Premium bonds and the math behind them continue to furrow the brows of many municipal investors.
March 2018 Market Commentary
A New Tariff in Town
Equities remained volatile during March due largely to tariff announcements from President Donald Trump related to some Chinese products and to steel and aluminum imports. In addition, volatility heated up due to concerns over privacy issues, potential regulation and high valuations in technology, rate hike concerns, and other factors.
The Dow and the S&P 500 had negative returns for the quarter, while the Nasdaq stayed marginally positive. U.S. Treasury and municipal bonds benefited from the weakness in equities and posted positive returns for the month, but negative returns for the first quarter. Importantly, the March FOMC meeting marked the first under the reign of new Fed chair Jerome Powell. Risks in the U.S. have contributed to declines in the U.S. dollar, which have occurred despite a persistent yield advantage in U.S. sovereign debt (Figure 1).
On the economic front, consumer confidence slipped to 127.7 in March from February’s strong 130, but it remains solid partly due to strong equity performance. The employment picture remains healthy, as February payrolls grew at an outsized 313,000, and January payrolls were revised upward to 239,000. Unemployment was unchanged at 4.1 percent in February.
Inflation remains contained, as headline CPI rose 0.2 percent in February and 2.2 percent for the year. Annual core inflation remains below the Fed’s 2 percent target, with core CPI at 1.8 percent and core PCE at 1.6 percent.
As anticipated, the FOMC voted to raise the federal funds rate to a range of 1.5 percent to 1.75 percent in March. The 2018 dot plot continues to point to three rate increases this year, with the potential for a fourth. The dots reflect an increase in median projections for future rates; however, the terminal rate projection remains below 3 percent. The pace of hikes was increased for 2019 and 2020, making an extended rate hike cycle more likely – as opposed to a faster pace of hikes in 2018. The market currently places an 80 percent probability on a June hike.
For March, Treasury yields performed better at longer maturities. Yields were unchanged in the two-year range, closing the month at 2.27 percent. For maturities five years and longer, Treasuries traded within a range of 10 basis points for most of the month, but rallied at month-end to close March between 9bps and 17bps lower. The five-, 10- and 30-year bonds finished the month at 2.56 percent, 2.74 percent and 2.97 percent, respectively – the monthly lows for those maturities.
Looking year-to-date, yields rose by 38bps and 36bps in two- and five-year maturities, respectively, while the 10-year yield rose 33bps and the 30-year closed 23bps higher. With outperformance at the long end of the Treasury curve, the 2s10s curve continued to flatten, finishing the month at 47bps – a multiyear low.
MUNICIPAL MARKET REVIEW
Technicals in Focus
For March, municipals underperformed U.S. Treasuries across the curve. Like Treasuries, municipal yields performed better at the long end. The 10-year and 30-year AAA municipal yields traded in narrow ranges over the month. The 10-year and 30-year closed at their monthly lows (2.42 percent and 2.95 percent, respectively).
With municipal underperformance in March, relative value improved with the five-year ratio closing at its high for the year. The two- and three-year ratios moved 5 percent higher but are still lower on the quarter. Ratios for longer maturities were rangebound in March, ending slightly higher in the 10-year and 30-year maturities at 88 percent and 99 percent, respectively.
The 2s10s curve flattened 18bps over the month. However, looking year-to-date, unlike the 2s10s Treasury curve which has flattened significantly, the municipal curve has steepened 35bps to close out March at 77bps (Figure 2).
March issuance jumped to $25 billion, a 46 percent increase from last month but a 24 percent drop from March 2017. The lower supply stems from issuance pulled forward in late 2017 ahead of new tax reform provisions. Year-to-date supply totaled $63 billion, a 32 percent decline from the same period last year.
The technical benefit of lower new issue supply has been partially offset by secondary selling from banks and insurance companies this year. Bid-wanted activity averaged $855 million a day during 1Q18, compared to $640 million a day during 2017.
This selling has been a closely watched theme in 2018. Following tax reform, banks and other crossover buyers now pay lower tax rates on alternatives to municipals. Therefore, in a retail outflow cycle when institutional investors are absorbing more supply, the clearing level for municipals – from a ratio perspective – is likely to be higher. That said, mutual fund investors have poured $6.5 billion into municipals year-to-date and municipal borrowers received strong demand for new bonds.
Municipal credit conditions remain largely unchanged from February. Many states are reporting an uptick in tax collections which, according to officials, mostly represent one-time revenues. The impact of the state and local tax (SALT) provisions remains unclear for most municipal market participants. Passage of the federal budget for fiscal year 2018 includes a substantial boost for defense spending and the lifting of sequester caps for non-defense items like R&D. This should boost economic activity in some regions and, perhaps, benefit research-oriented higher education and hospital credits.
CORPORATE MARKET REVIEW
Issues with New Issues
In March, the Bloomberg Barclays U.S. Corporate Investment Grade Index posted a return of 0.25 percent. The OAS widened further in March to 109bps, versus 96bps at the end of February. IG corporates lagged duration-matched Treasuries by 91bps.
Heavy supply, led by industrial companies, was one of the main culprits for spread widening in March. Issuance totaled $124 billion, versus $98 billion in February and $131 billion in March 2017, per Bank of America Merrill Lynch (BAML). Issuance was boosted by large new issues, such as CVS Health Corp.’s roughly $40 billion bond deal to fund its purchase of Aetna Inc. – the third-largest IG bond deal on record. Large deals caused some indigestion in the new issue market and concessions ticked higher to 11bps in March versus 5bps in February, per BAML.
On the demand side, flows have been positive year-to-date, but some IG market participants are concerned about slowing demand from foreign buyers. Headwinds to foreign demand include rising costs to hedge U.S. dollar debt, a greater pool of options for attractive yields globally and more worries about the unwind of short-term debt held overseas due to tax reform rules.
For 1Q18, fund inflows were $41.7 billion, down over 50 percent versus the same period last year, per Wells Fargo. In March, flows slowed to $123 million – the slowest monthly pace of new money into IG corporates over the past 26 months of inflows, per Wells.
On a sector performance basis, Packaging, Leisure and Home Construction did best during the month, while Paper, Metals and Mining, and Life Insurance companies had the worst performance. The widening in the Paper sector is partly due to International Paper Co.’s ongoing efforts to purchase Smurfit Kappa plc, while Metals and Mining was negatively impacted by fears of a trade war. Event risk may increase and impact returns as companies pursue M&A and shareholder enhancements. AA-rated bonds outperformed all other ratings categories for the month, while crossover bonds fared the worst.
Total debt-to-EBITDA for IG corporates has reached a record high and interest coverage has dropped. That said, looking forward, corporate earnings are expected to be strong, as tax reform is a net positive force for corporates, and this may slow increases in debt leverage. For our detailed thoughts on corporate IG bonds, see our 1Q18 Corporate Bond Outlook.
SECURITIZED MARKET REVIEW
Fed Balance Sheet Unwind Still Weighs on Market
In March, agency MBS were impacted by the spike in U.S. Treasury yields, which pushed nominal spreads versus the five- and 10-year Treasury blend 3bps higher to roughly 81bps. However, this is still considerably tighter than the 95bps range in September, when the Fed first announced its plans to unwind its balance sheet. Banks – historically the biggest buyers of MBS – significantly dropped their demand, as the sharp sell-off led to losses in their available-for-sale asset portfolios. Spreads are expected to widen further as the Fed balance sheet unwind makes an impact. However, refinancing and extension risk remain low despite higher interest rates, which should help mitigate significant widening. Year-to-date, organic supply has underwhelmed at roughly $60 billion versus $100 billion in 3Q17, and the Fed’s unwind is largely on track.
In ABS, prime, short defensive ABS sectors continue to outperform, reflecting the market’s risk-off tone. However, in March the rise in Libor/OIS and subsequently swap spreads prompted ABS OAS levels to widen in sympathy. Spreads to U.S. Treasury bonds have risen from the low-30s to the mid-40s. We continue to see the asset class as attractive, particularly relative to Treasuries, given that the sector remains a safe haven, defensive asset class. Fundamentals in prime ABS remain strong. Supply is expected to remain elevated, with issuers likely to push deals forward into higher rates later in the year. Year-to-date, supply has risen 10 percent to $64 billion.
STRATEGY AND OUTLOOK
We are closely monitoring risks for U.S. IG bonds, including tightening Fed policy and slowing foreign demand. However, solid economic data, particularly for housing and labor markets, continues to support credit fundamentals, in our view.
On the tax-efficient side, in some portfolios we are reducing our shorter-maturity exposure and increasing exposure in the middle range of the curve to take advantage of better absolute yields and more attractive relative value in the five- to 10-year maturity range.
In our view, municipal credit fundamentals remain stable; however, recent problematic municipal credit situations (such as Puerto Rico) illustrate the importance of monitoring “willingness” of states to service their debt. Breckinridge remains defensive and we believe that our high-quality bias will be beneficial given potential spread widening in the second half of 2018.
For our government credit strategies, given lower supply and tight spreads we continue to gradually moderate our taxable municipal allocation. Current valuations are also contributing to our high-quality basis, as the yield pickup from going lower in quality has declined year-to-date. The Committee continues to overweight AA-rated and A-rated bonds and underweight BBB-rated bonds, within an overweight corporate allocation. Within the corporate allocation we are overweight Banking, Pharma/Health Care and Energy sectors, and underweight the Transportation and REIT sectors.
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