PGIM Fixed Income Weekly View from the Desk

Mar 1, 2021

Gauging Central Banks’ Reaction Functions

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Despite some concerns about a U.S. fiscal cliff in 2022, a few factors should moderate the waning fiscal impulse next year and beyond. The sequential series of packages should extend their impact while savings expenditures by households and corporations should offset the reduction in fiscal stimulus. Prior to the pandemic, households’ savings amounted to $1.2T, and they are now three times larger at $3.9T as of January 2021. Furthermore, it will be difficult for households to spend the accumulated savings over a short time frame, thus prolonging their cushion for receding fiscal effects. In addition, the corporate savings rate (i.e. the plowback ratio) has risen from well under 0.2% early in the pandemic to nearly 0.4% more recently, which is the highest level since late 2014.
In terms of the Federal Reserve’s potential reaction function to the recent uptick in U.S. rates, we believe the Fed may find the increase acceptable to this point as long as its driven by an improving economic outlook, rather than restrictive liquidity and financial conditions. And U.S. financial conditions remain the loosest among the G4 economies and the loosest since the start of the Goldman Sachs Financial Conditions Index. However, if liquidity conditions in the Treasury market continue to deteriorate as they did last week, the Fed may also feel compelled to comment on liquidity conditions.
Global developed market economies still have a long way to go to reach full employment and central banks have chronically fallen short of their inflation targets, which explains why some central banks—e.g. the ECB, the BoJ, and the Reserve Bank of Australia—have increased the rhetoric pertaining to the economic risks of higher rates. In the case of the RBA, it increased its bond buying operations to $4B on Monday from its more typical size of $2B.
While the ECB previously said it is monitoring the recent increase in European rates, it also has plenty of flexibility to increase its QE purchases under the Pandemic Emergency Purchase Programme. Indeed, roughly €1T remains between its cumulative purchases and the total envelope of the PEPP.

As one measure of liquidity conditions in the Treasury market last week, the $62B 7-year auction tailed by 4.2 bps and contributed to the broader selloff in rates and across risk assets. We would also note the significant selloff on the re-introduced 20-year bond, which we see as trading 12 bps cheap to the 10-year and 30-year points on the curve.
We continue to believe that short positioning in long-term Treasuries has become an over-crowded trade with the potential to cause those investors some notable discomfort when the trade is unwound. While we don’t see a specific near-term catalyst for a turn in rates back toward 1.0%, when investors refocus on the secular factors that pushed rates lower over the past several decades, they may view elevated Treasury yields as competitive with risk assets given that the sector has been one of the few to price in higher risk premiums recently.
In terms of positioning, we’re maintaining short positioning in 5-year real rates in the U.S. and 10-year real rates in the UK. We’re also positioned for wider spreads on U.S. intermediate interest rate swaps.
MBS performance was mixed across the stack last week as lower coupons were hit into the rate selloff, but subsequently rebounded on heavy month-end demand. The market-cap weighted Treasury OAS tightened to 10 bps (-3), while the LIBOR OAS widened to 11 bps (+3). Origination was higher than normal as there was active hedging of pipelines as mortgage rates increased. MBS excess returns ended February at -26 bps and -2 bps YTD.

U.S. IG spreads widened by 1 bp last week to 90 bps amid the uptick in rates and the pressure on risk assets. Despite the pause, the primary market remained active as $35B priced on consistently oversubscribed order books and minimal concessions. Syndicate desks expect more than $40B to price this week and up to $150B to price in March. Energy names outperformed while utilities exposed to the outages in Texas, such as ATO and OGS, underperformed.
We anticipate incoming supply from Verizon and AT&T amid disclosures that they spent $45B and $23B, respectively on 5G capable spectrum, and the amount of the spending highlights the industry risks pertaining to returns on invested capital. Amid its huge debt load, AT&T also announced the sale of its DirecTV unit to private equity firm TPG.
European spreads tightened 3 bps to 89 bps last week with bank senior non-preferred / subordinated, long-end low-beta paper, & U.S. telecom names underperforming. Amongst the €12B in supply, BBB- rated airline easyJet’s 7-year deal underscored investors’ demand for new issues as the carrier upsized the deal to €1.2B from an initial €750M, and it priced with no concession to its existing curve, which tightened 30 bps the day before. The bond broke for as much as 20 bps tighter in the secondary market.

Emerging market hard and local currency debt saw a week of negative returns and emerging market stocks headed for their biggest weekly loss in a month as U.S. Treasury yields rose sharply. EM hard currency returned -1.67%, EM corporates returned -0.54%, hedged local rates returned -0.80%, and EMFX returned -1.25%. EM hard currency spreads widened by +13 bps to +359 bps, with the investment grade portion of the index widening +15 bps to +159 bps and the high yield portion widening by +9 bps to +608 bps.
Emerging market hard currency funds saw their second consecutive weekly outflow, but net EM bond fund flows were positive, totaling $1.01B. Hard currency funds saw outflows of $162M while local currency funds saw an inflow of $1.02B. This brings year-to-date total flows into EM bond funds to $20.56B, with hard currency, local currency, and blend strategies accounting for $9.07B, $9.33B, and $2.16B, respectively. EM equity funds saw $10.56B of inflows this past week.
In hard currency sovereigns, BBBs underperformed last week, largely as a result of their longer durations relative to other sectors. However, given the momentum in U.S. rates and spike in implied volatility, the overall market has remained relatively resilient. Year-to-date, IG spreads have widened by only 7 bps and HY spreads have widened by only 1 bp, which reflects the strong underlying global growth picture and supportive macro backdrop.
EM corporate spreads tightened last week by -6 bps and have tightened by -28 bps so far in 2021 on the back of lower default expectations, rising commodity prices, and a lower duration relative to the sovereign index.
Within local rates, the index yield rose 20 bps to 4.7%. Brazil was the worst performer in February, selling off by 100 bps despite aggressive rate hikes priced into the curve. Conversely, Chinese rates ignored the selloff in core rates, with the yield rising by only 5 bps in February. Last week, Philippines, South Africa, Malaysia, Russia, and Indonesia outperformed, while Thailand, Colombia, Chile, Hungary, and Brazil lagged.
In EMFX, currencies fell -1.25% against the U.S. dollar, the worst weekly performance of 2021, as currencies most vulnerable to a rising rate environment underperformed. The top performing EM currencies were the Romanian leu, Taiwan dollar, Indian rupee, Singapore dollar, and Hungarian forint; the Turkish lira, Brazilian real, Argentine peso, Mexican peso, and South African rand led the underperformers.

U.S. high yield returned -0.66% last week as rates became a focus, with the yield on the U.S. five-year Treasury Note rising to a high of 1.52% during the week. Average high yield prices declined 0.82 points last week and the index yield-to-worst rose 30 bps to 4.27% while spreads widened 11 bps to +352. Notably, spreads tightened by approximately -20 bps on Monday as equities rallied and rates stabilized.
In general, we have seen a flat spread curve for high yield bonds in the 5-10 maturity bucket for several months, primarily in BBs and Bs. The implication of the Treasury curve steepening is the 8, 9, and 10-year high yield bonds will need to move lower in price in order to prevent inverted curves. However, this is not a given as spread curves became inverted across many names during the March/April 2020 selloff as sellers sold the front end first and the market rebounded before moving out on the curve.
Despite the inflation/rates concerns, the economic backdrop remains positive, which is good news for high yield balance sheets. Due to expectations of a larger U.S. stimulus package, JP Morgan revised its real GDP forecast for 2021 upward and also reduced its 2021 high yield default rate forecast to 2% from 3.5%. In addition, JP Morgan expects $284B in upgrades from high yield to investment grade over the course of 2021 and 2022.
By quality, BBs, Bs, and CCCs returned -0.93%, -0.47%, and +0.06%, respectively, last week. U.S. high yield mutual funds reported an outflow of $2.1B, bringing year-to-date outflows to $4.6B. Last week's primary activity picked up, with 21 issues pricing for $12.5B in proceeds. However, this week's calendar appears relatively light, which, combined with an uptick in calls, tenders, and coupon payments over the coming week, leads us to a modestly more constructive near-term outlook.
U.S. leveraged loans generally held in better than other risk markets despite a heavy new issue calendar, returning +0.50% last week. Another inflow into bank loan mutual funds and strong CLO demand continued to support secondary price levels. Last week's inflow of $686M brings year-to-date inflows to nearly $7B as investors have increasingly sought out floating rate assets in search of rate protection. Notably, the last seven weeks of inflows equate to approximately 13% of bank loan mutual fund AUM.
Both Bank of America and JP Morgan increased their 2021 loan total return forecasts, with BofA now expecting loans to return 5.0% (up from 4.5%) and JPM now expecting loans to return 6.0% (up from 5.0%). JPM also reduced its 2021 loan default rate forecast to 2.0% from 3.5%. We have also increased our long term outlook for loans given our belief that the bulk of repricing activity, and resulting downward pressure in prices, is likely behind us.
In Europe, high yield bonds returned -0.45% as the rise in rates and concurrent decline in equities took center stage. Average yields were +15 bps higher at 2.88% and spreads widened +2 bps to +329 bps. Loans, however, had a positive one-week return of +0.11%, bringing the YTD total return to +1.71%. The bond primary market remained subdued, while the loan market was active across both new money issuance and repricing activity. February concluded with 24 loan deals worth €18B, with €7B of repricing activity and €2.7B of refinancings. Furthermore, the pipeline remains healthy with 18 deals totaling an estimated €17B on the horizon. Also in February, there were €2.9B of new issue CLOs and €7.4B paper printed through refinancings or resets.

U.S. conduit AAA CMBS spreads were unchanged last week. The CMBS market held up well in the rate selloff last week due to limited supply on both secondary and new issue market. One conduit deal is going to announce and price this week. With the refinance market beginning to open for CRE, outside of hotel and retail properties, we could see conduit supply slightly increase in Q2. We continue to favor senior, well-enhanced CMBS tranches with COVID-19 overhanging the CRE fundamentals.
CLO primary spreads at the top of the capital structure were relatively unchanged as lower mezzanine tranches were slightly weaker last week. We continue to see large anchor investors (Global CIO offices and asset managers) looking to source bonds across tenors and manager tiers. In the intermediate term, we continue to believe supply will limit further spread compression (market seeing signs of resistance last two weeks). We continue to expect robust issuance volumes this year as we are currently being marketed over 140 deals across the U.S. and Europe—not including resets or refinancings. US CLO primary spreads for higher quality portfolios ended the week at about ~3L+107/140/175/280/600 for AAA/AA/A/BBB/BB, respectively. We continue to favor senior CLO tranches, while we remain cautious about legacy junior mezzanine tranches.
ABS spreads were unchanged to tighter last week amid strong demand for new issues and secondary securities. Total new issue volume is $32B, 15% behind last year’s pace. Notable in secondary, 5yr One Main consumer loan subs cleared in +120s bps (~50 bps tighter on the year). This serves as another example of credit quality compression in ABS, particularly for non-benchmark sectors. That said, we expect the technical environment to remain strong in ABS with negative net new issuance in 2021 and steady demand.

Tax-exempt municipal bonds saw another week of underperformance against Treasuries as the back up in rates weighed on the market. Muni/Treasury ratios rose across the curve, with the 5-, 10-, and 30-year portions of the AAA-rated muni curve ending the week at 76.4% (up from 60.7% the prior week), 80.9% (up from 64.9%), and 83.5% (up from 71.1%).
Municipal bond funds saw net inflows totaling $38mm last week. Long-term and high-yield funds posted outflows of $238M and $330M, respectively, while intermediate funds reported inflows of $224M. Year-to-date inflows total $26B. Year-to-date issuance now totals $64B, including $22B of taxable issuance. Meanwhile, this week's calendar is estimated at $8B, including over $3B in taxable muni issuance.
Following the blackouts in Texas, Fitch placed Texas utilities in ERCOT on Rating Watch Negative. S&P also placed various Texas utility ratings on Negative CreditWatch, including San Antonio CPS, AA/AA-, which has close to $6B debt outstanding.

Source(s) of data (unless otherwise noted): PGIM Fixed Income as of March 2021

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1038861-00030-00 Ed: 03/2021

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PGIM Fixed Income Weekly View from the Desk

In this Article

Macro

Rates

Corporates

Emerging Markets Debt

High Yield

Securitized Products

Municipal Bonds

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In this Article

Macro

Rates

Corporates

Emerging Markets Debt

High Yield

Securitized Products

Municipal Bonds

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The Outlook For Value

Weekly Market Review

The Key to Capturing EM’s Dynamism