Contrary to expectations, the bond market posted solid returns in 2017. The total return of the Bloomberg Aggregate Bond index was 3.54%, which was somewhat surprising given the Federal Reserve's monetary policy actions during the year. The Fed increased the federal funds rate three times during 2017, for a total increase of 75 basis points (bps). This pushed the yield on short-maturity Treasury notes higher throughout the year, with the one-year Treasury note rising from a low of 0.98% to 1.70% at year-end.
While the Fed's actions had a direct impact on short-term yields, long-dated maturity yields declined. For example, the yield on the 30-year Treasury bond fell from 3.07% to 2.76%, while the 10-year Treasury note ended the year essentially unchanged at a 2.40%. This yield curve dynamic, called a “twist," occurs when short-term yields increase and long-term yields decline. The twisting yield curve was a major contributor to the positive total return for the broad bond market indices. Long-maturity bonds produced a significant amount of price gains to offset the slight price declines experienced on short-maturity holdings.
Low volatility was a consistent theme across all the capital markets in 2017, but particularly so in the bond market. Interest rates (as measured by the 10-year Treasury note) traded in a very narrow range, spanning from 2.60% in March to a low of 2.04% in September. This 55 bps range compares to an average annual range in excess of 1% and is the narrowest differential since 1968.
Corporate bonds had another impressive year in 2017. New-issue supply set its fifth consecutive annual record and demand remained robust. Total new-issuance supply for investment grade corporate bonds totaled $1.4 trillion, easily surpassing last year's record by over $100 billion. The additional yield investors require over Treasury yields (i.e., the yield spread) tightened throughout the year. The investment-grade corporate yield spread declined from 1.17% at the start of the year to 0.93% by year-end. Tightening spreads produced higher relative total returns on corporate bonds compared to Treasury securities.
Non-investment-grade corporate, or high yield, bonds delivered attractive returns for the second year in a row. A strong commodity market helped the energy, metals and mining sectors continue the robust price gains experienced in 2016. New-issue supply was manageable and demand was ample enough to drive yield spreads tighter from 400 bps at the start of the year to a low of 326 bps before settling back at 343 bps by year-end. The total return of the Merrill Lynch High Yield index was 7.50%, following 2016's stellar return of 17.1%.
The strongest fixed income sector in 2017 was emerging markets, especially local currency emerging markets debt. Dampened political strife, stronger commodity markets, improving current account deficits and lower inflation expectations helped spur strong annual performance. The JP Morgan Emerging Markets Bond index (local currency) returned 14.27%, while the U.S. dollar-denominated index was up 8.17%.
In 2017, municipal bonds had a comeback year following a somewhat disappointing 2016. In November 2016, investors had abandoned the asset class following the surprise outcome of the U.S. presidential election. In fact, November 2016 was one of the worst months on record for municipal bonds. Initially, concern about higher interest rates and the potential negative side effects of tax reform spooked investors. Retail investors quickly regained confidence that tax reform would not dramatically lower the top tax bracket and, more importantly, not change the tax-exempt status of the interest income on state and local municipal bonds. As a result, the municipal bond market quickly rebounded and posted six straight months of positive total returns.
Despite concern that banks and property and casualty insurance companies — the two major corporate purchasers of municipal bonds — would no longer buy municipal bonds, demand for municipal bond mutual funds was healthy. Net subscriptions for funds totaled more than $31 billion for 2017. New-issue supply of municipal bonds declined 30% from 2016's all-time record of $445 billion for the first 11 months of the year. There was also less refinancing activity as interest rates moved slightly higher.
Tax Legislation Concerns
As details of the new tax legislation became clear, there was a surge in supply in December. Earlier versions of the tax bill contained two provisions that eliminated access to the municipal bond market beginning in 2018. The initial Senate version of the new legislation eliminated the ability to refinance older debt prior to the stated call date (advance refunding), and also denied market access to private-activity issuers such as non-profit health care entities, stadium bonds, housing bonds and other project finance deals in which private entities have a beneficial interest. Once the potentially impacted issuers realized that these two components were in the legislation, many rushed to the market in late November and December before the window closed. As a result, new issue supply in December set an all-time record high for any month at more than $63 billion.
Fortunately, the final law restored market access for these private-activity issuers, but kept the provision to discontinue advance refundings. Approximately 15% to 20% of new issuance in any year represents advanced refundings, so the elimination is material. As a result of the uncertainty about what provisions the final tax bill would contain, year-end was much more volatile for the municipal bond market. As new-issue estimates plummeted from near $400 billion in 2017 to as low as $300 billion in 2018, municipal bonds rallied. This pushed yields lower, especially for longer-dated municipal bonds. The relative yield ratio between AAA-rated municipals and Treasuries fell to the lowest level in years.
Similar to the taxable fixed income market, performance of municipal bonds varied greatly depending on credit quality and maturity. Lower-quality and longer-maturity securities significantly outperformed shorter, high-quality securities. Given the positive macroeconomic backdrop, we believe municipal bond credit will remain strong. Through the first three quarters of 2017, net credit ratings were slightly positive, with four upgrades for every three downgrades. However, at the state level there were materially more downgrades than upgrades. The elimination of the federal deductibility of state and local taxes (SALT) will have ramifications on municipal budgets in the future as taxpayers' sensitivity to tax increases will be elevated. States and localities that already have a large tax burden and underfunded pension liabilities will be particularly vulnerable.
There will also be a bigger spotlight on the risk of population shifts, with wealthy individuals moving from high to low state and local tax jurisdictions. Obviously, this would just exacerbate the fiscal challenge for high-tax jurisdictions, but this is likely not a near-term problem. We expect more pressure on state and local governments to rationalize their spending. Budget negotiations will likely get more challenging. We do not believe the new tax landscape will be the sole catalyst for materially higher defaults, but we could easily see an acceleration of downgrades in the coming years ahead.
Our outlook for the fixed income market is for a gradual increase in rates, a flattening of the yield curve and a more modest tightening of credit spreads. We believe short-term interest rates will continue to gradually move higher with the Fed increasing the federal funds rate three more times in 2018 by a total of 75 bps. We don't expect intermediate- and longer-dated interest rates to move in lockstep with short-term rates, however, and instead increase by half as much.
We do not believe the yield curve will continue to twist but we do believe it will continue to flatten. Corporate bonds should benefit from stronger earnings and lower supply, but we will see little room for them to tighten significantly beyond their current narrow bands. High yield corporate bond spreads are also historically narrow and we would recommend caution despite the positive fundamentals generated by a stronger economy and higher earnings. The new tax legislation has components that may be challenging for more highly leveraged companies, particularly the limit on deductibility of interest expenses.
The supply-and-demand dynamics are setting up for a very good year for municipal bonds relative to Treasuries. New-issue supply will most likely drop materially from above $400 billion the last two years to below $300 billion, which would be a low in supply not seen in over 20 years. Demand should remain relatively strong from individuals and we do not believe institutional buyers such as property and casualty and insurance companies will become large net sellers. Demand will be particularly strong from high net worth individuals that reside in states that have high in-state income tax regimes. Expect to see the municipal bond yield curve continue to flatten, but not as dramatically as in 2017.
Importantly, we remind investors to avoid being concerned with how the tax bill could impact the fixed income market and instead focus on the role it plays in investors' portfolios. 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.