- Investors had much to consider in the third quarter: a July Federal Reserve (Fed) rate increase, U.S. government debt downgrade in August, a narrowly averted government shut down in September, and, near quarter end, Fed sentiment auguring for a higher-for-longer rate scenario.
- The Bloomberg (BBG) U.S. Corporate Investment Graded (IG) Bond Index (the Index) option-adjusted spread (OAS) narrowed by 2 basis points (bps) during the quarter, ending at 121 basis points (bps).
- Our base case calls for a no growth to mild economic recession over the next 6 to 12 months, with the Fed hiking once more in November by 25bps.
- Several factors could slow economic growth heading into the fourth quarter and 2024: 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 to slow economic activity.
- These factors may increase the likelihood that yields will fall after the Fed completes its rate-hiking campaign.
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.
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.
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.
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).
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.
 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.
 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.
 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.
 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.
 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.
 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.
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