Commentary November 10, 2017

October Market Commentary


What’s the Market Thinking?

On October 9, economist Richard H. Thaler was awarded a Nobel Prize for his contributions to behavioral economics. Thaler’s findings represent a central challenge to the assumption that people behave rationally when making economic decisions.

Of course, investor behavior couldn’t be more key at the moment. Investors enter November with a broad swath of significant information to process, and the reaction functions of investors and issuers will be key to investment grade performance (IG) in the near term.

First, on November 2, the House released its proposed tax reform bill. The reforms are expected to curb municipal and corporate supply, as well as create fiscal stimulus in the overall economy. The multipronged plan has both positive and negative implications for corporate and municipal bonds.

In addition, the market is digesting the release of new economic data. While October unemployment remained low at 4.1 percent—the lowest level since the financial crisis—poor wage growth is contributing to stubbornly low inflation. September core PCE came in at 1.3 percent growth year-over-year, and core CPI at 1.7 percent. Average hourly earnings fell 1 cent month-over-month for October.1 Durable goods data for September and productivity data for 3Q17 were solid.2

Second, the Fed kept rates steady in October, but, going forward, faces solid economic data with 3 percent GDP growth for 3Q17 juxtaposed with low global inflation and still-accommodative policies globally.3 Market expectations for a December rate hike are now at 92 percent, versus 70 percent at the end of September. For 2018, the market expects only one rate hike, while the Fed forecasts imply three.

Finally, the next Federal Reserve (Fed) chair was nominated: current Fed board of governors member Jerome Powell, who will be joined by a slew of new Fed governors. The market expects continuity from Powell after current chair Janet Yellen exits, but he is also expected to champion deregulation, such as less stringent rules in the Dodd-Frank Act for community banks.

For the month of October, Treasuries were rangebound at the start but rose towards month-end, primarily due to a higher perceived chance of a December rate hike, and concerns about tax reform and the new Fed chair. The 10-year Treasury bond reached 2.46 percent in late October, the highest close for the 10-year since March. The 10-year closed the month at about 2.4 percent, up just 5bps and close to where it began the year. Overall, the Treasury curve bear flattened.

Risk assets generally had a strong month. Equities performed best. IG corporates were the best IG performers in the month, benefiting from higher all-in yields, a solid U.S. economic backdrop and strong 3Q17 earnings. Municipals outperformed Treasuries for most of October, but toward the end of the month, municipals lagged on heavy supply. For the month, the Bloomberg Barclays Municipal 1-10 Year Blend Index had a modestly positive return for the month, while the 10-year Treasury posted a loss.4 


Ups and Downs

For October, muni yields were rangebound the first half of the month but rose later in October due to heavier supply and the Senate’s narrow passage of the new budget, which paved the way for tax reform. Overall for October, the curve flattened. Muni yields rose at the short end but moves in longer maturities were more muted (Figure 1). Maturities at 10 years, and beyond 15 years, were essentially flat.

In terms of relative value, muni yields significantly outperformed Treasuries until late in the month, when munis underperformed due to increased supply and some outflows. Ratios ended the month at 68 percent in the 3-year; at 70 percent in the 5-year; at 85 percent in the 10-year; and at 99 percent in the 30-year.

Digging deeper into the supply/demand trends, municipal supply was $36 billion in October, down 33.5 percent from October 2016. Refunding volume fell 71 percent, while new money volume rose 22.5 percent. October marked the first time the market digested two back-to-back weeks of $10 billion in issuance; however, Illinois represented 30 percent of it, with $6 billion of general obligation (GO) bonds issued. The bonds were issued to partially alleviate Illinois’ roughly $15 billion in unpaid vendor bills. Despite the state’s rising pension debt, weak long-term credit fundamentals and cuspy ratings (Baa3/BBB-/BBB), the bonds saw strong demand—although the $4.5 billion negotiated portion saw rates repriced higher—and broke into secondary markets weaker.5 Looking forward on supply, we note that the strong period of seasonal reinvestment has passed, and less money will be coming back into the market from maturities and coupon payments over the next few months.

On the demand side, the first week of October was met with outflows, snapping an 11-week streak of inflows. Later in the month, weekly funds saw a sharp reversal, with strong inflows pushing the year-to-date aggregate to $15 billion.

The credit environment remains stable, and we continue to view credit fundamentals to be “as good as they get.” Credit concerns continue to be focused on states with late budget proposals, such as Pennsylvania, Connecticut and New Jersey. Rating agency trends remain at a ratio of about 1.0 times for upgrades versus downgrades.

Tax Reform: Muni Impact

Municipal markets are now contending with the new House tax reform plan. For our take, please refer to our podcast, The House Tax Reform Plan: Potential Impacts to the Muni Market, in which we detail how the new plan could impact muni fundamentals and technicals. Senior members of our investment team discuss:

  • Elimination of the tax exemption for private activity bonds and advance refundings;
  • Elimination of the bulk of the state and local tax deduction; and
  • Retention of the top individual income tax rate of 39.6 percent.

In general, the supply side of the tax-exempt market could shrink, given tax reform in its current form. However, we note that the final version of tax reform could include many changes to the existing House proposal.


Foreign Investors Still Decide to Invest in Corporates

In October, IG corporates had another solid showing. The option-adjusted spread of the Bloomberg Barclays Credit Index tightened 5bps month-over-month, to 91bps. The Index outperformed duration-matched Treasuries by 46bps. The longer maturities performed better during the month (particularly the 10+ year bucket), and the curve flattened.6 IG corporate spreads benefited from a strong economic backdrop and rising Treasury yields, as increased Treasuries made the asset class more attractive to some yield-sensitive buyers (Figure 2).

As in prior months, lower-quality credits outperformed; specifically, crossover credits fared best, while Aa+ credits did worst. On a sector basis, the best-performing sectors were Metals and Mining and Energy bonds, per Barclays. Oil and copper prices rose, benefiting those sectors. The worst-performing sectors were Health Insurance, Sovereigns, Financial Companies, Foreign Agencies and Supranational credits.

Looking within sector performance, Retail benefited from two large tender offers announced during the month, from Wal-Mart Stores Inc. and Target Corp. However, this was offset by poor performance from CVS Health Corp. and Walgreens Boots Alliance Inc., on rising concerns that would enter the pharmaceutical space and reports that CVS was interested in acquiring Aetna Inc. The Pharmaceutical sector was also hurt by concerns about Amazon’s pharmaceutical push, as well as weak 3Q17 reporting from TEVA Pharmaceutical Industries Ltd. and unfavorable guidance from Celgene Corp.

3Q17 earnings were strong, particularly in Technology, Energy and Materials. U.S. Bank results were generally good, with strong capital and improved earnings, partially offset by a modest deterioration in consumer credit quality primarily in credit card and auto loan segments.

On the demand side, foreign buyers continue to show interest in the space as U.S. IG corporate yields continue to outpace foreign yields. IG funds reported $16 billion of inflows—the 21st consecutive month of inflows—bringing the year-to-date inflow total to $277 billion per Wells Fargo.

Demand was strong enough to prompt solid returns in October, despite another month of robust supply. Issuance was $130 billion in October, which is the highest volume for any October ever, per Bank of America Merrill Lynch (BAML).7 Deals were well-absorbed, although the average new issue concession widened modestly to 4.2bps from 3.7bps in September, per BAML. Looking forward, seasonally, November is typically busier because of the lack of earnings blackout periods. However, heavy volumes in October suggest that some deals may have been front-loaded.

Tax Reform: Corporate Impact

The new tax reform bill could also significantly impact corporate bonds. In general, we think the bill is positive for corporates in its current form, given the lower corporate tax rate and repatriation that may free up cash held overseas. Highlights of the tax bill include:

  • Corporate tax rate lowered to 20 percent from 35 percent, which could increase after-tax earnings;
  • Interest expense still deductible, except when it exceeds 30 percent of Ebitda;
  • A one-time 12 percent favorable repatriation rate on cash, which could lead to lower corporate supply, depending on company use of the repatriated cash;
  • Interest deductibility for capex in the year it’s incurred; and
  • No taxes on future foreign profits whether repatriated or not. However, as currently written, the framework appears designed to levy a 20 percent excise tax on companies that make payments to their offshore affiliates.

For more thoughts on the potential impact of tax reform, see our 3Q17 Corporate Commentary, written by our co-head of research, Nick Elfner.


Figuring Out the Value

For October, asset-backed securities (ABS) and agency commercial mortgage-backed securities (ACMBS) posted excess returns of 13bps and 33bps, respectively. Agency CMBS tightened in sympathy with U.S. corporates and benefited from investors getting a firmer handle on damage to collateralized properties from Hurricanes Harvey and Irma. In addition, Agency MBS had another month of positive excess returns, particularly in Conventionals. Agency MBS spreads reached the tights of 2017 in early October, driven by rangebound U.S. Treasury rates and low volatility (although by month end, Agency MBS spreads had widened off the tights). On the consumer ABS side, in October's Senior Loan Officer Opinion Survey (SLOOS), lenders reported net stronger demand for auto loans after three consecutive weaker prints, while demand for credit cards and other consumer loans remained relatively unchanged.8

In our view, given that the Fed’s balance sheet unwind was well telegraphed before the FOMC’s announcement in September, much of the MBS spread widening was already priced in and without a volatility catalyst on the horizon, we do not expect MBS to significantly widen over the near term.

ABS supply picked up in October, with $30.3 billion of new issuance, per Morgan Stanley. This is up more than 100 percent month-over-month, and up 28 percent year-over-year. Investor demand remains strong, with most deals pricing inside of guidance, and several deals upsized. ABS spreads remain tight, but still provide attractive carry and relative value versus other segments of the IG market.


On The Market's Mind: FOMC, Tax Reform

We are duration neutral in both our municipal and government/credit strategies. We are closely monitoring both fundamental and technical impacts of tax reform and FOMC changes. Our outlook considers that the market movements in October were partly driven by expected fiscal stimulus from tax reform. While the initial House proposal has been released, uncertainty remains as to the final construct of the bill. In particular, ultimate passage and final structure are both uncertain given the political climate as evidenced by some surprising results in U.S. elections November 7. But overall, we think the bill is positive for U.S. companies and could put upward pressure on Treasury rates. Additionally, we continue to think that the U.S. Treasury market is not adequately pricing in higher commodity prices and the Fed’s desire to normalize rates more quickly. In October, WTI rose 7 percent while copper rose 5 percent, which led to outperformance in cyclical sectors on the corporate side.

For IG municipal bonds, the credit environment remains stable. We recognize that significant demand remains for municipal bonds. Strong trading relationships remain important for taking part in deals, and it is important to get paid for risks in bonds coming to market. Even though Pennsylvania recently approved a revenue package, the state’s unwillingness to make unpopular choices such as tax increases could exacerbate weaknesses in the state’s pension situation or overall financial picture over the long term. Several other State GO credits remain under budgetary and pension pressure and should be closely monitored in terms of willingness and/or ability to repay debt. Also, credit profiles could change due to the new tax reform plans, as the shrinking muni market could make it more difficult for some municipalities to raise revenue.

On the corporate bond side, we note that October was another month of outperformance of higher-beta credits. We continue to closely monitor the valuation implications of outperformance of BBBs, as the pickup in spread from dropping to triple-BBB from single-A credit has compressed. This is especially important given our positioning in the credit cycle. We remain cautious on the corporate credit cycle, since financial leverage remains high. Still-elevated share buybacks and weak capex growth are indicative of a shorter-term focus by some management teams, and we are closely monitoring environmental, social and governance risks.


[1] The Bureau of Labor Statistics and the Bureau of Economic Analysis, October and November 2017.

[2] U.S. Census and Bureau of Labor Statistics, October and November 2017.

[3] In October, the ECB halved its quantitative easing (QE) purchases to 30 billion euros for January through September of 2018, and said that negative (deposit facility) rates could continue well beyond the end of QE.

[4] Barclays and Bank of America Merrill Lynch, as of November 1, 2017.

[5] Breckinridge Capital Advisors Credit Research, September and October 2017. 

[6] Barclays, as of November 1, 2017.

[7] The prior record October was $106 billion in 2016, per BAML.

[8] Barclays, as of November 1, 2017. 


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