In our latest commentary, get our take on year-end volatility and what's ahead for investment grade markets.
Hello this is Natalie Baker, vice president of marketing here at Breckinridge, and welcome to the Breckinridge podcast. Today we will be reviewing some of the major market events for the month of May. I am joined by two members of our portfolio management team, Sara Chanda and Jeff Glenn. So Sara, let's start with the general market and municipals. May certainly has no shortage of newsworthy topics to cover including more expectations of increased growth geopolitical headwinds and tough trade talk, just to name a few. Do you have some color?
Sure Natalie, so volatility returned to the markets during the month of May as the release of the Fed statement, announcements of increased Treasury supply, and geopolitics and trade all impacted the markets. Even though Q1 2018 GDP came in at 2.1%, growth is expected to pick up in the coming quarters and the increased supply of Treasuries due to the higher deficits pushed Treasury yields to their highs for the year earlier in the month. Yields fell sharply toward the end of the month on the political gridlock in Italy, uncertainty surrounding the summit with North Korea, and the increasing rhetoric around tariffs and potential trade war. On the equity side, U.S. equities endured a bumpy ride for the month but finished with positive month-to-date returns as the Dow and S&P closed at just over 1% and just over 2% respectively, and year-to-date the Dow is in the red just over 1%, while the S&P posted a positive 1.2%.
And what about Treasuries, how did they fare over the month?
So I would say over the month Treasuries had been range-bound but a stronger retail sales number and hawkish comments from San Francisco Fed President Williams midmonth caused yields to grind higher. I would say about more than 10 bps five years and longer. The 10-year Treasury broke through the taper tantrum highs, jumping to a 3.11. That was the highest level we have seen in seven years. However, they did quickly reverse course with Italy's political turmoil, which sent Italy's two-year bond to surge from a low of -33 bps, that was earlier in May, to an intraday high of 2.82 which marks a high since September 2012. So I would say for the month, yields were lower by roughly 10 bps across the curve. The 10-year Treasury closed out at a 2.83, that's after trading and roughly a 30 bps range and if you look at the spread between the two- and 10-year maturities, that did continue to flatten, closing at 43 bps which is a decade low.
Any updates from the Fed, related to either their May meeting or minutes? I know the FOMC continues to be a hot topic.
Yes, that's right. So during the May meeting, members voted unanimously to leave rates unchanged when they currently sit between 1.5 and 1.75, that is for Fed funds and that is after having raised rates in March. Minutes from the meeting show that officials do see the economy as strong, but they do remain worried about global trade tensions resulting from American and Chinese tariffs. Despite an uptick in inflation, the Fed continued to post more dovish remarks as some officials remarked they would be comfortable with a modest overshoot of the Fed's 2% inflation target.
And speaking of inflation, how did the economic data look?
So inflation data released earlier in the month showed that wages and prices are running at 2% per the personal consumption expenditure, that is the PCE index, which represents the target figure of the Fed. If you strip out food and energy, which can be volatile, the figure stood at 1.9%. So while the Fed does have a keen eye on inflation data, officials are also concerned with job growth and unemployment. As the market for jobs tightens, this could put upward pressure on wages. While this hasn't materialized yet and non-farm payrolls came in lower than expected at 164,000, the unemployment rate did hit an 18 year low of 3.9%.
And now, while the market is anticipating a June hike, it sounds like there is some differing views about the number of additional hikes as we head into the second half of the year.
Yes, as you mentioned, the market is expecting a June hike. That's really evident in Fed fund futures which is really at 100% probability at this point. However, some participants have been calling for two or more hikes in 2018 for a total of four, while others like us, think three for the year is more likely.
So what is the rationale behind our view?
So in our most recent Investment Committee meeting we noted that the Fed's path may be slowed if Treasuries move higher without significant policy changes or if the dollar continues to strengthen resulting in tighter financial conditions and as a note, some pundits have pulled back on that fourth hike considering the market volatility we have seen.
All right so let us switch gears and talk about municipals. With large swings in Treasuries, did munis keep pace?
So munis, like Treasuries, were range-bound for most of the month but rallied with the sizable Treasury move at month-end, outperforming across most of the curve. If you look at the five-year and 30-year range they perform the best with yields lower by about 20 bps. The two-year range dropped more than 10 bps to close at 1.75 while the ten-year lagged, only down 8 bps and that closer to 2.41, that is close to the year-to-date average.
Okay, we talked a lot about flattening. The 2s10s Treasury curve has flattened dramatically over the year. Have we seen the same occur in munis?
So interestingly, no. The reverse actually occurred as the 2s10s, AAA curve started the year at 42 bps which is the flattest we had seen for the year. It has steepened to 96 bps only to steadily decline through mid-May, only to steepen slightly with the underperformance in the 10-year.
And with municipal outperformance, I assume ratios tightened.
That's right. So ratios richened across most of the curve by about 2 to 4 ratios, the two-year and five-year closed at 73% and 74% respectively. The 30-year was at 96% and the exception to that was really the 10-year range which finished flat at 85%. The passage of tax reform and a cap on the SALT deduction may boost muni demand and lower the probability of ratios moving higher in the near-term.
Well supply has been running at a deficit this year. Was May able to reverse that trend?
New issue supply did rise for the third consecutive month with May totaling just about $31 billion. That is marginally higher than last month but down 20% from May of last year. Year-to-date supply does stand at $126 billion which is a 22% decline from the same period last year. So while the primary market has proved challenging as issuance remains light, there is less pressure from the secondary market as both dealer inventory and bids-wanted flow have declined.
Well, any noteworthy deals to mention?
Yes, there were actually. So during the month there were several issuers that came to market with sizable deals including the state of Pennsylvania. They sold just over $1 billion in the competitive market. Bank of America Merrill was the winning bid on that. The five- and 10-year range they priced at +45 and +60 to AAA's and they put all the bonds away that day. The state while facing some headwinds, it does continue to carry strong underlying fundamentals with ample taxing capacity to resolve both their short-term budget constraints and longer-term pension liabilities and that really is evident in the spread, which has really held steady for an extended period of time, unlike some other states we have seen which have faced more pressures and seen spread widening.
All right so switching gears again and talking about supply, we are entering a period of net negative supply and with issuance already constrained, do we expect this to offer support to munis over the next several months?
I would say yes, we do anticipate entering this period of net-negative supply and that is actually a total of about -$29 billion on average, that is from June to August since 2012. That is actually per Barclays, along with heavy maturity schedules that are expected to come through the summer, that should bode well for munis. That said, per MMA, they do point out that June has rarely been a positive month of price-performance but the removal of advance refunding deals has further constrained supply so that should help bolster munis.
I got you, and what about on the demand-side? Fund flows were more negative in April but with the market stabilizing in May, did flows reverse course?
So except for the first week of the month, mutual funds did post positive flows for four consecutive weeks pushing the four-week moving average to positive $171 million. The year-to-date total now stands at $4.8 billion.
Okay, and did the rally at month-end help propel munis into positive return territory?
Yes, in fact munis had the best month in a year posting positive returns across the curve. If you look at the Bloomberg Barclays Municipal Index posted a positive 1.1% return outpacing Treasuries. In the intermediate range if you look at the Bloomberg Barclays 1-10 Blend and the short intermediate managed money indices, those closed at 84 bps and 94 bps respectively. Across sectors, hospitals, housing and education were the best performing revenue sectors, while lower quality outpaced higher-quality, an all-too-familiar theme. The BBB's returned 1.48% versus AAAs at 1.06%.
So a couple of Illinois credits made headlines over the month if you could provide some insight there?
So, yes let's start with the state, since 2015 when Gov. Rauner took office, the state has failed to produce an on-time budget. Recall that the state was teetering on the edge of a junk rating last year when it finally passed a budget after a nearly two-year stalemate. Both the House and Senate passed a $38.5 billion proposal and the governor as of May does plan to approve it. While positive for the state, the budget does not address some of the well-known headwinds plaguing the state including the backlog of unpaid bills. That was reduced after a bond sale late last year and that now sits roughly at $7 billion, and its massive pension liability. Spreads tighten dramatically on the budget news. So if you look at the five-year beginning the month of May, it started at 190 bps over the AAA scale, tightened down to 165 bps. Looking at the 10-year, a year ago in June 2017 pre-budget it was over 300 bps over AAA's, tightening down to 165 bps post budget news. The other credit we were going to talk about is the Build Illinois bonds. They were hit with a five-notch downgrade by Fitch to A- after a ratings methodology change by the agency. That's for dedicated tax bonds and it illustrates that agencies are now looking to better align the ratings between states and issuers that have a bond security that include a statutory pledge tied back to that state.
Okay, so a lot of news about Illinois. And more broadly, I know President Trump signed the bill that now classifies investment grade municipals as high-quality liquid assets under bank liquidity rules.
Yes, so the President signed the Economic Growth Regulatory Relief and Consumer Protection Act two days after it passed in the house and why is this important for the muni market? Well, we want to ensure that we see continued sponsorship across a buyer base that has come to support the market over time. So as it stands, banks and insurance companies no longer have the same incentives with the passage of the 2018 tax reform, and this act will not prevent these entities from reducing their holdings, however it may help offset some of that selling.
All right. Thanks Sara.
So now let us move over to the corporate side. Let us start out with performance for the investment grade corporates in May. How did corporates hold up given all the headlines that Sarah mentioned?
May ended up being a pretty tough month for corporate bonds as spreads widened 7 bps and underperformed duration-matched Treasuries by 45 bps, a combination of political turmoil in Italy, concerns around slower growth in Europe, global trade wars and geopolitical tensions with North Korea all contributed to the negative sentiment in the corporate market. The option-adjusted spread of the Barclays Corporate Index now sits at 115 bps which is the widest level since May of 2017 and 30 bps off the year-to-date tights in early February.
Okay, so with all this widening what were the returns across the credit quality and maturity spectrums?
Given the risk off environment, higher quality outperformed as you'd expect although the rating categories all had negative excess returns. AA's fared the best generating -11 bps of excess returns while BBB's had -64 bps points of excess returns. In terms of the credit curve front-end maturities held up the best relatively flat excess returns compared to the long maturity corporates which underperformed duration-matched Treasuries by 114 bps and also of note, which I know we have highlighted in the past, the credit curve continued to steepen with one- to three-year corporate spreads widening two bps compared to 30-year bonds which ended closer to 10 bps wider.
All right, and did certain sectors perform better than others, and what were the key drivers?
The worst performing sectors were communications and basic industry. Within communications, cable and media credits were the main culprits due to elevated event risk surrounding possible bidding war between Disney and Comcast for Fox and the UK-based Sky. Headlines surrounding a possible tie-up with CBS and Viacom also weighed on the sector. Cable media spreads ended anywhere from 15 to 20 bps wider, and that led the sector to have negative excess returns at around 200 bps for the month. The metals and mining sector was impacted by trade war concerns and the announcement of steel tariffs on both steel and aluminum. This sector has a heavy weighting to emerging markets which was also under pressure during the month. Turning to the out-performers, consumer cyclicals held up well and were helped by solid performance from both autos and homebuilders. Technology was the other sector that outperformed and that was due mostly to lower supply in the sector.
Let us turn to new issuance and fund flows. What was corporate supply for the month?
The new issue calendar started the month off strong with deals from Keurig Dr. Pepper, General Dynamics, GlaxoSmithKline as well as a few Yankee banks like HSBC, Barclays and Westpac, but supply slowed down midmonth as sentiment in the corporate market turned pretty negative for all the headlines that we mentioned earlier. For the month, new issue supply approached $120 billion. That is down 25% versus May 2017 volumes. Currently we sit year-to-date with new issuance down around 7% while M&A-related supply remains pretty healthy, issuance from sectors that were most impacted by U.S. tax reform are down meaningfully. JP Morgan recently noted that issuance from the technology sector was down 78% year-over-year as corporations repatriate cash and therefore don't need to tap the debt markets.
And what about fund flows?
Fund flows continue to be strong with $8 billion in inflows over the month per Wells Fargo. Year-to-date inflows are also healthy at just under $50 billion but there has definitely been a noticeable rotation out of intermediate and long-duration strategies to short duration funds in response to higher Treasury yields.
Got it. And how did other IG fixed income sectors perform over the month?
So tax municipal spreads continued to outperform corporates with spreads generally unchanged for the month. Low supply, so new issuance is done around 25% this year, and strong demand help the sector. In the securitized space, agency mortgage-backed securities modestly underperform Treasuries as volatility picked up on the last week of the month. Net mortgage supply is still running lower year-over-year but is expected to increase as the Fed reinvestment caps jump to $12 billion and then to $16 billion in Q3. Lastly consumer ABS held up very well over the month given its short duration and defensive characteristics. Year-to-date ABS supply is just over $100 billion which is up around 10% versus the same period last year. And nominal ABS spreads have remained in a pretty tight range this year and we still believe they look attractive versus front-end corporates.
Well thanks, Jeff. We hope you and the field found this informative and we look forward to you joining us on our next podcast. Thank you.
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