by Mike Sanders, Head of Fixed Income
It was an eventful third quarter for fixed income markets. The yield curve normalized after 27 months of curve inversion, the Federal Reserve lowered rates by 50 basis points (bps), and investment grade corporate bond spreads moved tighter on the belief that the U.S. will avoid a recession. Longer duration bonds generally outperformed in the quarter as yields across the curve moved lower. The Bloomberg U.S. Aggregate Bond Index returned 5.2% for the quarter. Despite this solid performance and a potential tailwind from Fed policy, the market continues to send mixed signals on future rate and economic expectations. Investors will need to continue to weigh the risk and return tradeoff when navigating this environment.
Maintaining the ‘Just Right’ Landing
The widely debated economic ‘soft landing’ seems to be evolving into a ‘just right’ landing, with inflation slowing gradually and growth remaining stable. The second quarter’s final GDP showed the economy grew at an annualized rate of 3%, while expectations for the third quarter remain near 2.5%. Meanwhile, the ISM Services survey reflected healthy business conditions and sentiment. The Fed’s preferred inflation measure, Core PCE, slowed to 2.7% year-over-year, showing meaningful progress towards its stated 2% target. This follows higher-than-expected inflation at the start of the year. While the inflation trend has been welcomed by Fed members and markets alike, the labor market will likely chart the Fed’s policy path going forward.
Concerns emerged in the third quarter about a faster decline in labor markets, as the 4-week moving average of initial weekly jobless claims, now above 225k, remains elevated and well above the sub-200k level seen earlier this year. Additionally, the unemployment rate rose to 4.2%, the highest level since 2022. The string of weaker labor market data drew the attention of the Federal Open Market Committee (FOMC) heading into the September meeting, as several members highlighted the need to adjust policy proactively to avoid more severe labor market weakness. At that September meeting, the Fed cut its interest rate target range by 50 basis points from 5.25-5.50% to 4.75-5.00%. Along with the interest rate target cut, the Fed’s median interest rate forecast was also reduced to 4.375% by year-end 2024 and 3.375% by year-end 2025.
A surprisingly strong, trend-reversing jobs report in early October should suggest that the Fed will follow its dot plot as a guide for future rate cuts. The overly aggressive market pricing that concerned us in the third quarter has already adjusted in the first weeks of October.
We continue to think the inflation outlook remains more uncertain. With core inflation potentially settling around 2.5%, the key question for investors is whether the Fed will target a 3% terminal fed funds rate to keep inflation pressures in check. A terminal fed funds rate of 3% would put pressure on the long end of the yield curve, and yields could move higher. Absent a hard landing, we don’t expect long bonds (10+ years) to offer much price appreciation potential relative to intermediate bonds.
Higher for Longer Comes to an End
By the meeting date, the Fed’s move was widely anticipated, with investors pushing U.S. Treasury yields sharply lower. During the quarter, two-year Treasury yields declined 111 basis points while ten-year Treasury yields fell 62 basis points. These changes led to a sharply steeper yield curve, ending the ‘inverted’ two-to-ten-year Treasury curve in place since June 2022.
Intermediate term corporate bond spreads tightened five basis points in the quarter, with Utilities, Financials, and single-A corporate bonds tightening the most. Financial corporate bonds continue to offer more attractive spreads than higher-quality Industrial corporate bonds. However, given the recent outperformance of Financial corporate bonds, Financial spreads are now tighter than historical levels. Year-to-date, lower-quality corporate bonds (BBB) outperformed higher-quality corporate bonds (AAA and AA). With tighter spreads and lower interest rates, corporate bonds have experienced positive returns in 2024. The Bloomberg Intermediate Corporate index posted a +4.66% total return in the third quarter and a +5.71% total return year-to-date. However, with spreads near the tightest levels over the last decade, they provide little cushion to absorb the impact of a potential economic slowdown.
We maintain that investors are not being adequately compensated for taking risks in fixed income markets, particularly in BBBs, high-yield, and long duration. Historically, spread-widening events occur with little notice and very quickly. Investors should be aware of and plan for all fixed income risks in this environment.
Maximizing Risk-Adjusted Yield in 4Q 2024
As of 9/30/24, the Bloomberg Aggregate Bond Index yielded 4.2%, while the Intermediate Government/Credit Bond Index yielded 3.9%. On the surface, the Aggregate Bond Index, which holds bonds with maturities ranging from 1 to 30 years, offers investors a slightly higher yield than the Intermediate Bond Index, which is comprised of bonds maturing in 1 to 10 years. However, we think investors should also consider how they are being compensated for taking risks within fixed income.
When you adjust the yield for the exposure to interest rate risk within each index – 6.09 and 3.74, respectively – the Aggregate Bond Index is actually quite rich relative to its historical risk-adjusted yield. Meaning, investors are not being adequately compensated for taking on the extra interest rate risk, by historical standards.
Then, factor in where the Fed and market expect the fed funds rate to be at the end of 2025, which is 3.375%. Investors can lock in yields higher than where cash returns are projected to be in a year with an intermediate term bond portfolio.
Another factor investors must consider as they seek to maximize yield in their fixed income portfolios is exposure to spread sectors—like corporate and securitized bonds—and the risk that the additional yield over treasuries (spread) could widen and potentially cause the price of those bonds to fall significantly. Not only does the Aggregate Bond Index have more exposure to the spread sectors than the Intermediate Gov/Credit Index (51% vs. 30%), but the duration of those exposures is also much longer, potentially amplifying the effect of rising interest rates or widening spreads.
Looking Ahead: Risks and Opportunities
While the economic ‘soft landing’ narrative has provided stability, it is far from guaranteed. Should unemployment rise above 4.5% or economic data surprise to the downside, the Fed may be forced to ease more aggressively, which would likely impact credit spreads. In such a scenario, risk premiums could widen. We expect continued rate volatility as each economic release, especially employment and inflation data, is evaluated for its potential impact on future FOMC policy actions.
While opportunities remain within the fixed income market—particularly in intermediate high-quality bonds—investors should be mindful of the risks posed by tight spreads and economic uncertainty. We believe an active approach to managing fixed income risks will allow us to continue to find value in the market, and we stand ready to take further action as expectations for monetary policy adjust in the months ahead