Fixed Income Outlook

Global Interest Rates on Path to Normalization

U.S. bond market yields moved higher last year based on the Trump agenda, and if the major parts of that agenda do not get passed, then the economy is expected to move back to where it was – at 2.00% growth.

As we discussed in the previous issue of BBVA Compass Market Outlook, the baton is indeed passing from central bankers to policy makers. While not entirely glitch free, the Fed appears to have the path to higher interest rates well in hand. Progress on the Trump economic agenda has met with less success of late, showing some signs of unraveling after the Obamacare repeal fell through. Indeed, long-term interest rates fell in the wake of the unsuccessful bid, reflecting the consensus that the Trump stimulus initiatives are less of a given.

Long-term Treasury yields, which are largely driven by the U.S. economic and inflation outlook, declined modestly in the first quarter after spiking sharply in the wake of the presidential election. The 10-year U.S. Treasury yield ended the quarter at 2.38%, slightly down from 2.45% at yearend. The bellwether Treasury traded around 2.40% until the end of February when the Fed’s tone turned more hawkish. Yields then surged to 2.60% before declining after the repeal of Obamacare failed.

The bond market has been fairly volatile in the first quarter of the past few years due to economic malaise and flights to safety. One-percent swings in the 10-year Treasury yield have been fairly common. But this year, yields moved within a band of 2.30% to 2.60%, a relatively tame variance as the economy has performed as expected and there were no other major unexpected events.

Short-term Treasury yields, which are largely influenced by monetary policy, rose in the first quarter on expectations of two, and possibly three, more Fed rate hikes before yearend. The yield on the 2-year ended the year at 1.19% and rose to 1.26% at the end of the quarter. The Treasury yield curve flattened in the first quarter after the yield on the 2-year note rose seven basis points while the yield on the 10-year Treasury fell seven basis points. Expectations have been for the yield curve to steepen as the U.S. economy becomes more self-sufficient and Trump begins to make good on his stimulative campaign promises.

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10 Year Treasury Note First Quarter 2017

Record Corporate Issuance Shows No Sign of Stopping

Because historically low interest rates and steady economic growth create a good environment for leverage, companies have been loading up on cheap debt to finance share buybacks. And because investors have been desperate for yield, they have piled into these new corporate issues with both feet. Companies will issue either bonds or stock, depending on what is least expensive to issue, and right now that is debt. Indeed, investment-grade new bond supply for the first quarter crossed the half trillion-dollar mark. New issuance hit a record last year, but first-quarter 2017 investment-grade issuance was 11% higher than for the same period in 2016.

In the corporate market, the rising tide lifted and lowered all boats; there was not much distinction or segmentation between credit quality or position on the maturity curve. Because the equity market was fairly steady, corporate spreads generally followed the equity market’s lead. Secondary spreads gradually tightened in January and February, hitting their tightest point in the first week of March – the tightest level since September 2014. High yield corporate bonds followed the same pattern, even in the face of weaker oil prices. In mortgages, spreads on higher coupon bonds generally widened while lower coupon spreads stayed fairly tight relative to the 10-year Treasury.

Municipals Stuck In Wait and See Mode

Municipals started the year with strong buying thanks to bond holders who reinvested their December 31 coupon proceeds, but the rally faded as the quarter advanced. Limited supply coupled with steady demand from year end reinvestment pushed yields down. The yield on the 10-year Municipal dropped from 2.32% to 2.25%, while the 5-year declined from 1.79% to 1.55%. This created a steepening in the short to intermediate part of the yield curve. Issuance has been on the decline, down 6% in February versus the same period last year, and the March numbers will probably show a similar decline. With new supply down, the secondary market has firmed. We took advantage of the strong bids in the secondary markets to sell weaker credits in the BBVA Compass portfolios.

Fund flows have been erratic; a few weeks of positive flows followed by a few of negative ones, so that no real trend has emerged. This is certainly unlike last year when the municipal market saw over 30 weeks of positive flows into tax-free municipal funds. However, demand growth has languished some due largely to uncertainty surrounding tax reform. All things equal, lower marginal tax rates, as contemplated by Trump, lower the demand for tax-exempt bonds. There is also a great deal of ambiguity surrounding infrastructure spending and what happens to state and local budgets. Once tax reform and infrastructure spending are sorted out – and they all affect each other – we will have a better picture of the supply/demand landscape.

The relative value of municipals to Treasuries (i.e., the yield of 10-year AAA rated tax-exempt bonds as a percentage of 10-year Treasuries) closed the quarter at 95%, right in the middle of the historic 90% to 98% range.

Key Fixed Income Asset Class Returns First Quarter 2017

Outlook

Investors appear to be taking the migration toward higher interest rates in stride and have adopted a wait and see approach to the prospect of pro-growth initiatives.

Core bond dynamics were largely unchanged from last quarter and could continue in the same vein for much of the year, absent any major negative geopolitical events. Investors appear to be taking the migration toward higher interest rates in stride and have adopted a wait and see approach to the prospect of pro-growth initiatives. With the Fed raising short-term interest rates, it will take inflationary pressures to push long-term interest rates up more than short-term interest rates in order to steepen the yield curve. Because U.S. interest rates remain higher than those in other developed nations, foreign buying of U.S. Treasuries could continue to suppress long term interest rates.

We anticipate that the yield on the 10-year Treasury will close the year between 2.50% and 3.00%. The bond market is looking for cues from Washington and the Fed as Treasury yields are highly dependent upon both. Should the economy continue its sanguine trajectory, 10-year Treasury yields may remain in the neighborhood of 2.50%. But if the Fed tightens twice more, rates should rise. Similarly, if the Trump agenda meets with success, 10-year yields should begin pushing towards 3.00%. U.S. bond market yields moved higher last year based on the Trump agenda, and if the major parts of that agenda do not get passed, then the economy is expected to move back to where it was – at 2.00% growth.

On the fiscal side, tax reductions are the first order of business now that Supreme Court Justice Gorsuch has been sworn in. Republicans are expected to introduce lower individual tax rates and business tax reforms. The most controversial issue in tax reform is the border adjustment tax which casts American companies who rely on imports against those that rely strictly on exports. The former is against the proposal while the latter, the reform camp, supports it. The border adjustment tax was the carrot the Legislature was planning to use to make the argument on how to pay for tax cuts and balance the budget.

Corporate Credit Spreads Are Likely Range Bound

Investment-grade corporate bond supply should remain strong in the second quarter, although new issuance tends to die down during the summer months. Credit spreads will likely stay range bound short of a major victory for the Trump agenda, a victory which could induce additional spread tightening. Finance names have the best opportunity to tighten because additional rate hikes are very probable, which should help bank revenues. That said, even given the likelihood of rate hikes, for finance credit spreads to tighten materially, additional inflation is needed in order to push long-term yields higher and steepen the yield curve.

Municipals Should Continue to Track the Treasury Market

In the short run, municipals will closely track the Treasury market and relative values should remain in the 90% to 98% range short of any significant advances in stimulus programs. Barring stimulus-related swings, the next two quarters could be rather quiet for the municipal market. But fourth-quarter municipal markets tend to be less predictable due to supply/demand factors, and this year that will occur around the time that we will know more about tax reform.

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BBVA Compass is the trade name for Compass Bank, Member FDIC, and a member of the BBVA Group.

Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.

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), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).