End of the bond rally?

Hunger for yield was driving a rally, until the Fed caused investors to reassess.

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Despite low starting yields, questionable corporate fundamentals, and the potential for rate hikes, bonds have rallied in recent weeks. Bonds have outpaced U.S. stocks this year in general, with long-term Treasuries up nearly 10% for the year and high-yield bonds up more than 7%.

Viewpoints asked Tom DeMarco, CFA®, a market strategist in Fidelity Capital Markets’ fixed income division, what has been driving the rally, what the recent economic numbers suggest for future rate increases, and how valuations look. We also discussed whether Puerto Rico’s financial woes are likely to spill over into the broader municipal market.

DeMarco says that the market and Fed have had different expectations, and that has led to volatility in recent days, and could create more market moves in the weeks to come. While he says it’s generally become hard to find value in corporate bonds or munis, he thinks some pockets of those markets do look attractive.

Q: Investors in March were fairly optimistic about the health of the U.S. economy. What’s happened since then?

DEMARCO: On balance, we’ve seen weaker economic data in recent weeks. GDP growth in the first quarter was a disappointing 0.5%, and other economic indicators have come in below expectations: Manufacturing numbers remain fairly weak, the trend in payroll withholding taxes is negative, jobless claims have jumped the past couple weeks, and the most recent non-farm payroll report was somewhat sluggish.

Meanwhile, the senior loan officer survey, which measures lending standards for commercial and industrial loans, shows a clear trend toward tighter lending conditions, and that can foreshadow a turn in the credit and economic cycles. Some of the most recent data for the second quarter suggest we may see a rebound in activity from Q1, but the strength of any bounce back is questionable, in my opinion.

Q: How is soft economic data influencing the Federal Reserve’s interest rate policy?

DEMARCO: As recently as May 13, the markets were not pricing in any rate moves in 2016.

But minutes from the last Fed meeting, some statements from members of the Fed, and more recent economic data that indicated the economy may be bouncing back from a weak first quarter caused investors to reassess. As of Thursday, May 19, derivatives traders were pricing in a 32% probability that the Fed raises rates at its June 14-15 meeting. This level was up from 4% on Monday, May 16. The first month with better than even odds for a rate rise has also been brought forward to September.

I still think it seems unlikely that the Fed will move more than once this year, but that can change as the data comes in. I think if the Fed doesn’t move by June or July, it is probably on hold until December. While some Wall Street economists are calling for a September rate hike, I can’t help but wonder whether the Fed would want to take action so close to the November elections.

Historically, the market has anticipated rate hikes—90% of rate hikes were at least 70% priced in on the eve of the move, and 90% of all hikes were at least 50% priced in 30 days beforehand.

Q: How have bond investors reacted in this environment?

DEMARCO: There’s been an insatiable demand for duration lately, with very good results from the most recent seven- and 10-year Treasury auctions. Even some European sovereign issuers are issuing 50-year debt that is oversubscribed. And the corporate issuance calendar has picked up dramatically now that we’ve come out of the quiet period around quarterly earnings announcements. Meanwhile, credit has had a pretty significant rally—the lowest-rated, most distressed parts of the market have rallied the hardest.

Q: What’s driving the rally in lower-rated issues?

DEMARCO: The rally in high-yield bonds has been driven by a rebound in commodity prices and strong technicals. We’ve had a tug-of-war in the corporate market between fundamentals and technicals, and the technical factors—foreign demand, cash levels, and flows—have been winning the day.

There is roughly $9 trillion worth of debt globally trading at negative yields, so from that perspective, a 1.74% yield on a 10-year U.S. Treasury note looks attractive. The European Central Bank’s new corporate bond-buying program is likely to continue to keep downward pressure on yields globally.

But fundamentals in the high-yield market still worry me: We are in an earnings recession, and revenues are weak to declining. The default rate continues to tick higher, and I believe it will continue to rise through the year unless we see a tremendous snapback in economic growth.

Spreads in the most distressed part of the high-yield market have run pretty far, pretty fast. I think prices today are aggressive relative to my view of the fundamentals. If growth surpasses my expectations, or the commodity recovery continues, then the picture may brighten.

Q: What’s your outlook for the municipal bond market?

DEMARCO: Puerto Rico has been in the headlines as the commonwealth attempts to restructure its debt. The issues in Puerto Rico have been well telegraphed, but the issues around the strength of legal protections and potential impact of any restructuring on the bond insurers could get more attention as we move forward with this process.

More broadly, I do think pension liabilities are going to remain a challenge for municipal issuers that have significantly underfunded their liabilities.

A bigger issue for municipal bond investors these days is valuations (see graph): Two months ago, 10-year municipal bonds were looking pretty fairly valued, or even slightly cheap. Now, muni market valuations have gotten fairly rich, in my opinion.

Investors have viewed municipal bonds as a safe place to invest in this market. A tremendous amount of cash has flowed into the muni market. Close to $30 billion has flowed into tax-exempt funds this year, and there have been 34 consecutive weeks of positive inflows. I think some of this cash has come from the equity market—roughly $80 billion net has come out of U.S. equity funds year to date.1

But even with all this money coming into the muni market, the issuance calendar has been running below last year’s levels and refundings have been sharply lower. Those conditions have contributed to a very strong run for muni bonds, and we’re hitting a technical strong period for munis, with around $138 billion in redemptions scheduled for June, July, and August.

Furthermore, the negative yield issue I mentioned earlier is showing up in foreign demand not just for corporate and Treasury bonds but also for municipal bonds. Compared with the prefinancial crisis levels, foreigners have increased their holdings of munis by about 192%, while the total outstanding in the market overall increased by only about 23%. While foreigners are still a small slice of the market in terms of holdings overall, their sponsorship is adding support to the technical backdrop. As a result of all this, I don’t expect munis to get any cheaper in this environment, barring a significant Treasury shock or a significant economic move.

Q: Where in the bond markets are you seeing opportunities?

DEMARCO: In the municipal market, taxable munis are attractive not only versus tax-exempt muni bonds but also versus corporates, following the big run in the corporate market. The recent rally among corporate bonds has made it more difficult to identify attractively priced opportunities, but I think the financials sector still holds some value at present. In terms of ratings buckets, I prefer BBBs over A and AA credit.

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1. Source: EPFR Global, Fidelity Capital Markets
2. Bloomberg, The Municipal Market Monitor, Fidelity Capital Markets
3. Source, WSJ.com, as of May 19, 2016. Performance based on Barclays Aggregate Bond Index, Barclays Long U.S. Treasury Index, The Barclays U.S. Corporate Bond Index, the BofA Merrill Lynch U.S. High Yield Constrained Index, Merrill Lynch Corporate Master Index, and the Merrill Lynch Muni Master Index.
The information presented above reflects the opinions of Thomas DeMarco as of May 17, 2016. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.
Past performance is no guarantee of future results.
Diversification and asset allocation do not ensure a profit or guarantee against loss.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities.
High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.
The Citigroup Economic Surprise Index measures weighted historical standard deviations of data surprises, comparing actual economic data releases to the Bloomberg survey median. A positive reading of the Economic Surprise Index suggests that economic releases have on balance been beating consensus. The index is calculated daily in a rolling three-month window. The weights of economic indicators are derived from relative high-frequency spot FX impacts of 1 standard deviation data surprises. The index also employs a time decay function to replicate the limited memory of markets.
Bond ratings indicate the creditworthiness of an issuer. The Standard and Poor’s ratings indicate the following:
AAA: An obligor has EXTREMELY STRONG capacity to meet its financial commitments.
AA: An obligor has VERY STRONG capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree.
A: An obligor has STRONG capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.
BBBs: An obligor has ADEQUATE capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.
Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.
Barclays Aggregate Bond Index: The Barclays Aggregate Bond Index is a market value–weighted index that tracks the daily price, coupon, paydowns, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment-grade debt issues with at least $250 million par amount outstanding and with at least one year to final maturity.
Long-Term Treasury (Total Return): The Barclays Long U.S. Treasury Index includes all publicly issued U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value.
Barclays U.S. Corporate Bond Index: The Barclays U.S. Corporate Bond Index is designed to measure the performance of the corporate bond market. The index includes publicly issued U.S. dollar–denominated corporate issues that are rated investment grade (must be Baa3/BBB– or higher using the middle rating of Moody’s Investor Service, Inc.; Standard & Poor’s; and Fitch Ratings), and have $250 million or more of outstanding face value.
BofA Merrill Lynch U.S. High Yield Constrained Index: The BofA Merrill Lynch U.S. High Yield Constrained Index is a modified market capitalization–weighted index of U.S. dollar–denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade rating (based on an average of Moody’s, S&P, and Fitch). The country of risk of qualifying issuers must be an FX-G10 member, a Western European nation, or a territory of the United States or a Western European nation. The FX-G10 includes all Euro members, the United States, Japan, the UK, Canada, Australia, New Zealand, Switzerland, Norway, and Sweden. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule, and at least $100 million in outstanding face value. Defaulted securities are excluded. The index contains all securities of the BofA Merrill Lynch U.S. High Yield Index but caps issuer exposure at 2%.
Merrill Lynch Corporate Master Index: The index includes publicly issued, fixed-rate, nonconvertible investment-grade dollar-denominated, SEC-registered corporate debt having at least one year to maturity and an outstanding par value of at least $250 million.
Merrill Lynch Muni Master Index: The index measures the performance of municipal bonds.
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