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It Ain't Over Until It's Over: A Look at the Fixed Income Markets in 2024

Douglas Gimple

Senior Portfolio Specialist Douglas Gimple shares his insights on the fixed income markets. Tune in to hear about the latest from the Fed, market expectations CMBS, and more. (26 min podcast)

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Jessica Schmitt (0:04)


Hello everyone. I'm your host, Jessica Schmitt, Director of Investment Communications here at Diamond Hill, and welcome to another exciting episode of Understanding Edge. Today we're joined by Douglas Gimple, Senior Portfolio Specialist for our fixed income team here at Diamond Hill.

In today's episode, we're going to discuss the Fed’s latest comments on inflation and rates, we’ll also discuss the CMBS market, corporate bond market and potential opportunities investors might be finding out there.

Whether you're a regular listener or tuning in for the first time, we hope this episode offers valuable insights for you. So, sit back, grab a cup of coffee or tea, and let's dive right in. Thanks for joining us, and we hope you enjoy this conversation with Douglas Gimple.

Jessica Schmitt (0:53)

Hey Doug, great to have you back on the podcast.

Doug Gimple (0:57)

Thank you, Jess. I am excited to be here as always.

Jessica Schmitt (1:00)

Well, great. We're going to review the latest Fed comments and talk about some different areas of fixed income. Diving right in, the FOMC meeting was held earlier this week. Chairman Powell spoke yesterday, and the Fed decided to hold interest rates steady, reiterating the data dependent stance that it has taken for some time now. And they discussed what it would take to commence rate cuts still later this year. Share with us some of the main takeaways from that meeting.

Doug Gimple (1:34)

Yeah, it was pretty much a non-event, really. I mean, as we've discussed a couple of times, the Fed’s held the line on their outlook in order to get the market in line with their expectations, and they've succeeded. And we'll talk about that a little bit more. But they've made it clear that they're not yet ready to embark on an easing cycle. And Wednesday, yesterday's announcement, was just more of the same. I mean literally the verbiage, I think they changed one word from the previous meeting. So, I mean, it really was a non-event. So, there was no reduction in the fed funds rate, which we weren't really expecting. That had become kind of a foregone conclusion over the preceding weeks. The only news from the meeting was the release of the new dot plot, which again communicates each federal official's projection for the fed funds rate. And there wasn't a change there, at least for 2024.

So, despite the stronger pricing pressures that we've seen the first couple of months in 2024 compared to the cooler reports that we saw in late 2023, the Fed continues to project those three 25-basis point rate cuts by the end of this year. That stronger inflation data did, though, result in a reduction of the number of rate cuts in 2025. They went from four to three based on looking at median projection. In 2026, it was reduced from three to two. So this means that slightly higher rates are expected beyond 2024. So again, no change in 2024 is expectations, but a little bit of a drop in ‘25 and ’26, and even the long-run expectations, which is looking beyond 2026, inched higher only by six basis points or so. But again, it's that message that we're going to be here for a while, and yes, we're expecting some come down before the end of the year, but going forward, it won't be maybe as much as people expected.

They did discuss the balance sheet. Their plans remain unchanged to reduce the balance sheet by as much as, because it hasn't really been that much at any point, $95 billion per month through Treasuries and mortgages rolling off, though Powell did state that it would be appropriate to slow the pace of asset runoff fairly soon in his press conference following the meeting, which is a little bit more than what he had been giving in prior press conferences. So, it feels like we're getting a little bit closer there.

With the three expected rate cuts in 2024 and six meetings remaining, we're getting to that point where we're going to hit that first step of the next rate cycle. The market is expecting the Fed to stand firm at the next meeting, which is May 1st, and then implement the first cut at the June 12th meeting, but we're not going to know until we get there.

And then lastly, along with the dot plot, the quarterly statement of economic projections, or SEP, provides a Fed outlook for other parts of the economy, and the newly released SEP projected an increase in 2024 GDP to 2.1% from December's projection of 1.4%. So that's good news and decreased their projection for the unemployment level from 4.1% to 4.0%. But unlike what we saw with rates, projections for ‘25 and ‘26 really didn't change that much, and the longer-term expectation held steady at 1.8%.

Jessica Schmitt (5:00)

And Doug, one of the things you and I have talked about in several of these podcasts and that you've written about in your commentaries is the disconnect between the Fed and what they're saying and what the market is thinking that the Fed will do. And that can be one of the bigger drivers of volatility — that disconnect between Fed rate projections and market expectations. So, can you walk us through now how market expectations have shifted to get more in line with the Fed stance over the past, call it, three, four, or five weeks?

Doug Gimple (5:35)

Jess, it's been a painful reconciliation, but it looks like the market is finally in line with the Fed. The market's expectations for the future have shifted and the readjustment of those expectations led to this rather challenging February and really beginning of this year in the fixed income markets.

So, let's look back. At the start of the year, fed fund futures — which is really that market expectation for Fed action — were pricing in a 25-basis point rate cut in March, two 25-basis point cuts in June, and six total cuts by year-end. And again, that's right at the beginning of this year. Ongoing commentary from the Fed on what they expect for rates, and remember they're in control, as well as stronger economic data — that all finally sunk in. And the market has shifted expectations for the future to reflect the Fed's plan. So, by month-end February, and actually I looked earlier today, and this is still in line: expectations via the futures market were for zero rate cuts in March, obviously, and May and slightly more than three by year-end, which is right in line with what the Fed is saying.

So, while the Fed does not provide insight into the timing of the cuts, remember they're just saying by the end of the year, we're going to be 75 basis points lower than where we are right now. The market is kind of using a measured approach and saying in June, September and December, we're going to see 25 basis point cuts. Is there any reasoning behind that? Probably not. It's just at the end of a quarter that seems the best time to do it. There's some flexibility within the futures in how they're pricing those last two, but it does feel like June is the first one. But I would also follow that up by saying that we have no idea. And yes, a lot of the market's in line with that, but we've got inflation reports, we've got employment reports that are going to come out that'll give us a better understanding of where we stand, where we stand currently, and that'll give us a little more indication of what the Fed is thinking.

Jessica Schmitt (7:36)

Okay. Well, let's pivot now to your latest market commentary titled “Déjà Vu All Over Again?” which was inspired by the late Yogi Berra. In your commentary, you drew some parallels between the performance in fixed income markets thus far in 2024 and what we saw in a couple of the challenging years of late 2021 and 2022. Can you expand on those parallels for us and why 2024 feels a bit like déjà vu?

Doug Gimple (8:09)

So, springtime for me means baseball. So, as I was putting the finishing touches on this most recent commentary, I was also finalizing a spring break trip out to Scottsdale for the family. Part of that trip was to see my parents. Part of the trip was to see my baseball team, the Cleveland Guardians, take on the Los Angeles Dodgers and the Chicago Cubs over a couple of days. Mixed results — they beat the Dodgers, they lost to the Cubs in pretty humiliating fashion, but a good time, nonetheless. So definitely had baseball on the mind. I was looking at performance for the fixed income universe over the first two months of 2024, and it felt very similar to what we had experienced in the first few months of ‘21 and ‘22. Thus, the title Déjà Vu All Over Again popped into my head, and once I started down that path, it just felt right to bring some baseball into the discussion.

And who better to reference than one of the all-time greats, Yogi Berra. He's known for his ability on the baseball field but also for his quotes, which are pretty funny. I recommend looking any and all of them up, and we'll mention a couple of them, I'm sure, at some point. But back to the markets, recall that ‘21 and ‘22 delivered the first-ever back-to-back negative years for the Bloomberg US Aggregate Bond Index. That had never occurred since the index’s inception, and before 2021, the index had only printed a negative number in 1994, 1999 and 2013. And the challenging performance of those years began with losses over the first two months within the fixed income markets — 2021 was down -2.15%, 2022 was down -3.25%, so big numbers. But when you look at the loss we've seen through the first two months of this year, down -1.68%, while not fun, it's still kind of in that same territory of negativity.

The trajectory of the returns is similar, but the composition of the underlying sector returns is a bit different this time. In ‘21 and ‘22, the investment grade corporate market was the worst performing sector, losing nearly -3% and -5.3%, respectively, in those years, while Treasury and securitized mitigated some of the damage, though both were still negative. 2024 is a bit of a different story, with residential mortgages delivering the worst performance for the first two months of the year as rates pushed higher and interest rate-sensitive passthrough mortgages felt that pain. Credit and Treasury were both negative but were well ahead of residential mortgages. So, it's similar overall performance, but how we've come to that performance is a little bit different.

Jessica Schmitt (11:04)

And Doug, despite the rough start that we've had here in 2024, you noted reasons to believe that possibly this year could avoid a similar fate to ‘21 and ‘22. What are some of those key differentiating factors that have markets better positioned today than two to three years ago?

Doug Gimple (11:24)

I'll stick with the baseball theme, and I think Yogi's quote in 1973 when he was the manager of the New York Mets fits perfectly with the potential for recovery from this rough start. So, the Mets trailed the Chicago Cubs by 9.5 games in July with minimal expectations for the rest of the season. And when he was asked about the team's prospects for the postseason, Yogi allegedly delivered one of his most famous quotes, “It ain't over till it's over.” Now I say allegedly because the more I researched this quote, I learned that there's actually no proof that he said these exact words, but he said something similar that eventually became “It ain't over till it's over.”

Anyway, that's how investors should be thinking about the fixed income markets in 2024. Sure, we've had a rough start to the year, but if the Mets can rally to win the National League East title and earn a spot in the World Series that year, who is to say that fixed income markets can't rebound from here?

For example, look no further than last year. The fixed income markets were down nearly -3% through October before staging a furious rally in the last two months to finish the year up more than 5.5%. The markets, as we've discussed, appear to finally be on board with the Fed's data-dependent approach to interest rates, reinforced by the most recent dot plot, which we've already talked about. There has been significant volatility in the rates markets over the last, call it, 12 to 18 months, but there does seem to be some stabilization as market and Fed expectations have aligned.

The MOVE Index measures US bond market volatility by tracking US interest rate swaps across the yield curve and provides insight into relative volatility in the fixed income markets. While there have been some of those short periods of volatility that I mentioned in the past six months or so, we've seen some stabilization. We have to consider the overall market is in a much better place than it was coming into ‘21 or ‘22. The shift higher across the longer end of the curve over the past several months has settled a bit, and higher yields offer a nice buffer to the potential impacts of further rate fluctuation.

It's been a challenging start to the year, and investors have seen negative numbers in the fixed income column through February and wonder, are we back to challenging times for fixed income again already? And recall that the 10-year Treasury began 2022 at 1.51% and finished the year at 3.88%, a historic run higher in rates. Bond math dictates that if a portfolio has duration (or sensitivity to interest rate fluctuations), rising rates will hurt as bond prices move inversely with interest rates. The impact is exacerbated when a portfolio is earning historically low yield when those rates are climbing, limiting a portfolio's ability to generate enough income to offset principal losses.

As dangerous as it may be to say, this time does feel different. The yield to worst for the Bloomberg US Aggregate Bond Index started this year at 4.53%, which compares favorably to the 1.12% yield to worst to start 2021 and the 1.75% yield to worst to start 2022. So, we can't predict the future. No one can, but fixed income markets are better positioned to weather additional rate and spread volatility today than three years ago or than they've been in a very, very long time.

Jessica Schmitt (15:03)

Well, that is definitely good news for fixed income investors. Let's dive into some of the sub-sectors within fixed income markets, Doug. The corporate bond issuance has been extremely robust here year to date in 2024, but spreads have remained relatively range bound. So, what's driving the heavy issuance, and where is the demand coming from to absorb it?

Doug Gimple (15:33)

That's been really interesting this year. And as we talked about earlier, the corporate market dominated performance in the final two months of 2023, with the Bloomberg US Corporate Bond Index returning more than 10.5% as spread levels rallied from nearly 130 basis points to just under 100 basis points. So, it's a pretty sizable move. Despite the strong rally and spreads and strong performance to finish the year, the corporate market has stumbled from a performance standpoint, though spreads remain compressed, as you mentioned, indicating the impact of interest rate moves on the sector.

What's most fascinating is that spreads have barely moved despite the significant amount of issuance that has come to the market, indicating the market is ravenous for corporate debt. February's issuance of $196 billion represents the fifth largest issuance on record and an increase of 77% compared to the prior four-year average. And looking at that average, we take out 2020 because of what was going on and the issuance that we saw there.

Some additional up-to-date issuance — interesting facts for you — we're recording this call the day after the Fed's March 20th meeting, as we've said, and through yesterday, year-to-date investment grade corporate issuance is $509.9 billion, which makes the first quarter of 2024, which technically isn't over yet, the largest first quarter in the history of the investment grade market, but it's also the second largest issuance of any quarter in the market's history, trailing only the second quarter of 2020.

So, let's look at the action the day before the Fed meeting. This is the Tuesday of that week, nine borrowers came to the market on the 19th with $18.2 billion in supply — that makes it the largest pre-Fed Tuesday issuance since the pandemic, and despite over $18 billion in supply, interest in the bonds was more than five times oversubscribed, on average.

Only three of the 22 tranches issued were less than three times oversubscribed, with the expectation for an empty session on Wednesday, which is what we saw; any supply on Thursday will make this week the seventh consecutive week that exceeds market expectations for issuance. And investors have needed to put money to work with roughly $15 billion in net new flows into investment grade corporate mutual funds since the beginning of the year through February. That doesn't even mention the uptick in investing in general aggregate strategies as well.

So, a lot of issuance coming to the market but more than enough appetite as investors are getting back into the market and spending some of that cash. And you see that in that oversubscription and the fact that there's been all of this issuance, and the market really hasn't skipped a beat, and spreads remain very compressed.

Jessica Schmitt (18:41)

We're going to pivot now, Doug, into the commercial mortgage-backed securities market, or CMBS as we call it. But before we do, I do want to mention that you will be hosting a live podcast on April 30th at 2:00 PM Eastern Time with Wenting He. She's one of our fixed income analysts. And the two of you will be doing a deeper dive on CMBS, the market there. And so, for our listeners, if this is an area of interest, keep your eyes out for registration details, which will be available on our homepage at probably in the next week or so.

On that note, Doug, your commentary highlighted the outperformance of non-agency CMBS as an underdog story. What's been driving the strength in that sector and perhaps more broadly in securitized products?

Doug Gimple (19:38)

So, what we've seen in that broader non-agency CMBS market is a reversal of what that market experienced in the final months of 2023. During the final months of last year, non-agency CMBS were hit really hard across the board as concerns around the viability of the commercial real estate market continued to dominate headlines. If you picked up the Journal or looked at Bloomberg, there was an article almost every day, every other day, about commercial real estate.

Unfortunately, or fortunately, if you're a value investor looking for undervalued securities, the damage was widespread regardless of the quality of the underlying assets or the structure of the deal. That meant that solid deals with both good collateral and historical performance felt some pain despite solid metrics, which provided for very good buying opportunities.

Office has become the focus for commercial real estate, but there's this bifurcation between truly challenging properties and properties that maintain near-full occupancy and solid performance. And what happened in those latter parts of last year was that even the strong properties with near-full occupancy and solid performance saw spread widening and pricing coming down because of what was happening in the overall market.

The start of this year has delivered the exact opposite scenario, with the rising tide of CMBS lifting all boats from triple-B and lower-rated pools to the highest quality. The entire sector has benefited from investors looking for bargains because of what happened at the end of last year and a solid reentry point after the challenges.

Outside of short-duration asset-backed securities (ABS), the non-agency CMBS market is measured by the Bloomberg Non-Agency Investment Grade CMBS Index, which has generated the best sector performance since the calendar turned over in 2024. So, outside of just CMBS, ABS shorter duration has held up pretty well. Residential mortgages, as I mentioned earlier in our conversation, they felt some pain. So, it's been a little bit of a mixed bag within securitized. But CMBS, to a certain degree, the pain that was felt in the last part of last year, which may have been undeserved for certain parts. You could also say that the rally that we've seen is probably undeserved for certain parts as well. So, it's being able to differentiate between the two and focus on that bottom-up, value-driven, understanding what you own approach to really make sure you're making good choices in the portfolio.

Jessica Schmitt (22:14)

Going back to the quote, Doug, “It ain't over until it's over,” how is the fixed income team here at Diamond Hill positioned looking ahead, given the volatility that we've seen, but with higher starting yields as somewhat of a buffer?

Doug Gimple (22:30)

Jess, as you know, we're not investing our portfolios in an effort to take advantage of a short-term dislocation in the market. We're looking to build portfolios that hopefully can manage superiors of both difficulty and stability, always focused on long-term performance. That being said, we view volatility as an opportunity to find mispriced securities in the market.

Talking heads on financial television shows will continue to opine on what they believe the Fed could or should do, and they may even position their portfolios to reflect those beliefs. But we'd rather listen directly to the Fed and follow what they say and do rather than try and come up with what we think should happen, knowing that we don't have any power over it.

For example, for our Core Bond strategy, which has managed to a duration target within plus or minus 10% of the benchmark duration, we've moved that relative duration closer to neutral because we do believe the Fed is nearing the end of this rate-tightening cycle. That doesn't mean we're completely neutral because we don't know, but we've gotten a lot closer relative to where we had been a year, two years, even three years ago.

No one knows what the future holds or how the market will shift due to external pressures such as geopolitical risk or financial risk. So, we'll continue to work on building high-quality portfolios that offer transparency to our clients. There's a lot coming up. We still have discord in Washington. It seems like we've gotten past government shutdowns, maybe by kicking the can down the road, but we still have to get down the road. We've got a presidential election in November that is already contentious, and all these other issues that can impact what happens in the fixed income markets. So, we'll keep a close eye on it and continue to look for opportunities as they present themselves.

Jessica Schmitt (24:25)

So, Doug, with all that in mind, any final thoughts or key takeaways that you'd want to leave listeners with as they think about potentially reviewing their fixed income allocations right now?

Doug Gimple (24:37)

We know that the beginning of 2024 has been challenging, and we could very likely see negative returns for the first quarter for core and other fixed income strategies. But we do believe that there's a light at the end of the tunnel. Back in 2022, I opined in one of our commentaries that the light at the end of the tunnel could be a train. And after the performance of that year, many hopefully would concur with that opinion. But as we discussed earlier, the overall fixed income markets are in a very different place than they were in back in 2022 or even 2021 whether you're looking at yields or spreads. Fixed income investments are generating yields we've not seen in a very long time, and that should help as we move beyond the first quarter.

The key for investors in any cycle is to focus on the long-term rather than short-term dislocations. The message for listeners is stay the course. Studies have proven that, over time, the driver of performance in a diversified portfolio is maintaining a commitment to allocations rather than shifting in an effort to catch the hot market.

So, if we think that the Fed is done, and we believe that the next step for them is down, a rally in rates reflecting that is going to be very beneficial to fixed income portfolios. We've been through ‘22, we've been through the hard parts of ‘23 and the good parts of ‘23. And yes, it's been a little bit painful and challenging these first, call it, two to three months of this year, but it feels like we're getting to that point where fixed income is going to deliver fixed income and as well either principal stability or principal appreciation. So, we think that fixed income is probably in the best position it's been in a very long time. So we're excited at the prospects. We know that there will be challenges. We know there's going to be volatility, but we believe the market's in a much better place than it's been in many years.

Jessica Schmitt (26:40)

Well, as always, Doug, I really appreciate your insights. Thanks again for joining us today.

Doug Gimple (26:46)

Of course, always my pleasure.

Jessica Schmitt (26:49)

We'll look forward to your quarterly commentary, which will be out in April, and we hope our listeners will join us for the live CMBS podcast on April 30th. And we will catch up with you, Doug, again in early May. So, I hope everyone listening enjoyed our conversation. We appreciate your interest and time, and we look forward to continuing to bring you the latest in fixed income markets. Thanks, Doug.

Doug Gimple (27:15)

You're welcome.

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 Corporate Index measures the performance of the US investment grade fixed-rate taxable corporate bond market. Bloomberg Non-Agency US CMBS Investment Grade Index measures the market of US Non-Agency conduit and fusion CMBS deals with a minimum current deal size of $300mn. The indexes are unmanaged, 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: Bloomberg Index Services Limited. See for a full copy of the disclaimer.

MOVE Index, or Merrill Lynch Option Volatility Estimate Index, measures interest rate volatility in the US Treasury market. It is calculated from options prices, which reflect the collective expectations of market participants about future volatility.

Yield to Worst is the lowest potential bond yield received without the issuer defaulting, it assumes the worst-case scenario, or earliest redemption possible under terms of the bond.

The views expressed are those of Diamond Hill as of March 2024 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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