Lessons learned in markets in 2024

Steven Abrahams | December 20, 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.

The most interesting lessons of the last year revolved partly around portfolio strategy and partly around individual markets. Comparative advantage in investing and the value of betting against beta, both more about the investor than the market, showed their influence in places. Record balances in money funds taught a simple lesson about how cash gets allocated across markets. And lender cooperatives in broadly syndicated loans started getting more attention and may end up requiring a new layer of risk analysis above and beyond the usual credit fundamentals. There’s always something new to learn.

Pay attention to comparative advantage

Continued heavy annuity issuance this year put a nice spotlight on comparative advantage in investing, something that get woefully too little attention. But the imprint of comparative advantage is all over the fixed income markets. Yes, each asset class has distinct attributes—safety and liquidity in Treasury debt, prepayment risk in MBS, both corporate and consumer balance sheet risk in credit, for example—but asset classes usually get dominated by portfolios that have some comparative advantage in investing there. Banks, for example, usually invest in sectors with low regulatory risk weights and, these days, easy-to-manage interest rate risk. Life insurers can capitalize on accounting rules that tolerate illiquidity. Hedge funds have incentive to build and take advantage of highly specialized expertise. The list goes on.

With the continuing ability of insurers to issue annuities, that set of portfolios picked up further advantage for investing in corporate and structured credit.  Issuance of annuities has surged ever since the Fed started hiking in 2022, the higher interest rates drawing both individual and corporate buyers into the market. Not only has the surge given insurers a new source of funding for their investment demand, it has particularly encouraged demand for positively convex debt. Fixed annuities have the distinct property of getting shorter in average life as interest rates rise and getting longer as interest rates fall, reflecting the incentives for annuity holders to surrender their contracts for better alternatives as rates rise and hold onto those contracts longer as rates fall. This kind of funding fits best against positively convex debt with yield or coupon that exceeds the annuity rate—in other words, most corporate and structured credit and notably not negatively convex MBS. Hence, insurance demand has helped credit spreads get historically tight. Annuity funding and the resulting demand has momentum going into next year.

There are two important lessons embedded in the idea of comparative advantage in investing:

• If you have a good handle on the evolving comparative advantages of major investors in any asset class, you should be better able to anticipate changes in demand and its impact on spread, a necessary skill in investing for total return, and
• If you have a good handle on your own comparative advantage, you should be well equipped to figure out where your portfolio has the best chance to outperform competition. This sometimes takes bracing honesty about where funding, leverage, accounting, information, expertise, opportunity and other factors really amount to proprietary advantage.

Those are lessons worth relearning every year, if not more often.

It pays to bet against beta

I have long bought the argument that the most boring assets in a particular market sector can be among the most undervalued, at least measured by the expected return on the asset for the amount of risk taken. I know that goes against the ambition and instinct of most portfolio managers, but that might be exactly why the approach works. While a stampede of capital might chase assets with longer duration or deeper credit or more negative convexity, smart money can extract good risk-adjusted return from safer assets. This argument usually goes under the banner of betting against beta.

Given my bias, it might be a stretch to list this as a lesson learned, but I did see things that renewed my confidence. In particular:

• At least through mid-August, actively managed US bond mutual funds that ran portfolios with low beta—portfolios with returns less volatile than the Bloomberg Aggregate US Bond Market Index—beat the index by a much wider margin after adjusting for risk than funds with high beta. And the wider the margin of excess return, the more AUM the fund attracted.
• CLO managers that ran loan portfolios with low beta—portfolios with returns less volatile than the broad market—consistently delivered better returns than the overall loan market after adjusting for risk and better returns than peers with high beta. This is a longstanding pattern in CLO manager performance.
• The returns to CLO debt in 2024 also argued for betting against beta with the highest returns after adjusting for risk coming in ‘AAA’ debt, next in ‘AA’, then, ‘A’, ‘BBB’ and ‘BB’ (Exhibit 1). Although absolute return went up as rating went down, higher-rated debt showed more return for each unit of risk

Exhibit 1: The higher the rating, the more return per unit risk

Note: Returns on the Palmer Square indices for each rating category.
Source: Bloomberg, Santander US Capital Markets

To really bet against beta, it takes access and willingness to use financial leverage. That’s the tool that takes return per unit risk and magnifies it to get to the absolute return that a portfolio might need. Absent leverage, portfolios choosing to bet against beta will have to be satisfied competing on risk rather than on return alone.

The powerful draw of money market funds

I learned this year that the money fund AUM that finances large parts of fixed income largely reflects some simple math: if money fund yields top competing alternatives, AUM keeps climbing. Otherwise, it falls. The main competing alternatives are other liquid, riskless assets. Specifically, bank deposits and short Treasury debt. Most cash will try to find a home in one of those places.

That was not completely obvious as the Fed in late summer started leaning toward rate cuts. Some in the markets assumed the boom times for money market funds would come to an end. Money funds had added $1.76 trillion in AUM since the Fed started hiking in March 2022, so, the thinking went, cuts would turn that around (Exhibit 1). Instead, since the Fed started cutting in September, money funds have added another $447 billion.

Exhibit 2: Money fund AUM has kept climbing despite recent Fed cuts

Source: Bloomberg, Santander US Capital Markets

Money funds have kept drawing inflows in large part because money market rates still stand well above bank deposit rates and above yields on the Treasury curve out to 10 years. Until one or both of those conditions reverse, AUM should keep rising. And the rise and fall of money fund AUM for at least the last quarter century reflects those influences.

For the broader fixed income markets, hefty money fund balances should ensure plenty of cash for funding leveraged positions. That should be good news for dealers intermediating the rapidly growing market in US Treasury debt.

Cooperate or die

The leveraged loan market this year put on my radar a development that seems ripe for teaching lessons next year: lender cooperatives. Lender co-ops are agreements among investors in broadly syndicated loans to band together and protect the participants from actions by a borrower—priming and uptiering, for instance—that could implode the value of the existing loan. The twist in a co-op, however, is that not every investor in the existing loan can join. As one CLO manager described it to me, every time a loan trades down significantly in price, the phones start ringing to see who can put together a co-op first that controls 51% of the loan.

The increasing discussion around co-ops reflects both the covenant-lite loans that have dominated the last few years of BSL origination and the increasing ability of CLO managers to participate in co-ops. The actual level of activity is opaque, since most co-ops form quietly and only need to act if the borrower is running into credit problems.

For investors that end up on the inside, a co-op can be a big win, protecting them from actions that often leave the original loan subordinated to other debt and trading at a much lower price. For investors on the outside, a co-op can be a big loss. As a result, the risk of a co-op emerging and driving the restructuring of the loan becomes another layer of analysis for a leveraged loan investor, above and beyond the usual analysis of credit fundamentals. Understanding this dynamic and figuring out how to layer it into analysis of fair value seems like a rich area for learning in 2025.

* * *

The view in rates

With the December FOMC, the market has recalibrated it expectations for cuts next year. The Fed’s median dot for the end of 2025 shows two cuts, and fed fund futures now show the same. With discussions of tariffs, changes in immigration policy and an active battle underway in Congress over federal spending as of this writing, the range of potential paths next year for the Fed is getting wider by the day.

Other key market levels:

• Fed RRP balances stand at $98 billion as of Friday, down $38 billion for the week. The RRP overnight rate at 4.25% trails well behind overnight SOFR and short Treasury bills, likely the reason why RRP balances are declining
• Setting on 3-month term SOFR closed Friday at 433 bp, down 2 bp on the week.
• Further out the curve, the 2-year note traded Friday at 4.31%, up 7 bp on the week. The 10-year note traded at 4.53%, up 14 bp on the week.
• The Treasury yield curve traded Friday with 2s10s at 21 bp, steeper by 6 bp on the week. The 5s30s traded Friday at 34 bp, flatter by 1 bp over the same period
• Breakeven 10-year inflation traded Friday at 230 bp, down by 5 bp in the last week. The 10-year real rate finished the week at 222 bp, up 17 bp on the week.

The view in spreads

Funding pressures at the end of the year may put temporary pressure on spreads, but that should resolve quickly.

Implied rate volatility remains well below pre-election levels, and with Treasury supply putting upward pressure on riskless yields spreads in corporate debt and MBS should generally hold their ground or go tighter. Continuing drops in volatility will likely depend on the tariff and immigration policies implemented by the incoming administration.

The Bloomberg US investment grade corporate bond index OAS traded this week Friday at 79 bp, wider by 4 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 137 bp, wider by 1 bp in a week. Par 30-year MBS TOAS closed Friday at 43 bp, wider by 1 bp in the last week.

The view in credit

Fundamentals for consumer and corporate credit continue to look stable. Most investment grade corporate and most consumer balance sheets have fixed-rate funding so falling rates have limited immediate effect. The rate of serious delinquency in residential mortgages and of loans in foreclosure have barely changed over the last year. And although leveraged and middle market balance sheets are vulnerable, leveraged loan defaults and distressed exchanges have plateaued in recent months.