Encore! Encore? 2019 a tough act to follow
Like their taxable credit brethren, the municipal bond market experienced a strong 2019, abetted by record inflows, low supply and lower market rates. Except for a likely upward bias in rates, these trends should continue in 2020 amid solid credit dynamics linked to rising property values, favorable employment trends in most localities and an expanding economy. The one caveat: tax-exempt munis appear rich relative to Treasuries based on historical yield ratios, limiting the relative upside potential. That said, retail investor demand remains strong and may support this valuation for a time. Risk factors remain the same as last year: idiosyncratic cases of pension underfunding and lower bank and insurance company demand as a result of the lower corporate tax rate, with the latter diminishing the diversity of buyers for intermediate and long-term muni bonds.
—R. J. Gallo, senior portfolio manager
If we were to just describe our economic outlook for the next 12 months, it would sound a lot like it did a year ago: moderate GDP growth, modestly increasing inflation and an accommodative Fed. But when it comes to performance, 2019 is going to be a tough act to follow. Indeed, it was one for the books. As measured by the 8.72% total return for Bloomberg Barclays U.S. Aggregate Bond Index (or the Agg), 2019 was fixed income’s best year since 2002.
Why might this year be more challenging? In a word, valuations. Interest rates are running 50 to 100 basis points lower across the yield curve than they were a year ago. As an example, the yield to maturity on the Agg fell from 3.30% on Dec. 31, 2018, to 2.34% on Dec. 31, 2019. At the same time, the spread between investment-grade (IG), high yield (HY) and emerging market (EM) credit and comparable maturity Treasuries has narrowed 100 basis points to near cycle lows. So while the year’s second half may be dominated by the U.S. presidential and congressional elections, this struggle with low valuations likely will dominate the first half, with the low starting point for rates cutting into income’s contribution to total returns and the tight spreads raising the odds price returns could turn negative.
In post-crisis first, investment grade and high yield underweighted
Against this demanding backdrop, for the first time in a decade Federated is starting a new year underweight both IG and HY bonds. Even though we don’t expect a recession and think growth may perk up as the year progresses, it’s simply difficult to be constructive on credit when prices are so high and yields are so low. Strip out the small but riskier “high-yield tail,” consisting primarily of energy, commodity and pharmaceutical components of the HY benchmark, for example, and you’re left with spreads in the low 200s and yields under 4%. Not much upside from there. We also have eliminated our EM overweight but are sticking with a neutral position as we expect a stronger global economy and reduced trade tensions will lift commodities.
TIPS, yield curve and duration offer opportunities
As an offset to our credit underweights, we have shifted to overweight Treasury Inflation-Protected Securities (TIPS), which should benefit if inflation picks up as we think it will. Nothing major, but we’ve already seen consumer prices settle above 2%, and it’s not out of the realm to think the Fed’s preferred PCE Index may follow suit. Policymakers have said this is their preference and indicated they won’t pre-empt such a move. Elsewhere, we are positioned for a steepening yield curve and are slightly short duration. Again, nothing dramatic, just enough to add alpha if rates rise as anticipated.
2019 was unique, to say the least
It wasn’t so much that the fixed-income market’s high absolute returns were unheard of, but rather that rarely do the highest quality and lowest quality sectors achieve significantly above-coupon total returns in the same year. Most years, either rates or credit spreads dominate, but in 2019, both contributed and moved in favor of bondholders. In this environment, many active managers outperformed their respective benchmarks by going long on duration as Treasury yields trended down most of the year and by remaining slightly overweight in credit as spreads continued to narrow.
Q4 reaffirms our active management approach
Also surprising was fixed-income's strong finish to the year. Under our process of using multiple alpha sources to add value in fixed income portfolios, we reduced virtually all of our strategic bets in the fourth quarter and relied instead on security selection and a series of small tactical bets related to yield curve, currency and TIPs.