The Big Idea
Add carry and spread duration
This material is a Marketing Communication and does not constitute Independent Investment Research.
If there’s a lesson in debt market returns from the first half of the year, it’s that interest rate risk is a beast but carry and spread duration can save you. Rising rates cut returns through June by more than half from the pace last year while returns from carry and spread generally improved. With rates likely to swing in a narrow range for the balance of this year, adding carry and spread duration still looks like the better route by far to quality returns.
Returns have dropped this year although the ranking of risk across debt sectors is largely intact. Bloomberg’s aggregate market index has printed 1.34% annualized returns through June, for example, with 4.00% annualized volatility (Exhibit 1). Last year it printed an outsized 7.40% return but with a relatively similar 4.36% volatility. Across every other major market sector—leveraged loans, ABS, agency and private CMBS, investment grade and high yield corporate debt and Treasury and agency MBS—annualized returns have dropped but relative risk is still in the same neighborhood as last year. With lower returns but similar risk, the market has become less efficient.
Exhibit 1: Annualized returns through June have dropped from 2025 levels
Note: Returns based on Bloomberg market indices for each sector except leveraged loans, which is based on the Morningstar/LSTA leveraged loan index.
Source: Bloomberg, Santander US Capital Markets.
While total returns have dropped, annualized excess returns—returns after stripping out interest rate risk—have gone up this year for the most part. Investment grade and high yield corporate debt, agency and private CMBS and ABS all have better annualized excess return this year than 2025 (Exhibit 2). There are exceptions. Treasury debt, by definition, produces no excess return. MBS is lagging this year after spreads tightened sharply and produced standout excess return in 2025. And leveraged loans this year have underperformed a simple strategy of rolling 3-month Treasury bills.
Exhibit 2: Most debt sectors show better excess return this year
Note: Excess returns based on Bloomberg market indices for each sector except leveraged loans, which is based on the Morningstar/LSTA leveraged loan index.
Source: Bloomberg, Santander US Capital Markets.
This year’s lower total returns and better excess returns reflect the reversal in rate trend this year and relatively stable spreads. Rates on 2-, 5- and 10-year notes dropped through 2025 and lifted returns across most debt but have almost retraced to their earlier, higher levels in the last six months (Exhibit 3). Rising rates and asset duration have cut asset values. Meanwhile, spreads tightened significantly in MBS in 2025 and marginally in investment grade and high yield corporate debt but have been relatively stable since. Stable spreads have left excess returns intact.
Exhibit 3: Rates drop in 2025 and retrace in 2026
Source: Bloomberg, Santander US Capital Markets
Results like the first half of this year raise the question of whether investors get paid well enough to take interest rate risk compared to returns from the unique basis risk offered by each sector of fixed income outside the Treasury market. That basis risk is the source of excess return. Measures of return to the Treasury market index show it is a poor performer compared to risk sectors, at least for the volatility involved. This bears out across a wide range of markets. That argues that stripping the embedded interest rate risk out of corporate and structured credit and MBS would deliver more efficient returns. That is a hard strategy for a lot of portfolios to pull off unless they have access to some way to leverage the basis exposure. But even for portfolios that cannot create a leveraged position in basis risk, return history suggests time is better spent improving allocation and security selection in risk assets than in trying to call the direction of rates.
Carry and spread duration should continue to dominate asset returns. The trades:
- Go down-in-quality in credit, except in technology, where supply should keep pushing spreads wider
- Go up-in-coupon in 30-year MBS to 5.5% through 6.5% pass-throughs, where carry is high and spread duration is low
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The view in rates
The market for now is pricing 40 bp of Fed tightening by the end of 2026 with very little through 2027. The very front end of the curve is probably stuck at a floor of 4.00% or higher through 2026 depending on US-Iran and expected short-term inflation. The 10-year note continues to look like it will spend more time above 4.40% than below it for the balance of the year. A lasting and stable agreement between the US and Iran could take 10-year yields reliably below 4.40%.
Key market levels:
- Setting on 3-month term SOFR traded Friday at 376 bp
- Further out the curve, the 2-year note traded Friday at 4.21. The 10-year note traded at 4.56%.
- The Treasury yield curve traded Friday with 2s10s at 35 bp and with 5s30s at 76 bp
- Breakeven 10-year inflation traded Friday at 226 bp with 5-year forward 5-year breakeven at 219 bp, still signaling confidence that the Fed target still holds. The 10-year real rate finished the week at 230 bp.
The view in spreads
The supply and demand balance looks neutral-to-negative for MBS, neutral for corporate debt and particularly weak for technology debt. MBS net supply continues to run very low, but the expected steady bid from Fannie Mae and Freddie Mac has not materialized. Insurers continue to issue annuities and buy corporate and structured credit, but credit is facing significant needs to finance capital investment and the current AI buildout. MBS spreads look a little soft, most credit should continue slowly tightening and technology spreads look likely to lag both.
The Bloomberg US investment grade corporate bond index OAS traded on Friday at 75 bp. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 108 bp. Par 30-year MBS TOAS closed Friday at 20 bp.
The view in credit
Big companies have healthier balance sheets than smaller companies. Consumers at the middle-to-higher end of the income distribution also have liquidity and wealth. Bank lending to non-bank financial institutions, including private debt funds and business development companies continues to expand. Bank regulators continue to focus on that category of lending, which could eventually tighten the private credit markets. But for now, credit metrics for NBFI lending are strong relative to traditional bank lending such as C&I.
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