A Look Back on Fixed Income Markets in 2021
As the year winds down, revisiting the path we’ve been on might help us understand where we’re headed. First, let’s block out the noise–infrastructure bill, debt ceiling, COVID–and focus on fixed income markets. The first 10 months of 2021 delivered some of the most interesting changes in recent history, including a rising rate environment (Q1), a falling rate environment (Q2), a stagnant rate environment (Q3) and a historic jump on the shorter end of the curve (October).
Q1 2021 – Rising Rate Environment
Fueled by a euphoric mix of accelerated vaccine distribution, expectations for an end to quarantines, two stimulus packages and a re-opening of the national economy, markets began to rotate in anticipation of a juggernaut economy.
With those expectations came a meteoric increase in longer-term interest rates, as the 10-year Treasury increased 83 basis points (bps), beginning the quarter at 0.91% and finishing at 1.74% in March. From a historic standpoint, the absolute shift in yield for the 10-year Treasury ties as the ninth largest quarterly move higher since 1981. On a percentage move basis, the 90.2% increase in yield is the largest move on record, well ahead of the second highest percentage move of 53.3% in the final quarter of 2016.
Exhibit 1 – 10-Year Treasury Yield
Source: Bloomberg. As of June 30, 2021.
It should be noted that there were some extraneous impacts on the Treasury market in Q1–Japan and Korea sold longer dated U.S. Treasuries in preparation for their new fiscal year, a poorly received 7-year Treasury auction, duration hedging (climbing interest rates resulting in mortgage duration extension, forcing investors to sell long dated Treasuries to maintain overall portfolio duration) and the expiration of the Supplemental Leverage Ratio.
The impact of this historic move higher in interest rates was felt across fixed income markets, as longer duration assets felt the brunt of the impact. Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates–the longer the duration of a bond, the more sensitive that bond is to interest rate movements.
The Bloomberg U.S. Treasury Index lost 4.25% in Q1, which was the worst quarterly performance in over 40 years, and the Bloomberg U.S. Corporate Bond Index was down 4.65%, the index’s worst quarterly performance since the third quarter of 2008.
The silver lining to this calamitous quarter? The Bloomberg U.S. Securitized Index lost 118 bps, which is nothing to be excited about except when you consider its performance relative to the remainder of the investment grade fixed income universe. It is important to note that the Securitized index is very limited as to its inclusion rules, omitting nearly 95% of the asset backed securities (ABS) market and a significant portion of the residential mortgage-backed securities (RMBS) market.
Q2 2021 – Falling Rate Environment
The 10-year Treasury spent the early part of Q2 bouncing between 1.50% and 1.70% before hitting a low of 1.43% in June and ending the quarter at 1.47%. Unlike the volatility in Q1, the theme of the second quarter was stabilization.
- Stabilization in the Treasury market–following a near doubling in Q1 (0.91% to 1.74%), the 10-year Treasury yield clawed back 27 bps of yield to finish the quarter at 1.47%.
- Stabilization in the investment grade corporate bond market–a near-historic collapse in Q1 performance illustrated the risks of longer duration exposure.
- Stabilization in expectations from the Federal Reserve–who continued to beat the “transitory” and “substantial further progress” drums, albeit with a bit of a hawkish tilt in the dot plot as published by the FOMC.
Q2 saw a slight recovery in both the Treasury market (1.75%) and the investment grade corporate market (3.55%) but neither were enough to offset the damage wrought in Q1. The securitized sector also delivered positive performance (0.44%), though a bit lower than its sector brethren due to lower yield and shorter duration relative to Treasuries and investment grade corporates.
Q3 2021 – Stagnant Rate Environment
Throughout the quarter, there wasn’t much movement in the 10-year Treasury yield, a slight increase from 1.47% to 1.49%. But that illusion of calm belies the rollercoaster experienced by the bellwether security as it bottomed out at 1.17% in early August before climbing through the final two months to recover all that had been lost from a yield standpoint. The end result? A rather benign quarter that saw the Bloomberg U.S. Aggregate Index return 0.05%.
That said, we did get a Federal Reserve trading scandal, name calling from a prominent U.S. Senator, and some serious talk about tapering, which paved the way for the official announcement in early November. Not to mention lots of talk about the debt ceiling with nothing accomplished except kicking the can down the road to December.
October – Historic Jump on Short End of the Curve
The jump in the 2-year Treasury, a yield that has been mired below 20 bps since the pandemic began, was the story in October. From January through the end of September, the yield on the 2-year Treasury averaged 17.3 bps, held down by the prospect of a long-term hold on interest rates by the Fed. With the publication of the dot plot in September, expectations began to grow for a move by the Fed sooner than the end of 2022.
Why did the 2-year Treasury react in such a way? The market shifted from a possible rate hike by late 2022 to pricing in a nearly 40% chance that the Fed increases the Fed Funds rate in June 2022. Continued strength in the economy, despite supply chain issues and the fading threat of the Delta variant, shifted expectations although the Fed still has not provided clarity as to its expectations for interest rate management. The taper feels like a forgone conclusion by year end, the only real question is whether it starts in November or December.
The views expressed are those of the author as of November 2021 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.
The Bloomberg U.S. Treasury Index is an unmanaged index representing U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. The Bloomberg U.S. Aggregate Index is an unmanaged index representing the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through, and asset-backed securities. The Bloomberg U.S. Corporate Bond Index is an unmanaged index representing the investment grade fixed rate taxable corporate bond market including USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers. The Bloomberg U.S. Securitized Index is an unmanaged index representing the holdings from the securitized sector of the Bloomberg U.S. Aggregate Index. Index data source: Bloomberg Index Services Limited. See diamond-hill.com/disclosures for a full copy of the disclaimer.