2018 was a disappointing year for almost all asset classes. The bond market was less volatile than equities, but experienced more twists and turns than normal. The annual total return of the Bloomberg/Barclays Bond index was barely positive at 0.01%, but the ride was especially bumpy during the fourth quarter.
The Federal Reserve's widely anticipated quarter-point pace of tightening resulted in four rate hikes in 2018, increasing the federal funds rate from 1.5% to 2.5%. The tightening pushed yields on all Treasury maturities higher and, as expected, we saw a bear flattener with yields on short maturities increasing more than intermediate and long maturities. The yield on the benchmark 10-year U.S. Treasury note ranged from a low of 2.4% at the start of 2018 to a peak of 3.24% in early October. However, the 10-year note ended the year at 2.67%, only 28 basis points (bps) higher than where it began the year.
The shape of the Treasury yield curve garnered a great deal of attention as an inverted curve — where short-term yields are higher than long-term yields — historically has been a very good leading indicator of an economic recession. However, recessions typically do not occur until almost two years after the inversion. When determining an inverted yield curve, we prefer to look at the relationship between the yield on the two-year Treasury and the 30-year Treasury. As of year-end, this was still positive by 54 bps. While the yield curve flattened, it still has a meaningful way to go before it inverts.
Yields on intermediate- and longer-dated Treasuries were also influenced by the material increase in Treasury debt, from $15 trillion to $16 trillion. The increase in U.S. Treasury debt supply contributed to the widening of yield spread between U.S. government debt and other high-quality global sovereign issuers, such as German bunds. We expect this trend to continue in 2019.
The worst-performing sector within the Treasury bond market was Treasury Inflation Protection Securities (TIPS). Despite stronger global and domestic economic growth and a very low unemployment rate, inflation expectations fell in 2018. The implied break-even inflation rates on the 10-year TIPS declined from 200 bps to only 171 bps, largely due to the decline in the price of commodities, particularly oil.
Corporate bonds, both investment-grade and high yield, posted their worst year since 2008. During 2018, the yield spread on investment-grade corporate bonds increased from 89 basis points to 143 basis points and high yield spreads widened from 343 bps to 526 bps. Despite increased corporate profitability and lower new-issue supply, both investment-grade and high yield bond spreads increased materially. In fact, investment-grade issuance fell from $1.4 trillion to $1.2 trillion while high yield issuance fell more than 40%, which should have been supportive for yield spreads. However, demand turned extremely negative during the fourth quarter as investors became increasingly concerned about the impact slower global growth and weaker oil prices might have on corporate profitability. During the final three months of the year, mutual fund redemptions from corporate bond funds exceeded more than $60 billion, the largest level since the Great Recession.
In a reversal of 2017, the weakest fixed income sector was emerging markets, particularly local currency emerging market debt. Concerns about dampened global growth amid the trade tensions between the U.S. and China, as well as dramatic declines in the commodity markets, hurt bond prices. The J.P. Morgan Emerging Markets Bond index (Local Currency) delivered a total return of -3.4% while the U.S. dollar denominated index returned -2.46%.
Positive supply and demand dynamics helped produce slightly positive total returns for municipal bonds in 2018. Supply of new-issue municipal bonds declined roughly 24% from 2017 levels as the new tax legislation eliminated the ability for an issuer to refinance outstanding, higher interest rate debt prior to the call date. Consequentially, refunding activity declined by more than 35% and total new issuance volume fell from $436 billion to $340 billion. Demand for municipal bonds was robust during the first half of the year, with mutual fund inflows reaching $15 billion. However, rising interest rates during the third quarter weighed on investor sentiment, with nearly half of the $15 billion flowing out of municipal bond mutual funds in the latter half of the year. In contrast, demand from separately managed accounts was relatively strong throughout the whole year, with demand for maturities of 10-years or shorter particularly solid during the latter half of the year.
The combination of these factors resulted in materially different yield curve shifts in the municipal bond market compared to the Treasury yield curve. The municipal bond yield curve steepened, with yields on longer-dated maturities increasing 34 bps more than the yield on short maturities. The total return on the Bloomberg/Barclays Municipal Bond index was 1.28%, with the best-performing maturity profile five-years and shorter. The worst performing maturity profile was the 22- to 30-year, delivering a modest 0.34%. Municipal bond credit quality buckets also varied compared to the taxable bond market, with lower-quality outperforming higher-quality bonds. The total returns were as follows: BBB-rated at 1.96%, A-rated at 1.34%, AA-rated at 1.22%, and AAA-rated the worst at 1.05%.
Another factor influencing the supply and demand of municipal bonds during 2018 was activity of the two prominent “institutional" holders of municipal debt, banks and property/casualty insurance companies. The material decline in the effective tax brackets of corporations raised questions about the potential future demand for tax-exempt municipal bonds from banks and insurance companies — whether they may instead become net sellers of their $900 billion in bonds. Fortunately, the decline of $40 billion from regional banks was not as aggressive as feared. Nevertheless, the lack of demand for municipal securities beyond 10 years was evident and will continue to influence the shape of the municipal bond curve for many years to come.
Municipal Bond Credit
Although yield remains an important component of total return, we are careful not to aggressively reach for yield. Instead we favor higher credit quality municipal bonds by employing a disciplined approach to our security-selection process. The elimination of the federal deductibility of state and local taxes (SALT) will have ramifications on municipal budgets in the near future, especially in states that currently have large state and property tax burdens. We foresee much greater pushback from taxpayers to at least maintain the level of tax burden, not increase it. This will result in much less financial flexibility at the state and local levels, particularly when there is an economic downturn.
Fortunately, the recent strong economic base and the windfall created from the repatriation of foreign-held profits has helped buffer many ever-increasing budgets around the country. Furthermore, our outlook calls for slower economic growth with lower longer-term averages near 2%. We do not foresee a recession until at least 2021. As a result, we do not believe we will see a near-term spike in municipal bankruptcies, but we could easily see an acceleration of downgrades in the coming years. We also believe the rating agencies will be even less patient towards states and localities that chronically underfund their pension and other post-retirement liabilities. An added concern is the unrealistic long-term capital market expectation return targets that many public plans continue to maintain.
It appears the Federal Reserve is transitioning from a quarter-point pace of tightening to a semiannual pace as the federal funds rate has moved from 0% in late 2015 to near a more neutral level today. This implies that there will be less need to increase short-term interest rates in 2019 and beyond. Our outlook is for the Federal Reserve to only increase two more times in 2019, going from quarterly increases to semiannual ones. However, given growing economic uncertainty surrounding trade and geopolitical noise, we would not be surprised if the Federal Reserve only increased rates once — or not at all — during all of 2019.
In an environment with stable, short-term interest rates, intermediate- and longer-term interest rates should remain within the recent ranges held over the last few years. Therefore, the benchmark 10-year Treasury will likely remain between 2.25% and 3.25%. We are not calling for a completely inverted yield curve (based on the difference between 30-year yield below two-year) as our base case. But it may occur by late 2019 if the Federal Reserve increases rates more aggressively. Credit spreads have already increased materially, and thus we are calling for more stability in 2019. The combination of more modest stable credit spreads and range-bound interest rates should deliver modest total returns for fixed income in 2019.
We maintain a positive outlook for municipal bonds. Many taxpayers will realize the negative impacts from the capping of state and local deductions this spring. Demand for tax-exempt interest income should remain strong given the recent limits on state and local deductions and the income stability that municipal bonds provide. Supply of new issuance is expected to increase moderately but we believe the increase will be manageable. Credit quality will be a growing focus, but we are anticipating relative stable quality spreads there, too.
While the volatility and noise created by news headlines can be distracting, investors should stay focused on their long-term investment plan and the role fixed income can play within a well-diversified portfolio. It's very important to hold a mix of fixed income strategies that can provide relative stability, a source of income and diversification, especially during the later stage of an economic cycle.