What a difference a year can make. After a disappointing 2018, all asset classes delivered positive total returns in 2019. It was a unique year in that both equities and bonds produced outsized, positive returns. Typically, a dramatic decline in interest rates indicates a more pessimistic view about economic growth, which would lead to pressure on both corporate profits and equity prices. That was certainly not the case in 2019.
The Federal Reserve played a key role in boosting the price of bonds and other financial assets in 2019 by pivoting from an “auto pilot" policy of steady rate hikes to easing. The central bank lowered the federal funds rate three times, by 25 basis points each, moving the rate from 2.5% to 1.75%. The yield on the benchmark U.S. 10-year Treasury note ranged from a high of 2.67% in January to a low of 1.43% in September and ended the year at 1.93%.
In 2019, domestic interest rates did not decouple from the global interest rates as they did in 2018. U.S. interest rates moved in tandem with other high-quality sovereign issuers, like German Bund rates, which plunged to record lows. In fact, in September, we hit an astonishing peak of $17 trillion in negative-yielding sovereign debt worldwide. The relative attractiveness of the U.S. 10-year Treasury at 1.5%, compared to a 10-year German bond at negative 0.75%, helps explain the dramatic move lower in U.S. rates. We believe this “tethering" relationship will exist for the next several quarters.
The shape of the yield curve also influenced the Treasury bond market. An environment where short-term yields are higher than long-term yields – an inverted yield curve - has historically signaled that a recession will occur in the next 18–24 months. The three-month to 10-year Treasury yield curve inverted as early as March 2019. However, we believed that the inversion was driven mostly by global supply and demand factors, rather than a weak U.S. economy. We have long considered the relationship between the two-year Treasury note and the 30-Year Treasury bond to be a better barometer; even the two-year rate compared to the 10-year Treasury note may be preferable. Based on when the three-month to 10-year curve inverted, it would suggest a U.S. recession as early as the fall of 2020. However, we do not anticipate a recession in 2020.
Despite dire predictions that inflation was collapsing across the globe, Treasury Inflation Protection Securities (TIPS) posted solid returns during 2019. Although a bumpy ride, implied break-even inflation rates recovered in the latter half of 2019, ending the year near January's levels. Inflation and inflation expectations will be the most closely watched and influential economic indicators for the fixed income markets through 2020. The Fed has all but admitted that the increase in short-term interest rates in 2018 was probably a mistake because these hikes were not accompanied by increasing inflationary risk. Going forward, we expect the Fed will not increase the federal funds rates until both inflation and inflationary expectations get significantly higher than their asymmetrical target rate of 2% for a prolonged period.
Corporate bonds delivered impressive total returns in 2019, the best since 2011. Returns were driven by a combination of declining yields and collapsing credit spreads. Both investment grade and high yield corporate bonds delivered a total return in excess of 14%. Solid corporate profitability and a demand for yield also helped to drive the extraordinary price gains throughout 2019.
Supply of investment grade corporate bonds was similar to 2018 levels, roughly $1.2 trillion, as corporations continued to take advantage of the low interest rate environment. The supply of high yield bonds saw a material pickup compared to the previous years, with corporations taking advantage of both lower interest rates and materially tighter credit spreads.
Emerging Markets Debt
Similar to other sectors of the capital markets that were challenged in 2018, emerging markets debt posted a huge comeback in 2019. The J.P. Morgan Emerging Markets Bond index (local currency) delivered a total return of over 15%. Emerging market debt benefited from some of the same influences that helped buoy other fixed income sectors — a global reach for yield and a global deceleration of inflationary pressures.
The municipal bond market also posted attractive total returns in 2019. Strong demand from high net worth individuals, seeking to take advantage of one of the last remaining tax havens in the capital markets, continues to be the major theme for the municipal bond market. Open-end municipal bond mutual funds brought in more than $92 billion in net subscriptions during 2019, easily surpassing the previous record of $78 billion in 2009. Weekly inflows were positive for a record 52 weeks in a row, with strong demand from high, in-state tax jurisdictions like California and New York, pushing down yields even more dramatically.
Consistent with the Treasury bond market, the municipal bond yield curve experienced a material flattening during 2019, with long maturity yields moving lower. However, unlike the Treasury bond market, the municipal yield curve did not invert. The two-year AAA yield stayed lower than the 10-year AAA yield throughout the year. (The two-year Treasury and 10-year curve did invert for three days in early September). Interestingly, the municipal yield curve has never been inverted.
The flattening of the yield curve produced significant return differentials, with long maturities beating shorter maturities. The best performing municipal bond maturity profile was the Bloomberg Barclays Long Bond (22+) index, which delivered a total return in excess of 10%, whereas the Bloomberg Five-Year index returned less than 5.5%. It was also another year in which lower-quality municipal bonds total returns easily surpassed high-quality municipal bonds. The total return of BBB-rated securities posted returns near 10% compared to AAA-rated securities of less than 7%.
The supply of municipal bonds saw a strong recovery in 2019, compared to the relatively low levels in 2018 ($420 billion compared to $345 billion). Refunding activity accounted for 38% of the total volume. Interestingly, taxable municipal bond issuance climbed significantly from roughly $25 billion in 2018 to over $70 billion in 2019. This sizable increase in issuance is related to the 2017 tax legislation, which eliminated the ability of an issuer to refinance outstanding higher interest tax-exempt debt prior to the call date with new tax-exempt debt. However, the drastic decline in interest rates across the curve allowed traditional tax-exempt issuers to issue taxable municipal bonds at yields low enough to refund higher interest cost debt prior to its stated call date. If interest rates remain near current levels, we anticipate even more issuance of taxable municipal bonds in 2020, as more traditional tax-exempt issuers recognize the benefits of taxable advanced refundings. We would not be surprised if the total issuance of taxable municipal bond volume exceeds $100 billion in 2020, helping push the total annual supply toward the all-time record of $465 billion.
Municipal Bond Credit
Overall, the credit quality of municipal bonds continues to improve, with more upgrades than downgrades in 2019. Revenue collection by the vast majority of states and localities continues to climb, and in some circumstances, is even higher than predicted. The budgeting process in most state legislatures has been significantly less contentious compared to even a few years ago, with some states and localities using this revenue surplus to replenish rainy day funds.
While clearly a positive, we recommend clients be guarded against an acceleration of credit difficulties in the municipal landscape, as there are still some municipalities that are overspending, especially considering their underfunded pension and post-retirement liabilities. While we are not predicting a major downturn in municipal credit quality in 2020, we are still concerned that there will be more revenue imbalances versus liabilities, which will come to light as the economic cycle matures.
Given our outlook for slow global growth and moderate inflation, we expect a “lower for longer" interest rate environment with domestic rates tethered to global rates in 2020. Our base case is for the global economy to deliver near 3% and the U.S. economy to grow near 2% — possibly slightly higher if geopolitical risks subside. Under that scenario, we would anticipate an upward-sloping Treasury yield curve with intermediate- and long-term interest rates moving slightly higher by the end of 2020.
We expect interest rates to stay “lower for longer" domestically, especially on the short end of the curve, as the Fed should keep the federal funds rate below core inflation and inflation expectations for the foreseeable future. Short-term interest rates will be anchored at the current 1.75% level and may even be adjusted slightly lower in the first half of 2020 if both the economic and inflationary picture deteriorate. Our projection for the range on the 10-year Treasury note will be much tighter than last year, with the yield staying between 2.25% and 1.25%. The only way our domestic intermediate- and longer-term interest rates would move materially higher is in conjunction with other high-quality sovereign yields.
Our total return expectations across the whole fixed income space are muted compared to the strong returns experienced in 2019. Given that interest rates are already extremely low globally and credit spreads are already extremely tight, there is not that much opportunity to produce strong returns.
Despite our outlook for diminished opportunities and corresponding lower total return forecasts in the fixed income space, we remind clients that an actively managed portfolio that contains a mix of fixed income strategies will continue to play an important role during these uncertain times. The need to maintain exposure to a stable, income producing, tax-sensitive asset class with an emphasis for liquidity remains prominent as we navigate a potentially much more volatile investment environment.