Opportunities for Better Returns
After posting positive returns in 2023 bond markets turned downward during the first quarter given the more likely shallower easing cycle by the Federal Reserve. Broad United States bond markets, as measured by the ICE BofA US Corporate, Government & Mortgage Index, were down -0.7%, while measures of corporate and treasury bonds posted -0.4% and -2.9% returns respectively.
As the year began bond markets anticipated a weakening employment picture and steady decline of inflation that would lead to action by the Federal Open Market Committee (FOMC) to cut rates. Measures that reflect market participants’ estimates of the number of Fed rate cuts projected six rate cuts of 25 basis points, lowering the short-term borrowing cost for banks from 5.5% to 4%. However, data flow revealed inflation was peskier than expected resulting in comments from FOMC members that their outlook still favored three rate cuts of 25 basis points in 2024. Realization by bond investors that interest rates would remain “higher for longer” sent bond prices lower as yields climbed across the yield curve. United States Treasury debt from two to 30 years in maturity saw yields climb between 25 to 40 basis points with the 10-year maturity rising from 3.9% to 4.2% over the quarter. While 10-year United States Treasury rates are higher as the quarter ends they remain 78 basis points below their peak of last October.
On average, yields tend to fall in the six months prior to the first rate cut now targeted for June. While recent rising rates have left longer maturity bond returns trailing, we view this as an opportunity to start easing into extending the duration of portfolios. There remains meaningful room for yields to decline if the Fed eases at the June FOMC meeting. By comparison, prior to the FOMC first rate cut in 2019 rates had eased 75 basis points over a six-month period prior and yields still declined another 50 basis points over the next six months
following that first cut. We have been hesitant to extend duration aggressively due to the extent of the curve inversion and the associated negative carry. Front-end holdings having strong carry characteristics at yields above 5%
do not really benefit if yields decline to the same extent of longer duration holdings.
Positive equity markets combined with slowing issuance versus demand provided the perfect backdrop for corporate bond spreads to tighten relative to similar maturity United States Treasury bonds. Corporate bond demand remains strong as investment grade inflows to funds have outpaced outflows for over 20 weeks. Current spread levels are near 2018 and 2021 lows making the corporate bond market expensive in our view. However, there remains
segments where value can be found, specifically in the financial sector. This tight spread environment is likely to continue, barring a geopolitical event or sudden shift in the economic environment.
Demand for municipal bonds has outstripped supply thus far in 2024, despite the elevated tax-exempt calendar that saw supply of tax-exempt issues up 50% year-over- year, as inflows exceeded outflows for nine of 12 weeks of the
first quarter. This demand helped the sector report a -0.2% return, as measured by the ICE BofA one-12-year index for the quarter outpacing taxable parts of the market. We still view municipal bonds as rich by historical standards as 10-year tax-exempt AAA municipal bonds trade at a yield of just 60% of a 10-year United States Treasury, compared to a five-year average of 84%. Supply technical factors should provide opportunities to invest fresh cash over the next few months, but it will take slowing demand and an increase in supply as local and state municipalities raise funds to match the $350B for Federal highway funding provided by the 2021 Bipartisan Infrastructure Investment and Jobs Act.
The information provided has been obtained from sources deemed reliable, but BTC Capital Management and its affiliates cannot guarantee accuracy. Past performance is not a guarantee of future returns. Performance over periods exceeding 12 months has been annualized.
This content is provided for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Statements in this report are based on the views of BTC Capital Management and on information available at the time this report was prepared. Rates are subject to change based on market and/or other conditions without notice. This commentary contains no investment recommendations and should not be interpreted as investment, tax, legal, and/or financial planning advice. All investments involve risk, including the possible loss of principal. Investments are not FDIC insured and may lose value.