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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