2015 Midyear Bond Market Update

         
      

 

Craig Elder and Dave Violet
Craig Elder and Dave Violette, CFA

Senior Fixed Income Research Analysts
Private Wealth Management Research

“You can’t continue to put jobs on at 225,000–275,000 every month with no expectations of wage inflation.”

 

      
         

When will the Federal Reserve raise interest rates? How concerned should issuers and bondholders be over municipal challenges in Chicago and Puerto Rico? Baird sat down with Senior Fixed Income Research Analysts Craig Elder, author of Baird’s “Fixed Income Weekly,” and Dave Violette, author of Baird’s “Municipal Bond Market Weekly,” at the year’s halfway point for their insight into what’s in store for the bond market.

Baird:
Could you summarize for us the first six months of the 2015 bond market? How did we get here?

Dave:
The only thing that has happened so far in yields has been that the yield curve has steepened, and that's only from about seven-year maturities and out – the short-end of the curve (two- to five-year maturities) are mostly unchanged. This isn’t to say there hasn't been a whole lot of volatility, because at times there has been. We’ve had the weather issue, we've had a port strike, we’ve had the strengthening of the U.S. dollar all driving real yields lower. Recently there’s been some recovery in the economy, and risk premiums – the added compensation investors get for taking on risk – have started to build back up again and push yields higher.

It’s also worth remembering that we don't live in an isolated world, and we have to contend with global yields as well. For instance, when German bunds move, we have a tendency to move too. When German yields went from about 5 basis points up to 100 basis points, U.S. yields moved with them, though not as drastically.

Baird:
How have municipal yields performed compared to Treasurys? Do you anticipate the municipal-to-Treasury ratio to change?

Dave:
So far in 2015, munis have not really outperformed Treasurys, with the exception of the long end of the curve, and that can be attributed to the yield advantage that munis have over Treasurys. The return on munis – and on Treasurys, for that matter – hasn't been great, but you would expect that in a very low-yield environment.

As far as the municipal-to-Treasury ratio goes, a 10-year AAA GO ratio in the 80% range is a thing of the past, pre-2008. Now that municipal bonds have become more of a credit market, it doesn’t look like we’ll see a ratio sustainably below 90% returning any time soon. Between 2001 and 2007, the average for the 10-year AAA GO Ratio was 86%. Since then, it's been 101%, and that’s about where we are currently. The ratio has historically been conditional on absolute yields, so as yields go lower, ratios are higher. In fact, if yields do begin to go higher, I would expect the ratios to actually fall a bit. The 10-year AAA GO ratio is sitting right on what I call the normal line – if you drew a curve, the ratio would be sitting right on that line through those data points.

That’s not the case for the five-year. The five-year is still a little bit higher in ratio than what would be considered normal for the given yield.

Baird:
Given all the speculation around when the Federal Reserve will raise interest rates, what did we learn from the Fed’s June meeting? What impact will the Fed’s future actions have on the market?

Craig:
You may get one or two rate hikes this year. My best guess is that the Fed will move rates by 25 basis points in September, and possibly another 25 basis points in December. However, the Fed is proceeding with caution to ensure we don’t see another “taper tantrum” like we had in 2013, when then-Fed chair Ben Bernanke merely mentioned they would begin “tapering” the asset buyback program and ending QE3. That announcement resulted in the yield on the 10-year Treasury note going up almost 150 basis points from May to the end of the year in 2013.

Of course, all that said, we thought rates were going up every year since 2010 and they haven't, so I may be repeating myself in a few months.

Baird:
What are the risks of waiting too long to raise interest rates?

Craig:
Paraphrasing what St. Louis Fed president Jim Bullard said earlier this year, "I don't know really what the proper interest rate is – I just know zero is not the proper rate for this economy." We would agree with that assessment.

You can't continue to put jobs on the board at well over 200,000 a month going into next year without having some concerns about wage-driven inflation. I think that's why the Fed needs to get off this zero-bound range on the Fed funds target.

At this time, the Fed can raise rates at a “trajectory” that it wants. However, if they wait and the inflation numbers start to percolate, they may be forced to change that trajectory higher to fight inflation. It hasn’t been an issue yet, but as I mentioned, you can’t continue to put jobs on at 225,000–275,000 every month with no expectations of wage inflation.

Unfortunately, a problem the Fed has is the tightness in certain job markets in certain areas of the country where others have none. I can't imagine anybody who can write code has a problem getting hired anywhere right now, but if you do not have a skill set that is in demand, good luck finding a job.

Dave:
What people need to understand is that the Fed follows the market, and not the other way around. The Fed only acts on the very short end of the curve – the rest of the curve moves based on expectations. They will take action based on things that they see going on in the market, such as core inflation, labor market tightness and – despite their mandate – a 30,000-foot view of what's going on globally.

Baird:
We’ve seen that Puerto Rico may be getting closer to defaulting on its municipal bonds, and major cities in the U.S. have seen their bonds recently downgraded. Is this a trend we need to be concerned about?

Dave:
I think Puerto Rico in particular and municipal credits generally are idiosyncratic – I don't expect any kind of widespread defaults given the current conditions. However, there are some common attributes that could be problematic. Local economic deterioration is one of the most significant factors for the most troubled credits. Detroit, Puerto Rico and even places like Atlantic City all have local economic challenges that affect their credit ratings. Each of these challenges is unique to each location, but the effects on the ratings are the same.

And then there are some overarching issues like pensions. That's a big issue that's going to require some difficult decisions by politicians. Chicago, the whole state of Illinois and New Jersey are examples of that. But I wouldn't say that's necessarily a sign of deteriorating credits everywhere.

Baird:
What advice would you give potential issuers looking at the market?

Craig:
What we're seeing on the muni side has been just massive refunding rather than new issuance. High-yield issuance had been really strong, though it's tapered off the last few weeks, while investment-grade issuance continues to be strong. It seems as if every CFO is running to the market to issue debt. The issue I have, though, is when they're issuing debt to buy the shares back or increase dividends – historically that's not worked out well for bond investors.

Dave:
Year-to-date issuance is up about 50%, but that's after 2014 being down a lot and 2013 also down a fair amount. The first week of June was down because of the big run-up in yields, but the second week has been back up to somewhat normal levels.

As Craig mentioned, municipal activity has primarily been refunding, with people capitalizing on the low yields we saw earlier in the year. Also, it's somewhat assumed that there's pent-up supply out there. As an example, it’s generally believed we're in an infrastructure deficit, so it's possible we’ll continue to see additional issuance so long that yields behave and don't become too volatile.

For further insight into the bond market, check out Craig Elder’s “Fixed Income Weekly” and Dave Violette’s “Municipal Bond Market Weekly” at rwbaird.com/publicfinance.