Written by: Tracy Nolte | Advisor Asset Management
Fixed income markets have taken a breather so far in 2024. Year-to-date returns are somewhat negative for the Bloomberg Aggregate Index while excess returns are largely flat over the same timeframe. This middling performance stands starkly opposed to the returns witnessed in the final quarter of 2023. While it may seem like ancient history, the Bloomberg Agg generated 6.82%, the U.S. Treasury Index returned 5.66%, and the Bloomberg Corporate Index returned 8.50% during Q4 (fourth quarter) alone. The remarkable and concurrent profile of returns during the final two months of last year highlight that not only were expectations growing that Federal Open Market Committee (FOMC) policy would tilt markedly dovish during 2024, but that the credit riskier parts of the credit stack would emerge unscathed from 525 bps (basis points) of rate hikes.
It seems a good time to consider how tight spreads became over the final two months of 2023. We may uncover reasons for the markets recent and rampant attraction to credit risk and, using history as our guide, reflect upon where the potential sources of return in the fixed income markets may be expected to come from as we move through 2024 and into 2025. We believe there remain risks to the current level of optimism and, as our CIO Cliff Corso outlined recently in his CIO Outlook for 2024, “…the Fed dot plot pivot and dovish presser in December allowed the pivot party to go too far….”
The ebullient outlook which Cliff discusses in his commentary was, in part, due to some welcome and appropriate “softening” of the economic data which began last summer. As the final two months of 2023 unfolded, headline Consumer Price Index (CPI) — which began 2023 at 6.50% year over year (YoY) — had been halved by the end of October to 3.20%, Core CPI had fallen from 5.70% YoY to 4.00%, and the FOMC’s preferred measure of PCE had fallen from 4.86% to 3.37%. The FOMC’s policy response which began in 2022 appeared to finally begin relieving inflationary pressures.
Throughout 2023, monthly jobs added continued to be robust with an average 357,000 jobs added each month from January to October. Even in the face of such robust employment releases, average hourly wages had fallen from 4.90% over the prior year to 4.30% in October. Hires, as captured by JOLTS (Job Openings and Labor Turnover Survey) report, had fallen from 5.809 million in January to 5.446 million, moderating labor market pressures further.
Both events, the decline in inflation and the robust hiring environment, occurred with only a moderate increase in the unemployment rate from 3.50% in January to 3.80% by October. This evidence suggested that the FOMC had or was in the process of engineering an infamous soft landing. With this outlook came abundant optimism. Couple these factors with a change in tone from the FOMC in December and markets bet confidently that the central bank would continue holding rates steady and begin cutting rates aggressively in 2024. As Cliff also highlighted, this was the 3rd year in a row where markets had this expectation going into the next year.
With this optimism in hand, fixed income investors drove credit spreads another leg lower as they began a rampant and persistent push into the credit “riskier” parts of the stack for the second time since the end of the COVID recession. While fixed income markets have taken a bit of a breather since the beginning of the year, spreads remain at these tight levels. For BB-rated credits, spread to Treasuries have not been this tight since 2019, while B-rated credits were last at these levels in January 2019.
Source: ICE Data Indices, Federal Reserve of St. Louis | Past performance is not indicative of future results.
With an optimistic outlook for the economy and a sense that the FOMC has been successful in their mission, the siren song of yield can be difficult to resist. Looking at the table above, consider the 95bps increase in yield with only 56% of the duration exposure by investing in BB-rated debt instead of BBB-rated. Or, what about a 133bps pickup in yield with 82% of the duration risk by looking at B-rated debt versus BB-rated debt.
As the charts below illustrate, the appeal of these trades drove the relative spreads between these slices of the credit stack to their tightest level since before COVID.
Where does that leave us today when we cast our gaze forward into the next 12-18 months and try to determine how to generate fixed income returns most appropriately? The answer to that question depends on how lucky the FOMC may be in avoiding a recession or a material slowdown in the broader economy.
It is our view that the optimism of the past four months may be misplaced. This is not to suggest that the timing of such an event can be identified with ease. Instead, we remain convinced that there are significant challenges to the U.S. Economy which the recent tightness in credit spreads may not be appropriately considering.
Credit spreads for any bond are based upon the future expectations of default by the issuing company and the expected recovery a credit holder could reasonably expect to receive following that default. This concept of appropriately rewarding an investor for the credit risk they are taking is the reason that 5-year U.S. Treasury bonds pay 4.12% yield while the average 5-year BB-rated corporate bond pays a 6.62% yield. Therefore, the question to ask about an investment in a credit-risky bond is whether the additional compensation one receives, in this example an additional 250bps, for the additional credit risk is appropriate given one’s outlook.
While he was discussing economic events in his recent Viewpoints, Nick Williams, CFA and Portfolio Manager for the Separately Managed Accounts Equity Strategies, I think also summed up the disparity between the discipline of strategic, long-term fixed-income investing with the alluring siren song of yield:
“The inevitable departure of our expectations from reality demonstrates why maintaining a set of defined principals in our investing endeavors is so imperative.”
For the past 19 months, the spread between the 10-year and 2-year Treasury has been inverted. For the past 15 months, so too has the spread between the 10-year Treasury and the 3-month T-bill (Treasury Bill) been inverted. Never in the history of modern central banking has the U.S. had an inversion of this duration without facing a recession, and yet optimism abounds with the response that “this time it’s different.” Couple this with the fact that not since the 1980s has the U.S. economy been straddled with expectations of a broad commercial real estate crisis which is also joined at the hip with the smaller, local banking entities.
While clearly inflation may have moderated from the peaks of 2022, structural forces are working through the economy which, in our opinion, continue to skew higher the risks to inflation and an economic slowdown. It has often been said that Consumer Price Index (CPI) is, for example, the most mean-reverting time series in modern finance. However, there are periods in history when structural forces of the economy may force this mean level of inflation higher. As labor continues to push for higher wages, as companies continue to onshore supply chains, as global uncertainty places pricing pressures under a microscope, and as debt levels for the U.S. economy continue to rise, we believe that one must be exceptionally diligent about where one allocates credit risk in a fixed income portfolio.
We continue to find select, relative value throughout the credit stack, but it is our opinion that credit spreads may not be adequately compensating investors for the near-term risk we believe firms are facing. Although returns in Q4 2023 were remarkable by any standard, we continued to be positioned in reasonably priced quality, value, and income and maintain a defensive duration with an allocation to high quality assets and “dry powder.” As asset managers we remind our clients that investing isn’t about timing the market, it’s about time in the market and though returns in fixed income may be influenced by prices in the short run, over the longer run the preponderance of returns are generated by income.