Few times in history have tax burdens and tax revenues been more in focus, but of course, in November, the focus was on overall tax reform proposals from Congress.
- U.S. Treasury yields remain low but ticked higher in September.
- Muni/Treasury ratios touched close to historical lows in August, but relative value improved in September, as municipals underperformed Treasuries.
- IG corporates are now close to the tights last reached in June 2014, which were the tightest levels since the financial crisis.
- Conventional MBS performed well, as low volatility and strong buying eased fears related to the market’s response to the Fed’s balance sheet unwind.
When Autumn QEs Start to Fall
As we began a new season, September was an active month domestically with the hurricanes, FOMC meeting and additional clarity on President Donald Trump’s tax plan. Globally, central bankers looking to moderate accommodative policies, along with continuing fears over the tenuous relationship between the U. S. and North Korea, impacted markets.
Even so, volatility in September remained low across risk assets, as strong 2Q17 GDP data, rising commodity prices, the weaker U.S. dollar and tax-reform expectations more than offset geopolitical flare-ups and extreme weather. Trump’s agreement with Congress to increase the debt limit and provide funding for Hurricane Harvey relief – averting a crisis surrounding the September 30 debt ceiling deadline – also helped risk assets during the month. The month was risk-on with higher-beta assets performing better than lower-beta. However, stubbornly low inflation worked to keep long-end Treasury yields from rising significantly.
U.S. Treasury yields remain low but ticked higher in September, as comments from Fed Chair Janet Yellen were viewed as hawkish, causing the 10-year U.S. Treasury bond to spike. Also, several global central banks made announcements in September regarding tapering. In particular, as widely expected, the Fed announced that it would begin to unwind its balance sheet in October. The market’s expectation for a December rate hike rose from 33 percent at the start of the month to 70 percent on September 30. Globally, the Bank of England held rates fixed in September, but the minutes were more hawkish than expected. ECB President Mario Draghi also previewed tapering at that bank’s meeting held in September.
Market participants continue to examine the Phillips Curve to determine why lower unemployment and above-trend GDP growth has not led to significant wage growth (Figure 1). CPI rose 0.4 percent in August – the largest jump since January, mainly due to rising energy costs. CPI rose 1.9 percent year-over-year, still below the FOMC’s 2 percent target. Core CPI (excluding food and energy) rose 0.2 percent month-over-month and 1.7 percent year-over-year, while core PCE fell to 1.3 percent growth year-over-year. Low inflation in the U.S. is occurring amid extremely low inflation globally. For example, the Bank of Japan continues to fall short of its inflation target despite multiple years of accommodative policy.
Tax-Efficient Market Review
Supply Turns Over a New Leaf
Municipal yields struck year-to-date lows in early September, in sympathy with lower Treasury markets, as investors sought safe investments amid hurricane news and absorbed dovish comments from FOMC board member Lael Brainard. However, municipal yields increased into month-end, with short-dated bonds spiking 12 to 24 basis points (bps), while 10-year and longer maturities rose eight to 13bps. Municipal bond returns were negative for the month after a string of positive returns since December 2016 (June 2017 was the exception). The five- to seven-year range was the worst performer for September.
After touching close to historical lows in August for maturities seven years and shorter, relative value improved as municipals underperformed Treasuries in September. Ratios fell for most of the month before moving higher – especially in the short end – due mainly to an increase in supply the last week of the month. Month-end ratios for two-, three- and five-year maturities closed the month at 67 percent, 67 percent and 70 percent, respectively.
Supply in the last week of September was one of the heaviest in 2017, and included issues from the Texas Water Development Board ($1 billion) and the Pennsylvania Turnpike Commission ($499 million). In September, supply was down 34 percent versus 2016, at a total of $26.7 billion. Refunding issuance fell 47 percent and new money issuance declined 9 percent.
Also impacting municipals during the month, the Republican party released its tax plan. While the plan did not mention the municipal tax exemption, it did discuss a repeal of the alternative minimum tax (AMT), the elimination of the state and local tax deductions, an increase in the standard tax deduction for individuals and a reduction in the corporate tax. The proposed changes may, in some cases, reduce the allure of the muni tax deduction if implemented, and/or create additional demand for certain existing munis (AMT). For example, a reduced corporate tax rate may give businesses or banks less incentive to invest in tax-exempt bonds.
Credit fundamentals remain stable, and markets are still monitoring idiosyncratic risks from states with pension or budgetary problems. As expected, S&P Global Ratings downgraded Pennsylvania to A+/stable from AA-(negative watch), as the state is nearing a fourth month without a revenue plan to match its $32 billion budget. Lawmakers are facing a $2.3 billion budget gap, after the state’s fiscal year ended June 30.
Demand for municipal bonds remains strong. Mutual fund inflows were positive throughout the month and the year-to-date total stands at just over $13 billion of inflows. The 2Q17 Federal Reserve Flow of Funds data, released in September, indicated interest in municipals from foreign investors and mutual funds (Figure 2).
Government Credit Market Review
Foreign Investors Still Cozying Up to U.S. Corporates
In September, the Bloomberg Barclays Credit Index tightened 8bps to a spread of 96bps. The Index outperformed duration-matched Treasury bonds by 78bps. On a total return basis, the Index was down 22bps driven by the backup in interest rates. IG corporates are now close to the tights last reached in June 2014, which were the tightest levels since the financial crisis. The main drivers of tightening in September included higher Treasury yields that pushed up all-in yields for IG bonds and made them more attractive to some yield-focused investors.
Higher beta credits led performance, with cyclicals outperforming. Cable, Satellite, Independent Energy, Wirelines, Refining and Oil Field Services performed best during the quarter, per Barclays. Energy’s strong performance was largely due to an 8 percent jump in WTI oil prices (Figure 3). In addition, Metals and Mining continued to outperform on higher commodity pricing. Telecom, Media and Technology spreads benefited from a slowdown in M&A headlines following investor focus on merger talks from such credits as Charter Communications last month. The prospect of repatriation also boosted performance in TMT, as U.S. IG Technology companies collectively have roughly $643 billion of cash held overseas.1
Lower beta, defensive sectors lagged in September, including Capital Goods, Consumer Products and Utilities. Financials also underperformed; in particular, retail REITs have been the weakest performers in the REIT sector year-to-date.2 Further underscoring the risk-on sentiment during the month, BBB outperformed again. The spread between BBB and single-A bonds is now near cycle lows, at 48bps, on the outperformance of BBBs. Overall, IG corporate credit curves flattened, as longer bonds outperformed on a spread basis, reversing some of the steepening seen earlier in the year, per Barclays.
High-grade supply remained healthy, with the bulk of issuance occurring during the first two weeks of the month. Issuance totaled $138 billion, up from $108 billion priced in August and down from $144 billion priced in September 2016, which was the highest September ever.3 Year-to-date, new IG corporate issuance continues to track slightly ahead of last year’s pace with $1.15 trillion pricing through the end of the third quarter, versus $1.12 trillion in the same period of 2016.4
Fund flows were positive again in September, with IG funds reporting another $13 billion in inflows bringing the year-to-date total to $97 billion.5 Foreign investment remains a significant source of demand.
For more information on recent IG corporate bond performance, see our 3Q17 corporate commentary.
For September, asset-backed securities (ABS) and agency commercial mortgage-backed securities (ACMBS) have lagged slightly, while agency MBS have generated 24bps of positive excess returns.6 The solid performance in MBS has been driven primarily by the GN sector (Ginnie Mae) in response to written comments from Sen. Elizabeth Warren that could imply a slowdown in refinancing and slower prepay speeds. Meanwhile, retail performance weighed on CMBS, as secular retail pressures continue to impact malls and other retail stores and companies.
Conventional (Fannie Mae/Freddie Mac) MBS performed well, as low volatility and strong buying eased fears related to the market’s response to the Fed’s balance sheet unwind. ABS spreads continue to hover near year-to-date tights given the defensive nature of the sector, attractive carry and relative value versus other segments of the IG market. On the supply side, ABS supply has cooled recently after a strong start to the year. ABS supply is still on track to exceed $200 billion for the year, slightly ahead of the 2016 total.
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 widening was already priced in (see The Fed’s Shrinking Balance Sheet and MBS Opportunities for our take on the Fed’s unwind and its impact on the MBS market). The impact of extreme weather during the month is expected to be mitigated by insurance coverage and geographic and structural diversification of mortgages in the underlying pools.
Strategy and Outlook
FOMC Expects to Take Scenic Hikes
We are duration neutral in both our municipal and government/credit strategies. Our outlook and positioning consider the low yields in the IG space and the low volatility in both equity and fixed income markets. In our view, the impact of the fall in the U.S. dollar, the higher commodity prices and the Fed’s desire to normalize rates more quickly aren’t being reflected in current U.S. Treasury yields. The FOMC expects to hike rates three times in 2018, while the markets have priced in only one 2018 hike.
For IG municipal bonds, the credit environment remains stable. Even though Illinois and New Jersey spreads saw improvement in September, several state general obligation (GO) credits remain under budgetary and pension pressure and should be closely monitored in terms of willingness and/or ability to repay debt. While strong positive supply/demand technicals have driven performance in recent months, we expect this may moderate in the near term now that the summer period of substantial redemptions (from maturities coming due and interest payments available to reinvest) has passed. In addition, new issue supply is expected to tick up after a seasonally slower August. That said, the front loading of refinancing in 2016 and the lack of infrastructure spending is expected to keep supply subdued, and the ability to source bonds in secondary markets remains crucial.
On the corporate bond side, October supply is expected to see a seasonal slowdown given 3Q17 blackout periods and front-loading of some issuance. We continue to closely monitor idiosyncratic challenges and the valuation implications of outperformance of BBBs, as the pickup in spread from dropping from single-A to triple-BBB credit has compressed. Credit fundamentals remain strained, with gross leverage at a record high for IG companies and above the 2001-2002 peaks. High share buybacks and soft capex indicate a short-term focus by some management teams, and we continue to closely monitor environmental, social and governance (ESG) risks.
 CreditSights, as of October 5, 2017
 JP Morgan, as of 3Q17.
 Bank of America Merrill Lynch, as of October 2, 2017.
 Bloomberg League Tables, as of September 30, 2017.
 Investment Company Institute, data as of the week ending September 27, 2017.
 Data for analysis references The Bloomberg Barclays Aggregate Index.
DISCLAIMER: The opinions and views expressed are those of Breckinridge Capital Advisors, Inc. They are current as of the date(s) indicated but are subject to change without notice. Any estimates, targets, and projections are based on Breckinridge research, analysis and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.
Nothing contained herein should be construed or relied upon as financial, legal or tax advice. All investments involve risks, including the loss of principal. An investor should consult with their financial professional before making any investment decisions.
Some information has been taken directly from unaffiliated third party sources. Breckinridge believes such information is reliable, but does not guarantee its accuracy or completeness.
Any specific securities mentioned are for illustrative and example only. They do not necessarily represent actual investments in any client portfolio.