INSIGHTS

On April 08, 2024

AAM Viewpoints — First Quarter 2024 Fixed Income Update

The message from the Fed has been the direction of rates is lower and the pace may be slower than previously expected. With that messaging, the first quarter (Q1) was relatively calm compared to the volatility we experienced in the fourth quarter of 2023 when U.S. Treasury yields, across the breadth of the curve, declined dramatically to finish the year. The decline in yields in November and December allowed the broad ICE BAML U.S. Treasury Index to experience its best quarterly return since 2011. In Q1 2024 we’ve seen a bear flattening in the curve as the 2-year yield rose 37bps (basis points) to 4.62% while the 10-year yield rose 32bps to finish the quarter at 4.20%. The 2s10s (2-year Treasury vs 10-year Treasury) yield curve finished 5bps further inverted at -42bps after reaching -16bps on January 16.

Fixed income markets reversed course in March after two consecutive monthly losses in most asset classes in January and February. The Bloomberg U.S. Aggregate Index posted a -0.78% return in Q1 after being down 1.68% in the first two months of the quarter. As you can see below, the Treasury component was the largest detractor to overall performance in the index during the quarter with a loss of 0.96% as yields rose.

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

Treasuries

Since August 2023, Treasury has significantly increase issuance sizes for nominal coupon securities. The plan was to increase the auction sizes of the 3-year and 5-year by $3 billion per month, the 3-year by $2 billion per month and the 7-year by $1 billion per month through April 2024. Even with record auction sizes, demand remained strong and the additional issuance has been well received.

In Q1, the ICE BofA ML US Treasury Index was down 0.94% and is down 0.19% over the trailing 12-months. The index currently has a 4.45% yield-to-worst, a duration of 6.31, and the trailing 10-year average yield-to-worst for the index is only 2.10%. With the move-up in yields — to levels seldom seen since 2007 — Treasury bonds maturing in 10 years have dropped 20% in value if they were purchased at the March 2020 peak. The drop in 30-year bond values is closer to 50%. This does not mean avoid the asset class, but we believe investors should be selective in positioning assets.

The reduction in volatility, as previously mentioned, is reflected in the ICE BofA ML MOVE Index — a measure of implied volatility in the Treasury markets, which finally made it below 100 on March 12after spending only a handful of days below that threshold since March 2022. Volatility has been decreasing since October 3, 2023 when the index closed at 141.

Past performance is not indicative of future results.

Municipal Market

Yields in municipal bonds have improved as, like other fixed income assets, they have reset higher after a decade of extraordinarily low rates. The ICE BofA ML U.S. Municipal Bond Index posted a total return of -0.32% in Q1 with a price return of -1.37% and income return of 1.06% for the quarter. Although the index has negative performance in seven of the past 12 months, the total return is 3.24% during the period with the income component contributing 4.37% which further reinforces the importance of income in the total return calculation.

The 10-year Municipal-to-Treasury ratio, a popular metric to measure relative value for tax-exempt debt, finished Q1 at 59.89%, and remains well below the long-term average near 80%, reflecting tax-exempt municipals are expensive to Treasuries. Interest rates for Municipal Bonds maturating in 10 years peaked at 3.63% last October and have now settled near 2.5%.

Issuance in March increased for the third consecutive month and was up 37% to $98.5 billion during the first quarter because states and municipalities took advantage of lower rates, and the increase in demand, before the upcoming election. This issuance was met with strong demand as $98.5 billion was the most for the first quarter since 2021 as the number of deals in Q1 rose 18% from the previous year.

Credit Market

Investment Grade (IG) yields remain attractive and finished the quarter with a yield-to-worst of 5.36% which is 21bps higher year to date (YTD). Although that is off the 6.44% peak last October, it remains well above the trailing 10-year average of 3.52%. While most A rated bonds yield above 5%, the largest pick-up in yield is found moving from BBB rated to BBB- rated where investors get an extra 44bps in yield. IG issuance also remains robust as yields rest above 5%. In March borrowers priced $142.2 billion in gross new issuance pushing Q1 totals to a record $529.8 billion as investors continue to digest the pace of offerings with orderbooks averaging 3.8x oversubscribed.

Rising treasury yields and tightening spreads led to positive excess returns in the ICE BofA ML U.S. Corporate IG Index in Q1 at 1.04%. On a total return basis, IG finished the quarter with a return of

-0.10% with shorter tenor bonds outperforming. The 1–3-year range posted a total return of 0.83% while the 7–10-year range posted a -1.23% return. Although corporate bonds generally performed well in 2023 with the ICE BofA ML U.S. IG Corporate Index posting an 8.40% total return, Q1 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. BBB index returned 0.18% in Q1 and was the top performer by rating in IG.

High Yield (HY) corporates finished the quarter with a yield-to-worst of 7.75% which was 9bps higher in March and 6bps higher in 2024. Across ratings, yields are above 6% with the largest pick-up of 176bps when moving from B rated to B- rated bonds. Although yields are off the 9.53% peak last October, they remain 123bps higher than the trailing 10-year average of 6.52%. On a total return basis, high yield corporate bonds remained a top performer as the ICE BofA ML U.S. High Yield Index returned 1.51% in Q1 and has a trailing 12-month total return of 11.04%.

HY new issue supply was also strong in Q1 with $99 billion in new issuance, roughly double the amount priced in Q1 2023 ($46 billion) and 2022 ($53 billion).

Credit Spreads

ICE BofA ML U.S. IG Spreads continued to grind tighter in Q1 as IG spreads reach 91bps and HY reached 305bps in March (see chart below). These are levels last seen in late 2021 and near pre-Great Financial Crisis levels in 2007. IG spreads finished the quarter at 93bps which was 11bps tighter during the quarter as the front end of the curve rallied the most in Q1 with 1–3-year tenors tighter by 12bps and 3–5-year tenors tighter by 14bps.

As previously stated, in IG BBB rated bonds remained a top performer in the quarter with an excess return of 1.27% and a total return of 0.18%. The ICE BofA ML U.S. Corporate BBB Option Adjusted Spread (OAS) finished Q1 at 115bps over Treasuries while the ICE BofA ML U.S. Corporate BB OAS is 187bps. The yield pickup from dropping from BBB rated to BB rated finished the quarter at +87bps with only 54% of the duration exposure.

At the sector level, IG spreads tightened in Q1 with Real Estate, Banking and Insurance all 18bps tighter. At the end of Q1, Insurance had a spread of 110bps, Real Estate was 111bps and Banking was 96bps with all yielding above 5.4%.

Spreads in ICE BofA ML U.S. HY Index tightened 24bps in Q1. Investors reached down to the higher rated HY tranches as B rated tightened 31bps and BB rated tightened by 17bps while CCC rated widened 1bps. The largest HY moves were in February as spreads tightened 30bps and now sit 22bps 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 flattened from

18bps at the end of 2023 to 13bps on March 29th. While the 30-year minus the 5-year curve is 5bps flatter this year, the 10-year minus 2-year is more inverted by 4bps and finished the quarter at -42bps. The chart below reflects the inversion in 30s and 5s, 10s and 2s and 10s and 3-month Treasury bills. 10s and 2s have been inverted for 21 consecutive months. Historically speaking, that would point to a recession.

Past performance is not indicative of future results.

Summary

The economic data has improved as initial jobless claims remain low and payroll growth has remained solid while consumer spending, including goods and services remains a key support for the economy. Consumer sentiment jumped to the highest level since July 2021. U.S. manufacturing activity unexpectedly expanded in March for the first time since September 2022 on a sharp rebound in production and stronger demand. Q4 GDP was revised up to 3.4% following a 3.1% print in Q3 while the Atlanta Fed GDPNow estimate for Q1 2024 currently stands at 2.8%. However, risks remain as the budget deficit is concerning, credit card borrowing remains near records, banks have tightened credit standards and the personal saving rate reached its lowest level since December 2022 as consumers pulled back on savings to fuel their spending. I would expect that as the labor market cools, consumers will become more cautious about spending as we progress through the year.

In November and December, the rally in “all things fixed income” allowed the Investment Grade and High Yield slices of the stack to generate positive total returns and positive excess returns in 2023. In Q1 of 2024 virtually every fixed income asset class posted negative returns as Treasury yields rose 26–40bps across the curve and credit spreads tightened in IG and HY.

Moving through 2024, we believe investors need to focus on long-term investing and look beyond the headlines which include geopolitical concerns, inflation, consumer trends and the upcoming election. The headlines may add volatility in fixed income assets, but investment grade corporate bonds appear attractive for investors looking to earn higher yields without taking too much additional risk.

This environment presents both opportunities and risks for fixed income investors. In our view, 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: 2024-0405-11585 R

An investment in Municipal Bonds is subject to numerous risks, including higher interest rates, economic recession, deterioration of the municipal bond market, possible downgrades, changes to the tax status of the bonds and defaults of interest and/or principal. A bond’s call price could be less than the price paid for the bond. Bonds typically fall in value when interest rates rise and rise in value when interest rates fall. Bond insurance covers interest and principal payments when due and does not insure or guarantee the value of any bond in any way.