PMC Market Commentary: March 14, 2014

A Macro View – Year-to-Date Fixed Income Market Review

U.S. Treasuries: Weak economic data in January pushed Treasury rates lower, particularly in the second half of the month. Much of the blame for early weakness in the data so far this year has been placed on the dramatic weather events across the country. The Federal Reserve (Fed) announced a second reduction in its bond purchase program at the end of January, which has hampered returns in the Agency MBS (mortgage-backed securities) market. But the drop in rates in 20+ year Treasuries (leading to a nearly 6% return in January alone) indicates demand away from the Fed remains high. February was largely more stable, with rates from two years and longer moving down slightly over the course of the month. This is seen in much more muted returns for February, though the longer maturities continued to do exceptionally well.

Taxable Fixed Income: The taxable markets were driven by corporate securities during the first two months of the year, both investment and non-investment grade. Investment grade credit actually marginally outperformed high yield, though both were well behind convertible bonds, which rode the equity market rebound in February. Within the high yield market, maturity has played a bigger role in the first two months than credit quality. BB, B and CCC rated indexes all had relatively similar performance, but longer maturity securities outperformed by 2-3% vs. similarly rated intermediate maturities. Many fixed income managers and analysts believe the 10-Year Treasury yield will end the year around 3.5%, almost a full percentage point higher than today. With the Fed keeping short rates (0-2 years) more or less in place, this means the yield curve will likely be even steeper, particularly in the seven- to 12-year maturities. This would likely be followed in 2015/2016 by a flattening of the yield curve as short term rates finally move higher.

We believe the biggest risk to the domestic taxable market, particularly the investment grade market, remains a significant global shock or event that quickly turns the current “risk-on” environment into a “risk-off” market and an attendant sale of spread products (particularly high yield, emerging markets and bank loans) in favor of Treasuries.

Municipals: Municipal bond mutual fund flows finally reversed course in January and the first part of February. Fixed income analysts believe this is largely a seasonal flow (December maturities and coupon payments, plus rebalancing of accounts in light of the massive performance of equities in 2013), and will likely see some level of reversal in March and April (when many investors withdraw funds set aside to pay taxes and new issuance rises fairly dramatically). Coming into 2014 many managers viewed the municipal market as very attractive, particularly relative to the Treasuries. Significant outflows in the second half of the year left much of the market undervalued. However, the strong rally in the first two months of the year has left the market in many managers’ eyes as largely fairly valued.

The big headline for the second half of the year, and even so far in 2014, has been the standing of Puerto Rico. S&P downgraded most of Puerto Rico’s issuance to junk status in February, but this had little impact in the market which had already priced in the downgrade. The Barclays Puerto Rico Index rallied strongly in February, up 5.9% for the month and 7.2% for the year to date. With the market pricing in the downgrade, the real risk in Puerto Rico bonds lay in the ability of the Commonwealth to continue to access the market. This was resolved earlier this week when Puerto Rico priced and sold a $3.5 billion G.O. issue that was so oversubscribed the deal was increased from the original $3.0 billion. This alleviates the immediate default risk, but the Commonwealth must address its structural debt issues over the next 12 to 18 months.

International and Emerging Markets: The Barclays Global Aggregate ex-US (+2.8%) and EM USD Aggregate Index (+2.0%) Indexes were also up in the first two months of the quarter. The EM Local Currency Government Index rallied sharply in February to close the first two months of the year down just 35 basis points (in dollar terms). However, in all three Indexes there is a very wide dispersion of returns from country to country. Active managers will have the chance this year to show their skill. Many analysts continue to focus on many of the same issues as in the third and fourth quarters of 2013. The Fed’s continuation of the tapering process, expectations for high volatility due to both investor demand and significant currency swings and headline risk (real or imaginary) sweeping through regions (such as the very real risk in Russia currently) are expected to drive returns as much as economic fundamentals. Many managers continue to have a very positive outlook on Europe and the emerging markets (EM) debt markets for the long-term, but are very focused on managing short-term risk as well.

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