With volatility re-introduced to the market and asset valuations reminding us that they move both up and down, the summer calm presents the perfect opportunity for investors to revisit their fixed income portfolios.
Despite headlines spanning tariff wars, geopolitical power struggles, and mega-merger announcements, our view is that U.S. fixed income performance will largely be driven by fiscal and monetary policy – particularly relative to other asset classes.
With two rate hikes behind us and two more slated for the remainder of 2018, investors can expect the consistent, albeit gradual, pace of interest rate hikes to continue. These hikes are supported by persistently low levels of inflation and unemployment rates.
The rate increases have been more pronounced at the front end of the yield curve. Yield on the 2-year Treasury has risen 64 bps year-to-date compared to 23 bps for the 30-year, driving the curve to its flattest point since 2007[i]. With the spread between the 7- and 10-year Treasuries at only ~3 bps, there is increasing likelihood of an inversion event which we view as a leading indicator of a recession, or rather, a “canary in the coal mine.”
In addition to lowering tax rates for investors, the recent overhaul of U.S. tax policy will remove the ability for municipalities to pre-refund outstanding debt and cap the corporate interest expense deduction – which should result in lower issuance volumes.
While it is unlikely the minor reduction in individual tax rates will dampen demand for munis… 10-15%[ii] of annual muni issuance volume has historically come in the form of pre-refundings, and we do not foresee this volume being replaced. Decreased supply and consistent demand should support municipal bond prices.
Contrasting the benefit of reduced tax rates, corporate issuers are currently grappling with the new 30% of EBITDA cap on interest expense deductions. These changes are a tale of two rating bands. Less than 1%[iii] of investment grade issuers have interest expense ratios above the cap relative to ~8%[iv] of high yield issuers. Considering debt ratios, we anticipate issuance in the lower tiers of the high yield market to be more affected as these companies adjust to the new status quo.
Conclusion and Portfolio Positioning:
Unsurprisingly, we look to the Fed as the primary driver of near-term market performance. While the second half of 2018 will undoubtedly be littered with ‘market moving’ headlines, we recognize these events as noise, rather than signal.
We believe shorter-duration, higher-quality credits will continue to be a safe-haven for investors. While we don’t expect a rate hike surprise, an allocation to floating rate securities would offer additional protection should the Fed go off-script. Investors seeking incremental yield may find compelling opportunities in “fallen angels”. These bonds often suffer from forced selling, creating an attractive entry point. As demonstrated above, BB credits offer greater yields and less leverage than BBB credits.
[i] Federal Reserve Bank of St. Louis. As of June 21, 2018.
[ii] “Tax Reform and the Municipal Bond Market” GSAM, February 6, 2018.
[iii] Standard and Poor’s, “U.S. Tax Reform: An Overall (But Uneven) Benefit for U.S. Corporate Credit Quality,” December 18, 2017.
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