Rate volatility returned in October to end a multi-month Treasury rally. The MOVE Index (Merrill Lynch Option Volatility Estimate) shot up over 42% while rates across the curve sold off sharply. The 2-year treasury, +53 basis points (bps); 10-year treasury, +50 bps; and 30-year treasury, +36 bps each finished much higher in yield, while corporate bonds and asset-backed securities (ABS), on the other hand, managed to find yield buyers to support spreads. The large moves suggested that investors believed the long-term US treasury (UST) rally to be overdone, and reflected some growing comprehension of just how difficult the U.S. fiscal picture projects to be going forward.
The month began with relatively tame data in job openings and manufacturing but the first Friday brought a large upside miss in nonfarm payrolls (NFP). The month over month figure was +254k against a +150k estimate, and it featured a net upward revision of 72k for the prior two months. Adding to the surprise was a drop in the unemployment rate from 4.2% to 4.1%, along with a rise in average hourly earnings to 0.4%. In reaction to the strong report, the front end of the yield curve gapped up about 20 basis points (bps). Investors viewed the data as effectively eliminating any chance of a 50 bps cut at the November Fed meeting, settling into an expectation for a quarter point. Fed Funds futures began implying 7 quarter point cuts by year end 2025, compared to an expectation of 9 just a month before.
The 7-cut futures pricing was further diminished toward 6 cuts following the Consumer Price Index (CPI) release on the 10th. The figure was elevated with a September core of 0.3% which increased the 12-month rate. Headline CPI for the month was 0.2%, which indicated overall inflation at 2.4%, down a tenth of a percent from August. Worries over slowing disinflation ticked up as the rise in prices was fairly broad in this report, with food, transportation, commodities and medical services among the notables. The numbers seemed to lock in a 25 bps move in November, although President Bostic of the Federal Reserve Bank of Atlanta even said he’d be open to potentially leaving rates unchanged at the meeting. Rounding out the month, the Producer Price Index (PPI) increased slightly less than anticipated, retail sales were strong, job openings decreased by more than expected, and consumer confidence exceeded estimates. The European Central Bank cut rates as disinflation progress continued.
“Always drink upstream from the herd.”
- Will Rogers
Pre-pandemic, I used to travel a lot for business. Everyone has their favorite airport story. But I always feel like your favorite airport story is the equivalent of breaking out photos of your kids. Everyone pretends to be interested. They aren’t. I never minded traveling for business, but didn’t love it. Part of the job. But when you do enough of it though, you develop a routine. It becomes easier. You learn to block out the noise, and have a means to work the system enough so that things that ruin the vacations of those less-informed are avoided. You develop work-arounds. You know where to stand to insure you get overhead bin space. You know there is a Dunkin near that gate and you don’t have to mingle with the herd at the inferior Caribou coffee location right inside TSA check-point. One thing I never did get used to though is the sense that you just never got to the tier you wanted. No matter how much I traveled. No matter how many miles I put in, and what level of status I obtained, there always seemed to be another tier just out of my grasp. Worse, a tier I didn’t know existed. Indeed, nothing quite so humbling to finally hit some ridiculous loyalty level, only to have to move out of the way at preboarding for the guys who had a status you didn’t know existed. A status with a far cooler name than just gold or silver. A tier that seemed to ooze with respect and awe from the gate crew. Always a tier above you. And it dawns on you at this point, that your tier, well, you are being compressed in terms of importance. You are right back to the herd. Took a lot of persona risk to achieve the tier you were at, but as that upper tier walks by you, it dawns on you the reward for your loyalty and effort is that you simply aren’t in the middle seat of the last row. What you thought was a giant leap forward and proper reward for your tier, well, suddenly doesn’t seem like you got what you thought you were getting.
Lately we are watching a similar fate for tiering in the fixed income space. The landscape itself has changed and, if nothing else, is now defined by a resetting of the tiering. Or perhaps more appropriate, one that has been allowed to shift, and the benefits/reward of tiering are simply evaporating into the face of excessive demand. And demand is a very large part of this. Corporate bond issuance continues to rip into the end of the year. Prior to the slight pause due to the election, corporate bond issuance was a having a day. And the party isn’t stopping post-election. All told, we are on pace for the largest amount of corporate bond issuance in over a decade. As of the end of October, we had already witnessed some $1.7 trillion of corporate bond issuance, which by itself would be the highest total annual amount issued 7 out of the last 10 years. As a comparison, only the full year issuance 2020’s $2.27 trillion and 2021’s $1.96 trillion would be greater that what has already been issued year to date in 2024.
Source: SIFMA
There is seemingly endless demand for corporate debt. Deals are routinely excessively oversubscribed. Leading of course to hurt feelings of investors, who are perpetually disappointed in their allocations. Luckily those investors can turn to the secondary market to assuage their feelings. This in turn has led to strong secondary activity in the fixed income space as the disappointed eagerly snap-up vintage exposures of those issuers they “missed out on” in the new deal or snatch up the new issuance they just missed out on by those investors who make a living by instantly selling the allocations of the new deal they did receive into the secondary market, thereby capturing an instant profit on a bond that never physically hits their holdings report. That is done so typically at tighter credit spreads, which serves in a secondary manner to tighten outstanding bonds of similar and the same issuer.
The result of all of this activity: heavy issuance, excessive demand and eager secondary trading, is that credit spreads continue to grind in for corporate credit. We seemingly hear the phrase “historic” levels, a lot lately, when we talk about corporate credit, but in this case it is well earned. We are at that point, at least from what we have seen over the past twenty-years.
Source: Federal Reserve
And especially true over the past year, as even the lowest level of corporate credit, from a rating perspective, has seen credit spread compression into levels that seem dangerously tight.
Source: Federal Reserve
And yet, it really isn’t just the level of the spreads at this point that is concerning. More concerning is the fact that the tiering between levels of credit is evaporating. That is, the difference needed, as a reward for the risk investors are taking by moving down in the credit stack and taking on an increased level of risk, is shrinking. As one case see below, the credit spread difference between a B-rated corporate exposure and BB-rated corporate, as of the end of October 2024, was 104 bps, 74 bps tighter than the 20 year average option adjusted spread (OAS) between the two.
Source: Federal Reserve
The same came be said for the difference of credit spread between BB-rated corporates and BBB-rated corporates. As of the end of October 2024, the difference between a BB-rated corporates and BBB-rated corporates, credit-spread wise, was 65 bps, which is nearly 100 bps tighter than the 20-year average OAS difference between the two.
Source: Federal Reserve
While on occasion it is possible to see similar type of movement between a step or two in the corporate credit stack, what we are seeing now is a compression of the whole stack. Indeed, the credit spread difference between a B-rated and BBB-corporate credit has now compressed to the point that as of the end of October 2024, there is a mere 169 bps difference between the two, when historically 341 bps had been required. This means investors are pretty much receiving half of what they had historically required as compensation to move from investment grade BBB to deep sub-investment grade single B risk.
Source: Federal Reserve
What is required or even accepted by investors in terms of what should be paid for risk can change based on a number of influences, including the rate, economic and geopolitical environment. The last time, for instance, we saw something similar was during a moment when rates were so low, that just to generate yield, investors would reach deep down the credit stack for it. But this is a different moment. The current yields being offered, given elevated rates in the current environment, one would think, would satisfy investors desire for yield handily at better credits. A preference for stepping back, and taking what the market is providing. Instead, the opposite is occurring. Investors seem to be rushing to grab and reach for even higher yields by accepting and taking on additional and sometimes multiple levels of risk, ignoring the obvious signs that they are simply not getting paid to do so.
Source: Federal Reserve
In the past, a reaction such as this has typically resulted in a painful lesson. At some point, given the compression, credit spreads will revert to the mean. At this point though, and given the level of compression, even a slight widening of credit spreads could be quite painful. We continue to see danger in chasing credit spreads at these levels. And it doesn’t at this point even need to be a pandemic-level of financial crisis level moment, just some slight hiccups and we could see quite a move in spreads.
There are still a great deal of eager investors jumping into the credit trade. And judging by the current exuberance displayed for post-election issuance, not ending too soon. At levels such as this, and with yields accommodating, however, we prefer the higher ground. We prefer the higher credit quality trade, taking what the market is providing, finding comfort in the top of the credit stack at accommodating yields, and understanding that it isn’t necessarily fully insulated from credit widening, but with the expectation that whatever widening does occur, far more widening should occur at the lower more volatile points in the corporate credit stack.
We continue to revolve around future rate cuts in the market, with economic data the focus in determining which direction the Fed would take. The direction here being more a question of how much and not so much an “if.” Toward the end of the month that still was a focus, but presidential election outcomes and what that meant to treasury yields overtook the messaging. With Trump’s odds rising toward the end of the month, traders took to the markets pushing yields higher and higher. And suddenly what had been a nice easy, smoother ride toward rate cuts saw an about-face as despite the fact that everyone expects a Fed rate cut, rates actually sold off. Post-election, with Trump’s victory, the response was even swifter and dramatic with rates spiking the next session. The Fed is anticipated to keep on its rate cutting path, but in a more restrained manner. This especially so apparently after the Trump victory. There is some thought that given his actions during his first term, that he might publicly pressure for rate cuts thereby putting pressure on Chaiman Powell and others to maybe move in a more aggressive manner. Time will tell. For the near-term, until at least post-presidential transition, we expect the Fed to maintain its current more cautious approach as the data continues to unwind, with occasional bumpiness to whatever message Trump decides to publicly exert. All of this with year-end pressures adding some potential volatility as well.
Despite evidence of some slippage economically, credit, especially corporate credit, continues to tighten in a historical fashion. There continues to be incredible demand for risk, not only in corporate credit but structured as well. There seems to be little discretion as investors search to lock in at the higher yields and worry about credit distinctions later. This market reaction continues to be of concern, as history tells us that spreads are due at some point to reverse and widen, and given the overwhelming demand enveloping the market, a reversal might be of an exponential matter (see above). Chief concerns continue to revolve around commercial real estate which once again dominates markets as the poor performance of commercial mortgage-backed securities (CMBS) continues to evolve and become more and more evident. Recent damage to tranches previously rated AAA which are now reported as suffering large losses to principal on the notes furthers the narrative that this is an issue that isn’t going away any time soon. The fact that rates remain stubbornly high is further concern for the sector. We continue to anticipate some stress will push the credit markets wider. Private credit is still out in the horizon and never far from our thoughts as well. Post-election results, credit rallied in headline inducing mode, and that was expected, but given year-end pressures and further unwrapping of what the future administration policies will be could push spreads wider. At this point, it doesn’t seem there is much room to go tighter and so wider seems a more logical response as more details are revealed. We prefer to watch this evolve from higher ground, and remain more focused on staying up in credit and locking in higher yields at that level of risk.
Liquidity remains robust. In fact, overenthusiastic demand might be a better way to explain it. The primary market, new issuance, continued to roar in the month, with a slowdown occurring toward the end of the month as rates sold off due to the upcoming presidential election outcomes being pondered. Nevertheless, post-election, we once again saw a level of demand that borders on some of the most aggressive that historically comes to mind. With limited new issuance, secondary trading was abundant and aggressive. There seems a bid for just about anything as investors seem to be in a rush to capture and lock in yields. The aggressive liquidity, especially in the secondary market, allows for targeted trades and portfolio movement, providing an easy path to establish and put into practice strategic portfolio shifts and concentrations. We continue to use this level of liquidity to move into targeted durations and exposures, helping further build a foundation for what we feel will provide near-term overperformance.
A similar theme in the markets to the previous three or four months: favorable market conditions, including liquidity aiding our ability to continue adding to targeted opportunities. Despite the market enthusiasm, we remain wary of a sudden shift in terms of credit, expecting some widening in corporate credit spreads, and as such, feel more comfortable in sectors such as MBS (see below).
Noted asset sector target or bias this month includes:
Rate cuts, and election results are driving the narrative on the rate and credit markets. There will now be some waffling amongst pundits what this means for the rate market and the risk-on trade. We would expect daily gyrations and some bumpiness in the markets because of this balancing act. So in a similar manner we expect a similar view as previous months. The market is going to be moving around and daily headlines whether political, geopolitical or economic data is going to be more disruptive than previously. Thus, we continue to be consistent in our viewpoint on both: remain the course, and focus on high credit quality names, finding value in the targeted duration in the proper credits. We prefer to stay focused on highly liquid, targeted defensive sectors and exposures, as well as seeking opportunities within rate movements at certain points on the yield curve with the potential for higher returns. We feel the front end of the yield curve, the 3 year maturity area, specifically offers value, as well as the 10 year maturity area. Both areas provide some duration benefits in the right name, and potential overperformance as the rate rally continues. As near-term pressures move markets, we feel this area will provide a foundation for future performance targets.
Definition of Terms
Basis Points (bps) - refers to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%, or 0.0001, and is used to denote the percentage change in a financial instrument.
Curvature - A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
Mortgage-Backed Security (MBS) - A mortgage-backed security is an investment similar to a bond that is made up of a bundle of home loans bought from the banks that issued them.
Collateralized Loan Obligation (CLO) - A collateralized loan obligation is a single security backed by a pool of debt.
Commercial Real Estate Loan (CRE) - A mortgage secured by a lien on commercial property as opposed to residential property.
CRE CLO - The underlying assets of a CRE CLO are short-term floating rate loans collateralized by transitional properties.
Asset-Backed Security (ABS) - An asset-backed security is an investment security—a bond or note—which is collateralized by a pool of assets, such as loans, leases, credit card debt, royalties, or receivables.
Option-Adjusted Spread (OAS) - The measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option.
Enhanced Equipment Trust Certificate (EETC) - One form of equipment trust certificate that is issued and managed through special purpose vehicles known as pass-through trusts. These special purpose vehicles (SPEs) allow borrowers to aggregate multiple equipment purchases into one debt security.
Real Estate Investment Trust (REIT) - A company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool the capital of numerous investors.
London InterBank Offered Rate (LIBOR) - a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans.
Secured Overnight Financing Rate (SOFR) - a benchmark interest rate for dollar-denominated derivatives and loans that is replacing the London interbank offered rate (LIBOR).
Delta - the ratio that compares the change in the price of an asset, usually marketable securities, to the corresponding change in the price of its derivative.
Commercial Mortgage-Backed Security (CMBS) - fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate.
Floating-Rate Note (FRN) - a bond with a variable interest rate that allows investors to benefit from rising interest rates.
Consumer Price Index (CPI) - a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them.
Gross Domestic Product (GDP) - one of the most widely used measures of an economy's output or production. It is defined as the total value of goods and services produced within a country's borders in a specific time period—monthly, quarterly, or annually.
Perp - A perpetual bond, also known as a "consol bond" or "perp," is a fixed income security with no maturity date.
Nonfarm payrolls (NFPs) - the measure of the number of workers in the United States excluding farm workers and workers in a handful of other job classifications. This is measured by the federal Bureau of Labor Statistics (BLS), which surveys private and government entities throughout the U.S. about their payrolls.
Net Asset Value (NAV) - represents the net value of an entity and is calculated as the total value of the entity’s assets minus the total value of its liabilities.
S&P 500 - The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the stock performance of 500 large companies listed on exchanges in the United States.
German DAX - The DAX—also known as the Deutscher Aktien Index or the GER40—is a stock index that represents 40 of the largest and most liquid German companies that trade on the Frankfurt Exchange. The prices used to calculate the DAX Index come through Xetra, an electronic trading system.
NASDAQ - The Nasdaq Stock Market (National Association of Securities Dealers Automated Quotations Stock Market) is an American stock exchange based in New York City. It is ranked second on the list of stock exchanges by market capitalization of shares traded, behind the New York Stock Exchange.
MSCI EM Index - The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries. With 1,382 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Nikkei - The Nikkei is short for Japan's Nikkei 225 Stock Average, the leading and most-respected index of Japanese stocks. It is a price-weighted index composed of Japan's top 225 blue-chip companies traded on the Tokyo Stock Exchange.
Shanghai Composite - is a stock market index of all stocks (A shares and B shares) that are traded at the Shanghai Stock Exchange.
Bloomberg U.S. Agg - The Bloomberg Aggregate Bond Index or "the Agg" is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
MOVE Index - The ICE BofA MOVE Index (MOVE) measures Treasury rate volatility through options pricing.
VIX Index - The Cboe Volatility Index (VIX) is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 Index (SPX).
Dow Jones Industrial Average - The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry.
Hang Seng - The Hang Seng Index is a free-float capitalization-weighted index of a selection of companies from the Stock Exchange of Hong Kong.
STOXX Europe 600 - The STOXX Europe 600, also called STOXX 600, SXXP, is a stock index of European stocks designed by STOXX Ltd. This index has a fixed number of 600 components representing large, mid and small capitalization companies among 17 European countries, covering approximately 90% of the free-float market capitalization of the European stock market (not limited to the Eurozone).
Euro STOXX 50 - The EURO STOXX 50 Index is a market capitalization weighted stock index of 50 large, blue-chip European companies operating within eurozone nations.
CAC (France) - is a benchmark French stock market index. The index represents a capitalization-weighted measure of the 40 most significant stocks among the 100 largest market caps on the Euronext Paris (formerly the Paris Bourse).
U.S. MBS Index - The S&P U.S. Mortgage-Backed Securities Index is a rules-based, market-value-weighted index covering U.S. dollar-denominated, fixed-rate and adjustable-rate/hybrid mortgage pass-through securities issued by Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC).
Duration Risk - the name economists give to the risk associated with the sensitivity of a bond's price to a one percent change in interest rates.
Federal Open Market Committee (FOMC) - the branch of the Federal Reserve System (FRS) that determines the direction of monetary policy specifically by directing open market operations (OMO).
United States Treasury (UST) - the national treasury of the federal government of the United States where it serves as an executive department. The Treasury manages all of the money coming into the government and paid out by it.
High Yield (HY) - high-yield bonds (also called junk bonds) are bonds that pay higher interest rates because they have lower credit ratings than investment-grade bonds. High-yield bonds are more likely to default, so they must pay a higher yield than investment-grade bonds to compensate investors.
Investment Grade (IG) - an investment grade is a rating that signifies that a municipal or corporate bond presents a relatively low risk of default.
Exchange Traded Fund (ETF) - an exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same as a regular stock.
Federal Family Education Loan Program (FFELP) - a program that worked with private lenders to provide education loans guaranteed by the federal government.
Business Development Program (BDC) - an organization that invests in small- and medium-sized companies as well as distressed companies.
Job Opening and Labor Turnover Survey (JOLTS) Report - is a monthly report by the Bureau of Labor Statistics (BLS) of the U.S. Department of Labor counting job vacancies and separations, including the number of workers voluntarily quitting employment.
Sifma - The Securities Industry and Financial Markets Association (SIFMA) is a not-for-profit trade association that represents securities brokerage firms, investment banking institutions, and other investment firms.
Duration - A calculation of the average life of a bond (or portfolio of bonds) that is a useful measure of the bond's price sensitivity to interest rate changes. The higher the duration number, the greater the risk and reward potential of the bond.
Trust Preferred Securities (TruPS) - hybrid securities issued by large banks and bank holding companies (BHCs) included in regulatory tier 1 capital and whose dividend payments were tax deductible for the issuer.
Treasury Inflation-Protected Securities (TIPS) - are a type of Treasury security issued by the U.S. government. TIPS are indexed to inflation to protect investors from a decline in the purchasing power of their money. As inflation rises, rather than their yield increasing, TIPS instead adjust in price (principal amount) to maintain their real value. The interest rate on a TIPS investment is fixed at the time of issuance, but the interest payments keep up with inflation because they vary with the adjusted principal amount.
You should carefully consider the investment objectives, potential risks, management fees, charges and expenses of the fund before investing. The fund's prospectus contains this and other information about the fund and should be read carefully before investing. You may obtain a current copy of the fund's prospectus by calling 1-800-544-6060.
Fixed income investments are affected by a number of risks, including fluctuation in interest rates, credit risk, and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall.
Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. There is no guarantee that this, or any, investing strategy will succeed.
Diversification does not ensure a profit or guarantee against loss.
Yorktown funds are distributed by Ultimus Fund Distributors, LLC. There is no affiliation between Ultimus Fund Distributors, LLC and the other firms referenced in this material.