Quarterly Market Update
Fixed Income Outlook
Foreign Buying of U.S. Bonds Providing Price Support.
While low single-digit yields seem anemic from an absolute standpoint, the U.S. debt market offers one of the few places in the developed world where investors can find a relatively attractive yield.
Two major events roiled the U.S. Treasury market in the second quarter. Early in the quarter yields drifted higher as investors anticipated the Fed’s next rate hike. But yields quickly dropped after the initial May employment report indicated the slowest pace of jobs growth in five years. A few weeks later, on June 23, the United Kingdom unexpectedly voted to leave the E.U. As a result, interest rates plunged and forecasts for the next hike in the Fed Funds rate moved to 2017.
On the heels of Brexit, the rally in U.K. gilts pushed yields on that debt into negative territory, adding another $1 trillion to the amount of sovereign bonds worldwide yielding below 0.0%. Global sovereign debt with negative yields now sums to over $12 trillion. The yield on the Swiss Kurd went negative the complete length of the curve, from one-day issues to 30-year issues, an unprecedented event in the country’s history. The yield on the 10-year U.S. Treasury fell overnight from 1.75% to 1.47%, only fractions higher than the record closing low of 1.40% set in July 2012. Yields on the 10-year Treasury began the year at 2.17%, fell to 1.75% at the end of the first quarter, and ended the second quarter at 1.50%, resulting in the largest six-month price gain since the six-month period ended June 2010.
The theory of relativity certainly dominated the U.S. bond market in the second quarter. While low single-digit yields seem anemic from an absolute standpoint, the U.S. debt market offers one of the few places in the developed world where investors can find a relatively attractive yield. Moribund global economies have led to record levels of monetary stimulus abroad such that yields on 10-year government bonds in Germany, Japan, and Switzerland all trade below zero. Further increasing the attractiveness of U.S. debt, foreign investors have the potential for a double win – a higher yield than they can find in their own country plus potential for the dollar to appreciate versus the home currency. While many domestic Treasury buyers have remained on the sideline, the vast majority of Treasury purchases have come from overseas.
Corporate Credit Spreads Range Bound
Credit spreads remained relatively range bound the entire second quarter until Brexit. After the initial Brexit shock was digested, the corporate bond market responded more to Treasury market events than to Brexit. Globally, credit spreads on finance bonds initially widened on the U.K.’s surprise vote and uncertainty about how the exit would play out. But by quarter-end, spread widening had reversed on both the domestic and global front. The change in global credit spreads largely reflected what was happening in the equity market and to risk premiums in general. The initial investor response was “risk off” and then, upon further review, it became more apparent that the outcome of Brexit might not be as horrific as was originally feared. Equities and credit spreads subsequently rallied.
Companies continued to take advantage of the attractive financing opportunities afforded by the low interest rate environment as the quarter saw roughly $900 million in new supply. New issuance slowed temporarily around Brexit, but excluding that time period, corporate bond issuance continued at a strong clip. Because so many companies are eager to issue debt, the normal summer pattern of lighter issuance may not be as evident this year. With the proceeds from the new debt, companies are typically buying back shares or raising their stock dividend. Additionally, there has been a great deal of merger and acquisition activity financed through new bond issues.
Negative Yields Abroad Lure Foreign Investors into Municipals
Lipper recently noted that municipal bond funds have experienced positive cash inflows for 39 consecutive weeks. Demand for munis is coming not only from the traditional buy-and-hold mom and pop buyers, but, for the first time in history, from foreign buyers. Faced with negative interest rates in their own countries, foreign banks and pension funds are taking their first look at municipal bonds, and evidently liking what they see. The low volatility, steady returns, and low default rate of municipals are an attractive alternative to foreign investors. Given that overseas buyers do not benefit from U.S. tax-exemption on interest payments, they tend to favor higher yielding tax-exempt bonds and even taxable municipal bonds (yes, those exist).
Cash from international buyers has lifted municipal bond prices and held yields to record lows. The yield on the 10-year AAA general obligation bond began the second quarter at 1.70% and fell to 1.35% at quarter-end. The municipal curve continued to flatten. The spread between two-year and ten-year bonds shrank from 102 basis points to 70 basis points during the quarter. The spread between A- and AAA-rated bonds remained at roughly 52 basis points, where it has been tracking for the last six months.
While demand for municipal bonds may be strong, munis are not without their risks. On the last evening of the quarter, Puerto Rico defaulted on $2 billion of debt. The event was not a surprise to the market, as the default has been expected for some time. The next step will be for the U.S. Congress to begin restructuring the territory’s debt.
The notion of populism in global voting trends, such as what we saw with the Brexit vote, bears watching.
Bond Yields Constrained for Balance of the Year
We anticipate that the yield on the 10- year Treasury will end the year under 2.0%. With the Fed on hold and foreign buyers flooding in, it will be difficult for the yield to get above 2.0%. The front end of the curve is Fed dependent so it is not expected to move a great deal. The long end is more dependent on inflation and economic growth. Any flattening of the curve will be dependent on what the long end does. If the Fed remains on hold as expected for the remainder of the year, the yield curve should end the year about where it is, or even steepen a bit if inflation begins to emerge.
Corporates Attract Domestic Buyers
Because Treasury yields are so low, we anticipate corporate bond yields will fall as investors’ quest for income continues. Just as international investors are buying Treasuries, domestic investors are buying corporate debt, looking for bonds offering any additional credit spread.
Municipals Lure Foreign Investors
We anticipate that yields on municipal bonds will continue to track that of Treasuries, yielding on average 88% to 95% of Treasury yields. Demand will remain strong as investors seek the low volatility that municipals have historically offered. Foreign buying is likely to continue as municipal bonds offer a haven from financial-market turmoil because traditional investors tend to hold muni bonds until maturity, bypassing the bouts of selling that can cause prices to whipsaw.
Multiple Economic Headwinds and Few Tailwinds on the Horizon
The global economy faces a number of economic headwinds and few tailwinds. When combined with pending events, including the U.S. presidential election, a cautious approach to assuming risk is warranted. While the primary headwinds include the usual suspects – the Fed’s exit strategy and financial volatility on the domestic front, further slowdown in China and other emerging market countries and deflation/recession threats in Europe on the global front – a new risk to global economies is also taking shape.
The notion of populism in global voting trends, such as what we saw with the Brexit vote, bears watching. Because people are increasingly concerned about controlling their borders as incidents of terrorism increase, a hint of nationalism is evident as is the rejection of one world-order government. Should global voting trends continue in this direction, particularly if Mr. Trump were to become president, that would open the door for increased market volatility.
In the U.S., the presidential election is an opportunity for more volatility, particularly if protectionist rhetoric from both candidates grows louder. Pundits say that a Clinton choice is more market friendly since she is a more conventional candidate and known quantity. Her election is thought to render less market volatility. On the other hand, some pundits say that because Mr. Trump is new to the political landscape, any predictions about what he might do are difficult to gauge, thereby making his election a more charged result likely to produce roiling volatility in the bond and equity markets.
After the initial selloff that struck the financial markets in late June immediately after the Brexit vote, equity prices rebounded quickly and credit spreads likewise tightened back to levels present before the vote. The quick recovery was likely based on the notion that the U.K. could possibly get off lightly in terms of trade negotiations and remain essentially a de facto member of the E.U. We tend to disagree with this notion, anticipating that the other EU countries in the 19- nation currency union could hold a hard line against Great Britain when negotiating new trade agreements. Certainly, the loss of the U.K. costs the E.U. one of its strongest economies and largest military powers. Terms of the U.K. departure will be negotiated over the next two years, perhaps holding much of the entire European continent somewhat in limbo for a protracted period of time.
As we have repeated many times, uncertainty is an economic headwind. We anticipate protracted uncertainty in Europe, an area which represents a large chunk of global GDP. China and the U.S. will need pick up the pace to help carry global growth. While initiatives are underway to speed the Chinese recovery, including a cross-country high speed rail that will require a large amount of fiscal spending, the pace of recovery remains unclear.
In comparison, the U.S. has had essentially no help from the fiscal side due to political gridlock, leaving only the monetary side to stimulate growth. Our sympathies go out to central bankers around the world who have pledged to do whatever it takes to help stabilize their respective economies, while receiving little to no help from the fiscal side.
After penciling-in as many as four rate increases to be spread across 2016, it now appears that the Fed could be essentially out of business for the remainder of the year. The Fed must balance domestic and global concerns. Expectations for inflation are sinking, and the slowdown in China and other emerging countries could further weigh on the U.S. economy. Spring jobs data has been revised higher and consumption is holding on, but manufacturing and exports are in the doldrums. Given these facts, we look for the bond market to remain firm unless inflation begins to emerge (not likely just yet) or credit concerns from weak global growth infect the corporate bond market. Municipal bonds look to be the least volatile since the domestic economy looks okay, limiting the opportunity for significant credit spread widening. Even though the environment looks pretty supportive of bond prices, another rally like the one seen in the second quarter is very unlikely and, given the incredibly low level of interest rates, tight credit spreads, and long bond durations, maintaining a neutral to slightly short portfolio duration/average maturity while focusing on the better credits still looks like the most prudent path.
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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.
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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).