The Big Idea

Let your winners run

| January 5, 2024

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.

Cut your losers and let your winners run. That advice often serves investors well. And after a strong year for returns in corporate and structured credit, it argues for continuing to hold more than the usual amount of exposure to those debt sectors—at least into mid-March, when the Fed and the market should resolve their current fight over an initial rate cut. Credit looks likely to print higher and more stable returns than sectors leveraged to rates. And even after an almost inevitable showdown in March, credit still looks likely to come out of the volatility in good shape.

Credit tops absolute returns across debt sectors

Credit posted top returns in fixed income for the second half of 2023, continuing a run of strong relative returns since at least mid-2020. The Bloomberg high yield corporate index from June through December rose 7.7% with the Morningstar/LSTA index up 6.4% (Exhibit 1). The Bloomberg investment grade corporate index posted 5.1% with the private CMBS index just behind at 4.7%—the CMBS index helped by unusually sharp tightening in spreads in December. Agency MBS, agency CMBS, ABS and US Treasury indices all posted second-half returns below 4.0%.

Exhibit 1: A winding path for fixed income sector returns since June

Note: Results from 6/30/23 through 12/28/23. The Morningstar/LSTA US Leveraged Loan Total Return Index used for leveraged loans, Bloomberg indices used for all other sectors.
Source: Bloomberg, Santander US Capital Markets

Except for the largely floating-rate leveraged loan market, where rising SOFR and wide spreads created an average coupon above 9.5% and helped returns build up steadily, the path to final returns in the second half meandered. Rising interest rates pushed returns lower through late October in almost every asset class before falling rates provided a lifeboat and carried returns into positive territory to close the year.

Credit also posts strong returns for each unit of risk

The tradeoff between absolute returns and the volatility of the path to get there stands out in comparing annualized returns during the second half against annualized volatility. Of course, these are the raw ingredients of the Sharpe ratio. The steady leveraged loan market, for example, showed a 12.6% annualized return with less than 1% annualized return volatility for an extraordinary and likely unrepeatable ratio of 13.6 (Exhibit 2). At one extreme, leveraged loans and high yield corporate debt look relatively efficient, producing high returns with low-to-moderate volatility. At the other extreme, US Treasury debt, investment grade corporate debt and MBS look inefficient, coming in with lower returns than credit sectors and with much higher volatility. The Treasury and MBS markets may have better liquidity by multiple orders of magnitude, but it comes at a high cost.

Exhibit 2: Credit generally delivered higher returns with lower volatility

Note: Results from 6/30/23 through 12/28/23. Annualized return calculated as (average daily return x 260). Annualized volatility calculated as (daily standard deviation of return)^260. The Morningstar/LSTA US Leveraged Loan Total Return Index used for leveraged loans, Bloomberg indices used for all other sectors.
Source: Bloomberg, Santander US Capital Markets

Diversified bundles of risk do better

The differences across assets in returns and volatility mainly reflect differences in the share of overall risk coming from interest rates, with rates showing lots of volatility since June. Sectors with the lowest share of total risk coming from rates relied more on excess returns—the combined impact of higher coupons, reinvestment of coupon or principal and sharp tightening in spreads after October—to generate their higher and more stable returns. High yield, leveraged loans and investment grade credit generated most of their returns from sources outside of rates while all other sectors relied heavily on the drop in rates since October to print positive results (Exhibit 3). If every asset is a mix of different dimensions of risk—rates, corporate credit, real estate and consumer credit, prepayment risk and so on—then assets with a great share of non-rate exposure and arguably more intrinsic diversification did better.

Exhibit 3: Credit relied largely on return from coupon, reinvestment and spread

Note: Annualized results from 6/30/23 through 12/28/23. The Morningstar/LSTA US Leveraged Loan Total Return Index used for leveraged loans, Bloomberg indices used for all other sectors.
Source: Bloomberg, Santander US Capital Markets

Results parallel returns from the first half of 2023

Relative asset returns in the second half of 2023 roughly paralleled the first half and many other periods since mid-2020. High yield and leveraged loans finished with the highest first and second half returns, investment grade finished in the middle in both halves and other sectors trailed. Knowing first half results would have allowed you to explain 63% of the variation in returns across sectors in the second half (Exhibit 4).

Exhibit 4: Consistent relative returns from the first, second half of 2023

Note: The Morningstar/LSTA US Leveraged Loan Total Return Index used for leveraged loans, Bloomberg indices used for all other sectors.
Source: Bloomberg, Santander US Capital Markets

Letting the winners run

Credit has performed relatively well lately despite trading in the last six months at spreads on the tight side of the 5-year spread distribution, and MBS and structured products have printed weaker returns despite trading at spreads on the wide side of their 5-year distribution. The market has traded less on relative value than it has on general risk appetite. That does not mean there is no relative value to be had. My colleague Dan Bruzzo sees broad opportunity in financials within corporate credit, for instance, and my colleague Brian Landy sees advantage in MBS by owning higher coupons especially in Ginnie Mae pass-throughs. But relative value is not dominating the market for now.

The FOMC decision to describe monetary risks as balanced at the November 1 meeting turned risk appetite across almost all assets to high, and the December disclosure of dots showing 75 bp of easing in 2024 turned risk appetite up again. Lower rates promise to ease the pressure of interest expense and provide more liquidity to risk assets. All risk assets have tightened in the aftermath, but relative value has stayed roughly constant. The market has priced for aggressive Fed cuts and will likely stay that way until the Fed either cuts in March—as the market current prices—or does not. That showdown could shift risk appetite and add to spread volatility. In the meantime, corporate and structured credit at the very least should keep rolling up an advantage through coupon and reinvestment, adding to return with low volatility, a story told throughout 2023 and likely into at least March if not well beyond.

* * *

The view in rates

Despite the December FOMC and its dots showing three rate cuts by the end of 2024, fed funds futures now price for between five and six 25 bp cuts over that horizon. The implied probability of a first cut in March is now at 66%. Nevertheless, it seems unlikely the Fed will see enough data by March to firmly conclude that inflation is on its way to 2% with no chance of rebounding. With home prices rising and, at some delay, owners’ equivalent rent, too, Powell & Co. will likely take a little extra time to wait and make sure inflation is defeated.

Other key market levels:

  • Fed RRP balances closed Friday at $694 billion, roughly flat to the middle of December. Triparty and bilateral repo lately has traded at an attractive spread to the RRP’s 5.30% yield, and short Treasury bills yield more, too. Money market funds continue to move cash out of the RRP and into higher-yielding alternatives.
  • Setting on 3-month term SOFR traded Friday at 533 bp, down 3 bp since mid-December
  • Further out the curve, the 2-year note closed Friday near 4.39%, down 5 bp since mid-December. The 10-year note closed at 4.05%, up 14 bp since mid-December
  • The Treasury yield curve closed Friday afternoon with 2s10s at -34, steeper by 19 bp since mid-December. The 5s30s closed Friday at 19 bp, steeper by 9 bp.
  • Breakeven 10-year inflation traded Friday at 222 bp, roughly unchanged since mid-December. The 10-year real rate finished the week at 182 bp, up 12 bp since mid-December

The view in spreads

Despite the December pivot in Fed policy, liquidity is likely to trend lower through 2024 as QT and relatively high rates in the front end of the curve continue. Lower liquidity is likely to keep volatility elevated, keeping pressure on spreads. Nevertheless, the market current expects the Fed to ease in March and reduce liquidity pressures, so that should keep spreads stable to tighter until then. If the market unwinds that expectation, spread volatility should pick up and spreads should widen.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 104 bp, wider by 4 bp since mid-December. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 148 bp, wider by 2 bp since mid-December. Par 30-year MBS TOAS closed Friday at 40 bp, roughly unchanged since mid-December. Both nominal and option-adjusted spreads on MBS look rich. Fair value in MBS is likely closer to 70 bp, so a widening toward 70 bp looks reasonable.

The view in credit

Most investment grade corporate and most consumer balance sheets look relatively well protected against higher interest rates, and eventual Fed easing next year would relieve pressure from interest rate expense and falling liquidity. Fixed-rate funding has large blunted the impact of higher rates on both those corporate and consumer balance sheets, and healthy stocks of cash and liquid assets allow these balance sheets to absorb a moderate squeeze on income. Less than 7% of investment grade debt matures in the next year, so those balance sheets have some time. But other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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