Few times in history have tax burdens and tax revenues been more in focus, but of course, in November, the focus was on overall tax reform proposals from Congress.
- FOMC rhetoric and changing rate-hike expectations continue to drive rate volatility.
- In a reversal from last month, municipals posted positive returns across the curve.
- Due to municipal outperformance, ratios richened across most of the curve by two to four ratios.
- In corporates, given the risk-off environment, higher quality outperformed.
- The ABS market has had a strong start to 2018.
Treasuries at the Head Table
The royal wedding and its sartorial splendor captivated many viewers across the globe. Investors were also sharply focused on Europe in May – but not necessarily for the trends in fashion. Over the month, investment grade (IG) markets were impacted by a sell-off of European bonds, political tensions in Italy and emerging market concerns stemming from higher U.S. Treasury rates and a strong U.S. dollar. Trade also prompted market jitters, with the administration of President Donald Trump announcing metal tariffs on Europe, Canada and Mexico. Markets also closely watched the uncertainties surrounding the U.S.-North Korea summit.
In addition, FOMC rhetoric and changing rate-hike expectations continue to drive rate volatility. While the markets have now fully priced in a June rate hike, they have different views for the Fed’s future path. The market is assigning a roughly 50 percent chance of a fourth rate hike in 4Q18.
Also, the market continues to listen closely to any FOMC remarks on inflation. In its May statement, the FOMC continued to signal that it may be willing to “overshoot” and tolerate inflation above 2 percent.
On the economic front, data was mixed, with the ISM nonmanufacturing index for April falling by more than expected. On the other hand, factory orders rose by 1.6 percent in March, which was above consensus estimates. Employment growth remains strong, with nonfarm payrolls showing strong growth of 223,000 in May and the unemployment rate falling to an 18-year low of 3.8 percent in the month.
Treasuries continued to grind higher early in the month, with yields for maturities 5 years and longer rising more than 10 basis points (bps). Heightened growth expectations and the increased supply of Treasuries resulting from higher deficits pushed Treasury yields to their highs for the year. The 10-year Treasury jumped to 3.11 percent, which broke through the taper-tantrum high and hit the highest level in seven years. However, yields rapidly declined into month-end on the heels of geopolitical concerns across Italy and North Korea. The 10-year yield fell to 2.77 percent near month-end.
Overall, Treasury yields were lower by roughly 10bps across the curve, with the 10-year Treasury closing out the month at 2.83 percent after trading in a 30bps range. The spread between 2-year and 10-year maturities continued to flatten, closing at 43bps – a decade low.
Municipal bonds posted positive total returns for May, while IG corporates had positive total returns but negative excess returns. U.S. equities endured a bumpy ride for the month but finished with positive month-to-date returns.
Municipal Market Review
Illinois Says I Do to New Spending Plan
In a reversal from last month, municipals posted positive returns across the curve. The Bloomberg Barclays Municipal Index posted a positive 1.15 percent return in May. However, year-to-date, the Bloomberg Barclays Municipal Index is down 0.33 percent.
Municipals were rangebound most of the month but rallied at month-end alongside the sizable Treasury move, outperforming Treasuries across most of the curve. The 5-year and 30-year ranges performed the best, with yields lower by roughly 20bps. The 2-year range dropped more than 10bps, while the 10-year lagged, down 8bps to 2.41 percent. The underperformance in 10-years caused a modest steepening over the month. As of month-end, the 2s10s sits at 66bps, which resulted in a 24bps steepening year-to-date.
Lower quality outpaced higher quality, with Baa bonds returning 1.48 percent, compared with AAA bonds returning 1.06 percent.
Due to municipal outperformance, ratios richened across most of the curve by two to four ratios. The 2-year and 5-year ratios closed at 73 percent and 74 percent, respectively, and the 30-year closed at 96 percent. An exception to the richening across most of the curve was the 10-year range, which finished flat at 85 percent.
Municipal credit conditions remain stable, although pension problems, concerns about state willingness (see 2018 Municipal Bond Credit Outlook), and the treatment of revenue bonds during times of stress are continued themes to consider.
On May 31, Illinois enacted its first on-time budget in four years. However, its structural issues remain challenging and the ratings agencies, which currently rate them Baa3/BBB-, continue to note concerns. For more information on Illinois’ new budget, see The Pluses and Minuses of Illinois' New Budget. In other Illinois news, Fitch downgraded Build Illinois bonds by five notches to A-, following a revision to the rating agency’s criteria for state dedicated tax bonds.
Corporate Market Review
May No Piece of Cake
In May, the Bloomberg Barclays U.S. Corporate Index had total return of 0.54 percent, as strong Treasury performance more than offset spread widening. Excess return was down 0.45 percent for May. The option-adjusted spread (OAS) increased to 115bps versus 108bps at the end of April. That level is the widest OAS since May 2017 and 30bps higher than the year-to-date tights in early February. The Index has widened 22bps year-to-date and has underperformed equities and high yield bonds.
Corporate earnings were strong in 1Q18 due to organic growth and tax cuts. Overall, tax reform has been positive for IG corporate credit, but we are still mostly seeing buybacks, M&A and other shareholder-friendly uses of repatriated cash rather than debt paydown or capex (Figure 1).
IG cash was strained during the month mainly due to events outside the U.S., such as emerging market concerns, higher Treasury rates and issues in Italy mentioned earlier. In addition, hedging costs have increased for foreign investors, which has led to concerns about foreign demand.
Given the risk-off environment, higher quality outperformed. AAA bonds generated -3bps of excess returns and AAs posted -14bps, while BBBs had -55bps of excess returns. However, year-to-date, BBBs have outperformed As, with BBBs posting excess returns of -107bps while As have posted -141bps.
Front-end maturities held up the best, with 3bps of excess returns, compared to long-maturity corporates, which underperformed duration-matched Treasuries by 114bps. The credit curve continued to steepen.
On a sector basis, the worst performers were Communications and Basic Industries. On the flip side, Consumer Cyclicals was one of the best-performing sectors. Technology also outperformed, as supply remains low in the sector.
Monthly IG corporate issuance totaled $125.7 billion, up modestly from $123.9 billion in April but down 23 percent year-over-year from $164.1 billion in May 2017, per Bank of America Merrill Lynch (BAML). Notably, the share of floating-rate supply rose to 23 percent – the highest levels since at least 2013, per BAML.
IG saw more than $8 billion in inflows over the month, per Wells Fargo and EPFR Global. Year-to-date, inflows are just under $50 billion. May fund flows data evidenced the rotation out of intermediate and long-duration strategies to short-duration funds, as investors are concerned about rising Treasury yields.
Securitized Market Review
Consumer Debt Headlines Ushered In
The asset-backed securities (ABS) Index outperformed Treasuries by 3bps in May. The ABS market has had a strong start to 2018.1 About $105 billion of new issuance has priced year-to-date, which is up 10 percent versus 2017.
We continue to find valuations attractive, however, we are closely monitoring some potential normalization of consumer credit fundamentals after a protracted period of strength. The 90+ day credit card delinquency rate rose above 8 percent in 1Q18 for the first time since 2015, the New York Fed’s Household Debt and Credit report showed (Figure 2).
In terms of autos, headlines in subprime have returned. Housing sales and auto sales have both experienced flat to slightly negative growth so far in 2018.
In mortgage-backed securities (MBS), the Index2 produced negative 5bps of excess returns in May, most of which was realized at month-end when geopolitical headlines came to the forefront. Year-to-date returns have fallen to -27 bps. Even so, valuations in the sector are mixed or even leaning expensive, in our view.
Positives to MBS fundamentals include low refinancing risk due to the path of rates over the past few years and the large number of homeowners who have already refinanced (burnout). Extension risk remains in full focus, given rising Treasury yields. While the Fed’s roll-off is gaining pace, Fed hikes and the Fed MBS runoff have been slow, methodical and communicated to the market in a clear manner, which has helped shield against a taper-tantrum-level response.
Strategy and Outlook
Here Comes the Hike
Breckinridge’s Investment Committee is closely monitoring Treasury rates and the path of the Fed. While we expect the Fed to continue its path toward normalization, we note that the Fed’s path may be slowed if Treasuries move higher without significant policy moves, or if the U.S. dollar continues to strengthen. In addition, the Fed’s balance sheet unwind is still a major market topic (particularly related to long-end Treasuries) and this, along with any downturn in economic data, could keep a cap on rates. That said, inflation has been trending higher this year and labor conditions continue to strengthen.
Our Investment Committee continues to expect a parallel shift in the curve, with short-end rates pressured higher by Fed rate hikes, and long-end rates increasing on the Fed’s unwind and rising growth/inflation expectations (see: The Trouble with the Curve: Rate Hike Considerations). Risks to our economic outlook include stagflation in the global economy, a European hard landing and U.S. fiscal policy not leading to a sustained increase in corporate investment and productivity.
On the tax-exempt municipal side, technicals may provide a boost in the summer. Maturity reinvestment from May through August is approaching the high levels seen last summer; however, we are entering this year’s cycle with significantly less supply and lower ratios. In addition, we note that with the passage of tax reform earlier this year, an overhang of tax uncertainty has been eliminated, which could provide continued underlying support to munis. With the credit cycle in its later stages, our high-quality bias in credit and sector allocation remained unchanged in tax-efficient strategies.
For corporate bonds, the Investment Committee is monitoring widening in the sector and potential opportunities for value. Given the Fed’s path of rate hikes, the length of the expansion and high corporate leverage, the Investment Committee views the credit cycle as late stage and maintains a higher-quality bias across our Government Credit and Core strategies.
We remain duration-neutral in our Tax Efficient and Government Credit strategies relative to their benchmarks.
 The ABS Component of the Bloomberg Barclays U.S. Aggregate Index.
 The MBS Component of the Bloomberg Barclays U.S. Aggregate Index.
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