For 796 days, the 10-year Treasury failed to produce a higher yield than the 2-year Treasury; finally, on September 6, 2024, the 2y10y (2-year Treasury vs. 10-year Treasury) yield curve turned positive. While this is clearly a notable event given that this curve inversion was the longest on record, students of history may be forgiven for being less than ebullient. There are many reasons why some analysts and economists believe that “this time is different,” but let’s not forget that God created economists to make weathermen look good. Historically, the flattening of the yield curve unfortunately does not provide a signal that “all is clear.” In fact, when it occurs at the end of an FOMC (Federal Open Market Committee) tightening cycle, it is a touchstone that continues to suggest that risks of an economic slowdown are the horizon. Whether these risks escalate and continue to manifest through the coming 12 months remains to be seen. If the flattening of the yield curve tells us anything, it is that now — more than at any time during the post-COVID recovery — is the time to conduct a critical and detailed assessment of the credit risk within any fixed income portfolio.
Having now conquered inflation, even if only for a moment, the FOMC has subsequently shifted their policy focus from fighting pricing pressures to supporting the labor market. In doing so, the rationale is that the move to more accommodative policy will also help avoid a broad economic slowdown since inflation appears to be, at least temporarily, subdued. In this regard, history can provide us with some measure of the FOMC’s prior success. In the nearly 80 years since World War II, 1994 was the single period when the economy managed to avoid a recession following FOMC restrictive policy. If we exclude the COVID-driven recession, this means that the U.S. economy avoided recession one time out of 11. To borrow a phrase from statistics, it’s clear that the probability of a soft landing is non-zero, but we’re not convinced that such a small sample size affords much optimism.
For fixed income investors, whether the U.S. economy enters or avoids a recession does not alter the fact that over longer periods of time the preponderance of fixed income returns are generated by income. The three charts below highlight total return and the price and income components of that return for various slices of the credit stack. It is easy to see how the influence of income rises with an increase in holding period.
ICE BofA Market Indices | Past performance is not indicative of future results.
It stands to reason, therefore, that given the importance of income to total return, the greatest threat to income in a fixed income portfolio is the risk of non-payment — the risk of default. When an economy is growing, volatility and defaults tend to be lower. Fixed income investors are certainly aware of credit risk but pay less attention to it because there is lower probability of it impacting their investments at that time. However, with history as our guide, it stands to reason that regardless of an investors outlook, it is more important now than at any time during the prior 36 months to have a strong sense of how much credit risk exposure resides within any fixed income portfolio.
Source: Federal Reserve Bank of St. Louis (FRED)
It has been easy for investors to be lulled into a sense of security from the consistently remarkable performance of equity and bond markets over the prior 36 months. These charts of the VIX Index and the MOVE Index illustrate how expected volatility in both asset classes has declined since the beginning of 2023 and when volatility expectations decline, risk assets tend to perform well, i.e., equity returns tend to be positive and bond returns tend to be higher in the credit riskier slices of the credit stack. It is no accident that credit risk itself also declines as volatility declines.
However, the recent rise in volatility beginning in late July has occurred while economic uncertainty has also been growing. As an example, one measure of the uncertain outlook is that the number of jobs added monthly has been less than expectations for the prior three months. Concurrently, the trailing twelve-month (TTM) average of jobs added is approaching lows last set in 2019, pre-COVID.
Source: ICE BofA Market Indices | Past performance is not indicative of future results
Additionally, this recent increase in volatility across the fixed income markets is reflected in the dispersion of total returns throughout the credit stack. While returns for credit exposure continue to be attractive over the TTM, the composition of the returns generated in the prior 60 days has focused higher in the stack, in upper investment grade bonds and U.S. Treasuries. This recent improvement in the performance of “less-risky” credit exposure seems to be consistent with growing uncertainty in the FOMC’s ability to engineer a soft landing and the growing uncertainty in the economic outlook. On a relative value basis, the composition of spread returns in the fixed income market exhibits a resistance to the level of compensation being offered to take credit exposure in the face of potentially higher credit risk.
As a brief reminder, the yield paid to an investor on a corporate bond includes, among many things, a premium which compensates the investor for accepting credit risk above some “riskless” benchmark, commonly a U.S. Treasury bond. This additional compensation, referred to as spread (in this case OAS — option adjusted spread), increases as credit rating decreases. The concept should be familiar to all investors because it is consistent with each of our expectations that we receive appropriate compensation for taking on additional risk.
Historically speaking, investors can think of credit spreads as being akin to a canary in a coal mine. Clearly it is possible that that spreads may continue to tighten in the current environment. As mentioned earlier, the possibility this will occur is non-zero regardless of our opinion that spreads may not be adequately rewarding investors for the credit risk being assumed. However, given the broader economic implications of the flattening (now slightly positive) yield curve, the FOMCs change to accommodative policy, and the change in composition of performance of the credit stack, we believe the risk to spreads are asymmetrically skewed higher.
Source: ICE BofA Market Indices | Past performance is not indicative of future results.
The objective of AAM’s active fixed income management approach is to bring our expertise to bear on what fixed income assets may present the best value. We thoroughly believe that intelligent investing results from time in the market, not timing the market. Relative valuation among and within various slices of the credit stack is a cornerstone of fixed income investing. Valuing bonds through the context of their component risks can allow fixed income investors to more appropriately evaluate investments and improve the consistency of their choices with their investment outlook and risk tolerance. The manifest risk to long-term performance of a fixed income portfolio requires that now, more than any point since COVID, investors have a clear understanding of the credit risk in their portfolio.
Source: Federal Reserve Bank of St. Louis (FRED)
CRN: 2024-0903-11952 R