Mixed Bag for Bonds in 2018

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Before Congress passed the tax bill, most economists, strategists and portfolio managers were expecting moderate growth, three Federal Reserve rate hikes and a modest rise in interest rates in 2018, all somewhat negative for bond prices but not critical. The tax bill, which is expected to swell the federal debt by $1 trillion to $1.5 trillion over 10 years, changes those calculations.

It adds 0.25% to 0.50% to annual growth in 2018, along with slightly higher inflation, a likely fourth Fed rate hike, and ultimately higher interest rates, between roughly 2.7% and 3% for the 10-year Treasury by year-end 2018.

(Related: Untimely Fiscal Stimulus Is a Bond Nightmare)

Unemployment is expected to fall below 4%, heading toward 3.5% or lower, which would lift wages and inflation, forcing the Fed into a more aggressive monetary policy, and that is worrying some analysts.

“An overheated labor market puts us at risk for a potential policy mistake,” according to the 2018 Global Market Outlook from Russell Investments. “The Fed could raise interest rates too aggressively, restrict growth and unintentionally start a recession.”

(Related: Fed Surprises Financial Markets, Indicating 3 Rate Hikes Next Year)

“The new tax bill is likely to provide a short-term bump for activity that the Fed will very carefully take away,” writes Paul Eitelman, investment strategist at Russell Investments.

What to Watch in Bonds

Economists and strategists will be watching to see if the already flatter yield curve inverts, with long-term rates falling below short-term rates, which is an early sign of a recession.

The current spread between the two-year and 10-year Treasury is 59 basis points. It was 2.5 times that a year ago primarily because the Fed had yet to hike rates three more times. The spread is expected to narrow further in 2018 as the Fed hikes rates three to four times, at 25 basis points a pop, and long-term rates increase just 25 to 50 basis points.

How high long-term rates rise will depend on inflation, inflation expectations and how the Treasury structures its auctions to accommodate the additional supply needed to finance the tax bill.

“The effect on interest rates and the curve of the increased Treasury borrowing will depend upon the maturity structure of the increase in Treasury borrowing and debt,” write economists at Jefferies. “Treasury will need to add new longer-term issues to the auction calendar or the sizes of existing auctions will become unwieldy. It would require coordination between the Fed and Treasury, but the Fed could adjust the ongoing balance sheet normalization by rolling some of the MBS proceeds into bills.”

The supply story for corporate bonds may be just the opposite of the forecast for Treasuries, for several reasons.

“The cut in the corporate tax rate, the repatriation of foreign earnings, new limits on interest deductibility and increased expenses of capital equipment could generate additional corporate cash flow and result in less debt issued in the U.S. — reducing supply and boosting bond prices,” according to a T. Rowe Price analysis.

But the impact of the tax bill on lower rated high-yield bonds could be a negative one. “The most highly leveraged issuers that fall largely in the CCC rating category stand to be hurt most by the interest limitation,” write strategists at the Chief Investment Office Americas, Wealth Management, for UBS. “The spreads for CCC issuers have underperformed since earlier this year, which should limit the extent of further tax-related repricing.”

The municipal bond market is expected to face multiple challenges as a result of the tax cut bill. Demand from banks and other financial companies, which account for about 29% of muni bond holders this year, could decline because they’ll have less need for tax-free interest as their corporate taxes fall. 

The muni market is also expected to be impacted by the elimination of the deductibility of state and local property taxes, which could harm the credit quality of bonds from high-tax state issues such as California, Connecticut, Illinois, Massachusetts, New Jersey and New York, according to Athena Capital Advisors.

On the flip side, muni bond supply could decrease because starting next year advance refunding bonds will no longer be eligible for a federal tax exemption. Advance refis issued this year are grandfathered, which explains the burst of new supply of such bonds in recent weeks. State and local governments issued $43 billion in new bonds through the first 15 days of December, the largest amount of government borrowing during that same period since 1990, according to Thomson Reuters. 

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