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Investing Commentary published on July 31, 2016

July 2016 Commentary


  • In July, the municipal curve steepened, but long-end yields remain low on a historical basis.
  • Demand for U.S. high-grade corporate and municipal bonds remains robust due to even-lower yields abroad and rising interests from nontraditional buyers.
  • Intermediate high-grade corporate bond spreads widened following Brexit, but then plummeted to the lowest levels since June 2015.
  • While challenged, U.S. credit fundamentals remain supported by monetary easing from global central banks.

Market Review

U.S. Investment-Grade Fixed Income: A Global Phenomenon

At the 2016 Olympic Games, athletes across the world have converged on Brazil to take part in an elite competition that dates back to 776 BC in Olympia, Greece.[1] As one of the most-popular events in the world, the Olympic Games are also a magnet for fans from all corners of the world to converge, ready to show their enthusiastic support for the athletes. Perhaps taking a cue from the Olympic Games, U.S. investment-grade global investors are converging on the asset class in droves (Table 1).

Heavy foreign demand for longer-maturity Treasury bonds helped keep long-end rates anchored versus the rest of the curve in July, even as some major pension funds reported a greater unfunded status. (Reduced demand from pension funds potentially lowers demand for longer bonds).

Following Brexit at the end of June, a fairly standard flight to quality ensued: U.S. Treasury yields fell, municipal bond yields dropped, the U.S. dollar rose, global equities declined and investment-grade credit spreads increased. However, in the four trading days following Brexit, world equity markets recovered most of the ground that was lost. The S&P 500 Index rose more than 5 percent in the full trading week following Brexit, boosted by a strong payroll report. U.S. equity markets retreated in late July, but remained higher than at the start of the month.

In U.S. credit markets, the post-Brexit rate rally culminated in a record-low 10-year Treasury yield of 1.37 percent on July 5. The rate rally finally reversed midmonth, but Treasury yields remain low on a historical basis.[2] With U.S. equities zooming to record highs during July, bonds and equities have shown strength, bucking the usual trend of negative correlation between the two asset classes. Much of this is likely attributable to ultralow yields elsewhere that have prompted demand for U.S. Treasury bonds as well as U.S. dividend-paying stocks. Roughly 29 percent of the J.P. Morgan GBI Broad Index is trading with negative yields.[3]

In general, high-grade credit had a muted reaction to Brexit. U.S. credit fundamentals remain supported by Central Bank easing in the U.S., Europe, Japan and China; improved housing, retail sales and job data in the U.S.; a turnaround in crude oil pricing; and decreased correlation between credit risk sentiment and oil prices.[4] U.S. growth is sufficient for high-grade credit to perform well, but there are pockets of risk in municipal and corporate bonds.

Overall, 10-year Treasury bonds were flat and 30-year Treasury bonds fell 6 basis points (bps) during the month of July. Yields in shorter maturities were flat to slightly higher. Muni yields have generally been following the same trends as Treasuries. On July 6, the 10-year AAA general obligation (GO) bond repeated its all-time low of 1.29 percent and the 30-year hit a new all-time low of 1.93 percent.[5] However, muni yields began increasing after that. In corporate bonds, intermediate high-grade bonds widened following Brexit but then plummeted to the lowest levels since June 2015.[6]

Entering August, the focus is on Europe’s response to Brexit. The Bank of England (BoE) opted not to move policy rates in its July 14 meeting, but offered that they would enact stimulus in the future that could include lowering rates. Consensus had expected a 25bps rate cut.

The BoE eventually announced a rate cut at its closely watched August 3 meeting; the BoE cut the bank rate by 25bps to 0.25 percent and announced £435 billion of asset purchases including up to £10 billion of U.K. corporate bonds.[7] This stimulus was more generous than the market expected.

Tax-Exempt Market Review

Gold Medalist: Market Technicals

Municipal bonds showed modest returns in July, following the trend of U.S. Treasury bonds. Short-end yields fell about 7bps. Meanwhile, long-end yields rose, and for the month the curve bear steepened (Figure 1). However, long-end yields remain low on a historical basis and the curve is still flatter than at the start of the year.

Ratios drifted higher at the long end, while short-end ratios dropped. The short end continues to exhibit the most attractive ratios given that the long end has rallied the most year-to-date.

Entering August, Brexit anxiety has diminished. This changing risk sentiment has prompted a pullback in post-Brexit gains for Treasuries and municipal bonds. Nonetheless, municipal bonds continue to benefit from stable fundamentals and strong technicals.

In terms of fundamentals, municipals continue to be supported by slow-but-steady U.S. economic growth. Municipals are benefiting from improving wages and upbeat housing data, which is getting a boost from low mortgage rates. Sales of previously owned homes rose at its fastest pace in a decade in June. The pace of municipal defaults so far in 2016 (excluding Puerto Rico) lags 2015 and 2014 defaults for the same period,[8] which is likely another fillip for foreign investors seeking a stable asset class.

The technical backdrop is still strong, resulting in many deals being oversubscribed and seeing yields lowered from initial price guidance. Year-to-date municipal bond fund inflows totaled $38.8 billion as of July 27, per Lipper. Demand is coming from traditional mutual funds as well as foreign investors and banks.

Supply fell to $26.07 billion in July. This is a significant drop from $47.39 billion in June and $35.62 billion in July 2015, per The Bond Buyer. Bids wanted declined to the lowest of the year as the lower supply curbed price discovery, MMA data shows. Lower supply is in line with seasonal trends; usually, July supply decreases due to the Fourth of July holiday and other factors. August is off to a busier start in the primary market.[9]

In specific credit news for July:

  • Puerto Rico defaulted on over $900 million in debt service on July 1. The market reaction was quiet given the previously announced debt moratoriums. The default included principal and interest payments on Puerto Rican GO debt.
  • In mid-July, Pennsylvania passed a $31 billion budget that includes $1.3 billion in additional spending. The budget was passed about two weeks after a July 1 deadline, and a $1 billion Pennsylvania state GO deal occurred in early August.
    The budget is largely balanced, aside from certain one-time infusions including a $200 million loan from the state medical malpractice insurance fund (Figure 2).[10]

  • In New York, the state’s controller reported that first-quarter income tax collections were $454 million below expectations, or close to 4 percent below the same period last year.[11] We note that New York’s finances are closely tied to Wall Street compensation and, with large banks tightening their belts, tax collection numbers may not improve. Several other states have been reporting tax revenue/budget shortfalls as well. These situations highlight the importance of keeping a close eye on municipal credit fundamentals even with the strong technical backdrop.

Government Credit Market Review

Gold Medalist: Metals and Mining

U.S. investment-grade corporate bonds performed well in July and the asset class redeemed itself from post-Brexit spread widening. The Barclays U.S. Intermediate Corporate Index tightened 10bps during July, closing at 116.5bps on July 29.

In sector performance, the Metals and Mining sector benefited from its position as a wider-trading sector, as investors were risk-on during most of the month. The best-performing sectors were Metals, Wireless, Paper, Wirelines and Supermarkets. Oil-Field Services, Independent (energy) and Integrated (energy) fared the worst. Crossover credits were the best-performing ratings class, while Aa+ credits had the worst showing.[12]

Spread widening in the Oil and Gas sector was largely due to a decline in oil prices. Brent crude oil pricing exceeded the psychological $50 threshold in May, but since then oil prices have retreated on concerns that production could once again overshoot. In addition, refining companies did not perform as strong as usual this summer due to increasing fuel costs and rising costs related to the purchases of ethanol credits. Notably, Moody’s released a statement declaring that U.S. and Canadian oil exploration & production (E&P) companies were paying executives to “focus on boosting production and replacing reserves, rather than conserving capital and reducing debt.” Moody’s said that the compensation structure is negative for investors, and it continues despite oil price declines.[13]

In addition to spread widening in the Oil and Gas sector, Banks continued to underperform due to low bond yields impacting net interest margins, expectations of increased supply due to total loss-absorbing capacity (TLAC) requirements, declining M&A and better relative performance in the Energy sector (Figure 3). However, per JP Morgan, many investors are seeing value in Financials following the widening. Banks have been cutting costs largely by staffing and compensation reductions, and efficiency ratios have improved modestly. Banks are aiming to be as lean as possible given the very low interest rates, rising costs from Compliance, increased risk management needs and hefty capital requirements for trading activity.


Earnings season is underway, and roughly 90 percent of companies in the S&P 500 Index have now reported.[14] Earnings growth in U.S. domestic-focused investment-grade companies continues to outperform those with higher exposure to overseas markets. The U.S. dollar has ratcheted up following positive U.S. economic data.[15] We are moving through a declining credit phase, characterized by high debt, weak profits and rating downgrades. However, we think we are nearing the bottom of the credit cycle.

In supply and demand, high-grade supply was a solid $96 billion in July, up from $86 billion in June despite some companies entering a second-quarter earnings blackout period. Issuance was below the record-high $174 billion in May.[16]

Year-to-date investment-grade supply was respectable at $802 billion in the first half of 2016. However, this was below $848 billion for the first half of 2015[17] partly because of the slowdown in M&A megadeals (those above $10 billion). Only 16 M&A megadeals have been announced in the first half of the year, per Dealogic. Additionally, withdrawn deals rose to more than $600 billion in the first half of the year—the highest total for any first half on record—partly due to increased antitrust scrutiny from the Department of Justice, Dealogic data shows. This total includes pulled M&A deals from health care companies Pfizer Inc/Allergan plc ($160 billion) as well as from large industrials United Technologies/Honeywell ($91 billion).[18]

Demand was strong throughout the month and deals were well received, as a respite to the rate rally made high-grade corporate yields more attractive. In an example of the month’s robust demand, Comcast issued $4.5 billion to help fund its acquisition of DreamWorks. The deal was reportedly four times oversubscribed and it priced with no new issue concession. [19]

Retail mutual fund investors have poured $0.8 billion into investment-grade corporate bonds year-to-date.[20]

Breckinridge Strategy

Gold Medalist: Payroll Data

In its July meeting, the Fed painted a more optimistic view of the economy and came off modestly more hawkish versus June. The Fed pointed to “strong” household spending and better labor data. The Federal Open Market Committee (FOMC) added the sentence “Near-term risks to the economic outlook have diminished." Still, investors were positioned for the Fed to be even more hawkish than they were.

Continuing the momentum from June, July job gains came in above expectations at 255,000. However, inflation remains at a level too high to completely diffuse rate hike concerns, but too low for the Fed to move more quickly on its path to normalize rates. June core inflation came in at 2.3 percent year over year.

Overall, central banks remain accommodative. In addition to easing from the U.K., Japanese Prime Minister Shinzo Abe announced a fiscal package in excess of JPY28 trillion and an increase in ETF purchases to an annual pace of about 6 trillion yen.[21]

Our strategy reflects negative foreign interest rates and the slow-growth pattern of the U.S. economy, where employment is tightening but consumption and manufacturing are weak. We continue to believe that the Treasury curve will bear flatten through 2017, but our positioning reflects risks that inflation increases faster than expected and the Fed doesn’t act, prompting a steeper yield curve. In our tax-efficient strategies, we continue to moderate our barbell positioning. However, our duration targets remain neutral to the indices.

The Investment Committee did not make any changes to asset allocation targets in Government Credit strategies this month. High-grade corporate bonds continue to offer more yield than other high-quality assets.[22] However, credit fundamentals have been buffeted by high leverage, as companies have borrowed to take advantage of low interest rates. We continue to espouse in-depth credit research to manage idiosyncratic risks.

In municipal bonds, credit fundamentals remain stable. We remain high-quality given that yields across much of the curve remain close to historic lows. The credit environment remains challenging for some regions, particularly those states with revenues concentrated in the oil sector.

[1] International Olympic Committee, as of May 2012.

[2] U.S. Treasury, as of August 1, 2016.

[3] J.P. Morgan, as of July 28, 2016. The Government Bond Index (GBI) Broad Index is a developed market index, and J.P. Morgan’s most encompassing index.

[4] Goldman Sachs, as of July 14, 2016.

[5] MMA, as of August 1 2016.

[6] Barclays, as of June 29, 2016.

[7] Bank of England, as of August 4, 2016.

[8] MMA, as of August 4, 2016.

[9] MMA and Breckinridge Capital Markets, as of August 2016.

[10] Pennsylvania Office of the Budget and Breckinridge Capital Advisors, as of August 2016.

[11] The Office of the New York State Comptroller, Thomas P. DiNapoli, as of July 21, 2016.

[12] Barclays, as of August 1, 2016.

[13] Moody’s Investors Service, as of July 21, 2016.

[14] Bloomberg, as of August 10, 2016.

[15] Bloomberg, as of July 29, 2016.

[16] Bank of America Merrill Lynch, as of August 1, 2016.

[17] Bank of America Merrill Lynch, as of August 1, 2016.

[18] Bank of America Merrill Lynch, as of August 1, 2016; Pfizer Inc., as of November 23, 2015 and April 6, 2016; Honeywell, as of February, 2016 and March 1, 2016.

[19] Bloomberg, Breckinridge Capital Advisors, as of July 15, 2016.

[20] Wells Fargo, as of August 1, 2016.

[21] Bank of Japan, as of July 29, 2016.

[22] Bloomberg, Barclays, as of August 1, 2016.


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