What has been driving the movement in rates this year and what is the bond market telling you about the state of the economy?
So far this year, we’ve seen a partial pullback following the sharp rise in rates at the end of 2024. We’re also seeing a lot of volatility day to day, where rates markets are responding strongly to incoming data points—employment reports, inflation, GDP, and so on. So, while the underlying trend is lower rates, markets are continually repricing their expectations for the economy and Fed policy, unsure as to the path of Fed rates, where the term premia will be, and what factors will ultimately drive inflation and the economy one way or another. We think rates will continue to bounce around within a range until we see either a breakout of inflation expectations to the upside or growth and employment expectations to the downside.
What is the team’s outlook on spread sectors, and what impact will tariffs and other policies from this new administration have?
Credit spreads remain exceptionally tight (low single-digit percentiles over the past 25 years). This tells us that the credit market sees no recession or negative impact from the administration’s trade, immigration, fiscal or regulatory policies. While the rates market reflects tremendous uncertainty, the credit market has become somewhat complacent, with spreads growing tighter. The administration’s policies will likely have conflicting effects on inflation, growth, and employment. Tariffs tend to be inflationary, at least in the short run. Immigration policy has the potential to be inflationary if it pushes up labor costs. Fiscal policies will have an impact on term premia and the yield curve. Deregulatory efforts will have the potential to promote growth and act against inflation. This situation is a bit incongruous, with all these interrelated factors having potentially conflicting effects and credit market pricing reflecting no disruptions. So, we’re carefully watching if the market reprices this risk at some point.
How do you and your team approach sector allocations, and more specifically, how does it relate to the contribution to overall duration?
We tend to believe in mean reversion when it comes to spreads and market pricing of risk. Generally, we will take more risk when the reward for taking risk is higher. We’ll take less risk when the reward for taking risk is lower. Currently, the market isn’t offering much reward for taking credit risk. Unless we have a strong thesis that agrees with the market’s risk pricing, we will maintain our discipline and pull back from exposure to these risks.
In our experience, when markets grow complacent and credit spreads tighten to current levels, any widening tends to happen suddenly and unexpectedly.
Where we do take credit risk, we look at our contribution to duration, or the share of duration of our portfolios coming from credit. Our contribution to duration from a credit or a spread sector is at a fairly historic low. We’re always skewed towards higher quality within the credit market, but even more so now.
Over the past few months, we’ve seen a massive move in rates both up and down. Can you explain why fixed income remains a key component in a portfolio?
As much as we’ve seen volatility and rates move down, rates were up significantly at the end of 2024. Looking back a few years, rates remain substantially higher than in late 2021 and early 2022 when the Fed began its tightening cycle and throughout much of the post-financial crisis period. In an intermediate portfolio with a 4.5%-5% yield, that yield now represents a significant portion of the portfolio’s expected return. It also offers greater protection against negative price movements—whether from rising rates or widening spreads—than was the case in the post-financial crisis era.
In a portfolio, these higher yields allow fixed income to fulfill its historical role of dampening volatility, providing diversification from equities, and offering reliable returns that are not dependent on price movements.