In this month's LDI market commentary:
May’s Bond Market Activity — Strong New Issuance
Political turmoil prompted fixed income markets to doubt that stimulative policies, such as tax reform and infrastructure investment, would be implemented this year. Treasuries rallied strongly in May and investment-grade spreads barely tightened. Equity markets did not confirm these concerns as equities moved back toward record levels.
Ten-year Treasury yields dropped 8 basis points to 2.20% while 30-year Treasuries fell 9 bps, ending the month at 2.86%. Investment-grade credit spreads tightened 3 bps. Yankee banks had another strong month. Positive earnings results triggered a strong move in health care and pharmaceutical issues, as well.
Sector Outlook — Utilities
The outlook for the utility sector is relatively stable. Despite the lack of load growth, the sector has growth opportunities as companies continue to invest in their infrastructure. Industry capex continues to increase and is expected to hit a new peak of $120 billion for 2017. Regulation is a large portion of the overall business risk profile and the regulatory environment has been relatively benign.
The overall business profile for the utility sector has been improving as companies move to more regulated strategies. In 2002, the sector was 57% regulated. Today, it is 80% regulated. Event risk is lower for the next year or two given the denial by regulators on two high-profile mergers and the potential for tax reform. With tax reform, the credit impact could be negative. However, the utility industry is seeking special consideration, a carve-out, with respect to the current tax proposals, similar to a carve-out received in the 1986 tax reform act.
Structural Issues — Why A 20-Year Treasury Could Have Traction
The Trump administration has expressed interest in issuing 50-year and 100-year Treasury bonds, following the lead of several European countries. At its May 2 meeting, the Treasury Borrowing Advisory Committee advised that there was unlikely to be strong or sustainable demand for coupon-bearing Treasuries with maturities longer than 30 years. The committee instead recommended that Treasury consider issuing 50-year zero coupon bonds and reintroducing the 20-year Treasury bond, which was discontinued in 1986 in favor of the 30-year bond.
The most likely outcome is no change in issuance policy. Treasury Secretary Steven Mnuchin favors issuing ultralong maturities, but the market response has been negative. There is demand for a 20-year, but this option does not seem to have official sponsorship.
LDI investors — both defined-benefit pension plans and life insurance companies — would form a natural pool of buyers for a 20-year Treasury bond. Regular issuance in this sector would enhance the liquidity of the Treasury market as a whole by filling a maturity gap that has existed for the past few decades. Furthermore, the existence of a new, highly liquid 20-year pricing benchmark could well encourage more corporate issuance at that maturity point, thus improving liquidity in the corporate bond market and making it possible for LDI investors to match 20-year liabilities with lower transaction costs.
One reason the 20-year bond was abandoned 30 years ago is that it was optically more expensive for the Treasury; the yield curve was typically downward sloping from 20 to 30 years. Yield curve estimates indicate that this trend persisted even after issuance stopped. Between 1986 and 2010, the average slope was -10 bps, and it had become as inverted as -100 bps at times. By contrast, during the post-QE period from 2010 to the present, the average 20–30 slope has been +25 bps, and it has never been inverted.
Arguably, when the yield curve as a whole is relatively flat, an inverted 20–30 curve is justified; a 30-year bond has significantly more convexity than a 20-year bond, and this trait should be reflected in a yield premium — the so-called “convexity bias.” However, during the QE period, this convexity bias may not have been priced efficiently.
(Porfolio managers Andy Barth and David Lee, along with analysts Karen Choi and Tom Hollenberg, contributed to this report.)