Despite the enthusiasm for pro-growth policies following the surprising Republican sweep of the White House and Congress in November, the U.S. economy muddled along during the first half of the year at roughly the same pace experienced over the last six years. Optimism began to fade as the new administration failed to pass any material fiscal stimulus on health care, tax reform and infrastructure. Yet, equity markets were buoyed by solid corporate earnings, while the bond market seemed to focus on the current economic scorecard. Consequentially, yields on intermediate- and longer-dated maturities were generally lower during the reporting period, despite the Federal Reserve pushing short-term yields higher.


Muted inflationary pressures and low global sovereign yields were the main catalyst that drove intermediate- and longer-term Treasury yields lower during the first half of the year. The 10-year Treasury note yield ranged from a high of 2.63% in early March to a low of 2.12% in early June. The benchmark ended the period only modestly lower than the beginning of the year, at 2.31% versus 2.44%. In contrast, the federal funds rate increased by 25 basis points following both the March and June Federal Open Market Committee meetings, and is above 1% for the first time in over seven years. Treasury Inflation Protection Securities (TIPS) yields lagged nominal Treasuries as lower energy costs dampened inflation expectations. Consequently, TIPS underperformed nominal Treasuries by over 1% during the first six months of 2017.

Corporate Bonds

Both investment grade and high yield corporate bonds delivered strong returns during the first half of 2017 as demand for yield remained a dominant theme. New issue supply has maintained the same record setting pace experienced over the last three years, but investors’ appetite has grown equally impressive. Investment grade corporate bond spreads grinded tighter throughout the reporting period and now sit at a mere 1% above Treasury yields. High yield corporate bond spreads tightened as well, but certainly not as dramatically as they did in 2016. High yield corporate bond spreads ranged from roughly 400 bps to 350 bps over Treasury yields and ended at 364 bps, which is materially lower than long-term averages. Expectations for a pickup in global and domestic growth points to even fewer corporate bankruptcies, which seems to be emboldening investors to accept lower yields.

Municipal Bonds

During the first half of 2017, municipal bonds performed very well with the Bloomberg Barclays Municipal Index delivering a total return of 3.57%, easily outpacing the Bloomberg Barclays Aggregate Bond Index which returned 2.27%. The municipal bond market recouped almost all of the losses experienced in the latter half of 2016. In fact, the municipal bond market had six straight months of positive total returns following the November rout.

Demand has been steady with $6 billion flowing into open-ended mutual funds during the first half of 2017. Concerns about potential tax reform under the new Trump administration and Republican-dominated Congress have diminished greatly since November. More and more investors do not believe a major overhaul of the tax code is likely, and consequentially, the benefits of tax-exempt income will mostly stay in place. Importantly, the fear that institutional holders, especially banks and property insurance companies, would curtail demand and potentially become net sellers of bonds has not materialized. Supply has been approximately 14% lower than the same period last year, but 2016 was a record year for municipal bond supply with total issuance nearing $445 billion. This year’s pace is closer to an estimated $400 billion, due to a material decline in refinancing activity.

The first half of the year marked another period in which the longer the maturity and lower the credit quality, the better the performance (the relative yield relationship between 10-year AAA-rated municipal bonds and 10-year Treasury securities dropped back down toward 90%, which highlights the relative outperformance). Longer-dated maturities (22+ years) outperformed the five-year maturities by more than 130 bps and the BBB-rated category outperformed the AAA-rated category by 113 bps.

Municipal Bond Credit

While the credit quality of municipal bonds has continued to improve since the Great Recession, cracks are beginning to appear in more locations. Overly aggressive investment return projections are not materializing, making the budget process more difficult. A few states and localities that have failed to institute discipline to fund their annual required contributions for both pension and post-retirement are now feeling the pressure. Many budgets have been delayed well past their normal time period. The state of Illinois has been the worst state at funding its pension obligations and, not surprisingly, adopting a budget. After significant public pressure in early July, the state of Illinois finally pieced together enough political cohesiveness to overcome the governor’s veto and passed a much needed budget for the first time in two years. While the state of Illinois is an outlier, the theme of budgeting pressures seems to be growing, which merits close attention and scrutiny when obtaining appropriate risk versus reward security selection.


Our outlook for the fixed income market remains unchanged from the first half of 2017. We expect muted bond market returns and slightly higher interest rates. Treasury yields will most likely drift slightly higher, with short-term yields increasing more than intermediate- and long-term yields. Credit spreads, both investment grade and high yield, will most likely remain near their recent levels. Strong demand for yield and a healthy economic outlook should keep bankruptcies empirically low. We believe municipal bonds will also perform relatively well, with demand outpacing diminished supply and tax reform not having a material impact for the remainder of the year.

Importantly, we remind investors to avoid being overly predictive as to the direction or magnitude of interest rate movements. While our outlook calls for modest returns for fixed income, we believe it is very important to hold a mix of fixed income strategies to provide stability and a source of income within a well-diversified investment portfolio.


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