Fixed Income Update: June 2017 James Kochan Chief Fixed-Income Strategist
Overview Political turmoil may obscure but does not usually overwhelm the economic fundamentals that drive the bond markets.. Those economic fundamentals are now almost uniformly positive, as illustrated by the latest initial claims, industrial production and employment releases. The Fed would likely be expected to respond to these indicators by recommitting to its policy normalization strategy. The Treasury market, however, apparently has assumed that political events are sufficient to keep the fed funds rate from increasing more than once in the next seven months. In view of the momentum the economy is showing, that could be a highly questionable assumption. The latest set of FOMC minutes contained several warnings of multiple rate increases during the rest of 2017 and the start of balance sheet reductions before year-end. To be sure, this outlook assumes that the first-quarter GDP slowdown proves to be transitory. Most economic indicators released in April and May were consistent with a rebound in GDP growth to around 3% in the second quarter. If those trends continue in June, talk of a weaker economy would probably cease. The minutes also described the mechanics of balance sheet reduction. The FOMC will set caps or limits on the amounts of Treasury and MBS allowed to run off each month, and these caps would increase gradually over time. Principal payments in excess of those caps would be reinvested. Initially, the caps would be quite low, but would automatically increase every three months. This makes the process predictable and should, it is hoped, have minimal effects on the financial markets. Fed officials also appear nervous about the possibility of highly stimulative fiscal policy initiatives that could possibly require more frequent increases in the fed funds rate. The markets appear relatively less nervous, assuming that recent political developments have reduced the chances of tax cuts and spending increases. Anything that changes that perception may also reduce the complacency that currently pervades most areas of the bond markets. With the economy at or near full employment, the Fed raising rates and reversing quantitative easing, with fiscal policy likely to become more expansive and growth overseas improving, the risks associated with long-duration investment strategies are, in our view, increasing, not decreasing. Those who favor the longer durations expect curves to flatten further as short-term rates rise. Curves, however, have already flattened and, during the past five years, they have steepened during market selloffs. The advanced phase of the economic cycle or of the interest rate cycle is typically not the time to take on a high degree of market risk. Yield curves will not, in our view, flatten enough to prevent bond yields from rising almost in step with short term rates over the next twelve months. 2
High Yield vs. Treasury Spread: 1996-2017 Source: Bloomberg (H0A0 G0Q0 YTW) The rally that began in February of last year has taken the yield on the BofAML high yield market index from 10% to around 5 ½%, and sparked warnings that the high yield market is overvalued. At first glance, a spread of 375 basis points (bps; 100 bps equals 1.00%) between that index yield and the yield on the Treasury market index appears too narrow. If, however, the crisis/recession periods are excluded from the spread history, and we focus on periods in which yields were relatively stable and default rates were low, the current spread is not unusually narrow. In periods such as 1996-98 and 2004-07 this spread was typically within the 300-400 bps range. If this spread were to drop below 300 bps, it would be a warning that investors are no longer adequately compensated for the credit risk. Then, the CCC and weaker credit sector would likely be expected to be the most vulnerable to a correction. At the current spreads, however, with default rates projected to remain near cyclical lows, we would expect total returns to approximate the coupon income. The chart illustrates that a recession is probably the greatest risk to high yield investors. Currently, we see few if any signs of a recession in the next 12-24 months. 3
Treasury benchmark 3.50 3.00 10-Year Treasury Yields 5-Years Good Value 2.50 2.00 1.50 Poor Value 1.00 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Source: Bloomberg (H15T10Y Index - US Treasury Yield Curve Constant 10-Year). Past performance is no guarantee of future results. If the FOMC s view of the economy is accurate, the fed funds rate will probably have increased by at least 50 basis points by year-end, and the Fed will be reducing its holdings of Treasury notes and bonds. For the yield on the 10-year note to be around the current reading of 2 ¼% in that environment would imply a degree of curve flattening that would be extremely unusual for a non-recession period. Curves that flatten typically emerge when the market senses that short-term rates are near a cyclical peak. In this cycle, the curve has steepened during selloffs and flattened during rallies. If the current rally is completed, the next curve move is likely to be a steepening curve. Then, Treasury maturities beyond 5 years would probably record negative returns over the next 12 months. The 5- year note could likely withstand a 45 bps increase in yield before the 12-month return would be negative. The scenario results are typically similar for TIPS. Yields on 5-year TIPS could increase an estimated 60 bps before the 12-month return would be negative. The 5-year and shorter maturities are, in our view, much better positioned to produce positive returns over the next 12 months than the longer maturities. 4
Investment-grade corporate bonds 4.00 3.50 Investment-grade Corporate Bond Yields 5-Years Good Value 3.00 2.50 Poor Value 2.00 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Source: Bloomberg (BVCSUP10 Index - US Industrials Yield Curve A 10-Year). Past performance is no guarantee of future results. The moderately higher yields on investment grade corporates gives them a better chance than Treasuries of producing positive returns over a 12-month holding period. The latest rally, however, has pulled yields on 10-year A rated notes to the lower bound of our fair value range. Those yields are now in the 3% to 3 ¼% range. Yields above 3% are, in our view, sufficient to produce positive returns, but we would avoid issues with yields below that threshold. In the 5-year segment of this market, yields could rise approximately 60 bps before 12-month returns would be expected to be negative. Thus, the shorter maturities are probably the better alternative until a market correction creates more realistic yield levels. The last time the markets were expecting Fed rate increases, during the tapering tantrum of 2013, yields in the 10-year A rated sectors were 3 ½% to 3 ¾%. Now those yields are approximately 50 bps below that range. For the 5-year maturities, however, yields around 2 ¼ % today are approximately 30 bps above those reached in 2013, so those maturities should be better prepared for higher short term rates than the 10-years and longer segments. 5
Investment-grade corporates: Scorecard Yield Levels Now (June 2017) A 10Y 3.10% 3.00 3.75% BBB 10Y 3.50% 3.50-4.25% Spreads Now (June 2017) 2004-2007 A 10Y 90 bps 55-75 bps 75-100 bps BBB 10Y 130 bps 100-130 bps 125-150 bps Source: Bloomberg 6
High yield market 10.00 9.00 8.00 High Yield History Yield to Worst Conventional - 5-years Good Value 7.00 6.00 5.00 4.00 Poor Value Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12 Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Dec-15 Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 May-17 Source: Bloomberg (HUC0 BofAML US High Yield Index Yield To Worst) Yields in most segments of the junk bond market remain within what we regard as fair value ranges. That is, we expect those segments to produce positive total returns over the next 12 months. At 5.55%, the yield on the BofAML Market Index is near the lower bound of our fair value range. Spreads to Treasuries are near the middle of the ranges that typically prevail during periods of moderate economic growth, steady corporate earnings and low default rates. Spreads often begin an extended widening trend when the market anticipates a recession. Among what are widely accepted as leading economic indicators, none are now predicting a recession. The scenario analysis on page 11 suggests that yields in the 10-year maturity segment would need to rise almost 75 basis points before those maturities would record negative returns over the next 12 months. In the 3-year segment, yields would need to increase more than 175 bps. In our view, an increase in the fed funds rate to around 1 ¾% a year from now would not be sufficient to produce yield increases of those magnitudes. 7
High yield: Scorecard Yield Levels (%) Now (June 2017) BB 10Y 5.50% 5.00 6.00% B 10Y 6.10% 5.75 6.75% Source: Bloomberg BB 3Y 3.40% 2.75 3.75% B 3Y 4.20% 3.75 4.75% Spreads (bps) Now (June 2017) 2004-2007 BB 10Y 325 200-265 275 350 B 10Y 380 250-325 350 425 BB 3Y 195 125-200 150 250 B 3Y 275 150-225 250-350 8
Municipal market 4.50 4.00 3.50 3.00 10-Year A Municipal Yields: 2013-Current Good Value 2.50 2.00 1.50 Poor Value 1.00 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jul-15 Sep-15 Nov-15 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Source: Bloomberg (BMSC1A10 Index - US Municipal GO Curve A 10-Year). Past performance is no guarantee of future results. The municipal market has performed much better than the taxable markets thus far in 2017. The YTD total return of 3.6% is well above the 2.4% return from the aggregate index. After this outperformance, municipal-to-treasury yield ratios are not as generous as they were in recent years. Ratios for 10-year AAA muni to 10-year Treasury yields are now around 0.87, below the typical range of 0.90 to 1.10 of the past five years. In addition, the latest rally has pulled yields on 10-year and longer maturities below our fair value ranges. The scenario analysis on page 11 suggests that yields on maturities beyond five years are not high enough for those issues to produce positive returns over the next 12 months. For the AAA 30-year sector, yield increases of only 15 bps over the next 12 months would result in negative returns. For the A rated 10-year issues, yields could increase only 30 basis points before returns would be negative. For the 5-year maturities, yields would need to increase 45 basis points before 12-month total returns would be negative. In our view, the 1-5-year A/BBB segments offer the best odds of positive returns over the next 12 months. 9
Municipals: Scorecard Yield Levels (%) Now (June 2017) AAA 10Y 1.90% 2.00 2.50% A 10Y 2.40% 2.75 3.50% BBB 10Y 3.00% 3.25 4.00% AAA 30Y 2.75% 2.75 3.50% A 30Y 3.50% 3.50 4.25% Bond Buyer 20Y Index 3.69% 3.50 4.25% Ratios to Treasuries Now (June 2017) Pre-Crisis Range AAA 10Y 0.89 0.80-0.90 A 10Y 1.11 1.00-1.10 Bond Buyer 20Y Index 1.27 1.00 1.20 AAA 30Y 0.98 0.85-0.95 A 30Y 1.24 1.00 1.10 Source: Bloomberg 10
Scenario analysis Source: Bloomberg Future Yield Levels Producing Zero Total Returns (Market yields as of 06/01/17) Sector Holding Periods 1 year 2 year 3 year 30 Yr. Treasury @ 2.90% 3.05% 3.25% 3.40% 10 Yr. Treasury @ 2.25% 2.50% 2.90% 3.35% 10 Yr. A Corporate @ 3.15% 3.50% 4.25% 5.00% 5 Yr. A Corporate @ 2.40% 3.00% 3.80% 5.20% 10 Yr. BB Corporate @ 5.50% 6.25% 7.10% 8.50% 3 Yr. BB Corporate @ 3.40% 5.25% n.a. n.a. 10 Yr. AAA Muni @ 1.90% 2.15% 2.70% 3.25% 10 Yr. A Muni @ 2.50% 2.85% 3.50% 4.10% 5 Yr. A Muni @ 1.80% 2.25% 3.15% 4.90% 10 Yr. BBB Muni @ 3.00% 3.50% 4.10% 4.80% This analysis attempts to show the risks of negative returns in the Treasury, municipal and corporate sectors. If, for example, an investor were to purchase the 10-year Treasury note today at a yield of 2.25% and over the next twelve months, yields in that market segment were to rise above 2.50%, the one-year total return would likely be negative. In the 10-year AAA segment of the muni market, an increase in market yields of more than 25 basis points would probably result in negative returns. Yields in the 10-year segment of the BB corporate market could increase to around 6.30% or approximately 75 basis points before the estimated one-year returns would become negative. 11
Conclusion The bond market in 2017 is behaving almost exactly as it did during the first half of 2016. The 2017 rally is not nearly as powerful last year the yield on the 10-year Treasury declined 100 basis points to a low of 1.35%. The drop this year has been 40 basis points. That would suggest that if the 2016 pattern were to continue, a second-half correction would not entail a 100 bps rise in that yield. Even if the market were to retrace and send the 10-year yield back to around 2.60% where it was in December, total returns on Treasury maturities beyond five years would be negative. For the bond, with a duration of 20 years, returns would be steeply negative. History suggests that there is a better-than-even chance of such a correction. In five of the past seven years, bond yields have increased significantly during the second half after declining during the first half. This seasonal anomaly appears to be in response to a similar pattern in the economic data. Weak first-half data convince the markets that yields are more likely to fall than to rise, and when those data strengthen later in the year, the markets reverse. While there is no guarantee this will happen again in 2017, if the Fed s forecasts are prescient, a 50 basis point increase in the fed funds rate could be enough for the market to retrace the first-half rally. The scenario analysis on page 11 illustrates the high degree of market risk the longest maturities are now likely to present. If, over the next 12 months, yields on 10-year and longer Treasuries and AAA munis were to move back to January levels, total returns would be negative. The analysis is slightly more favorable to investment grade corporates, because they typically provide more interest income. The best results are for A/BBB credits in the 3-7-year maturity range. Those yield could rise almost 75 basis points before 12-month returns would be negative. The municipal market is no longer exceptionally cheap to taxables. Municipal-Treasury yield ratios that were frequently over 1.0 these past seven years are now much lower. For 10-year AAA munis, the ratios are around 0.87. Ratios were much lower than now before the financial crisis, but have not been much lower since 2009. This suggests that if Treasury yields were to increase, municipal yields would probably increase in step. Thus, we continue to recommend cautious duration strategies in this sector. The scenario analysis for high yield corporates remains the most favorable of any market. Yields have declined as much or somewhat more than in the Treasury market, but spreads to Treasuries remain near the middle of what we regard as sustainable ranges. Those ranges are similar to those prevailing during previous periods of low default rates. There is room for the spreads to narrow if Treasury yields were to rise. As a result, it is our view that total returns in this market will approximate the current YTMs. Those would probably be in the 5-6% range for a conservative bond portfolio and 3-3 ½% for a short-duration portfolio. 12
Disclosures The views expressed are as of 06-01-17 and are those of Chief Fixed-Income Strategist James Kochan and Wells Fargo Funds Management, LLC. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements. Carefully consider a fund's investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, visit wellsfargofunds.com. Read it carefully before investing. Mutual fund investing involves risks, including the possible loss of principal. Consult a fund's prospectus for additional information on risks. The ratings indicated are from Standard & Poor s. Credit-quality ratings apply to underlying holdings of the fund and not the fund itself. Standard and Poor's rates the creditworthiness of bonds, ranging from AAA (highest) to D (lowest). Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. Wells Fargo Funds Management, LLC, a wholly owned subsidiary of Wells Fargo & Company, provides investment advisory and administrative services for Wells Fargo Funds. Other affiliates of Wells Fargo & Company provide subadvisory and other services for the funds. The funds are distributed by Wells Fargo Funds Distributor, LLC, Member FINRA, an affiliate of Wells Fargo & Company. Neither Wells Fargo Funds Management nor Wells Fargo Funds Distributor has fund customer accounts/assets, and neither provides investment advice/recommendations or acts as an investment advice fiduciary to any investor. 303937 06-17 NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE 13