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Our view on rates
The flight to quality that ensued caused Treasury rates to rally across the board, with the biggest impact felt in the 2-year yield despite the Fed delivering another 25bps hike in the Federal funds rate. The 10-year yield fell from 4.1% in the beginning of March to a low of 3.25% in early April. The 2-year rate reached 5% in early March and continued lower reaching 3.65% in early April. Hence, the 2-year/10-year curve hit its largest inversion of the past four decades, reaching close to –110bps in early March, only to find itself in a substantial re-steepening as the market began to price in the end of the Fed’s tightening cycle and subsequent rate cuts later this year. The 2-year/10-year curve is currently –50bps, and the market is pricing in around 100bps of rate cuts by year end.
Our view on rates has not changed dramatically despite the banking sector concerns. We believe rates are likely to decline into year-end due to the weakening economic environment but at a slower rate than market forwards would imply. However, we also advise investors not to chase rates, but to wait for opportunities and sell-offs to take longer positions. We are shifting down our target range for the 10-year yield to ~3.3–3.75% over the next few months as we believe that the highs have likely already been seen. Yet, with volatility remaining high and inflation continuing its narrative, we would put money to work and add duration as interest rates back up.
Opportunities in IG
We continue to view IG credit as our most preferred asset class. The instability in the banking sector caused IG spreads to widen by over 30bps. Despite the widening, IG bonds posted a positive total return of 1.5% in March, thanks to lower rates. We believe that with a spread in the range of 150bps and yield of 5.2%, IG offers attractive opportunities. Regarding banking exposure, given the swift actions by the regulators, we do not view recent events as a systemic risk. We acknowledge the possibility of continued uncertainties in the banking sector, but believe that the decisive actions by the regulators show their ability to stem a further crisis. We also believe that the Big 6 US banks, which are considered to be globally systemically important banks (GSIBs), will maintain strong credit profiles. As such, we believe that investors can find attractive opportunities in IG, both in select financials and non-financials.
Muni market thoughts
Municipal bonds are generally better insulated from the volatility surrounding market disruptions. This is because state and local government banking deposits are usually fully collateralized, and the revenues necessary for daily operations come from various forms of taxation or user fees on essential services. As such, the recent flight to quality on the back of the banking failures has benefited muni performance.
Additionally, when compared to taxable debt, the muni market now offers better relative value as compared to earlier this year. Given the attractive yields, we continue to recommend that investors position in high grade munis within high-quality sectors. Our top sector picks include state governments, muni electric utilities, and water and sewer service providers. We would reduce exposure to lower-quality sectors that may be encountering challenges as the economy slows. Some of these sectors include not-for-profit hospitals and smaller private colleges.
Read the full report Fixed Income Strategist: When something breaks 6 April 2023.
Main contributors: Leslie Falconio and Alina Golant
This content is a product of the UBS Chief Investment Office.