risk-off sentiment, the Bloomberg Barclays U.S. Corporate Index option-adjusted spread widened 16bps in December to 153bps, underperforming duration-matched Treasuries by 106bps. For the year, spreads widened about 60bps. Most of the widening occurred in the October-December time frame when the continued issuance of M&A-related debt deals was met with insufficient demand. Notably, the weakness in IG corporates was U.S.-centric. European high grade spreads widened just 2.5bps in December to end the year at 152bps4 (Figure 3).
The credit curve steepened in 2018, as IG corporate bonds posted positive total returns in shorter maturities given stronger demand versus longer. However, on an excess return basis, all U.S. IG corporate maturities posted negative returns, with longer bonds faring worst.
For December, the best-performing sectors were Supranationals, Foreign Agencies, Integrated (Energy), Office REITS and Consumer Products. The worst-performing were Tobacco, Transportation Services, Refining (Energy), Independent (Energy), and Food & Beverage.5
Higher-quality did better over the month; Aa+ fared the best across the IG quality spectrum, while crossover fared the worst. Investors continue to focus on the higher proportion of BBB names in the investment grade index (see Risks and Opportunities in Today’s Corporate Bond Market).
Monthly issuance volumes were solid through November, averaging $112 billion per month, per Bank of America Merrill Lynch (BAML). However, supply dropped to only $9 billion in December – the lowest month on record since at least 1998, BAML research noted. On the demand side, the average new issue concession rose to 10.7bps in December from 7.3bps in November.
In terms of flows, IG funds reported a 2018 inflow of $20 billion, which is below $138 billion of full-year inflows for 2017.6
Looking forward, higher yields on IG corporates could be attractive to yield-sensitive buyers, increasing demand. Although the credit cycle has reached its late stages and downgrades could tick higher, IG companies have begun to demonstrate greater efforts to reduce debt leverage due to pressure from ratings agencies and investors. Margins remain steady, as companies have effectively managed costs through the cycle. However, with continued high leverage, rising financing costs and slower global growth, 2019 will likely be a challenging environment for corporates.
Securitized Market Review
ABS Benefits from Safe Haven Status
In December, MBS spreads increased further to end at the widest levels of the year. The widening is primarily due to the supply-demand imbalance in the market. The Fed balance sheet runoff is at peak levels (see The Fed’s Shrinking Balance Sheet and MBS Opportunities), and Fed assets have fallen to just over $4 trillion at the end of December, from $4.5 trillion in early 20157 (Figure 4). With the Fed no longer reinvesting in MBS, and with assets rolling off, the market has growing concerns about who the marginal buyer will be. In our view, money managers will continue to step in, but market technicals will still be challenging.
On the supply side, healthy levels of organic issuance continued to hit the market in December. Supply through 3Q18 was $248 billion. For 2019, organic supply projections are $225 billion. The Fed runoff is projected to add another $175 billion to $200 billion to the total.
In terms of fundamentals, housing data has softened. Higher rates and years of strong home appreciation have started to manifest themselves into weaker home sales. However, inventory levels have started to rise, which could moderate home prices going forward. Refinancing risk remains low but could accelerate given the flatter Treasury curve. The flatter curve implies lower forward rates, then faster prepayments, which shorten MBS durations – particularly for higher-coupon bonds.
For ABS, excess spreads were down 8bps in December; while negative, this was one of the better performing spread sectors. For the year, the market took advantage of the “safe haven” qualities of ABS such as strong structural protections, and produced positive 13bps of excess returns.8
In 2019, we think there will be greater focus on fundamentals in ABS (see Five Key Themes in the Securitized Market). Credit card trust fundamentals have deteriorated on the margin, as the consumer balance sheet normalizes and issuers seek to diversify their business mix away from the low-risk convenience users into revolving balances customers. In subprime autos, negative headlines have resurfaced, and concerns have risen about questionable underwriting practices.
In terms of supply, $242 billion of bonds priced in 2018, up 3 percent versus 2017. For 2019, supply is projected to come in around $255 billion.
 Based on the Bloomberg Barclays U.S. Investment Grade Corporate Index, as of December 31, 2018.
 General Obligation (GO) AAAs, Yield to Worst.
 Twelve months ending 3Q18 over 3Q17.
 The Bloomberg Barclays Euro-Aggregate Corporate Index.
 Bloomberg Barclays U.S. Investment Grade Corporate Update, as of January 3, 2019.
 U.S. Federal Reserve, Credit and Liquidity Programs and the Balance Sheet.
 Proxy used is the Bloomberg Barclays Asset-Backed Securities Index.
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