Data releases and Fed announcements contributed to market performance this month.
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, Sara Chanda and Khurram Gillani, and we’ll be going through some of the market events for the month.
So Sara while we’ve had volatile months over the past couple of years, February is certainly one to remember with equity markets plummeting, setting daily point loss records, a massive spike in the volatility index along with the changing of the guard at the Fed.
That's right, Natalie. I’d say there's really no shortage of newsworthy items for this month so let's just start with equities. If we look back, not since 2008 have equities experienced the volatility of this scale and magnitude. The Dow plummeted more than 3,200 points or 12% in two weeks only to rebound, recovery nearly 75% of those losses. To cap off the wild month, the market lost 680 points in the final two days of the month, leaving it down about 1,600 points from the highs in late January, and then, really to cap off the month, both Dow and S&P Indices posted their worst performance in two years.
What was the catalyst for such dramatic moves in the equity market?
So I'd say two words, inflation fears. Bond yields started to climb really on the back of newly incepted tax cuts and a strengthening economy, and the question really became, you know, could the Fed, already on a path of normalization, be forced to raise rates at a swifter pace, and as that fear started to flood the market, it set off a reaction in the equity space.
So clearly a volatile month, and this volatility is measured by the VIX, which jumped dramatically, is that right?
That is. So earlier in the month the volatility index, or VIX as it's referred to, skyrocketed by 116% in one day. That marked the biggest move that we had seen since February of ‘07 when the index rose about 64% and the highest daily percentage recorded since 1990. Unknown to many though, there are funds designed with an inverse relationship to the VIX, effectively betting that volatility would remain low, so when it jumped, those funds really endured some significant losses.
Okay, moving over to FOMC news, newly appointed chair Jerome Powell testified in his inaugural address to Congress. Any color there?
Yes, so Fed Chair Powell spoke to Congress at the end of the month. He stated that recent data suggested a strengthening economy and improving inflation outlook. He hinted at three or four rate hikes in 2018, and as a result, the market expectations for rate hikes jump significantly. Looking at Fed Fund futures, a March rate hike is priced in, which would push the Fed Funds rate to a target range of 1.5 to 1.75%. While the FOMC remains accommodative, market expectations are getting more closely aligned with the Fed forecast for rate hikes.
So speaking of rate hikes, were there any economic data over the month that may bolster the Fed's case as they continue on their path to normalization?
Yes, we had a few releases that could offer the FOMC the necessary support for multiple rate hikes. I’d say first the consumer looks strong in January with personal income up 0.4% and 3.77% year-over-year, while the consumer sentiment shot up 4 points to 99.7. On the employment front, nonfarm payrolls came in at 200,000 in January, which was above consensus, as the gain was really felt across a wide spectrum of industries with construction, manufacturing, business services and leisure seeing strong growth. The unemployment rate did stay its course at 4.1% for the fourth consecutive month, and looking at wage pressures, those had been closely watched, and there was a 0.3% rise month-over-month after posting an improvement of 0.4% for December, and then, it was basically a 2.9% annual rate, which marks the highest since 2009.
Okay, so while the data would suggest a more hawkish Fed, did the FOMC minutes from their January meeting provide additional support?
While the minutes did not project out four rate hikes like some strategists are predicting, the overall sentiment from the minutes were viewed as more hawkish as the statement highlighted that members expected that economic conditions would evolve in a manner that would warrant for the gradual increase in the Federal Funds rate, and per “capita economics” officials were firmly on track to raise interest rates in March even before the latest incoming data showed stronger wage growth and core inflation or to boost the federal spending. So several members had actually moved their forecast for economic growth higher after considering the recent tax cuts and the impact they will have.
With all this volatility in the equity space, how do fixed income markets react over the month?
So as I just mentioned wage growth, which is a key component in the economic recovery, jumped to the highest level since 2009, which caused Treasury yields to climb, rising roughly 10 to 20 basis points across the curve over the month and about 30 or 40 basis points year-to-date. So after opening up the year right at 2.45, the 10-year traded as high as a 2.95 before settling back into a range around 2.80-2.90 for the balance of the month. So with inflation in check and the Fed raising short-term rates, the 2s-10s curve had flattened; however, the curve steepened to about 78 basis points earlier in the month and then settled out around 60 basis points.
All right, so turning to the tax-exempt market, how did munis fare relative to Treasuries?
So munis over the month solidly out performed in the front end. I’d say the 2-year yield dropped a few basis points to 1.52, while bonds five years and longer kept pace and modestly outperformed Treasuries. Yields closed out at year-to-date highs nearing 2% in the 5-year range, closing in at 2.5% in 10 years and just over 3% in the 30-year space.
Okay, but given the outperformance in the front end, I assume ratios were impacted there?
That's right. So short ratios were pushed lower to sub-70% in that 2- to 3-year range, while ratios out longer were really unchanged over the month, 74% and 86% in the five- and ten-year range and then 97% in 30 years. Constrained supply I’d say continues to be a driver of tax-exempt relative value.
Okay and speaking of supply, that's a good transition to talk about market technicals. While the market benefited from three consecutive years of healthy supply, it seems like this year we’ve seen a marked decline?
That's right, so supply for February totaled about $17 billion; that’s a 29% decline from February of 2017, a 38% reduction for the same period last year and is roughly 30% lower for the average over the past five years, which comes in around $48 billion. This is as the market continues to feel the effects of the advance refunding restriction. Refunding volume over the month totaled about $2 billion compared to $6 billion we saw in February of 2017. Actually, another good indicator in the supply decline to look at is the CUSIP request we’ve seen from muni issuers which dropped 57% in January with the year-over-year request volume that's from January of ’16 into ‘17 off about 26%. So near-term market direction will likely be determined by the balance between primary and secondary supply.
Supply has been constrained by tax reform and the elimination of advance refunding deals. As a result, there have been discussions surrounding issuers and possibility of using shorter calls to gain some flexibility in managing their debt. What have we seen?
So since advance refunding are no longer permitted, some issuers and underwriters may get creative with deal structures, and to date, we have seen some deals come with shorter calls. Mid-month there was actually a new story that hit the wire about the state of California and how it may look to shorter calls and variable-rate debt as an alternative. So if issuers do start to seek these structures, we will continually need to assess whether we’re being adequately compensated for less call protection.
I know secondary market flow spiked in January due to elevated selling from some bank portfolios. Did that trend continue?
So during the month of February, the pace of secondary selling slowed and dealer inventories declined. According to a J.P. Morgan piece, inventories were only 14% above the trailing one-year average near the end of the month, which is considerably lower from the 28% and 49% above-average readings we saw in mid-January and mid-December. So that said, selling from the banks and insurance companies have helped to provide a source of supply as new-issue volume continues to underwhelm.
Demand was strong to start the year, but with the rise in rates, how does it look now?
So after stringing together five consecutive weeks of inflows, mutual funds posted an outflow of $591 million for the last week of the month, that's per Lipper. In the month, it overall closed out mixed. That outflow actually pushed the four-week moving average to -$3 million, and the year-to-date aggregate closed in around $6 billion.
And how did performance stack up?
So despite outperforming Treasuries, munis actually posted negative returns with the Bloomberg Barclays Muni Bond Index closing the month down about 30 basis points, and it’s now down just close to a percent and a half year-to-date. The Bloomberg Barclay’s 1-to-10 Blend was down about 22 basis points for the month and 80 basis points year to date. With the muni curve steepening, the only positive returns were in the shortest maturities, while the 6-to-10-year range showed the worst total returns. Quality distribution had a minimal impact as BBBs and AAAs showed roughly the same losses, and the weakest performing sectors were electric rev, leasing and special tax while housing, resource recovery and industrial development bonds actually fared the best over the month.
Moving over to credit, in light of limited supply and continued spread compression, what are some of the credit stories we continue to follow as 2018 unfolds?
So while overall credit is stable, we do acknowledge some areas of risk within the credit space, one of which is within the states. If you recall, states struggled last year to produce on-time budgets with 11 states missing their budget deadline and another 10 passed budgets in special sessions, and headwinds do persist. So I can give you maybe a few examples. The first I’d talk about is Illinois. So Governor Rauner actually released a $37 billion fiscal year ‘19 budget proposal with a lot of one-time politically challenged initiatives, some of which include interfund loans, cuts to Medicaid providers, reforms to employee healthcare benefits and then a first phase to shift pension cost to local governments and education institutions, and why that's important is the fact that the state currently absorbs most of those total pension costs for those types of credits. So K-12 school and community college districts may be at risk, especially where tax bills are already high so any additional increase would be burdensome. So really if the state can't get a balanced budget passed, it runs the risk of a downgrade, and it had teetered on the edge of junk last summer so agencies may not be as kind this time around.
I see. Well, Illinois has continued to battle headwinds on numerous fronts. How about concerns with more fiscally sound states?
So I’d say some of the states that would to be good examples of that would be California and New York, both of which will be impacted with the new federal tax law changes. Unlike in Illinois, California does remain in reasonably good fiscal shape with general fund reserves growing to nearly $16 billion; that's about 12% of their budget, and it’s anchored by a large and diverse economy. Economic recovery is outpacing the nation, and it really has significantly improved its reserves and liquidity, but that said, they have headwinds that do persist. They have a highly volatile tax structure with personal income tax accounting for 70% of their general fund revenues, and again, they have exposure to those federal policy changes, and the most recent budget does not account for those changes. So one example would be if they’re exposed across many fronts, including the cap on the SALT deduction, which could encourage high-wage earners to move. On the New York side, again, positives for the state of New York would be well-funded pensions, above-average wealth and a diverse economy, but again, unlike the past, they’ve been facing a larger than normal budget gap in 2019. It's roughly $4.4 billion, and it's about the largest since 2011, and like California, they may be at risk to losing higher wage earners with that $10,000 cap on the SALT deduction. They also do face revenue volatility, weak demographic trends and a large OPEB liability. So really this just serves as a reminder that even the more insulated states do face some challenges. We have to be diligent in monitoring all of them.
All right, thanks, Sarah.
So let's move over to the corporate side. Let's start out with performance for investment-grade corporates in February. How did they do compared to January?
So after a rather impressive start to the year in terms of excess returns in January, the sentiment in February shifted. Corporates lagged Treasuries in February due to higher Treasury rates, widespread risk-off environment with the S&P 500 being down over 4%. M&A-related supply also weighed a little on spreads in February. The Corporate Index underperformed Treasuries by 62 basis points and generated -162 basis points of total returns. Intermediate corporates generated a -39 basis points of excess returns, outperforming long corporates by 81 basis points. Within sectors, Energy was the worst performer due to lower WTI and rent prices. Health insurance and pharma also lagged the Corporate Index. However, REITs and home construction outperformed the broader corporate market. From a Barclays sector level II, utilities outperformed and industrials lagged.
Okay, so what were returns across the credit quality spectrum? Did lower quality outperform?
So this month was pretty neutral. AA corporates performed the best in terms of total and excess returns, and there was really no difference between excess returns for As and BBB corporates this month. BBBs and As spreads both widened 10 basis points during the month while spreads for AA corporates widened 9 basis points. The spread differential between BBBs and As remains historically narrow at 40 basis points at the end of the month, which is a smallest difference since mid-2014.
Okay and what has happened to the credit curve this year?
So year-to-date, the credit curve has flattened meaningfully. One-to-three-year corporates are 10 basis points wider, while 10-plus-year corporates are 4 basis points tighter. For example, the 5s-10s credit curve stands at only 30 basis points, which is the lowest level since late 2016. The 10s-30s credit curve has also flattened to 30 basis points partly due to rising Treasury yields. In February, we saw a modest contribution to the flattening with one- to three-year corporates widening 12 basis points while 10-plus-year corporates widened 8-9 basis points. Anecdotally, the Tax Act that was passed recently allows companies to repatriate cash from overseas, and this has decreased the demand for companies to purchase shorter duration bonds. This in turn has caused spreads for shorter corporate bonds to increase. Over the last 12 months, however, long corporates have meaningfully outperformed short and intermediate corporate bonds in terms of total and excess returns.
And switching gears now to talk about technicals, how is corporate supply relative to last year?
So IG corporate bond supply this month was about $109 billion, which is up 21% compared to 2017; however, our year-to-date supply is down 12% to $265 billion. Unlike January, industrials dominated the calendar this month. Notable deals included Anthem, Baa2/A, which priced $2.1 billion in 10- and 20-year. The 10-year priced at +120 or 7 basis points wider relative to existing secondaries. Bank of America priced $7 billion at the end of the month with 10-15 basis points on new-issue concession, and Boeing A2/A priced $1.4 billion in 5-, 10-, 20- and 30-year with negative new-issue concessions, except for the 30-year, which had about 6 basis points of new-issue concession. Celgene, which is a BBB biotech company, brought four-part $4.5-billion deal for M&A. The 10-year priced at +110 basis points, which is 10 basis points wider than existing secondaries.
Okay and was there any M&A news in investment-grade corporates?
Yeah, so a couple. General Mills agreed to buy Blue Buffalo brand for $8 billion. General Mills received rating downgrades by Moody's and S&P this past month. Bonds were quoted 15 to 25 basis points wider after the news hit, and they’ve pretty much stayed that way throughout the month. Also, Comcast made a surprise $31-billion offer for UK paid-TV company Sky. Comcast’s offer for Sky exceeds an offer made by Rupert Murdock’s 21st Century Fox for the 61% stake it doesn't already own in Sky. Bonds were 10 to 15 basis points wider for Comcast during the month on the news.
All right. So what about demand? Have fund flows kept up with the delusion of supply?
Investment-grade in-flows for the month was a modest $4.8 billion. The second week of February had an almost $2 billion outflow, which was the first major outflow since April 2017; however, that quickly reversed during the third week of February, and over the course of the month, we were net positive.
All right. So let’s switch gears again and talk about securitized products. What are the biggest trends you're seeing in agency mortgage-backed securities right now?
So the biggest market-moving event we are watching is the Feb balance sheet unwind and its impact on net supply this year. We are expecting around $250 to $300 billion of organic net supply, depending on the path of interest rates this year. The Fed will be adding another $150 billion or so on top of that that the market will have to digest. So far this year, we have seen MBS spreads widen as the market settles into this new reality of not having a backstop liquidity bid for the first time in quite some time. As the Fed’s reinvestment cap jumps to $12 billion a month in Q2 and $16 billion a month in Q3 before finally reaching the terminal level of $20 billion in Q4, we could see further spread widening of MBS spreads as the market digests the supply.
Okay and what about GSE reform? I know that's another hot topic.
That’s right. Another story that we are watching that we believe will have less of a pricing impact is GSE reform. There’s a draft bill out there right now from Senators Bob Corker and Mark Warner that essentially would make MBS issued by Fannie and Freddie explicitly government guaranteed. This could change some of the pricing dynamics between Fannie and Freddie relative to Ginnie Mae, which is already explicitly government guaranteed. We caution that nothing is close to being finalized on this front, but this bill is an updated iteration of a bill from a few years ago that covers many of the things that the earlier version failed to do, namely affordable housing and first-time home buyer assistance. The current bill probably has the best chance of passing out of any other proposals we’ve seen in recent years, and GSE reform could begin to gain traction after the midterm elections later this year.
Okay and so for more information on some trends in agency MBS, please see the blog post from our securitized trader John Bastoni, which is currently on our website.
So Khurram, what about consumer ABS?
So on the consumer ABS side, we continue to monitor trust credit fundamentals in prime credit cards and auto deals and the natural normalization of the levels given where we are in the later stages of a broader credit cycle. Prime consumer fundamentals continue to show strength, and we are cautious on the subprime and lower quality sectors. Given the lower quality sectors are not a segment of the market we invest in, we feel good about our current positioning given our views on the general tone and credit. We still see pockets of value in the sector in shorter-dated, structurally sound, high-quality collateral sectors and see a good risk-reward with widening swap spreads following Libor’s ascent providing attractive entry points.
All right, well, thanks Khurram.
We hope that you in the field have found this informative, and we look forward to you joining us on our next podcast. Thank you.
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