ABS
Highlights Chart 1Buy The 2-Year, Sell The 10-Year Treasury yields have been volatile of late, but the biggest move has been a flattening of the yield curve led by a sell-off at the front-end. Our recommended yield curve positioning (short the 5-year bullet / long a duration-matched 2/10 barbell) was well suited to profit from this move but has now run its course. The solid lines in the bottom panel of Chart 1 show the paths discounted in the forward curve for the 2-year and 10-year yields. The dashed lines show the fair value paths for each yield in a scenario where the Fed starts hiking in December 2022 and proceeds at a pace of 100 bps per year until reaching a 2.08% terminal rate. We can see that the 2-year yield looks a bit too high relative to fair value and the 10-year looks too low. Taken together, our fair value estimates show that the 2/10 Treasury slope should flatten during the next 12 months, but not by as much as is currently discounted in the forward curve (Chart 1, top panel). Investors should maintain below-benchmark portfolio duration but should shift out of 2/10 flatteners and into steepeners. Specifically, we close our prior yield curve trade and open a new one: Long the 2-year note, short a duration-matched barbell consisting of cash and the 10-year note. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds performed in line with the duration-equivalent Treasury index in October, leaving year-to-date excess returns unchanged at +193 bps (Chart 2). The combination of above-trend economic growth and accommodative monetary policy continues to support positive excess returns for spread product versus Treasuries. The recent flattening of the yield curve is a strong reminder that the window of outperformance for corporate bonds will eventually close, but the curve will need to be a lot flatter before we start to worry. Specifically, we are targeting a level of 50 bps for the 3-year/10-year Treasury slope as a level where we will turn more cautious on spread product relative to Treasuries. This slope currently sits at 80 bps and the pace of flattening should moderate during the next few months. A recent report presented the results of a scenario analysis for investment grade corporate bond returns during the next 12 months.1 We concluded that investment grade corporate bond total returns will be close to zero or negative during the next 12 months and that excess returns versus duration-matched Treasuries are capped at 85 bps. With that in mind, we advise investors to seek out higher returns in junk bonds, municipal bonds and USD-denominated Emerging Market sovereign and corporate bonds. We also recommend favoring long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 14 basis points in October, bringing year-to-date excess returns up to +572 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.1% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.6% through the first nine months of the year, well below the estimate generated by our model. Another recent report considered different plausible scenarios for junk bond returns during the next 12 months.4 We concluded that junk bond total returns will fall into a range of -0.29% to +1.80% during the next 12 months and that excess returns versus duration-matched Treasuries will be between +0.94% and +1.84%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 1 basis point in October, dragging year-to-date excess returns down to -44 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 16 bps in October. The spread looks tight relative to levels seen during the past year and relative to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) tightened 3 bps in October to reach 29 bps (panel 3). This is only just above the 28 bps offered by Aaa-rated consumer ABS but below the 54 bps offered by Aa-rated corporate bonds and the 30 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index performed in-line with the duration-equivalent Treasury index in October, leaving year-to-date excess returns unchanged at 68 bps. Sovereign debt outperformed duration-equivalent Treasuries by 23 basis points October, bringing year-to-date excess returns up to -65 bps. Foreign Agencies underperformed the Treasury benchmark by 5 bps on the month, dragging year-to-date excess returns down to +44 bps. Local Authority bonds outperformed by 16 bps in October, bringing year-to-date excess returns up to +423 bps. Domestic Agency bonds underperformed by 15 bps, dragging year-to-date excess returns down to +9 bps. Supranationals underperformed by 11 bps, dragging year-to-date excess returns down to +16 bps. The investment grade Emerging Market Sovereign bond index outperformed the equivalent-duration US corporate bond index by 35 bps in October. The Emerging Market Corporate & Quasi-Sovereign index delivered 8 bps of outperformance versus duration-matched US corporates (Chart 5). Despite this outperformance, both indexes continue to offer significant yield advantages versus US corporate bonds with the same credit rating and duration. We continue to recommend overweighting USD-denominated EM sovereigns and corporates versus investment grade US corporates with the same credit rating and duration.6 Within EM sovereigns, attractive countries include: Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 48 basis points in October, bringing year-to-date excess returns up to +341 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings are incredibly high (Chart 6) and individual tax hikes will only increase the attractiveness of tax-exempt munis if they are included in the upcoming reconciliation bill. Last week’s report showed that the average duration of municipal bond indexes has fallen significantly during the past few decades, a trend that has implications for how we should perceive municipal bond valuation.7 Specifically, the trend makes municipal bonds more attractive relative to both Treasury securities and investment grade corporates. Long-maturity municipal bonds are especially compelling. We calculate that 17-year+ maturity General Obligation Munis offer a before-tax yield pick-up relative to credit rating and duration-matched corporate credit. The same goes for 17-year+ Revenue bonds. High-yield muni spreads are reasonably attractive relative to high-yield corporates (panel 4), but we recommend only a neutral allocation to high-yield munis versus high-yield corporates. The deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2-Year Bullet Versus Cash/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened dramatically in October. The 2-year/10-year Treasury slope flattened 17 bps to end the month at 107 bps. The 5-year/30-year slope flattened 35 bps to end the month at 75 bps. As is mentioned on the first page of this report, the large flattening of the yield curve has led us to take profits on our prior 2/10 flattener (short 5-year bullet versus 2/10 barbell) and to initiate a 2/10 curve steepener (long 2-year bullet versus cash/10 barbell). We also noted on the front page that we still expect the 2/10 slope to flatten during the next 12 months, just not by as much as what is currently priced into the forward curve. The 2/5/10 butterfly spread has risen a lot during the past few weeks and it now looks extremely high, both in absolute terms and relative to our fair value model (Chart 7). The 2/5/10 butterfly spread can rise because of either 2/5 steepening or 5/10 flattening. We contend that the current elevated 2/5/10 butterfly is mostly the result of a 5/10 slope that is too flat, not a 2/5 slope that is too steep. The bottom two panels of Chart 7 show the 2/5 and 5/10 slopes along with dashed lines indicating where those slopes were on prior Fed liftoff dates in 2015 and 2004. We see that the 2/5 slope is not unusually steep compared to those prior liftoff dates, but the 5/10 slope is unusually flat. For this reason, we want long exposure to the 2-year note and short exposure to the 10-year note between now and Fed liftoff in late-2022. The best way to achieve this exposure is to buy the 2-year note and short a duration-matched barbell consisting of the 10-year note and cash. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 106 basis points in October, bringing year-to-date excess returns up to +740 bps. The 10-year TIPS breakeven inflation rate rose 15 bps on the month and the 5-year/5-year forward TIPS breakeven inflation rate fell 10 bps. At 2.54%, the 10-year TIPS breakeven inflation rate is now slightly above the 2.3% to 2.5% range that is consistent with inflation expectations being well-anchored around the Fed’s target (Chart 8). Meanwhile, at 2.14%, the 5-year/5-year forward TIPS breakeven inflation rate has dipped below the Fed’s target range (panel 3). The divergence between 10-year and 5-year/5-year breakeven rates underscores the flatness of the inflation curve (bottom panel). Near-term inflation expectations are extremely high, but they decline sharply further out the curve. Our view is that inflationary pressures will wane during the next 6-12 months and this will lead to a steep decline in short-maturity TIPS breakeven inflation rates.8 Breakeven rates at the long-end should remain relatively close to the Fed’s target range. We recommend positioning for this outcome by entering inflation curve steepeners or real yield curve (aka TIPS curve) flatteners. We also advise entering an outright short position in 2-year TIPS. The 2-year TIPS yield has a lot of room to rise as the cost of 2-year inflation compensation falls and the 2-year nominal yield remains close to its fair value. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 7 basis points in October, dragging year-to-date excess returns down to +35 bps. Aaa-rated ABS underperformed by 8 bps on the month, dragging year-to-date excess returns down to +25 bps. Non-Aaa ABS underperformed by 5 bps, dragging year-to-date excess returns down to +93 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 1 basis point in October, bringing year-to-date excess returns up to +196 bps. Aaa Non-Agency CMBS underperformed Treasuries by 3 bps in October, dragging year-to-date excess returns down to +93 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 17 bps, bringing year-to-date excess returns up to +543 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to +105 bps. The average index option-adjusted spread tightened 3 bps on the month. It currently sits at 30 bps (bottom panel). Though Agency CMBS spreads have recovered to well below their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 29th, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of October 29th, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -60 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 flattens by less than 60 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 For more details please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 7 Please see US Bond Strategy Weekly Report, “The Best & Worst Spots On The Yield Curve”, dated October 26, 2021. 8 Please see US Bond Strategy Weekly Report, “Right Price, Wrong Reason”, dated October 19, 2021.
Highlights Chart 1Bond Yields Still Track The "Re-Opening" Trade Bond yields rose notably in September, with the bulk of the move coming in the days after the Fed teased an upcoming tapering of its asset purchases and revealed slightly hawkish revisions to its interest rate projections. Interestingly, some of the details of the bond market move don’t mesh nicely with the mildly hawkish policy surprise that the Fed delivered. For example, the Treasury curve steepened on the month and long-maturity TIPS breakeven inflation rates rose. Our sense is that September’s market moves were less driven by the Fed and more by a revival of the reflation (or re-opening) trade from earlier this year. The daily new US COVID case count ticked down and, while overall S&P 500 returns were negative on the month, a basket of equities designed to profit from the end of the pandemic soundly beat a basket of “COVID winners” (Chart 1). With the delta COVID wave receding, we remain confident that economic growth will be sufficiently strong for the Fed to launch a new rate hike cycle in December 2022. The Treasury curve will bear-flatten as that outcome gets priced in. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 26 basis points in September, bringing year-to-date excess returns up to +193 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 99 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report presented the results of a scenario analysis for investment grade corporate bond returns during the next 12 months.1 We concluded that investment grade corporate bond total returns will be close to zero or negative during the next 12 months and that excess returns versus duration-matched Treasuries are capped at 85 bps. With that in mind, we advise investors to seek out higher returns in junk bonds, municipal bonds and USD-denominated Emerging Market sovereign and corporate bonds. We also recommend favoring long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 53 basis points in September, bringing year-to-date excess returns up to 558 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first eight months of the year, well below the estimate generated by our macro model. Another recent report considered different plausible scenarios for junk bond returns during the next 12 months.4 We concluded that junk bond total returns will fall into a range of -0.29% to +1.80% during the next 12 months and that excess returns versus duration-matched Treasuries will be between +0.94% and +1.84%. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 24 basis points in September, bringing year-to-date excess returns up to -43 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 19 bps in September. The spread is wide compared to recent history, but it remains tight compared to the recent pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) tightened 6 bps in September to reach 31 bps (panel 3). This is above the 22 bps offered by Aaa-rated consumer ABS but below the 52 bps offered by Aa-rated corporate bonds and the 33 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 15 basis points in September, dragging year-to-date excess returns down to +69 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 95 bps in September, dragging year-to-date excess returns down to -87 bps. Foreign Agencies outperformed the Treasury benchmark by 5 bps on the month, bringing year-to-date excess returns up to +49 bps. Local Authority bonds outperformed by 24 bps in September, bringing year-to-date excess returns up to +406 bps. Domestic Agency bonds underperformed by 7 bps, dragging year-to-date excess returns down to +24 bps. Supranationals underperformed by 4 bps, dragging year-to-date excess returns down to +27 bps. Last week’s report looked at performance and valuation trends for Emerging Market sovereign and corporate bonds relative to US corporates.6 The recent underperformance of EM bonds versus US corporates has led to attractive relative valuations in the sector. We see investment grade EM sovereign and corporate bonds both outperforming investment grade US corporates during the next 12 months. The outperformance will be the result of better starting valuations and an acceleration of EM growth in 2022. The bonds of Colombia, Russia, Mexico, Indonesia, Saudi Arabia, UAE and Qatar look particularly attractive within the USD-denominated EM sovereign space. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 29 basis points in September, bringing year-to-date excess returns up to +292 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 Both General Obligation (GO) and Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporate bonds with the same credit rating and duration (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in September, with yields moving sharply higher – especially in the 5-10 year maturity space. The 2-year/10-year Treasury slope steepened 14 bps to end the month at 124 bps. The 5-year/30-year slope flattened 5 bps to end the month at 110 bps. We expect bond yields to be higher in 6-12 months, but we also anticipate that the next significant move higher in bond yields will coincide with curve flattening, not steepening. At 2.08%, the 5-year/5-year forward Treasury yield is already within our target fair value range of 2% - 2.25%. In a recent report, we demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.30% in one year’s time and 1.62% in five years (Chart 7). The latter rate has 131 bps of upside if it converges all the way back to its 2018 high, but this pales in comparison to the 256 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 47 basis points in September, bringing year-to-date excess returns up to +627 bps. The 10-year TIPS breakeven inflation rate rose 3 bps on the month, while the 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps. At 2.41%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is only just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to a steepening of the inflation curve (bottom panel). We recommend that investors position for a steeper 2/10 inflation curve, or alternatively for a flatter 2/10 real Treasury curve. We noted in last week’s report that the combination of nominal curve flattening and inflation curve steepening will lead to a large flattening of the 2/10 real curve during the next 6-12 months.9The 2-year TIPS yield, in particular, has a lot of upside. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent nominal Treasury index by 3 basis points in September, bringing year-to-date excess returns up to +43 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +32 bps. Non-Aaa ABS outperformed by 7 bps, bringing year-to-date excess returns up to +99 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 2 basis points in September, bringing year-to-date excess returns up to +195 bps. Aaa Non-Agency CMBS outperformed Treasuries by 4 bps in September, bringing year-to-date excess returns up to +96 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 4 bps on the month, dragging year-to-date excess returns down to +525 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 3 basis points in September, bringing year-to-date excess returns up to +94 bps. The average index option-adjusted spread tightened 1 bp on the month. It currently sits at 33 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 30th, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of September 30th, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of -17 bps in the 5 over 2/10 cell means that we would expect the 5-year to outperform the 2/10 if the 2/10 flattens by less than 17 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of September 30th, 2021) Footnotes 1 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 2 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “Expected Returns In Corporate Bonds”, dated September 21, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 9 Please see US Bond Strategy Weekly Report, “Damage Assessment”, dated September 28, 2021.
Highlights Chart 1Employment Growth Will Rebound August’s weak employment growth reflects the surge of Delta variant COVID cases in the United States. This is evidenced by the fact that Leisure & Hospitality sector payrolls held flat in August after having grown by 415k in July and 397k in June (Chart 1). While Delta could still be a drag on employment growth for another month or two, there is mounting evidence that the daily new case count is close to its peak. Leisure & Hospitality employment growth will regain its prior pace as new Delta cases trend down. This will lead to a resumption of strong monthly payroll reports (500k – 1000k) as we head into the new year. For monetary policy, we calculate that average monthly nonfarm payroll growth of 414k will be sufficient for the Fed to start rate hikes before the end of 2022 (bottom panel). We anticipate that this threshold will easily be met. The Treasury curve will bear-flatten as employment growth improves and the market prices-in an earlier start and quicker pace of Fed rate hikes. Investors should maintain below-benchmark portfolio duration and stay short the 5-year Treasury note versus a duration-matched 2/10 barbell. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 5 basis points in August, dragging year-to-date excess returns down to +166 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 91 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled for corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated Emerging Market sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in August, bringing year-to-date excess returns up to +502 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.0% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.7% through the first seven months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 3 basis points in August, dragging year-to-date excess returns down to -67 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 4 bps in August. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 2 bps in August (panel 2), and it is now starting to look attractive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 38 bps, below the 56 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 35 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 27 basis points in August, bringing year-to-date excess returns up to +84 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 122 bps in August, bringing year-to-date excess returns up to +7 bps. Foreign Agencies outperformed the Treasury benchmark by 8 bps on the month, bringing year-to-date excess returns up to +44 bps. Local Authority bonds outperformed by 9 bps in August, bringing year-to-date excess returns up to +382 bps. Domestic Agency bonds outperformed by 3 bps, bringing year-to-date excess returns up to +30 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to +31 bps. USD-denominated Emerging Market (EM) Sovereign bonds outperformed US corporates in August and relative valuation between the two sectors is starting to equalize (panel 4). That said, we retain a preference for EM sovereigns over US corporates, particularly the bonds of Russia, Mexico, Saudi Arabia, UAE and Qatar where value remains attractive. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 9 basis points in August, dragging year-to-date excess returns down to +262 bps (before adjusting for the tax advantage). The economic and policy back-drop remains favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 5% breakeven tax rate versus corporates with the same credit rating and duration. 12-17 year Revenue munis actually offer a before-tax yield pick-up (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 23% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview Treasury yields moved higher in August, with the 5-year and 7-year maturities bearing the brunt of the sell-off. The 2-year/10-year Treasury slope steepened 5 bps to end the month at 110 bps. The 5-year/30-year slope flattened 5 bps to end the month at 115 bps. We expect bond yields to be higher in 6-12 months, but we also anticipate that the next significant move higher in bond yields will coincide with curve flattening, not steepening. At 1.93%, the 5-year/5-year forward Treasury yield is not that far below our target fair value range of 2% - 2.25%. In a recent report, we demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.21% in one year’s time and 1.47% in five years (Chart 7). The latter rate has 146 bps of upside if it converges all the way back to its 2018 high, but this pales in comparison to the 265 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Neutral Chart 8TIPS Market Overview TIPS performed in line with the duration-equivalent nominal Treasury index in August, leaving year-to-date excess returns unchanged at +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates both fell by 7 bps in August. At 2.37%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.21%, the 5-year/5-year forward TIPS breakeven inflation rate is only just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation continues to moderate from its current extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in August, bringing year-to-date excess returns up to +40 bps. Aaa-rated ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +30 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +92 bps. The stimulus from last year’s CARES Act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in August, bringing year-to-date excess returns up to +193 bps. Aaa Non-Agency CMBS outperformed Treasuries by 10 bps in August, bringing year-to-date excess returns up to +92 bps. Non-Aaa Non-Agency CMBS underperformed Treasuries by 9 bps on the month, dragging year-to-date excess returns down to +529 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 4 basis points in August, bringing year-to-date excess returns up to +91 bps. The average index option-adjusted spread held flat on the month. It currently sits at 35 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of August 31st, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of August 31st, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 12 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 12 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of August 31st, 2021) Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.
Highlights Chart 1Still Close To Fair Value Treasury yields fell significantly in July, particularly at the long end of the curve. We continue to view this move as an overreaction to mediocre economic data that will be reversed this fall when labor supply constraints ease and employment surprises to the upside. It’s important to note, however, that despite the drop in long-dated yields the 5-year/5-year forward Treasury yield remains within the bounds of its 1.75% to 2.5% fair value range (Chart 1). That is, shorter-maturity Treasury yields have much more upside than long-dated yields on a 6-12 month investment horizon. We expect the next big move in bonds to be a bear-flattening of the yield curve as the market prices in a Fed rate hike cycle that we see starting near the end of 2022. Investors should position for that outcome today by keeping portfolio duration low and by entering yield curve flatteners. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +172 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 89 bps, the 3-year/10-year Treasury slope remains steep. This is a strong signal that monetary conditions are accommodative. But despite the positive macro back-drop, investment grade valuations are extremely tight (Chart 2). A recent report looked at what different combinations of Treasury slope and corporate spreads have historically signaled about corporate bond excess returns.1 It shows that tight corporate spreads only correlate with negative excess returns once the 3-year/10-year Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend that investors shift into high-yield corporates, municipal bonds and USD-denominated EM sovereigns and corporates. We also advise investors to favor long-maturity corporate bonds and those corporate sectors with elevated Duration-Times-Spread.2 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +433 bps. A recent report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.3 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, below what the market currently discounts. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.6% through the first six months of the year, well below the estimate generated by our macro model. Another recent report looked at the incremental spread pick-up investors can earn by moving out of investment grade corporates and into junk.4 It concluded that the extra spread available in high-yield is worth grabbing and that B-rated bonds look particularly attractive in risk-adjusted terms. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in July, dragging year-to-date excess returns down to -64 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 8 bps in July. The spread is wide compared to recent history, but it remains tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 3 bps in July (panel 3), and it is now starting to look more competitive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 36 bps, below the 54 bps offered by Aa-rated corporate bonds but above the 20 bps offered by Aaa-rated consumer ABS and the 34 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.5 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be higher in 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related Index underperformed the duration-equivalent Treasury index by 34 basis points in July, dragging year-to-date excess returns down to +57 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 149 bps in July, dragging year-to-date excess returns down to -113 bps. Foreign Agencies underperformed the Treasury benchmark by 11 bps on the month, dragging year-to-date excess returns down to +35 bps. Local Authority bonds underperformed by 19 bps in July, dragging year-to-date excess returns down to +372 bps. Domestic Agency bonds outperformed by 2 bps, bringing year-to-date excess returns up to +28 bps. Supranationals performed in line with Treasuries in July, year-to-date excess returns held flat at +26 bps. USD-denominated Emerging Market (EM) Sovereign bonds continue to offer an attractive spread pick-up versus investment grade US corporate bonds with the same credit rating and duration. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico and Russia. A recent report looked at valuation within the investment grade USD-denominated EM corporate space.6 It found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. It also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 37 basis points in July, dragging year-to-date excess returns down to +271 bps (before adjusting for the tax advantage). The economic and policy back-drop is favorable for municipal bond performance. Trailing 4-quarter net state & local government savings were already positive through the end of Q1 2021 and they received another significant boost in Q2 as funds from the American Rescue Plan were doled out (Chart 6). With state & local government balance sheets in such good shape, we are comfortable moving down in quality within municipal bonds. A move down in quality is especially compelling because of tight Aaa muni valuations relative to Treasuries (top panel). Valuation is more compelling in the lower investment grade credit tiers, especially at the long-end of the curve.7 GO munis in the 12-17 year maturity bucket offer a 10% breakeven tax rate versus corporates with the same credit rating and duration. The breakeven tax rate for Revenue munis is just 2% (panel 2). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 25% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened in July. Bond yields were down across the curve, but by much more at the long end. The 2-year/10-year slope flattened 15 bps to end the month at 105 bps. The 5-year/30-year slope steepened 1 bp to end the month at 120 bps. While we expect the recent decline in bond yields to reverse during the next 6-12 months, we do not think this reversal will coincide with a re-steepening of the 2/10 yield curve. We noted on the first page of this report that the 5-year/5-year forward Treasury yield remains close to its fair value range. Last week’s report demonstrated that yield curve steepening only occurs when either the Fed is cutting rates or the 5-year/5-year forward yield rises.8 This means that the 2/10 Treasury curve is more likely to flatten than steepen during the next 6-12 months, even as bond yields move higher. Similarly, we observe that the overnight index swap (OIS) curve is priced for the fed funds rate to be 0.17% in one year’s time and 1.36% in five years (Chart 7). While the latter rate has 157 bps of upside if it converges all the way back to its 2018 high, this pales in comparison to the 269 bps of upside in the 12-month forward rate. The yield curve will flatten as the 12-month forward OIS rate converges with the 5-year forward rate (panel 3). Investors should position in yield curve flatteners on a 6-12 month horizon. Specifically, we recommend shorting the 5-year bullet versus a duration-matched 2/10 barbell. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 112 basis points in July, bringing year-to-date excess returns up to +578 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose by 9 bps and 8 bps, respectively, on the month. At 2.43%, the 10-year TIPS breakeven inflation rate is near the middle of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is just below target (panel 3). With long-dated inflation expectations close to the Fed’s target levels, we see limited upside on a 6-12 month investment horizon. We also see the cost of short-maturity inflation protection falling during the next few months as realized inflation moderates from its extremely high level. This will lead to some modest steepening of the inflation curve (bottom panel). While the inflation curve has some room to steepen, we don’t see it returning to positive territory. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one. This is because the Fed’s new framework calls for it to attack its inflation target from above rather than from below. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to +37 bps. Aaa-rated ABS underperformed by 3 bps on the month, dragging year-to-date excess returns down to +28 bps. Non-Aaa ABS outperformed by 4 bps, bringing year-to-date excess returns up to +88 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile, pushing the savings rate higher yet again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in July, bringing year-to-date excess returns up to +187 bps. Aaa Non-Agency CMBS performed in-line with Treasuries in July, keeping year-to-date excess returns steady at +82 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 16 bps on the month, bringing year-to-date excess returns up to +539 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 28 basis points in July, dragging year-to-date excess returns down to +87 bps. The average index option-adjusted spread widened 5 bps on the month and it currently sits at 34 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 30TH, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 30TH, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 26 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 26 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 30TH, 2021) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 For ideas on how to increase the average spread of a US bond portfolio please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 3 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 4 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 5 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 6 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 7 Please see US Bond Strategy Weekly Report, “The Collapsing Credit Risk Premium”, dated July 20, 2021. 8 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021.
Highlights Chart 1Employment Growth June’s employment report revealed that 850 thousand jobs were added to nonfarm payrolls during the month. This is well above the 416k to 505k threshold that is required to hit the Fed’s “maximum employment” target in time for a rate hike in 2022 (Chart 1). The bond market, however, didn’t see things this way. Treasury yields fell across the entire curve following the report’s release on Friday. This is likely because, in contrast to the establishment survey’s strong +850k print, the household employment survey showed a decline of 18k jobs and an uptick in the unemployment rate from 5.8% to 5.9%. Importantly, the household survey tends to be more volatile than the establishment survey, and we expect it will catch up in the coming months. We see the bond market as overly complacent in the face of what is shaping up to be a rapid labor market recovery that will only accelerate once schools re-open and expanded unemployment benefits lapse in September. US bond investors should maintain below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 50 basis points in June, bringing year-to-date excess returns up to +209 bps. The combination of above-trend economic growth and accommodative monetary policy supports continued positive excess returns for spread product versus Treasuries. At 99 bps, the 3/10 Treasury slope remains very steep and the 5-year/5-year forward TIPS breakeven inflation rate is below the Fed’s 2.3% to 2.5% target range. The message from these two indicators is that the Fed is not yet ready for monetary conditions to turn restrictive. Despite the positive macro back-drop, investment grade valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is at its lowest since 1995 (Chart 2). Last week’s report looked at what different combinations of Treasury slope and corporate spreads have historically signaled about corporate bond excess returns.1 We found that tight corporate spreads only correlate with negative excess returns once the 3/10 Treasury slope is below 50 bps. Though we retain a positive view of spread product as a whole, better value can be found outside of the investment grade corporate sector. Specifically, we recommend favoring high-yield over investment grade. We also prefer municipal bonds, USD-denominated EM sovereigns and USD-denominated EM corporates over investment grade US corporates with the same credit rating and duration. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 122 basis points in June, bringing year-to-date excess returns up to +468 bps. Last week’s report looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 2.8% (Chart 3). Using a model of the 12-month trailing speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we estimate that the 12-month default rate will fall to between 2.3% and 2.8%, slightly below what the market currently discounts. This estimate assumes 7% real GDP growth (an input we use to forecast corporate profit growth) and corporate debt growth of between 0% and 8%. Notably, the corporate default rate is tracking at an annualized rate of roughly 1.8% through the first five months of the year, below the estimate generated by our macro model. At 267 bps, the average option-adjusted spread on the High-Yield index is at its lowest since 2007. However, our above analysis suggests that these spread levels are still consistent with earning positive excess returns versus duration-matched Treasuries because default losses will also be low. High-yield spreads also look relatively attractive compared to investment grade spreads. Investors still receive an additional 97 bps of spread as compensation for moving out of the Baa credit tier and into the Ba tier (panel 2). Given the accommodative macro environment, we advise investors to grab this extra spread. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 36 basis points in June, dragging year-to-date excess returns down to -45 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 8 bps in June. The spread remains wide compared to recent history, but it is still tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) widened 13 bps in June (panel 3), and it is now starting to look more competitive compared to other similarly risky spread sectors. The conventional 30-year MBS OAS sits at 34 bps, below the 49 bps offered by Aa-rated corporate bonds but above the 17 bps offered by Aaa-rated consumer ABS and the 30 bps offered by Agency CMBS. In a recent report we looked at MBS performance and valuation across the coupon stack.3 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will rise during the next 6-12 months, we recommend favoring high coupons (4%, 4.5%) over low coupons (2%, 2.5%, 3%) within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 4 basis points in June, bringing year-to-date excess returns up to +91 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 16 bps in June, dragging year-to-date excess returns down to +36 bps. Foreign Agencies outperformed the Treasury benchmark by 10 bps on the month, bringing year-to-date excess returns up to +46 bps. Local Authority bonds outperformed by 31 bps in June, bringing year-to-date excess returns up to +392 bps. Domestic Agency bonds underperformed by 1 bp, dragging year-to-date excess returns down to +26 bps. Supranationals outperformed by 3 bps, bringing year-to-date excess returns up to +26 bps. USD-denominated Emerging Market (EM) Sovereign bonds continue to offer an attractive spread pick-up versus investment grade US corporate bonds with the same credit rating and duration. Attractive countries include: Qatar, UAE, Saudi Arabia, Mexico and Russia. Last week’s report looked at valuation within the investment grade USD-denominated EM corporate space.4 We found that EM corporates are attractively priced relative to US corporate bonds across the entire investment grade credit spectrum. We also found that EM corporates are attractive relative to EM sovereigns within the A and Baa credit tiers. EM sovereigns have the edge in the Aa credit tier. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 22 basis points in June, bringing year-to-date excess returns up to +309 bps (before adjusting for the tax advantage). We took a detailed look at municipal bond performance and valuation in a recent report and come to the following conclusions.5 First, the economic and policy back-drop is favorable for municipal bond performance. The recently enacted American Rescue Plan includes $350 billion of funding for state & local governments, a bailout that came after state & local government revenues already exceeded expenditures in 2020 (Chart 6). Second, Aaa-rated municipal bonds look expensive relative to Treasuries (top panel). Muni investors should move down in quality to pick up additional yield. Third, General Obligation (GO) and Revenue munis offer better value than investment grade corporates with the same credit rating and duration, particularly at the long-end of the curve. Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporates. GO munis offer a breakeven tax of just 6% (panel 2). Fourth, taxable munis offer a yield advantage over credit rating and duration-matched investment grade corporates that investors should grab (panel 3). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 20% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them susceptible to extension risk if bond yields rise. Treasury Curve: Buy 2/10 Barbell Versus 5-Year Bullet Chart 7Treasury Yield Curve Overview The Treasury curve underwent a massive re-shaping in June. Yields at the front-end of the curve rose significantly after the June FOMC meeting while longer-maturity yields declined. All told, the yield curve flattened dramatically on the month. The 2/10 slope flattened 24 bps to end the month at 120 bps. The 5/30 slope flattened 28 bps to end the month at 119 bps. As we wrote in a recent report, we believe that the June FOMC meeting marks an inflection point for the yield curve.6 Prior to the meeting, the yield curve up to the 10-year maturity point had generally been in a bear-steepening/bull-flattening regime, where the slope of the yield curve was positively correlated with the average level of yields (Chart 7). But bond investors appear to have left the June FOMC meeting with a sense that we are now marching toward a Fed rate hike cycle. In that new world, it makes more sense for the yield curve to be negatively correlated with the average level of yields: a bear-flattening/bull-steepening regime. Given that we expect the Fed to lift rates before the end of 2022, we are now sufficiently close to a tightening cycle that the yield curve should bear-flatten between now and then. We therefore recommend that investors short the 5-year bullet and go long a duration-matched barbell consisting of the 2-year and 10-year notes. This position offers a negative yield pick-up, but it looks modestly cheap on our fair value model (see Appendix A) and it will earn capital gains as the 2/10 slope flattens. TIPS: Neutral Chart 8TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 22 basis points in June, dragging year-to-date excess returns down to +461 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates both fell 10 bps on the month. At 2.35%, the 10-year TIPS breakeven inflation rate is just within the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.18%, the 5-year/5-year forward TIPS breakeven inflation rate is below where the Fed would like it to be (panel 3). We see some upside in long-maturity TIPS breakeven inflation rates during the next 6-12 months, as we expect that the 5-year/5-year forward breakeven will find its way back into the Fed’s target range before the first rate hike. However, once the Fed starts tightening it will have a strong incentive to keep long-maturity breakevens below 2.5%. This means that a long position in TIPS versus nominal Treasuries has limited upside. We also see the cost of short-maturity inflation protection falling somewhat during the next few months, as realized inflation is likely at its peak. This will lead to some modest steepening of the inflation curve (panel 4). We do expect, however, that the inflation curve will remain inverted. An inverted inflation curve is simply more consistent with the Fed’s Average Inflation Target than a positively sloped one, as the Fed will be attacking its inflation target from above rather than from below. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in June, bringing year-to-date excess returns up to +39 bps. Aaa-rated ABS outperformed by 5 bps on the month, bringing year-to-date excess returns up to +31 bps. Non-Aaa ABS outperformed by 14 bps on the month, bringing year-to-date excess returns up to +84 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. That excess savings has still not been spent and the most recent round of stimulus checks has only added to the stockpile by pushing the savings rate higher yet again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 20 basis points in June, bringing year-to-date excess returns up to +183 bps. Aaa Non-Agency CMBS outperformed Treasuries by 4 basis points in June, bringing year-to-date excess returns up to +82 bps. Non-Aaa Non-Agency CMBS outperformed Treasuries by 66 bps in June, bringing year-to-date excess returns up to a whopping +522 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Even with the economic recovery well underway, commercial real estate loan demand continues to contract and banks are not making lending standards more accommodative (panels 3 & 4). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in June, dragging year-to-date excess returns down to +116 bps. The average index option-adjusted spread widened 3 bps on the month and it currently sits at 30 bps (bottom panel). Though Agency CMBS spreads have recovered to well below pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of June 30TH, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of June 30TH, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 9 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 9 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of June 30TH, 2021) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 2 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 3 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 4 Please see US Bond Strategy Weekly Report, “The Post-FOMC Credit Environment”, dated June 29, 2021. 5 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. 6 Please see US Bond Strategy / Global Fixed Income Strategy Weekly Report, “How To Re-Shape The Yield Curve Without Really Trying”, dated June 22, 2021.
Highlights Chart 1Tracking Nonfarm Payrolls With 12-month PCE inflation already above the Fed’s 2% target, it is progress toward the Fed’s “maximum employment” goal that will determine both the timing of Fed liftoff and whether bond yields rise or fall. On that note, the bond market is currently priced for Fed liftoff in early 2023. We also calculate that average monthly nonfarm payroll growth of between 378k and 462k is required to meet the Fed’s “maximum employment” goal by the end of 2022, in time for an early-2023 rate hike. It follows from this analysis that any monthly employment print above +462k should be considered bond-bearish and any print below +378k should be considered bond-bullish (Chart 1). In that light, May’s +559k print is bond-bearish, and we anticipate further bond-bearish employment reports in the coming months as COVID fears fade and people return to a labor market that is already awash with demand. Investors should maintain below-benchmark portfolio duration in US bond portfolios and also continue to favor spread product over duration-matched Treasuries. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 47 basis points in May, bringing year-to-date excess returns up to +159 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. At 142 bps, the 2/10 Treasury slope is very steep and the 5-year/5-year forward TIPS breakeven inflation rate sits at 2.27% - almost, but not quite, within the 2.3% to 2.5% range that the Fed considers “well anchored”.1 The message from these two indicators is that the Fed is not yet ready for monetary conditions to turn restrictive. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is almost at its lowest since 1995 (Chart 2). Though we retain a positive view of spread product as a whole, tight valuations cause us to recommend only a neutral allocation to investment grade corporates. We prefer high-yield corporates, municipal bonds and USD-denominated Emerging Market Sovereigns. Last week, the Fed announced that it will wind down its corporate bond portfolio over the coming months. The corporate bond purchase facility has not been operational since December 2020, meaning that the corporate bond market has been functioning without an explicit Fed back-stop for all of 2021. The portfolio itself is also quite small compared to the size of the corporate bond market. As a result, we anticipate no material impact on spreads. Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 8 basis points in May, bringing year-to-date excess returns up to +343 bps. In a recent report, we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.2 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.3% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (pre-tax profits over total debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth. The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s corporate debt binge will moderate in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4%, very close to what is priced into junk spreads. Given that the large amount of fiscal stimulus coming down the pike makes the Fed’s 6.5% real GDP growth forecast look conservative, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 36 basis points in May, dragging year-to-date excess returns down to -9 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries widened 7 bps in May. The spread remains wide compared to recent history, but it is still tight compared to the pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) currently sits at 24 bps. This is considerably below the 51 bps offered by Aa-rated corporate bonds and the 27 bps offered by Agency CMBS. It is only slightly more than the 18 bps offered by Aaa-rated consumer ABS. All in all, value in MBS is not appealing compared to other similarly risky sectors. In a recent report, we looked at MBS performance and valuation across the coupon stack.3 We noted that the higher convexity of high-coupon MBS makes them likely to outperform lower-coupon MBS in a rising yield environment. Higher coupon MBS also have greater OAS than lower coupons. This makes the high-coupon MBS more likely to outperform in a flat bond yield environment as well. Given our view that bond yields will be flat-to-higher during the next 6-12 months, we recommend favoring high coupons over low coupons within an overall underweight allocation to Agency MBS. Government-Related: Neutral Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 15 basis points in May, bringing year-to-date excess returns up to +87 bps (Chart 5). Sovereign debt outperformed duration-equivalent Treasuries by 32 bps in May, bringing year-to-date excess returns up to +53 bps. Foreign Agencies outperformed the Treasury benchmark by 2 bps on the month, bringing year-to-date excess returns up to +37 bps. Local Authority bonds outperformed by 30 bps in May, bringing year-to-date excess returns up to +360 bps. Domestic Agency bonds and Supranationals both outperformed by 8 bps, bringing year-to-date excess returns up to +27 bps and +24 bps, respectively. We recently took a detailed look at USD-denominated Emerging Market (EM) Sovereign valuation.4 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Qatar, UAE, Saudi Arabia, Indonesia, Mexico, Russia and Colombia. We prefer US corporates over EM Sovereigns in the high-yield space where there is still some value left in US corporate spreads and where the EM space is dominated by distressed credits like Turkey and Argentina. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 21 basis points in May, dragging year-to-date excess returns down to +286 bps (before adjusting for the tax advantage). We took a detailed look at municipal bond performance and valuation in a recent report and came to the following conclusions.5 First, the economic and policy back-drop is favorable for municipal bond performance. The recently enacted American Rescue Plan includes $350 billion of funding for state & local governments, a bailout that comes after state & local government revenues already exceeded expenditures in 2020 (Chart 6). President Biden has also proposed increasing income tax rates. However, there may not be time to pass these tax hikes before the 2022 midterm elections. Second, Aaa-rated municipal bonds look expensive relative to Treasuries (top panel). Muni investors should move down in quality to pick up additional yield. Third, General Obligation (GO) and Revenue munis offer better value than investment grade corporates with the same credit rating and duration, particularly at the long-end of the curve. Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporates. GO munis offer a breakeven tax rate of just 7% (panel 2). Fourth, taxable munis offer a yield advantage over investment grade corporates that investors should take advantage of (panel 3). Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering a breakeven tax rate of 22% (panel 4). But despite the attractive spread, we recommend only a neutral allocation to high-yield munis versus high-yield corporates as the deep negative convexity of high-yield munis makes them prone to extension risk if bond yields gap higher. Treasury Curve: Buy 5-Year Bullet Versus 2/30 Barbell Chart 7Treasury Yield Curve Overview Treasury yields fell in May, with the 5-10 year part of the curve benefiting the most. The 7-year yield fell 8 bps in May while the 5-year and 10-year yields both fell 7 bps. Yield declines were smaller for shorter (< 5-year) and longer (> 10-year) maturities. The 2/10 Treasury slope flattened 5 bps to end the month at 144 bps. The 5/30 Treasury slope steepened 3 bps to end the month at 147 bps (Chart 7). We recently changed our recommended yield curve position from a 5 over 2/10 butterfly to a 5 over 2/30 butterfly.6 In making the switch we noted that the slope of the Treasury curve has behaved differently since bond yields peaked in early April. Prior to April, the rise in bond yields was concentrated at the very long-end (10-year +) of the curve. During the past two months, the belly of the curve (5-7 years) has seen more volatility. We conclude that we are now close enough to an expected Fed liftoff date that further significant increases in yields will be met with a flatter curve beyond the 5-year maturity point and that the 5-year and 7-year notes are likely to benefit the most if bond yields dip. We also observe an exceptional yield pick-up of +33 bps in the 5-year bullet over a duration-matched 2/30 barbell. Given our view that bond yields will be flat-to-higher during the next 6-12 months, we recommend buying the 5-year bullet over a duration-matched 2/30 barbell to take advantage of the strong positive carry in a flat yield environment, and as a hedge against our below-benchmark portfolio duration stance. TIPS: Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 86 basis points in May, bringing year-to-date excess returns up to +484 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 1 bp and 2 bps on the month, respectively. At 2.42%, the 10-year TIPS breakeven inflation rate is near the top-end of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.27%, the 5-year/5-year forward TIPS breakeven inflation rate is just below the target band (panel 3). With long-maturity breakevens already consistent (or close to consistent) with the Fed’s target, they have limited upside going forward. The Fed has so far welcomed rising TIPS breakeven inflation rates, but it will have an increasing incentive to lean against them if they continue to move up. We also think that the market has priced-in an overly aggressive inflation outlook at the front-end of the curve. The 1-year and 2-year CPI swap rates stand at 3.76% and 3.12%, respectively. There is a good chance that these lofty inflation expectations will not be confirmed by the actual data. With all that in mind, investors should maintain a neutral allocation to TIPS versus nominal Treasuries and also a neutral posture towards the inflation curve (panel 4). The inflation curve could steepen somewhat in the near-term if short-maturity inflation expectations moderate, but we expect the curve to remain inverted for a long time yet. An inverted inflation curve is more consistent with the Fed’s Average Inflation Target than a positively sloped one, and it should be considered the natural state of affairs moving forward. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 13 basis points in May, bringing year-to-date excess returns up to +33 bps. Aaa-rated ABS outperformed by 13 bps on the month, bringing year-to-date excess returns up to +26 bps. Non-Aaa ABS outperformed by 12 bps on the month, bringing year-to-date excess returns up to +70 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed in April 2020. This excess savings has still not been spent and, already, the most recent round of stimulus checks is pushing the savings rate higher again (Chart 9). The extraordinarily large stock of household savings means that the collateral quality of consumer ABS is also extraordinarily high. Indeed, many households have been using their windfalls to pay down consumer debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 41 basis points in May, bringing year-to-date excess returns up to +163 bps. Aaa Non-Agency CMBS outperformed Treasuries by 27 bps in May, bringing year-to-date excess returns up to +78 bps. Non-Aaa Non-Agency CMBS outperformed by 84 bps, bringing year-to-date excess returns up to +453 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Even with the economic recovery well underway, commercial real estate loan demand continues to weaken and banks are not making lending standards more accommodative (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 37 basis points in May, bringing year-to-date excess returns up to +125 bps. The average index option-adjusted spread tightened 7 bps on the month and it currently sits at 27 bps (bottom panel). Though Agency CMBS spreads have completely recovered their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 28TH, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 28TH, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 57 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 57 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 28TH, 2021) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For further discussion of how we assess the state of monetary policy vis-à-vis spread product please see US Bond Strategy Weekly Report, “Lower For Longer, Then Faster Than You Think”, dated May 25, 2021. 2 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021. 3 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 4 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021. 5 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. 6 Please see US Bond Strategy Weekly Report, “Entering A New Yield Curve Regime”, dated May 11, 2021.
Highlights Chart 1Inflation Pressures Building As expected, base effects kicked in and pushed 12-month core PCE inflation from 1.37% to 1.83% in March. But a favorable comparison to last year’s depressed price level only explains part of inflation’s jump. Core PCE also rose at an annualized monthly rate of 4.4% in March, one of the highest readings seen during the past few years (Chart 1). Jerome Powell spoke about the Fed’s view of inflation at last week’s FOMC press conference and he reiterated that the Fed views current upward price pressures as transitory, the result of both base effects and temporary bottlenecks resulting from an economic re-opening where demand recovers more quickly than supply. Powell’s message is that the Fed won’t lift rates until the labor market returns to “maximum employment” and it won’t start tapering asset purchases until it sees “substantial further progress” toward that goal. Our view remains that the Fed will see enough improvement in the labor market to start tapering asset purchases in late-2021 or early-2022. It will also begin lifting rates before the end of 2022. As a result, we continue to recommend below-benchmark portfolio duration. Feature Table 1Recommended Portfolio Specification Table 2Fixed Income Sector Performance Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 13 basis points in April, bringing year-to-date excess returns up to +111 bps. The combination of above-trend economic growth and accommodative monetary policy supports positive excess returns for spread product versus Treasuries. At 149 bps, the 2/10 Treasury slope is very steep and the 5-year/5-year forward TIPS breakeven inflation rate sits at 2.26% – almost, but not quite, equal to the lower-end of the 2.3% - 2.5% range that the Fed considers “well anchored”. The message from these two indicators is that the Fed is not yet ready to turn monetary policy more restrictive. Despite the positive macro back-drop, investment grade corporate valuations are extremely tight. The investment grade corporate index’s 12-month breakeven spread is down to its 1st percentile (Chart 2). This means that the breakeven spread has only been tighter 1% of the time since 1995. The same measure shows that Baa-rated bonds have only been more expensive 2% of the time (panel 3). We don’t anticipate material underperformance versus Treasuries, but we see better opportunities outside of the investment grade corporate space. Specifically, we advise investors to favor both tax-exempt and taxable municipal bonds over investment grade corporates with the same credit rating and duration (see page 9). We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration (see page 8). Finally, the supportive macro environment means we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors to pick up the additional spread offered by high-yield corporates (see page 6). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 70 basis points in April, bringing year-to-date excess returns up to +335 bps. In a recent report, we looked at the default expectations that are currently priced into the junk index and considered whether they are likely to be met.1 If we demand an excess spread of 100 bps and assume a 40% recovery rate on defaulted debt, then the High-Yield index embeds an expected default rate of 3.2% (Chart 3). Using a model of the speculative grade default rate that is based on gross corporate leverage (aka pre-tax profits over debt) and C&I lending standards, we can estimate a likely default rate for the next 12 months using assumptions for profit and debt growth. The median FOMC forecast of 6.5% real GDP growth in 2021 is consistent with 31% corporate profit growth. We also assume that last year’s debt binge will be followed by relatively weak corporate debt growth in 2021. According to our model, 30% profit growth and 2% debt growth is consistent with a default rate of 3.4%, very close to what is priced into junk spreads. Given that the large amount of fiscal stimulus coming down the pike makes the Fed’s 6.5% real GDP growth forecast look conservative, and the fact that the combination of strong economic growth and accommodative monetary policy could easily cause valuations to overshoot in the near-term, we are inclined to maintain an overweight allocation to High-Yield bonds. MBS: Underweight Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 11 basis points in April, bringing year-to-date excess returns up to +26 bps. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened 5 bps in April. This spread remains wide compared to levels seen during the past few years, but it is still tight compared to the recent pace of mortgage refinancings (Chart 4). The conventional 30-year MBS option-adjusted spread (OAS) currently sits at 11 bps. This is considerably below the 51 bps offered by Aa-rated corporate bonds, the 33 bps offered by Agency CMBS and the 24 bps offered by Aaa-rated consumer ABS. All in all, the value in MBS is not appealing compared to other similarly risky sectors. In a recent report, we looked at recent MBS performance and valuation across the coupon stack.2 We noted that high coupon MBS have delivered strong excess returns versus Treasuries since bond yields troughed last August, while low coupon MBS have lagged (panel 4). This divergence occurred because the higher coupon securities are less negatively convex and thus their durations didn’t extend as much during the back-up in yields. Looking ahead, we recommend favoring 4% and 4.5% coupons and avoiding 2%, 2.5% and 3% coupons. The higher OAS and less negative convexity of those higher coupon securities will cause them to outperform in an environment of flat or rising bond yields. Lower coupon MBS only look poised to outperform in an environment of falling bond yields, which is not our base case. Chart 4MBS Market Overview Government-Related: Neutral The Government-Related index outperformed the duration-equivalent Treasury index by 6 basis points in April, bringing year-to-date excess returns up to +72 bps (Chart 5). Sovereign debt underperformed duration-equivalent Treasuries by 19 bps in April, dragging year-to-date excess returns down to +21 bps. Foreign Agencies outperformed the Treasury benchmark by 2 bps on the month, bringing year-to-date excess returns up to +34 bps. Local Authority bonds outperformed by 41 bps in April, bringing year-to-date excess returns up to +329 bps. Domestic Agency bonds outperformed by 5 bps, bringing year-to-date excess returns up to +19 bps. Supranationals outperformed by 3 bps, bringing year-to-date excess returns up to +16 bps. We recently took a detailed look at USD-denominated Emerging Market (EM) Sovereign valuation.3 We found that, on an equivalent-duration basis, EM Sovereigns offer a spread advantage over investment grade US corporates. Attractive countries include: Mexico, Russia, Indonesia, Colombia, Saudi Arabia, Qatar and UAE. We prefer US corporates over EM Sovereigns in the high-yield space where there is still some value left in US corporate spreads and where the EM space is dominated by distressed credits like Turkey and Argentina. Chart 5Government-Related Market Overview Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 17 basis points in April, bringing year-to-date excess returns up to +308 bps (before adjusting for the tax advantage). We took a detailed look at recent municipal bond performance and valuation in last week’s report and came to the following conclusions.4 First, the economic and policy back-drop is favorable for municipal bond performance. The recently passed American Rescue Plan includes $350 billion of funding for state & local governments, a bailout that comes after state & local government revenues already exceeded expenditures in 2020 (Chart 6). President Biden has also proposed increasing income tax rates. Though these increases may not pass before the 2022 midterm, the threat of higher tax rates could increase interest in municipal bonds. Second, Aaa-rated municipal bonds look expensive relative to Treasuries (top panel). Muni investors should move down the quality spectrum to pick up additional yield. Third, General Obligation (GO) and Revenue munis offer better value than investment grade corporates with the same credit rating and duration, particularly at the long-end of the curve. Revenue munis in the 12-17 year maturity bucket offer a before-tax yield pick-up versus corporates, while GO munis offer a breakeven tax rate of just 7% (panel 2). Fourth, taxable munis offer a yield advantage versus investment grade corporates (panel 3), one that investors should take advantage of. Finally, high-yield muni spreads are reasonably attractive relative to high-yield corporates, offering investors a breakeven tax rate of 19% (panel 4). Despite the attractive spread, we only recommend a neutral allocation to high-yield munis versus high-yield corporates since high-yield munis’ deep negative convexity makes the sector prone to extension risk if bond yields should rise. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened in April, even as the economic data continued to surprise on the upside. The 2/10 Treasury slope flattened 9 bps to end the month at 149 bps. The 5/30 slope flattened 5 bps to end the month at 144 bps (Chart 7). As we showed in a recent report, the Treasury curve continues to trade directionally with yields out to the 10-year maturity point.5 Beyond 10 years, the curve has transitioned into a bear-flattening/bull-steepening regime where higher yields coincide with a flatter curve and vice-versa (bottom panel). For now, we are content to stick with our recommended steepener: long the 5-year bullet and short a duration-matched 2/10 barbell. However, we will eventually be close enough to an expected Fed liftoff date that the 5/10 slope will follow the 10/30 slope and transition into a bear-flattening/bull-steepening regime. When that happens, it will make more sense to either position in a steepener at the front-end of the curve (long 3-year bullet / short 2/5 barbell) or a flattener at the long-end of the curve (long 5/30 barbell / short 10-year bullet). We don’t yet see sufficient evidence of 5/10 bear-flattening to shift out of our current recommended position and into these new ones, and so we stay the course for now. TIPS: Overweight Neutral Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 52 basis points in April, bringing year-to-date excess returns up to +394 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 4 bps and 5 bps on the month, respectively. At 2.43%, the 10-year TIPS breakeven inflation rate is near the top-end of the 2.3% to 2.5% range that is consistent with inflation expectations being well anchored around the Fed’s target (Chart 8). Meanwhile, at 2.26%, the 5-year/5-year forward TIPS breakeven inflation rate is just below the target band (panel 3). This week, we are downgrading our TIPS allocation from overweight to neutral for two reasons. First, as noted above, long-maturity breakevens are consistent with the Fed’s target. The Fed has so far welcomed rising TIPS breakeven inflation rates, but it will have an increasing incentive to lean against them if they continue to move up. Second, TIPS breakevens and CPI swap rates are even higher at the front-end of the curve – the 1-year CPI swap rate is currently 2.93% – and there is a good chance that those lofty expectations will not be confirmed by the realized inflation data. In addition to shifting from overweight to neutral on TIPS versus nominal Treasuries, we also book profits on our inflation curve flattener trade (panel 4) and on our real yield curve steepener (bottom panel). The inflation curve will likely stay inverted, but it will have difficulty flattening further unless short-maturity inflation expectations move even higher. The real yield curve may continue to steepen as bond yields rise, but without additional inflation curve flattening it is better to position for that outcome along the nominal Treasury curve. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 4 basis points in April, bringing year-to-date excess returns up to +19 bps. Aaa-rated ABS outperformed by 4 bps on the month, bringing year-to-date excess returns up to +13 bps. Non-Aaa ABS outperformed by 2 bps on the month, bringing year-to-date excess returns up to +58 bps. The stimulus from last year’s CARES act led to a significant increase in household savings when individual checks were mailed last April. This excess savings has still not been spent and already the most recent round of stimulus is pushing the savings rate higher again (Chart 9). The large stock of household savings means that the collateral quality of consumer ABS is very high, with many households using their windfalls to pay down debt (bottom panel). Investors should remain overweight consumer ABS and should also take advantage of the high quality of household balance sheets by moving down the quality spectrum. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 44 basis points in April, bringing year-to-date excess returns up to +121 bps. Aaa Non-Agency CMBS outperformed Treasuries by 36 bps in April, bringing year-to-date excess returns up to +50 bps. Meanwhile, non-Aaa Non-Agency CMBS outperformed by 70 bps, bringing year-to-date excess returns up to +365 bps (Chart 10). Though returns have been strong and spreads remain attractive, particularly for lower-rated CMBS, we continue to recommend only a neutral allocation to the sector because of the structurally challenging environment for commercial real estate. Even with the economic recovery well underway, commercial real estate loan demand continues to weaken and banks are not making lending standards more accommodative (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 38 basis points in April, bringing year-to-date excess returns up to +87 bps. The average index option-adjusted spread tightened 4 bps on the month and it currently sits at 33 bps (bottom panel). Though Agency CMBS spreads have completely recovered to their pre-COVID levels, they still look attractive compared to other similarly risky spread products. Stay overweight. Appendix A: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of April 30TH, 2021) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of April 30TH, 2021) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 47 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 47 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix B: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of April 30TH, 2021) Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “That Uneasy Feeling”, dated March 30, 2021. 2 Please see US Bond Strategy Weekly Report, “A New Conundrum”, dated April 20, 2021. 3 Please see US Bond Strategy Weekly Report, “Searching For Value In Spread Product”, dated January 26, 2021. 4 Please see US Bond Strategy Weekly Report, “Making Money In Municipal Bonds”, dated April 27, 2021. 5 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021.
Aspectos destacados
Duración: El ritmo de las subidas de tipos que actualmente cotiza el mercado es razonable. Sin embargo, vemos altas probabilidades de que las expectativas del mercado aumenten en los próximos meses, como resultado de la continuidad de sólidos datos económicos y de que la Fed comience a hablar de reducir sus compras de activos. Los inversores deberían mantener la duración de la cartera por debajo del índice de referencia.
MBS: Los MBS siguen siendo poco atractivos en comparación con otros productos de spread estadounidenses. Pero dentro de una asignación infraponderada a MBS, tiene sentido una inclinación hacia cupones altos.
Inflación: La inflación interanual del IPC se vio impulsada al alza por efectos de base en marzo, pero el informe también mostró evidencia de crecientes presiones inflacionarias más allá de los simples efectos de base.
Tema
Tras una caída considerable el pasado jueves, los rendimientos del Tesoro están ahora significativamente por debajo de sus máximos recientes. El rendimiento del Treasury a 10 años alcanzó un máximo de 1.74% el 31 de marzo.º pero terminó la semana pasada en solo 1.59%. Lo que hace que la caída sea desconcertante es que los rendimientos han bajado a pesar de una serie de datos económicos estadounidenses muy sólidos (Gráfico 1).
Este desarrollo reciente se parece al famoso enigma de los bonos de 2004/05, cuando el presidente de la Fed Alan Greenspan luchó por entender por qué los rendimientos de los Treasuries a largo plazo estaban cayendo incluso cuando la Fed aumentaba las tasas a corto plazo.1 Hoy, los inversores también están luchando por entender por qué los rendimientos a largo plazo están cayendo, solo que esta vez el “enigma” es que lo hacen frente a datos económicos fuertes.
Desde nuestro punto de vista, ambos enigmas tienen la misma respuesta: el mercado ya ha descontado gran parte de las noticias.
El 29 de junio.º de 2004 – el día antes de la primera subida de tipos de ese ciclo – la curva del overnight index swap (OIS) estaba valuada para 243 pb de subidas de la Fed en los siguientes 12 meses. La Fed llegó a aplicar 200 pb de subidas durante ese periodo, algo menos de lo que esperaba el mercado. En ese entorno es totalmente consistente que los rendimientos de los bonos cayeran (Gráfico 2).
Gráfico 1
Rendimientos a la baja pese a datos económicos sólidos
Rendimientos a la baja por datos sólidos
Rendimientos a la baja por datos sólidos
Gráfico 2
El enigma de los bonos 2004/05
El enigma de los bonos 2004/05
El enigma de los bonos 2004/05
Hoy, la curva OIS cotiza que la Fed elevará las tasas por encima del límite de cero en diciembre de 2022 y que habrá un total de 86 pb de subidas para finales de 2023 (Gráfico 3). Dado el nuevo régimen de Objetivo de Inflación Promedio (Average Inflation Targeting) de la Fed, este tipo de ciclo de subidas solo se alcanzará si hay una recuperación económica de EE. UU. muy fuerte. Los datos entrantes de EE. UU. hasta ahora confirman esa narrativa, pero no han sido lo bastante fuertes como para elevar aún más las expectativas de tipos.
Gráfico 3
El mercado cotiza despegue en diciembre de 2022
El mercado descuenta un despegue en diciembre de 2022
El mercado descuenta un despegue en diciembre de 2022
Como escribimos en el informe de la semana pasada, creemos que las expectativas de subidas de tipos que actualmente tiene el mercado parecen razonables.2 Sin embargo, vemos un riesgo significativo de que podrían aumentar en los próximos meses a medida que continúe la rápida recuperación económica de EE. UU. y la Fed empiece a alejarse de su mensaje extremadamente acomodaticio.
Gráfico 4
EE. UU. alcanzará 75% de vacunación mucho antes de septiembre
Estados Unidos alcanzará el 75% de vacunación mucho antes de septiembre
Estados Unidos alcanzará el 75% de vacunación mucho antes de septiembre
Por ejemplo, el presidente de la Fed, Jay Powell, ha dicho repetidamente que es demasiado pronto para hablar sobre la reducción de las compras de activos de la Fed. Nos preocupa, sin embargo, que este tono pueda dar a los inversores una falsa sensación de seguridad. Si la recuperación económica continúa al ritmo actual, esperamos plenamente que la Fed empiece a hablar sobre la reducción este año y que inicie el proceso ya sea a finales de 2021 o a principios de 2022.
La semana pasada, el presidente de la Fed de St. Louis, Jim Bullard, dijo que se sentiría cómodo iniciando conversaciones sobre la reducción cuando el 75%-80% de la población de EE. UU. haya sido vacunada. Estimamos que si las vacunaciones continúan a un ritmo lineal, alcanzaremos el 75% de vacunación para septiembre (Gráfico 4). Dado el ritmo exponencial de vacunaciones hasta la fecha, es probable que lleguemos al 75% mucho antes de septiembre.
La conclusión es que vemos el ritmo de subidas de tipos que actualmente cotiza el mercado como razonable. Sin embargo, también vemos altas probabilidades de que las expectativas del mercado aumenten en los próximos meses, como resultado de la continuidad de sólidos datos económicos y de que la Fed empiece a hablar de reducir sus compras de activos. Los inversores deberían mantener la duración de la cartera por debajo del índice de referencia.
MBS: Mantenerse en cupones altos
No sorprende que la apuesta por la reflación haya sido beneficiosa para los activos de riesgo. Dentro de la renta fija estadounidense, los productos de spread en general han superado a los Treasuries desde que los rendimientos tocaron suelo en agosto pasado. Sin embargo, ciertos sectores de spread han tenido mejor desempeño que otros.
Por ejemplo, los Agency Mortgage-Backed Securities no lo han hecho tan bien. Los MBS convencionales Agency a 30 años solo han superado a una posición en títulos del Tesoro con duración equivalente por 73 pb desde que los rendimientos tocaron suelo el 4 de agosto.º de 2020 (Gráfico 5). Esto se compara con 446 pb de sobrerendimiento para los corporativos con calificación Aaa, 342 pb de sobrerendimiento para los corporativos con calificación Aa (Gráfico 5, panel 2) y 232 pb de sobrerendimiento para Agency CMBS (Gráfico 5, panel 3). Solo los ABS de consumo con la notoria calificación de bajo riesgo Aaa han ofrecido menos sobrerendimiento que los Agency MBS (Gráfico 5, panel inferior).
Aunque los Agency MBS no han tenido un buen desempeño en conjunto, ciertos segmentos de la escala de cupones han entregado rendimientos en exceso decentes. Específicamente, los MBS de cupones altos lo han hecho mucho mejor que los de cupones bajos durante el reciente repunte de los rendimientos. Desde el pasado agosto, los MBS con cupón 4% han superado a los Treasuries con duración equivalente por 176 pb y los cupones 4.5% han superado por 257 pb. Mientras tanto, los cupones de 2.5% han quedado rezagados por 10 pb y los cupones de 3% han quedado rezagados por 15 pb (Gráfico 6).
Gráfico 5
Rendimiento de productos de spread desde el mínimo de los rendimientos de bonos
Desempeño del producto de spread desde el punto más bajo de los rendimientos de los bonos
Desempeño del producto de spread desde el punto más bajo de los rendimientos de los bonos
Gráfico 6
Favorecer cupones premium en un entorno de tipos al alza
Prefiera cupones premium en un entorno de tasas al alza
Prefiera cupones premium en un entorno de tasas al alza
La divergencia en el desempeño entre cupones altos y bajos se explica fácilmente por las características de riesgo de esos bonos. Al observar la diferencia entre los cupones de 2.5% y 4%, por ejemplo, vemos que los cupones de 2.5% tienen una duración significativamente mayor y una convexidad significativamente menor (Gráfico 6, los dos paneles inferiores). La mayor duración significa que la subida de los rendimientos perjudica más a los cupones de 2.5% y la menor convexidad significa que la subida de los rendimientos hará que la brecha entre la duración del cupón 2.5% y la del 4% se amplíe aún más. En resumen, un entorno de rendimientos al alza es terrible para los MBS de cupones bajos. A la inversa, una alta duración y baja convexidad son atributos deseables en un entorno de rendimientos a la baja. Si los rendimientos de los bonos caen de forma considerable en el futuro, entonces los MBS de cupones bajos superarán a los de cupones altos.
Gráfico 7A muestra cómo el spread ajustado por opciones (OAS) varía con la duración a lo largo de la escala de cupones convencionales Agency MBS a 30 años. Vemos que los cupones más bajos tienen las duraciones más altas y los OAS más bajos. Los cupones premium tienen duraciones bajas y OAS altos.
Gráfico 7A
Pila de cupones MBS agency convencionales a 30 años: OAS vs. duración
Un Nuevo Enigma
Un Nuevo Enigma
Gráfico 7B muestra cómo el OAS varía con la convexidad a lo largo de la escala de cupones. Aquí vemos que los cupones de 2%, 2.5% y 3% tienen las convexidades más negativas. Esto tiene sentido ya que esos cupones están más próximos a la tasa hipotecaria actual del 3.04%. Un aumento adicional en la tasa hipotecaria haría que esos cupones fueran menos propensos a refinanciarse, provocando una extensión significativa de las duraciones. A la inversa, una caída en la tasa hipotecaria llevaría a más refinanciaciones para esos cupones, provocando que las duraciones se acorten. Nótese que los MBS con cupón 1.5% tienen una convexidad relativamente alta. Esto se debe a que la refinanciación ya es poco atractiva para esos bonos y la duración del índice de 1.5% ya se ha extendido.
Gráfico 7B
Pila de cupones MBS agency convencionales a 30 años: OAS vs. convexidad
Un nuevo enigma
Un nuevo enigma
Dado nuestro punto de vista de que los rendimientos del Tesoro de EE. UU. estarán planos o al alza en los próximos 6-12 meses, recomendamos una inclinación hacia cupones altos dentro de los Agency MBS. Específicamente, los cupones de 2%, 2.5% y 3% tienen mayor margen para la extensión de la duración en un entorno de rendimientos al alza y deben evitarse. Los cupones de 4% y 4.5%, por otro lado, son menos negativos en convexidad y están mejor preparados para capear la tormenta de rendimientos al alza.
En un entorno de rendimientos planos, los cupones que mejor se comportarán probablemente serán aquellos con los OAS más amplios. Esto hace que los cupones de 4% y 4.5% parezcan mucho más atractivos que los cupones de 1.5%, aunque tengan convexidades similares.
En general, recomendamos poseer los cupones de 4% y 4.5% dentro de la escala de cupones convencionales Agency MBS a 30 años y evitar los cupones de 2%, 2.5% y 3%.
Un último punto que vale la pena mencionar es que también seguimos recomendando una asignación infraponderada a MBS dentro de una cartera de bonos de EE. UU. Es decir, aunque los MBS de cupones altos se ven mejor que los de cupones bajos, todo el sector resulta poco atractivo en comparación con alternativas como los ABS de consumo, los Agency CMBS e incluso los bonos corporativos de grado de inversión.
Gráfico 8 muestra una versión de nuestro Excess Return Bond Map, una guía visual que es útil para evaluar rápidamente la relación riesgo/recompensa entre distintos productos de spread estadounidenses.3 El Mapa muestra el OAS como medida de rendimiento esperado en el eje Y, y una medida propietaria de riesgo llamada “Risk Of Losing 100 Bps” en el eje X. Un número más alto en el eje X indica menos riesgo de perder 100 pb y viceversa.
Gráfico 8
Mapa de rendimiento en exceso de bonos
Un nuevo enigma
Un nuevo enigma
Nuestro Mapa de Bonos deja claro que solo los MBS con cupón 4% y 4.5% se acercan a ofrecer un equilibrio riesgo/recompensa comparable al de otros sectores de spread. Los cupones MBS por debajo del 4% ofrecen un rendimiento esperado demasiado bajo dado el nivel de riesgo.
Conclusión: Mantener infraponderación en MBS dentro de una cartera de bonos de EE. UU., pero favorecer los cupones de 4% y 4.5% sobre los cupones de 2%, 2.5% y 3% dentro de la escala de cupones Agency MBS.
IPC de marzo: más que un efecto de base
Era bien sabido antes de la publicación del IPC de marzo de la semana pasada que la cifra de inflación interanual iba a ser muy alta. Esto se debe a efectos de base que persistirán hasta fines de mayo. Es decir, la inflación de 12 meses está destinada a aumentar a medida que las cifras mensuales negativas de inflación de marzo, abril y mayo de 2020 salgan de la muestra móvil de 12 meses.
Las cifras de inflación interanual sí aumentaron bruscamente en marzo (Gráfico 9). El IPC general a 12 meses saltó de 1.68% a 2.64% y el IPC subyacente a 12 meses aumentó de 1.28% a 1.65%. Los efectos de base ejercen menos influencia sobre el IPC de media recortada, y ese índice solo subió de 2.04% a 2.12%. La brecha entre el IPC subyacente a 12 meses y el IPC de media recortada a 12 meses sigue siendo amplia, pero debería cerrarse en mayo cuando se agoten los efectos de base del año pasado (Gráfico 9, panel inferior).
Gráfico 9
Inflación anual
Inflación anual
Inflación anual
Gráfico 10
Inflación mensual
Inflación mensual
Inflación mensual
Pero los efectos de base fueron solo parte de la historia la semana pasada. La inflación mes a mes también fue muy fuerte para las medidas general, subyacente y de media recortada. El IPC general subió 0.62% en marzo, el IPC subyacente subió 0.34% y la media recortada subió 0.24% (Gráfico 10).
Para poner esos números en contexto, si esas cifras mensuales se repitieran en abril y mayo, el IPC general a 12 meses aumentaría hasta 4.75% en mayo y el IPC subyacente a 12 meses aumentaría hasta 2.79%. Incluso si asumimos tasas de inflación más típicas del 0.15% para abril y mayo, aún esperaríamos que el IPC general a 12 meses alcance 3.77% en mayo y que el IPC subyacente a 12 meses alcance 2.41%.
En conjunto, el mensaje del informe del IPC de marzo es que la economía está mostrando señales de crecientes presiones inflacionarias más allá de los simples efectos de base. Anteriormente hemos escrito sobre la abundante evidencia de cuellos de botella tanto en los sectores de bienes como de servicios, y ahora parece que esos cuellos de botella aparecen en los datos de precios.4
No hay duda de que la inflación a 12 meses caerá algo entre mayo y fines de año. Sin embargo, anticipamos que la inflación todavía estará cerca del objetivo de la Fed a fines de 2021. Esto ciertamente será así si las cifras mensuales de inflación se mantienen consistentes con la lectura de marzo. La principal implicación para la inversión de esta visión es que la baja inflación no impedirá que la Fed reduzca sus compras de activos ya sea a finales de este año o a principios del próximo, y tampoco impedirá que la Fed suba las tasas en 2022.
Notas al pie
1 Comentarios de Greenspan: https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm
2 Consulte el Informe semanal de estrategia de bonos de EE. UU., “Overshoot Territory”, fechado el 13 de abril de 2021, disponible en usbs.bcaresearch.com
3 Para más detalles sobre el Bond Map, consulte la página 16 de US Bond Strategy Portfolio Allocation Summary, “It’s A Boom!”, fechado el 6 de abril de 2021, disponible en usbs.bcaresearch.com
4 Consulte el Informe semanal de estrategia de bonos de EE. UU., “Limit Rate Risk, Load Up On Credit”, fechado el 16 de marzo de 2021, disponible en usbs.bcaresearch.com
Ryan Swift Estratega de bonos de EE. UU. rswift@bcaresearch.com
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