Quarterly Market Update
Fixed Income Outlook
Slow March to Higher Rates Begins
After posting the largest declines since 1999 last year, the bond market unexpectedly rallied in January on weaker weather-related economic numbers and a flight to safety bid caused by Russia’s politically divisive annexation of Crimea. The brief rally pushed the yield on the 10-year Treasury to 2.56% from a high of 3.03% where it ended the previous year. However, toward quarter end, improving consumer confidence and a moderate advance in the pace of U.S. job market growth reversed much of these earlier gains, allowing the yield on the 10-year Treasury to drift up to 2.72%.
Although weather and geopolitical themes initially shaped bond market returns in the first quarter, the fate of the bond market ultimately appears to lie in the hands of the Fed. The tapering process which began on December 18 continued with bond purchases being reduced by $10 billion at each of the Federal Open Market Committee’s past three meetings. Now at $55 billion, monthly bond purchases are expected to conclude by the end of the current year.
At a February press conference, newly appointed Fed Chairwoman Janet Yellen remarked that the Fed could commence tightening the Federal Funds Rate Target, now at 0.25%, by June 2015, ahead of the previously announced December 2015 inception date. She further projected a Fed Funds Rate of 1.00% by the end of 2015 and 2.25% by the end of 2016. In response to this apparent acceleration, rates at the front end of the yield curve rose and credit spreads tightened even further in a continuation of last quarter’s trend. Before receiving additional clarity from Yellen regarding the timeline for changes to the Fed Funds Rate, investors also began to abandon the intermediate section of the yield curve.
Municipal Bond Supply Continues to Shrink
The municipal bond curve also flattened at the prospect of an accelerated time frame, with intermediate-term yields rising much faster than the long-term yields. However, supply was a mitigating factor. Too many investors chasing too few bonds has supported the municipal market for some time now. Year-to-date new issuance is down 21% compared to the same period last year. New financings are relatively flat, up only 6.7%, while refunding issues are down 52%. Most cities have already refinanced issues that are eligible to be refinanced and local and state officials are reluctant to take on new debt.
Corporate Bonds Outperformed on Spread Compression
Chairwoman Yellen’s remarks also led to considerable positioning at the front end of the yield curve in the corporate bond market. The corporate bond market saw some new supply in February, but the pace decreased in March and overall issuance for the quarter was light. Appetite for new issuance is strong and accordingly corporates experienced a great deal of spread compression.
Agency Market Increasingly Moves in Lockstep with Treasury
In November 2008, during the subprime mortgage crisis, the U.S. Treasury placed government-sponsored enterprises Fannie Mae and Freddie Mac into conservatorship. The government will eventually replace the Agencies with another institution designed to create an effective secondary mortgage market, but in the meantime the existing Agencies have not issued a great deal of new debt. Amid uncertainty about the end game and the form their replacement entity will take, and as supply has dried up, the credit spread between Agencies and U.S. Treasuries has compressed to the extent that Agencies no longer add much in the way of incremental yield. For the quarter, Agencies trailed U.S. Treasuries by only six basis points as measured by the BofA Merrill Lynch U.S. Treasury 1-10 Year Index and the BofA Merrill Lynch U.S. Agencies 1-10 Year Index.
Figure 1. Investors focused on the short-end of the curve and spreads compressed.
Figure 2. Total returns by fixed income asset classes - Treasuries, Agencies, Corporates and Municipals over the first quarter 2014 compared to 2012 and 2013.
Fixed Income Outlook
The consensus is for bond yields to be in the neighborhood of 3.25% or more by the end of the year.
Our outlook for the municipal market is cautious knowing that any improved economic data will push rates higher. However the municipal market does have a dearth of supply which may slow the pace of the inevitable rise. We do not anticipate the passage of any major tax reform that could cap the deductibility of tax-exempt interest in 2014.
The corporate bond market will continue along the current trajectory as we are likely in the midst of the last hoorah for historically low rates. Much as on the municipal market side, most new issuance has been refinancing – buying back older debt with higher coupons and reissuing debt at lower rates.
Fed Taper Baked Into the Market
ISI Research is calling for the yield on the 10-year Treasury to be at 3.5% by the end of 2014, up from 3.03% at the end of 2013. While we concur that the natural drift is upward, we anticipate that it will be a slow drift and one whose ascent is carefully orchestrated by the Fed. The Fed has a vested interest in keeping interest rates low in that higher debt service costs on Treasuries drives the budget deficit higher. In fact, 6.40% of the budget deficit is simply interest expense. It is thought that a general rise in Treasury yields of as much as 1% would dramatically increase the budget deficit to the point of being prohibitive. Rising public debt service costs are damaging to the private sector to the extent they starve it of the capital needed to fuel economic expansion.
In our opinion, municipal bond yields could rise at a slower pace than taxable yields throughout the year as municipal buyers, driven by higher federal income tax rates, return to the bond markets earlier, willing to accept a certain level of yield and hold their bonds to maturity.
When all the noise is subtracted, the main event continues to be the long, slow march toward higher interest rates. Events that temporarily derailed the march – the weather and the geopolitical situation in Ukraine – are transitory. Baked into the market now, should economic data continue as expected, is the expectation and increasing acceptance that the Fed will raise interest rates by mid-2015.
The primary determinant of the economic outlook and resulting Fed action continues to be the U.S. job market. We are coming into the season that typically produces fairly healthy employment numbers, so experts are optimistic that economic growth will accelerate. The Fed has indicated that monthly employment gains between 200,000 and 240,000 are capable of generating GDP of 2.5% to 3.0%. Such a pace would encourage the continued tapering at the rate of $10 billion per monthly meeting.
Sustained payroll gains under 200,000 imply that the first quarter weakness originally attributed to weather may be more structural in nature. Payroll gains greater than say 240,000 may indicate that the economy is growing faster than originally thought and, more importantly, could compel the Fed to accelerate the tapering process. Payroll gains in the “sweet spot” of say 200,000 to 240,000 appear ideal in order to keep interest rates in their current band while preventing equity investors from worrying about more aggressive monetary tightening.
We are keeping an eye on revisions to the first quarter economic data. Should weaker data than was assumed to be weather related be revised significantly upward, it could bump rates higher more quickly than anticipated.
The consensus is for bond yields to be in the neighborhood of 3.25% to 3.40% by the end of the year. Given that yield on the 10-year Treasury closed the quarter at 2.72%, the ascent is likely to be gradual. Investors will want to respond accordingly when events occur. As the rise in interest rates accelerates, if it happens, then shorter duration laddered portfolios will allow maturing bonds to be reinvested into higher-yielding bonds more quickly.
As always, there is the potential for unforeseen events, such as the earthquakes recently experienced in Los Angeles and Chile, to derail the existing trajectory. Certainly geopolitical events continue to be a factor, although the situation in Ukraine appears to be tamped down for the moment. Mid- term elections are in November and the makeup of the House and Senate could influence bond yields. Investors typically do not like one party controlling both houses of Congress as such a situation allows the controlling party to more successfully push its agenda.
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In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).