Slowing global growth, worries about an escalation of trade tensions and low inflation pushed global bond yields lower during the first half of the year. As a result, central banks around the world have shifted to a more accommodative stance. This significant move lower in global rates, along with low inflation, helped deliver attractive fixed income returns, with higher yielding sectors delivering the strongest results.
In January, the Federal Reserve pivoted from their “autopilot" policy of gradually increasing short-term interest rates toward neutral to a more patient approach — a dramatic reversal of monetary policy. As trade uncertainties weighed on the Fed's economic outlook and inflation remained muted, the central bank pivoted once again, from indicating a readiness to cut interest rates should the economy show signs of further deterioration. The Fed is now poised to cut short-term interest rates from 2.5% back down toward 1.5%, based on its latest forecast. If it occurs, this action would essentially eliminate all the increases put into place by the Fed in 2018.
The key question for the Fed is: How severe will the slowdown actually be? While we expect both global economic growth and domestic growth to slow this year and next, our outlook does not call for a recession anytime soon. A partial inversion of the Treasury yield curve — in particular the three-month Treasury bill versus the 10-year Treasury note — has raised concern about what may lie ahead for the economy. Although an inverted yield curve has been useful in predicting a coming recession in the past, we do not believe it is a reliable indicator this time around. Our view is that the move to lower short-term rates is largely due to a lack of consistent inflation at or above the Fed's 2% target, rather than a negative outlook about economic growth. Also, many portions of the yield curve remain normally sloped. The spread between the two-year Treasury and the 30-year Treasury remains positive at 75 basis points (bps), which is actually steeper than where it began 2019.
The yield of the U.S. 10-year Treasury note has declined meaningfully since the fourth quarter of 2018. After peaking at 3.25% in October of 2018, the 10-year note ended the second quarter at 2%. Although U.S. Treasury interest rates decoupled from the very low global yields during 2018, U.S. rates are once again tethered to global rates. Demand for U.S. government debt is robust given that nearly $13 trillion of sovereign bonds are currently yielding less than zero. This helps explain the stronger demand for U.S. Treasury securities despite the additional supply generated from an ever-growing federal budget deficit.
Treasury Inflation-Protected Securities (TIPS) continued to struggle relative to nominal Treasury securities during the first half of 2019. Inflation expectations bounced around but still ended lower mid-year compared to the beginning of the year and well below the Fed's target of at least 2%.
After a disappointing 2018, corporate bonds posted very strong gains during the first half of 2019. Similar to the equity market, the dramatic sell-off in the fourth quarter of 2018 was completely reversed. Credit spreads, which peaked in late December, collapsed back down toward the multiyear lows experienced in 2018. Spreads on investment-grade corporate bonds were much less volatile than high yield spreads, but also narrowed. Yield spreads on investment-grade corporate bonds tightened from 143 bps to 110 bps, whereas high yield bond spreads went from 526 bps to 360 bps. Tighter spreads, coupled with declining interest rates, produced year-to-date total returns of nearly 10% for both investment-grade and high yield corporate bonds. Interestingly, the supply of high yield corporate bonds posted their first quarterly increase since 2015, which is a positive signal for future economic activity.
The municipal bond market posted solid semiannual total returns as positive supply/demand dynamics, which began in 2018, continued into the first half of 2019. Demand for municipal bonds actually accelerated in 2019 and supply was muted compared to 2015–2017. A record $45 billion in net subscriptions flowed into open-ended municipal bond funds during the first half of the year. Weekly flows were positive for 25 consecutive weeks, which is also a record. If the pace of flows continues in the second half, annual flows would easily surpass the all-time highest positive inflow period of 2009 (which was $72 billion).
Unlike last year, the municipal yield curve flattened, following the pattern of the Treasury yield curve. Demand from mutual funds more than offset the selling pressure encountered from banks and insurance companies at the long-end of the maturity profile. Retail buying of individual, high-quality securities with maturities of 10 years and shorter remained robust, but has recently softened. As a result of a very flat yield curve and low nominal yields, especially between one- and five-years, demand for bonds further out on the curve and for long-maturity mutual funds has increased. The new federal cap on state and local tax deductions has also spurred demand for municipal bonds in high-tax states, such as California and New York.
Longer-dated bonds delivered stronger returns during the first half of the year, with the Bloomberg/Barclays Municipal Bond 22+ Year index producing a return of 6.9% versus the Bloomberg/Barclays Municipal Bond Five-Year index, which delivered 3.8%. Lower-rated credit quality municipal bonds again outperformed higher quality, with BBB-rated securities up 6.6% compared to AAA-rated securities, which were up 4.6%.
Municipal Bond Credit
Credit quality of the vast majority of municipal bonds issuers continues to improve. Strong economic growth in 2018, repatriated, foreign-held corporate profits and positive capital markets all helped to strengthen the revenues of state and local governments. The growth in revenues has allowed most jurisdictions to make required annual pension contributions. More cyclically sensitive states, like California, have even been able to replenish rainy day funds. This year, all states should have much less contentious budget negotiation processes and meet their midsummer budget deadlines. This is a departure from just three years ago when many states, including Pennsylvania, Connecticut, Louisiana and New Jersey, all struggled to meet their summer balanced-budget timelines.
However, there are still certain states and localities that have not effectively taken advantage of a strong, decade-long economic expansion to properly fund massively underfunded pensions and post retirement obligations. Far too many jurisdictions all but ignored their required annual contributions, from the late 1990s well through the great recession. Many jurisdictions are only now waking up to the reality of having to use a growing portion of the general fund to meet current pension liabilities. They will be vulnerable if we have another recession. It is very likely the municipal bond market will experience more volatile downgrades of credit ratings and possibly more defaults from the most extreme violators, but this will not be a common experience nationwide — and could be several years away. Also, it should be noted that municipal credit quality is a lagging indicator, often taking several years after a downturn for municipalities to feel the complete impact on finances.
Fixed income returns are expected to be more muted for the second half of 2019, as the majority of the rate move has most likely already occurred. Uncertainty about the pace of global growth and below-target inflation pressures should allow global central banks to be more accommodative, with the Fed poised to lower the short-term rate back towards 1.5% over the course of the next year. Lower short-term rates may help to stimulate the economy and reinvigorate inflationary pressures back toward 2%. This could actually push intermediate- and longer-term interest rates slightly higher toward the end of the year or into the first half of 2020.
Our base case for interest rates is “lower for longer," and our new range for the yield on the 10-year Treasury note is 1.75%-2.25%. Interest rates could be volatile, moving lower, if trade tensions escalate, or higher, if a trade resolution is reached. The latter could lead to what would be a much-welcomed steepening of the yield curve, with longer maturities going slightly higher and short-term rates only falling toward 2%.
Our outlook on credit spreads is more positive. Corporate profitability appears relatively stable and the global demand for yield seems fairly strong, which should keep credit spreads reasonably contained. However, investors should expect a return of capital rather than the degree of price appreciation realized in the first half of the year. Importantly, we remind clients that having a well-diversified, high-quality bond portfolio, coupled with actively managed satellite fixed income solutions, is imperative in these uncertain times.