The unprecedented economic turmoil created by the COVID-19 pandemic dramatically shook the global capital markets during the first half of 2020. While much of the media attention was on the wild swings in equity markets, the bond market also experienced heightened volatility not seen since the Great Recession of 2008.
Understandably, investors initially sought safety, which helped propel Treasury bond prices higher and push yields to historic lows. The yield on the benchmark 10-year Treasury note plummeted from a high of 1.92% at the beginning of the year to an intraday low of just 0.32% on March 9th before ending the second quarter at 0.66%. The move lower in interest rates boosted the total returns for Treasury securities to an impressive 8.7% for the semiannual period.
Treasury Inflation Protected Securities (TIPS) underperformed nominal coupon Treasury securities but had a significant comeback by late June from the lows of mid-March. The implied breakeven rate on the 10-year TIPS fell from 1.70% to 0.55% in sympathy to the record collapse in oil prices. Yet, by the end of June, higher oil prices helped implied breakeven rates climb back to 1.34%.
Fortunately, the Federal Reserve reacted swiftly and aggressively to try and ward off the potential of a depression-like economic slowdown caused by COVID-19. In early March, the Fed lowered the federal funds rate from 1.50% to 1.25%, quickly followed by lowering the rate to near zero in mid-March. However, the Fed was very vocal that they did not intend to move the federal funds rate into negative territory like other central banks around the globe. Instead, the Fed reintroduced many of the monetary policy tools that were utilized in 2008 and created new tools to specifically target vulnerable portions of the fixed income market to provide much needed stability. Two novel tools were the Money Market Mutual Fund Liquidity Facility and the Secondary Market Corporate Credit Facility. The Money Market Mutual Fund Liquidity Facility allowed the Fed to purchase high quality fixed income securities held in many funds, which were under extreme selling pressure to meet redemptions. Probably even more impactful and surprising was the Secondary Market Corporate Credit Facility, which allowed the Fed to purchase corporate bonds in the secondary marketplace and announced that corporate bonds whose credit quality rating were rated investment grade as of March 21, 2020 would be eligible even if they were subsequently downgraded into the junk bond territory. Both of these new tools, combined with many other policy actions,* created a much needed backstop for the fixed income markets, especially during March and April.
*A listing of Fed programs and tools can be found in the appendix.
The first six months of 2020 were extremely noteworthy for the corporate bond market. The combination of spread volatility and record-setting new issue volume surprised even the most experienced bond market experts. Typically, during volatile price environments, new issue supply drops materially. The opposite occurred during this period. Massive redemptions from both investment grade and high yield mutual funds during March and April initially pushed prices lower (and yield spreads higher), but corporations still tapped into the new issue market to help manage cash flow stresses caused by COVID-19.
The number and total volume of new issue corporate bond deals shattered the previous record for any semiannual period for both investment grade and high yield issuers. Despite the massive new issue volume, prices recovered in the latter part of the reporting period and investment grade corporate bonds actually produced positive total returns in excess of 5%. High yield bonds, as measured by the Bloomberg/Barclays U.S. Corporate High Yield Index, declined as much as 19.8% peak to trough through March 23. The asset class recovered a majority of its losses by June 30 down only 3.8%.
Emerging Market Debt
Emerging market debt posted negative returns for the first half of 2020, as a result of extreme outflows in March and April. In addition to the risk-off sentiment, emerging market energy exporting countries were also affected by the dramatic price swoons of oil and natural gas. However, much like other risky portions of the capital markets, emerging market debt rebounded during May and June as investors returned to the asset class. On the positive side, emerging market debt continues to offer higher yields in a low-to-negative global rate environment with the outlook for muted inflationary pressures.
The municipal bond market experienced one of the most volatile six months in recent memory. After the record annual inflows into municipal bond mutual funds in 2019, of $93.6 billion, investors unloaded their holdings during March and April. An astonishing $55 billion of net redemptions overwhelmed the secondary marketplace, pushing yields on even the highest quality municipal bonds up almost 2% across the entire yield curve. However, the market quickly regained its footing with support from both the Fed and new demand from non-traditional crossover buyers.
Initially, the pressure on the municipal bond market came from selling of municipal money market securities, especially high quality variable rate securities. In fact, the rate on SIFMA* 7-day Swap Index hit a high of 5.2% on March 18th, but once the new Money Market Mutual Fund Liquidity program began operating, the interest rate on high quality, short-term municipal securities quickly plummeted back down towards zero.
As yields on high quality short maturity municipal securities recovered and moved lower, other yields followed, especially high quality municipal securities. Despite all the volatility, the AAA yield curve actually ended the reporting period lower than the beginning of the year and the yields on all maturities either touched or ended at all-time record lows. However, growing credit concerns dampened demand for mid- to lower-rated investment grade, particularly below investment grade municipal securities. In other words, yield spreads between AAA and BBB widened materially during the period. This spread widening produced the largest return deviations between AAA-rated securities and BBB-rated securities since 2008.
Total new issue supply of municipal bonds reached $198 billion, which was 14.6% higher than the first half of 2019. However, much of the increase came from the large increase of taxable municipal bonds, which many municipal bond issuers have been utilizing. The concept being that it is easier for issuers, especially private universities and not-for-profit healthcare entities, to tap into the taxable bond market and with Treasury yields so low, their additional interest cost is minimal. Interestingly, the newly created Municipal Liquidity Facility gave municipal bond issuers the option to borrow money directly from the Fed for a term of three years at varying rates, depending on their credit ratings. Although the facility has been used by few issuers, the idea that the Fed would loan municipal issuers capital has created a much needed borrower of last resort for the marketplace.
Municipal Bond Credit
In many ways, the economic impact from COVID-19 is unparalleled in both swiftness and scope. The complete shutdown of the economy late in the first quarter and into the second quarter is much different than even the Great Recession of 2008. That crisis was focused on the real estate portion of the economy and the forced unwinding of financial leverage that ensued when the real estate market dramatically deteriorated. The COVID-19 pandemic has impacted a much broader portion of the economy, with areas such as consumer spending, manufacturing, transportation, education and healthcare collapsing due to demand destruction dictated by social distancing.
Understandably, a large percentage of municipal bond issuers' credit quality are sensitive to the economy. Typically, general obligation bonds are supported by a narrow list of revenues, mainly personal income, corporate taxes and property taxes. While the recent downturn in the economy will result in lower tax collections, municipal bond credit quality is a lagging indicator. Collections are based on historical economic activity. Most of this year's collections are based on economic activity that occurred in 2019. Property taxes usually look at a three-year rolling average of assessed valuations, which helps smooth short-term declines. Therefore, the immediate credit impact on general obligation entities will be cushioned. Importantly, most municipalities came into this downturn with some form of 'rainy day' reserves. The combination of the 'lagging impact' and reserves will give municipalities flexibility to weather this economic downturn in the near term.
Furthermore, there has always been a financial 'waterfall' between the federal government, state and local governments. The federal government disperses funds to the states and states disperse these funds to the local governments for services such as education, transportation and healthcare. This 'waterfall' effect has already accelerated in 2020. The CARES Act resulted in states and their subdivisions receiving an additional $200 billion in a combination of direct state aid and specific support for healthcare, transportation and education. In late June, the HEROES Act was passed by the House, which would potentially provide an additional $1 trillion in aid to state and localities.
The credit impact on the revenue bond sectors of the municipal bond market is much more varied. Essential service revenue bonds, such as water/sewer and power, will be extremely well insulated from any kind of economic downturn because the usage and payments are not economically sensitive. However, certain revenue bond sectors, such as sales tax, hotel tax, airport revenue, healthcare and mass transit revenue bonds aremore vulnerable to the recent economic downturn. Fortunately, the vast majority of these types of revenue bond issuers are not highly leveraged and debt service coverage as a percentage of overall operating expenses is very low. Many of these issuers are highly rated and have significant financial flexibility to easily handle the dramatic decline in revenue that occurred in the second quarter. Also, the vast majority of deals have debt service reserves in place to pay one year worth of debt service for emergency situations. Consequently, we are not anticipating a larger percentage of actual defaults. We could see defaults approach 1%, up from an average annual default rate of less than 0.2%. But, that is still significantly lower than the corporate bond market, which averages close to 3% and could easily approach more than 5% over the next few years. Importantly, we anticipate the majority of the municipal bond issuers that actually go into default will be concentrated in the more obscure portions of the marketplace like nursing homes, raw land development, convention centers and hotel projects. Realistically, we believe there will be an increase in rating downgrades but the market has already appropriately priced in this risk.
In January, our outlook for the interest rate environment was 'lower for longer.' The COVID-19 induced economic slowdown not only extends the time horizon but also pushed interest rates even lower. Short-term interest rates will most likely remain anchored near zero for many quarters ahead. The Fed has been very transparent with forward guidance of this 'zero rate' policy. On the other hand, they have also been very vocal about their apprehension to implement a 'negative rate' policy. In the near term, we are not concerned about the bond market's ability to absorb the increase in additional debt from both the federal government and corporations. We also do not believe that the additional borrowing will result in a material increase in inflation or inflation expectations beyond the Fed's 2% target anytime soon.
Consequently, we are not calling for a large increase in yields on intermediate- or long-term Treasury securities. We could see a slight steepening of the yield curve with yields on longer-term maturities drifting slightly higher by year end, but only if we get a coordinated move higher with other global sovereign bond yields. The dominate theme in the Treasury bond market has been, and continues to be, the massive amount of global sovereign debt with negative yields, which stands in excess of $14 trillion. Thus, we believe U.S. long-term rates will be limited in how much higher they can drift.
We also want to remind clients that there is still the potential for continued volatility of credit spreads in the corporate bond market, especially the high yield market. The economic uncertainty will produce earnings volatility that could result in accelerated concerns about both credit worthiness and ongoing viability of corporations. However, we continue to believe that actual defaults will most likely be contained within the sectors that have already experienced stress, such as retail and energy. We also believe that it is highly unlikely we will repeat the volatility and liquidity pressures we experienced in March and April. The Fed's policy tools, which are now operational, should mitigate much of that risk. The same holds true for the municipal bond market. Credit concerns will be cushioned by the growing likelihood of additional direct support from the federal government and access to short-term borrowing if needed from the Fed. Demand for municipal bonds has turned positive over the last two months and should remain strong as the outlook for potentially higher personal income taxes on the wealthy increases amid the looming U.S. presidential election.
While our expectations for more muted returns at the start of the year were based on our expectations that interest rates would move higher, the opposite has occurred. Now that interest rates are near zero, we are even more realistic about how much more return can be garnered in the current environment. Interest rates are extremely low and credit spreads for both investment grade and below investment grade corporate bonds have recovered, which will most likely produce more modest total returns over the next several quarters. Despite our expectations for limited opportunities and lower total return in the fixed income markets, we remind clients that a high quality, well diversified, actively managed portfolio, in combination with other fixed income strategies, will continue to play an important role during these uncertain times. In our view, it is important to maintain exposure to a stable, income producing, tax-sensitive asset class as we navigate a potentially more volatile investment environment.