Increasing risk aversion alongside a flight-to-quality bid pushed the volatility in the 2-year versus the 10-year yield to historical levels. While the 10-year yield today sits at 3.5% (a mere 38bps lower from end-2022) and the 2-year sits at 4.07% (28bps lower than at the start of the year), realized volatility has not dictated such a smooth path. The high to low yield in March was 4.08% to 3.27% for the 10-year, and 5.08% to 3.55% for the 2-year. Although the relative changes in volatility will subside in the near term, the absolute level will likely remain higher until 2H23.
The divergence between the market sentiment on the future path for the federal funds rate versus the Fed’s own projected guidance continues. As of 29 March, there was a 100bps difference between the two. Today, a mere two days later, as the market shows signs of stabilization for the time being, this differential has gone down to 60bps, with the market anticipating the first rate cut in September.
Investors quickly learned over the past year that projecting the impact of increasing the federal funds rate with such a large magnitude has become more of an art than a science and subject to quick sentiment shifts. However, asset price stability versus credit quality are two separate variables, and while volatility may remain elevated for higher-quality assets, the compensation of risk premium for higher credit embedded sectors remains thin given the likelihood of slower growth in 2H23.
CIO fixed income portfolios entered the year with a bias toward longer interest rate exposure, and we added to that position when the 10-year yield was near 3.95%. Although we cannot rule out that this level will be retested if the recent tightening in lending standards proves a mild headwind to growth, or if the market prices out the current easing as inflation remains elevated, we are moving our yield forecast for the 10-year from a 3.4–3.9% range to 3.3–3.75%. (We will dive deeper into this in our next Fixed Income Strategist
report, to be published 6 April.)
Although volatile, the 2-year/10-year yield curve remains inverted (–58bps), and therefore we barbell our positioning with short-end investment grade (IG) corporates combined with longer 7–10-year IG, alongside agency MBS. We barbell to the intermediate part of the yield curve (i.e., the 5-year area), as we believe this leads the way as the Fed comes to the end of the tightening cycle.
Fixed income performance for March
There have been three main themes within our fixed income recommendations during the first quarter: stay with higher quality; opportunistically add interest rate risk; and third, but most important, push back on the material outperformance witnessed in January (as we discussed in our February issue, Fixed Income Strategist: Pulling forward to push . Investors that entered the year long versus those that chased the January FOMO (“fear of missing out”) are experiencing different end-of-first-quarter results.
We show the fixed income performance for spreads and total returns for the month and year-to-date. As risk aversion dominated March, risk premiums, which we emphasized were not ample heading into the year, blew out for those sectors that have high embedded credit or are highly correlated to financials. Preferred securities suffered the most in March, underperforming junk CCC high yield (HY) credit. Spreads on preferreds are now wider than BB HY, and the sector boasted a substantial roughly –6.5% return, while 10-year Treasury yields declined roughly 50bps over the month.
Few sectors were cushioned from the market volatility, and most sector spreads widened. However, the tailwind from lower Treasury yields pushed month-to-date returns into positive territory—except for preferreds and lower-rated high yield. Although we remain biased toward higher-quality fixed income as we expect equities to underperform in 2H23, we are currently selectively reviewing those preferreds that might have experienced underperformance by association versus those with true credit-quality concerns.
Our IG allocation wasn’t unscathed from the spread-widening; however, the bias toward greater interest rate exposure cushioned the widening as yields declined. The short end or 1–5-year in IG has a heavier weighting toward financials and fueled the wider spreads. However, we maintain our barbell in IG and take the incremental carry in the short end given the Fed’s quick response to the current banking situation.
Agency MBS remains our preferred allocation and has widened due to the heightened volatility risk. Agency MBS remains cheap, and although we are closely monitoring the sector alongside potential pockets of vulnerability should another shoe drop in the financial sector, we view agency MBS as the cheapest AAA sector in the market and look for spreads to compress as the market stabilizes. Watch out for our MBS update in the coming weeks and our Fixed Income Strategist on 6 April.
Read the original blog March fixed income: Paving performance 31 March 2023.
Main contributors: Leslie Falconio and John Murtagh
This content is a product of the UBS Chief Investment Office.