A good quarter for credit, but duration may soon have its day

Steven Abrahams | July 12, 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. This material does not constitute research.

Returns across different sectors of US fixed income in the second quarter painted a familiar picture. Credit, especially deep credit, delivered the highest absolute and risk-adjusted returns and some of the best excess returns as well. Sectors most sensitive to interest rates trailed on all those benchmarks. Some version of this picture has come through in most quarters since mid-2020. But with benign core CPI in May and now June, the picture may start to change if CPI is benign again in July and the Fed gets closer to its first cut.

The race for absolute returns

The Morningstar/LSTA leveraged loan index rose a leading 1.8% in the second quarter with the Bloomberg high yield index coming in second at 1.3% (Exhibit 1). ABS and agency and private CMBS all followed at 1.2%. Treasuries, agency MBS and investment grade corporates trailed at 0.8%.

Exhibit 1: Credit sectors outpaced rates sectors again in the second quarter

Note: results from 3/31/24 through 6/28/24 based on the Morningstar/LSTA US Leveraged Loan Total Return Index for leveraged loans and Bloomberg indices for all other sectors.
Source: Bloomberg, Santander US Capital Markets.

The competition for quality of returns

Beyond absolute return, the quality of return—measured as return for each increment of risk—also favored credit. Leveraged loans, for example, delivered 7.2% annualized returns in the second quarter with only 0.6% annualized volatility—nearly 12 bp of return for every 1 bp of volatility (Exhibit 2).  ABS, high yield corporate debt and private CMBS also delivered quality returns of between 1.3 bp and 2.4 bp for each basis point of volatility. Sectors more sensitive to interest rates such as Treasury debt, investment grade corporate debt and MBS delivered weaker performance of less than a basis point of return for each basis point of risk. MBS, for example, delivered 3.7% annualized returns with 7.0% annualized volatility—only 0.5 bp of return for every 1 bp of volatility.

Exhibit 2: Credit printed broadly higher returns with less volatility than rates

Note: results from 3/31/24 through 6/28/24 based on the Morningstar/LSTA US Leveraged Loan Total Return Index for leveraged loans and Bloomberg indices for all other sectors. Data shows annualized returns.
Source: Bloomberg, Santander US Capital Markets.

Results followed sector duration closely

Both returns and the volatility of those returns in the second quarter closely reflected differences in the maturity or duration of the asset class. The inverted yield curve delivered more income to sectors with shorter duration, lifting relative returns. Leveraged loans with 0.25-year duration returned an annualized 7.22%, for example, while investment grade corporate debt with a 7.0-year duration returned 3.21% (Exhibit 3). Interest rate volatility then eroded the quality of returns in sectors with longer duration. Although interest rates across the yield curve started and ended the quarter at roughly similar levels, they traveled over a healthy range. The 10-year yield, for example, started at 4.31% and ended at 4.40% but ranged between 4.22% and 4.70%. As a result, sectors with longer duration showed more daily return volatility. An inverted curve and volatile rates handed the race to sectors with short duration.

Exhibit 3: Sector duration aligned closely with sector return in the second quarter

Note: results from 3/31/24 through 6/28/24 based on the Morningstar/LSTA US Leveraged Loan Total Return Index for leveraged loans and Bloomberg indices for all other sectors. Data shows annualized returns.
Source: Bloomberg, Santander US Capital Markets.

Stripping out the effect of interest rates

Stripping out the effect of interest rates to get at the unique excess return from each sector—return due to excess coupon, reinvestment of that coupon and to changes in sector spreads—the numbers also favored credit, although not equally. Leveraged loans delivered the highest annualized excess returns at 1.88% followed by high yield at 1.03%, for example, but leveraged loans’ excess returns showed only a quarter of the volatility of high yield (Exhibit 4). Excess returns on agency CMBS almost matched high yield with much less volatility, even though agency CMBS is mainly an interest rate and prepayment exposure. The Treasury index, of course, delivered no excess return. And investment grade corporate debt and MBS delivered negative annualized excess return.

Exhibit 4: The level and volatility of excess returns also leaned toward credit

Note: results from 3/31/24 through 6/28/24 based on the Morningstar/LSTA US Leveraged Loan Total Return Index for leveraged loans and Bloomberg indices for all other sectors. Data shows annualized excess returns.
Source: Bloomberg, Santander US Capital Markets.

Measuring diversification

Finally, daily returns in the second quarter turned out highly correlated across some sectors and less so across others. Treasuries, MBS, investment grade corporate debt, both agency and private CMBS and ABS all showed correlations with one another of 0.95 or greater (Exhibit 5). The high correlation reflects the dominant influence of interest rate risk in all these sectors. Leveraged loans and high yield corporate debt, meanwhile, showed modest correlation of 0.41 with one another, reflecting common exposure to the balance sheets of highly leveraged corporations. High yield showed returns more highly correlated with other sectors, reflecting overlapping interest rate risk, while floating-rate leveraged loans showed returns with lower correlations to other sectors. These results parallel similar results in many quarters past.

Exhibit 5: Return correlations reflected different degrees of rate, credit exposure

Note: results from 3/31/24 through 6/28/24 based on the Morningstar/LSTA US Leveraged Loan Total Return Index for leveraged loans and Bloomberg indices for all other sectors. Data correlation of daily returns.
Source: Bloomberg, Santander US Capital Markets.

Add duration

Important parts of absolute return and risk across sectors lately reflect the current inverted yield curve, and that curve should start to change as the Fed gets closer to its first cut. Core CPI came through in May at 0.0% month-over-month and in June at 0.1%. If July prints below 0.2%, the Fed may have what it needs to cut in September. That should start to change the level and shape of the yield curve. Yields on the front end of the curve should start to drop as the market feels more comfortable that the Fed will start to bring rates back toward neutral. And since yields on the long end usually drop as expectations for the Fed path change—the 10-year yield, for instance, dropping since 2012 by 40 bp for every 100 bp of expected Fed easing—yields on the long end should follow. Rates should drop across the curve, and the curve should steepen. And in that market, some of the sectors that have had a rough time in recent quarters because of their longer duration should finally get back in the race for best returns in fixed income.

* * *

The view in rates

Fed funds futures now price in 64 bp of easing this year as of the Friday close, up nearly 20 bp from two weeks ago. The market sees a 95% chance of a cut in September and an 88% chance of December. The Fed has said it will need to see several months of benign inflation readings, and the May and June reports on core CPI put the Fed on the cusp. If July comes in below 0.2% month-over-month, that could set up the Fed for a September cut. The report for July comes out August 14.

Other key market levels:

• Fed RRP balances closed Friday at $407 billion, up $16 billion on the week but down $258 billion after balances spiked at the end of the second quarter. Except for that spike, RRP balances have bounced between $400 billion and $500 billion since the start of March. RRP balances could break below that range if SOFR or effective fed funds rise enough to draw cash away.
• Setting on 3-month term SOFR closed Friday at 529 bp, down 4 bp in the last two weeks.
• Further out the curve, the 2-year note closed Friday near 4.45%, down 30 bp in the last two weeks. The 10-year note closed at 4.18%, down 22 bp in the last two weeks.
• The Treasury yield curve closed Friday afternoon with 2s10s at -27, steeper by 8 bp in the last two weeks. The 5s30s closed Friday at 29 bp, steeper by 11 bp over the same period
• Breakeven 10-year inflation traded Friday at 224 bp, down 5 bp in the last two weeks. The 10-year real rate finished the week at 194 bp, down 17 bp in the last two weeks.

The view in spreads

Implied rate volatility has come off a recent peak, helping tighten risk asset spreads. Credit still has momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risk and riskless.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 90 bp, tighter by 4 bp in the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 137 bp, 6 bp wider on the week. Par 30-year MBS TOAS closed Friday at 41 bp, tighter by 11 bp in the last two weeks. Both nominal and option-adjusted spreads on MBS look rich but likely to remain steady on low supply and low demand.

The view in credit

Higher interest rate should raise concerns about the credit quality of the most leveraged corporate balance sheets and commercial office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding and look relatively well protected against higher interest rates—even if Fed easing comes late this year. Healthy stocks of cash and liquid assets also allow these balance sheets to absorb a moderate squeeze on income. Consumer balance sheets also benefit from record levels of home equity and steady gains in real income. Consumer delinquencies show no clear signs of stress, with most metrics renormalizing back to late 2019 levels. Auto loans show rising delinquencies that have as much to do with the price of used cars as it does the consumer balance sheet. Less than 7% of investment grade debt matures in 2024, 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. US banks nevertheless have a benign view of credit in syndicated loans. 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.