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Written by: Tracy Nolte | Advisor Asset Management
A broad survey of the bond market currently tends to be overwhelming for fixed income investors attempting to find the value in the market. Broadly speaking, incrementally softer economic data has allowed the Federal Open Market Committee (FOMC) to tilt the central bank’s policy to be more dovish without appearing too out of touch. Recently, softer inflationary data has also supported the idea that the FOMC has engineered a “soft landing.” The result is that a “perfect landing” expectation has taken root in risk markets and has led to dramatic declines in volatility and volatility expectations.
Source: Federal Reserve Bank of St. Louis (FRED)
By standardizing the VIX (CBOE Volatility Index) and MOVE (Merrill Lynch Option Volatility Estimate) Index data, we can see just how far expected volatility in both asset classes has declined. The graphs above make it easy to see how — relative to average expected volatility since the beginning of 2023 — both fixed income and equity volatility expectations are near their lowest levels. When volatility expectations decline, risk assets tend to perform well. Equity returns tend to be positive and bond returns tend to be higher in the credit riskier slices of the credit stack.
Source: ICE BofA Market Indices | Past performance is not indicative of future results.
As a brief reminder, the yield paid to an investor on a corporate bond includes, among many things, a premium which compensates the investor for accepting credit risk above some “riskless” benchmark — commonly a U.S. Treasury bond. This additional compensation, referred to as spread (in this case OAS — Option-Adjusted Spread), increases as credit rating decreases. The concept should be familiar to all investors because it is consistent with each of our expectations that we receive appropriate compensation for taking on additional risk.
Source: ICE BofA Market Indices | Past performance is not indicative of future results.
Additionally, bond investors not only take on credit related risk, but also assume exposure to changes in interest rates. This interest rate exposure, referred to as duration, is the risk associated to the change in value of a bond or a bond portfolio resulting from changes in yields. While it is easy to get bogged down in the weeds with various details of duration exposure, for our purposes here it is most important to see how duration risk decreases when credit risk increases. This decline in duration risk is directly related to the average maturity of and average coupon paid by lower-rated credits. Companies with higher credit ratings can issue debt with longer maturities and lower coupons whereas companies with lower credit ratings must issue shorter maturity, higher coupon debt.
From here we have a baseline to understand how, and why investment returns in fixed income are differentiated during periods of declining volatility. When volatility declines, investors tend to become more accepting of risk and in doing so riskier assets tend to outperform. While we all are aware of how remarkable equity performance has been in the prior 12 months, the chart below highlights both total return and excess returns for various ICE BofA Bond Indices. It should be clear how credit exposure has been rewarded over the same timeframe.
The challenge is, at some point in the economic cycle investors must evaluate if they are being appropriately rewarded for the risks they clearly are taking. In the case of fixed income this means considering if the level of spread compensation for additional credit and rate risk are consistent with an investors outlook. History shows that it is easier to generate returns in a “risk on” market when spreads are wider than their average, than when they are tighter. This reflection is the basis of finding attractive relative value in the bond market. As we do when looking at some sectors of the equity markets such as the “Magnificent 7,” surveying the horizon of publicly traded corporate debt we find some parts of the market may be relatively unattractive.
Source: Federal Reserve Bank of St. Louis (FRED) | Past performance is not indicative of future results
The next chart illustrates a key component in the behavior of spreads over time because spreads are clearly connected to the market’s economic outlook. With the factors outlined earlier, it may now be easier to see how credit spreads, and consequently, corporate fixed income returns are influenced by an optimistic outlook. When rate volatility declines, when expectations for growth are less dispersed, and when FOMC policy rates are viewed as dovish, credit spreads decline as a result. Fixed income investors are more willing to accept lower compensation for higher credit risk. This lower rate of required return subsequently results in tighter spreads as investors move more assets into lower slices of the credit stack.
From where we stand today, spreads in some slices of the stack are as tight to Treasuries as they have been since 2019 and some ratios are as low as they’ve been since 2014. The level of spreads we are witnessing today tend to be historically associated to late cycle economic activity. This observation is not intended to fearmonger but to simply observe that some challenges we believe the U.S. economy continues to face may not be adequately discounted by some portions of the fixed income markets. The Portfolio Management team at AAM firmly believes, as English economist John Maynard Keynes first mentioned in the 1930s, that “(M)arkets can stay irrational longer than you can stay solvent.” As a result, our experience suggests that it is critical for fixed income investors to carefully find the most appropriate value in today’s market.
Source: ICE BofA Market Indices | Past performance is not indicative of future results.
To show how relative value analysis can be a useful tool for the fixed income investor, we would like to illustrate the difference between the ICE BofA BBB-rated corporate bond index and how it compares to the current coupon CMO (Collateralized Mortgage Obligation) index to highlight why we feel that along with careful BBB and BB-rated investing, Agency MBS (Mortgage-Backed Securities) present a compelling value for appropriate investors.
You may recall that securities issues by the Government National Mortgage Association (Ginnie Mae), a corporation within the U.S. Department of Housing, are unique in that they carry full-faith-and-credit backing by the U.S. government. As a result, we tend to consider their credit risk as being lower than that of a corporate bond. When discussing securities issued by Ginnie Mae, it may be tempting to consider them akin to Treasuries, but it is critically important to understand that the risks which these securities carry make them very different. In fact, one primary reason that Ginne Mae CMOs trade wider than U.S. Treasuries is that they carry the risk of uncertain cash flows. These uncertain cash flows may subject the investor to two types of risk; extension risk, the risk that cash flows occur over a longer period, or contraction risk where the cash flows are returned over a shorter period. Given that our estimates of yields are influenced by the timing of cash flows, this cash-flow uncertainty can adversely affect an investors yield.
However, the Ginne Mae (GNMA) securities of the index which we will be discussing are those which have cash flows structured in such a way to avoid unacceptable levels of extension or contraction risk.
Considering what we have just highlighted with regards the credit risk embedded in a run-of-the-mill Ginnie Mae CMO, versus the risk in a run-of-the-mill BBB-rated corporate credit, you may be surprised to see in the table below that spreads on the Ginnie Mae 30-year index are only 9 bps (basis points) tighter than that of the BBB-rated index.
This near equivalency of credit spread between BBB-rated bonds and current coupon GNMA CMOs suggests, that the market is pricing the credit risk between these two assets as also equivalent. It should be clear that credit risk between these markets is not equivalent. In our opinion, this near equivalency of spreads for very different credit-risk exposures is a function of the ebullience in the corporate bond market. It reflects the increasingly optimistic assumptions which we discussed earlier. These are the same assumptions which have reduced equity and rate volatility to 1.5-year lows.
Given that investment in fixed income is a matter of credit and interest rate exposure, let’s quickly look at the interest rate risk in each of these assets. As you can see above, when measured by effective duration, the ICE BofA BBB-rated index has an effective duration of 6.55 versus 3.66 of the GNMA 30-year current coupon index. That is to say that the average BBB-rated bond has 78% more duration than that of a current coupon GNMA CMO. Shocking, isn’t it?
The objective of AAM’s active fixed income management approach is to bring our expertise to bear on what fixed income assets may present the best value. We thoroughly believe that intelligent investing results from time in the market, not timing the market. As we look 12-18 months into the future, we believe that the quality of the income being generated by a fixed income portfolio may help mitigate stickier inflation, a change in FOMC policy objectives, and elevated sovereign debt loads, which may force rates higher. Relative valuation among and within various asset classes is a cornerstone of fixed income investing. Valuing bonds through the context of their component risks can allow fixed income investors to more appropriately evaluate investments and improve the consistency of their choices with their investment outlook and risk tolerance.
Related: Forward-Looking Cohorts Must Now Consider Rate Cuts