March saw continued market volatility, the expected bump higher in policy rates and stable muni credit conditions.
STRATEGY AND OUTLOOK
- U.S. Treasury Curve: We believe that strong employment trends alongside moderate inflation should keep the Fed on track to continue raising rates, but at a measured pace.
- Tax-Exempt Municipal/Treasury Ratios: Ratios remained rangebound and ended the month modestly higher.
- Municipal Market Technicals: Mutual funds have seen continued outflows, which has led to elevated levels of bid-wanted activity and dealer inventories that have pressured the municipal market.
- Corporate Credit Quality: The investment team is closely monitoring late-cycle risks and additional headwinds to corporates, such as increasing labor costs and high leverage.
- Corporate Supply and Demand: Supply fell in the month versus a very strong October 2017, and year-to-date volumes are down partly due to the repatriation of corporate cash.
- Securitized Trends: MBS spreads last month broke out of the range and are currently at the cheapest level of the year.
September Minutes Put Markets on Notice
In October, equity volatility was front and center (Figure 2), with the S&P 500 Index closing down roughly 7 percent and the NASDAQ Index down by 9 percent – its worst month since November 2008. The equity rout was driven by various trends, including hawkish Fed minutes, tariff-trade tensions, high equity valuations, geopolitical risks and weaker housing data. While 3Q18 corporate earnings were strong, uncertain outlooks from management teams were viewed negatively.
Through most of the month, the bond market did not benefit from the flight-to-quality bid typically seen in periods of equity market dislocation. U.S. Treasury bonds were volatile, trading in roughly 20 basis points (bps) ranges for maturities 7 years and longer. Early in the month, rates rose significantly, and the 10-year reached 3.23 percent – the highest level since 2011. Across the fixed income spectrum, factors such as the Fed’s continued path of tightening, an ever-increasing federal deficit, and increased Treasury supply pushed yields higher for the majority of October.
Treasury yields reversed course later in the month, in part due to risk-off sentiment related to U.S. / Saudi relations. The 10-year closed at 3.15 percent. Following mixed performance over the month, corporate, municipal and securitized product assets also saw negative returns for October. Investment grade (IG) corporate bond option-adjusted spreads (OAS) widened1 and muni yields closed out at or near the year-to-date highs.
In Treasuries, the flattening trend moderated. The 2s10s curve steepened slightly over the month, closing at about 30bps. However, the curve has flattened 25bps year-to-date.
The U.S. economy remains strong, with the September nonmanufacturing ISM posting its highest reading since its inception in 2008. In addition, confidence surveys have soared to cycle highs.2 Third quarter 2018 GDP growth eased but remained strong at 3.5 percent versus 4.2 percent in 2Q18. Inflation readings for the 12 months ending in September showed core CPI at 2.2 percent – above the Fed’s targeted 2 percent. Housing affordability remains challenged, as evidenced by September housing starts falling 5.3 percent month-over-month and building permits dropping 0.6 percent.
Comments from the FOMC, largely seen as hawkish, were a large driver of performance across markets in October. The Fed released minutes for its September meeting, and implied that the group could be comfortable temporarily raising policy rates above the long-term neutral Fed Funds rate. The FOMC expects one additional hike in 2018 and three hikes in 2019. By contrast, the market expects one hike in December and only two in 2019.
Municipal Market Review
Technical Trends Continue Playing Major Role
Municipal yields followed the lead of Treasury yields and trended higher over the month. Munis underperformed Treasuries,3 and returns were negative across the curve except for the 1-year maturity. The long end fared the worst given the softening demand from banks. While lower quality has consistently outperformed higher quality, this dynamic reversed over the month as AAAs outperformed all rating categories (down 0.56 percent), while BBBs fared the worst (down 0.81 percent).4
Muni yields rose about 10bps for maturities 5 years and shorter, finishing at 2.1 percent in the 2-year and 2.3 percent in the 5-year maturity. Yields increased 15bps in the 10-year maturity to close at 2.73 percent, and 19bps in the 30-year maturity to end the month at 3.38 percent. After flattening in 3Q18, the municipal curve bear steepened.
Ratios remained rangebound and moved modestly higher in the 2-, 5- and 10-year maturities. The 30-year ratio was unchanged at 100 percent. While the 2-year is nearly 11 percent lower year-to-date, it has cheapened more than 10 percent from the lows achieved in mid-July.
On the heels of a lighter issuance month in September, October supply surged more than 30 percent month-over-month to $33.5 billion, partly due to seasonality. The month included the highest supply week of the year, per JP Morgan. However, year-to-date gross supply has fallen 14 percent.5
Secondary market activity climbed in October, as illustrated by a sharp spike in bids-wanted. The month’s daily average bids-wanted surged to more than $1 billion, only the fourth month this has occurred since 2013.6 However, elevated secondary market supply has had a limited impact on the market. The more-pressing matter for the month was flows, which continued their negative trajectory. The month closed with a sixth consecutive week of outflows that totaled $1.3 billion, the largest outflow since December 2016.7
On the credit side, elections are in focus, particularly the potential for the new Congress to boost chances of an infrastructure bill. In addition, the outcome of state and federal elections may affect the multiyear credit “glidepath” for some states and sectors. Credit conditions remain healthy despite some modest slowing in the real estate market nationally.
Pension contributions remain a concern as well, particularly given the equity volatility seen this month. A new study from the Center for Retirement Research at Boston College estimates funding ratios if there is a market correction in 2019, followed by strong returns (Figure 3).8
Corporate Market Review
Ratings Downgrades Cause Concern
For October, the Bloomberg Barclays U.S. Corporate IG Index widened 12bps and posted negative excess returns of 82bps. In September, longer bonds fared better as the curve flattened. This flipped in October, when longer bonds were the worst performers. Lower-quality bonds underperformed during the month (Figure 4).
IG corporates gave up all the gains made in September, as the sector was challenged by risk-off sentiment and various fundamental and technical trends. In terms of credit fundamentals, higher raw materials costs that could squeeze margins are in focus, particularly for cyclical sectors like Autos, Capital Goods and Diversified Manufacturing. The shift from quantitative easing to quantitative tightening in the U.S. and potential tariff-trade war impacts are also a concern, particularly given the high debt leverage shouldered by the IG corporate sector. Higher wage inflation is also a potential headwind to profitability.
A notable theme in the month was ratings downgrades in larger A-rated credits. Those downgrades drove spread volatility throughout the asset class and heightened investor concerns about ratings risk. High leverage among some BBB-rated corporates, and the potential for an uptick in fallen angels, also received more attention in October. We appreciate the increase in investors’ concern about credit fundamentals (see our Q3 2018 Corporate Bond Market Outlook) but we’d note that about 85 percent of companies in the Bank of America Merrill Lynch (BAML) Investment Grade Corporate Index have a stable outlook (while 7 percent are positive and 8 percent are negative), reducing the potential for downgrades en masse.
On the technical side, hedging costs have increased, partly due to rising Libor, and the Tax Cuts and Jobs Act has also reduced some companies’ demand for IG corporates due to an increase in cash repatriated from overseas. Barclays estimates that foreign holdings of IG corporates have declined. Corporate treasury and insurance company holdings have also fallen. That said, retail and household ownership has ticked higher, per Barclays data.9
IG bond funds reported outflows of more than $7 billion in October.10 Year-to-date, IG funds have seen net inflows of $96 billion.
IG supply was muted by 3Q18 earnings blackouts and a year-end seasonal supply slowdown. Supply was boosted by large M&A deals again this month that led to $38 billion in M&A-related supply for October. However, monthly supply still fell 25 percent year-over-year to $96 billion, per BAML. New issue performance declined, with the average new issue concession widening to 6bps from 5.4bps in September, per BAML.
Securitized Market Review
ABS Supply Rises
On the MBS side, excess returns were down 37bps in October, taking year-to-date returns to -43bps.11 Given October’s weak performance, levels have become more attractive. Net supply for 2018 is on track to reach $270 billion, per BAML.
We think the overall level of risk is relatively low but possibly increasing, particularly given that the Fed reinvestment caps have risen to $20 billion and the Fed’s net takeout12 is zero. Approximately 95 percent of the coupons in the outstanding conventional MBS are not refinanceable, assuming a 50bps refinancing hurdle rate. In our view, this means that extension risk is fairly muted, and we think a much larger decline in rates would be required before we see a significant refinancing event throughout the market. Increasingly, the market is watching for mortgages that have higher note rates, loan sizes and FICO scores being pooled into securities; these mortgages have the potential to introduce incremental negative convexity.
In ABS, nominal spreads moderately widened last month in sympathy with other risk assets.13 However, the extent of the widening was relatively contained, per Bloomberg Barclays indices. Supply was $26.5 billion in October – the highest monthly volume of 2018, per BAML. Year-to-date supply has reached $215 billion, up 3 percent from the same period in 2017.
Broadly, ABS credit trends continue to normalize. Credit card fundamentals are coming down from impressively high levels as the consumer balance sheet normalizes and issuers seek to diversify their business mix away from the low-risk convenience users.
Auto headlines in subprime have resurfaced, and lease and retail segments have been challenged due to a glut of supply from cars coming off fleet. Falling used car values also weighed on the sector. However, prime auto remains fundamentally strong.
 Based on the Bloomberg Barclays Corporate Index.
 Based on the Conference Board Consumer Confidence Index and the Conference Board Consumer Expectations Index, as of October 30, 2018.
 Based on the Bloomberg Barclays Municipal Bond Index and the Bloomberg Barclays U.S. Treasury Index, as of October 31, 2018.
 The Bloomberg Barclays Municipal Bond Index, as of October 31, 2018.
 Supply data taken from the Bond Buyer.
 MMA, October 2018 Advisor.
 JP Morgan data. Outflow number and related data taken from weekly reporting funds, Lipper, for the period ending October 31, 2018.
 Center for Retirement Research at Boston College, as of October 2018. Market correction as defined by the piece author (using the Wilshire 5000), and projections for 2019-2022 are provided by the author. 2014-2017 funding ratios are actual; 2018 funding ratios are estimated based on actual returns of the Wilshire 5000. Funding ratios are referring to the 180 plans in the Public Plans Database (PPD).
 Barclays, “Tax Cuts and Treasury Yields Affect Investment Grade Demand,” as of October 26, 2018.
 EPFR Global, per Wells Fargo, October 31, 2018.
 Proxy for returns is the Bloomberg Barclays U.S. Mortgage Backed Securities Index.
 Net takeout is the ratio of the Fed’s monthly purchases to 1-month forward issuance.
 Proxy for spreads is the ABS component of the Bloomberg Barclays U.S. Aggregate Index.
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