The fixed income markets certainly started off 2019 on the right foot. To use an old saying generally reserved for the month of March (though this is a quarterly commentary), the first quarter came in like a lion. The first two weeks of 2019 saw 10-year Treasury yields jump by over 20 basis points. And the first quarter went out… like a lion. Following the volatility that we saw in the last quarter of 2018 in risk assets (equities and non-Treasury securities) and the resulting flight to quality, the Federal Reserve’s attempt at calming the markets had an over-sized effect of sending them in the opposite direction.
Over the years a number of buzzwords or phrases have been concocted to explain the Fed’s intentions; more commonplace are the terms “rate hikes” or “rate cuts.” But more technical terms might include “quantitative easing,” “dot plot,” and “symmetrical.” There is also the more unusual, such as “irrational exuberance” used by then Fed Chairman Alan Greenspan in a speech in 1996 about the dot-com bubble.
More recently, by the time the Fed raised the overnight rate in December to 2.25%-2.50% (the fourth quarter-point increase in 2018), equity markets had fallen dramatically, and credit spreads were closing in on the widest they had been since the middle of 2016.1 The markets needed a new buzzword—one that should describe the Fed’s new intentions: patience.
During the press conference following the Federal Open Market Committee (FOMC) meeting on January 30, the market was keen on hearing patience, and Chairman Powell revealed some big changes in Fed thinking since the previous meeting in December. The Fed’s monetary policy statement referred to softer inflation expectations, a downgrade to economic growth, and specifically stated that “the Committee will be patient…”. What Powell did not talk about was the dot plot (individual Fed Governors’ expectations for the fed funds rate going forward). That left open the potential for the Fed to more easily drop the levels at subsequent meetings.
Suddenly the markets were reveling in the idea the Fed could “pause”
any further rate hikes to at least much later this year (that is another
buzzword heard many times over the past few months). At the March 20
FOMC meeting, the Fed made no change to the overnight rate, spoke more
of the global economic slowdown and its effects on our economy, lowered
the dot plot materially, and confirmed it will have a larger balance
sheet than originally thought. The Fed will again be one of the biggest
buyers of Treasury securities. There is a buzzword for that: “reverse
taper.” The second half of March saw 10-year Treasury yields fall a full
20 basis points, down almost twice as much from the high-water mark in
the middle of January. Strong performance in the fixed income markets
prevailed with some sectors trading as though the next move by the Fed
will actually be a rate cut by mid-year. In our view, a near-term rate
cut is unlikely, though we do believe the overnight rate will hold
steady the remainder of this year.
For the quarter, the Bloomberg Barclays U.S. Aggregate Index, the broadest bond market index, returned 2.94%. The Bloomberg Barclays Intermediate Government/Credit Index, our benchmark, returned 2.32%. Intermediate Treasuries returned 1.59%, while intermediate corporate bonds returned 3.82%. Investors welcomed back corporate debt in a big way during the first quarter as seen in the spread compression of the Bloomberg Barclays Aggregate option-adjusted spread. After topping at 157 basis points in January, spreads rallied back to finish the quarter at 119 basis points.2 In the corporate bond market, as is typical with risk-on trade, not only do lower rated bonds outperform higher quality names, but long maturities outperform short maturities. Within the broad market index, triple-B rated securities, the lowest category of investment grade bonds, returned almost 6%. The highest quality returned just over 2%. The longest maturity bonds returned approximately 6.5%, while the 1–3-year maturity range returned 1.22%. Intermediate investment grade financial bonds performed very well during the quarter, returning 3.85%. We have been selectively adding financial names (banks and non-banks) to our clients’ portfolios, as we see strengthening balance sheets and the potential for mergers and acquisitions.
In the tax-exempt markets, the Bloomberg Barclays Quality Intermediate Index returned 2.35% for the first quarter of 2019. So far this year in the municipal bond market, we have not seen new issue supply keep pace with demand. We noted in the fourth quarter commentary how retail demand had been picking up last year due to tax law changes. Demand for tax-exempt bonds has remained robust this year, possibly due to tax payers now seeing the effects of reduced SALT deductions as tax returns are being prepared.3 In high tax states (NY, CA, and others), it is especially telling as yields on in-state bonds have fallen below the general market, triple-A rated yields. Inflows to tax-exempt mutual funds, just one sign of increased demand, have averaged almost $1 billion per week this year, well ahead of previous years. Municipal bonds relative to Treasury securities less than 10-years to maturity are the richest they have been in at least a decade. For these reasons, and for greater diversification, we have been adding more general market, tax free securities and using the 10 to 15-year maturity range to add incremental income and find more attractive offerings.
During the first quarter we have continued work on our strategic objective of increasing the overall quality of our clients’ fixed income portfolios. We continue to believe the chances of a recession in the near term are low but not out of the question. In this late cycle environment, we are keeping a close eye on lower rated bonds. We know that in the first quarter, downgrades for U.S. companies versus upgrades were the highest since early 2016. The snapback in price on many such securities provides a better exit opportunity. We look at our positions on a case by case basis in order to maintain high current income without subjecting the portfolios to undue risk and volatility. We are comfortable with our neutral duration target for benchmarked accounts with a slight overweight to credit in the taxable portfolios. For our clients invested in municipal bonds, we are adding intermediate maturity bonds priced to a shorter call feature. The year has started with strong price performance, but adding incremental income will help performance for the entire year and beyond.
1, 2 Bloomberg Barclays US Aggregate Corporate Average Option Adjusted Spread
3 The federal cap on state and local tax deductions that was part of the 2017 tax overhaul which went into effect in 2018.