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Investing Commentary published on January 21, 2020

December 2019 Market Commentary

Summary

  • U.S. Treasury Curve: Treasury yields declined at the short end of the yield curve and increased at the intermediate and long segments during December, a continuation of a trend during the fourth quarter of an overall curve steepening. The brief summer yield curve inversion at the 2- and 10-year segments was all but forgotten by year-end.
  • Tax-Exempt Municipal/Treasury Ratios: Municipals outperformed Treasuries for the month, the quarter and the year. Ratios fell during the same time periods across the curve.
  • Municipal Market Technicals: Strong mutual fund demand for municipal bonds continued to easily absorb new issue supply, which positively influenced muni performance in December, just as it had throughout the second half. Over the quarter, monthly supply averaged $48 billion, assisted by taxable issuance which closed the year at $70 billion, an eye-popping 115 percent increase year-over-year.
  • Corporate Market Technicals: Increased supply was met with increased demand in the investment grade (IG) corporate bond market as well during the month, quarter and year. Demand for IG bonds was solid, with long-term IG mutual fund inflows of $160 billion in 2019 and healthy foreign flows.
  • Securitized Trends: During December, the mortgage-backed securities (MBS) market benefited from favorable conditions. Given their more defensive characteristics, asset-backed securities (ABS) and agency commercial mortgage-backed securities (agency CMBS) lagged other risk assets.

Market Review

Treasury yields dropped broadly —75 to 90 basis points (bps) — in 2019. The 10-year Treasury closed 2019 at 1.92 percent. The Treasury yield curve steepened in Q4 on another Federal Reserve (Fed) rate cut as short-term rates fell and 20- and 30-year maturity yields moved 20bps to 30bps higher.

In the quarter, the municipal yield curve moved directionally in line with Treasuries but outperformed across the curve. Municipal outperformance pushed municipal/Treasury ratios lower.

Favorable trends that characterized most of 2019 continued to benefit investment grade (IG) corporate bonds during December. The trends included strong equity markets and moderate net IG supply that was well absorbed by foreign buyers, insurance companies and continued robust flows into IG bond mutual funds based on Investment Company Institute data.

A majority of companies in the S&P 500 Index reported positive earnings-per-share (EPS) and revenue surprises against generally muted expectations during the fourth quarter, per FactSet. Reported EPS growth was 1 percent lower than the prior quarter while revenue growth was 3.5 percent higher, per Bloomberg.

Municipal Market Review

In the month and the quarter, the municipal yield curve moved directionally in line with Treasuries but outperformed across the curve. Shorter maturities fell about 14bps to 18bps in the quarter, while the longer maturities moved higher by 2bps to 8bps. Over the quarter, municipal bond yields fell by 1bp to 4bps on the front end of the curve from four years and shorter, and 1 and 2bps in the 9- to 10-year range, respectively. Yields were the same or just slightly higher for the month on the remainder of the curve.

Municipal/Treasury ratios fell during the month, quarter and year. Notable changes occurred during the quarter in the 2- and 5-year spots where ratios fell by more than 4 and 14 ratios, respectively. In the 10- and 30-year maturities, ratios fell by more than 9 and nearly 13 ratios, respectively, with the largest share of the changes coming in the last month of the year as the curve continued to steepen following the Fed’s last rate cut of the year.

The positive technical environment (high mutual fund flows absorbing consistent new municipal bond issue supply) was a persistent influence throughout 2019. Municipal bond mutual fund inflows for 2019 topped the prior record set back in 2009, with a full year of positive flows totaling a staggering $93.6 billion, as reported by Lipper on January 1, 2020. Data from The Bond Buyer showed new issue supply closed the quarter at $143 billion, a 54 percent jump from the same quarter last year, pushing supply to $422 billion for the full year, 22 percent higher than 2018. Perhaps the most compelling aspect of new muni bond supply in 2019 was high taxable municipal bond issuance, which closed the year at $70 billion, a 115 percent increase year-over-year, marking the highest yearly total since 2010 when the Build America Bond program expired.

While returns slowed from the strong pace earlier in the year, municipals posted positive returns for the month, quarter and the year. The Bloomberg Barclays (BBG) Municipal Bond Index returned 0.31 percent for the month of December, 0.74 percent for Q4 and 7.54 percent for the year. The BBG Municipal 1-10 Year Blend Index gained 0.30 percent for the month of December, 0.86 percent for Q4 and 5.63 percent for the year.

In terms of returns, the 4- to 8-year maturity range showed the strongest returns while bonds rated BBB outperformed all other rating categories by 30bps. Illinois, New Jersey and Puerto Rico stood out as strong performers over the quarter, according to Bloomberg Barclays indices.

Municipal credit fundamentals remained broadly stable amid slowing economic growth and lingering structural issues. Top-line indicators of credit stability; the economy, tax receipts and debt service coverage in the revenue sector, suggest a continuation of the benign credit environment.

Corporate Market Review

Favorable trends that characterized most of 2019 continued to benefit investment grade (IG) corporate bonds during December and the fourth quarter. The trends included strong equity markets, robust flows into IG bond funds, per the Investment Company Institute’s data, and moderate net IG supply that was accommodated by continued strong demand.

Corporate spreads tightened 22bps in Q4, ending the quarter at 93bps which is the lowest level since February 2018, according to Bloomberg Barclays data. The BBG U.S. IG Corporate Index generated 119bps of excess return for December and 242bps of excess returns in the quarter, leaving year-to-date excess returns at 676bps.

Bonds of lower quality and longer maturities outperformed other quality and maturity sectors. For the month, the best performing sectors included Energy and Basic Industry while Capital Goods and Banking lagged. The best performing sectors for the quarter were Basic Industry and Communications while Capital Goods, Consumer Cyclical, and Banking lagged.

Index-eligible IG corporate fixed-rate supply was $993 billion in 2019, up by 8 percent year-over-year, while IG fixed-rate net supply of $350 billion was up 26 percent in 2019, per Barclays data.

Corporate credit fundamentals remained mixed with high leverage partially offset by strong margins. Debt used in mergers has declined in recent years and deleveraging should continue among larger borrowers. As it relates to environmental, social and governance (ESG) factors, IG issuers are devoting an increasing amount of attention to sustainability.

Securitized Market Review

Within securitized sectors during the month, the mortgage-backed securities (MBS) market was characterized by slightly higher rates, a steeper yield curve, lower volatility, slower prepayments and relatively wide spreads; all favorable conditions for MBS at least in the near term. As a result, agency mortgage-backed securities (agency MBS), as represented by the BBG MBS Index, outperformed relative to Treasuries with similar durations, producing 34bps of excess returns.

Given their more defensive characteristics, asset-backed securities (ABS) and agency commercial mortgage-backed securities (agency CMBS) both lagged other risk assets such as IG corporates. BBG indices indicated that credit card ABS rated AAA had negative 6bps of excess returns, while agency CMBS had negative 14bps of excess returns.

 

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