It was a busy third quarter. In my inaugural attempt to write the Quarterly Newsletter in the middle of 2018, I said that the more things changed, the more they seemed to stay the same. That was not the case for July through September of this year. Granted, not everything we closely monitor in the fixed income markets was rapidly changing. One that instantly comes to mind is the up and back headlines surrounding trade negotiations between the U.S. and China. Another is inflation expectations which remain low; in fact, they drifted a little lower at the end of the quarter versus June 30 as measured by the 10- year breakeven inflation rate. Except for a few well documented instances, volatility in the fixed income markets was relatively low in 2018. Crosscurrents have been growing in 2019. Many of those hit the markets at once this quarter, including:
• Non-farm payroll growth slowing
• Consumer sentiment falling
• Eurozone economies flashing recession warnings
• Volume of bonds with negative interest rates hitting an all-time high
• Federal Reserve cutting the overnight rate twice (July and September)
• 2yr/10yr Treasury curve inverting for the first time since 2007
• Dollar strengthening
• Crude prices volatile but generally lower
• Record amount of corporate bond issuance in September
The Treasury curve inverting in August is a dire sign for the domestic economy. The Treasury curve has a long history of predicting a recession once the yield on the 2-year Treasury note falls below that of the 10-year Treasury. In general, early stages of a slowing economy help fixed income returns, as has been the case for 2019. The fixed income markets are also expecting the Fed to inject enough stimulus to avert negative growth which has, so far, helped returns of low investment grade and non-investment grade bonds.
For the third quarter, the Bloomberg Barclays Intermediate US Government/Credit Index, our benchmark for total return portfolios, returned 1.37% (YTD 6.41%). Two modestly negative months (July and September) bookended a very strong August when 10-year Treasury yields traded at a multi-year low, under 1.50%. For the broader market, the Bloomberg Barclays US Aggregate Index returned 2.27% (YTD 8.52%). Spread products (i.e. non-Treasury securities) and longer maturity securities in general once again provided the bulk of the fixed income returns in the third quarter, as has been the case throughout 2019. Intermediate government bonds returned 1.38% (YTD 5.67%), while intermediate corporate bonds returned 1.74% for the third quarter (YTD 8.94%).
This is also a good time to discuss a growing sector within the taxable bond market. As we continually look to diversify our clients’ fixed income portfolios and provide additional income and total return potential, we have been increasing our allocation to taxable municipal bonds. Taxable municipal bonds are issued, traded, and have the same high-quality credit fundamentals as the tax-free municipal bonds we have been purchasing for many years. The only difference is the income is federally taxable like that of Treasuries, agencies and corporate bonds. The income may still be state tax-exempt.
The combination of low interest rates and a flatter yield curve (short maturity yields have not fallen as much as intermediate and longer maturity yields) has allowed municipal issuers to refinance older tax-free bonds with new taxable bonds. While taxable municipal bonds have existed for many years, the market continues to grow and mature. As a complement to our government bond allocation, which has historically been investments in Treasury and agency securities, we are purchasing taxable municipal bonds and adding incremental income while maintaining very high-quality portfolios. For the third quarter, intermediate taxable municipal bonds have proved their worth by returning slightly more than intermediate government bonds. Greater diversification and more yield—a fine combination.
Switching gears to the (traditional) municipal bond market, the Bloomberg Barclays Quality Intermediate Index, our benchmark for tax-free bond portfolios, retuned .87% for the third quarter (YTD 4.98%). While positive for the quarter, September handed the municipal bond market its first negative month of 2019. Throughout the third quarter, demand for tax-free bonds remained strong from retail investors and through mutual funds. What changed in the third quarter, especially in September, was the spike in new issuance as local governments took advantage of the low interest rate environment. As mentioned earlier, a similar spike occurred in the corporate bond market, but large supply changes always affect the municipal bond market to a greater extent. Since the municipal bond market is generally a domestic market without the support of global investors that flow to our government and corporate securities, sometimes too much is just too much in the municipal bond market. Looking ahead, we expect new issue supply to stabilize—and probably drop—as these ‘opportunistic’ deals reduce the need for future funding. Along with closely monitoring credit fundamentals, we are constantly tracking supply projections, tax law changes, and taxable equivalent yields, among other factors, which drive our portfolio management decisions to maximize after-tax return.
Looking ahead to the final quarter of 2019, we are keenly aware of slowing global and domestic economies, and we are monitoring our allocation to corporate bonds. Over the course of 2019, we have reduced our exposure to lower rated credits while maintaining the sector over-weight. Much is riding on the Fed manufacturing a soft landing and keeping our economy out of recession. We expect at least one additional quarter-point cut in the overnight rate by year-end. There is always the potential for a cut at each of the two remaining FOMC meetings in 2019. We continue to be neutral on duration to our benchmarks for total return accounts and slightly longer for our current income accounts. We still see value in investing in intermediate maturities as yields on longer-term bonds don’t compensate for the additional risks. Other than increasing the overall credit fundamentals, our strategic fixed income objectives remained unchanged in the third quarter.