Treasury yields decline further amid economic uncertainty

Weekly fixed income update highlights

• Treasuries, MBS, investment grade and high yield corporates, taxable munis, preferreds, senior loans and emerging markets all had positive returns.
• Municipal bond yields declined across the curve. New issue supply was $8.6B, and fund inflows were $785M. This week’s new issuance is $12.2B.

The decline in U.S. Treasury yields accelerated amid continued economic uncertainty. Markets are digesting downside risks to the U.S. economy as well as potential risks from tariffs. Spread sectors broadly underperformed Treasuries.

Watchlist

• 10-year Treasury yields declined again, and we expect yields to remain range bound during 2025.
• Spread sectors broadly underperformed Treasuries, reflecting marginally higher concerns about the U.S. economic outlook.
• We expect the technical environment for municipal bonds to remain strong this year.

Investment views

Rates are set to stay higher for longer, as the Fed approaches rate cuts cautiously.

The underlying growth outlook remains healthy thanks to strong consumer balance sheets and solid levels of business investment. This combination should keep corporate defaults low.

Risk premiums may widen further, with entry points for taxable fixed income likely to become more attractive over the coming quarters. Credit selection remains key as we search for bonds with favorable income and solid fundamentals.

Key risks

• Inflation fails to continue moderating as expected, weighing on asset prices.
• Policymakers unsuccessfully juggle fighting inflation with supporting economies still struggling to gain traction.
• Geopolitical flare-ups intensify around the world.

Investment grade corporate spreads widen

The decrease in U.S. Treasury yields accelerated last week. The 10-year yield was down -22 basis points (bps) to 4.21%, capping seven consecutive weeks of declines. 2-year yields fell -21 bps to drop below 4% for the first time since October. Markets are digesting downside risks to the U.S. economy, highlighted by recent softer data, as well as potential risks from tariffs. Attention will be focused on this week’s jobs report. Recent inflation data have largely been supportive, with core PCE inflation decelerating to 2.6% year-over-year in January. Moving forward, we expect the economy to continue slowing but not tip into recession, and for inflation to moderate only marginally further in 2025.

Investment grade corporates benefited from the rate decline, returning 1.05% for the week but lagging similar-duration Treasuries by -47 bps. Spread levels for the investment grade index widened 7 bps, the largest weekly move since last August. In addition to the potential economic headwinds affecting broader investor sentiment, the IG asset class also contended with a week of elevated supply, which further pressured spreads. The $51.3 billion of new issuance was almost 50% more than consensus expectations. Those deals faced somewhat slimmer demand than recently, with average oversubscription rates of 3x and concessions of 3 bps. Nevertheless, broader demand remained healthy with inflows bouncing to $6.1 billion.

High yield corporates advanced 0.40%, while senior loans returned 0.01%. High yield underperformed similar-duration Treasuries by -35 bps, as spread levels widened. The widening pressure was less acute than for high grades, with spread levels expanding by 9 bps in high yield and 5 bps in loans. The asset classes were helped by calmer supply, with less than $2 billion pricing in high yield and around $8.5 billion in loans. Both asset classes enjoyed another week of inflows, though the magnitude of flows into loans slowed from its recent, extremely robust pace.

Emerging markets gained 0.90%, though the asset class underperformed similar-duration Treasuries by -46 bps. Hard currency sovereign spreads widened 6 bps, and unlike in U.S. corporates, the high grade segment considerably outperformed high yield (2 bps wider versus 12 bps wider). Inflows were strong again, with $294 million entering the asset class, including $613 million into hard currency funds. Supply was also lighter at just over $8 billion. Those deals met solid demand, averaging oversubscription rates of 3.5x.

Muni bond supply and demand remain strong

The municipal bond yield curve rallied last week. Short-term yields fell -10 bps and long-term yields declined -4 bps. New issue supply was well received. Fund flows were positive, including $610 million in exchange-traded fund inflows. This week’s new issue supply is expected to be outsized, so we may see rates cheapen.

Muni market returns remain impressive, despite trailing Treasuries in part due to outsized muni new issue supply. The new issue municipal calendar closed on Friday at $69 billion year-to-date. Demand has also been very strong, with seven out of eight weeks positive this year. Also, concern over inflation is easing, so the average investor seems to be deploying cash sooner rather than later. This boosts fixed income in general.

South Carolina Public Service Authority (Santee Cooper) issued $1 billion of revenue bonds (rated A3/A-). This issue generates a good portion of its power from operating a nuclear reactor. The deal was well received. For example, Assured Guaranty-backed 5% bonds were issued at a 4.11% yield and traded at a premium in the secondary at 4.04%.

The high yield municipal market saw another strong week of inflows at $430 million. Inflows total $3.2 billion in the first two months of the year, which is a faster annualized pace than last year. We observed firmer demand for high beta names last week, such as COFINA and Buckeye Tobacco. Buckeye 5% coupon bonds are now trading through a 5.60% yield, more than 30 bps tighter year-to-date.

Investment grade corporates saw $51.3B of new issuance last week, almost 50% more than consensus expectations.

In focus: Germany goes to the polls

Amid massive voter turnout, Germany’s elections yielded a market-friendly result. The conservative Christian Democratic Union (and the Christian Social Union) collectively won 28.6% of the vote. The far-right Alternative for Germany roughly doubled its 2021 total, garnering 20.8%, but fell short of the one-third necessary to block reforms to Germany’s constitution.

Friedrich Merz, the next German chancellor, must form a coalition government quickly. Germany’s economy requires a jumpstart, with GDP contracting 0.2% in the fourth quarter. In addition, Merz needs to bolster the country’s defense capabilities, a challenge made more formidable given President Trump’s recent pivot away from the traditional U.S./European partnership. But boosting spending requires amending the constitution, as Germany’s “debt brake” caps the government’s new borrowing at 0.35% of GDP. We think an increase to 1% is possible given the need for fiscal action.

On the fixed income front, we still favor German bunds and believe the 10-year yield could fall from around 2.40% as of Friday to 2.20% by mid-year. Our view is based on (1) the likelihood that the effects of any government spending won’t spill over into the broader economy until 2026 at the earliest and (2) the remaining downside risks to growth. The latter underpins our expectation that the European Central Bank should continue to cut interest rates through September, pausing when they reach 1.75%.