US Treasuries: Treasury bonds kicked off 2020 with a strong rally in prices as global uncertainty escalated from dormant levels. Significant headline risk caused a volatile month for stocks, leading investors to the safety of Treasuries and other high-quality bonds. The S&P 500 finished the month slightly negative – the first monthly decline since August 2019. The Treasury yield curve flattened significantly in January, once again stirring up talks of a potential yield curve inversion and the consequences that come along with that. The Federal Reserve held its key policy rate steady at its meeting on January 29 and maintained its position that rates will be on hold until 2021.
Municipals: Municipal bonds opened 2020 with the best month for the sector since 2014. Yields approached and hovered around all-time lows, and relative valuations versus Treasuries continued to reach historically expensive levels. Despite this, the sector continues to see strong and increasing demand. Many signs indicate a shrinking supply, which should be an additional catalyst for prices. Taxable municipal issuance has increased and become a larger subset of the municipal market as the global search for yield continues.
Corporates: After finishing 2019 with the best year in over a decade, investment-grade corporate bonds continued their hot streak in January 2020, returning over 2%. However, high yield bonds generated negative returns as volatility emerged, oil prices declined and spreads widened out, most notably at the end of the month when global equities took a dive. Corporate spreads versus equivalent US Treasuries also widened slightly during the month, as investors exercised some caution and took more cover in the form of US Treasuries. Institutional asset managers are again raising doubts about corporate bonds with the lower, investment-grade ratings as growth concerns persist.
TREASURY MARKET OVERVIEW
Treasury prices increased notably in January as fear overwhelmed the risk-on environment that took hold during Q4 2019. Treasury bonds got a head start on global equities in January with news of the outbreak of the coronavirus, coupled with geopolitical news out of the Middle East led investors to the safety of Treasuries. This continued the trend of stocks running counter to bonds that really emerged in Q4 2019. However, in this case, it was the Treasury bonds that led the way, finishing the month up over 3% – the best month since August 2019.
After beginning 2020 at its lowest beginning yield since 2013, the 10-year Treasury yield fell 41 basis points. The benchmark yield finished January at 1.51%, just 16 basis points above the all-time low! Yields across the Treasury curve declined sharply, but those with longer maturities experienced the largest move downward, as headlines raised already strong concerns over global growth and uncertainty. In this case, the fear came largely from a source very few expected (disease outbreak), and we attribute this unexpected catalyst as a significant reason for the demand for bonds in January.
The Federal Reserve’s Open Market Committee met for the first time in 2020 on January 29 and held its key policy rate steady. Despite the barrage of negative headlines, the committee indicated that it still expects no further action on rates until 2021. Chairman Powell explained that he wants to see inflation (leading to interest rate hikes) or the economy faltering (leading to interest rate cuts) before making any changes to the committee’s assessment.
However, the interest rate futures market disagrees. As of January 31, futures indicated that the market assigned a 91% chance to 1 Fed Rate cut and a 65% chance of more than 2 Fed Rate cuts. These are way up from the end of 2019, where the market assigned a 50% chance to 1 cut and a 14% chance of more than 2 cuts. As such, the 2-year Treasury, which tends to be the most tied to Fed actions declined to 1.31%, a level that is well below the Fed’s target range of 1.5 to 1.75%. The 2-10 spread, which had widened to its highest level of 2019 in December, reversed course and narrowed to 19 basis points at the end of January.
A lot can change in a month, and Treasury market participants are certainly expecting action soon from the Fed based on these signals.
MUNICIPAL MARKET OVERVIEW
TAX-EXEMPT YIELD SUMMARY:
TAX-EXEMPT YIELDS AS A PERCENTAGE OF TREASURIES:
Municipal bonds gained more than 7% in 2019, their biggest annual jump in 5 years. The party did not stop in January 2020, as the sector generated the best month since 2014, fueled by safe-haven demand but also favorable supply/demand interplay. Municipals have now gained in 14 out of 15 months, providing steady returns as tax-exempt yields reach historic lows. The 10-year AAA municipal benchmark yield closed January at 1.18%, the lowest close of all-time. This breached the previous low of 1.25% reached in August 2019.
These historically expensive levels continue to be met with an overwhelming demand for investors seeking tax-exempt income. Municipal bond mutual funds saw $1.8 billion of new cash for the last week of January, the 56th consecutive week of inflows. This was higher than the $1.5 billion average weekly inflow for 2019.
One technical dynamic supporting the municipal market is the slowly shrinking size of the entire municipal market as a result of negative net issuance. Simply put – the money investors receive from interest and principal payments of existing debt exceed the amount of new debt being sold. Citigroup estimates that in February 2020, this difference will amount to approximately $10.5 billion.
While the difference on a monthly basis is slight, the $3.8 trillion municipal markets have shrunk in the face of record issuance. Expectations for 2020 are for $420-450 billion of issuance, a 10% increase from 2019. Much of this has been taxable municipal issuance, which totaled $80 billion in 2019, more than double from the previous year.
However, according to Breckinridge Capital Advisors, the municipal market has shrunk by over $100 billion over the last 2 years. This is occurring at a time when demographic shifts and legislative changes have caused significant money to pour into municipal bonds. Supply and demand statistics indicate that the strength in munis will likely continue until there is a downside catalyst, such as a sharp rise in interest rates.
Municipal valuations across the curve reached historically expensive levels, especially on bonds with shorter maturities. Specifically, the 1-year AAA municipal yield declined to 57% of an equivalent US Treasury, the lowest level in the last year. On the longer end, the 10-year AAA municipal yield offers 78.5% of a 10-year US Treasury. This ratio declined to 72% in mid-January but increased to finish the month closer to its 2019 average of around 80%.
The municipal yield curve flattened slightly in January as yields on longer-term bonds fell slightly more than that of short-term bonds. The 2-10 spread in municipals decreased to 36 basis points in January while the Treasury curve sits at 19 basis points. Similarly, the 2-30 spread in municipals is 32 basis points above the same spread for Treasuries. Despite this flattening, relative value still resides on the intermediate and long portion of the municipal yield curve.
CORPORATE MARKET OVERVIEW
INVESTMENT GRADE YIELD SUMMARY:
CORPORATE BOND SPREADS VERSUS TREASURIES:
Investment-grade corporate bonds continued their momentum from last year with a strong, positive month in January as equity market volatility emerged. As measured by LQD (corporate bond benchmark ETF), corporate bonds returned 2.45% during the month. High yield bonds, on the other hand, struggled with this volatility and a sharp decline in oil prices(down 15.6%) added to the negative performance.
Corporate bond spreads widened slightly in January, off historically low levels. Using the 10-year corporate spread as a benchmark, the spread finished the month at 112 basis points after closing at the lowest yearly spread of all-time at the end of 2019. Widening spreads in high yield bonds are also of note, as investors bought Treasuries and other safe havens instead.
The issue “du jour” for the corporate markets continues to be the swelling debt levels, especially of BBB-rated credits, and the overall leverage in the corporate market as the US economy potentially enters the late-cycle. The pace of bond sales in January reached $130 billion, the second-biggest January by dollar volume on record. With economic growth relatively stagnant in major global economies, heightened risk of disappointing earnings and greater regulation in areas like technology, a wave of investment-grade companies could get cut to junk over the next 12 to 18 months, according to institutional asset manager KKR.
While BBB bonds gained more than the overall corporate market in 2019, slowly deteriorating economic conditions are a headwind for these credits, which are one step above junk. KKR expects more than 20% of BBBs in the US, or $660 billion, to get cut to junk in the next downgrade wave, amounting to a record level of new high-yield bonds known as fallen angels. This would create a ripple throughout fixed income markets, as investors and funds that have strict credit requirements would be forced out of these bonds, adding further to downward pricing pressure. The corporate market has been expecting a catalyst to set off this domino effect as far back as 2018. At that time General Electric, a long-time blue-chip company, plunged into considerable turmoil after another leadership change and an increasingly toxic balance sheet. This set off several warning signals in the corporate market and contributed to the widening of spreads and a minor sense of panic in Q4 2018. While we don’t necessarily expect it soon, there is reason to believe that even a small wave of downgrades in BBB bonds could have a significant impact on the overall corporate bond market.