Municipal and Treasury rates rose in November largely due to a risk-on sentiment that drove investors into riskier assets.
March 2017 Commentary
No Surprise Ending with the Fed’s 25bp Hike
In one of the biggest upsets in NCAA basketball history, the women of Mississippi State University defeated the venerated University of Connecticut Huskies – a team with an 111-game winning streak that beat the Bulldogs by a staggering 60 points in a tournament game just last year.
While fixed-income investors experienced many surprises in March, the Fed’s hike came in line with expectations. On March 15, the Fed hiked rates by 25 basis points (bps) to a range of 75 to 100bps, as widely expected given a striking hawkish shift earlier in the month. The Fed also made little change to existing economic projections (including GDP growth, unemployment and inflation). The Fed’s “dot plot” median estimates continue to indicate three rate hikes in 2017, and the long-run projection of the neutral rate remains at 3 percent.
Treasury yields were relatively unchanged during March. Yields rose significantly at the start of the month on strong economic data and Fed hawkish commentary, before dropping after the Fed announcement. In terms of economic data, labor numbers indicated strong job creation. The nonfarm payroll release for February showed a solid 235,000 added jobs, with modest upward revisions to the month of January.1
Investment-grade (IG) corporate bond spreads ticked slightly higher in March, mainly due to heavy seasonal supply. In municipals, ratios were lower at the 10- and 30-year maturities. Shorter-maturity municipal ratios rose, mainly because municipals couldn’t keep up with the drop in short-end Treasuries following the Fed rate hike announcement.
Tax-Efficient Market Review
Uncertainty Still Looms
Municipals outperformed Treasuries early in the month during the run-up to the FOMC meeting. Following the meeting, ratios shot higher in the shorter maturities, and the 2, 3 and 5 year maturities ended with flat to higher ratios, while the 10 and 30 year maturities ended with lower ratios. The month ended at ratios of 81, 80, 94 and 101 for the 2, 5, 10 and 30-year maturities.2
In March, municipal funds saw outflows following a five-week streak of inflows. This illustrated the market’s increased expectations for a March rate hike, with municipal bonds moving higher in sympathy with rising Treasury yields.
On the supply side, March issuance came in lighter than the same period last year due to uncertainties surrounding the FOMC decision, healthcare, tax and infrastructure reform (Figure 1). For the month, issuance totaled $29.8 billion, down from $42.5 billion in March 2016. New money issuance fell about 8.5 percent while refunding volume declined 57.5 percent, per The Bond Buyer.
Going forward, we are monitoring the potential for a ratings downgrade of the State of Illinois to junk, which would be the first time ever that a state GO has been downgraded below investment grade. This could have ripple effects in state and local government bonds.
Following the defeat of the proposed American Health Care Act (AHCA), markets are watching to see whether tax reform can get passed even with the recent Congressional Budget Office (CBO) report3 detailing how cuts to government revenue could be detrimental to the U.S. economy. That report could hurt public sentiment for tax reform – just as a CBO report on negative aspects of the AHCA helped lead to its withdrawal before a floor vote in the House. In addition, we are closely watching developments in Puerto Rico.
Government Credit Market Review
In March, the Bloomberg Barclays Credit Index widened 1bp to a spread of 112bps. The index underperformed duration-matched Treasury bonds by 8bps.
The best-performing corporate sectors were Packaging and Wireless. Refining, Oil Field Services, Midstream, Natural Gas and Metals fared worst, given a retreat in commodity prices. In mid-March, WTI Crude oil dropped to its lowest level in four months (Figure 2), although prices did rebound in the second half of the month. Autos also had less-than-stellar performance in March partly due to negative trends in auto sales.
Investment-grade corporates grappled with several issues in March, including a rise in potential challenges for President Donald Trump’s tax reform. The defeat of AHCA takes away a significant expected funding source for tax cuts, making them less likely and possibly impacting corporate credit, as lower taxes could boost profitability.
In our view, however, the biggest headwind for March performance was a surge in IG supply. In the first quarter of 2017, IG bonds issued a record $401 billion, including $129 billion in March alone.4
March issuance included $19 billion in the Financial sector, $61 billion in non-Financial bonds and $50 billion in Yankee bonds, per Bank of America Merrill Lynch. Looking ahead, April is typically a slower month for issuance given earnings blackouts.
Even though corporate supply was extremely high during the month, the Barclays IG Intermediate Index widened only about 3bps. The main reason for spreads holding in was strong demand. Higher all-in yields continue to make IG corporate bonds more attractive to foreign buyers and to investors who had slid down the credit curve into high yield (Figure 3 illustrates decline in HY spreads versus IG spreads over the past year). Low defaults in IG bonds, an expected uptick in revenues and earnings as well as potential for fiscal stimulus offset concerns regarding weak credit fundamentals and tight valuations. Flows into IG mutual funds for the first quarter of 2017 totaled $60.3 billion, per Lipper.
Strategy and Outlook
What Surprises Are on the Horizon?
Importantly, “soft data,” or data that measures confidence or sentiment, is currently quite strong for the U.S. economy. For example, the University of Michigan Consumer Sentiment Index rose by 0.6 points in March to reach 96.9,5 as consumer income expectations increased strongly.
Soft data handily outpaces “hard data,” or data measuring trends that are quantifiable (such as stock prices or retail sales). Hard and soft data have reached a record divergence, as soft data has shot higher while hard data has come in roughly as expected, per a March report from Morgan Stanley. The risk is that if hard data such as U.S. GDP does not fully “catch up” to market expectations, volatility could increase across risk assets.
Since the end of December, the Treasury curve has flattened with increased expectations for Fed hikes. However, there continues to be uncertainty as to whether potential fiscal stimulus from the Trump administration will prompt economic growth. Equity and fixed income pricing continues to reflect market confidence in pro-growth trends such as wage inflation, U.S. dollar strength and tax reform from Trump’s policies. Over the next 12 months, Breckinridge expects the U.S. Treasury curve to modestly bear flatten.
In the municipal market, we remain very high quality, and we are closely monitoring local GOs in states with pension issues due to a potential increase in liquidity risks.
We have not changed our tax-efficient duration targets and we remain duration-neutral, but we continue to be flexible given significant uncertainties related to infrastructure spending and tax policies.
In our government credit strategies, we remain modestly short duration. We are keeping close watch on valuations in the corporate bond market, given that investment-grade corporate spreads approached their post-financial tights in early March.6 We continue to see positive catalysts in the corporate market primarily related to corporate profit growth, potential tax cuts, cash repatriation and deregulation, although we recognize uncertainties surrounding Trump’s fiscal plans.
 Bureau of Labor Statistics, as of March 10, 2017.
 Thomson Reuters, Municipal Market Monitor (TM3), as of April 1, 2017.
 Congressional Budget Office, “The 2017 Long-Term Budget Outlook,” March 2017.
 Bank of America Merrill Lynch, as of April 3, 2017.
 The Surveys of Consumers are conducted by the Survey Research Center, under the direction of
Richard T. Curtin, at the University of Michigan. For questions used in the survey, visit https://data.sca.isr.umich.edu/fetchdoc.php?docid=24770.
 Barclays, as of April 1, 2017.
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. Any specific securities or portfolio characteristics listed above are for illustrative purposes and example only. They may not reflect actual investments in a client portfolio. All investments involve risk – including loss of principal. An investor should consult with an investment professional before making any investment decisions. This document may contain material directly taken from unaffiliated third party sources, including but not limited to federal and various state & local government documents, official financial reports, academic articles, and other public materials. If third party material is included, it is believed to be accurate, and reliable. However, none of the third party information should be relied upon without independent verification. All information contained in this document is current as of the date(s) indicated, and is subject to change without notice. No assurance can be given that any forward looking statements or estimates will prove accurate or profitable.