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Investment Commentary

Fixed Income Update: Third Quarter 2020

The COVID-19 pandemic persisted, but bond investors largely shrugged off concerns with an accommodative central bank and hopes of government aid.

 

KEY POINTS

  • The COVID-19 pandemic has continued, but investors largely shrugged off concerns in hopes of government aid and an accommodative central bank.
  • Although the economy is struggling, it is showing signs of improvement. The pandemic has persisted and will dampen growth in the near term; however, financial markets remain resilient.

 

EXHIBIT 1: INFLATION
Core personal consumption expenditures (PCE), the Fed’s preferred measure of inflation, has failed to consistently produce inflation above 2%. Massive stimulus has only had modest impact to date.

Fixed Income Update - 3Q2020 - Chart 1

 


ECONOMY

  • The economy showed improvement in the third quarter, but remains The unemployment rate fell to 7.9% from 11.9% during the quarter, underscoring the tepid reopening of the U.S. economy. Markit Purchasing Manager Indices for both manufacturing (53.2) and services (54.6) rose and are now comfortably in expansionary territory (>50).
  • The U.S. House of Representatives and U.S. Senate failed to agree on a new stimulus package, but the Federal Reserve’s support aided the improvement in financial markets.


EXHIBIT 2: U. S. ECONOMIC BACKDROP

As individuals return to work, manufacturing, services, and employment have all benefitted, as shown by purchasing manager indexes (PMI). The unemployment rate still remains well above pre-pandemic readings.


Fixed Income Update - 3Q2020 - Chart 2



CENTRAL BANKS

  • Global central banks sustained their “whatever it takes” attitude to support economies: capital restrictions, increases to large scale asset purchasing programs, and tweaks to direct lending
  • The Fed extended all of its current lending facilities through the remainder of the It also announced a move to a flexible inflation target, allowing inflation to run above its previous 2% target for a period of time. Lastly, it announced large banks’ dividend restrictions and prohibited share buybacks through the end of the year.


EXHIBIT 3: CORPORATE BOND OPTION-ADJUSTED SPREADS (OAS)

Improved liquidity and the Fed back-stopping has helped credit spreads compress.

Fixed Income Update - 3Q2020 - Chart 3



ULTRA-SHORT/CASH

  • Short-term investment grade new issues were heavily oversubscribed given light issuance and improving credit Most issuers came to market with longer-dated bonds, locking in low rates.
  • In the absence of additional fiscal stimulus and related Treasury bill issuance, money market yields continued to move lower despite modest money market fund industry Credit spreads remain near historic lows and the 3-month Libor rate set an all-time low.


EXHIBIT 4: CHANGE IN 3-MONTH LIBOR YIELD VS. 9/30/20 (BASIS POINTS)

The 3-month Libor yield continues to fall as supply decreases.


Fixed Income Update - 3Q2020 - Chart 4



TREASURYS AND TREASURY INFLATION-PROTECTED SECURITIES (TIPS)

  • Mixed economic data along with uncertainty surrounding potential fiscal stimulus and S. election outcomes kept rates relatively flat throughout the quarter. Ten-year Treasury yields traded in a tight range centered around 68 basis points throughout most of the quarter.
  • Ten year Treasury Inflation-Protected Securities (TIPS), a measure of expected inflation, had a very strong quarter and rallied 29 basis points. Given the uncertainties noted, TIPS returned to fair value while investors wait for more information.


EXHIBIT 5: 10-YEAR TIPS BREAKEVEN RATE (%)

The strong recovery in TIPS is typical of economies emerging from recession. TIPS decreased from their highs as Congress failed to pass a new stimulus bill. Breakeven rates are a gauge of expected inflation.


Fixed Income Update - 3Q2020 - Chart 5



INVESTMENT GRADE BONDS

  • Companies continued to take advantage of low cost funding ahead of the election, setting monthly issuance records two months of the U.S. investment grade issuance in 2020 has now surpassed the 2017 full-year record and stands at $1.57 trillion.
  • Supported by large inflows and the Fed, credit spreads tightened by 14 basis points during the quarter and are approaching pre-pandemic levels. The option-adjusted spread widened slightly as equity markets fell off near the end of the quarter.


EXHIBIT 6: YEARLY INVESTMENT GRADE ISSUANCE ($ TRILLIONS)

Large inflows into investment grade mutual funds have absorbed record issuance in the asset class.


Fixed Income Update - 3Q2020 - Chart 6



HIGH-YIELD BONDS

  • As the economic outlook improved, lower quality bonds performed most High yield mutual funds had $6.7 billion of inflows during the quarter, which supports high yield valuations.
  • Management teams continued to take advantage of low rates to extend maturity schedules, pushing 2020 to a record issuance Year-to-date high yield issuance stands at $372 billion.


EXHIBIT 7: CORPORATE BOND RETURNS BY RATINGS CATEGORY (%)

Lower quality credit across both assets classes performed better than their higher rated peers, as investors searched for yield.


Fixed Income Update - 3Q2020 - Chart 7



MUNICIPAL BONDS

  • We expect the heaviest amount of new issuance this year in October, with taxable municipal bonds the main Tax-exempt issuance is flat year-to-date.
  • Lack of additional federal aid has led state and local issuers to refinance outstanding debt and backfill deficits amid strong


EXHIBIT 8: MUNCIPAL BOND RETURNS BY RATINGS CATEGORY (%)

Higher quality bonds have outperformed year-to-date, but lower quality bonds rallied this quarter as investors reach for yield.

Fixed Income Update - 3Q2020 - Chart 8

 


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