Investment Review and Outlook

Yields moved dramatically higher during the third quarter, as investor uncertainty increased

The Fed declined to raise rates in September but it lowered expectations for rate cuts in 2024 to just 50bps, confirming a higher-rates-for-longer sentiment in its efforts to reduce and control inflation. While bond market volatility did not approach the higher levels seen earlier in 2023, there were periods during the third quarter when it spiked noticeably, as measured by the Bank of America/Merrill Lynch MOVE Index.²

Events that prompted episodes of rate volatility included the Fed’s short-term interest rate increase in July, a downgrade of U.S. government debt in August by Fitch Rating Services, market concern about increased Treasury issuance to address higher federal deficits, the Fed’s September rate increase and a stated bias to higher rates for a longer period, and the uncertainty surrounding a potential government shutdown as the end of the quarter approached. 

Uncertainty stemming from these events prompted yields to rise across Treasury and corporate bond yield curves, with longer-term yields increasing more than yields on shorter maturity bonds. The effect was to lessen the inversion at the front end of the Treasury yield curve that has been in place for more than a year.

The Fed targets an annual inflation rate of 2 percent. The Bureau of Economic Analysis (BEA) reported August Personal Consumption Expenditures, excluding food and energy, were 3.9 percent higher on a year-over-year (Y/Y) basis. While that number remains above the Fed’s target, it was 0.4 percent lower than the prior month.

On September 2, the BEA’s third estimate of second quarter gross domestic product (GDP) showed a 2.1 percent annual growth rate. Within the context of 20 months of interest rate hikes, analysts continued to describe GDP as resilient. 

Wage and job growth continued. The Federal Reserve Bank of Atlanta’s Wage Tracker’s showed growth as steady or slightly decelerating, depending on unsmoothed and smoothed measures, respectively. Meanwhile, jobs data released by the Bureau of Labor Statistics in late August showed some easing of labor demand, although job openings continued to exceed the number of people looking for work.

The Fed’s updated Summary of Economic Projections (SEP) reinforced the outlook for a higher rate environment over the near to medium term. The September SEP projects the federal funds rate in 2024 to be 5.1 percent and 3.9 percent in 2025, compared projections of 4.6 for 2024 and 3.4 percent in 2025, as reported in the June 2023 SEP.

At Breckinridge, the Investment Committee’s base case calls for a no-growth to mild economic recession over the next 6 to 12 months. We believe the Fed will hike rates once more in November by 25bps.

Breckinridge is weighing factors that could slow economic growth. These include renewed uncertainty around a potential government shutdown when the current 45-day resolution expires, higher oil and gas prices, continued work stoppages in the auto, entertainment, and hospital sectors, potential upticks in bond defaults, the depletion of excess consumer savings and the delayed impact of higher rates finally starting slow economic activity. These may increase the likelihood that yields will fall after the Fed completes its rate-hiking campaign.

Breckinridge sees upside risks to its outlook if growth continues, including stronger-than-expected job creation, resilient consumer spending, and a wealth effect from rising asset values. Downside risks include further price pressure on commercial real estate, tightened bank lending standards, and increased bankruptcies among small businesses.

Fundamentals

Credit Fundamentals Are Softening But From a Solid Position.

For the trailing three quarters, S&P 500 Index³ companies have reported negative earnings growth, with negative 7 percent year-over-year (Y/Y) for 2Q23 and flat growth projected for 3Q23. Yet, while credit metrics are softening, they are doing so from a solid position.

Net debt-to-earnings before interest, taxes, depreciation, and amortization (EBITDA) is mixed versus its 20-year average across quality buckets (e.g., AAA/AA, A, BBB). In aggregate, AAA/AA net leverage is below its long-term mean, while A and BBB cohorts are above it by 0.6 times and 0.3 times, respectively. 

The AAA/AA rating cohort is small, at 16 percent of the market value of the Index. These issuers run high cash balances relative to debt. The A and BBB cohorts are large, at 40 percent and 44 percent of the Index, respectively. 

 Technicals

Corporate Supply Slightly Lower in 3Q23, as Flows Turned Negative

Fixed-rate, gross investment grade corporate supply was $259 billion in 3Q23, down slightly from $282 billion in 3Q22, in what is typically a seasonally slow quarter, BBG data showed. Net supply for 3Q23 was a muted $135 billion, down from $141 billion in 3Q22.

 In recent years, BBG data showed corporate supply has averaged $1.2 trillion, while net supply is typically around $500 billion. A notable shift year-to-date (YTD) through 3Q23 is Financial sector supply, which at $393 billion is down from $489 billion in 3Q22 based on sector volatility.

About $4 billion in assets flowed out of U.S. IG bond funds in 3Q23, per Lipper. On a YTD basis, Emerging Portfolio Funds Research (EPFR) reported $114 billion of net inflows into IG bond funds, split about equally between IG mutual funds and IG exchange-traded funds.

Valuations

IG Yields at Mid-2009 Levels, While Spreads Are Notably Tighter

Prior to the Global Financial Crisis (2007 to 2008), when the Fed was in a steady hiking mode, IG spreads stayed tight (80 to 100bps over duration-matched Treasury yields), as all-in corporate yields⁴ moved higher. The Fed took rates from 1 percent in March 2004 to 5.25 percent in June 2006 and held at that level for a year before cutting rates by 50bps.

The Index OAS was low relative to the all-in yield during that time, averaging 18 percent. Today, through 3Q23, the corporate spread was 20 percent of the all-in IG yield. This is intuitive based on solid credit fundamentals and a high risk-free rate.

Since the Fed began hiking in March 2022, spreads have ranged from +110bps to +165bps. At +120bps, spreads are tight, but may stay this way for a time given high all-in yields. If a recession were to emerge the gap between spreads and yields may compress.

Credit Curves Flattened Sharply Continuing the Recent Trend

The backup in bond yields during 3Q23 and YTD, an inverted short end, and flat belly of the curve have driven notable divergence in spread moves. In 3Q23, 5-year and 10-year Treasury yields increased by 47bps and 74bps, respectively. 

 Credit curves flattened in 3Q23, continuing a recent trend. The BBG U.S. Corporate IG 5-Year to 7-Year Index⁵ (5-7 Year Index) saw widening of 3bps, while the BBG U.S. Corporate IG 10+-Year Index⁶ (10+ Year Index) tightened 16bps. In 2023 through September 30, the 5-7 Year Index and the 10+ Year Index tightened by 10bps and 24bps, respectively.

At the start of 2023, the gap between these indices was 24bps and it was 10bps at 3Q23. It has averaged 26bps over the past 20 years. Credit curves may invert briefly during periods of stress (for example, in 2008) and may be flat during benign periods (for example, from 2004 to 2006).

Sustainable Spotlight

Two developments at the federal level regarding sustainable investing and environmental, social and governance (ESG) factors in security analysis during the third quarter were notable.

First, the U.S Department of the Treasury released a report titled The Impact of Climate Change on American Household Finances. The report finds that more than half of U.S. counties—populated by millions of Americans—face heightened future exposure to at least one of three consequential climate hazards: flooding, wildfire, or extreme heat. Further, approximately one-fifth of all U.S. counties face both elevated vulnerability and elevated future exposure to these climate hazards. The Treasury department prepared the report in consultation with members of the Financial Literacy and Education Commission.

Second, a federal judge in Texas dismissed a lawsuit brought by 25 states asking the court to strike a rule adopted by the U.S. Department of Labor that would allow fiduciaries managing the assets of retirement plans to weigh ESG factors in investment decisions. The judge found that the rule was not contrary to the Employee Retirement Income Security Act (ERISA) of 1974, as alleged by the plaintiff. Further, the judged noted that even the plaintiff “concede that ESG factors can be considered for risk-return purposes in appropriate circumstances.”

At Breckinridge, sustainability and ESG analysis continue to factor into security analysis. Integration of sustainability assessments with our analysis fundamental investment analysis aligns with our tradition of in-depth research and our long-term perspective. Three articles in Breckinridge third quarter ESG Newsletter offered additional insight into current considerations of note.

With climate change continuing to follow the pace predicted by scientific models, Breckinridge’s net zero investing approach works to manage transition risks for IG corporate bond portfolios across all sectors, including sectors with elevated greenhouse gas (GHG) emissions. The article Enhancing Portfolio Resilience Amidst Climate Change explores our views further.

As the number and frequency of extreme weather events continues to increase, we explored some of the strategies employed by property and casualty insurance companies and bond investors, like Breckinridge. We found important commonalities. More details are included in the article In Evaluating Risks from Weather Extremes, Insurers and Bond Investors Share Strategies and Goals.

Finally, Breckinridge continues to expand its suite of customization options in response to client demand and is now offering a Tax-Efficient Climate Vulnerability Customization. Read more about this customization in the article Using Municipal SMAs To Assist Climate-Vulnerable Communities.

BCAI-10092023-ILOSVEKY (10/12/23)

[1] The Bloomberg U.S. Corporate IG Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index.

[2] The Bank of America Merrill Lynch MOVE Index measures U.S. interest rate volatility by tracking the movement in U.S. Treasury yield volatility implied by current prices of one-month over-the-counter options on 2-year, 5-year, 10-year and 30-year Treasuries. Historically, the index rises as concerns grow that interest rates are moving higher. You cannot invest directly in an index.

[3] The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. Itis a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index.

[4] All-in corporate bond yields are the IG corporate credit spread plus the duration-matched Treasury Index yield. The Bloomberg U.S. Treasury Bond Index is an unmanaged index of prices of U.S. Treasury bonds with maturities of 1 to 30 years. You cannot invest directly in an index. You cannot invest directly in an index.

[5] The Bloomberg U.S. Corporate IG 5-Year to 7-Year Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of five to seven years. You cannot invest directly in an index.

[6] The Bloomberg U.S. Corporate IG 10+ Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of 10 years or more. You cannot invest directly in an index.

Disclosures:

This material provides general and/or educational information and should not be construed as a solicitation or offer of Breckinridge services or products or as legal, tax or investment advice. The content is current as of the time of writing or as designated within the material. All information, including the opinions and views of Breckinridge, is subject to change without notice. 

Any estimates, targets, and projections are based on Breckinridge research, analysis, and assumptions. No assurances can be made that any such estimate, target or projection will be accurate; actual results may differ substantially.

Past performance is not a guarantee of future results. Breckinridge makes no assurances, warranties or representations that any strategies described herein will meet their investment objectives or incur any profits. Any index results shown are for illustrative purposes and do not represent the performance of any specific investment. Indices are unmanaged and investors cannot directly invest in them. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, income and capital gains. Performance of indices may be more or less volatile than any investment strategy.

All investments involve risk, including loss of principal. Diversification cannot assure a profit or protect against loss. Fixed income investments have varying degrees of credit risk, interest rate risk, default risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Income from municipal bonds can be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the IRS or state tax authorities, or noncompliant conduct of a bond issuer.

Separate accounts may not be suitable for all investors.

Breckinridge believes that the assessment of ESG risks, including those associated with climate change, can improve overall risk analysis. When integrating ESG analysis with traditional financial analysis, Breckinridge’s investment team will consider ESG factors but may conclude that other attributes outweigh the ESG considerations when making investment decisions. 

There is no guarantee that integrating ESG analysis will improve risk-adjusted returns, lower portfolio volatility over any specific time period, or outperform the broader market or other strategies that do not utilize ESG analysis when selecting investments. The consideration of ESG factors may limit investment opportunities available to a portfolio. In addition, ESG data often lacks standardization, consistency and transparency and for certain companies such data may not be available, complete or accurate.

Breckinridge’s ESG analysis is based on third party data and Breckinridge analysts’ internal analysis. Analysts will review a variety of sources such as corporate sustainability reports, data subscriptions, and research reports to obtain available metrics for internally developed ESG frameworks. Qualitative ESG information is obtained from corporate sustainability reports, engagement discussion with corporate management teams, among others. A high sustainability rating does not mean it will be included in a portfolio, nor does it mean that a bond will provide profits or avoid losses.

Some information has been taken directly from unaffiliated third-party sources. Breckinridge believes the data provided by unaffiliated third parties to be reliable but investors should conduct their own independent verification prior to use. Some economic and market conditions contained herein have been obtained from published sources and/or prepared by third parties, and in certain cases have not been updated through the date hereof. All information contained herein is subject to revision. Any third-party websites included in the content has been provided for reference only.

Certain third parties require us to include the following language when using their information:

BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg does not approve or endorse this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The S&P500 Index (“Index”) and associated data is a product of S&P Dow Jones Indices LLC, its affiliates and/or their licensors and has been licensed for use by Breckinridge. © 2023 S&P Dow Jones Indices LLC, its affiliates and/or their licensors. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC. For more information on any of S&P Dow Jones Indices LLC’s indices please visit www.spdji.com. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (“SPFS”) and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). Neither S&P Dow Jones Indices LLC, SPFS, Dow Jones, their affiliates nor their licensors (“S&P DJI”) make any representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and S&P DJI shall have no liability for any errors, omissions, or interruptions of any index or the data included therein.