Colin Prescott (00:00):
Welcome to Understanding Edge, where we take a closer look at the trends and themes shaping today's fixed income markets. I'm your host today, Colin Prescott, Managing Director of Business Development here at Diamond Hill. Today I'm joined by Douglas Gimple, client portfolio manager and author of our monthly fixed income commentary. Looking forward to discussing what's been driving the markets as we head into the year, Doug, how are we doing?
Douglas Gimple (00:26):
We're doing well. I'll apologize if my voice is a little scratchy. I was yelling and cheering at my daughter's college graduation.
Colin Prescott (00:33):
Got it.
Douglas Gimple (00:34):
Busy weekend.
Colin Prescott (00:35):
Very fun. Let's get right into it. First, I wanted to talk about what's going on in the market. It's not a lot, right? No wars, nothing. But unlike usual, we had a bit of a surprise in that usually when we have a war or any sort of geopolitical crisis, investors expect a flight to quality. You buy treasuries, yields fall, risk assets come under pressure, but that's not exactly the story this time, right?
Douglas Gimple (00:59):
Yeah, that's right. And it's interesting. So I went back and I looked at kind of significant, we'll call it significant geopolitical events over the last several years all the way back to when the US invaded Grenada. And looked at the one month change in two year treasuries, 10 year treasuries, the yields, and then the one month return on the S&P 500. And what I found was that for the most part, you do have that kind of knee-jerk reaction, flight to quality, there's uncertainty, there's conflict. But what I also found is that a month on things kind of, I wouldn't say revert back to normal, but if it's a prolonged conflict, operation desert storm. A month later, the two year was 35 basis points tighter, the 10 year was 26 basis points tighter. But if it's shorter term, something like Russia's invasion of Georgia, the two year a month later was down by 12 basis points and the 10 year was down by 22 basis points, but something longer term.
So think Russia invades Ukraine and I'm not going for a theme here, but just looking at different events. One month after that, I think it was February invasion, I think it was 22 maybe, two year treasury was 69 basis points higher and the 10 year treasury was 51 basis points higher. So maybe it's more recent conflicts that we see that and we're seeing that now and we saw that the conflict started February 28th, I think is when we started. That was a Saturday so you didn't have market reaction, but the following week and subsequently since then we've seen yields back up on the treasury side. We initially saw spreads tighten in, or I'm sorry, widen out in the early days, but since then we're really back to where we started the year. And that's one of the things that I talk about in the commentary this month is how we've gone on this kind of mini rollercoaster ride where spreads were grinding tighter up until February, widened out in March into mid-March maybe, and then spent the rest of the time from March into April compressing again.
But the other side of that is that treasury yields have continued to climb and we're recording this on May 19th and today's another big day, another big move higher in treasury yields. So I think there's more to it than just conflict and geopolitical uncertainty.
Colin Prescott (03:35):
Any nuance to the short end of the curve? Is the short end pricing in this is more of like a temporary energy shock or perhaps something a little bit more persistent?
Douglas Gimple (03:47):
Yeah. I mean, there's so many things to talk about specifically with the shorter end, but I mean, we can talk about the whole curve, but really if we look at the two year treasury, it traded really in a range from the beginning of the year to the end of February. And it was a range of 3.38 as a low and a high of 3.61. But once everything kind of ramped up and the hostilities commenced, the treasury pushed higher ending April at about 3.87, which is 40 basis points higher than where it was at the end of 2025. And I think there's a couple things going on there, right? I mean, you've got what you mentioned with energy and prices going higher because of the Strait of Hormuz still closed, double blockade going on. The concern of that leaking into the rest of the economy is very real.
And we saw that with the most recent CPI number, which we expected to go higher, but until this is resolved, we're going to continue to see that. And you saw it on the longer end as well, but not as much. The 10 years up 20 basis points since the beginning of the year, the 30 years up 12 basis points since the beginning of the year. So it's very much front end loaded. And the other part of what's going on in the front end is we've got a new Fed chair. Kevin Warsh is going to step in. His first meeting will be June 17th and that's when we're going to find out if he's more of a Stephen Miran who said everything he needed to say during his confirmation hearing about independence and then immediately every meeting he was in, he wanted to cut 25 basis points, then 50 basis points and really holding the line from the White House of lower rates.
Kevin Warsh has done the same thing in that during his confirmation hearing he talked about and touted the independence of the Fed, but the rubber will hit the road when we have our meeting in June and we find out exactly what direction he wants to go in. And it's important to note that Miran is out. Powell is staying, which is the first time that that has happened in 80 years. And so that's another thing that we have to think about is that the Fed is changing and we have to see Warsh has only one vote, but he will have a lot of influence. And I would expect based on what he has said both recently and in the past, that we're going to get less communication from the Fed. I mean, if you look at the Fed calendar on a monthly basis, it's everyone speaking at these different events.
It sounds like he's going to try and dial that back a little bit and I know that there's been talk about the dot plot potentially going away, which I've always said that it's useful the moment it comes out and then immediately is irrelevant because the markets change and things shift. But yeah, so there's a lot going on, but I do think on the shorter end it's concerns about energy and it's concerned about prolonged inflation.
Colin Prescott (06:54):
No, that's helpful and certainly seems like treasuries have struggled, but credit markets largely absorbed a lot of this shock and investment grade and high yield spreads widened initially, but then came almost all the way back. Why do they remain so resilient despite this geopolitical backdrop that we're in?
Douglas Gimple (07:14):
It almost feels like the reverse of what you would normally expect with global conflict and energy embargoes and things of that nature and that you would expect people to run to treasuries, you would expect people to dump risk assets like we talked about in the beginning. It feels like right now the markets are saying we're more worried about sovereign debt and that goes beyond the US. I mean, we're talking Great Britain's their 10 year or their 30 year hit levels not seen since 2008. Japan's long term bond hit record level highs. Germany is experiencing the same thing. So it feels more like markets are moving away from perceived safe assets in search of yield. And so that's why we see credit markets, whether high yield or investment grade, experience that little bit of a hiccup and then immediately grind tighter back to where they started and it feels the opposite of what we should expect, right?
We should expect strain on corporates, we should expect strain in riskier parts of the market and really outside of private credit, which is a whole other animal, haven't seen that. We had that short term, but since the beginning of the year, as you pointed out, spreads are pretty much at the same level. And if you look at investment grade spreads, we're half of, well, maybe a little bit more than half of what the average has been over the last 25 years from a spread standpoint. So the yields are still attractive, but your spread of what you're getting over treasuries is amazingly compressed.
Colin Prescott (08:55):
Yeah, that's one thing that really stood out to me and should stand out to our advisors and our clients across the board just how tight those spreads are. I think I saw that investment grade spreads reach their lowest level in almost 30 years. And I really want to hear from you on this, is this strength justified by corporate fundamentals or are we as investors reaching for yield in the market?
Douglas Gimple (09:18):
I think it's a combination of both, right? I mean, you can't say that we've been pushing spreads so much lower and people aren't out trying to buy yield and that's the difference from what we saw maybe previously is that spreads are tight, but your yield that you're getting is still fairly attractive. And so yes, maybe you're reaching for yield, but relative to treasuries, are you taking on that much risk? And so I think that fundamentals remain strong. I mean, if you look at the credit quality of the index, yes, there's more triple B, but you don't have significant default rates when you get into high yield. And I think you have more rising angels, rising stars than you do rising stars and falling angels, more rising stars than you have falling angels. And that's part of the strength of this global economy despite the stress that's been put on consumers.
We continue to see these companies doing fairly well. You haven't had kind of a culling of the herd that you would maybe expect as rates moved higher. We always talked about zombie companies that were just kind of staggering along benefiting from these lower rates, but rates have gone higher and you still have not seen a massive wave of defaults. And I think that gets to the ongoing strength. Now, can we continue that really remains the question because we've always talked about the consumer drives the economy and they continue to do so and there's a lot of talk about a K-shape recovery and I agree with that, but the question becomes, is the upper echelon of that K-shaped recovery enough to carry the broader economy and right now at least it feels like that, but I think we need to wait a good six to 12 months before we see if that really continues because I filled up my tank whatever it was two days ago and it was like 75 bucks.
And for me and for people I think in our industry, it's not, am I making a choice? Do I have to buy gas or food or medicine? But when you look at the lower end of the economy, those questions, those challenges are really starting to surface and we see it with Walmart and their earnings talking about people running out of money by the end of the month. So I think that K-shape is going to become more pronounced and that's why as investors, you have to be very, very sharp and very diligent in understanding underlying investments that you're making to make sure that you are protected if things do get a little diceier.
Colin Prescott (12:03):
Yeah. I'm glad you brought up the consumer and I think it's a great segue into the securitized markets, which tend to have larger consumer exposure directly in the portfolio. So it seemed like securitized credit had its own story and one of the more interesting insights that you had shared with me recently was that securitized credit wasn't driven only by the war or only by treasury volatility. It had kind of its own sector specific catalysts. And I wanted to revisit one of the topics we discussed a couple months ago, which was around credit card ABS seemed like at the time it was disrupted by the proposed 10% credit card interest rate limit. How did the markets process that policy risk and how was that kind of shaken out over the subsequent several months?
Douglas Gimple (12:52):
So that was a pretty interesting time. I think it was January 9th, I could be wrong, where the president proposed this 10% limit on credit card interest rates, which was already, it actually is in a Senate bill that's waiting to get out of approval process, but it was created very, very coldly, I guess I would say. We did see in some of the subprime credit card issuances, issuers spreads widened out a little bit, but most importantly, what we saw was that issuance itself in credit card ABS just stopped. It just ground to a halt and it had been doing fairly well in 2025. December is always a slow month across the board, but after that came out, issuance just stopped and then we didn't see issuance pick up again. I think it was maybe early March, mid-March we saw issuers come back into the market as this 10% limit just faded away and we don't even hear anything about it anymore because there were concerns about if you do that, then majority of the economy loses access to credit because you are not going to lend to somebody at 10% when your losses could be 15%.
So seeing that market come back was reassuring and that market, much like the rest of the securitized market, a little bit of a hiccup in early March, mid-March, but then has tightened back in. So a little bit of a hiccup again in January, mid to early January with some of the lower echelon issuers, but even those tighten in pretty quick. So it was really a buying opportunity if you were willing to see through all the noise. Another thing that we talked about previously that we've got a little more clarity on was the GSCs, the government sponsored entities, Fannie Freddie, Ginnie, coming out and saying, "We're going to buy 200 billion in agency mortgages." And what that did, you talked about these mini stories, that created spread tightening in the mortgage market and we saw spreads go from an agency mortgages from like 26 to I think a low of 14.
And again, we didn't get a lot of clarity, we didn't get a lot of transparency on exactly what it was. We just knew that the GSE said we're standing ready and able to do this and they did, but it was, I want to say like four billion in January and maybe eight billion in February of this $200 billion. So we got a little bit more clarity that, okay, it's not going to be $200 billion this month or this quarter and then there's going to be more throughout the year. It feels like it's 200 billion from now until that money runs out. Call it 12 to 14 months. The impact to mortgage rates was very short lived. The impact of spreads was very short lived. We bounced back up as the market kind of digested that, okay, this was more of a headline grabbing thing that had a very short term impact. And so unless we have another pronouncement of a trillion dollars of mortgages being bought, which I'm not saying that's going to happen, I don't think it is, but I think we've seen the effects already priced in by the market and not much of a
Colin Prescott (16:23):
Not meaningful.
Douglas Gimple (16:24):
Yeah.
Colin Prescott (16:25):
Well, you mentioned the consumer and the K-shaped nature of the consumer today. I guess with that in mind or just looking broadly across securitized credit, where do we see the most compelling risk adjusted opportunities moving forward?
Douglas Gimple (16:42):
Yeah, it's a good question. I mean, right now we're still spending time in the ABS market, asset-backed securities. So within credit card and consumer unsecured, because of some of those concerns around this structure of the recovery, if it is a recovery, if it's just the new normal going forward, heading into this year, we were lightening up on riskier parts of the consumer market and that wasn't because we knew it was going to happen with Iran. It was more so we saw inflation turning out to be a little bit more stubborn. We saw at the time the labor market was starting to show some cracks. Labor markets seems to have bounced back a little bit, but we were just a little bit more cautious and so we were upgrading that part of the portfolio, meaning that we would move into if we were buying new issue, we were buying kind of front pay tranches that are going to get paid off sooner.
We were avoiding the subprime part of the market with consumer unsecured and credit card, which is one of the themes that we focused on for the last, again, 12 to 18 months and focusing on near prime and prime. And then within autos more, there we are looking to delve into subprime because you've got hard collateral, you've got recovery values and frankly in prime you're not getting paid adequately we think there's just not a lot of risk so you're not going to get paid a lot. On the mortgage side, I think one of the more interesting things that I've seen is twofold. One, looking at COVID era mortgages, call it one and a half to kind of two and a half percent mortgages that are trading at significant discounts. And so an arbitrary number like 60 to 70 cents on the dollar because that yield to worst when you factor in the price that you pay, even though it's a one and a half to two and a half percent coupon, you're looking at five and a half to five and three quarters percent type yield to worst.
And if these bonds get called for whatever reason, you're getting your money back sooner and you're able to deploy back into higher rates. So it's a good option for something like a core strategy where you can take on that longer duration and you can stomach that and not really worry about how it's altering the structure of your portfolio. And then the other side of that on the mortgage side is looking at these higher coupon, more recent or new issues coming in at seven, seven and a half percent that you maybe pay a little bit of a premium because of where the yield is or what the coupon is, but it's basically free carry and these are going to be shorter duration because the coupons are so high that if rates on the longer end come down, you're going to see prepayments accelerate because if I've got a seven and a half percent mortgage and rates go down to six or six and a half percent or even lower, then I can refinance out of that and as an investor, I'm getting my money back that much sooner, which at times can be a negative, but in the meantime until that happens, I'm earning fantastic carry with a duration of maybe three because even though it's a new issue, the expectation is that the rate is so high that it's going to be prepaid very quickly if rates move and if rates stay where they are or even move a little bit higher, you may get a little bit of extension, but you still have that carry that you're bringing into the portfolio.
Colin Prescott (20:24):
Thanks as always, Doug. This has been really helpful. It's great hearing your insights and the insights from the broader fixed income desk here at Diamond Hill. Also want to say thanks to all of our clients. We appreciate your partnership and we're eager to chat with all of you.