The Big Idea
A good quarter for duration, but spread and carry await
Steven Abrahams | October 4, 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.
US fixed income assets with lots of duration led absolute returns in the third quarter, something that looked likely as the quarter started. But credit, especially deep credit, kept up a long streak of posting the best returns for the amount of risk taken. And when it came to stripping out interest risk and looking at returns from everything else, private CMBS and agency MBS finished ahead of the pack. For most portfolios, the prospects for winning again from adding extra duration look much lower than a few months ago. Instead, spread and carry look like the better path to good performance.
The third quarter race for absolute returns
Interest rate exposure almost entirely determined total return in the third quarter. If you had lots of it, it was good. If you did not, you were playing from behind.
Investment grade corporate debt led fixed income total returns in the third quarter at 6.40% with agency MBS close behind at 6.25% (Exhibit 1). High yield came next with a total return of 5.43% trailed by Treasury debt at 5.34% and agency CMBS at 5.21%. Private CMBS posted a return of 4.86% with ABS at 3.51%. And leveraged loans brought up the rear at 2.01%.
Exhibit 1: All sectors of fixed income posted positive returns in the third quarter
Not surprisingly in a quarter where 2-year Treasury rates dropped 112 bp and 10-year rates dropped 68 bp, the duration or interest rate sensitivity of each sector at the start of the quarter largely determined each sector’s total return. Investment grade corporate debt started the quarter with the longest duration at 6.93 years and finished with the highest return (Exhibit 2). Leveraged loans started the quarter with the shortest duration at 0.25 years and finished with the lowest return. Sectors with duration in between generally delivered return in proportion to duration
Exhibit 2: Annualized total returns lined up closely with initial duration
Returns for leveraged investors
For investors able to leverage different assets and create a targeted interest rate sensitivity or duration of equity in a position, the quality of return matters more than absolute return. On that front, as has often been the case in these periodic reviews of asset performance, credit turned in the best numbers in the third quarter, at least as measured by Sharpe ratios of return to risk. High yield delivered a leading 8.6 bp of return for each 1 bp of risk followed by ABS with 6.3 bp of return for each 1 bp of risk and leveraged loans with 6.0 bp of return for each 1 bp of risk (Exhibit 3). Treasury debt, at the other extreme, delivered the poorest quality with 4.3 bp of return for each 1 bp of risk.
Exhibit 3: High yield, ABS and leveraged loans led in returns per unit risk
In practice, terms of leverage including advance rates and funding costs vary from asset to asset, sometimes making it difficult to scale asset returns efficiently.
The ratio of return to risk also clearly reflects all the embedded risks in each asset, from duration to credit to prepayment risk or negative convexity. All of these contribute to return volatility, for which investors need compensation.
Returns for hedged or match-funded or benchmarked investors
For investors able to hedge interest rate risk or match assets with offsetting funding or liabilities or trying to beat market benchmarks, excess returns—returns net of interest rate risk—matter more than absolute returns. Carry and spread widening or tightening create excess return. High yield topped excess return in the third quarter at an annualized 6.93% followed by agency MBS at 2.54%. Of course, higher excess return came with higher volatility of those excess returns, although the excess return in MBS was more efficient than the excess return from high yield—2.5 bp of excess return for 1 bp of risk in MBS compared to 1.8 bp of excess return for 1 bp of risk in high yield. The most efficient excess return came from private CMBS, with 3.3 bp of excess for each 1 bp of risk.
Exhibit 4: High yield had the highest excess return, MBS the most efficient
Diversification
The third quarter included a prime example of potential diversification as sectors mainly sensitive to interest rates and credit responded differently to the market in early August. At that point, a weak July jobs report and concerns about rising rates in Japan triggered a brief flight-to-quality. Sectors most sensitive to rates such as the MBS and Treasury market along with investment grade corporate debt and agency CMBS rallied sharply as interest rates suddenly fell. Sectors most sensitive to credit such as high yield corporate debt and leveraged loans, meanwhile, dropped in value as concern about a slowing economy widened spreads.
Getting diversification in a fixed income portfolio is usually difficult because of the common exposure to interest rates across sectors. Even though each sector has a different overall duration and different exposure to parts of the yield curve, most of the yield curve tends to move in tandem, with short and long rates going up and down together although in different amounts. That creates high correlation across sectors where most of the risk is duration rather than credit or prepayments. However, high yield and leveraged loans embed significant credit exposure, reducing their correlation to other assets. When strong economic news comes out, for instance, rates may rise while credit spreads tighten, creating offsetting returns in rate and credit assets. In the third quarter, as seen often in these periodic reviews, high yield and leveraged loans showed low or negative correlation with sectors mainly sensitive to rates (Exhibit 5). Deep credit in the third quarter again provided significant diversification to a broad fixed income portfolio.
Exhibit 5: Deep credit again shows low correlation with other fixed income assets
Add spread and carry
At this point, the most likely path for interest rates seems priced in, limiting potential absolute returns from adding duration and tilting the best outcomes toward asset allocations that add spread and carry. Fed funds futures and the overnight index swap curve follow the Fed dots fairly closely, unlike the situation at the end of the second quarter. That argues for neutral or fair value on duration. Adding agency MBS and credit exposure for spread and carry seems the strategy most likely to add excess return to a portfolio. Spreads may have marginal room to tighten further, especially with heavy Treasury issuance continuing, but extra yield should add up to better returns. And diversification should continue to pay well, so portfolios with mandates that can accommodate speculative grade corporate or structured credit should add to exposure there.
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The view in rates
Neutral on rates for now, given that the market is now priced right in line with the Fed dots. As of Friday, fed funds futures priced in another 54 bp of easing this year and 150 bp through 2025, implying fed funds at the end of next year around 3.31%. As fed funds head toward the neighborhood of 3%, the front end of the yield curve should drop to reflect the lower policy rate with the 10-year and longer end of the curve moving much more slowly if at all. Opportunities to outperform the broad market have shifted from rate positioning to spread positioning.
Other key market levels:
- Fed RRP balances closed Friday at $330 billion, down $106 billion in the last week. Since the Fed dropped policy rates by 50 bp on September 18 and set the RRP rate at 4.80%, balances initially jumped as T-bill yields dropped well below RRP yields. But in the last week repo rates for general Treasury and MBS collateral have far exceed RRP, drawing balances away from the Fed facility.
- Setting on 3-month term SOFR closed Friday at 458 bp, down 1 bp on the week.
- Further out the curve, the 2-year note closed Friday at 3.92%, up 36 bp in the last week as Fed Chair Powell indicated a slow pace for easing and payrolls for September came in strong. The 10-year note closed at 3.97%, up 22 bp in the last week.
- The Treasury yield curve closed Friday afternoon with 2s10s at 4 bp, flatter by 15 bp in the last week. The 5s30s closed Friday at 45 bp, flatter by 15 bp over the same period
- Breakeven 10-year inflation traded Friday at 223 bp, up 7 bp in the last week. The 10-year real rate finished the week at 173 bp, up 15 bp over the last week.
The view in spreads
Strong September payrolls has surprised the market and pushed implied rate volatility up again. That is a marginal negative for spreads in risk assets. The Bloomberg US investment grade corporate bond index OAS closed Friday at 87 bp, tighter by 3 bp on the week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 134 bp, wider by 9 bp in the last week. Par 30-year MBS TOAS closed Friday at 34 bp, wider by 3 bp over the last week.
The view in credit
Fundamentals for consumer and corporate credit still look relatively robust. The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Unemployment is showing signs of plateauing for now, and high levels of home equity and investment appreciation should buffer any stress on consumers. Leveraged and middle market balance sheets are vulnerable, although leveraged loan defaults and distressed exchanges have plateaued in recent months. Commercial office real estate looks weak along with its mortgage debt.