April Fixed Income Insights: Understanding Market Dynamics

Hello everyone. Welcome to another episode of Understanding Edge, brought to you by Diamond Hill. I'm Jessica Schmitt, Director of Investment Communications, and today, I'm joined by Douglas Gimple, our firm's senior portfolio specialist for fixed income.

In today's episode, we'll discuss the Fed's recent meeting and the latest outlook on inflation and rates. We'll also discuss bond markets’ recent performance and risks and opportunities for investors going forward.

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 get started. Thank you for tuning in, and I hope you enjoy this conversation with Douglas Gimple.

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

Thanks, Jess, as always, for having me. It's a pleasure being here.

Well, great. We're going to talk about all things fixed income markets today, but let's start off as we usually do with the recent FOMC meeting, which was held last week. It seemed to be a rather benign event, and Fed Chairman Jerome Powell reiterated the Fed's consistent messaging, whether you prefer the phrase “wait and see” or “dated dependent” or “higher for longer.” But what were the main takeaways from that meeting, Doug?

The main takeaway from this meeting was, as you mentioned, higher for longer. To no one's surprise, the Fed kept rates unchanged, citing strength in the labor market and the stubbornness of inflation, which we all knew was coming.

The only thing that was different from prior meetings was the announcement that the Fed would begin to slow the reduction of Treasury holdings starting this process in June. So, what exactly does this entail? The Fed has set a monthly redemption cap of $60 billion for Treasury securities, which means that anything greater than $60 billion in maturities during a month will be reinvested back into the Treasury market and put on their balance sheet. That redemption cap has now been reduced to $25 billion, meaning that only $25 billion at most will roll off the balance sheet monthly starting in June. So, while the cap for Treasuries has been reduced, the cap for agency debt and agency mortgage-backed securities remains unchanged at $35 billion. The reason being is that the mortgage reduction has been agonizingly slow when you compare it to Treasuries.

Treasury levels on the Fed's balance sheet have decreased from $5.7 trillion in June of 2022, when the most recent version of quantitative tightening began to a reported level of $4.4 trillion in early May of this year. Over the same time period, mortgage levels have only decreased from $2.7 trillion to $2.4 trillion as most of the mortgages held by the Fed carry very low interest rates and holders really have no incentive to prepay those mortgages in the current rate environment.

So the meeting ended with a fairly dovish tone as Powell reiterated his expectations for higher rates for longer, but refused to put rate hikes back on the table, which was, I think most interesting because as we got closer to that meeting, there were some grumblings that maybe a rate hike is in the future because inflation is stubborn and the jobs market is doing so well. But he clearly came out and said, we're just not putting rate hikes back on the table just yet.

That was probably a welcome message for the market, but of course, as we know, two days later, Doug, the jobs report was released showing a slowdown in job growth, bucking the trend from the past several months. So, what impact did that have on market expectations and potentially future Fed actions?

It was a pretty interesting response. So, heading into the second day of the FOMC meeting, when the Fed makes their announcement and has the press conference, Fed fund futures were pricing in roughly 28 basis points of cuts by year-end. Once the market digested the official announcement of no change, as well as Powell's press conference, expectations shifted to roughly 35 basis points in rate cuts by year-end — slightly more dovish.

We moved forward to that Friday, and as you mentioned, the non-farm payroll release and the futures market moved to nearly 45 basis points in rate cuts by year-end as the report was lower than expected. Specifically, the economy added 175,000 jobs, which compared to the expected level of 240,000 jobs and the prior month’s 303,000 jobs.

But looking at it, was it really all that bad? April's job report brought the total number of jobs created since the start of the year to 1.1 million, which is only slightly behind the 2023 number of 1.3 million and well ahead of the average from 2001 to 2019, which is 379,000 over the first four months of the year. The unemployment number climbed from 3.8 to 3.9%, which I guess could be construed as somewhat bad news but considering that the average level of unemployment since the turn of the century is 5.7%, we're still in pretty good shape.

The lower-than-expected non-farm payroll print pushed expectations a little more dovish than the day before, but not by much. The shift from 35 basis points in cuts to 45 basis points isn't monumental, and I believe it's indicative of the type of moves that we're going to see in the coming months as different economic news comes to light.

Okay, well, time will tell. Let's move over now, Doug, to recent performance within fixed income markets, which you're covering in your monthly commentary, which will be available on our website.

So, in April, the Bloomberg Barclays US Aggregate Bond Index declined roughly -2.5% in the month of April, which brought year-to-date returns to roughly -3.3%. Can you provide some insights into performance so far this year and maybe highlight any particular sectors that have shown notable strength or weakness?

So, we thought the year started off rough with the first quarter return for the index down 78 basis points as the market adjusted expectations for the future path of rates to bring itself in line with the Federal Reserve. But as you mentioned, the loss in April was significant, dwarfing the pain in the first quarter with the worst monthly returns since September 2023’s drop of -2.54% ranking this past April as the ninth worst since the turn of the century.

The year-to-date performance that you referenced, a loss of -3.3%, represents the largest loss during the first four months of the year since 1994’s loss of -3.64%, and I'm excluding the first four months of the historically poor 2022 when the index lost -9.5%.

But before we get too far into April, it's not all doom and gloom in fixed income. We're recording this episode on May 8th, and April's nasty performance has made way for May's positive performance at least so far. Through the first full week of May, the Bloomberg Aggregate Bond Index has generated a positive return of 1.6%, which helps to offset some of that pain that we felt during the first four months of the year.

But let's go back to the breakdown of April. Performance so far this year has been driven by rates as the continued push higher across the curve has hurt all areas of the market, even as spread levels across risk sectors remain compressed, especially from a historical standpoint. A notable example of the impact of rates via duration can be seen in the corporate sector. The Bloomberg US Corporate Bond Index can be broken down in various ways, but let's look at it from a credit quality standpoint. The highest quality segment of the corporate market, AAA, consists of two corporate names as well as a handful of foundations and higher education institutions. This segment has the longest duration of the corporate index at 10.24 years, meaning that the issuers have taken advantage of lower rates afforded to higher quality credit by issuing longer-dated securities. Makes sense.

Duration indicates a bond’s sensitivity to interest rate fluctuations, and the longer the duration, the more sensitive a bond will be to move higher or lower in rates. For example, in April, the AAA-rated segment lost 4.55% from a pricing standpoint, and that was offset by a return of 0.31% from coupons, resulting in a return of negative -4.24%. Again, for AAA-rated corporates. Compare this to the BBB-rated segment of the same sector — that carries a duration of 6.61 years — shorter duration, higher risk, so you're not going to be able to go out as long when you're financing. This group saw a loss from pricing of -2.82% that was offset by coupon return of 0.39% for a loss of -2.43%.

So, you look at the same information since the beginning of the year, it's going to be more of the same. Longer duration sectors have taken a significant hit, while shorter duration bonds, while down, have not been hit as hard.

Doug, you touched on the corporate market. Let's shift gears and talk about the securitized sectors. For new listeners, that's an area that our team here specializes in. So, these areas include asset-backed securities, or ABS, residential mortgage-backed securities, or RMBS, and commercial mortgage-backed securities, or CMBS. So Doug, how have these sectors performed recently and what have the key drivers been behind that performance?

The securitized sector felt the most pain during the month of April losing -2.91%, thanks mostly in part to interest rate-sensitive residential mortgage-backed securities. But that doesn't mean that all parts of the securitized market were that bad. There definitely was this bifurcation in performance within the securitized sector.

So, let's talk residential mortgages first. You can split that sector out from the rest, and the Bloomberg US MBS Index returned or lost -3.03% during the month, so the biggest loser. Unlike the corporate sector where we talked about quality and duration, here we're going to break it down by coupon. So the coupon that the pool of mortgages is paying on average. In April, the lower the coupon on the pool of mortgages, the worse the performance. Lower coupon mortgages have a longer duration, therefore felt the most pain from rising rates. Think about it this way: if I'm invested in a pool of mortgages with an average coupon of 2.5% and rates climb substantially, the 2.5% coupon that I'm earning becomes less and less attractive and thus cheaper when compared to the current level of interest rates. Meaning I could go buy a new issue mortgage with an average coupon of, let's say, 6.5% or 7%. Why buy or own a 2.5% coupon when I can go out and get those higher coupons in the current market unless I'm getting that lower coupon at a substantial discount? The more rates climb, the less attractive and cheaper the lower coupon bond becomes. And then you add in the fact that the underlying mortgage holders are less and less incentivized to refinance or pay off their mortgage. If rates are climbing and you've got duration, that's going to extend because the life of that mortgage is going to get longer and longer because people just aren't going to refinance that 2.5% mortgage anytime soon. So it's kind of a double whammy. You've got surging rates erode the value in the security because of the longer duration, while that increase in rates results in even longer duration for the same security.

Specific for how we think about our mortgage allocation, this is one of the reasons that we favor collateralized mortgage obligations or CMOs over plain vanilla pass-through mortgages, as CMOs can provide better cashflow structure and some protection against rate volatility that I was just talking about.

Asset backed securities. They tend to have lower duration, so that definitely helped during the month. The Bloomberg ABS Index was down just -0.62%, which isn't great, but is much better than most of the fixed income universe. As investors continue to show interest in high quality, shorter duration securities.

Within ABS, credit card ABS were positive, delivering 0.1% during the month, while auto ABS lost just a mere 20 basis points or 0.2%. Other esoteric parts of the market held up very well, supported by interest in higher-yielding issuance. Even new instruments, and this is really interesting. We had two new issues come out. We did not participate in them, but they were securitized. One was securitized by the revenue tied to IP addresses, so internet addresses and the other was securitized by a combination of fine art, wine, spirits, and fine jewelry — both of which were met with open arms and significant interest during the month.

And lastly, non-agency commercial mortgage-backed securities, or as you mentioned, Jess, CMBS were the lone bright spot during the first quarter, delivering nearly 2% as the prospect for lower rates fueled the sector, but the positive performance couldn't last, and the sector was down in April, but to a much lesser degree than other segments losing around -1.7% during the month.

The CMBS market is split into three variations: conduits, CRE CLO (commercial real estate collateralized loan obligation and single asset, single borrower (or SASB) with only conduit deals eligible for inclusion in the broader indices. Non-index-eligible CMBS performed much better than their index-eligible counterparts thanks to higher yields associated with these parts of the market.

Let me just ask a follow-up question, Doug, related to CMBS. Given the evolving landscape of commercial real estate and the current environment, how is the CMBS market adapting? Are there any trends or risks investors should be monitoring?

Just as the prospect of lower rates helped in the first quarter, the possibility of Powell's higher-for-longer scenario reversed some of that impact. Higher rates, tighter financial conditions have both caused refinancing success rates to fall sharply, with office loans the major driver of the low refinanced success rate, which makes sense because this new work-from-home hybrid model that we're all operating under, for the most part, means that you've got less people in offices, which we all know. More than 10% of office loans are 60-plus days delinquent or special servicing, with the majority of those being older buildings. If refinancing rates remain low, deals will now have outsized exposure to the loan modification process. And if the loan mods are not successful, loans will either default with the loss or could be extended once again, pushing maturities out by up to four years or more.

Staying on the topic of office space rating agency, KBRA (or Kroll) estimated that total distressed office space in conduit and single asset, single borrower rose to a combined $52 billion in March of this year, almost twice the amount from the same time last year. Chicago holds the highest distress rate at 75%, followed by major cities like Denver at 65%, Houston at 57%, Philly at 52% and Atlanta at 49%. This information and what we're learning just helps to reiterate the importance of due diligence and understanding what you own within all areas of the market, but specifically within the CMBS landscape and, more importantly, within the office market.

Thanks for that perspective, Doug. That's all we have for today's episode of Understanding Edge. But before we go, I'll mention a few upcoming events.

On May 22 at 2:00 PM Eastern Time, Doug will join a panel of other leading industry experts, including Kevin Flanagan of Wisdom Tree and Scott Barnard of Westwood Holdings Group, and they'll be doing a live webinar in which they'll share their expertise and practical strategies for success in fixed income investing. So, check out our website for registration details — those are live now.

And, of course, Doug and I will be back on the podcast mics in June. And then in July, Doug and I will bring a live episode of Understanding Edge to our audience, so stay tuned for those upcoming events as we continue to follow fixed income markets throughout the year. Doug, thank you again for joining us. It's always a pleasure to have you.

Of course, my pleasure. As always.

Great. For more insights and a full download of Doug's latest market commentary on fixed income markets, visit our website at www.diamond-hill.com. Until next time, take care.