The Big Idea

Credit wins in 2024 with good prospects to repeat in 2025

Steven Abrahams | January 3, 2025

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.

In the regular competition to generate returns from taking interest rate or credit risk, the last quarter and the full year of 2024 handed a win again to the credit side. The less rate exposure and the more credit, the better the result. There’s a lesson in there for the New Year: Even with current credit spreads historically tight, the prospects of beating returns from interest rate risk still look good.

A picture of total returns

Credit risk has generally delivered better returns than rate risk since mid-2020, and last year was no exception. Leveraged loans stood out not just by printing a leading 8.85% final return but by accumulating it steadily over the year—the only exception coming in early August when a weak July jobs report raised concern about economic slowdown and briefly widened credit spreads (Exhibit 1). The floating coupons on leveraged loans helped the sector avoid the interest rate volatility that hit every other asset. High yield followed a modestly volatile path to an 8.66% return. Then came private CMBS at 6.88% and ABS with 5.17%. Returns then fell sharply and became more volatile with agency CMBS, investment grade corporate debt, MBS and US Treasury debt all printing 3.24% final returns or lower.

Exhibit 1: Deep credit helped returns in 2024, rate exposure did not

Note: Returns based on Bloomberg indices for each sector except leveraged loans, which use the Morningstar/LSTA Leveraged Loan Total Return Index.
Source: Bloomberg, Santander US Capital Markets.

The contrast across assets between final returns and the path to get there really stands out in the ratio of final return to the annualized daily volatility of those returns, a stand measure of risk. Leveraged loans printed 11 bp of return for each unit of risk in 2024 and nearly 18 bp of return for each unit of risk in the fourth quarter (Exhibit 2). Those ratios drop toward 3 bp or lower for every other asset class for the full year and go negative for all but high yield in the fourth quarter, reflecting the final quarter’s sharp move higher in interest rates and differences across assets in duration and spreads.

Exhibit 2: The ratio of return to risk highlights the high, steady returns in loans

Note: Returns and volatility based on Bloomberg indices for each sector except leveraged loans, which use the Morningstar/LSTA Leveraged Loan Total Return Index.
Source: Bloomberg, Santander US Capital Markets.

The impact of duration

Returns and their volatility reflected differences in duration almost lockstep. At mid-year and generally throughout the year, the assets with the shortest duration showed the highest and least volatile returns. Leveraged loans, ABS, high yield and private CMBS had the shortest duration and returns ranging between 5% and 9% while agency CMBS, Treasury debt, MBS and investment grade corporate debt had the longest duration and returns between 1% and roughly 3% (Exhibit 3).

Exhibit 3: Assets with shorter duration did better than assets with longer

Note: Duration based on Bloomberg indices for each sector except leveraged loans, where coupons usually reset quarterly.
Source: Bloomberg, Santander US Capital Markets.

Duration dominated absolute returns in fixed income as yields on 10-year Treasury notes started the year near 3.90%, rose to 4.70% in April, dropped to nearly 3.60% in September and finished the year near 4.60% (Exhibit 4). Yields on 2-year notes were even more volatile, although typically having less than a quarter of the price impact for every basis point.

Exhibit 4: Volatile interest rates made duration differences important

Source: Bloomberg, Santander US Capital Markets.

Stripping out duration and interest rate risk

After stripping out the impact of duration and interest rates, the picture changes slightly but still puts credit on top. Excess returns across assets reflect differences in coupon and reinvestment along with the impact of changes in asset spreads. Risk assets always start with a coupon advantage. And in a year where spreads on risk assets generally tightened, the riskiest assets got the biggest lift.

High yield posted the highest and most volatile excess return at 5.00% with private CMBS next with a much less volatile 4.26% (Exhibit 5). Leveraged loans showed up with a low-volatility 3.59% excess return followed by volatile investment grade corporate debt at 2.45%. ABS delivered 1.52%, agency CMBS posted 1.34%, MBS a thin and volatile 0.37% and US Treasury debt, by definition, delivered 0.0%.

Exhibit 5: Excess return favored credit, but with big differences in volatility

Note: Excess returns based on Bloomberg indices for each sector except leveraged loans, which use the Morningstar/LSTA Leveraged Loan Total Return Index.
Source: Bloomberg, Santander US Capital Markets.

Effective diversification

Beyond differences in return and risk, asset classes continue to show big differences in effective ability to diversify a fixed income portfolio. Leveraged loans and high yield show the most distinctive patterns and the most potential to diversity. Daily returns on high yield corporate debt through 2024 showed correlations with other assets ranging between 0.43 and 0.52 (Exhibit 6). Leveraged loans showed correlations ranging from -0.14 to 0.43. And every other asset class, beyond their correlations with high yield and loans, showed correlations between 0.92 and 0.99.

Exhibit 6: High yield, loans show low to moderate correlation with other assets

Note: Based on daily returns in 2024.
Source: Bloomberg, Santander US Capital Markets

Implications for portfolio strategy

Assets with shorter duration and higher yield have routinely outperformed the field in recent years, initially explained by the resilient fundamentals of corporate and consumer balance sheets after the onset of pandemic and then by Fed tightening and rising interest rates since early 2022. Performance has also reflected significant shifts in demand, with the Fed and banks piling into Treasury debt and MBS from early 2020 through mid-2022 and then reversing course, although bank demand stabilized last year.

With the Fed likely easing at a slow pace through 2025, carry looks likely to matter more than duration in portfolio returns. Despite historically tight spreads, carry should give credit the advantage over rates. Carry should also give MBS a better chance to beat rates, although MBS is much more sensitive than credit to changes in demand from banks.

The obvious caveat is that anything triggering volatility or flight to quality should give the return advantage to rates. A couple of possibilities come to mind:

Shifts in US trade, tariff or immigration policy that increase prospects for a significant slowdown in US growth
Developments in China-Taiwan, Iran-Israel or Russia-Ukraine that increase prospects for global economic slowdown

These risks could easily keep rate volatility higher than expected this year. But absent circumstances running clearly in the direction of these risks, the prospects for good returns in credit continue to look good. Credit and carry should win again this year.

* * *

The view in rates

In the aftermath of 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 1.7. 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 $237 billion as of Friday, down from $473 billion on December 31. Money markets continue to show distortions on dates where regulators take snapshots of bank balance sheets and leverage, points where match-book repo balloons those balance sheets. It looks like money market funds at year-end were forced to go to the RRP.
Setting on 3-month term SOFR closed Friday at 429 bp, down 4 bp in the last two weeks.
Further out the curve, the 2-year note traded Friday at 4.26%, down 5 bp in the last two weeks. The 10-year note traded at 4.58%, up 5 bp in the last two weeks.
The Treasury yield curve traded Friday with 2s10s at 32 bp, steeper by 11 bp in the last two weeks. The 5s30s traded Friday at 41 bp, steeper by 7 bp over the same period
Breakeven 10-year inflation traded Friday at 234 bp, up by 4 bp in the last two weeks. The 10-year real rate finished the week at 224 bp, up 2 bp in the last two weeks.

The view in spreads

Funding pressures at the end of the year put temporary pressure on spreads, but that pressure is coming off quickly.

Implied rate volatility, however, refuses to die. 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 on Friday at 80 bp, wider by 1 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 138 bp, wider by 1 bp in the last two weeks. Par 30-year MBS TOAS closed Friday at 46 bp, wider by 3 bp in the last two weeks.

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.

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

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