INSIGHTS

On July 10, 2023

AAM Viewpoints — 2023 Mid-Year Fixed Income Review

The U.S. Treasury yield curve approached its most inverted level in decades at the end of June as expectations increased for the Fed to hike one or two more times before year end. The inversion touched 110bps (basis points) in March and near that last week — levels last seen in the early 1980s. The Fed left rates unchanged in June after 10 straight rate increases and the meeting minutes indicated some disagreement among members with comments that rates should go higher as inflation remains elevated. While the labor market remains strong, the headline reading for the Personal Consumption Expenditures Index declined in May but the Core measure held at 4.6% in May, which is little changed since December.

The impact from stronger-than-expected economic data has added volatility. Fixed income markets reversed course from a strong first quarter (Q1) as virtually all fixed income assets, with the exception of high yield, had negative returns in Q2. Following the worst year on record in 2022, the Bloomberg US Aggregate Index (AGG) posted a -0.84% return after gaining 2.96% in Q1 and now stands at a 2.09% gain year-to-date. The Corporate component of the AGG was down 0.29% in Q2 while Treasury component was down 1.38%. Year-to-date both are still positive at 3.21% and 1.59% respectively.

Source: AAM, Barclays Live | Past performance is not indicative of future results.

Treasuries

The 10-year U.S. Treasury started this year yielding 3.87%, 236bps higher than where it started 2022. The 10-year yield closed out the first half of 2023 with a yield of 3.84%, down 3bps. As the Fed terminal rate moved higher this year, short Treasury yields move above 5% while longer dated Treasury yields held steady. The 10-year Treasury yield at 3.84% only generates 47bps of yield per unit of duration.

The bulk of the Treasury curve bear flattened in June with the 2-year rising 49bps to 4.90% and the 10-year rising only 19bps to 3.84%. One key driver was Fed terminal rate pricing moving higher to 5.4% after strong economic data.

The ICE BofA ML MOVE Index, a measure of implied volatility in the Treasury markets, reached 198 on March 15, which was a level last seen at the end of the great financial crises in 2008. Volatility remained elevated through the end of June with a 200-day moving average of 129.

Past performance is not indicative of future results.

Credit Market

Rising Treasury yields and tightening spreads led to positive total and excess returns in the ICE BofA ML U.S. Corporate IG Index in June at 0.29% and 1.07% respectively. IG finished the first half with a total return of 3.23% with longer maturity bonds outperforming. The 7–10-year range returned 3.56% while the 5–7-year range returned only 2.69% year-to-date.

Corporate bonds generally performed well in the first half of 2023. The risk-on sentiment prompted investors to reach down the rating spectrum, leading to outperformance in lower rated IG as the ICE BofA ML U.S. Corporate BBB Index returned -0.21% in Q2 and is up 3.58% year-to-date which matches AAAs as the top performer by rating. The AAAs duration contributed to its outperformance as the duration is 3 years longer than BBBs.

High Yield remained a top performer as the ICE BofA ML U.S. High Yield Index returned 1.63% in June and finished the first half with a total return of 5.42%. In HY, spreads tightened across all rating tranches, tenors and sectors in June.

Municipal Market

The June price return for the ICE BofA ML U.S. Municipal Bond Index was 0.55% and that was the only positive monthly price return during Q2 and the third best June return since 2011. For the quarter, the price return was -1.05% and total return was 0.01% as lower-rated bonds outperformed. Year-to-date total return is 2.84% and excess return of 1.35%.

The 10-year Municipal-to-Treasury ratio, a popular metric to measure relative value for tax-exempt debt, finished Q2 at 66.45% and remains well below the 10-year average of 97% reflecting tax-exempt municipals are expensive to Treasuries. Duration was rewarded in June as long maturity bonds outperformed. The 1-3 Year Index was up 0.49% in the month while 12–22-year bonds were up 0.97% and 22+ year bonds were up 1.37%.

Municipal bond issuance of $171.0B year-to-date is 21.6% lower than $218.3B last year for the same period. This compares to the 6-month average $198.3B from 2014–2023 ($201.3B from 2014–2022). Issuance has been constrained with aggressive tightening of monetary policy by the Federal Reserve and concerns over a pending recession.

Source: AAM, The Bond Buyer

Credit Spreads

Spreads in ICE BofA ML U.S. Investment Grade Index continued to tighten another 12bps in June as the IG index now sits at 130bps. IG Index spreads are 8bps tighter year-to-date. The belly of the curve rallied the most in June, with 3–5 and 5–7-year maturities both tighter 15bps for the month and 5–7-year maturities are 13bps tighter year-to-date.

The ICE BofA ML U.S. Corporate BBB Option Adjusted Spread is 161bps over treasuries and the ICE BofA ML U.S. High Yield Option Adjusted Spread is 405bps (see chart below). Both of which are roughly 25% tighter than they were this time last year when spreads were 204bps and 587bps respectively. BBB spreads peaked at 198bps on March 15 and HY peaked at 522bps on March 24 shortly after the SVB fallout.

At the sector level, IG spreads tightened across the board with Leisure 25bps tighter followed by Financial Services, Media, and Real Estate which all tightening by 17bps. Financials and Banking were also among the sectors with the largest spread tightening of 13bps over the month as the market continues to reprice risk in the Financial sector post the regional banking crisis.

Spreads in ICE BofA ML U.S. HY Index tightened 64bps. HY investors reached down to the lower rated tranches as CCCs tightened 129bps while Bs and BBs tightened by 68bps and 46bps, respectively. HY spreads tightened more than IG in June and closed the month with a spread difference of just 275bps which is only slightly off the year-to-date tight of 273bps from early March.

Past performance is not indicative of future results.

Yield Curve

The spread between the 30-year U.S. Treasury yield and the 5-year U.S. Treasury yield further inverted from -3bps at the end of 2022 to -30bps on June 30. While the 30-year minus the 5-year curve is 27bps more inverted year-to-date, the 10-year minus 2-year is more inverted by 51bps. The chart below reflects the inversion in 30s and 5s, 10s and 2s and 10s and 3-month T-bills (Treasury bonds). All of which are pointing to a recession.

Defaults

There are risks with corporate bond investing. The risk of default is generally low with investment grade-rated issuers because they tend to have stronger balance sheets and more stable cash flows than below investment grade issuers. An economic slowdown can create headwinds and we think higher rated bonds may hold their value more than high yield bonds as we expect volatility to remain elevated through the end of 2023.

Moody’s reports the global trailing 12-month speculative default rate closed May at 3.4% which was up from 3.2% at the end of April. The expectation is for the global default rate to finish 2023 at 4.6%, which would be higher than the long-term average of 4.1%. The U.S. speculative default rate closed May at 3.1% and was up from 2.8% in April. Moody’s forecasts the U.S. speculative grade default rate will finish 2023 at 5.4%. Well above the long-term average of 4.5%.

Outlook

The predictions from our CIO office in the first half of 2023 were mostly accurate as we expected inflation to ease but remain sticky, slowing U.S. economic growth and the Fed appears to be nearing the end of the rate-hike cycle. We anticipate a recession in 2023, but Q1 GDP was revised up to 2.0%, driven by net exports and consumer spending on durable goods, while the latest Federal Reserve Bank of Atlanta GDPNow estimate for Q2 is 1.9% so we will continue to monitor the data.

The New York Fed probability of a recession in 12-months is 70.9%, the highest since the early 80s, as the Treasury yield curve remains deeply inverted and suggests a pending recession. 2s/10s (2-year Treasury vs 10-year Treasury) have been inverted since 7/5/22, reached a 42-year closing low of -107bps on March 8 and currently remain near -100bps. The 3Ms/10s (3-month Treasury vs 10-year Treasury) inversion reached a historic low of -186bps on May 3, 2023 and remains below -130bps today. In the face of a challenging economic outlook, credit spreads indicate markets have not yet appropriately discounted a difficult 2023 and 2024 even in the face of another potential 25bps hike by the FOMC.

Performance in the second half of the year may be similar to the first half and we anticipate volatility will remain high. To combat volatility, we continue to look for higher coupon bonds as the income return will be a large contributor to total return this year. With default rates rising, we continue to see a greater risk of price declines with high-yield corporate bonds.

Although challenges are on the horizon, “we have income back in fixed income” and investment grade corporate bonds appear attractive for investors looking to earn higher yields without taking too much additional risk. The ICE BofA ML IG Index yield to worst at the end of June was 5.56% and remains at levels seldom seen since 2009 and well off the January 2021 low of 1.78%. With exception of the Great Financial Crisis, yields are sitting near 20-year highs. Investors have been reluctant to consider longer-term bonds, but the opportunity to selectively take advantage of these yields is here. When evaluating these opportunities, remember to stay within your risk tolerance as volatility will remain elevated and we anticipate economic growth will continue to slow.

This environment presents both opportunities and risks for fixed income investors. This is the time to understand where the risk lies in your fixed income portfolio and hiring a professional management team with an experienced track record may help clients sleep at night during this stage of the cycle. Active managers will diversify portfolios across asset classes, sectors, maturities and tactically adjust duration as needed.

CRN: 2023-0706-10975 R