Blame it on the Fourth of July holiday, or blame it on the organizational skills of the author, but my fifth quarterly bond market review has been a little delayed this quarter. In the previous quarter, the pull forward of market expectations of the terminus of quantitative easing and the pace of the withdrawal of extraordinary monetary accommodation after the FOMC meeting concluded in early May, rattled global markets and sent interest rates materially higher. Given the dramatic changes in a host of bond markets that occurred in the second quarter, I believe a review is better late than never despite being a week tardy relative to the schedule at which I normally author this piece. Because of this delay, this article will focus on a forward-looking examination of the relative value of various fixed income markets in addition to the review of second quarter price actions.
Treasuries sold off across the curve in the second quarter. The front end of the yield curve markedly steepened as additional Fed Funds rate hikes were priced in over the next five years. With a -1.92% return, the Barclays Capital Treasury Index (NYSEARCA:GOVT) had its worst quarterly return since the fourth quarter of 2010. While the increase in yield was most acute in the 3-5 year part of the curve, long duration bonds, owing to their high duration nature, performed the worst as the Barclays Long Treasury Index (NYSEARCA:TLT) returned -5.58%.
Remarkably, while the second quarter will be remembered for the Fed tapering-induced selloff, in early May we were actually at our year-to-date yield lows before reaching our year-to-date high yield levels just weeks later. Below is a table with the beginning of the quarter yields, the intra-quarter high and low watermarks, and the closing yield for the quarter.
Notice that the spread between the 2-yr Treasury and the 5-yr Treasury closed the quarter at 105bps, which is greater than the difference between the yields of the 10-yr and 30-yr Treasury. Fixed income investors can earn as much additional carry extending three years in the front end as they can for three times the incremental duration in the long end of the curve. I believe that the five-year currently prices in the maximum amount of near-term easing from the Federal Reserve, and could be an optimal place for fixed income investors to position between very low front-end yields and the likely negative impact of a continued rate selloff in the more duration sensitive long end of the curve.
The agency mortgage-backed securities market had been relatively mundane over the past several quarters as quantitative easing from the Federal Reserve was effectively purchasing all of the net mortgage origination, driving down mortgage yields and up the prices of mortgage-backed securities. This certainly changed in the second quarter as an increase in mortgage rates to two-year highs hammered mortgage-backed securities, notably the 3 and 3.5% coupons, which now trade at meaningful discounts. Owners of leveraged mortgage-backed securities in the form of mortgage REITs were especially hard hit.
Non-agency mortgage-backed securities also meaningfully underperformed. A large list from the "bad bank" of a European financial was sold into the market before prices weakened with a U.S. broker dealer taking down a meaningful amount of the list. This secondary supply overhang weighed on spreads through the end of the second quarter. Ultimately, these securities are more sensitive to home price appreciation and credit availability than to mortgage rates, but should continue to trade at a discount to the government guaranteed sector.
Mortgage REITs have raised record amounts of equity over the past year, feeding demand from new investors seeking high capital returns amidst a steep yield curve and Fed-suppressed volatility. A reduction in interest rate volatility from the recent spike will serve MBS and mortgage REIT investors well. I personally believe that we have likely seen the end of the 3.5% mortgage in this cycle and potentially in my lifetime, and if this rate is moving higher then the price on mortgage related securities is heading lower.
Investment Grade Corporate Bonds
Corporate credit spreads had been relatively range-bound through the first five months of the year, trading in less than a 10bp point range and slowly compressing to new post-crisis lows. Financial spreads moderately compressed against industrial spreads, as idiosyncratic releveraging fears wrought by proposed deals at Dell and Heinz and shareholder activism in the energy sector weighed on the broad industrial sector. The rise in rates in May pressed corporate credit spreads to new year-to-date wides. Broad-based selling of fixed income funds put pressure on the asset class with more liquid sectors, including banks and telecom coming under the most pressure. Like in the Treasury sector, long duration bonds suffered the worst returns on the quarter. The Barclays Intermediate Term Corporate Bond Index (NYSEARCA:ITR) returned -2.38% and the Barclays Long Term Corporate Bond Index (NYSEARCA:LWC) returned -5.74%.
High Yield Corporate Bonds
In early May, the yield-to-worst on the Barclays Capital High Yield Index (NYSEARCA:JNK) traded through 5% for the first time before selling off to nearly 7% less than two months later. It is important to note that for the quarter, total returns for the three main quality cohorts were: Ba/BB -1.87%, B -1.49%, and Caa/CCC -0.47%. This was not a selloff driven by an increase in default expectations. With the backup in rates, retail fund flows reversed from the asset class, putting pressure on credit spreads. The longer duration, more liquid BB-rated bonds came under the most pressure and underperformed for the quarter.
With an average credit spread of 454 bps at quarter-end and trailing twelve month realized defaults of 2.93% on speculative grade debt rated by Moody's, high yield bonds appear to be pricing in sufficient compensation for future credit losses. While credit spreads widened as rates sold off in the second quarter given the rapid market move, I would expect the normal negative correlation between rates and credit spreads to resume as markets normalize, and that high yield will offer coupon-like returns for the next twelve months as credit spreads modestly compress and rates continue to move higher at a more modest pace.
Emerging Market Bonds
Like high yield bonds, emerging market fixed income came under pressure from the flow of funds out of the asset class, which forced asset managers to liquidate securities, putting downward pressure on prices. Like the -8% second quarter return produced by emerging market equities, investors became increasingly nervous that higher U.S. rates could trigger a halt in capital flows to emerging market economies. Mix in geopolitical risk like what we witnessed in Turkey, a country with large external funding needs, and we can see sharp downturns in emerging market debt rapidly. If you are bullish on the emerging markets, favor emerging market stocks (VWO, EEM), which have underperformed the S&P 500 (NYSEARCA:SPY) by nearly twenty percent over the past year over emerging market debt, which still is trading at historically rich levels despite the recent dip in prices.
Municipal bonds, an asset class disproportionately held by retail investors because of the unique tax exemption, also came under pressure during the quarter as households broadly sold out of fixed income investments as rates rose. The last weeks of the second quarter saw the highest rates of municipal bond mutual fund outflows since the fourth quarter of 2010.
Like most long duration fixed income asset classes, the municipal market sold off sharply in the days following the FOMC meeting. Muni ratios, which measure the attractiveness of tax-exempt muni yields relative to Treasury yields are now over 100%. The Detroit bankruptcy not withstanding, fundamentals have modestly improved in recent months as tax receipts rise. Long-term holders should use fund outflows from rising rates to opportunistically add the asset class.
As I suggested in The Swoon in Build America Bonds, the ultra long duration portion of the market will be disproportionately affected by the move higher in rates. The -5.9% return in the Build America Bond ETF (NYSEARCA:BAB) in the second quarter more than offset the annual dividend yield paid by the fund.
Fixed income returns in the second quarter were ugly. Investors should come to expect low or negative real returns on high quality fixed income assets over forward periods as rates normalize as the Fed slowly withdraws extraordinary support. Risk averse fixed income investors should understand that in domestic markets they face greater risk in the long end of the curve than they do further out the credit curve given the likelihood of continued low default rates. In a recent example of the risk in the long duration portion of the fixed income market, I demonstrated that Apple's (NASDAQ:AAPL) long bonds have been more volatile since issuance than the company's very topical stock price.
I recommend investors position in the five-year portion of the yield curve given the recent steepening of the front end as this curve position offers favorable rolldown, but does not expose investors to the potential for the large price swings of longer duration investments. As long-time readers know, I have long been a fan of the double-BB rated portion of the credit curve given high incremental spread relative to historical default rates. For investors seeking higher returns, I would prefer employing investment leverage than moving out the yield curve or down the credit curve. Retail fund flows from various asset classes should be viewed as tactical buying opportunities when flows stabilize.
Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.