In July, U.S. investment-grade global investors are converged on the asset class in droves.
STRATEGY AND OUTLOOK
- U.S. Treasury Curve: We are closely watching supply and demand trends in U.S. Treasuries, as the rising U.S. deficit will prompt greater supply, while the Fed’s unwind of its balance sheet is curbing demand from a major buyer.
- Tax-Exempt Municipal/Treasury Ratios: In 2019, a potential increase in infrastructure spending, coupled with softer demand from banks and insurance companies, could put upward pressure on longer-maturity municipal ratios.
- Municipal Market Technicals: Mutual funds saw outflows and elevated bids wanted again in November, but moderate supply helped offset this.
- Corporate Credit Quality: The market continues to focus on BBB-rated credits, margin pressure and high debt leverage, but some companies are showing a renewed focus on deleveraging.
- Corporate Supply and Demand: Supply fell modestly in November, and 2019 issuance could trend lower due to a shift in management priorities away from M&A and an uptick in interest rates.
- Securitized Trends: Mortgage-backed securities (MBS) spreads last month rose to the cheapest level of the year, and the pace of the Fed’s balance sheet unwind is in focus.
Flight to Quality
In November, risk assets were negatively impacted by a wide range of factors. Heightened fears of a U.S. economic slowdown, conflicting reports about the state of tariff negotiations, ongoing wildfires in California, declining oil prices, and rising concerns about Brexit and Italy’s fiscal situation caused volatility in markets. Investment grade (IG) and high yield corporates had negative returns, and the S&P 500 saw declines for most of the month. On the other hand, U.S. Treasury bonds and municipal bonds benefited from a flight to quality.
After a volatile October, Treasury yields trended lower in November, and the 10-year Treasury yield fell below 3 percent for the first time since mid-September. This comes after the 10-year soared to a seven-year high in October.
Treasury yields fell across the curve, with the biggest decrease in the 5- to 10-year range, causing the 2s10s curve (the spread between the 2-year and 10-year bond) to flatten to 20 basis points (bps). However, the 10s30s curve steepened to 30bps.
Late in the month, at a speech at the Economic Club of New York, Fed Chair Jerome Powell stated that interest rates “remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.” This was interpreted as dovish by the markets. The S&P 500 saw its second-best single-day rally of the year to close out the month up 1.8 percent overall. Treasury and municipal yields fell further toward the close of the month. That said, the Fed remains data dependent.
Following Powell’s comments, the market is now pricing in one hike next year compared to the Fed’s projected three hikes. While solid 3Q18 GDP growth of 3.5 percent and ongoing strong labor data suggest that the Fed will stay on course to normalize rates, inflation has softened from the middle of the year. Core CPI inflation rose 2.1 percent year-over-year in October, and core PCE rose 1.8 percent.
Housing data has also spawned concern. Existing home sales fell 5.1 percent year-over-year,1 while housing starts declined 2.9 percent in October.2 Also, the higher cost of dollar hedging for overseas buyers is negatively affecting U.S. credit. IG municipals saw a decline in fund flows for the month, while IG corporate flows were only modestly positive.3
Municipal Market Review
Modest Supply, Outflows Continued
Municipal yields hit year-to-date highs early in the month, mainly due to rising rate concerns. However, following the midterm elections, municipal yields followed Treasuries lower and closed out at month-to-date lows. The municipal curve modestly flattened, with 2s10s at 59bps and 2s30s at 130bps.
Ratios were stable for most of November until municipals outperformed Treasuries late in the month. Overall, ratios fell across the curve. The two-year ratio closed the month at 68 percent, the five-year at 75 percent, the 10-year at 83 percent and the 30-year at 97 percent. Levels ended near their three-month averages on all points on the curve except the 30-year.
The Bloomberg Barclays Municipal Bond Index rebounded from October and posted a solid total return of 1.1 percent for the month. The strength in performance was driven largely by longer-maturity funds, as yields fell most in the 10- to 20-year range and the curve flattened.
Returns were fairly consistent across the rating spectrum, with AAs and BBBs performing in-line with the Bloomberg Barclays Municipal Bond Index. However, in a trend reversal, higher quality outpaced lower quality, with AAAs outperforming all other ratings categories.
Modest supply helped boost returns. November supply dropped to $23.8 billion, down 48 percent from November 2017 when issuers were scrambling to push advanced refunding and private activity bond deals into the market ahead of tax reform, per the Bond Buyer. Year-to-date, supply has reached $312 billion, an 18 percent decline from last year, per Bond Buyer data.
On the demand side, however, outflows continued. For the 10th consecutive week,4 funds flowed out of municipal bond mutual funds, and this cut year-to-date aggregate flows to below $2 billion versus the $11 billion peak achieved in September. The last time that Lipper reported outflows for 10 straight weeks was a 2.5-month period beginning in May 2015, per MMA. Bids wanted remained elevated, with daily volume exceeding $1 billion for the month, JP Morgan data shows. Overall, trading volume has come down from 1H18 when yields were higher (Figure 2).
On the credit front, fundamentals remain stable. Following the midterm elections, we expect renewed discussion of a federal infrastructure bill. We are also monitoring the trajectory of oil and real estate prices, which are likely to impact credit fundamentals for some states and local governments to varying degrees. For example, an increase in infrastructure spending could lead to a potential uptick in supply. For more details on the various parts of the muni market impacted by the election, see Quick Post-Election Thoughts on Munis.
Corporate Market Review
Spreads Widen, Credit Fundamentals in Focus
Given the risk-off sentiment prevalent in November, the Bloomberg Barclays U.S. Corporate Bond Index widened 20bps to 137bps, underperforming duration-matched Treasuries by 120bps. This marked the largest monthly excess return losses since January 2016.
The best-performing sectors were Supranationals and Government-Guaranteed, which benefited from the flight to quality over the month. Consumer Products was aided by solid earnings reports in some credits and by performance from Newell Rubbermaid, given planned debt reduction at the company.
The worst-performing sectors included Energy names, due mainly to the oil-price drop. Oil Field Services and Independent Energy had excess returns of -299bps and -293bps, respectively. Finance Companies, Tobacco, and Refining also fared poorly. Within the Banking sector, headline risk at Goldman Sachs was one of the biggest idiosyncratic events impacting the Index.
Aa+ credits fared the best across the IG quality spectrum, while BBBs notably underperformed the Bloomberg Barclays U.S. Corporate Index. In November, longer corporate bonds were again the worst performers, while shorter bonds did best.
For the month, new issuance totaled $96.6 billion, only slightly higher than $96.2 billion in October and well below $120 billion issued in November 2017.5 Year-to-date, supply is $1.2 trillion, down about 11 percent from the same period in 2017. Still, there was a palpable weakness in technicals, with marginal new inflows of $0.7 billion for November. Year-to-date, fund flows have reached $82 billion.
IG markets continued to worry about BBB credit quality and ratings risk following the downgrade of General Electric Co. in October. Gross IG leverage of 2.4 times is near record highs and could rise even higher in a recession. However, rays of deleveraging are coming through the IG space. In calls with analysts during the last month, twice as many Russell 3000 companies mentioned “deleveraging” as did in 2014, per Bloomberg. Companies such as AB InBev have cut dividends, while other companies have flatlined dividends or halted share repurchases to pay down M&A-related debt.
In addition to concerns about trade/tariff negotiations and hedging costs for foreign investors, infrastructure and manufacturing cost increases are also being closely watched. Given the strain on margins, companies could perform more price hikes and/or announce job layoffs in 4Q18.
For more thoughts on BBB credits and IG debt, see our perspective, Risks and Opportunities in Today’s Corporate Bond Market.
Securitized Market Review
New Questions on Pace of Fed Unwind
In agency mortgage-backed securities (MBS), spreads were volatile and closed the month at the widest level of the year. While fundamental risks in agency MBS remain relatively low, the market continues to focus on the Fed’s balance sheet runoff, which is expected to peak at a range of $175 billion to $200 billion in 2019,6 adding supply to the agency MBS market. With the Fed no longer removing much of the worst-to-deliver collateral, the market is watching increasing weighted average coupons, rising loan sizes and increasing FICO scores, all of which have the potential to introduce faster prepayments and greater negative convexity on the margin (Figure 3).
The pace of the runoff has come back into focus in markets because U.S. Treasury Secretary Steven Mnuchin has sought opinions on accelerating the runoff in lieu of rate hikes.7 Also, there has been a recalibration in the market’s expectations for rate hikes next year. A faster end to the runoff could also hinder MBS performance, because the Fed could restart growth in its balance sheet through purchases of Treasuries rather than MBS.
We also note that we expect minimal impact on MBS spreads as a result of universal mortgage-backed securities (UMBS) in 2019. The IRS ruled that exchanges of Freddie Mac securities for a new UMBS security will not be a taxable event. However, it is unclear how the Bloomberg Barclays indices will evolve to account for the exchanged securities or whether the Fed will exchange the Freddie Mac securities on its balance sheet.
In addition, the housing market slowdown has accelerated, largely a result of years of strong home price appreciation and the resulting decline in affordability. Rising rates have started to take their toll on the housing market. Mortgage indicators now show a purchase-dominated market, with fewer sellers prepared to leave their existing homes.
On the asset-backed securities (ABS) side, we are seeing broad normalization in fundamentals. ABS spreads saw marginal spread widening over the month in sympathy with other risk assets and is now trading at year-to-date wides. Year-to-date, $233 billion has priced, which is up 3 percent versus the same period last year.
Credit card trust fundamentals have deteriorated on the margin, as the consumer balance sheet normalizes and issuers seek to diversify their business mix away from the low-risk convenience users and into revolving balances customers.
 National Association of Realtors, as of November 21, 2018.
 U.S. Census Bureau and the U.S. Department of Housing and Urban Development, as of November 20, 2018.
 For IG municipal flows, source: Lipper, per JP Morgan data as of November 28, 2018. For IG corporate flows, source: EPFR Global, per Wells Fargo.
 Lipper, for the week ending November 28, 2018, per MMA.
 Bank of America Merrill Lynch, as of December 3, 2018.
 JP Morgan and Breckinridge, as of December 7, 2018.
 Rich Miller, Saleha Mohsin and Liz McCormick, “Mnuchin Asked About Fed Option That Could Avoid Rate Hikes,” Bloomberg, November 28, 2018.
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