Lessons from a bear market in rates

| April 9, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

As interest rates go, so go returns in fixed income. That is old news to the seasoned crowd, but performance this year pounds the table on that point. Rising rates have swept away most other sources of return on debt. But it is only spring. Rates still look biased higher, especially in the intermediate and shorter part of the curve. Prepayment risk looks neutral. Credit risk—deep credit especially—could salvage performance.

Diversification, which is hard to come by in the debt markets, is almost by definition invaluable in unexpected ways. Most instruments share a healthy dose of interest rate exposure and move together with rates. But performance this year and in many past shows diversification in the interplay between interest rate risk and credit. Assets with duration rally as economies actually or potentially fall apart and assets with credit exposure weaken. And in rebounding economies like the one in the first quarter, duration loses value as credit picks it up. Mixing interest rate risk with deep credit may seem hard for portfolios often committed to conserving capital, but it may be the most effective strategy.

The first quarter priced in an aggressively easy Fed, more fiscal stimulus and a large part but not all of a pending US rebound. Yields along the Treasury curve rose and steepened. But improving economics helped most option-adjusted spreads tighten (Exhibit 1). ABS, the only exception, widened 2 bp. Prices on leveraged loans went up.

Exhibit 1: The yield curve rose and steepened in 1Q21, most spreads tightened

Note: All OAS to the Treasury curve.
Source: Bloomberg for UST yields, Bloomberg Barclays indices for OAS, S&P/LSTA for average leverage loan price, Amherst Pierpont Securities

The move in rates dominated asset returns and day-to-day return volatility. Assets with short durations easily outperformed assets with long durations (Exhibit 2). Leveraged loans, with the shortest duration among key asset classes, led with annualized gains of 7.5%. High yield corporate debt, with the third shortest duration, followed at 2.1%. ABS, with the second shortest duration, finished with an annualized loss of 0.5%. Investment grade corporate debt, at the other end of the spectrum with the longest duration, lost an annualized 20.1%. US Treasury debt, with the second longest duration, lost 18.4%. And agency CMBS, with the third longest duration, notched a loss of 12.7%. MBS and private CMBS fell in between.

Exhibit 2: Returns and volatility in 1Q21 lined up closely with asset duration

Note: Annualized from daily returns from Bloomberg Barclays indices, and from the S&P/LSTA Total Return Index. OADs from Bloomberg Barclays indices.
Source: Bloomberg, Amherst Pierpont Securities

Risk assets did manage to bring home some excess return—returns attributable to credit, prepayment, liquidity or other risks—and offset at least some of the interest rate hit. The 50 bp tightening in high yield OAS and the rising price of leverage loans lifted these assets to positive returns (Exhibit 3). Other risk assets added some excess return, but not enough to outweigh the impact of rising rates.

Exhibit 3: Excess return pulled high yield and leverage loans into positive territory

The big move in rates also drove up the correlation between asset returns, underscoring the shared rate risk across assets. Correlations between most assets in the first quarter came in higher than in the prior quarter (Exhibit 4). The only asset where correlations dropped was leveraged loans, which happens to be almost entirely a floating-rate asset. It also highlights the value of leveraged loans—and by extension the CLO market—as a valuable diversifying asset in a fixed income portfolio. The diversifying potential of leveraged loans and high yield credit seems routinely underappreciated. Both leveraged loans and high yield returns routinely show negative correlation with assets dominated by interest rate risk.

Exhibit 4: Asset return correlations rose slightly in 1Q2021

Note: correlation of daily returns.
Source: Bloomberg, Amherst Pierpont Securities

The balance of the year is likely to be less dramatic than the first quarter, at least measured by moves in rates and spreads. There is still well justified uncertainty about rates, although mainly in the 5-year and shorter part of the yield curve. The options markets reflect it. The MOVE index is back up to levels of a year ago, reflecting risks of quick tightening in the labor market, rising inflation and shifts in Fed policy. Rates should rise along the curve, but much more in the shorter end of the curve. Rising rates and rate volatility could easily undermine performance in MBS. The equity options markets, on the other hand, seem increasingly at ease about earnings growth and equity valuations with the VIX within reach of pre-pandemic marks. Confidence in equities should support credit spreads. The carry in credit and tightening spreads should help offset interest rate risk. And the deeper the credit, the bigger the likely offset.

* * *

The view in rates

The very shortest end of the rates curve remains under a crush of cash depressing yields. SOFR has stood at 1 bp since March 11. QE continues. The Treasury continues to draw down its cash balances. Fiscal stimulus is in the process of putting more cash into the financial system. The FOMC minutes did contain a clue that the Fed might intervene between regularly scheduled meetings to raise the rate on its reverse repo facility, currently at zero. It has already expanded the amount it will take at the RRP from any one counterparty, presumably a prelude to soaking up more cash from the system. The RRP sets the floor for the system.

The 10-year note has finished the most recent session at 1.66%, roughly table over the last two weeks and solidly in the middle of the expected range of 1.50% to 1.95% for the balance of the year. My colleague, Stephen Stanley, is expecting extraordinary growth and inflation pressure this year, a start to tapering in October and Fed liftoff by the spring of 2022. If that unfolds, the 10-year note could jump above 2.00%. Equilibrium is probably at 2.50%, but that should take much more evidence of sustainable growth and inflation beyond the surge anticipated as pandemic ends and monetary and fiscal policy kick in.

The Treasury yield curve has finished its most recent session with 2s10s at 151 bp, also roughly steady over the last two weeks. The 5s30s curve has bounced sideways between 140 bp and 160 bp since mid-February. As 30-year rates approach 2.50%, they should have less room to move up, and the 5s30 curve should start to flatten. Inflation expectations measured by the spread between 10-year notes and TIPS have dipped a few basis points in recent weeks to 232 bp, modestly below the high for the last five years. Real rates have bounced sideways through March. Volatility has jumped back above levels last seen around the elections in November and back to levels of last April.

The view in spreads

MBS spreads should be much more volatile than credit spreads until banks get solidly back to the business of buying. MBS duration has nearly doubled from 2 years at the start of February to 4 years lately, leaving many banks more exposed to interest rate risk than preferred and inclined to rebalance by reinvesting in cash assets. That takes a strong bid out of the MBS market. Spreads should eventually tighten back towards pre-February levels as a heavy flow of cash forces banks back into their usual habitat.

In credit, support from insurers and money managers should keep spreads tightening. The latest $1.9 trillion round of fiscal stimulus, easy monetary policy and a narrowing pandemic has already started showing up in the economic numbers. Major gains in employment are likely the next phase. Weaker credits should outperform stronger credits, with high yield topping investment grade debt and both topping safe assets such as agency MBS and Treasury debt. The consumer balance sheets has come out of 2020 stronger than ever—at least on average—and consumer credit should outperform corporate credit.

The view in credit

Consumers in aggregate are coming out of 2020 with a $12 trillion surge in net worth. Aggregate savings are up, home values are up and investment portfolios are up. Consumers have not added much debt. Although there is an underlying distribution of haves and have nots, the aggregate consumer balance sheet is strong. Corporate balance sheets have taken on substantial amounts of debt and will need earnings to rebound for either debt-to-EBITDA or EBITDA-to-interest-expense to drop back to better levels. Strong growth in 2021 and 2022 should continue easing credit concerns.

john.killian@santander.us 1 (646) 776-7714

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