Treasury yields continued to decline to new lows over the last two weeks, with intermediate and long dated maturities reaching levels last seen in June 2013. With the ten year US Treasury note declining nearly twenty basis to 2.48%, all fixed income sectors produced strong monthly returns in May, adding further to impressive 2014 returns. On the economic front, the only release of note last week was the sharp—and surprisingly large—downward revision to first quarter GDP. The second estimate of 1Q GDP showed a decline of 1.0%, down from the previous figure of a 0.1% gain. The culprits behind the revisions were a larger inventory contraction and harsh winter weather.
Over the course of the last month, we have received several inquiries from clients as to the reasons behind the sudden 2014 drop in interest rates that has seemingly caught everyone off guard. Though there appear to be a multitude of factors (chief among them: increased China demand and pension needs), most reasons are not rooted in fundamentals. A strong contributor—that is only recently gaining attention and was briefly highlighted by the Wall Street Journal last week—is the role banks and financial institutions are playing in keeping yields low. Due to increased regulation and oversight, banks are now required to hold a larger percentage of high quality assets on their balance sheets than before the financial crisis. As the following chart from the FDIC depicts, banks collectively held $237 billion of US Treasuries as of March 31st, versus just $31 billion in December 2007. Interesting to note as well, this collective figure represents 6,245 banks—a decline of 1,160 from December 2007.
With interest rate volatility non-existent of late, fixed income participants remain on high alert this week, with two notable events scheduled for Thursday and Friday. On Thursday, the European Central Bank is expected to announce aggressive actions similar to the Federal Reserve’s Quantitative Easing (QE) program, with hopes of jump starting a fragile European economy. Friday is the payrolls report for May. Current expectations are for a gain of +210k. With a surprising gain of +288k last month, and absent some other fundamental justification, we suspect interest rates will have a difficult time maintaining current levels with a similar print.
Weekly 10 Year Treasury Yields versus 10 Year AAA MMD – including MMD to TSY ratio (beginning in January 2008)
Source: Bloomberg, Thomson Reuters and Castleton Partners
Led by tepid supply and strong demand, the tax exempt rally of 2014 remains very much intact. With gains of over 1.25% for the month, May extends a streak of five consecutive months of positive returns to start the year—the first such time since 1991, according to Bank of America Merrill Lynch. In sharp contrast to 2013, longer dated and lower rated securities have led returns. Per Barclays Capital, investment grade tax exempts have returned +5.91% year to date, while high yield tax exempts have returned +9.48%. Despite annual declines in cigarette trends, tax exempt high yield tobacco bonds lead all sectors of the municipal universe with returns of over 16%.
With an additional +$653 million of net new cash from the mutual fund complex, tax exempt activity was rather robust despite the holiday shortened week. With new issue activity registering oversubscriptions, muni yields recorded further declines, with short and intermediate maturities outperforming. Ten year benchmark tax free yields now rest at 2.16%, a decline of 61 basis points so far in 2014. As the best performing sector in fixed income YTD, we fully expect tax exempts to maintain their strong relative outperformance as we enter a seasonally favorable technical period for municipals. Over the course of the next three months, $92 billion of demand from interest payments, bond maturities and called bonds is expected to find its way back into municipals—exceeding expected supply by nearly $20 billion, according to Citigroup.
Tax exempt supply rises to nearly $7 billion this week, with the transportation sector being the most prevalent. A $431mm negotiated loan for Colorado Regional Transportation District (Aa3/A/A) and a $340mm loan for the Miami-Dade Expressway Authority (A3/A-/A-) are the largest deals expected to price.
AAA Municipal Market Data (MMD) Yield Curve
Source: Thomson Reuters
Weekly Municipal Mutual Fund Flow Data
Source: Lipper AMG Data
US investment grade corporate bond spreads ended the week broadly unchanged, with financials registering a small outperformance relative to other taxable sectors (i.e. energy/ consumer staples/ etc.). With YTD returns of +5.6% (per Barclays), the performance of corporate bonds remains impressive, outperforming both equities and high yield. Despite the third lowest supply week of 2014, high profile issuers such as Disney (A2/A), 3M Corp (AA2/AA-), and Wells Fargo (A2/A+) all priced to strong demand, lowering yield and spreads from initial price talk.
With merger and acquisition (M&A) activity on the rise, we reiterate our neutral position on corporate spreads, suspecting low interest rates will lead to releveraging of balance sheets. Despite $18 billion of corporate notes and bonds maturing in June and lending support to the asset class, we suspect spread volatility may be on the rise, limiting the potential for any further near term tightening in spreads.