Credit Dominated in 2016

Geopolitical events had a profound impact on both sovereign and U.S. Treasury rates during 2016. Notably, the Brexit vote in June accelerated concerns about the potential of a global economic slowdown. The reaction was particularly acute in the European sovereign bond market with many high-quality sovereign yields hitting all-time record lows. At its peak, there was an astonishing $13 trillion worth of sovereign debt with negative yields. The impact was also felt across the pond. The yield on the U.S. 10-year Treasury note declined nearly 100 basis points (bps) during the first half of the year, from a 2.30% to near 1.35%.

Economic concerns surrounding the Brexit vote quickly dissipated during the third quarter of 2016 as interest rates edged slightly higher from their record lows. The November election in the United States was another catalyst for interest rate volatility; however, this time rates did not fall, but increased materially in November and December. The push higher in rates was fueled by expectations for economic growth and inflation under a Republican-dominated government. This trend higher was also felt across the globe.

Year-over-year, U.S. Treasury rates ended where we predicted at the beginning of the year, slightly higher. The Federal Reserve, however, was unable to push short-term interest rates up nearly as much as it communicated in January, with only one 25 bps move higher in December as opposed to the predicted four increases. The move in Treasury yields was pretty uniform across the maturity profile with the 5- and 10-year increasing by 18 bps and the 30-year increasing by just 5 bps.

It was a solid year for Treasury Inflation Protected Securities (TIPS), especially relative to similar maturity nominal coupon Treasuries. The implied breakeven inflation rate on the 10-year TIPS rose almost 40 bps to end the year near 200 bps. The implied inflation breakeven rate has been highly correlated to the price of oil and consequently fell in the early part of the year as oil prices declined to below $30 a barrel, but quickly recovered when oil prices stabilized and moved higher.

Corporate Bonds

Corporate bonds had an impressive year. For the fourth year in a row, new issue supply of investment grade corporate debt set another all-time record high. Corporations continued to take advantage of empirically low interest rates and seemingly insatiable demand. The total return of the corporate bond sector, as measured by the Bloomberg Barclays Aggregate Index, was 6.11%, compared to just 1.04% for Treasury securities. Longer-dated corporate bonds were particularly strong with total returns exceeding 10%. After a rough first two months, investment grade corporate bond spreads methodically tightened relative to Treasury yields. After starting the year at 165 bps, the yield spread peaked in mid-February above 200 bps but rallied back to end the year near 120 bps.

After a rocky start, high yield corporate bonds posted an even better year than investment grade corporate bonds. When oil was below $30 a barrel, many of the more leveraged companies in the energy, metals and mining subsectors appeared to be on the edge of bankruptcy, but subsequently rallied as oil prices rebounded from the mid-February low. On average, energy, metals and mining subsectors posted positive total returns in excess of 35% and helped boost the overall Bloomberg Barclays High Yield Index to its strongest year since 2009, with a total return of more the 17%. Correspondingly, yield spreads were volatile during the period. High yield spreads began the year near 660 bps and quickly widened to near 840 bps as oil fell during the first six weeks of the year. From mid-February, high yield spreads snapped back and continued to tighten throughout the remainder of the year. Yield spreads ended 2016 near 400 bps over Treasuries, some 250 bps tighter on the year.

Municipal Bonds

During the first three quarters of 2016, the municipal bond market posted modest total returns. Record-setting new issue supply was amply met by strong demand. Open-end municipal bond mutual funds had positive inflows starting in the fall of 2015 for 51 weeks in a row, totaling roughly $51 billion. The fourth quarter was a different story. Heavy supply continued but demand slowed as investors became concerned about higher Treasury yields and potential tax reform under the new Trump administration. The total return on the Bloomberg Barclays Municipal Bond Index in November was -3.73% compared to -2.37% for taxable bonds. That marked the third worst monthly return of the Bloomberg Barclays Municipal Bond Index in more than 20 years.

Outflows from municipal bond mutual funds exceeded more than $20 billion in the last eight weeks of the year. Tax-loss harvesting explains some of the year-end selling, but the municipal bond market clearly adjusted for the risk of the individual top marginal tax bracket and corporate tax rates both shifting lower under the Republican-proposed tax reform. Meanwhile, total new issue supply of municipal bonds set an all-time record of $445 billion, slightly surpassing the previous record of $434 billion, set in 2010, and last year’s level of $400 billion. Almost 40% of the new issuance came from states and localities refinancing older, higher interest cost debt.

The relative yield relationship between 10-year AAA-rated municipal bonds and similar Treasury securities adjusted by more than 10% in November. The yield on the 10-year AAA-rated municipal bond was actually higher than the 10-year Treasury yield before recovering in December to end the year at 95%, which is up from 85% at the beginning of the year.

Credit

As anticipated, the Commonwealth of Puerto Rico failed to pay debt service on their general obligation debt on July 1, marking the largest bankruptcy in the history of municipal bonds. The nonpayment of a constitutionally mandated liability was a key reason for Congress to step in and establish a federal oversight fiscal control board. While we still anticipate additional financial stress in Puerto Rico, the control board is needed to establish necessary discipline and force reasonable haircuts to ease the debt burden. However, given the complexity and large number of distinct interested parties, we are not optimistic about a quick resolution. Although the city of Detroit resolved its bankruptcy process within 18 months, Puerto Rico has many different issuers with their own unique structures, so it could take two or three years to work out the restructuring process.

Other than Puerto Rico, the overall credit landscape for municipal bond issuers continues to improve with a growing economy and rising property values. Compared to five years ago, the vast majority of states and localities have additional revenue sources to balance budgets. However, pension challenges remain and many general obligation issuers still maintain projected return assumptions on the pension assets that are too optimistic. There will continue to be isolated situations where our issuer has mismanaged their long-term liabilities, but we believe it is very important to maintain a critical eye toward credit quality to ensure an appropriate risk versus return profile.

Outlook

Our 2017 outlook for the fixed income market is similar to last year. We believe interest rates for intermediate and longer dated securities will end the year only slightly higher, but we may see volatility throughout the year. We continue to expect the Fed will be patient and gradual with its efforts to shift monetary policy from an aggressively accommodative policy (zero rate) to just accommodative. We believe the Fed will move the federal funds rate higher twice in 2017, once in the first half and again late in the year.

Given our expectation for the U.S. economy to grow at a modest pace for the eighth year in a row, the risk of the economy or inflation becoming “overheated” in 2017 remains low. We expect fiscal, regulatory and tax reform to have a positive impact on the economy, but negotiating the many complex details through Congress and the White House will take time. Consequently, we are more upbeat about the latter half of 2017. There are still important headwinds to consider, like a stronger dollar that will hamper trade for large multinational companies and continued geopolitical risk, including many important European elections in 2017.

Last year, the taxable bond market was buoyed by strong returns from both investment grade and particularly high yield corporate bonds. Given the relatively tight spread levels in the current market environment, it is highly unlikely that either asset class will deliver similar returns as last year. However, our positive economic outlook supports maintaining an overweight in both those credit markets compared to Treasury securities or other relatively low yielding, high-quality securities. We expect TIPS will again outperform nominal coupon Treasury securities, but caution against a material overweight given the superior performance that occurred in 2016.

We believe the municipal bond market is currently attractive and that concerns about dramatic tax reform and much lower top tax brackets are overdone. New issue supply should be materially lower in 2017 because higher interest rates will result in a significant decline of refinancings. Our projected level of new issue supply of municipal bonds is $400 billion, or 10% lower than 2016. We believe demand will be renewed once investors realize that even if tax reform is implemented, the top tax bracket will most likely be above 30%, making the after-tax advantages of municipal bonds still attractive.     

Although the bond market has recently seen heightened volatility and the indication is for rising interest rates, we caution clients against becoming overly pessimistic about bonds. We continue to recommend a well-diversified portfolio given the stabilizing role bonds play, as well as providing an important source of income. Especially critical in this environment is our active management approach that utilizes a rigorous, bottom–up process to identify undervalued securities, and thoughtfully controls risk.

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