So far this year, fixed income returns have been modest to slightly negative, although there have been pockets of strength from high yield and municipal bonds as investors search for yield. We believe the outlook for economic growth in the second half of the year is strong and expect intermediate- and long-term Treasury rates to move modestly higher. We are forecasting the 10-year Treasury yield to hit a new high for the year – yet staying under 2.0% – and for the magnitude of corporate credit outperformance to diminish.
This all supports our small underweight to fixed income overall. But don’t abandon fixed income altogether. A high quality, well-diversified fixed income portfolio should continue to play an important role within an investment portfolio, serving as a ballast during uncertain times.
Here we discuss what’s happened in the first half of this year in the U.S. fixed income markets, and what to expect between now and year-end.
U.S. Treasury Curve to Modestly Flatten
At the beginning of 2021 we expected a V-shaped recovery to ignite temporary inflationary pressures and push the U.S. 10-year Treasury yield to a high of 1.75%. That happened, but much faster than expected, as the Democrat’s surprise win in the Georgia senatorial run-off election raised the possibility of the Democrat’s slim Senate majority leading to greater fiscal spending.
The Democrats did take advantage of their new-found majority to pass the $1.9 trillion American Rescue Plan. The additional fiscal stimulus, coupled with a higher probability of an infrastructure bill getting through Congress, pulled the rise in intermediate- and long-term Treasury yields we expected over the course of the year into the first quarter.
The trend of higher yields reversed in the second quarter, however, with the 10-year Treasury yield rolling back down toward 1.50%, despite impressive economic growth and corresponding inflationary pressures. While U.S. economic data did begin to moderate, we believe the move lower in Treasury yields is more technically driven and not a signal that the economy is slowing down. In our view, this up and down move in interest rates is likely to continue as markets wrestle with the strength of economic data, higher inflation expectations and the fading of both fiscal and monetary policy.
Exhibit 1: Interest Rates Stabilize
Total returns for domestic taxable fixed income securities were slightly negative to positive for the first half of the year, with a move lower in longer-term Treasury yields during the second quarter helping to trim first quarter losses. The Bloomberg/Barclays Aggregate Bond Index delivered a negative total return of 1.6% for the first half. The Treasury market component of the benchmark was the worst performing, with returns down 2.6%. Treasury Inflation-Protected Securities (TIPS) fared much better during the first six months of the year, producing a slightly positive return of 1.7%.
Exhibit 2: Index Total Returns
For the rest of this year, stronger economic growth will underpin higher inflation expectations, which should nudge Treasury yields higher – with moves more pronounced at the short end of the curve. While persistent economic growth may accelerate the timing and magnitude of the Fed Reserve’s bond purchases, we do not believe the Fed will alter monetary policy – especially the federal funds rate – for at least another year. As the bond market prices in the eventual interest rate lift-off, yields on 3- to 7-year Treasury notes will likely push higher to a greater degree than the long-end. In other words, we could experience more flattening of the yield curve, much like we saw in the second quarter of this year. Year-to-date, the 2- to 30-year Treasury yield differential has been volatile: 150 basis points at the start of the year, steepening to nearly 240 basis points by the end of the first quarter, and ending the second quarter near historical norms of 180 basis points. We would not be surprised to see the curve continue to flatten towards 150 basis points before year-end.
Exhibit 3: Treasury 2s-30s Yield Curve
Our outlook now recognizes the growing likelihood that the benchmark 10-year Treasury yield will hit a new high over the next few quarters. However, we would be surprised if it climbs materially above 2% or dips below 1% anytime soon.
The breakeven rates on TIPS have also been quite volatile. The 5-year TIPS breakeven rate peaked at the end of the first quarter near 275 basis points and ended the first half of the year below 250 basis points. We still favor some exposure to TIPS, and would look to increase our holdings on weakness, because we believe TIPS will outperform nominal Treasury securities. Even so, we caution against materially overweighting TIPS, as our total return outlook for all Treasury securities is muted to negative.
Exhibit 4: 5-year TIPS Breakeven Rate
Credit Outperformance may Diminish
Corporate bonds posted relatively strong performance over the first six months of 2021, led by high yield bonds. Demand for yield coupled with an improving credit quality outlook helped cushion the price declines attributed to higher Treasury yields. Investment grade corporate bonds nonetheless produced negative returns for the first half of the year, while lower credit quality high yield bonds experienced positive total returns.
Exhibit 5: Credit Spreads Even Tighter
Following last year’s record-setting new issue volume, investment grade corporate bond supply fell by more than 33% in the first half, compared with the same period in 2020. However, high yield new issue volume set a record-high in the first six months of the year and is on pace to set another record by year-end. Corporations have been aggressively borrowing capital to take advantage of the low interest rate environment and to extend debt maturities. Many corporations have been borrowing with no immediate plan for the use of proceeds, other than “general corporate purposes.” The level of issuance is quite bullish for the equity markets, as corporations deploy capital to finance mergers and acquisitions, pay dividends, or buy back shares. However, bond investors need to be vigilant and monitor the risk of corporations becoming too leveraged, especially if the economy deteriorates.
While the corporate bond market has performed relatively well versus Treasuries year-to-date, we believe the magnitude of outperformance will be diminished in the quarters ahead. The degree of additional yield pickup by going from AAA to lower credit quality corporate bonds has compressed toward historically narrow levels. That said, we recognize that strong corporate profitability, low defaults, and robust global demand for any form of additional yield should guard against a significant widening of spreads. Corporate bond new issuance may also continue to trend lower as corporations have already borrowed aggressively, and a slightly higher interest rate environment could dampen enthusiasm for further borrowing.
Municipal Bond Demand Still Strong
After slightly underperforming taxable fixed income in 2020, municipal bonds posted much stronger relative and nominal returns in the first half of 2021. Demand has been buoyed by the combination of a drastically improved fiscal outlook and the prospect for higher taxation of the wealthy. Municipal bonds attracted more than $55 billion inflows in the first six months of the year. At this pace, it looks set to shatter the previous record of $93 billion in 2019.
Exhibit 6: Municipal Flows Accelerate
Strong demand outweighed supply and helped cushion the move higher in municipal bond yields relative to Treasury bonds. The yield on AAA-rated 10-year municipal bonds only increased 27 basis points compared to 54 basis points on the 10-year Treasury note. Demand was particularly acute for longer maturity and lower credit quality munis. The yield on 30-year AAA-rated municipal bonds inceased just 7 basis points, versus 47 basis points on the 30-year Treasury yield. During the first half, the total return of lower credit quality BBB-rated municipal bonds significantly outpaced high-quality AAA-rated returns, up 4.0% and 0.30%, respectively.
Exhibit 7: Municipal Bond Yields as a Percentage of Treasury Yields
Exhibit 8: AAA-Rated Municipal Bond Yield Curve
The economic recovery and the direct support of $350 billion to states and localities from the American Rescue Plan Act has led to a complete turnaround for even some of the weakest municipal credits. In a somewhat surprising event, Moody’s Ratings Agency upgraded Illinois from low-BBB to mid-BBB at the end of the second quarter.
Most states and localities probably did not even need support. For example, in June last year the state of California had projected a deficit as large as $50 billion on a $165 billion annual budget. However, as early as December of 2020 those negative forecasts were clearly wrong. Nevertheless, the state of California received an additional $30 billion in direct federal aid in the first quarter of 2021. Earlier this month it was reported that the state of California could have a surplus of more than $75 billion.
Some municipal bond issuers that were negatively impacted financially by the pandemic – like the Metropolitan Transportation Authority of New York – arguably needed direct support. Nevertheless, the credit quality of municipal bond issuers is now much stronger and helps rationalize the strong returns on the low credit quality issuers over the past six months.
Exhibit 9: Percentage Change in Total Reserves
Our outlook for the municipal bond market for the rest of the year is more cautious. Although munis significantly outperformed Treasuries during the first half of the year, we don’t anticipate the same degree of outperformance for the remainder of 2021. The supply/demand imbalance has pushed down the relative after-tax advantage of tax-free municipal bonds to historical lows on all maturities. Furthermore, the additional yield differential between low- and high-quality municipal bonds has also collapsed. Also, longer maturity municipal bonds have already produced outsized returns, diminishing the opportunity set going forward.
Exhibit 10: Municipal Credit Quality Returns
Even so, a slowdown in demand for munis still seems unlikely and supply will be manageable. The fear of higher taxes supports demand, and even if a large infrastructure bill makes its way through Congress it will most likely be financed through the taxable bond market rather than the tax-free municipal bond market. Also, the near-term credit outlook for munis is as favorable as we can recall. The fiscal stimulus has truly been a gift for states and localities. Federal support and increasing tax revenues have swelled general fund balances for most municipalities. But the bad news is spending budgets are also expanding, which could make it more difficult to manage during an economic downturn.
Emerging Market Debt Still Offers High Yields
Emerging market debt had a very bumpy ride over the last six months. On average, emerging market bonds have much longer maturities compared to other taxable fixed income markets, which makes them more sensitive to rising Treasury yields. Not surprisingly, the first quarter of 2021 was very difficult for the asset class. The Bloomberg/Barclays Emerging Markets USD Aggregate Index was down nearly 3.5% for the first quarter, but by the end of June the index almost fully retraced its first quarter losses. We think emerging market debt continues to offer attractive yields relative to even high yield corporate bonds.
Exhibit 11: U.S. Corporate High Yield Index vs Emerging markets USD Aggregate: Yield-To-Worst
For the second half of the year we expect interest rates to continue their pattern of rolling up and down, but with a modestly higher trajectory. Higher yields will translate into muted total returns for the fixed income market overall, which is why we maintain a small underweight. However, we remind our clients that having some exposure to the asset class is important during times of uncertainty. Our thorough, disciplined approach to fixed income investing can serve to both protect our clients’ assets as well as uncover opportunities to increase long-term value.