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Investing Commentary published on April 11, 2019

March 2019 Market Commentary

STRATEGY AND OUTLOOK

  • U.S. Treasury Curve: Late in the month, the 3mo10yr Treasury curve inverted for the first time since 2007, and a majority of market participants now expect a December 2019 rate cut.
  • Tax-Exempt Municipal/Treasury Ratios: Ratios shorter than 10 years cheapened in March, while the 10-year ratio was flat and the 30-year ratio fell 4 basis points (bps).
  • Municipal Market Technicals: The juggernaut of muni inflows continued in March, while supply remained modest at $24.2 billion for the month.
  • Corporate Credit Quality: Due partly to ratings pressure, investment grade (IG) corporates have shown signs of shifting toward deleveraging and a more credit-friendly posture.
  • Corporate Supply and Demand: Primary issuance remained steady for the month and totaled $121 billion, per Bank of America Merrill Lynch (BAML). New issues were well-received by investors.
  • Securitized Trends: The Fed announced that its ongoing runoff of mortgage-backed securities (MBS) will end in September, and beginning in October the maturing MBS would be reinvested into Treasuries with a cap of $20 billion per month.

Monthly Recap

Market Review

Accommodative Fed

In March, performance in risk assets remained mixed, with IG fixed income performing well. Treasury yields fell roughly 30bps across the curve, as market participants sought safety from global growth concerns and reacted to a dovish Fed.

In its March meeting, the Fed held rates pat at a range of 2.25 percent to 2.5 percent. However, the Fed was still more accommodative than expected. The Fed said that it expects the federal funds rate to remain at 2.4 percent through the end of the year; by contrast, in December, the Fed expected two hikes in 2019.

In addition, the Fed announced that it will end its $50 billion-per-month runoff of mortgage-backed securities (MBS) by September. Beginning in May, the Fed’s reinvestment cap for Treasuries and agencies will decrease to $35 billion. Beginning in October, the maturing MBS will be reinvested in Treasuries up to a cap of $20 billion; anything over $20 billion a month will still be in MBS.

The Fed also reduced expectations on GDP growth and inflation, and the Fed’s expected unemployment rate edged higher.

Weak manufacturing data in Germany and France, ongoing U.S.-China trade concerns, the declining benefit of the 2017 tax cuts, Brexit uncertainty and stubbornly low inflation have led to increasing worries about global growth and have bolstered global central banks’ arguments to continue easing. The Bank of Japan and the European Central Bank still have negative policy rates, and new stimulus was announced from the People’s Bank of China in March. Macro concerns, along with the Fed’s restraint on hiking, led to an increased probability of a recession being priced into the curve. The 3mo10yr Treasury curve inverted on March 22, the first time for this event since 2007. The 3mo10yr typically inverts roughly 16 months prior to a recession based on the average of the past seven economic recessions.

As of the end of March, the market is pricing in a 60 percent chance of a rate cut in December, and no Fed action in June and September.

One upbeat piece of data was February existing home sales, which surged 11.8 percent to 5.51 million – above expectations and the largest month-over-month gain since 2015.

Municipal Market Review

Robust Inflows

Municipal yields fell in March, as strong inflows from municipal mutual funds continued to support pricing. For the week ending March 27, year-to-date inflows totaled $22.5 billion – the highest level of inflows since 1992.1 The demand was largely prompted by individual investors seeking tax-exempt assets to combat higher tax obligations (see Taking Stock of the Recent Rise in Municipal Demand). In addition, the more-attractive relative value out long in January and February brought in interest from some institutional investors.

At the same time, supply remained modest, reaching $24.2 billion for the month – the lowest March supply since 2011, per the Bond Buyer. Primary dealer inventories, per the Fed, have dropped 50 percent since the recent peak in 3Q18, and are at the lowest level since 1Q15.2 Net supply could fall further in the near term given that expected maturities are at record levels in five of the next nine months, per Siebert.

In contrast to January and February, when shorter munis outperformed, municipal bond yields declined most in the long end in March, and the curve flattened (Figure 2). Yields fell roughly 40bps for bonds maturing in 20 years and higher. Meanwhile, yields for maturities five years and below fell roughly 10bps, and 10-year bonds fell 24bps.

In terms of ratios, short-end munis underperformed Treasuries, while long-end munis outperformed. The 30-year ratio fell 4bps to end the month at 92 percent, while 5-year ratios increased 4bps to 70 percent. Strength in longer municipals resulted largely from the dovish Fed comments, which convinced investors that rates would stay lower for longer. In addition, inflation remains low; in February, Fed Chair Jerome Powell noted that he didn’t see higher wage growth as a threat to inflation.

On the credit side, we continue to see municipal credit as stable, although the possibility of a softening economy and the after-effects of tax reform muddy the near-term outlook, a bit. The global economy has been slightly weaker in the past few months, and the government shutdown in December-January slowed sales and income tax receipts. Moreover, many taxpayers altered the timing of their 2017 income tax payments, and preliminary 4Q18 data shows that 23 of 41 states witnessed a decline in personal income taxes (“PITs”) versus 4Q17. The steepest declines in PITs were in high-tax states (Connecticut, New York, California and New Jersey). Losses in equities in 2018 may also have dampened capital gains and income tax collections. The extent of revenue decline will be more clear after April 2019 tax payments are made.

Corporate Market Review

Some Shift Toward Deleveraging

In March, the Bloomberg Barclays Investment Grade Corporate Index generated excess return of 24bps, capping another solid month. Spreads fell 2bps to 119bps as the pace of spread tightening slowed from last month, when spreads fell 7bps. Spreads benefited from a dovish Fed, which was offset by continuing global growth concerns. In addition, overall rate volatility declined, which was positive for spreads. Finally, lower Treasury rates helped boost IG corporate total returns.

For March, the best-performing sectors were Tobacco, Refining and Chemicals, while Aerospace/Defense, Health Insurance and Oil Field Services fared worst. BBB fared the best across the investment grade quality spectrum, while Crossover fared the worst, per Barclays.

From a credit perspective, S&P 500 Index companies reported operating earnings growth of 12 percent in 4Q18 on a year-over-year basis, marking the fifth straight quarter of double-digit growth, per Bloomberg. However, as the benefit of tax cuts rolls off and some economies slow and wages rise, operating trends are expected to moderate.

We continue to see some shift in IG companies toward deleveraging (see Risks and Opportunities in Today’s Corporate Bond Market). For example, some larger companies involved in mergers across Communications, Food and Beverage, and Pharmaceutical sectors are prioritizing debt reduction. Overall, net leverage (ex-financials) for the Bloomberg Barclays U.S. Corporate Index was roughly flat in 4Q18 versus 4Q17, with Consumer Noncyclical and Communications leverage increasing, and Energy leverage declining.

Technicals remain supported. March IG corporate supply was light at just under $100 billion, which is down almost 30 percent year-over-year. New issues were well received. Fund flows were solid in March, with inflows totaling $18.9 billion, bringing net year-to-date inflows to $66 billion.3

Securitized Market Review

Increasing Convexity Risk

In mortgage-backed securities (MBS), refinancing risk is in full focus following the sharp Treasury rate rally in March. Excess returns for March were -11bps; however, the returns were 28bps year-to-date.4 The Fed reinvestment caps remain at $20 billion, with reinvestments being shifted to Treasuries as part of the end of the balance sheet runoff. It is projected that with the Fed MBS runoff, an additional $25 billion to $50 billion of MBS will need to be absorbed by private market.5

In addition, the recent drop in Treasury rates increases convexity risk, as 20 percent to 30 percent of the conventional universe has at least 50bps of refinancing incentive.6 With the Fed no longer removing the worst-to-deliver collateral for the foreseeable future, the market focused on high weighted-average coupons, loan sizes and FICO scores, which will introduce greater negative convexity into the market in the coming months. On the fundamental supply side, new and existing home sales have been volatile and clouded by seasonal and weather-related impacts.

In asset-backed securities (ABS), 1Q19 saw strong outperformance. Net supply started the year off slowly, with a decline of 9 percent versus 1Q18. The ABS sector continues to see broad normalization in credit trends, particularly in credit cards (Figure 3). In auto loans, the delinquency rate for subprime auto loan ABS has ticked higher, but this has overshadowed the decline in the delinquency rate for prime auto loan ABS. In our opinion, prime auto and credit card sectors are still in a strong position fundamentally, and well-protected by structure. Excess returns were 2bps in March, and were 40bps year-to-date.7 

[1] Lipper, as of March 27, 2019.

[2] MMA, as of March 18, 2019.

[3] EPFR, per Wells Fargo, as of April 1, 2019.

[4] Bloomberg Barclays U.S. MBS Index, as of March 29, 2019.

[5] Breckinridge Capital Advisors and Bank of America Merrill Lynch, as of March 29, 2019.

[6] Breckinridge Capital Advisors and Bank of America Merrill Lynch, as of March 29, 2019.

[7] Bloomberg Barclays U.S. ABS Index, as of March 29, 2019.

 

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