INSIGHTS

On October 16, 2023

AAM Viewpoints — Third Quarter Fixed Income Update

In the first half of 2023 stronger than expected economic data added to fixed income market volatility. In Q3 (3^rd quarter) the yield curve began a rapid steepening from -108bps (basis points) in July to -28bps in the first week of October. During the quarter we witnessed a bear steepener as the 2-year Treasury moved from 4.90% on 6/30/23 to 5.04% (+14bps) on 9/29/23 after reaching 5.17% on the September 20 which was the highest yield since 2007. The 10-year Treasury moved further during the same period as the yield went from 3.84% at the end of Q2 to 4.57% (+73bps) at the end of Q3.

The message would make sense as 2-year yields are more sensitive to changes in monetary policy and the initial thought would be 10-year yields are responding to rising growth expectations. However, in August, the Treasury Department increased the estimated amount of debt it would have to issue during the second half of 2023. Since that announcement, investors became more reluctant to bid for longer dated paper which drove prices down and yields higher as volatility increased.

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 increase through the end of September with a 200-day moving average of 122 and peaked at 141 on October 3.

Treasuries

The increase in September Treasury issuance and stronger than expected economic data put upward pressure on yields as the higher for longer narrative took hold. The 2-year peaked at 5.20% while the 10-year yield peaked at 4.69% before reaching 4.80% in October. Through Q3, the ICE BofA ML Treasury Index was down 3.33% and is now down 1.76% year-to-date.

As yields have been climbing back to levels not seen since 2007, Treasury bonds maturing in 10 years have dropped 46% in value since the March 2020 peak. The drop in 30-year bond values is closer to 53%. These losses are twice the size of those seen in 1981 when yields were closer to 16%. In our opinion, this doesn’t mean you avoid the asset class, but investors should be selective in positioning assets.

Past performance is not indicative of future results.

Credit Market

Rising Treasury yields and tightening spreads led to positive excess returns in the ICE BofA ML U.S. Corporate IG Index in Q3 at 1.04%. Investment Grade (IG) finished the quarter with a total return of -2.71% and a year-to-date total return of 0.44% 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.

Although Corporate bonds generally performed well in the first half of 2023, Q3 presented some challenges. 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 -2.38% in Q3 and is up 1.11% year-to-date which is the top performer by rating in IG.

On a total return basis, High Yield Corporate bonds remained a top performer as the ICE BofA ML U.S. High Yield Index returned 0.51% in Q3 and finished the quarter with a total return of 5.95% year-to-date. In HY, spreads tightened 2bps with CCCs tighter 24bps and BBs wider by 10bps. Longer paper tightened the most in Q3 with 1–3-year and 3–5-year paper wider by 12bps and 1bps respectively.

Municipal Market

The ICE BofA ML U.S. Municipal Bond Index posted a total return of -2.84% in September with a price return of -3.20% for the month. It was the third month in a row with a negative return and the sixth monthly decline this year. Year-to-date the total return is -1.04% with a price return of -4.185% and income return of 3.142%.

The 10-year Municipal-to-Treasury ratio, a popular metric to measure relative value for tax-exempt debt, finished Q3 at 75.28% after peaking on September 28^th at 76.15% and remains well below the 10-year average of 97% reflecting tax-exempt municipals are expensive to Treasuries. Duration was punished in September as long maturity bonds underperformed. The 1–3-year index was down 0.58% in the month while 12–20-year bonds were down 3.34% and 22+ year bonds were down 4.36%.

Municipal bond issuance of $266.5 billion year-to-date is 9% lower than the same period last year. Total new issue volume was $29 billion in September, down 24% from August but 10% higher than September 2022. After three months of negative net supply, new issue volume in September exceeded redemptions by $9 billion.

Credit Spreads

ICE BofA ML IG spreads narrowed to 119bps twice during the quarter, in July and again in September, and finished the quarter 6bps tighter at 125bps while remaining between 119bps and 130bps for the entire quarter. The belly of the curve rallied the most this year as the 5–7-year maturities are 15bps tighter year-to-date after widening 5bps in September.

As previously stated, in IG BBBs remained a top performer on the quarter and continue to outperform on a year-to-date basis with an excess return of 3.25% year-to-date and a total return of 1.11%. The ICE BofA ML U.S. Corporate BBB Option Adjusted Spread finished Q3 at 151bps over Treasuries and the ICE BofA ML U.S. High Yield Option Adjusted Spread is 403bps (see chart below).

At the sector level, IG spreads tightened in Q3 with Real Estate 15 bps tighter followed by Utilities and Insurance which were 14bps tighter and Energy tighter by 11bps. At the end of Q3, Financials were at 137bps and Energy was 132bps while Real Estate held the widest spread at 157bps.

Spreads in ICE BofA ML U.S. HY Index widened 34bps in Q3. High Yield (HY) investors reached down to the lower rated tranches as CCCs tightened 24bps while Bs tightened 15bps and BBs widened by 10bps. The largest HY moves were in September as spreads widened 18bps and now sit 76bps tighter year-to-date.

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 steepened from

-3bps at the end of 2022 to 9bps on September 30. While the 30-year minus the 5-year curve is 12bps steeper this year, the 10-year minus 2-year is less inverted by 8bps after reaching -108bps in early July. The chart below reflects the inversion in 30s and 5s, 10s and 2s and 10s and 3-month Treasuries. All of which suggest a recession may be on the horizon.

Past performance is not indicative of future results.

Outlook

The most widely anticipated recession in history seems to keep getting pushed back as sticky inflation forces the Fed to hike and hold. The New York Fed probability of a recession in 12-months peaked at 70.9%, the highest since the early 80s, in May of this year. It has since tapered off to 56.16% in September as the Treasury yield curve remains deeply inverted and suggests a pending recession.

2s/10s have been inverted since 7/5/22, reached a 42-year closing low of -108bps on July 3 and currently remains near -40bps. The 3Ms/10s inversion reached a historic low of -186bps on 5/3/23 and remains near -88bps today. In the face of a challenging economic outlook, credit spreads indicate markets have not yet appropriately discounted a difficult 2023 and 2024.

We believe investors need to focus on long-term investing and look beyond the headlines which include geopolitical concerns and consumer trends. The headlines may add volatility in fixed income assets, but investment grade corporate bonds appear attractive for investors looking to earn higher yields potential without taking too much additional credit risk. The ICE BofA ML IG Index yield to worst at the end of September was 6.38%. This yield has been seldom seen since the 2009. Except for 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, expect volatility to 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: 2023-1002-11152 R