PERSPECTIVE3-5 min to read

No need to read the Fed tea leaves: Compelling opportunities can be found across multiple sectors of the bond market

In Q1 2024, corporates continued to benefit from strong demand, while segments of the securitized market have become attractively cheap.

06/05/2024
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In early April, we experienced a 4.8-magnitude earthquake in the Northeast United States, the largest one for the region in 140 years. For our team members who have lived on the West Coast, this was not an unfamiliar experience. For those born and raised elsewhere, though, it was a bit unnerving. The event demonstrated you have to be prepared for the unexpected, and today’s bond markets seem to be imparting the same lesson. Day in and day out, market participants continue to parse through both the economic data and comments from the US Federal Reserve (Fed) Board of Governors. The fact that Neel Kashkari, the president of the Federal Reserve Bank of Minneapolis, went from being the most dovish Fed policymaker, up until July 14, 2022, to the most hawkish, starting around January 12, 2023, resonates with us, as market expectations continue to evolve. The shift in thinking is evident from the federal funds rate projections (the “dot plot”) by each of the Fed’s 19 policymakers, as revealed after Federal Open Market Committee meetings dating back to late 2021. (See Figure 1.) While the median projection for year-end 2024 was unchanged, remaining at 4.625% from December 2023 to March 2024, the one lone dovish dot for year-end 2024 moved from 3.875% to 4.375%.

Figure 1: A move to a hawkish consensus

Implied fed funds target rate in %

1Q 2024 Fixed Income charts_1296pxW_Figure 1

Source: Bloomberg

The shift in the market’s expectations for rate cuts has been dramatic, as reflected by the pricing of fed funds futures contracts. At the start of the year, the markets had been expecting the equivalent of six rate cuts of 25 bps each in 2024. By the end of March, the markets were pricing in the possibility of just two cuts this year. (See Figure 2.)

Figure 2: Market expectations for rate cuts move dramatically over just two months

Total scale of fed funds rate cuts based on current market implied rate

1Q 2024 Fixed Income charts_1296pxW_Figure 2

Source: Bloomberg. Forecast may not be realized.

Repos” volume provides insights into the Fed’s plans for QT

Another dynamic closely followed by institutional investors is the volume of the central bank’s Reverse Repurchase Agreements (RRP), which can be a leading indicator of any Fed plan to slow the pace of its Quantitative Tightening (QT) program. A reduction in RRPs injects liquidity into the markets and thereby offsets QT. At the moment, the scale of the reduction in RRPs reveals the rate at which the Fed is adding liquidity to the markets. At some point, before RRPs reach zero, the Fed is expected to begin tapering its QT program. That development would be viewed as a modest tailwind for the Treasury market.

More important to markets will be how well the Fed manages any liquidity dislocations in money markets that might result when the central bank’s RRPs approach zero and QT tapering begins. In September 2019, a sudden liquidity squeeze in the repurchase agreement (“repo”) market caused overnight lending rates to shoot up to 10%, and the Fed had to take aggressive action to restore liquidity to the system.

For consumers, a tale of two economies

Fundamentally, the US economy is now bifurcated, split between two groups of consumers who have quite different circumstances. On one side are homeowners who acquired or refinanced their mortgages with a fixed rate before the spike in interest rates. They are sitting in the catbird’s seat relative to the other group. They locked in their largest liability at a low fixed cost for up to 30 years. Nearly 9 in 10 of them – 88% – have a mortgage at a rate below 6%1. Even a slight reduction in interest rates would benefit this group, increasing the value of what is likely their most valuable asset and making it possible for them to borrow against the equity in their homes at a lower cost. Given that this group is responsible for 40% of consumption in the US, the economy would also benefit if their improved financial circumstances, from a modest rate cut, encourages them to spend more.

In the other camp are renters. Younger adults today are more likely to be in this category, as both lifestyles and high home prices have caused many of them to delay homeownership. Inflation is causing their rents to increase significantly, and their current financial burden is evident from the rise in credit card and auto loan debt, especially among younger age groups. Delinquency rates on personal debt have been rising for consumers across all generations. Still, the percentages of people under age 40 who have gone 90 days past the due date for their auto loan or credit card payments are much higher than the numbers for older groups. (See Figure 3.) The younger cohort’s rising debt obligations, to the extent they curb their spending to manage them, could have an adverse effect on the broader economy.

Figure 3: Delinquency rates are higher for younger age groups

1Q 2024 Fixed Income charts_1296pxW_Figure 3

Source: New York Fed Consumer Credit Panel/Equifax, New York Fed Reserve Bank, as of Q4 2023

This bifurcation in the economy only further complicates the challenge that lies ahead for the Fed. While looking for a rate policy that will curb inflation without putting the brakes too hard on the economy, it must also bear in mind the impacts interest rate levels have on these two different groups of consumers.

While it remains to be seen if the Fed will cut rates this summer, or whether, in the bigger picture, it manages to orchestrate a soft landing, there are already signs of an economic slowdown in parts of the economy. Certainly, as we move through 2024 and into 2025, the full effects of higher for longer will begin to bite harder.

As investors, we make our security selection decisions on the basis of where we think we can be adequately compensated for risk. As always, we are closely examining valuations across the broad sectors of the bond market and letting the opportunities we see in each sector drive the allocation choices we make for our clients’ portfolios.

The good news kept coming for corporate bonds in Q1

The first quarter was an extraordinary time because of the insatiable demand for fixed income and corporate credit, in particular. Long corporate bond spreads are hovering in a low range similar to what we saw back in 2004-2007, when spreads remained compressed below 110 bps, as measured by the Bloomberg US Long Corporate index. (See Figure 4.) Certainly, the long-term impact of stimulus and a whole host of federal programs like the Inflation Reduction Act and the CHIPS and Science Act have fostered a stronger than expected economy. Another important contributor to these highly favorable conditions has been the funded status of the 100 largest defined benefit plans. The funding ratio of these plans, as measured by the Milliman 100 Pension Funding Index, was 105.6%, as of March 31, 20242. Investor demand for longer duration paper and the muted issuance of 30-year bonds have led to a relatively flat 10s30s curve. In some sectors, like financials, the slope of the curve between 10-year and 30-year bonds even inverted.

This strong technical tailwind, coupled with the stable economic environment, led a few well-respected corporate bond strategists to revise their 2024 year-end corporate spread outlooks to levels substantially below what they had estimated at the beginning of the year. Spreads for the Bloomberg US Corporate index, at 90 bps as of quarter-end (Figure 4), have been in steady decline over the past 12 months and are now in the 8th percentile of their 10-year history. As value managers, we took the opportunity to minimize our active corporate bond spread risk, also known as Duration Times Spread (DxS), as spreads continued to compress throughout the quarter.

Figure 4: Corporate spreads have been in steady decline for the last 12 months

Bloomberg US Corporate spreads vs. Bloomberg US Long Corporate spreads

1Q 2024 Fixed Income charts_1296pxW_Figure 4

Source: Bloomberg, as of March 31, 2024. Current performance trends are not a guide to future results and may not continue.

Even with the strong global technical dynamics from institutional investors, we remain highly attuned to the potential impact of changes in market liquidity. There has been exponential growth in the level of outstanding investment-grade debt. The value of the benchmark for this sector, the ICE BofA US Corporate Index, now stands at almost $9 trillion. The sheer size of the market has the potential to overwhelm the shrinking dealer community, which has a bond inventory of just $50 billion. Ever since the end of the Global Financial Crisis, dealers have been reluctant to expand their balance sheets. But if they were forced to, in order to cope with the volume of trades in this enormous market, they might be willing to unload some of their inventory at cheaper prices. We’re always on the watch for occasions when such technical changes in the market present an opportunity for us to re-risk portfolios and take advantage of short-term pricing dislocations.

We continue to maintain a substantial portion of our corporate risk in financials. A key concern investors often now raise is the risk for bank loan portfolios that comes from commercial real estate (CRE). Borrowers in the commercial property market are contending not only with today’s high interest rates, but also with the diminished demand for office space as work-from-home options endure and the reduced need for retail outlets as ecommerce continues to rise. Despite these investor fears, financials performed well in the first quarter, relative to the other sectors. Even with those gains, we believe financials still offer value. We are comfortable with the amount of CRE risk in the Global Systematically Important Banks (G-SIBs) and super regionals. This exposure is very manageable for the larger credit issuers. Our bank analyst describes the risks of CRE for the large financial institutions as an “Aleve type of pain as opposed to morphine pain.” CRE is only about 10%-12% of the G-SIBs’ and super regionals’ loan portfolios. However, for smaller community banks, it is a whopping 40%. When it comes to CRE risk, that is where we think the real pain lies.

As the year progresses, we plan to apply the relatively conservative approach of aiming to hit singles and doubles. That will mean investing in new issues that either come with new issue concessions or have, in our view, room for spread tightening after their initial pricing. Again, we believe the technical dynamics are strong for fixed income. Yields north of 5% have always been one of the key drivers of buyer demand, even when debt levels have been modestly on the rise or coverage ratios, reflecting companies’ ability to repay their debt, have been moderately weaker.

Compelling opportunities across the securitized market

One area of the bond market where we are finding considerable relative value, especially in our “up in quality” trade, is the securitized market. This sector remains attractive, relative to other sectors, and offers a wide variety of structures, with some offering compelling yields and spreads.

In the first quarter, several key factors influenced the performance of the securitized market. The housing market continued to be driven by lock-in effects, with homeowners opting to stay put and renovate rather than move, thereby impacting the supply of homes on the market. Home price appreciation (HPA) has been modest, at around 2%-3% overall, but it has been noticeably stronger in the eastern part of the United States. This regional variation in HPA has implications for the performance of residential mortgage-backed securities (MBS), which have seen low delinquency rates. The continuing decline of interest rate volatility, as evidenced by the Merrill Lynch Option Volatility Estimate (MOVE) Index being at 52-week lows (Figure 5), has provided a more stable backdrop for MBS, although volatility remains above pre-COVID-19 levels.

Figure 5: MOVE Index hit lowest level in a year at quarter-end

Changes in the Merrill Lynch Option Volatility Estimate (MOVE) Index 3/1/23 to 3/31/24

1Q 2024 Fixed Income charts_1296pxW_Figure 5

Source: Bloomberg, as of March 31, 2024

In the auto loan sector, there has been a divergence in the delinquency rates of subprime and prime borrowers. Subprime auto loan delinquencies remained elevated and higher than pre-COVID-19 levels, while the delinquency rate for prime borrowers was in line with historical averages. The restarting of student loan payments has added another dynamic to the consumer credit landscape. Meanwhile, bank demand for agency MBS remained muted, with only a few G-SIBs adding Government National Mortgage Association (GNMA) pass-through securities. Foreign demand has been mostly from Asia, particularly Japan, undoubtedly in response to the prospect of Fed rate cuts. Interestingly, the UK and Canada emerged as new buyers in 2024, a departure from past behavior when they showed little interest in the agency MBS market. Within the sector, agency MBS screens as one of the most attractive opportunities. We have been patiently adding here, given continual drawdowns from banks and the Federal Reserve over the last couple of years, but now believe the attractive valuations and improving technicals warrant a larger exposure. Still, we believe outperformance will not occur until there is a sustained period of low rate volatility and/or technical improvements. Within the agency MBS sector, the conventional current coupon looks attractive to us with a carry trade strategy, particularly when the securities’ nominal yields offer +155-160 basis point spreads relative to US Treasuries.

In the US asset-backed securities (ABS) sector, prime autos and credit cards have divergent prospects. Autos still look cheap to short corporates, in our view, while credit cards appear to be fair valued but cheap relative to corporates. In the US AAA-rated collateralized loan obligation (CLO) sector, tier 1 manager new issues look fair valued to us, as do tier 2 manager new issues. However, the prices at which some of these securities have been trading in the secondary market look slightly rich to us. Still that assessment depends, for each CLO, on our view of the quality of its manager and also on where the security is in the non-call and reinvestment period.

Our attention to detail proved its worth in the municipal market given the issues with BABs

Following a notably strong performance for the municipal bond market in December 2023, the landscape proved to be more challenging for this sector in the first quarter of 2024. We saw a significant shift in our proprietary metric for comparing valuations for municipal bonds and corporates, the Net Implied Tax Rate (NIT), which cheapened from 8.6% to 11.0%. The change reflects the broader market's adoption of the “higher for longer” interest rate sentiment, an expectation that notably dampened retail demand for municipal bonds. Despite this, it is crucial to remember that municipals were recalibrating from what were considered to be exceptionally high valuations. Specifically, the yield curve from 10-year down to 1-year maturity bonds remained markedly overpriced. That led us to find better value in Treasuries.

The valuation surge for short-term tax-exempt municipal bonds has been significantly driven by the expansion of retail separately managed accounts, a segment estimated to have ballooned to over $750 billion. These mandates persistently invest in short municipals, disregarding their elevated prices. As adept crossover managers, we strategically divested from our pricier short municipals to pivot toward more attractively priced taxable bonds, such as Treasuries or corporates. This strategic shift was driven by the peculiar dynamics of the municipal curve. It exhibits an upward slope of 71 basis points from 2-30 years, in stark contrast to the Treasury curve's -28 basis point inversion. Ultimately, our positioning across both sectors allows us to capitalize on the high yields available on the long end of the municipal yield curve, which were upwards of 4% at quarter-end, and the high yields on the front end of the taxable yield curve.

Given current developments with Build America Bonds (BABs), our past decision to stop engaging with them demonstrates the value of our meticulous credit analysis and the depth of experience on our team. These bonds represent a substantial part – close to 40% -- of the taxable municipals market. When we were actively trading BABs, we took notice of the extraordinary redemption provision (ERP) within the majority of the $181-billion BABs market. This provision meant that bonds could be called away if the federal subsidy supporting them faced impairment or disruption. Such a scenario played out in March 2013 when the Treasury Department reduced part of the coupon subsidy because deficit reduction targets set forth in the Budget Control Act of 2011 were not being met. Despite this, the market's response allowed these bonds to continue trading above their ERP call prices. Over a decade later, issuers are now activating that ERP. Some managers – those who had not diligently reviewed bond documents – were caught off guard. They have resorted to legal action against issuers to halt the ERP. If these efforts fail, we anticipate a substantial call of BABs in the near term. Our rigorous process enabled us to avoid becoming embroiled in these circumstances. BABs have significantly underperformed other taxable municipals, as evident from the unprecedented level of spread widening between the two over the last couple of months. (See Figure 6.) The entire situation reaffirms why we take full responsibility and consider ourselves accountable for every decision we make for our client portfolios and why we remain so committed to thoroughly understanding every detail of the bonds we select for our clients’ portfolios.

Figure 6: The spread between non-BAB taxable municipals and BABs has widened to its highest level since the bonds were issued in 2009

Comparison of yields for non-BAB taxable municipals and Build America Bonds

1Q 2024 Fixed Income charts_1296pxW_Figure 6

Source: Bloomberg, as of March 31, 2024. Current performance trends are not a guide to future results and may not continue.

A mixed bag for EM debt in Q1 but a cautious optimism it can resume its recovery

Emerging market debt performed well to start 2024. While overall valuations, particularly on dollar investment-grade bonds remains fairly full, valuations on local currency debt and sub-investment-grade issuers remain more compelling. Despite the possibility that the global disinflation process could enter a more difficult phase, we still believe high yielding 10-year local government bonds will be supported by several key factors. These include the high level of real rates in these countries, the cautious approach their central banks are taking to monetary easing, and the potential for reallocations into these markets by foreign investors.

There is the possibility that global growth activity will remain resilient with the potential for economic growth to broaden beyond its narrow current state of US leadership, and that development should benefit emerging markets. We believe commodity prices are likely to remain elevated on a more structural basis. That possibility, combined with the fact that many emerging markets benefit from reshoring, suggests longer term tailwinds for regions such as Mexico, Brazil and India. Finally, we think many EM countries will benefit because they have stabilized or improved their fiscal health by keeping their government debt-to-GDP ratios relatively low – in stark contrast to what has happened in many developed markets and the US, in particular.

Conclusion: An opportunity to take advantage of the fact that fixed income now offers yield

The opportunity in higher quality fixed income remains a compelling one, not just relative to its own history, but also relative to other asset classes. After significant volatility and drawdowns over the last few years, it not surprising that investors remain wary and nervous about prospective returns in the asset class. We believe investors should be selective within the asset class. Riskier segments, such as long-dated corporates or high yield, are trading at historically expensive spread premiums while more attractive risk-adjusted opportunities are available in higher rated sectors, such as securitized markets and Treasuries.

While yields and inflation are likely to remain structurally higher over the next decade than they were in the previous one, fixed income once again provides something it hasn’t for many years – yield! Nominal and real yields are the most attractive we have seen in 15 years. This fact, combined with sticky but moderating inflation and a Fed that appears to be moving to the sidelines, suggests that patient investors could be well rewarded with their bond allocations.

Notes:

[1] Source: Report from the real estate company Redfin, as cited in “Nearly 9 in 10 US homeowners have mortgage rate below 6 percent: Report,” The Hill, 1/12/24

[2] Source: “Pension Funding Index April 2024,” Milliman, 4/4/24

Any reference to regions/ countries/ sectors/ stocks/ securities is for illustrative purposes only and not a recommendation to buy or sell any financial instruments or adopt a specific investment strategy.

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