Until recently, investors were no doubt pleased with the continued strong equity performance in 2024 that resulted in new highs in the major domestic indices and strong returns globally.
The fixed income markets, however, have remained range bound and at times volatile with regards to duration positioning as investors have had to navigate uncertainty around the FOMC’s path to lower rates. All the while, the credit markets have remained relatively contained. Since the beginning of July, the steep fall in equity prices has garnered much of the attention, but the rally in U.S. Treasuries is even more striking as the 10-year U.S. Treasury has moved from nearly 4.5 percent to a low of 3.64 percent before retreating to the approximate 3.68 percent level we have now. Credit spreads have widened over this period, but we see this as more a function of cross asset volatility than a sign of credit weakness being priced into the markets.
As we approach the final months of 2024, the economic data continues to deteriorate and investors’ expectations of economic slowdown have given rise to increased market volatility, and investors are now aggressively pricing in rate cuts. From a markets perspective, at least one rate cut is priced into each of the three remaining FOMC meetings in 2024 – which is more monetary accommodation than the FOMC members are forecasting. The key takeaway remains, after the pause in rate hikes, the next expected move is towards lower interest rates. Historically, rate reductions have led to better performance in the fixed income allocations of diversified portfolios.
Last fiscal year ending June, investors endured volatile yields, spreads, and currencies, fueled by uncertainty around the economic and geopolitical backdrop. From a sector perspective, investors were rewarded for taking corporate credit risk as investment grade bonds, high yield bonds and broadly syndicated loans all generated positive total and excess returns in an uncertain environment. Generating the best outcome was floating rate debt, which benefited from the Fed’s tightening cycle. Aside from these sectors, U.S. Treasuries and securitized debt also produced positive outcomes for investors, albeit it not to the extent corporate credit did. While the dollar appreciated relative to non-U.S. currencies, relative strength and weakness during the timeframe was driven in-part by changes to Fed rate cut expectations. Finally, Private Credit was a key part of the financial landscape during the fiscal year and given the effect of regulatory efforts impacting the banking system in North America and Europe, we believe it will remain so for some time to come. While much of the capital entering the space in North America chose to focus on the larger borrower, driving spreads much tighter in that segment of the market, there remain many opportunities for investors to take advantage of wider spreads, tighter covenants, and lower leverage by lending to small to mid-size borrowers in our view, as well as tilting away from corporate borrowers and into asset-based finance and other opportunistic strategies.
As we look forward, corporate credit defaults have remained well-behaved, but the longer the Fed Funds rate remains high, the more stress borrowers will be under due to elevated interest expense. Given this backdrop, we don’t find credit spreads overly compelling, it’s a bond pickers environment, and we remain watchful for both risk and opportunity. With regards to interest rate volatility and duration exposure, core bonds remain attractive from a carry perspective and are primed to benefit from a move lower in interest rates, which will likely lead to capital appreciation. Whether the Fed stays higher for longer, or eases from here, there continues to be many levers to pull in fixed income portfolios to achieve an attractive risk-adjusted outcome for investors.
