Core Fixed Income Post Best Quarterly Returns in 35 Years
Core bonds returned 6.8% in the fourth quarter, which was the best quarterly return since 1989. We have highlighted in the past that core fixed income is a compounding asset class versus others such as commodities that tend to revert. This means total return graphs move up and to the right over time. Periods of drawdown create the energy for the next move higher. In this case, a higher starting yield helps create current income in flat interest rate environments and price appreciation when rates fall.
For the year, core fixed income returned 5.53%. This ended a two-year losing streak, but the 36-month rolling return is -9.6%. Core fixed income posted more than 40 consecutive years of positive 36-month rolling returns from 1981 to 2022. Since then, it has been 19 consecutive below zero. It is certainly possible that yields can move higher in coming quarters, which would extend the length of drawdown, but there will eventually be a down cycle in rates that will fuel sustained positive returns. The more yields rise initially, the more outsized the future gains. In 1985, the rolling 36-month return on core fixed income exceeded 71.0%, which was a 19.8% average return over three years.
- The 10-year Treasury yield moved 69 basis points lower in the fourth quarter. It finished the year less than one basis point away from where it began.
- 10-year real interest rates fell 52 basis points in the quarter, which was the largest quarterly drop since 2016. This helped ignite a rally in nearly all asset classes.
- Corporate bonds returned 8.5% for the year as spreads compressed.
The Hiking Cycle Ends
The Federal Reserve held rates steady for the third consecutive meeting. They signaled cuts to come in 2024 as they view real interest rates to be restrictive and inflation is moderating. The debate now is when will the cuts begin. The signaling of cuts helps push up asset prices and ease financial conditions. In this case, it was so much that now some officials want to delay cuts. Delaying interest rate cuts may cause yields to rise and the equity rally to falter, which then tightens conditions and makes cuts more likely. Forward guidance is likely a hindrance to the Fed at this juncture.
The portfolios are currently just short of neutral on duration. 10-year Treasury yields are at a critical level having made a huge move through the 200-day moving average and then pulling back from 3.8% to 4.0%. A drop back below 3.8% and odds are skewed to sustain lower interest rate levels. However, if yields start consistently closing above the 200-day moving average, around 4.05%, then the odds skew toward the rally being nothing but an oversold bounce with higher yields much more likely.
The portfolios are a slightly underweight credit risk at this time, but the expectation is that most of the year we will maintain neutral-to-overweight allocation. The expectation is that corporate bonds likely have a sharp, short window of underperformance that may resemble the banking crisis this year. This will be followed by steady outperformance after the event. Given the starting spreads on corporates, it is unlikely they can duplicate the strong performance of 2023.
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.