Fixed Income Market Update – Third Quarter 2024


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.

Current Valuations by Sector

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.

Yield Duration Chart

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.

AGG vs IGC 9 30 24

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

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

In addition to the ongoing market risk applicable to portfolio securities, bonds are subject to interest rate risk, credit risk and inflation risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Credit risk is the possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. Bonds may also be subject to call risk, which allows the issuer to retain the right to redeem the debt, fully or partially, before the scheduled maturity date. Proceeds from sales prior to maturity may be more or less than originally invested due to changes in market conditions or changes in the credit quality of the issuer. In a low-interest environment, there may be less opportunity for price appreciation. Bond Spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, and risk, calculated by deducting yield of one instrument from another.

Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. Duration measures how long it takes, in years, for an investor to be repaid the bond’s price by the bond’s total cash flows.

The federal funds rate is the target interest rate range set by the Federal Open Market Committee (FOMC) for banks to lend or borrow excess reserves overnight. It influences monetary and financial conditions, short-term interest rates, and the stock market.

Diversification does not assure a profit or protect against loss in a declining market. A basis point is one hundredth of a percent. Yield Curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes: normal (upward sloping curve), inverted (downward sloping curve) and flat.

Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

The Bloomberg US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).

The Bloomberg Intermediate Govt/Credit Bond Index tracks the performance of intermediate term US government and corporate bonds.

The Bloomberg US Intermediate Corporate Bond Index measures performance of United States dollar-denominated investment grade, fixed-rate, taxable corporate bond securities with maturities greater than or equal to one year, but less than ten years, that are issued by U.S and non-U.S. industrial, utility and financial issuers.

The Personal Consumption Expenditures Price Index is a measure of the prices that people living in the United States, or those buying on their behalf, pay for goods and services.

The ISM Services PMI, also known as the Institute for Supply Management's Services Purchasing Managers' Index, is a widely recognized economic indicator that provides insight into the health of the services sector of the United States economy. It gauges the sentiment and business conditions among purchasing managers in various service-based industries such as healthcare, finance, retail, and transportation. The index is calculated from a survey comprising questions where respondents indicate whether certain aspects of their business, such as new orders, employment levels, and prices, have improved, remained unchanged, or deteriorated compared to the previous month.

Option-adjusted spread (OAS) is the yield spread of a bond over a risk-free rate, usually a similar maturity Treasury, adjusted for the bond’s embedded options. It reflects the additional return investors require to compensate for the risks and potential changes in cash flows due to options such as a bond’s callability.