The fixed income market experienced an extraordinary rally in the fourth quarter on elevated odds of an economic soft landing and dovish signals from the Federal Reserve. The strong performance was a sharp reversal from the prior quarter, which briefly raised the specter of an unprecedented third consecutive loss for the bond market. Sentiment was bolstered first by news that the US Treasury’s borrowing needs were lower than feared and then lifted further by a series of upbeat economic readings and moderating price pressure. The final stage of the rally was powered by the arrival of the long-awaited Fed pivot, which left little doubt that the hiking cycle had concluded. Both the rates market and credit swiftly repriced to reflect a more rapid series of cuts and narrower risk premia, lifting asset prices across the board, and broadly easing financial conditions.
The Treasury market posted its strongest gains since the onset of Covid. The closely watched 10-year Treasury yield fell from a post-GFC closing high of 4.99% in October to 3.88% at yearend — a decline of more than a full percentage point in just over two months. Despite the broad-based rally, the slope of the curve was little changed and remained firmly in negative territory. Inflation breakevens drifted slightly lower, but the main driver of lower rates was the decline in real yields as financial conditions eased. Mortgage-backed securities saw their best quarter since the GFC on the back of the Fed’s pivot. The sector benefited from the sharp downtick in rate volatility, lower seasonal originations, and increased bank demand.
Corporates significantly outperformed Treasuries as credit spreads compressed to their tightest levels in two years. The prospect of more accommodative financial conditions boosted the outlook for the space, which was already helped by a benign default outlook and durable profit margins. Corporations continue to enjoy low interest expenses as a residual benefit of debt issued when rates were low, while robust economic growth and reliable consumer spending remain supportive of credit metrics. The best performing sectors were the most capital-intensive and interest-rate sensitive, including home construction, communications, and basic materials. The more defensive consumer non-cyclical sector was a relative underperformer. According to Moody’s, the US speculative grade corporate default rate over the last 12 months has been 5.3%, but should improve to 4.1% in the year ahead, closer to the historical average.
After a brief period in the second quarter that saw the bond market converge with the Fed’s dot plot, a rift has once again formed. The Fed projects three rate cuts in 2024 while the Fed funds futures market expects more than six. Similarly, the persistent inversion of the yield curve suggests the bond market is pricing in elevated odds of a recession, while the Fed’s median projections don’t see GDP growth falling below 1.4%. The inversion of the yield curve seems less likely to persist indefinitely, especially if rates normalize into a soft landing.
A soft landing would provide a favorable backdrop for corporate fundamentals. By creating conditions that allow the Fed to cut rates, it would both support topline growth and promote favorable liquidity conditions, thereby easing future refinancing needs. It would also be constructive on a technical basis, given it would enhance the appeal of spread product. Valuations at current levels are less appealing, with breakevens versus Treasuries at the lower end of their historical range and leaving little room for error. As such, we believe this backdrop supports a neutral view of credit. Within the space, we favor names with defensive operating and financial metrics, given that investors do not seem to be assigning a meaningful discount to riskier business profiles. Within the MBS space, we see a continued interest from banks helping support demand as valuations edge closer to long-term averages. We continue to favor seasoned, high-coupon pools that offer higher carry and better convexity profiles.
Read GW&K’s Quarterly Investment Review for the fourth quarter here.
With contributions from members of our Taxable Bond Team.