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Reading Between the Spreads: Corporate Debt Dynamics in Shifting Markets

Douglas Gimple

In our latest podcast, we discussed Fed policy, corporate bonds, and our fixed income market outlook with Douglas Gimple. Listen as we break down market dynamics, risks and areas of opportunity. (27 min podcast)

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Jessica Schmitt (0:04)

Greetings. I'm Jessica Schmitt, Director of Investment Communications here at Diamond Hill and this is Understanding Edge. Today, I am joined on the podcast by Douglas Gimple, our senior portfolio specialist for our fixed income team here at Diamond Hill. We're going to talk about the latest comments from the Federal Reserve and specifically the impact the tightening environment has had on the corporate bond market. As always stay safe and stay healthy, and I hope you enjoy my conversation with Douglas Gimple.

Jessica Schmitt (0:35)

Hi Doug. Welcome back to the podcast.

Doug Gimple (0:38)

Hello. Thanks for having me once again.

Jessica Schmitt (0:40)

Of course. Well, it's been a couple months, and as usual, we have a variety of fixed income topics on the agenda today. But let's, of course, start out with some quick takeaways from this week's Fed meetings since Chairman Jerome Powell just spoke the last two days. And I think, Doug, the latest catchphrase that we seem to be hearing is “higher for longer”. So, maybe you could give us a quick recap of what was discussed at the meetings this week and what you thought were some of the more important takeaways, especially for fixed income investors.

Doug Gimple (1:14)

Yeah, I think you nailed it right there. Higher for longer is definitely what everyone is talking about. And we have this on the schedule and it's right after we're recording it the day after the meeting. And I know one of the headlines in the Wall Street Journal today was “Higher for Longer, Maybe Forever,” which I think is a bit much, but it just shows you how much that idea is permeating everywhere we look. So, to recap the meeting, the Fed held rates steady at five and a quarter to five and a half, still at 22-year highs, but they kept the door open for one more increase before the year is over. So that means either November or December — there's no meeting in October. I think the November meeting's around November 1, so right at the end of October. But there's still the possibility and they still feel there's a possibility that there's going to be another rate hike by the end of the year.

The dot plot was pretty interesting, and I always say the dot plot does not age well. Within two or three days, it's useless, but it did show a shift: the 25 basis points by the end of the year, which we were thinking was going to be there, but what was interesting was two fewer rate reductions in 2024 than what we saw in the June dot plot. So, in June, they were projecting 100 basis points of cuts by the end of 2024 with this dot plot, they cut that in half with only two rate cuts in all of 2024. So that's getting to that higher-for-longer mindset that people are starting to adapt to. They boosted the GDP forecast to 2.1% for 2023 from June's level of 1% and 2024 showing up to 1.5% from 1.1% back in June. But the key to all of this is data dependency and flexibility, and that's what they've been hammering home the last couple of meetings.

And that's what he was talking about in the press conference afterwards, which has now gotten redundant. There's not a lot of news there, but there are things out there that are going to maybe change the script a little bit and we'll talk about those a little later on. But one of those is the fact that oil prices continue to rise, but as I said, we'll get to that a little bit later on. Their year-end unemployment expectations were in line with where we are right now, 3.8% and that's down from June's expectation of 4.1%. And then lastly, and I know we'll talk about this as well a little bit, they're continuing to reduce their balance sheet. So, no news there, really just continuing to do what they've been doing and letting it slowly roll off as time has gone on.

Jessica Schmitt (4:06)

And Doug, I know heading into this week's Fed meetings, bonds were at their highest yield levels since 2007, and we've talked about it a little bit, and of course a lot of people have talked about bonds are back, yields are back, but how might you think the next 6 to 12 months evolve for investors of fixed income markets based on some of the background you just gave us?

Doug Gimple (4:30)

Yeah, when I saw this question, I thought of a couple of different ways of talking about it, but let's look forward by looking back. Let's take a real quick look at where we've been this year. 2023 has been a mixed bag with regards to performance for fixed income markets. Nearly 3% return for the Agg, I'm sorry, the Bloomberg US Aggregate Bond Index. The first quarter was obviously a welcome respite from what we went through in 2022 when the index lost roughly 13%, but there was a lot of noise in that first quarter number. The index was negative for the first two months of the year. And the regional bank crisis inspired rally, really mid-March, pushed the market into strong positive territory. But the further we moved away from those challenging early days of that pretty short-lived crisis, the more the market stabilized and the more it reflected the expectations for the resumption of the Fed's tightening cycle, which never really stopped. They maybe slowed it down a little bit on the heels of what went on with the regional banks, but this resulted in a return for the second quarter that was down nearly 1%. So where do we stand right now?

So, through yesterday, which is September 20th, the index is barely above zero. So yesterday was 0.06% on a year-to-date basis. And so, we've experienced additional loss during the third quarter. Obviously the third quarter's not done yet, but the index is down almost 2% as rates continue to climb. And so, what can we expect through the end of the year and into 2024?

Well, I don't have a crystal ball, but if we believe that the Fed is in the final innings of their tightening cycle, that we could see another 25-basis point hike before year end, it's going to depend on incoming economic data. The fact that the Fed reduced the number of expected rate cuts next year leads me to believe that they don't think they're as close to achieving their goal as maybe they did just three months ago.

So, looking out beyond the coming months, it's difficult. Too many variables can impact the financial markets. And as portfolio manager, Mark Jackson likes to say, “There are a lot of things that can happen and one of them will.” So what are some of the things that can happen and are happening right now? You've got the continued upward trajectory of the cost of oil, the resumption of student loan payments, which we don't know how that's going to impact the economy moving forward, the ongoing war in Ukraine, simmering tensions with China and Taiwan, and the upcoming election in 2024. But here's one that's silently creeping up — and we've managed through government shutdowns in the past — but the possible upcoming shutdown adds another wrinkle for the Fed.

And I mention this because if the government shuts down, we'll see the closing of national parks, the suspension of passport processing and a freeze on government employee hiring, to name some of the historical impacts. But most important to this conversation, if the government shuts down, the Fed won't be receiving any data pertaining to unemployment or inflation, which as we know are the keys to their decision-making. So they could be trying to navigate the final stages of this tightening cycle in the dark.

But to your original question about what we think is going to happen the next six months…it’s anyone's guess. Do we see the fixed income markets finishing the year in negative territory? Probably not, and we say that because if we are closer to the end of this tightening cycle, and even if we've reached the end of the tightening cycle, then hopefully we won't see as much principal impact as we've seen so far this year with regards to interest rate sensitivity and rates moving higher.

So, I think if we can eke out a little bit of positive return by the end of the year, we're going to be well positioned. And by we, I mean the fixed income markets in general, well positioned going forward because we've got pretty attractive carry — the most attractive carry that we've had in many, many years. And so that should help to mitigate any further principal impacts. But yeah, I'm not sure if we should be really expecting those if we think that the Fed is going to cut even just 50 basis points next year, that should be beneficial to fixed income.

Jessica Schmitt (8:58)

Okay. And circling back, you had mentioned the ongoing reduction in the Fed's balance sheet and they continue to do that. So what implications does that activity have for fixed income investors?

Doug Gimple (9:12)

So being a fixed income nerd, one of the things that I look at each week, and it's available today, Thursday, it should be out around 4:30 pm. The New York Fed publishes the balance sheet where it is at the end of the week. So you can look at it week over week, which there aren't a lot of drastic changes week over week. But what you can see is that since they started this process of reducing their balance sheet, it's come down by over a trillion dollars or 12% of the starting balance back in June 2022 when they started this process. The lion's share of that reduction has come from the Treasury component, which is down roughly 14 and a quarter percent while mortgages have been reduced by less than 8%. The reason for the difference is that treasuries pay on a regular basis the 15th or 30th of the month, they pay down every six months.

So, it's going to continue. And with the difference with mortgages, and I think we've talked about this in the past, is that mortgage rates continue to climb. I think today they closed north of 7.20%. As that happens, you have slower prepayments, which means that people are not paying ahead of schedule on their mortgages, meaning they're not refinancing. Obviously, no one's refinancing right now, they're not upsizing, they're not necessarily relocating, or if they don't have to, they won't. So you have less money coming into these pools. So the payments are slowing down. Nothing wrong with the mortgages themselves, but the mortgages that the Fed holds — and keep in mind that the majority of the mortgages that the Fed holds (roughly 90%) are three and a half percent and lower coupons. So I don't want to sell my house if I've got a 3% mortgage because if I go buy a new house, I've got to pay 7%.

And so that's why you see inventory, there's not a lot out there for sale, people just aren't making those transitions. What that means to the balance sheet is you have less money coming into the mortgage component. And then alongside of that, you've got the process of the FDIC wrapping up, and pretty much have wrapped up, the liquidation of Signature Bank and Silicon Valley Bank. As those are being wrapped up, that changes the dynamics of the mortgage market as well, which we'll talk about in a little bit. But that's something that is out there as well, which keeps the mortgage market in flux. So that's one of the things along with the Fed balance sheet reduction that's impacting the overall markets.

Jessica Schmitt (11:56)

I'm going to shift into your latest commentary, Doug, that you wrote. Each month you write one, and they're all available on our website at And this month you wrote about the corporate market, and we haven't focused on that area of the market in a little bit of time — you've covered a bunch of the other areas. But we know treasury yields have risen substantially this year. And as you mentioned, mortgage rates have gone up, but corporate spreads have narrowed. And so help us understand why has the corporate market diverged from mortgages in terms of their spread reaction, and what does this indicate about how investors are thinking about risk?

Doug Gimple (12:42)

So, the goal of this past month's commentary was to examine that relationship, as you mentioned, between treasury yields, mortgages and corporate debt. And as you talked about, and we're all aware, Treasury yields have steadily climbed, outside of that short bout of volatility around the regional bank crisis. And mortgage rates have risen in near lock step, but what really stands out is what's happening in the corporate debt market. Specifically, I'm looking at the investment grade space. So, the evaluation of corporate debt takes into account the risk-free rate, which is the rate on comparable duration Treasury debt, as well as the amount of yield or spread needed to take on the risk associated with corporate debt, which can be specific to each industry, sub-sector and company.

In the commentary, I use the example of the Bloomberg US Corporate Bond Index during the financial crisis to illustrate how a change in the perception of risk impacts the spread earned over the risk-free rate. So, in the days leading up to the Lehman Brothers bankruptcy in mid-September 2008, the spread for the corporate index was roughly 320 to 330 basis points, or roughly 3.2% to 3.3% over comparable Treasuries. After the Lehman filing, spreads in the corporate market rocketed higher, peaking at 618 basis points in early December 2008 at a time when Treasury yields were actually coming down. So, exacerbating that spread, if you will, and the meaning of that spread.

If we look closer into the financial sector, which is where it all started, we can see just how dramatic the shift in risk premium was during this period. The spread for financials pushed above 500 basis points following the Lehman filing and eclipsed 800 basis points by mid-March 2009. To provide some comparison, the average from late-2002 to the day before the Lehman filing for the financial sector, the average spread was 119 basis points.

So, with that background, let's talk about where we currently stand in the corporate market. There's no doubt that corporate debt has become more expensive as companies have to pay up for credit as rates have risen over the past couple of years. That's kind of a no-brainer. But is the market demanding additional risk premium for this debt? Despite the ongoing concerns regarding the potential for an upcoming recession, whether it be shallow or deep, the more economically sensitive corporate market is now trading near its historic tight levels with regards to spread.

Since the regional banking crisis in March, corporate spreads, both investment grade and high yield, have been steadily dropping to the point where investment grade spreads are right around 117 basis points, which is well below the average level of 150 basis points since the turn of the century. So this can be translated that investors are comfortable with the future potential performance of the corporate market and that worries about the recession have abated, whether we believe it's a soft landing or not, or no landing, the corporate market is showing that there's less concern despite the fact that it's going to be much more expensive to refinance, the spread to take on the risk associated with those corporate names is actually lower than it's been throughout history.

Jessica Schmitt (16:16)

Doug, switching to another area of the market, I think we'd be remiss to not touch on commercial real estate because everybody is talking about commercial real estate. You hosted an internal discussion earlier this week here at Diamond Hill and shared what I thought were some interesting insights when you got a question from the group about how long you think it will take for the office space to “normalize.” Would you mind sharing those thoughts with us today because I thought they were pretty interesting?

Doug Gimple (16:46)

Yeah, of course. And it was a tough question during that internal discussion, and it's a tough question now. I don't know if we're ever going to see office space “normalize” after what we've experienced over the past several years. More and more companies are becoming very clear on their expectations for the future of office attendance, whether it's three days a week or four days a week. But think about that…the norm is now becoming three to four days a week in the office is fully acceptable.

We can look at Diamond Hill as an example. Jess, you're part of a group of Diamond Hill employees that work remotely, and we've found a way to make it work for everyone. At our headquarters in Columbus, we've gotten used to the flexibility that's emerged from the pandemic with people having the ability to work from home as needed while maintaining their productivity.

People are coming back, but it's just, it's at a slow pace and I don't believe we're ever going to get back to where we once were because we've created this environment where I've got somebody coming to fix my water heater or air conditioning, so I'm going to work from home so I can answer the door, get them in, get that taken care of, but I'm still going to get all my stuff done. But that does mean that my occupancy level at the office is going to be a little bit lower because of that flexibility.

Now, some measurements report that the top 10 city average for return to office is closing in on 50% of 2019 levels. So think of Chicago, San Francisco, New York, where you had huge migrations. But I think right now, normalize is not the right word and that maybe we should refer to it more as the evolution of the office environment because it's going to result in changes. Here in Columbus, there's a 25-story office building. It's now in the process of being converted into 253 individual apartments. It's the third such instance in recent months. So, it's to show, that again, the office is coming back slowly, but it's not going to resemble what it once was. We're just not going to need as much office space maybe as we had in the past.

Jessica Schmitt (18:55)

That's interesting, and I think it's something we'll continue to look at as we go forward, and I'm sure people will be interested in how that all does evolve, as you mentioned. So, getting back to your commentary, you highlighted that better relative value — from your perspective and from the perspective of the investment team here at Diamond Hill — can be found in securitized markets like CMBS (commercial mortgage-backed securities) and ABS (asset-backed securities), versus corporates. Going back to what we were talking about before, what specific dynamics are making those sectors attractive in the current environment?

Doug Gimple (19:27)

First and foremost, these sectors are offering strong spread levels relative to both comparable duration Treasuries and credit. And I've got an example that I can talk about, but as we discussed before, spread levels in the corporate market are extremely tight relative to history. While spread levels in the securitized market are much more attractive. We had a lot of spread widening in the securitized market broadly, so asset-backed securities, commercial mortgages, residential mortgages last year. And we've tightened in a bit, but we're still at very attractive levels. But the example that I used in the commentary was looking at the spread levels for the ICE BofA CMBS Fixed Rate AAA 7-10 Years Index compared to the ICE BofA Single-A Corporate Index. And they both have a duration or sensitivity to interest rate movements in the, we'll call it 6.6 to 6.9 year range.

So comparable durations, the higher quality CMBS index, remember AAA-rated has a spread level above 115 basis points while the single-A corporate index has a spread level near 100 basis points. So, you're getting higher quality CMBS, which has hard collateral, and you're getting 115 basis points compared to 100 basis points of option adjusted spread (OAS). So right there, that's the opportunity to get a little bit of value. And if an investor is considering a step down in quality in that same space, the BBB index of the CMBS 7-10 Year index has an OAS of nearly 850 basis points.

Now that reflects a lot of the angst that's gone on in the commercial real estate space. So, it's not to say go out and buy that because you're getting a ton of spread, but it is if you're willing to do the homework and you're bottom up, you can find those pockets of opportunity that maybe have been mispriced because everything associated with commercial real estate has been hit from a spread standpoint but it offers quite a bit of value.

And then some of the dynamics associated with the securitized sectors, that in our opinion make them more attractive for investment, are the very structures in which they're put together. Securitized products are built with an assortment of credit enhancements that help to protect investors in addition to the collateral associated with the deal. So how they're structured, whether it's a reserve account, which is a certain amount of money set aside to offset losses, or excess spread that's coming in every month, or the subordination or the overcollateralization, it's all of these things offer additional credit enhancements above and beyond what you'd see in the corporate market. So, for us, when we're making that relative value decision, we can get a bit more spread. The risk is comparable to maybe better, but you have to be willing to do the homework and really dig into the securities to find those opportunities.

Jessica Schmitt (22:45)

And Doug, I know you don't want to do a shameless promotion of your upcoming webinar, but it is on this very topic. So I will do the shameless promotion for you. For our listeners, Doug will be on a webinar with our partner VettaFi on October 3rd at 1:00 PM Eastern Time where he'll be talking about just this, the risks and benefits of securitized products. You can also get one credit for continuing education for attending that webinar, which is great. So, if you do go to the homepage on our website,, there will be a link to register for that.

So Doug, just wanted to take a moment to promote that for you before getting into our last question. But in light those interesting and beneficial characteristics of securitized products, how are you positioning the portfolios here at Diamond Hill to capitalize on those relative value opportunities in securitized areas versus corporate bonds or elsewhere?

Doug Gimple (23:44)

Yeah, I won't get into the specifics because I don't want to get in trouble with compliance, but broadly speaking, we've been increasing our allocation to the securitized sector now in our main strategies. That's traditionally been the case. The mix has shifted a little bit. We had been reducing our exposure to commercial mortgages, but again, as I said earlier, finding these pockets of opportunity because everything's been hit hard, you're finding these chances to add selectively other areas of the securitized market, again, relative to corporates. The residential mortgage market is probably the most attractive we've seen it since the financial crisis because you've had, as we talked about before, the Fed has been involved, it was buying mortgages and with what's going on with the FDIC, but it's the idea that we're getting pretty attractively structured cash flows. So, what I mean by that is we're not buying just straight pass-through mortgages, though that is a small part of it, but looking at things like collateralized mortgage obligations, which are pools of residential mortgages that are sliced and diced into certain types of cash flows.

And that's providing quite a bit of opportunity that we think will be very good in the long run. Asset-backed securities, there continues to be significant issuance. So there's definitely volume out there for us to go out and add. And I would say that just the last couple of weeks there's been significant issuance in the ABS market enough to bring year-to-date issuance in line with 2022 after having trailed by 10% to 15% since the beginning of the year. So, on pace right now to match what we saw last year. And even CMBS, which had been dead in the water with regards to issuance (very minimal) have started to emerge a little bit. So again, providing more opportunity, but it's that relative value. And in lieu of investing in corporates where you're not getting as much spread, we're going to continue to focus on securitized — that doesn't mean we're not buying on the corporate side, but we'll tend to be underweight credit because we feel there's better value and better opportunity in the securitized market.

Jessica Schmitt (26:18)

Well, that covers all my questions for you today, Doug. I appreciate you coming back on the podcast, and hopefully we can catch up with you in another month or so and see how things are evolving.

Doug Gimple (26:29)

My pleasure being here, and thank you so much for the shameless plug, so I don't have to shame myself and hope to hear or talk to everyone on October 3.

Jessica Schmitt (26:41)

Great. Thanks, Doug.

Bonds rated AAA, AA, A and BBB are considered investment grade.

Bloomberg US Aggregate Bond Index measures the performance of investment grade, fixed-rate taxable bond market and includes government and corporate bonds, agency mortgage-backed, asset-backed and commercial mortgage-backed securities (agency and non-agency). Bloomberg US CMBS AAA Index measures the market of US agency and US non-agency conduit and fusion CMBS deals rated AAA with a minimum current deal size of $300 million. Bloomberg US Corporate A-Rated Index measures the single-A rated, fixed-rate, taxable, corporate bond market. The indexes are unmanaged, market capitalization weighted, include net reinvested dividends, do not reflect fees or expenses (which would lower the return) and are not available for direct investment. Index data source: London Stock Exchange Group PLC. See for a full copy of the disclaimer.

The views expressed are those of Diamond Hill as of November 2023 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.

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