Weekly fixed income commentary | 01/22/2023 (2024)

Weekly fixed income update highlights

• The total returns were negative across most major asset classes, including Treasuries, investment grade and high yield corporates, preferreds and emerging markets. Each of those asset classes outperformed Treasuries.
• Municipal bond yields increased. New issue supply was $6.3B and fund inflows were $898M. This week’s new issuance is estimated to be $8.3B.

U.S. Treasury yields rose on healthy U.S. economic data and hawkish central bank commentary. Nevertheless, spread sectors generally outperformed Treasuries. The market-implied odds of a rate cut by March fell from 83% to 49%.

Watchlist

• The 10-year U.S. Treasury yield rose last week, but we anticipate declines in overall rates in the months ahead.
• Spread assets broadly outperformed Treasuries.
• Increased seasonal supply should provide an attractive entry point for municipal bonds.

Investment views

Rates have probably peaked for this cycle,as attention pivots toward rate cuts in response to softer growth and easing inflation.

The underlying growth outlook remainshealthythanks to strong consumer balance sheets and solid levels of business investment. This combination should keep corporate defaults low.

Risk premiums may widen further,with entry points for taxable fixed income likely to become more attractive over the coming quarters. Credit selection is key as we search for bonds with favorable income and solid fundamentals.

Key risks

• Inflation fails to continue moderating as expected, weighing on asset prices.
• Policymakers unsuccessfully juggle fighting inflation with supporting economies still struggling to gain traction.
• Geopolitical flare-ups intensify: Israel,China, Russiaand Iran.

Investment grade corporates see heavy issuance in January

U.S. Treasury yields rose last week,with the 10-year yield ending 18 basis points (bps) higher and the 2-year yield up 24 bps. The moves responded to strong U.S. economic data and hawkish central bank commentary. On the data front, retail sales beat expectations for December, with the core measure expanding 0.8% for the month and 5.6% year-over-year, the fastest pace in almost a year. Meanwhile, U.S. Federal Reserve Governor Waller said rate cuts are likely this year, “as long as inflation doesn’t rebound.” Waller is considered a useful gauge of the committee’s thinking and supports “methodically and carefully” lowering rates this year. The market-implied odds of a cut by March fell from 83% to 49%, and the total cuts priced for this year fell from 6.7 to 5.4.

Investment grade corporates weakened,returning -1.00% for the week. Nevertheless, spreads tightened further, to 95 bps for the index, leading the investment grade asset class to outperform similarduration Treasuries by 18 bps. Heavy new issuance of more than $47 billion met strong demand, with oversubscription rates of 4x on average. That resulted in very low new issue concessions of only 0.9 bps. New issuance has totaled around $145 billion so far this month – only $5 to $10 billion away from the preJanuary estimates for full-month supply – with eight trading days remaining.

High yield corporates also sold off,returning -0.52% for the week. The asset class outperformed similar-duration Treasuries by 5 bps. High yield corporates were helped by their relatively shorter duration versus investment grade. This dynamic also supported senior loans, returning 0.14% for the week. High yield saw a healthy inflow of $1 billion, while loan funds experienced outflows of -$3 million. Both markets saw relatively active new issuance, with $5.5 billion pricing in high yield and $23.9 billion in loans.

Emerging markets retreated -0.77%for the week but outpaced similar-duration Treasuries by 26 bps. Spreads tightened across the hard currency sovereign space, with both investment grade and high yield names compressing. Outflows nevertheless continued, with -$351 million leaving hard currency funds and -$210 million exiting local currency funds. Local currency markets returned -1.69% for the week. Unlike the U.S. corporate markets, the new issue market was relatively quiet in emerging markets. Only $10 billion priced for the week, the smallest weekly total of the year so far.

The municipal bond market sees impressive inflows

Municipal yields sold off last week across the curve.Short-term yields ended 11 bps cheaper, while long-term yields ended 14 bps cheaper. The new issue calendar was priced to sell and well received. Fund inflows were the highest in 25 weeks, including exchange-traded fund inflows of $189 million. This week’s new issue calendar should be priced to sell, as dealers want to keep inventory moving.

Muni bond yields are rich compared to Treasuries, so it makes sense that the tax-exempt space followed the Treasury sell off. Tax-exempt investors need more yield compensation versus rising government yields. However, much of the $37 billion of 01 January reinvestment money has yet to be invested. This should provide stability in the municipal market. New issue supply is building, but still manageable. We believe Treasuries in general should remain range bound, with munis following this pattern.

The North Carolina Turnpike Authorityissued $340 million revenue bonds (rated AA by S&P, as the deal was AGMC insured). It was priced to sell, but interest was tepid. In fact, some bonds traded in the secondary market at the same price as they were issued. For example, the 5% coupon bond due in 2058 came at a 4.23% yield and traded in block size at the same yield.

High yield municipal bond yields increased13 bps on average last week. Mutual fund inflows saw another strong week, and exchange-traded fund outflows slowed. New issue deals were well subscribed. The tobacco sector performed worst, led by Buckeye 5% coupon bonds with yields increasing 30 bps and producing a one-week total return of -4%. This week’s new issue calendar is expected to be very light, and demand in the secondary market should strengthen as a result to the extent fund flows remain on a positive trend.

$37 billion of 01 January reinvestment money should provide stability in the municipal market.

In focus: Securitized sectors looking sunny in 2024

The securitized sectors offer substantial value compared to similarly rated taxable fixed income sectors and are supported by strong fundamentals.

Mortgage-backed: Mortgage market fundamentals remain strong despite declines in home sales and high interest rates. Low home supply benefits the sector, but rising mortgage rates have cooled issuance. Non-agency MBS is particularly appealing given its high yields and supportive macroeconomic conditions. Agency MBS may be favorable for highgrade portfolios due to attractive valuations. We are selectively adding agencies to extend portfolio duration heading into the predicted Fed rate cuts this year.

Commercial mortgage-backed: While CMBS struggled in 2023, the current outlook is slightly more positive based on a soft landing and potential rate cuts in 2024. We are selectively adding high quality office exposure in tier one cities while looking to add credit risk in lower-rated defensive sectors like industrial and self-storage.

Asset-backed: Consumer and commercial credit performance have shown signs of stabilization, but risks remain where asset valuations have come under pressure. Because the fourth quarter rally generally tightened the sector, we expect ABS market sentiment to be driven by inflation, economic growth and the outlook for Fed rate policy.