There is an old saying that the more things change, the more they stay the same. It actually is an old saying. The interpretation we most recognize dates back to a French translation by Jean-Baptiste Alphonse Karr (1808-1890) who was a French novelist with a reputation of having a bitter wit.1 In thinking about the second quarter, what probably sticks in most memories was the volatility seen in the investment markets. An example would be the 10-year Treasury note trading in a 40 basis point range, touching a low yield near 2.75% twice and a high yield over 3% twice. Through all the changes, the yield finished the second quarter near 2.80%, just basis points away from where the second quarter began. Breaking that 3% yield has become a somewhat more difficult barrier than once thought.
The Federal Reserve continued on its path of raising short-term interest rates with a quarter point tightening of the federal funds rate on June 13. But even with this change, the 10-year Treasury yield stayed relatively the same. From previous quarterly commentaries we all know what happens when short rates are rising while intermediate and longer-term rates stay the same: the yield curve continues to flatten. Finishing the second quarter at 33 basis points (10-year Treasury minus 2-year Treasury), it was down another 14 basis points from the end of the first quarter.
To put this in perspective, we must go back to the middle of 2005 to find a yield curve this flat. That time, like now, it was the Fed raising short-term rates while longer-term rates did not react with the same increases. At roughly 33 basis points currently, it is getting the attention of many on the Street as to whether the curve will invert (a condition where short rates are higher than long-term rates). The Fed is expected to raise rates another two times this year – by more than 33 basis points. Could the Fed invert the curve? Yes. Will the Fed invert the curve? Probably not.
Notwithstanding inflation has remained within the Fed’s target – we can’t say “subdued” any longer but not the run-away inflation some expected from the strengthening economy – and the constant headlines of the ongoing trade war hitting the equity markets, we continue to expect gently rising intermediate and longer-term yields to keep the curve positive and even re-steepening. Inflation expectations will have a much more pronounced effect on yields than the trade debate which will affect the equity markets to a greater degree. The Fed is still the biggest inflation fighter around, so we are cautiously optimistic inflation expectations will remain in check. But the days of disinflation are behind us. We will, of course, monitor the “seeds” of inflation in the economy and commodities markets which could sprout into growing inflation expectations.
Dollar strength, something we saw throughout the second quarter, is one factor to hold down inflation but longer-term strengthening seems unlikely. (Sidebar: if you are planning a trip to Europe, now is a good time as the dollar is up nicely against the Euro and British Pound.)
There wasn’t all negative performance in the fixed income benchmarks like we saw in the first quarter. The broadest market index, the U.S. Aggregate, returned -1.62% while the Intermediate Government/ Credit index (our benchmark) returned -.98%. The Government side of that index was slightly negative. The index was pulled down to a greater extent by the corporate bond market. Bucking the trend, though, the U.S. Corporate High Yield index returned +16 basis points and the Quality Intermediate Municipal Bond index led the pack with +79 basis points.
That’s both quarters this year that high yield has performed better than the market as a whole. Of course, we all want to receive a high yield on our investments, but in this case, it is a term used to describe the class of securities that are not investment grade. They are sometimes called junk bonds, but as a group that is probably a bit too strong. Rating categories are metrics of determining the likelihood of your bond paying interest on time and returning all your principle at maturity. Investment grade has four classifications (triple-B to triple-A). High yield has five classifications (double-B to C). In some of those groups there are identifiers of the low end, middle and high end of the rating group. Clearly, at the very low end of those ratings (and there is also one if a bond has already defaulted), you could call them junk. We have consistently maintained high quality fixed income portfolios for all of our clients’ accounts, though we do opportunistically look at and purchase the highest of the non-investment grade market (i.e. BB bonds). In the near term, due to the additional yield and relatively shorter durations in the high yield market, they could continue to have some small relative outperformance. Longer-term, we remain more cautious about the sector and will only look to add non-investment grade bonds when we believe the added yield justifies the higher risk.
It was a tough second quarter for investment grade corporate bonds, though most of the negative performance was with long maturity bonds. New issue supply was heavy, and those borrowings are costing companies higher interest rates at a time when earnings are not rising as fast. The investment grade corporate market in the U.S. has grown dramatically over the past ten years and much of that outstanding debt needs to be re-issued in the coming years. We don’t see value yet in the long maturity corporate bonds and will continue to add positions in maturities under ten years where prices will be much less volatile.
Switching gears to the tax-exempt bond market also lets us switch gears to some positive returns for the second quarter, which recovered almost all the lost ground from the first quarter. The big theme in the municipal bond market coming into 2018 was tax overhaul. Lower tax rates mean lower after-tax equivalents of municipal bonds and investors looking to other sectors, or at least that is what happened in the first quarter. More recently, investors, especially in high tax states like New York and California, are once again loading up on municipal bonds and tightening spreads in those states. Investors continue to like the tax shelter provided by holding municipal bonds. Lower new issue supply (as compared to corporate bonds like we mentioned earlier and, of course, the growing debt of the U.S. Treasury) will help performance in the sector. We continue to favor the first half of the yield curve (i.e. maturities from one to 15 years) since we can pick up most of the yield of the entire curve without adding volatility found in the longer maturities. Entering the third quarter and the “summer doldrums” in the municipal bond market generally lead to better technicals for the sector, yet we remain defensive.
Looking ahead to the rest of the year, we see continued strength in
the economy. Forecasts vary with the Atlanta Federal Reserve metrics
showing robust growth over 4% while most economists are less optimistic,
with forecasts averaging under 3% growth. We would expect this to
generate gently rising yields although they never move in a straight
line. Our yield forecast is aided by the Federal Reserve raising the fed
funds rate two more times this year (once in the third quarter and once
again in the fourth quarter) and additional rate hikes in 2019. Our
strategy continues to over-weight spread products (non-Treasury) to
capture the incremental income and to remain over-weight quality as
returns in some sectors don’t justify the risk of lower quality bonds.
Summer is upon us and while total returns in the fixed income markets
are not expected to heat up as much as the daily highs here in
Rochester, we are comfortable with our current strategies to maintain
and grow wealth for our clients.
1 1911 Encyclopedia Britannica
