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Investing Commentary published on October 12, 2018

September 2018 Market Commentary

Strategy and Outlook

  • U.S. Treasury Curve: We believe that risks such as emerging market troubles, a noticeably flat U.S. Treasury curve and trade concerns will keep the Fed’s rate increases at a measured pace.
  • Tax-Exempt Municipal/Treasury Ratios: Shorter-term municipal/Treasury ratios (1- to 3-year maturities) moved between 3% and 5% higher in September after hitting low points over the summer.
  • Municipal Market Technicals: The supportive supply/demand environment continued for most of the quarter, but the tailwind from low supply has started to fade.
  • Corporate Credit Quality: Trade tensions, increasing hedging costs for foreign buyers and fading tailwinds of tax reform and tightening Fed policy are risks.
  • Corporate Supply and Demand: Issuance was extremely robust the first few weeks of September and M&A was a heavy contributor.
  • Securitized Trends: MBS had a strong month and quarter; however, we are entering a new paradigm with the Fed exit. ABS remained steady in September, as the sector continues to benefit from a lack of any sector-specific negative headlines and strong duration-adjusted carry.


Market Review

Sun Continues to Rise on GDP, Payrolls

The autumnal equinox arrived September 22, indicating the first day of fall, nights getting longer and days getting shorter. Total returns in some fixed income sectors also took a “darker” turn in the month, as U.S. Treasury yields ratcheted higher; however, there was also evidence of light, as high yield and high grade corporate bond spreads declined.1

During September, markets were “risk-on,” continuing the trend seen throughout the third quarter. Equity markets gained despite the announcement of escalating tariffs on Chinese goods, the weakness in emerging markets (EM) and concerns over the Italian budget deficit. Treasury yields reversed the declines seen in August and rose around 20 basis points (bps) across the yield curve. Toward month end, the 10-year Treasury yield came close to its year-to-date high of 3.11 percent. Municipal bond yields followed Treasury yields higher over the month, and municipal bond returns fell.2

Despite the rise in Treasury yields, the Treasury curve remains very flat, with the slope between 2- and 10-year maturities at just 25bps – close to a decade low. While short-maturity yields have responded to potentially further rate hikes from the FOMC, longer-term yields have been held in check by tame inflation data, concerns about EM economies and an expanding Italian budget deficit.

Economic growth remained strong in September with an updated reading of 4.2 percent for 2Q18 GDP. The U.S. economy has benefited from continued strength in employment, strong corporate profit growth and record-high readings on consumer confidence.

Despite the U.S. economic strength, inflation is rising slowly as CPI came in below expectations for August, at 0.2 percent growth month-over-month and 2.7 percent growth year-over-year. Core CPI was up 2.2 percent for the 12 months ending in August.

Also driving Treasuries higher, the FOMC raised the target for the policy rate to a range of 2 percent to 2.25 percent at its September meeting. As expected, the Committee removed the descriptive term “accommodative” from its stance on policy, although Fed Chairman Jerome Powell downplayed the significance of the change. He noted that moving to a restrictive stance is “very possible” and would be a historically normal step. The Fed’s median 2018 GDP growth forecast rose to 3.1 percent. The dot plot was slightly more hawkish versus June; it now reflects another hike in December, another three hikes next year, one more hike in 2020 and then a hold at 3.375 percent in 2021.

We recognize that mild inflation and strong labor data support rate normalization. However, we feel that several risks will cause the Fed to want to maintain a moderate pace of rate hikes, including: EM troubles; the Treasury curve being noticeably flat; the FOMC’s potential need to manage market expectations; the potential macro impacts to Chinese tariffs rising to 25 percent at year-end; and the potential for a stronger dollar.

Municipal Market Review

Good Harvest in 2Q State/Local Tax Collections

Rising yields pushed municipal returns into negative territory for the month, with the most-negative returns coming in the longest maturities. The Bloomberg Barclays Municipal Bond Index was down 65bps for the month, with the one-year index down only 19bps, while the Long-Bond index was down 91bps.

Short-maturity municipal bonds underperformed Treasuries of similar maturities during the month, pushing ratios well above the summer lows. However, year-to-date, the 2-year ratio is still down 12 percent, while the 30-year is up 9 percent. All spots on the curve closed near their year-to-date averages in ratios. Unlike many other months this year, lower-quality bonds performed in-line with higher-quality bonds.

One of the biggest trends of the year has been the municipal spread tightening in California (see Pricing and the Way Forward in California Muni Bonds). The outperformance of California bonds paused during the month, but spreads have still fallen significantly year-to-date.

After a strong August, new issue supply took a step back in September. Total issuance came in at just under $24 billion, 19 percent lower than August 2017 and the lowest September supply since 2015. New money issuance continued its rebound with almost $20 billion worth of issuance, higher by 23 percent versus September 2017. By contrast, refunding volume was lower by 70 percent at just $2.7 billion. Gross supply for the year now stands at $249 billion, lower by 15 percent versus the same period last year.

The strong summer technical has started to fade as mutual fund flows were modestly negative throughout September, reducing the year-to-date total to just under $11 billion. The Fed flow of funds data reported a $10 billion (2 percent) reduction in bank holdings in 2Q18, and a year-to-date reduction of over $26 billion (close to 5 percent). The overall size of the municipal market remained virtually the same when compared to 1Q18, at $3.8 trillion.

On the credit side, second quarter data on aggregate state and local tax collections was strong (Figure 2), although it partly reflects volatile oil prices which are now hovering around $80/barrel. Tax collections in the 10 major oil and gas producing states are up 13 percent through the first half of 2018.

Corporate Market Review

Fall in Spreads

Despite heavy supply in the month and trade concerns in the backdrop, the Bloomberg Barclays Corporate Index option-adjusted spread (OAS) was rangebound and ended 8bps lower, as investment grade (IG) demand benefited from higher U.S. Treasury yields. The total return was negative 36bps, but excess return was positive 78bps. BBB credits outpaced single As and double As, after being the weakest of the three in August, on an excess return basis. Telecom and Media had particularly strong months, as did commodity-related sectors given higher oil prices. Long-dated corporates were the strongest performers while shorter maturities lagged, on an excess return basis.

Following the summer slowdown in supply, issuance was extremely robust the first few weeks of September but new issues were well absorbed by the market. IG supply increased to $145 billion in September, up 8 percent versus September 2017, per Bank of America Merrill Lynch. A salient theme this year has been heavy M&A supply, and September continued the trend with a $20 billion deal from Cigna Corp. to back its acquisition of Express Scripts Holding Co. – the second-largest bond deal of the year. We think supply pressure from M&A could continue.

On the flip side, the repatriation of foreign corporate cash (related to tax reform), the reduced regulatory issuance related to TLAC3 and the high level of principal repayments have helped moderate net supply in recent months.

On the demand side, Federal Reserve Flow of Funds data show that corporate pensions ramped up their purchases of corporate bonds in recent quarters, potentially helped by higher all-in rates and increased pension-funding ratios. Retail fund inflows were strong in September at $6.4 billion, per EPFR.

Tax cuts and repatriation have improved financial flexibility for some corporates. However, record-high gross leverage remains a key risk and we note that leverage could increase further in the event of a recession. For a more detailed look at our credit views, see our 3Q18 Corporate Credit Outlook.

Securitized Market Review

Home Prices Still Heated

Agency mortgage-backed securities (agency MBS) saw 11bps of excess returns in September. However, year-to-date excess returns are -7bps.4 Spreads are near year-to-date wides, but are tighter than last September when the Fed announced its unwind plans.

While volatility has remained low through 3Q18, worsening mortgage funding conditions due to the Fed’s unwind and moderating housing data are taking their toll. Higher rates and years of strong home price appreciation have started to manifest themselves into weaker home sales (Figure 3). The Fed reinvestment cap on agency MBS reinvestments shifts from $16 billion to $20 billion in October, and their net buying is now zero.5 This is the first time since the early 2000s that the sector has not had a buyer of last resort, as pre-crisis, Fannie and Freddie bought MBS for their retained portfolios when the securities got cheap relative to their funding costs.

MBS OAS look attractive to us. However the nominal spread pickup from MBS to corporates has increased this year and relative value flows from money managers could tilt back to corporates if this trend continues.

The asset-backed securities (ABS) market has been steady this summer. For September, ABS excess returns matched agency MBS returns at 11bps. ABS nominal spreads versus benchmark swaps have remained in a tight range for most of the year.6

In credit cards, we continue to see delinquency rates rising, and auto subprime headlines have resurfaced. The weakness in the auto sector is around the subprime, lease and retail segments, as a glut of supply from cars coming off fleet, along with falling used car values, have weighed on the sector. However, our universe and focus are on the most prime sectors where we believe these bonds are still in a very strong position fundamentally and well protected by structure.


[1] Proxies for indices include the Bloomberg Barclays Intermediate U.S. High Yield Index (OAS) and the Bloomberg Barclays Intermediate Corporate Index (OAS).

[2] Proxy is the Bloomberg Barclays Municipal Bond Index.

[3] The Financial Stability Board has required some larger U.S. banks to meet minimum holdings of “total loss-absorbing capacity” (TLAC) securities, a change that was primarily put in place as a cushion for depositors and taxpayers.

[4] Proxy used is the Bloomberg Barclays Aggregate Index.

[5] In September 2017, the FOMC directed the Open Market Trading Desk to reinvest each month’s principal payments from Treasury, agency and agency mortgage-backed securities only to the extent that such payments exceed gradually rising caps.

[6] Proxy used is the Bloomberg Barclays Aggregate Index.

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