Taxable Fixed Income Markets
The more things change, the more they stay the same. While interest rates have moved within a well-defined post-election range, there has been very little change in long-term Treasury yields since mid-November. Short-term rates of less than one year jumped in early March after repeated comments by Federal Open Market Committee members telegraphing the March 15 rate increase of 25 basis points. With unemployment trending lower, inflation moving slowly higher and stock prices at all-time highs, the Committee expressed the potential for further rate increases in 2017 and 2018, pushing short-term rates even higher. The optimism reflected by the Federal Reserve was tempered by the political defeat later in March of the new administration’s first major legislative effort to enact the American Health Care Act to repeal and replace the Affordable Care Act. This defeat called into question the ability of the administration to work with Congress on other vital growth initiatives, such as tax reform and infrastructure spending. The economic news swung full circle while interest rates returned very close to their starting point at the beginning of the quarter. In this environment of stable, range-bound interest rates, corporate bonds generated strong excess returns, especially in high yield securities. Corporate credit looks attractive for income-oriented investors as solid corporate profits, low inflation and few indicators of an imminent recession result in continued strong corporate credit quality.
Municipal bond interest rates remained largely range bound through the first quarter as the 10-year AAA rated municipal bond yield fell six basis points to 2.25%. This level represents 95% of U.S. Treasury yields of similar maturity. The largest downward move in rates was on the front end of the yield curve as near term reflation expectations faded as the quarter progressed.
Fund flows for the broader municipal market have remained slightly negative for the quarter. The general feel is that investors are waiting for further clarity on what tax law changes may emerge from the new administration. While we continue to believe there will be changes, it appears that the battle to get them enacted into law will be tougher than initially thought. It also appears that the magnitude of changes will be more subdued than initially expected. Given where municipal yields are and the tax advantages most likely available under a new taxation scheme, we would view a short term dislocation as a technical move rather than a long term fundamental change and a potential buying opportunity with municipal credits still in our “fair value” range, albeit at the expensive side of that range.