Welcome to Piton Investment Management’s Q3 fixed income update. Piton's team leverages extensive experience and market access to design customized taxable and tax-exempt solutions, ranging from liquid "cash management" to longer duration strategies. They cover the high-quality fixed income spectrum, catering to clients seeking safety, diversification, or income, with strategies that balance risk and reward.
We have Piton’s Chief Investment Officer, Brian Lockwood, who has over twenty years’ experience managing Fixed Income portfolios.
Recorded October 1, 2024
Q1: How have fixed income markets performed in the third quarter of 2024?
Fixed income markets had a solid quarter. As a matter of fact, they kept pace with equity markets, which are having another banner year. But, importantly, if you look over the last three months, fixed income performed above or over a percent per month for every month in the third quarter and has outperformed cash handily. Really solid performance, driven by the front end of the yield curve. We saw two-year notes lower by over a hundred basis points and ten-year notes lower by 60 basis points.(1) So, a real curve steepening, but also lower rates, which drove the performance of the bond market.
Key Takeaways:
Strong Performance Matching Equities: Fixed income markets had a solid third quarter, keeping pace with equity markets, which are experiencing another strong year.
Consistent Monthly Returns and Outperforming Cash: Over the last three months, fixed income assets delivered returns exceeding 1% per month, significantly outperforming cash during the quarter.
Yield Curve Movements Drove Performance: The robust performance was driven by a steepening yield curve and lower interest rates, with two-year notes decreasing by over 100 basis points and ten-year notes by 60 basis points.
Q2: Please provide context on performance across the different sectors?
As we mentioned before, obviously treasuries were positive as rates dropped, and the front end leading the way on that. However, we did see some spread widening in corporate spreads throughout the month when equities were falling off, but that came back in September as we saw all markets buoyant after the Fed lowered rates. In terms of the risk sectors, they had a good quarter - high yield, emerging markets - are both up 8 percent year to date, and preferreds are up 11 percent year to date (2), with much of that happening in the third quarter as spreads came back. Corporates outperformed treasuries, mostly because of September, and we saw that big move come back. Municipal bonds, because they were fairly priced coming into this third quarter, have lagged a little bit. They're still up, but they've lagged a little bit versus some of the other safety markets.
Key Takeaways:
Treasuries Benefited from Dropping Rates: Treasuries saw positive performance as interest rates declined, particularly at the front end of the yield curve.
Strong Gains in Risk Sectors: High-yield and emerging market debts are up 8% year-to-date, and preferred securities have gained 11%, with significant gains occurring in the third quarter.
Corporate Bonds Outperformed Treasuries: Corporate spreads widened during equity market declines but tightened in September after the Fed lowered rates, leading corporate bonds to outperform treasuries.
Q3: How has cash as an asset class fared this year?
That is a good question about cash because it has done its job. Rates have been at 5.5 percent up until a few weeks ago when we saw the first move lower in rates. We saw cash rates go from money market fund going from a 530 to now like a 480 over the next few weeks. The yields are still there for cash. They're still doing exactly what they're supposed to do. But they're no longer king in terms of returns. When you think of cash as one day fixed income, fixed income is now outperforming because the yield is in fixed income, and now they're getting the price action where prices aren't going down and bonds, they're either staying level or going up. You are getting better total return and better risk reward out of fixed income than you are in the cash market, but it's still high yielding. And if people realize that if markets do start to price out cash will lead other markets for time periods.
Key Takeaways:
Cash Yields Have Slightly Declined but Remain Solid: Cash rates were around 5.5% but have recently decreased to approximately 4.8%; however, yields are still robust.
Fixed Income Now Outperforms Cash: Fixed income assets are outperforming cash due to higher yields and stable or rising bond prices, offering better total returns and risk-reward profiles.
Cash Is No Longer Leading in Returns: While cash remains high-yielding, it is no longer the top-performing asset class but may lead other markets during certain periods if conditions change.
Q4: What is the current state of the market, and what are the primary drivers?
The current state of the market, I think both fixed income and equity markets are priced to the idea that a soft landing is the base case, a soft landing of the economy. And what we here at Piton look at is the outliers. Because we think of soft landing is very hard for a Fed to engineer. Not to mention we have a business cycle. We have a Fed cycle that tends to happen over the next few years. We're looking at two sides of the coin, no landing, the possibility that inflation starts to come back and the Fed will have to pause any sort of further rate cuts to a more likely scenario based on the data that we're seeing and that is the fact that we might be in recession at this point next year. We'll start to see some data in September. We saw some numbers where consumer confidence was the lowest we've seen since 2021. We're starting to see jobs numbers come down. All of those will affect GDP and the U.S. consumer, and that could drive markets going forward. But right now, markets are priced to this idea that the Fed will engineer a soft landing, and they'll be sort of a continued Goldilocks experience in markets.
Key Takeaways:
Markets Priced for a Soft Landing: Both fixed income and equity markets currently assume a soft landing of the economy as the base case scenario.
Challenges to the Soft Landing Scenario: Achieving a soft landing is difficult for the Fed; alternative outcomes include resurgent inflation ("no landing") requiring the Fed to pause rate cuts, or a potential recession next year based on emerging data.
Signs of Economic Weakness Emerging: Indicators like declining consumer confidence and decreasing job numbers suggest potential impacts on GDP and the U.S. consumer, which could influence markets moving forward.
Q5: The FOMC (Federal Open Market Committee) decreased rates by 50 basis points at their September meeting. How are you positioning portfolios in this environment?
Since the Fed meeting, we haven't changed portfolios too much. What we've done in some of our broader portfolios is sell longer securities, like 20 and 30 year bonds, and buy what's called the belly of the curve, the five-year area. But the biggest move that we made was coming into this, the beginning of the Fed easing cycle, which just started in September. We extended our durations into this, and now we're sitting at a more neutral stance where we want to see where the next leg of the economy is going. We understand that the fed is in an easing cycle, but now we want to understand how the economy is going to react to this.
Key Takeaways:
Minimal Portfolio Changes Post-Fed Rate Cut: Following the Fed's 50 basis point rate decrease in September, the portfolios haven't undergone significant changes.
Shift from Long-Term to Mid-Term Bonds: The strategy involved selling longer-term bonds (20- and 30-year maturities) and purchasing bonds in the five-year range, known as the "belly of the curve."
Neutral Stance Awaiting Economic Signals: After initially extending durations at the start of the Fed's easing cycle, the portfolios are now positioned more neutrally, waiting to see how the economy reacts to the easing measures.
Q6: You mentioned that markets will remain sensitive to economic and inflation data. What economic indicators are you keeping a close eye on?
That’s a big shift for us, and I think for the market in general. We are no longer completely focused on inflation data. I think the PCE that came out the other day, super important for the markets, but going forward, it seems that the Fed, after starting this easing cycle, they have taken a little bit of a victory lap on inflation data. And are now focused on the jobs numbers. So, things like today's jolts and things like monthly non-farm payrolls will be omnipotent to markets.
Key Takeaways:
Shift in Market Focus from Inflation to Employment Data: The market and the Fed are now less concentrated on inflation metrics and are paying closer attention to employment data.
Fed's Confidence in Inflation Control: After starting the easing cycle, the Fed appears more confident about managing inflation, viewing recent PCE data as a positive sign.
Jobs Numbers as Crucial Indicators: Key employment reports like the JOLTS report and monthly non-farm payrolls are now highly influential and will significantly impact market movements.
Q7: You mentioned the upcoming November Presidential election will influence fiscal policy decisions, global relationships, and even the Federal Reserve’s composition. What should investors be watching for?
I think right now, I'm writing my monthly piece on September and realizing that we had a debate in September for the presidency and it just feels so long ago since the Fed meeting. But for us, the focus is getting through the election, realizing that the political cycle isn't as strong as the economic cycle. So, focus on what we know, focus on the data that we're seeing in terms of the economy. We think that's the bigger picture. Short term, absolutely. There'll be a volatility and we'll get through the election, and then people will realize what can actually be done from either side of the political parties, and then we'll move back to the economic cycle.
Key Takeaways:
Focus on Economic Data Over Political Events: Investors should prioritize economic indicators over political developments, as the economic cycle has a stronger influence on markets than the political cycle.
Expect Short-Term Volatility Due to the Election: The upcoming presidential election may cause short-term market volatility, but it's important to look beyond this temporary instability.
Post-Election Shift Back to Economic Fundamentals: After the election, attention will return to economic fundamentals as the actual policy actions of the elected party become clearer.
Q8: Over the past few months, what topics have you been speaking about that investors have shown the greatest interest?
I think we saw it on September 4th. The yield curve when uninverted or disinverted for the first time in 2 years. We've heard a lot of talk about that. I mean, in terms of bond market returns, that's not a super important over time. That's not a super important part of total return. It is a part for the structure and where you want to buy bonds and where you want to construct portfolios. We get a lot of those questions about the yield curve and the fact that the yield curve has somewhat normalized over the past month, and so that's one of the main ones. The other one is obviously what markets are rich and cheap, what are the tax sensitive markets? And I mentioned before, for the most part, municipal bonds and tax exempt bonds are somewhat expensive or fair value to expensive right now. We're seeing a lot of clients opt to taxable bonds rather than tax exempt bonds, more liquidity, more liquid, and a better after-tax yield for some part. Still in some high tax states, municipal bonds make a lot of sense.
Key Takeaways:
Interest in Yield Curve Disinversion: Investors are focused on the recent yield curve disinversion—the first in two years—and its impact on bond strategies.
Emphasis on Market Valuations: There's significant interest in identifying overvalued ("rich") and undervalued ("cheap") markets, especially in tax-sensitive areas.
Shift Toward Taxable Bonds: Clients are opting for taxable bonds over expensive municipal bonds due to better liquidity and after-tax yields, though munis remain attractive in high-tax states.
Q9: How are changes in corporate fundamentals and credit quality influencing your outlook on corporate bonds?
Two years ago, our taxable portfolios were 60 to 65 percent corporate bonds and just a small amount of government bonds. Over the last two years, that script has flipped where we're overweight, government bonds and have a smaller weight to corporates. It's not saying that we think any of these corporates are not money good or there's bankruptcy issues in them. It's just that spreads have remained so tight for so long that which coincides with great equity markets as well. You are not getting the risk reward you are, you are still getting a better return and we saw better returns in corporate bonds over government bonds in the third quarter and September. But going forward, we don't think you're getting paid to go down the ladder of credit risk versus government bonds in this marketplace. Spreads are still historically tight. They can get tighter, and they can stay here for a long time. But we think optimally, you'll see some at some point, whether it's geopolitical, whether it's the election, whether it's Fed policy, you will see some sort of spread widening over the next year.
Key Takeaways:
Shift to Government Bonds: Portfolios have reduced exposure to corporate bonds in favor of being overweight in government bonds.
Tight Spreads Limit Risk-Reward: Tight credit spreads mean corporate bonds don't offer enough extra return to compensate for their higher risk compared to government bonds.
Cautious on Corporate Bonds Despite Recent Gains: Even though corporates outperformed recently, future risks like geopolitical events or Fed policy changes could widen spreads and affect returns.
Q10: How do you see the fixed income market evolving as we approach 2025?
I think it's a little bit of what we talked about before getting through the election and then realizing that we are in an easing cycle. So regardless of how we want to position portfolios day to day, month to month, the fact is the curve is going to ratchet lower. We are going to be in an easing cycle for some time, easing to stable cycle. And that bodes well for where yields are right now - what you can get out of the bond market. And the fact that cash is going to be drawing lower, there should be more money flowing into the bond market. There's some buoyancy to fixed income markets right now.
Key Takeaways:
Extended Easing Cycle Expected: Interest rates are likely to decrease or remain stable as we approach 2025.
Lower Yield Curve Benefits Bonds: A declining yield curve enhances the attractiveness of bonds and supports current yields.
Increased Investment into Bonds: As cash yields fall, more funds may flow into the bond market, adding buoyancy to fixed income markets.
Note:
(1) Question 1: Performance of the Bloomberg Aggregate Index. See monthly total return figures are > 1% for each of three months. The Bloomberg Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar denominated, fixed-rate taxable bond market. Bloomberg Indices/Bloomberg L.P.
(2) Question 2. High yield/emerging markets up approximately 8% ytd. Preferred index up 11+%. Indices below / all gathered from Bloomberg L.P.
The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Bloomberg EM country definition, are excluded. (Future Ticker: I00012US).
The Bloomberg Emerging Markets Hard Currency Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD-denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. (Future Ticker: I00014US).