The tax legislation passed by Congress in December 2017 was the main catalyst for stronger domestic economic growth in the first half of 2018. Real gross domestic product (GDP) grew an annualized 2.7% during the period compared to only 2.3% for 2017, while the unemployment rate fell below 4% for the first time in almost two decades.
The rosier economic backdrop gave the Federal Reserve ample justification to continue their policy of gradually notching up short-term interest rates. Not surprisingly, the federal funds rate was increased 25 basis points (bps) following both the March and June Open Market Committee Meetings.
Unlike 2017, intermediate- and longer-term domestic rates actually moved higher in correlation with the increases in short-term rates and with slightly higher expectations for future inflation. The range of yields on the Treasury 10-year note went from 2.5% at the beginning of the year to a high of 3.1% in May before settling in at 2.9% by the end of June.
Consequentially, the total return on most fixed income benchmarks was negative for the first half of 2018. The Bloomberg/Barclays Aggregate Bond index returned -1.6%, while the Bloomberg/Barclays Municipal Bond index returned -0.3%.
Global Interest Rates Unchanged
The move higher in interest rates was mostly isolated to the U.S. Interest rates on sovereign bonds for the other G5 countries were essentially unchanged, and many still peg their short-term rates at or near zero. The theme of synchronized global growth did not materialize to the degree most economists had predicted. Brexit negotiations and the threat of more meaningful trade wars seem to have dampened non-U.S. growth.
Another ingredient for higher domestic interest rates is the material increase in Treasury supply. The tax legislation and additional budget-driven deficits have resulted in an increase of nearly $1 trillion of borrowing needs in 2018. That follows the additional $500 billion increase in 2017. Taking the additional borrowing needs into consideration, the rise in interest rates has been rather orderly. For now, foreign demand has been ample due to the increasing relative attractiveness of U.S. yields.
Investment-grade corporate bonds had a disappointing first half of 2018. Investment-grade bond credit spreads increased 27 bps, from 89 bps at the beginning of the year to 116 bps at the end of June. This produced negative total returns for the reporting period. The Bloomberg/Barclays Aggregate Bond index was -3.3%, with financial companies as the worst-performing subsector.
Equity market volatility and renewed concerns in the European banking system were the major reasons for the weaker tone. In addition, the expected material slowdown of new corporate bond issuance did not occur. Predictions of a slowdown of new-issue supply ranged 10–20% lower than last year's record level. Continued borrowing from merger and acquisition deals offset the concept of corporate repatriation of foreign-held profits, resulting in less need for new domestic borrowings. As a result, new-issue supply of investment-grade corporate debt is on pace to match last year's record level.
Non-investment grade, or high-yield, corporate bonds produced better total returns than investment-grade corporate bonds did for the period. The range of yield spreads was more volatile, but the actual widening was less severe. High-yield spreads only increased 20 bps and the total sector produced a modest 0.3% return.
Emerging Market Debt
In a bit of a reversal of fortune, the worst-performing portion of the fixed income market has been emerging market debt. After back-to-back years of significant outperformance, the Bloomberg/Barclays Emerging Market index posted a negative return of -3.8% for dollar-denominated bonds and -5.5% for unhedged, or local, currency. Growing concerns about trade wars and isolated political uncertainty from countries like Argentina and Turkey were key drivers for negative returns. In local currency, Argentinian sovereign debt posted a return of -38% and Turkey was not much better at -26%.
As many predicted, municipal bonds faired relatively well compared to taxable fixed income securities in the first half of 2018. However, the underlying components of the return differentials were somewhat surprising. The increase in yields of an AAA-rated 10-year municipal bond was actually slightly more than the yield of a 10-year Treasury note over the reporting period, and the increase in yields of 30-year AAA-rated municipals was almost double the increase in yields on the 30-year Treasury bond. Short-maturity municipal bonds significantly outperformed relative-maturity Treasury securities.
The yield-curve dynamics between the two markets were quite different. The municipal bond market had a "bear steepener" and the Treasury market had a "bear flattener" (i.e., yields on longer municipals moved higher than short maturities and Treasury short-maturity yields moved higher than the yields on longer-dated Treasuries). In addition, unlike corporate bonds, the yield spreads on lower-quality municipal bonds tightened during the period. In fact, the worst-performing quality bucket was AAA-rated securities, which returned -0.5% compared to 0.4% for BBB-rated municipals.
The outperformance is attributable to favorable supply/demand characteristics in the municipal bond market. Last year's supply of roughly $425 billion was punctuated by the all-time monthly record supply of $63 billion in December. The real and perceived threat of changes to the tax code pushed many issuers to come to market before year-end 2017. That resulted in a lull of issuance during the first half of 2018. Supply of new issue municipal bonds in 2018 is on pace to be closer to $325 billion, or $100 billion lower than last year. Furthermore, the concern about potential large net selling from traditional institutional holders of municipal securities (banks, property and casualty insurance companies) has yet to materialize.
As of year-end 2017, institutional buyers held roughly $900 billion of the $3.9 trillion of outstanding municipal securities. Given the potential effective tax bracket reduction from 35% to as low as 21%, the need for tax-exempt interest income for these owners was justifiably much lower. However, our estimate of net secondary selling of municipal securities from institutional holders was in the $25 billion range, most of that coming from regional banks. Many institutional holders seem content to allow holdings to roll off or mature rather than sell large portions of their portfolios.
Furthermore, demand from high net worth individuals was positive and steady, especially after tax season. Total inflows into open-end municipal bond mutual funds exceeded $6 billion. Demand from high net worth investors who reside in states that were heavily impacted by the limited deductibility of high in-state income and property taxes has been particularly robust. California municipal securities have seen an outsized imbalance, which has driven their total returns materially higher than national averages.
Another factor for the outperformance of municipal securities is an improving credit outlook, especially for states. As of the beginning of July, only one state does not have a fully enacted budget. At this time last year, 10 states lacked a fully enacted budget. Budget passage was less combative this year due to higher projected tax revenues generated from stabilized economies. A contributing factor in forecasted revenue growth was the additional revenue that will hypothetically be generated from the Supreme Court ruling allowing states to tax online sales.
With growing economies and enacted budgets, state ratings should stabilize over the near term. Over the last two fiscal years, 11 states have seen their credit ratings decline, with only a few upgrades. Furthermore, many states are using some of the additional tax revenue to potentially replenish underfunded pensions, but this action varies drastically state by state and many states and localities have put themselves in very deep and troubling positions. Consequentially, we remain guarded and particularly concerned about how municipal credits will fair in the next recession.
Our outlook for the remainder of 2018 is for a slight improvement in total returns across fixed income markets. While we still believe the Federal Reserve has the desire to increase interest rates two more times in 2018, we would not be surprised to see only one additional tightening. As of early July, the market is pricing only a 47% probability of two 25 basis point moves for the remainder of the year. We are also calling for a flatter yield curve, so intermediate- and long-term interest rates could very easily be roughly unchanged by year-end. This, coupled with stabilizing credit spreads, should help boost fixed income total returns on the taxable side.
However, we reiterate our concern about potential volatility in the high-yield space and caution investors who have an overweight position there. We also continue to favor floating-rate high yield compared to fixed high yield. Our outlook for municipal bonds is for continued relative strong performance. A favorable supply/demand environment with stable credit outlook should help maintain a positive tone. Additionally, we are monitoring the recent weakness in the emerging market fixed income arena. This overdue correction may lead to an opportunity to get a limited exposure back into our client portfolios, but an immediate move into the emerging markets could prove premature.
While our outlook calls for less supply and more modest returns, we believe it is very important to hold a mix of fixed income strategies to provide stability and a source of income within a well-diversified portfolio. Investors should avoid the noise generated by the political news cycle and instead focus on the important role fixed income plays in their portfolios.