The investment grade (IG) space combatted its own set of difficult conditions in April, as IG corporates and municipals weathered higher U.S. Treasury yields, rising hedging costs for foreign investors and unfavorable technicals.
- Treasury rates ratcheted higher across the curve, and the FOMC signaled that more rate hikes are expected.
- The muni curve steepened, and muni returns were positive only in the shortest maturities.
- The best-performing corporate sectors for January were Metals and Mining, Wirelines and oil-related sectors such as Refining and Independent Energy.
- In Agency MBS, the month started with low volatility and tightening spreads, but a sell-off occurred later in the month.
What a Game
Fans of Super Bowl LII who wanted to see the game in person paid an average ticket price of more than $5,0001 to watch every dramatic turn. Markets offered their own drama in January, with equity markets setting records, global rates ticking higher, stock and bond volatility rising and all eyes on macroeconomic reports, the FOMC, the State of the Union address and commodities. Reflecting the market’s risk-on mentality, January was the best month for the Dow Jones Industrial Average and the Standard & Poor’s 500 Index since March 2016.2
On the other hand, U.S. Treasury yields jumped higher across the curve. Treasury yields were higher by 25 basis points in two-years, roughly 30bps from three- to 10-years and about 20bps in the 30-year maturity. The 10-year Treasury reached 2.73 percent near month-end, which was the highest level since 2014.3 Given the rise in Treasuries, market volatility and other factors in January, investment grade (IG) corporate market total returns were negative despite a decline in credit spreads. IG municipal bonds posted losses as well, while high yield corporate bond total returns rose.
The Treasury backup was primarily due to the potential for more-aggressive Fed rate hikes in 2018, early signs of higher inflation and an increase in Treasury bond issuance due to rising Federal deficits. The FOMC signaled that more rate hikes are to be expected given solid economic growth and low unemployment, and also cited strong household spending. The new Fed chair, Jerome Powell, took over on February 5 and is said to be more hawkish than Janet Yellen, although he has not dissented on any of her policies.
The employment report for January was a strong one, with 200,000 jobs added and wage gains showing life. Average hourly earnings were up 0.3 percent for the month and 2.9 percent year-over-year. Fourth quarter GDP rose 2.6 percent in the advance estimate, which showed steady growth albeit lower than expectations of 3 percent due in part to more tepid inventory growth and a wider trade gap. The core PCE price index rose 1.9 percent in 4Q17, following a 1.3 percent increase in 3Q17.4 Oil prices hit $60 a barrel at year end and continued to trade in that range, closing the month just below $65 – a level not seen since mid 2015.5
Municipal Market Review
For January, the Bloomberg Barclays Municipal Bond Index posted a loss of 1.18 percent, erasing all gains accrued in December 2017 when the Index returned 1.05 percent. Returns were positive only in the shortest maturities, while the long bond index (22 years and longer) had a loss of 1.84 percent. Education, water-sewer and special tax bonds were the weakest-performing sectors, while resource recovery, IDR/PCR and electric revenue bonds fared best, on a relative basis. AAA-rated bonds posted a decline of 1.2 percent, while BBB-rated bonds had a loss of 1.13 percent.
Three-year muni yields rose slightly, five-year yields climbed 15bps and yields from 10-30 years spiked higher by almost 40bps, causing the curve to steepen.6 A combination of factors prompted higher municipal yields, with rising Treasury yields a major contributor. While retail municipal demand remained strong, corporate tax changes caused some pullback in muni appetite from the institutional side (banks and insurers). There was also selling due to banks liquidating some of their positions.
Municipal bonds outperformed U.S. Treasuries inside of 10 years, while underperforming from 10- to 30-year maturities. Ratios in two- to three-years fell back into the low 70 percent range, versus a low 80 percent range at the end of 2017. The five-year ratio fell to 73 percent at the end of January, from 76 percent at the end of 2017. The 10- and 30-year ratios rose to 87 percent and 99 percent, up from 82 percent and 93 percent, respectively.7
After record-setting issuance in December, supply plummeted to $16.8 billion versus $36 billion in January 2017. Notably, January had only one deal exceeding $1 billion in issue size, and refunding volume slowed to a paltry $1.8 billion versus $8.8 billion in the same month a year ago.8
Mutual funds started the year strong. For the period ending January 31, combined weekly/monthly reporting funds indicated inflows of $543 million, increasing aggregate inflows to $3.3 billion for 2018, per Lipper. However, the positive technicals from low supply and positive inflows were offset by heavy selling in the secondary market and the liquidation of a large portion of a bank portfolio.
Corporate Market Review
Earnings Kick Off Strongly
In January, the spread on the Bloomberg Barclays Credit Index narrowed 7bps to 82bps, outperforming duration-matched Treasuries by 69bps. The Index posted a negative total return (-93bps). IG corporate performance in January brought spreads down to the lowest level since early 2007 (Figure 1).9 Spreads benefited from solid fourth quarter earnings reports and rising growth expectations due to tax law changes. In addition, higher interest rates and lower-than-anticipated supply helped compress spreads.
The best-performing sectors for January were Metals and Mining, Wirelines and oil-related sectors such as Refining and Independent Energy. The strong performance in these sectors was largely due to rising oil prices, as WTI climbed nearly 10 percent in January to a 2.5-year high. The laggards for the month included Autos, Consumer Products and Diversified Manufacturing, which was impacted by widening spreads in General Electric bonds. GE was hurt by negative headlines related to significant charges on its legacy reinsurance business. Further igniting volatility, the company discussed a potential breakup and became the subject of an investigation by the SEC concerning its past accounting practices.
Some healthcare names were impacted negatively at the end of the month by an unexpected threat from Amazon.com Inc., Berkshire Hathaway Inc. and JP Morgan Chase & Co. The trio announced plans to partner and create an independent company that will address the healthcare needs of their U.S. employees. That said, the healthcare sector still wound up with 70bps of excess returns in January.10
New issue supply was $133 billion, down from a record monthly $176 billion in January 2017 per Bank of America Merrill Lynch (BAML). The slowdown in supply is partly responsible for the low spread levels in today’s market.
This year’s issuance has been driven by a significant amount of financial issuance, which soared to $100 billion – the highest month of financial supply on record, per BAML (Figure 2). The boon in financial supply was based on the close of earnings blackout periods, refinancing of near-term maturities and required regulatory debt issuance.
Demand for new issues was strong, with new issue concessions averaging only 1bp, versus 6bps in December. IG inflows for the month were strong at $13.5 billion, per Lipper.
Securitized Market Review
After the Half
It was the tale of two halves for Agency MBS in January. The month started off with a continuation of what we saw for most of Q317 and Q417; specifically, yield curve flattening and low volatility driving headline nominal spreads tighter. Spreads fell below 70bps versus the five-to-10-year Treasury blend for the first time since five years ago when QE3 was announced.
However, a sell-off occurred later in the month, primarily in the longer end, driving the 2s10s Treasury curve steeper, implied volatility higher and spreads wider. Net supply and prepayment speeds are both expected to moderate going into the slow seasonal time of the year; however, January also saw the Fed’s reinvestment cap jump from $4 billion a month to $8 billion a month and the prospects of a world without a buyer of last resort began to set in. The realization of less Fed buying going forward weighed further on valuations in the sector.
On the ABS side, spreads remain rangebound even with January supply soaring to its highest level since January 2008 ($23 billion). Carry, diversification and strong underlying credit fundamentals remain the story in the prime sector. Meanwhile, increasing defaults in the subprime auto sector were recently the subject of a story from Bloomberg News.11 We continue to closely watch the trends in subprime defaults and monitor for any signs of possible spill over into other sectors.
Strategy and Outlook
The Fed’s Call on the Field
The Investment Committee continues to closely monitor the impacts of tax reform, as we expect the reactions from equity and fixed income markets to play out over the next several months. The risk of budget deficits, additional rate hikes and higher inflation expectations could result in a steeper yield curve.
On the tax-efficient side, ratios ticked higher in longer maturities in January, and ratios now closer to the averages prior to the financial crisis and tax reform discussions. However, the Committee expects the limited supply to keep ratios from increasing substantially going forward. Municipal credit conditions remain stable, as the economy continues to grow and unemployment remains low. Infrastructure is now a focus for the administration, but it’s unclear what impact this will have on municipal supply.
We do see some signs of complacency in munis, particularly in sectors that have risks that may not be reflected in spreads (e.g. Hospitals). For example, market demand was strong even for very risky deals in 2017 (Figure 3). As a result, Breckinridge remains defensive and we believe that our high-quality bias will be beneficial as we continue to work through the later stages of the municipal credit cycle. In addition, crossover trading will play an important role in 2018, as market conditions may dictate better relative value in taxable bonds at various times.
On the government/credit side, the Committee continues to monitor tight spreads in corporate bonds and taxable municipal bonds. Notably, spread tightening comes amid several risks to spreads, including high leverage, equity market volatility and possible rate-related outflows.
We continue to be defensively positioned in taxable portfolios as well. The Committee is overweighting AA-rated and A-rated corporates and underweighting BBB-rated issuers, within an overweight corporate allocation in government/credit strategies.
 StubHub, as of February 2, 2018.
 Morningstar, as of February 7, 2018.
 U.S. Treasury, as of February 7, 2018.
 The Bureau of Economic Analysis, as of January 26, 2018.
 Bloomberg, as of February 8, 2018.
 Thomson Reuters Municipal Market Monitor (TM3), as of January 31, 2018.
 Thomson Reuters Municipal Market Monitor (TM3), as of January 31, 2018.
 The Bond Buyer, as of February 7, 2018.
 Based on the Bloomberg Barclays U.S. Corporate Index.
 Based on the Bloomberg Barclays U.S. Corporate Index.
 Cecile Gutscher, “Subprime Auto Defaults Infect ABS Bond Pools Yet Sales Boom,” Bloomberg News, February 2, 2018.
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