We favor a risk-on stance, focused on credits with durable free cash flow and solid balance sheets across a wide range of sectors. Mid-quality rating segments appear particularly attractive. Essential service municipal bonds also look compelling.
Key Risks
• Inflation rises in a disorderly way, negatively impacting asset values.
• Policymakers remove accommodation too rapidly, undermining the global economic expansion.
• Further complications with the Covid-19 vaccine rollout and Delta or future variants.
• Geopolitical flare-ups: China, Russia, Turkey, Iran.
High Yield Corporates Get Boost From Their Lower Duration
U.S. Treasury yields rose across the curve last week, with both 2- and 10-year yields ending 11 basis points (bps) higher. Most of the increase happened on Wednesday, due to high inflation data and a weak 30-year auction. Headline consumer prices rose 0.9% month-over-month, taking the year-over-year rate to 6.2%, the fastest rate since 1990. The monthly data partially reflected familiar factors that are unlikely to be sustained into next year, such as rising gas and auto prices. However, the inflationary pressures appear to be broadening, with no categories showing offsetting price declines as they typically do. Given the higher inflation numbers and pressure on long-end Treasuries, the 30- year auction met with very weak demand.
Investment grade corporates weakened, as the selloff in Treasuries pressured returns, returning -0.99% last week and underperforming similar-duration Treasuries by -15 bps. Spreads ended the week 1 bp wider at 88 bps, in line with the average level this year, though 9 bps wider than the tightest levels reached in June. The technical backdrop was favorable, though not enough to offset the pressure from rates, as the asset class saw inflows of $1.8 billion and new supply of $22 billion.
High yield corporates performed relatively better, helped by their lower duration, returning -0.25% but outperforming similar-duration Treasuries by 26 bps. New issuance was high at $15 billion, though inflows totaled $2.6 billion. Since April, three of the four largest weekly inflows have been in the last four weeks. Loans performed well, returning 0.17%, as their floating-rate attribute makes higher rates a tailwind. Loans also saw strong inflows at $970 million. In both markets, lower-rated segments outperformed, with CCC bonds returning 0.59% and CCC loans up 0.61%.
Emerging markets also outperformed compared to Treasuries by 41 bps, though total returns were negative at -0.32%. Similar to the dynamic in U.S. high yield, the asset class saw strong retail inflows of $1 billion into hard currency funds. Attention was focused on the China property sector, with another major selloff at the start of the week. The weakness fed into investment grade-rated names for the first time, with many high-rated bonds weakening -15 to -20 points in price. However, conditions stabilized later in the week after reports circulated that the government will alter policies to support the sector, plus monthly mortgage origination numbers beat expectations.
High Yield Muni Demand Recovers
Municipal bond prices rallied early last week, then sold off due to disappointing inflation data, ending the week basically unchanged.