The Big Idea
Trailing returns put a spotlight on volatility, supply
This material is a Marketing Communication and does not constitute Independent Investment Research.
Last year ended with a clue to potential returns in US debt markets this year. The volatility in returns across rates and credit that marked early 2025 largely disappeared. Returns had wandered over a wide range from January to September. But things converged in the last three months as uncertainty fell around US policy, the economy and the Fed. That’s the right recipe to start this year, although significant supply differences should still leave credit wider to Treasury debt and MBS.
Falling volatility in returns across rates and credit
The broad dispersion in total returns across sectors that showed up in the first half last year dropped sharply in the second. Annualized returns in the first quarter ranged from a high of 13.4% in MBS to a low of 2.0% in leveraged loans, an 11.4 percentage point difference, thanks to rising concern about tariffs (Exhibit 1). Although Liberation Day on April 2 turned up the heat, the rest of the quarter started to dampen those concerns as tariffs went on hold. Returns flipped across sectors in the second quarter but stayed wide, with high yield rebounding to a leading 15.0% and Treasury debt sinking to a trailing 3.6%, another 11.4 percentage point difference. The range dropped in the third quarter to 4.8 percentage points and dropped again in the fourth quarter to 3.4 percentage points.
Exhibit 1: The range of quarterly total returns narrowed in the second half of 2025
Note: Quarterly returns based on Bloomberg indices for all sectors except leveraged loans, which is based on the Morningstar/LSTA index.
Source: Bloomberg, Santander US Capital Markets
The declining volatility did not just reflect declining volatility in rates. Excess returns due to coupon and spreads, stripping out the impact of rates, showed a similar pattern. The spread between the highest and lowest excess return went from 5.6 percentage points in the first quarter to 7.2 in the second, 4.9 in the third and 3.1 in the fourth (Exhibit 2).
Exhibit 2: The range of excess returns also narrowed in the second half of 2025
Note: Quarterly returns based on Bloomberg indices for all sectors except leveraged loans, which is based on the Morningstar/LSTA index.
Source: Bloomberg, Santander US Capital Markets
Falling correlation as macro gives way to micro
As the year went on, the quarter-to-quarter correlation of sector returns also fell, showing that any portfolio had to be extraordinarily nimble to reallocate and win consistently. Total returns between the first and second quarters correlated at -0.69 as tariff concerns rose in the first and fell in the second (Exhibit 3). Returns from the second quarter to the third correlated at 0.40 as concerns continued to decline. Returns from the third to the fourth quarter correlated at 0.17 as major macro influences gave way to more idiosyncratic concerns about credit. Correlations of excess returns from quarter to quarter showed the same pattern. Of course, the small number of sectors means the correlations are measured with a healthy dose of possible error. But they show an interesting trend of fading cross-sector macro influence.
Exhibit 3: Return correlation fell as macro factors gave way to idiosyncratic
Note: includes quarterly returns in IG, HY, MBS, Private CMBS, Agency CMBS, ABS and leveraged loans. Returns based on Bloomberg indices for all sectors except leveraged loans, which is based on the Morningstar/LSTA index.
Source: Bloomberg, Santander US Capital Markets
The particulars of fourth quarter performance
The more detailed particulars of asset performance in the last quarter are also notable since volatility continued to fall while concerns about credit rose. Agency MBS posted a leading annualized 7.32% total return in the last quarter while investment grade credit posted a trailing 3.95% (Exhibit 4). Returns in most other sectors clustered between 5% and 6%, although with lower volatility than MBS or investment grade credit.
Exhibit 4: In the last quarter, MBS led and investment grade corporates lagged
Note: Returns based on Bloomberg indices for all sectors except leveraged loans, which is based on the Morningstar/LSTA index.
Source: Bloomberg, Santander US Capital Markets
Agency MBS also stands out when looking at excess returns in the fourth quarter. MBS posted an annualized 292 bp of excess while investment grade lost 10 bp (Exhibit 5). Other sectors delivered between zero and 100 bp of excess. The pattern reflected falling volatility, which helped agency MBS especially, and reflected fresh concern about credit, which hurt credit.
Exhibit 5: MBS also led excess returns in late 2025 as investment grade lagged
Note: Excess returns based on Bloomberg indices for all sectors except leveraged loans, which is based on the Morningstar/LSTA index and author calculations.
Source: Bloomberg, Santander US Capital Markets
A story in net supply
Besides shifts in volatility and credit, the fourth quarter also saw meaningful differences in net supply across sectors. Most notably, the two sectors with the most excess return—MBS and private CMBS—saw net outstanding supply drop in the fourth quarter (Exhibit 6). All other sectors saw supply rise. The combination of scarce supply and falling volatility likely helped MBS in particular post such high excess returns.
Exhibit 6: Notable net supply differences across sectors in the fourth quarter
Source: Bloomberg, Santander US Capital Markets
The market ahead
The market still has to see the new nominee for the Fed, but absent a candidate that raises concerns about Fed independence, market volatility should drift lower. Tariffs should continue to work their way into prices, but the prospects of major changes in tariffs looks low. Even if the Supreme Court rules some of the current tariffs illegal under the International Emergency Economic Powers Act and the administration tries to apply news ones under the International Trade Act of 1974, peak tariff uncertainty still has likely passed. Supply in MBS looks likely to grow by 2% or less while net supply in investment grade credit could rise by around 10%, keeping MBS spreads tight and widening credit. Results from the fourth quarter look like prologue to the market ahead.
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