Markets took a step back in December with selloffs in equities and rates. The U.S. Treasury curve bear steepened with the 10-year and 30-year yields higher by 40 and 42 basis points (bps), respectively, while the 2-year sold off 9 bps. High yield credit spreads widened 20-30 bps across rating categories, while investment grade moved out 2-3 bps. Agency mortgage backed-securities (MBS) were better bid and high-grade asset-backed securities (ABS) finished unchanged on spread.
A great deal of the yield curve movement revolved around expectations for the mid-December Fed meeting, followed by the curve’s post-meeting reactions. While the December 6th jobs report and the December 11th Consumer Price Index (CPI) failed to deliver major surprises, markets were growing wary of the likelihood of a “hawkish cut” at the upcoming Fed meeting. This was because fourth quarter economic figures had been stronger than the Fed’s projections from late summer. Many commentators, including the prominent Fed reporter, Jon Hilsenrath, noted that Gross Domestic Product (GDP), unemployment, and inflation have continued to defy the Fed’s projections. The economy has simply been stronger than the central bank anticipated a few months back. At that time, prior to the September Fed meeting, rate futures markets predicted between 75 bps and 100 bps of cuts through the end of 2024. Fast forwarding to the December meeting, in which a cut was considered a near-certainty to bring us to that target of 100 bps for 2024, traders felt uneasy. The Fed had stayed on its projected policy path through year end, yet the economic data was stronger than it had projected. Fed actions were thus interpreted by some as being at odds with the data. Meanwhile, core CPI and Personal Consumption Expenditures (PCE) readings have not improved in several months. Therefore, rate markets concluded that a Fed slowdown or pause was likely ahead.
This proved accurate and the meeting was read as clearly hawkish. The Fed Funds rate was cut to the 4.25%-4.50% range, but longer-term projections were raised, and the terminal rate moved to 3.0%. The Fed now projected just two interest rate cuts in 2025, emphasizing data dependence from here, with a need for lower inflation figures in order to see cuts. The recalibration phase that Chair Powell had frequently cited this fall seems to have passed. Not long before the meeting, many had estimated 4 cuts for 2025 and another 2 for 2026. Concerningly, the Fed now sees core inflation unlikely to return to its 2% target until 2027, and the 2025 inflation forecast was increased from 2.2% to 2.5%. It lowered its unemployment projection for 2025 as well. Therefore, it is becoming harder to justify a dovish Fed, and interest rate uncertainty has risen in response.
Yorktown Funds Fixed Income Focus – New Faces, Same Party
“Before you marry a person you should first make them use a computer with slow internet to see who they really are.”
- Will Ferrell
I don’t get invited to a lot of parties. I’m okay with that. When I was younger, going out, especially to a party, was pretty appealing. These days, I’m more than happy to stay home. If you do see me at a party, it’s not necessarily because my wife handcuffed me or held a gun to my head. Although full transparency, as I get older, I find we’re probably not that far away from such drastic measures. No, it’s because I was most likely promised we would only swing by for a “few minutes” on the way to something I much more preferred to be doing. You would think once we were there though that I would get into the party and enjoy myself. You would think wrong. I spend most of my time trying to decipher wife-speak and calculate what does “a few minutes” actually mean? Time is not necessarily debatable, but there is a distinct difference between holding my hand over an open flame for 15 seconds and me adjusting my lounge chair for 15 seconds. One thing is for sure, as I’ve gotten older I’ve come to expect there will be some different faces at the party. We tend to hang out with the same people, but I’m at the age where spouses, partners and significant others come and go. Nothing nefarious. Nothing worthy of gossip. People just move on. A few new faces. But it sure can change the party vibes. It’s basically the same party we’ve been at for years, but sometimes it can be the reason for a subtle, almost undetectable shift in how the party progresses. Same party, new faces, and definitely a different feel.
It's been a non-stop party in the Treasury market for a while. The ongoing issuance hasn’t slowed or even paused. We seem to reach higher and higher amounts of outstanding Treasury debt on a daily basis. At the end of December 2024, in fact, the reported amount by the Federal Reserve for outstanding Treasury debt was well over $36 trillion.
The swelling of the national debt isn’t necessarily a new issue. It is typically highlighted during an election year, but over the last few years has also cropped up during debates over raising the debt limit, creating an opportunity for political arguments and attempts to get concessions. An added wrinkle, though, with higher rates, is just how noticeably expensive it’s getting to maintain the debt. And boy is it getting expensive. At year-end 2024, the average interest rate on outstanding U.S. debt was reported to be 3.32%, which is almost a full 100 bps higher than that of 2015.
In the past we might’ve mixed things up in terms of maturities or laddering the debt. Given the influx of money market fund assets, the U.S. can often take advantage and front load some of the debt for that audience, which typically saves some of its interest cost. And that has occurred. We are now well over $6 trillion in Treasury bills issuance, 6 times more than was issued 30 years ago.
But that hasn’t changed the average maturity, given the total amount issued in Treasury debt overall. Even the larger amount of Treasury bills issued in fact hasn’t made a dent. The Federal Reserve reports the average maturity of outstanding U.S. debt to now be 71 months. This is right at near-term highs, and certainly well above levels previously recorded even 20 years ago.
Source: Bloomberg
Furthermore, even the high amount of Treasury bills issued doesn’t shift the cost of all this down any. In the past, perhaps with a normal yield curve, the greater amount of bills issued would be done so at more advantageous rates and thus save some on the interest cost. But with an inverted yield curve over the past few years, that has actually worked against that metric. In fact, we as a nation have now paid over $1.0 trillion in interest costs on an annual basis for the first time in our history.
So we have acknowledged the high amount of outstanding debt. Because of the high-rate environment, it’s especially costly. We’ve also had rate volatility continuing into the new year. And the volatility has occurred along with economic reports that show lower inflation compared with 2023, with only the most recent employment report coming in hotter than anticipated. So we need to think about why. Aren’t the same faces at this party? One of the reasons given recently for Treasury selling off has been a lack of support. We are issuing a lot of additional debt, so are there enough buyers to support it? A big concern in the past has been that we were beholden to foreign buyers, and especially China.
At a certain moment in time, China and Japan collectively held over 8% of outstanding Treasury issuance. The worry was that China could at the wrong moment shed their large holdings and send Treasuries into a tailspin. It hasn’t necessarily been for retaliatory reasons, but China has indeed slowed their purchases and sold Treasuries. At its peak, China held about 3.5% of outstanding Treasuries. As of the end of third quarter 2024, that amount was down to 2.1%. Taken together with Japan, what once was over 8% is now down to roughly 5% of outstanding Treasury holdings. That should have meant a dent in support for Treasuries, and potentially been a reason for the increased volatility we see. But even that isn’t what happened.
In fact, total foreign holdings of outstanding Treasury debt, even at these elevated levels of debt, continue to be fairly consistent with past results. This has been relatively stable over the past few years, with foreign buyers accounting for around 25% of outstanding US debt. At the end of the third quarter in 2024, the Federal Reserve indicated the amount owned by foreign holders was around 24%. So down a little but still consistent with previous years. As such, while China and Japan have stepped back, other foreign holders have stepped up and replaced them.
Source: Federal Reserve
The bottom line is that there’s currently a great deal of volatility in the market with rates, which is in turn being driven by Treasuries selling off. There seems to be a disconnect somewhere. Numerous reasons are given for rates, and ultimately Treasuries, selling off. There is angst over recent economic data and how inflation hasn’t really gone away. Then there is the China concern, or support from large holders, but that isn’t quite it as well. Furthermore, this is occurring at a moment where economic data is hotter than expected yet still within reason. Recent data including producer price index (PPI) and CPI haven’t strayed far from expectations. Only the most recent employment number was aggressively strong compared to expectations. There are headlines indicating the potential agenda and initiatives from the incoming Trump administration will be inflationary in nature. But we don’t really know that just yet, because we haven’t seen any real proposals and there is on-going debate on what they will actually look like. So not quite it as well.
We feel perhaps a more simple reason is the driving force. A new face changing the vibes? Well, kind of. The pressure on Treasuries is simply the bond market, and those dubbed bond vigilantes, finally coming to the realization that the outstanding amount of Treasury debt is just too high. The market is almost demanding to see some sign of reform or response in terms of addressing what is becoming a concerning issue to the investor base. We would suspect that some effort to control the issue might actually get the Treasury market to quiet. Once that occurs, we would see Treasuries regain their footing and a clearer picture of rates and expectations would formalize.
Going forward, we would expect that some effort in tackling the deficit will provide some relief from the volatility in Treasuries. We shall see. We continue to mitigate as much as possible credit risk in the portfolio, preferring higher ground, and with additional focus on liquidity, and diversification. As we transition to a new presidential administration, we want to keep as much dry powder as possible to take advantage of whatever opportunities reveal themselves, and hopefully, under the backdrop of the Treasury market steadying itself for the next cycle.
Investment Focus
- The prospect of further rate cuts is beginning to fade. Certainly, the number of cuts now expected by market participants is dwindling and potentially down to 1 or 2. This has resulted in the yield curve steepening, with the back-end of the curve pushing-up while a smaller movement down occurs in the front-end. Recent Fed speak continues to support this view, and at present, the only thing that seems to shake that expectation is when the market ponders the actions of the new presidential administration, the impact of their agenda and what that might mean to economic activity and ultimately rates.
- Overall the credit environment seemingly remains fairly benign, and investors continue to use economic data releases which further that narrative by aggressively chasing credit. Credit spreads, especially in the single B and CCC rated part of the corporate curve continue to compress into historic lows and on occasion, setting new lows. We continue to remain unmoved by this aggressive chasing of credit. High grade credit further up the credit stack remains more attractive and with credit spreads compressed, the value in those names seems more compelling. Indeed, despite the rate movement that penalizes some of the value in the short-term, longer dated maturities, at attractive coupons, seems to present an opportunity to lock in long-horizon overperformance.
- Liquidity continues to be aggressively robust, especially on the primary side. ABS, corporate and structured credit primary issuance is being met with seemingly bottomless demand. New deal pipelines for corporates is being pumped out to the market at records levels, and ABS and collateralized loan obligation (CLO) debt is easily massively oversubscribed when announced. Secondary trading continues to be strong as well, albeit a little more muted than primary issuance simply due to investors not necessarily eager to sell what they already own. Nevertheless, dealers seem to have appetite to position offerings and bid-side interest for securities being offered is strong. We find this current environment conducive to our plans to move out of positions no longer presenting much more upside and into targeted issuers and sectors we feel offer more long-term value.
Noted asset sector target or bias this month includes:
- Agency MBS spreads tightened in December, performing well against Treasuries, but they were naturally lower in dollar price into the rate selloff. Newer production bonds fell by about three quarters of a point. Conditional prepayment rates were lower compared with the prior month, with much slower refi activity into higher rates. We expect speeds to stay muted with rates remaining sticky and the winter seasonal drag on turnover in full effect. Given the level of rates, most of the mortgage universe still sits out of the money to refinance. The headline 30-year mortgage rate is around 7%, while underwhelming bank demand and challenging refinance break-evens still represent headwinds to the asset class. Our long-term outlook for agency MBS is positive. Mortgage spreads are still wide as technical demand has not returned following the banking issues in March of 2023. The current level of interest rates offers long-term performance potential for rate-driven products, leaving many MBS return profiles attractive to us. We continue to believe the asset class looks noticeably cheap to corporate debt. Higher coupon securities at reasonable valuations offer sufficient carry to weather some near-term spread volatility, if needed, as there isn’t a direct reason to expect imminent basis tightening.
- Agency debt remains a preferred sector. With credit spreads compressing in corporate debt, especially so in the high yield market, the difference in spread between agency risk and corporate debt is shrinking to the point where it seems hard to justify taking additional credit risk for an ever decreasing differential of yield. Rate volatility does present some challenges in determining ultimate maturity, due to outlook on embedded calls shifting slightly with a higher for longer rate outlook. Nevertheless, new issue and attractive coupons still provide short-term yield value and longer-term upside, if credit deteriorates. Further, the embedded calls, especially on newer issue, still present an opportunity to build out a maturity on the front end of the portfolio.
- Corporate debt overall remains neutral. Certain segments are still attractive, but credit spreads have tightened to the point where tiering not only between issuers in the same sector but simply credits up and down the credit stack have compressed to a point that encourages reaching for credit for just a few bps of pick-up. The additional risk for very little reward is unappetizing. Nevertheless, certain segments continue to shine, such as preferreds. With the promise of less regulatory restraint, bank paper seems primed for an uptick in performance and preferreds with their higher yielding profiles capturing a lot of attention, providing yield pick-up and the possibility of long-term overperformance. We are less attracted to corporate or insurance names in this space, due to less likelihood of early calls, given there are little to no impetuses such as regulatory reasons for them to exercise the call. The current environment of heavy primary issuance and demand in corporate paper, however, does provide an attractive liquidity setting, and that allows for easier than normal ability to execute any new strategy initiatives or defensive moves that might seem prudent at the time.
- Credit spreads continue to compress in ABS, but still lag in corporates at similar credit rating levels. Thus, there is still some value to be had in ABS, in selective sectors. Given our viewpoint on the economy and the health of sub-segments within it, we continue to prefer a few ABS sectors to others. We do find value in segments such as auto, consumer and CLOs. But we are also beginning to see delinquencies rise across several ABS sectors and as such prefer the top of the credit stack for credit and liquidity reasons. New issue is being met with ever increasing demand, and we do expect spreads to continue to grind in. Therefore, similar to the last few months, we prefer secondary offerings, with some seasoning, to the new issue space. Segments to avoid include more esoteric areas such as data centers and solar.
- Energy is having a moment. Fossil fuel seems poised for some upside, with an incoming presidential administration that is expected to be supportive. At the same time, green energy seems to be expected to take a step back. We continue to avoid the sector overall, given the uncertainty and the on-going geopolitical events that produce a volatility in the sector we are not comfortable with.
With the election behind us, and now seemingly daily updates and press conferences from the incoming Trump administration and its representatives, the markets do seem a bit jumpy and easily swayed. It seems many of the fears might be overblown and many impacts and effects still remain to be properly digested. As such, we do expect some market turbulence in the near-term as investors, officials and regulators adjust to the new presidential initiatives and how his agenda is formulated and executed. As such, we remain consistent in our view and stay focused on high credit quality names, 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 and in, specifically offers more value.
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.
Baby Bonds – a bond that has a face value of less than $1,000.
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.
Dry Powder – cash or marketable securities that are low-risk and highly liquid and easily convertible to cash.
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.