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Quarterly Market Update

Fixed Income Outlook

Fed to Resume Role as Dominant Force Affecting Bond Market

The pending fed funds rate increase cycle is the dominant force affecting bond yields.

There have been several flight-to-safety inspired rallies in U.S. Treasury prices so far in 2015. However, although the safe-haven bidding has not ended, its impact on yields does appear to be waning. Despite the intra-quarter volatility witnessed on the heels of Greece’s threatened default and exit from the euro, Puerto Rico’s threatened default on its $72 billion outstanding debt, and a significant correction in the Chinese stock market, the yield on the 10-year Treasury continued to tread water in a fairly narrow band in the second quarter. The yield on the 10-year Treasury began the quarter at 1.92%, reached an intraday high of 2.49 % on June 10, and ended the quarter at 2.354%. The asset class generated a total return of -0.47% for the quarter and 0.87% for the year-to-date, as measured by the Bank of America Merrill Lynch U.S. Treasuries 1-10 Year Index.

The Treasury market has been caught in the middle between current events and future ones, but it increasingly appears that the future may be gaining the advantage. On the one hand, overseas threats have prompted safe haven buying in Treasuries, artificially suppressing yields. On the other, the U.S. economy is growing, albeit at a moderate pace, and payrolls are improving. As a result, the Fed has made it clear that it intends to move off the 0% fed funds rate which has been in place since 2008. This pressure to raise rates in order to head off inflation (and perhaps prevent another stock market bubble) has become the dominant force affecting bond yields.

Given that the Fed is poised to raise short-term rates, one would expect short-term rates to rise relative to long-term rates, resulting in a flatter yield curve. Instead, the U.S. yield curve steepened in the second quarter, perhaps indicating that the market is pricing in higher inflation in the future. Higher inflation expectations are reflected in higher long-term bond yields.


Figure 1. The yield on the 10-year Treasury continued to tread water in a fairly narrow band in the second quarter, and for much of the past year.

Although domestic inflation and Fed policy are perhaps the biggest influences on the position and shape of the U.S. yield curve, yields on foreign sovereign debt also have significant impact. All things equal, higher yields overseas mean higher yields in the U.S. and vice versa.

The Eurozone bond rally in place since the end of 2013 ended abruptly in the second quarter. The yield on Germany’s 10-year Bund, considered the risk-free rate inside the euro currency bloc, hit a record low in mid-April of 0.05%, rose above 1.0% in June, and ended the quarter at 0.77%, 158 basis points lower than that of its U.S. counterpart, and in line with the historical 150 basis points difference between the yields on the two instruments. The drop in German Bund yields caused by the onset of quantitative easing and weak European growth had clearly gotten overdone, so the correction there back to higher rates was not unexpected. The sharp rise in German yields clearly affected longer-term U.S. yields.

Corporate Bond Spreads Unexpectedly Widen

Investment grade corporate bond issuance stood at $870 billion through June 30, putting volume for the year on pace to exceed the current annual record of $1.15 trillion. Despite heavy supply, demand has remained strong for corporate bonds.

Spreads ended the second quarter on average 15 basis points higher on 10-year, A-rated financial bonds and 20 basis points higher on 10-year, A-rated industrial bonds, marking the first time corporate credit spreads have widened in several quarters. Industrials, which are more tied to the struggling cyclical economy, slightly underperformed financials. Rising interest rates actually helped limit credit spread widening on financials. All things equal, higher interest rates are a positive for financial companies to the extent they can earn more interest on loans. Bank credit rating upgrades also boosted returns on financial company debt. Moody’s conducted a review of the large domestic banks and found improved metrics (e.g. less debt on the books and healthy cash reserve levels) which warranted upgrades in some instances. Goldman Sachs and Bank of America were among the banks receiving upgrades from Moody’s.

Heavy flows into the Treasury market during the second quarter overwhelmed the corporate market and were another contributing factor to corporate spread widening. Treasuries outperformed both the financial and industrial bond sectors. Absolute returns for fixed income asset classes were overall negative for the quarter, but returns were less negative for Treasuries than corporate bonds, as measured by the Bank of America Merrill Lynch U.S. Corporates 1-10 Years A-AAA Index.


Figure 2. Given that the Fed is poised to raise short-term rates, one might predict short-term rates to rise relative to long- term rates. Contrary to expectations, the U.S. Treasury yield curve steepened in the second quarter.

Puerto Rico’s Debt Crisis is to the U.S. as Greece’s Debt Crisis is to the EU

The situation in Puerto Rico dominated municipal headlines. Some pundits contend that Puerto Rico’s debt crisis is to the U.S. as Greece’s debt crisis is to the EU, although Puerto Rico’s outstanding debt is “only” $72 billion compared to Greece’s $370 billion. Like Greece, the U.S. territory suffers from excessive borrowing, expansive social programs which have created public dependence, and a high unemployment rate of around 12%. Late in the quarter, the governor of Puerto Rico, Alejandro Garcia Padilla, announced that the territory’s $72 billion debt “is not payable”. Ultimately, Puerto Rico borrowed from an insurer to make its June payments. Going forward, some form of debt restructuring will be required to keep the Caribbean island afloat.

Puerto Rico municipal bond debt issues reach deep into the mutual fund, ETF, and hedge fund worlds. The island’s debt is triple tax exempt – federal, state, and local – across all 50 states, so frequently state-specific mutual funds will include Puerto Rico debt in their portfolios in order to boost the yield or fill the gap when sufficiently attractive state-specific municipal bonds are scarce. Because Puerto Rico cannot officially declare bankruptcy, as many as 35 major hedge funds began buying the debt a year to 18-months ago, betting that a solution will be reached. The attorneys for these hedge funds will likely play a large role in the overall restructuring and recovery rates on the island’s outstanding debt.

Puerto Rico aside, overall municipal bond credit quality trends have been improving as municipalities take advantage of strengthening local economies. S&P recently upgraded California, often painted as the “poster child” for municipal bond problems, to its highest rating in 20 years. Conversely, states with underfunded pensions including Illinois, New Jersey, Connecticut, and Kentucky have seen spreads widen on their credits.

Demand for munis remains relatively strong as high tax-free yields continue to attract investor interest. For the quarter, the yield on municipal bonds generally drifted higher in sympathy with U.S. Treasuries. The total return slightly lagged that of U.S. Treasuries, as measured by the Bank of America Merrill Lynch U.S. Municipals 1-10 Years A-AAA Index.


Figure 3. U.S. Treasuries outperformed both investment grade corporate and municipal debt in the 10-year space during the second quarter, 2015.


The real risk of Greece’s default on its sovereign debt and possible exit from the euro currency bloc is that it could potentially encourage other countries to attempt the same maneuver.

The Fed appears to have adapted to Greece’s default on its sovereign debt and possible exit from the euro currency bloc, indicating that the real risk is political rather than monetary. The overall amount of Greek debt spread among the major players in the EU including France, Germany, Spain and others is probably insignificant. The truth of the matter is that such situations are always about contagion – few care about Greece per se because its debt level is low, relatively speaking. The real risk is that Greece’s stand potentially emboldens left wing socialist candidates in other countries to attempt the same maneuver. If Greece should exit the EU, reinstate its local currency and economic conditions improve as a result, it could encourage other countries within the currency bloc to attempt the same. If on the other hand, conditions in Greece were to tank after the country left the currency bloc, then Greece’s example would be a harbinger to other countries considering an exit from the EMU and might compel those countries to assume some austerity measures voluntarily to make certain they stay in good standing with their creditors. Finally, if the EU and Greece ultimately reach a modified debt repayment agreement as expected, the austerity required of Greece will also act as strong motivation for other peripheral countries to get their act together and make good on their sovereign debt obligations.

U.S. Treasury Bond Yields May be Stuck in a Rut

We anticipate that yields on the 10-year U.S. Treasury will continue to hover within a narrow band of 2.25% to 2.50%. As we saw this quarter, it will take a larger crisis than those witnessed in China, Puerto Rico, and Greece to push the yield below 2.25%, and it will take stronger economic growth than current levels to push the yield above 2.50%.

New Capital Requirements Make Professional Investment Management Critical

We anticipate that corporate credit spreads will tighten to levels seen at the beginning of the second quarter, barring any significant credit event. Overall credit quality is improving which is inconsistent with widening credit spreads.

However, relatively new capital requirements may be pushing corporate bond credit spreads higher. The demise of the financial system in 2007 resulted in new laws requiring broker dealers to carry more capital to support their bond inventory. These requirements indirectly incent broker dealers to bring deals at an attractive price sufficient to get the bonds sold right off the bat, rather than hold them in their inventory. This can sometimes negatively affect bond prices toward quarter end because brokers are not bidding aggressively, thus allowing prices to fall and credit spreads to widen. Although not a liquidity crunch per se, the situation does create a sloppier market which makes professional investment management more critical than ever.

Municipal Bond Relative Returns Should Remain Attractive in a Rising Interest Rate Environment

As was the case in the first quarter, approximately 70% of all new issuance year-to-date is attributable to the refunding of old issues. Therefore, if interest rates remain low, supply will likely remain heavy. We anticipate that demand will continue to be strong for municipal bonds even if interest rates rise, given the federal tax structure with its 39% top bracket and 3.8% Obamacare tax. The Municipal/Treasury yield ratio in the 10-year space (as evidenced by AAA-rated municipal bonds yielding the same as comparable maturity Treasuries on an absolute basis) is currently 100%, up from the historical average of 85%. If interest rates rise by way of Fed tightening, then buyers will likely rush to buy municipals and the 100% ratio could again normalize at 85%.

While the absolute return of municipal bonds may not be positive in a rising interest rate environment, the relative return should remain strong versus other asset classes within fixed income.

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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.

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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;;; 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).