Third Quarter 2023 | Fixed Income Commentary
Published on October 24th, 2023
Fixed Income markets declined in the third quarter as higher interest rates and wider credit spreads weighed on valuations. The Current Income Portfolio declined 0.1% gross (0.4% net),1 the Bloomberg Intermediate US Govt/Credit Index declined 0.8%, the Bloomberg Intermediate US Corporate Index declined 1.0%, and the ICE BofA Fixed Rate Preferred Securities Index declined 1.2%.2 CIP’s outperformance was primarily driven by its shorter duration relative to these indices as well as its allocation to fixed to floating rate coupon securities.3
During the quarter, 10Y US Treasury yields increased 74 bps to reach the highest level since 2007.4 The FOMC hiked interest rates by 25 bps in July, and although the committee chose to pause on additional rate hikes in September, participants raised forecasts for the Federal Funds Rate in 2024 by 50 bps (by predicting fewer interest rate cuts) compared with similar projections that were made in June.5 Forecasts for policy rates to be held “higher for longer” were likely driven by recent strong economic growth, given the latest increases in U.S. consumption, as opposed to expectations for higher inflation.6 In fact, core measures of inflation have moderated somewhat since this time last year, while real GDP has exceeded expectations, increasing by 2.2% and 2.1% (y/y) in the first and second quarters, respectively.5,7 In addition to expectations for higher growth, we think some of the increase in longer-term yields may also be attributable to a rise in “term premium”, which can be understood as compensation to bondholders for the uncertainty around future inflation. Term premiums can increase from changes in longer-term trends such as deglobalization, a global shortage of workers due to changing demographics, or inflated federal debt that needs to be financed by printing money, in our view.
Median Dot Plot Projections Increased from the June and September 2023 FOMC Meetings
FOMC Dot Plot Projections as of 06/14/23: Grey line
FOMC Dot Plot Projections as of 09/20/23: Green line
Median forecasts for the Fed Funds Target Rate (as depicted by the FOMC “Dot Plot”) increased by roughly 50 bps in the 2024 and 2025 period projections, from the June 2023 to the September 2023 Federal Reserve meetings. We believe this “higher for longer” outlook contributed to the recent rise in government yields across the tenors of the yield curve.
We believe credit spread widening also contributed to a moderate decline in fixed income security prices during the third quarter. Factors that drove spreads wider may have included the threat of a U.S. government shutdown and strikes by automobile industry workers, in Hollywood, and at UPS. Concerns over potential pressures building on the consumer from the expected resumption of student loan payments, rising oil prices and depleted excess savings accumulated during the pandemic may also have added to general spread widening.8 Finally, geopolitical concerns could have also had a negative impact on credit spreads. Growth is slowing in China and its property development sector and related financial institutions may be overleveraged,9 the Ukraine conflict appears locked in a stalemate,10 prolonging its inflationary impacts on the global economy, and a new conflict in the Middle East may also add risk to the global economic outlook.11
Higher government yields and growing credit risk may also continue to exacerbate challenges in commercial real estate and in the banking sector.12 Although deposits at the largest U.S. banks appear to have stabilized (average deposits across large U.S. banks fell just 0.4% in the third quarter), the value of banks’ securities portfolios typically declines when government yields rise.12,13 At present, however, we believe the largest US banks are well capitalized enough to withstand potential further unrealized losses. Many banks are cutting costs and building capital in preparation for the “Basel III Endgame” requirements to be phased in over the next two years.14 We believe this will result in (among other things) significantly more capital being held on bank balance sheets as a buffer to withstand further material declines in valuations.
Commercial real estate values, particularly in the office and retail sectors, may continue to be stressed as higher capitalization rates, shifts in work from home trends, and increased vacancy rates persist.13 In fact, many banks have already begun to work out solutions with some of their stressed borrowers, which we believe could have a slight advantage over those loans that are syndicated out through CMBS and still need to be worked out. Additionally, while rents might be down on office properties this year, in other sectors such as multi-family, rents have increased in many parts of the country.15 Moreover, the largest U.S. banks have diversified loan portfolios such that the greatest exposure to office properties, for any single issuer, is at most 4% of total loans.16 Nevertheless, we think banks’ earnings will continue to face pressures, as higher rates are paid out on deposits and on other funding sources (such as borrowing from the Bank Term Funding Program), and tighter regulations and higher capital requirements dampen profitability across the industry.13 Ultimately, however, we expect the collective impact of new financial regulatory requirements to be net-positive to the credit quality of large U.S. banks.
Looking forward, we believe it is unclear as to how much higher longer-term yields will factor into the Federal Reserve’s decision to keep tightening at the short end of the yield curve. (Recall that when inflation expectations fall and the policy rate is held constant, the Federal Reserve is still effectively “tightening” monetary policy because “real” interest rates are still rising as a result.) Also, given the typical lagged impact from monetary policy tightening, it could be a while before the data starts to reflect the Fed’s recent hikes. We think upside risks to the future path of interest rates could include strength in spending and payrolls, while downside risks could include weak global growth.
What we believe will matter most is the overall impact on the consumer, which has been resilient thus far thanks to a robust employment market, excess savings, and strength of late in both home prices and stock prices, in our view. We expect the student loan repayment impact to be concentrated in lower-tier discretionary retail, similar to the reduction in SNAP payments that occurred in February, and we believe Beijing has the means and the will to contain its financial system risks, though economic growth in China may remain sluggish. Government shutdowns (not to be confused with debt ceiling brinksmanship, which we believe introduces more risk to capital markets) typically have very limited economic or market impacts, even when they are prolonged, as may occur in this instance.17
We continue to position the portfolio defensively with respect to credit risk and potential volatility from changes in interest rates. Our target duration of ~4 years on the corporate bond allocation is unchanged (although many of our existing accounts have a shorter duration on the corporate bond sleeve, which we may look to extend by swapping some shorter maturity securities for those with slightly longer maturities). We also maintain a target mix of fixed and fixed to floating rate coupon securities on the preferred allocation. Lastly, we prefer the largest U.S. banks to the regional U.S. banks due to their diversified deposit base and stricter regulatory requirements already adhered to and planned to increase in the future. We still look to diversify the preferred allocation into various non-financial industry groupings and remain selective within our corporate credit security selection.
1.GIPS Composite Preliminary Performance 3Q2023
2.Bloomberg Port: Bloomberg Intermediate US Govt/Credit Index, Bloomberg Intermediate US Corporate Index, ICE BofA Fixed Rate Preferred Securities Index
3.Bloomberg Port: OAS
4.Bloomberg Port: USGG10YR Index
5.Transcript of Chair Powell’s Press Conference September 20 2023.pdf
6.The Fed – September 20, 2023_ FOMC Projections materials, accessible version.pdf
7.Gross Domestic Product (Third Estimate), Corporate Profits (Revised Estimate), Second Quarter 2023 and Comprehensive Update _ U.S. Bureau of Economic Analysis (BEA).pdf
8,U.S. Economy Could Withstand One Shock, but Four at Once_ – WSJ.pdf
9.China Slowdown Means It May Never Overtake US Economy, New Forecast Shows – Bloomberg.pdf
10.Opinion _ Ukraine war analysis shows territory stalemate, economy, refugees – Washington Post.pdf
11.Israel-Hamas War Impact Could Tip Global Economy Into Recession – Bloomberg.pdf
12.Speech by Governor Bowman on financial stability in uncertain times – Federal Reserve Board.pdf
13.Federal Reserve Board – Assets and Liabilities of Commercial Banks in the United States – H.8 – October 06, 2023.pdf
14.FDIC_ Speeches, Statements & Testimonies – 6_22_2023 – Remarks by Chairman Martin J. Gruenberg on the Basel III Endgame at the Peterson Institute for International Economics.pdf
15.Examining Apartment Rent Growth Year-to-Date in Mid-2023 _ RealPage Analytics.pdf
17.Breaching the debt ceiling is not the same as a government shutdown. Its consequences could be dire. _ PIIE.pdf
As of September 30, 2023