The US Presidential election and the anticipation of the Federal Reserve rate hike largely influenced the markets in the fourth quarter of 2016. US Equities had a good run in 2016 with S&P 500 total return index performing 11.96% and the Russell 2000 returning 21.3%. Strength in commodity-related sectors have helped stabilize credit markets after oil prices were the main culprit in the first quarter turmoil. Liquidity has improved recently as demand for corporate credit has been strong from both domestic and international buyers. In corporates, third quarter earnings growth has been flat yet have exceeded depressed analyst expectations while leverage remains higher than a few years ago. Despite this, corporate management has been able to take advantage of the low cost of capital environment to continue to access the debt markets. Additionally, expectations for future profit growth are now higher amidst anticipation of a lower corporate tax regime. Despite the volatility in the credit markets for much of the year, 2016 issuance in the investment-grade corporate debt market was up 3.7% relative to the issuance in 2015. Mortgage related issuance was up 9% y-o-y while Asset backed and high yield issuance was down 19% and 9.6% y-o-y respectively.
The 10-year Treasury yielded 2.26% at the end of 2015 and increased to 2.46% towards the end of 2016. The fourth quarter saw a steep rise in rates. Post-election “reflationary” expectations became more baked into expectations for growth.The 10-year Treasury traded as high as 2.6% on December 15, 2016. The yield on 30-year Treasury was 3.06% at the end of December up from 2.09% in July 2016. FOMC raised the target range for the federal funds rate in December and has signaled three more rate hikes in 2017. The current probability of a Fed rate hike by May 2017 is about 49%.
Within high-grade fixed income, credit spreads in the Barclays Aggregate Index widened to 200 bps in February from 155 bps at the end of 2015. By the end of December, spreads tightened back to 118 bps retracing all of their widening. Spreads ended 2011 at 217 bps, 2012 at 131 bps, 2013 at 111bps, and widened to 125 bps at 2014 before widening further in 2015. The year-to-date excess return for the Barclays Credit Index was positive 442 bps along with longer duration credit outperforming duration neutral treasuries by 904 bps. The Barclays Corporate IG Index produced a negative 283 bps return for the quarter and positive 493 bps excess return over duration neutral Treasuries year-to-date. At the sector level, spreads on Industrial credit tightened to 125 bps from 140 bps off Treasuries at the Q3 2016 and 183 bps in December 2015. Year-to-date, the sector produced a positive 603 bps of excess return. Spreads on financial credit tightened to 120 bps from 137 bps from the previous quarter end, and the sector produced a positive 278 bps of excess return YTD. Utilities also saw spreads tighten from 150 bps in 2015 to 132 bps in September to 117 bps in 2016 and posted positive 483 bps of excess return YTD.
CMBS spreads have tightened alongside other credit sectors yet pockets of the market remain wide due to commercial real estate (CRE) fundamental concerns. The largest fear has primarily been the outlook for the retail sector, as malls have had mixed performance with the rise of Amazon and other Internet based transactions gaining market share. In ABS, credit has tightened materially over the last several months, as lower macro volatility and higher front-end yields have helped technically, attracting capital to the sector. Fundamentally, the US consumer has continued to perform well, helping ABS subsectors tied to consumer credit such as auto receivables and credit cards. Student loan debt remains the exception, as the future of the space continues to experience policy uncertainty. In the Agency MBS sector, the steepening of the yield curve has led to underperformance of lower coupon conventional mortgage paper as the negative convexity inherent in the space was on full display. The MBS index lengthened into the rates sell-off, exacerbating underperformance versus treasuries. Spreads in the MBS sector tightened by 1 bp to 15 bps at the end of Q4 from 16 bps at Q3 2016. Year-to-date the sector delivered a negative 11 bps of excess return. ABS spreads widened by 4 bps from 55 bps in September to 59 bps, and the sector produced a positive 95 bps of excess return. CMBS spreads tightened from 121 bps in 2015 to 75 bps at quarter-end. The sector produced a positive 236 bps of excess return. The Barclays Aggregate Index posted a negative 2.98% total return for the Q4 2016 and a total return of 2.65% for the year.