Quarterly Market Update
Fixed Income Outlook
Too Tight is Not a Mistake the Fed Intends to Make
Bond markets may be hard pressed to repeat the outstanding performance of the first quarter.
Despite the roller coaster ride, the global bond market had one of its best quarters ever, thanks mostly to sharp credit spread tightening in the second half of the quarter. Until reaching the fulcrum point on February 11, oil prices had been going down along with economic growth expectations while stock prices were plummeting and international volatility surged. Corporate credit spreads widened as recession and default fears rose at the same time Treasury yields, benefiting from a flight to safety, declined.
After February 11, financial market dynamics reversed – oil prices rose and the global fear premium fell, leading to a modest selloff in Treasuries and sovereign bonds. In comparison, yields on corporate bonds fell sharply as credit spreads tightened concurrent with the rally in stock prices caused by renewed hope that recession would be avoided.
These events exemplified the two faces of the bond market. Sovereign bonds benefit from flight to safety when the “fear premium” increases. Conversely, corporate bond credit spreads, which widen when recession or default threatens, are indicative of the economy’s underlying health. Although corporate bond credit spreads widen or tighten based on the economy, corporate bond prices may not necessarily move much because they are still subject to changes in benchmark interest rates (i.e., Treasury yields). For example, if Treasury yields drop 20 basis points at the same time credit spreads widen 20 basis points, then the price of the corporate bond stays roughly the same. However in February, the corporate spread widening exceeded the appreciation of Treasuries. In short, the credit deterioration was such that it overcame the fact that Treasury rates in general were falling. In March, events reversed and while Treasury yields drifted up a bit, credit spreads tightened significantly, allowing corporate bonds to lift the performance of the overall bond market.
Thanks to a friendlier Fed and modestly improving economic data, the yield on the 10-year U.S. Treasury, which began the year at 2.25%, fell to 1.75% by quarter end, a 50 basis point decline. At the end of 2015, it was widely expected that the Fed would tighten the fed funds rate on a quarterly basis in 2016. But when economic activity slowed, international problems rose (e.g., Brussels bombings), and the price of oil fell from $50 to $26, the Fed reduced the anticipated number of rate hikes from four to two and increased the time range for implementing the hikes. Additionally, the tremendous amount of foreign sovereign debt sporting negative yields or yields less than 1.0% pushed global buyers into U.S. Treasuries where yields are comparatively attractive.
Corporate Credit Spread Volatility Proliferates
Perhaps the quarter’s biggest surprise was the volatility of credit spreads. Prior to February 11, the equity market had declined roughly 10.0% and credit spreads on 10-year investment-grade corporate bonds had widened by 20 to 40 basis points. After February 11, credit spreads rallied sharply, tightening roughly 30 to 50 basis points at the same time the equity market bounced back, ending the quarter with a small gain. Currently, credit spreads stand where they were in late November, marking a full recovery from the quarter’s volatility after world markets stabilized.
Credit spreads on high yield bonds, which tend to behave much like stocks, were even more volatile in the first quarter. The return on high yield bonds as measured by the Bank of America Merrill Lynch High Yield Index was down 6.0% at one point, then up 4.42% in March before ending the quarter with a gain of 3.25%. Going into January, high yield bonds had posted negative returns in seven of the last eight months, driven largely by the decline in oil prices. High yield bonds are very sensitive to oil prices since roughly one third of the high yield market is comprised of companies in the oil/energy business. As oil prices tumbled and the ability of oil/energy companies to repay their debt became suspect, credit spreads on their debt widened dramatically before tightening abruptly as oil prices recovered.
Municipals Offer Investors
Relative Calm Yields on municipal bonds generally tracked the direction of U.S. Treasury yields in the first quarter, although with a bit less volatility. Investment-grade municipal bonds featuring yields close to 100% of the yield available on longer maturity Treasury securities continue to attract investors seeking good relative value. Municipal credit spreads remain firm for all credits except for a few well-known distressed issues (e.g., Puerto Rico debt).
Investor demand for munis is practically insatiable - Lipper reported 25 consecutive weeks of net inflows into tax-free bond funds. Investors are looking for assets with low volatility and steady returns, and, of course, tax-free income. Despite the strong demand, municipal bond supply is down about 8% from the same period last year. While there have been a good number of new money deals, the refunding of old outstanding municipal bonds has diminished sharply.
The Fed would rather err on the side of rising inflation than risk economic slowdown caused by overly restrictive monetary policy.
In the stock market, the phrase “sell in May, go away” is well known. While the rally off of the February lows may continue, a stock market rally without earnings growth looks doubtful because price/earnings ratios are already on the high side. A summer slowdown would be a headwind for stocks and a tailwind for government debt if it leads to a delay in the next Fed tightening. For bond investors, the summer doldrums could render a fairly low and flat Treasury yield curve coupled with gently widening credit spreads. In a weak economy, companies earn less and, therefore, have less capacity to pay their debt obligations.
The outlook for Treasury yields will largely be determined by Fed action and the degree of international interest in U.S. debt. Following the March meeting of the Federal Open Market Committee, financial markets responded positively to Fed Chair Yellen’s inference that the Fed is willing to err on the side of rising inflation and stronger-than-expected growth more so than it is willing to risk an economic slowdown resulting from overly restrictive monetary policy.
The outlook for financial markets is also closely linked to the fate of oil prices. Should oil prices go up, all other things being equal, a “risk on” mentality would ensue whereby stock prices go up, Treasury bond prices go down, and credit spreads tighten. Should oil prices go down, then it is “risk off” and stock prices go down, Treasury bond prices go up, and credit spreads widen.
Regardless of which scenario takes precedent, given the combination of a data-dependent Fed, an election year, international turmoil, and the fact that Great Britain will vote in June on whether or not to leave the European Union, the financial markets are likely in for a great deal of volatility and muted returns. In fact, it is possible that the best quarter of bond returns may already be behind us.
Corporate Bond Issuance will Remain Strong
At the beginning of the year, projections were for $1.2 trillion in new supply in investment grade corporate bonds, but year-to-date, the market is already on pace for $1.5 trillion in new issuance. Corporate issuance should be strong especially if interest rates remain low. Credit spreads are currently in the middle of their range established over the last few years, leaving plenty of room to either tighten or expand, depending on the direction of the economy. Low rates and tighter spreads offer the best of both worlds, providing corporations with extremely cheap financing. Similarly, we anticipate significant refinancing in the mortgage market.
Municipal Yields May be less Volatile than Treasuries
We anticipate an uptick in supply in the second half of the year as refundings come into play because the pool of outstanding bonds to be refunded is quite large. Municipal bond yields will likely continue to follow Treasures as both are subject to the same economic conditions. However, muni yields have the potential to be less volatile than Treasury yields because of favorable supply/demand dynamics.
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
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.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
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).