That was the start of the Fed’s aggressive policy shift that resulted in four consecutive 75-basis point rate hikes followed by 50bps in December and the 25bps expected this Wednesday. While the 35bps decline in 10-year yields in January is respectable—fueling positive total returns for higher embedded interest rate sectors such as taxable municipals, investment grade corporates (IG), and preferreds—in the end the sheer compression of spreads within fixed income risk assets drove some of the best one-month performance in over a decade.
The 2022 theme of rising interest rates combined with a sharp rise in volatility resulted in the higher-quality sectors such as IG, munis, and agency MBS underperforming those that do not display as much sensitivity to changes in rates or volatility, i.e., the higher credit embedded sectors such as high yield corporates (HY) or loans. However, while January saw a decline in yields alongside a collapse in volatility, the trend of these lower-quality sectors outperforming higher-quality sectors has continued. In fact, CCC HY is off to its best start since 2003, returning over 6%, while preferred securities, which embody both embedded credit risk alongside interest rate risk, benefited from both fronts, recouping a substantial amount of their 2022 loss with a return of 13% in January alone.
These returns are hardly one that foretell a hard landing over the next several months. However, it is important to distinguish between the momentum-versus-value element and the technical factors that are serving as a tailwind to such strong performance out of the gate. After a year of outflows out of bond fund—USD 133bn in IG funds alone, then over USD 9 billion in January—combined with the steep decline in HY supply (down over 70% in 2022), technicals remained a tailwind as we start the new year. As the market comfortably digests a pause from the Fed over the next few months, the level of the terminal rate and the magnitude of interest rate cuts starting in 2H23 through 2024 remain a topic of debate. Currently, the market foresees a terminal rate of 4.9% and 160bps of easing. The 34bps decline in 10-year yields in January, alongside the continued inversion of the 2-year/10-year and 3-month/10-year yield curves, has resulted in the market’s disbelief that the Fed can hold its higher-for-longer stance for a material length of time. We believe that 10-year yields will trend higher toward the upper end of the 3.9% range over the next few weeks, as the Fed maintains its higher-for-longer stance to suppress loosening financial conditions, and as the speculative community continues to increase short positions, which are currently already the largest since 2018.
On 9 February, we will be publishing our Fixed Income Strategist, “Prepare for landing,” where we will discuss our performance expectations and allocations over the next few months. We are not expecting the performance in January to mark the trend for 2023. Below we show the yield and spreads over various time frames for fixed income. While yields remain well above their 10-year average, spreads do not. For sectors such as HY and preferreds, these yields are nearly 1% lower than the start of the year given spread compression and the decline in interest rates. As the credit cycle continues to slow, this lower cushion will contribute to widening spreads as we enter 2Q23.
Read the original blog Fixed income performance: The kickoff 31 January 2023.
Main contributor: Leslie Falconio
This content is a product of the UBS Chief Investment Office.
