Holding serve

I can’t say that 2023 was the most challenging year in my three-plus decades, but for Federated Hermes, it was a bit more of a mix than we are accustomed to. Our fixed-income committees (Alpha Pods) that advise on yield curve, duration, sector and currency positioning got some things right—and some not so much. Both warrant review in a new year, with markets optimistically pricing in aggressive rate cuts and the Federal Reserve seemingly shifting focus from the inflation fight to supporting the soft landing.

Interest rates At the beginning of 2023, we expected that core and long rates, having experienced the bulk of their increases in 2021 and 2022, would produce positive bond returns after 2022’s historic bear market. That call, which ultimately proved correct, doesn’t seem so heroic now, but was out of favor over much of 2023 as the Bloomberg Agg and other bond indices wallowed in negative territory.

In totality, the 10-year yield started the year at 3.87% and finished 2023 at 3.88%, so our neutral duration call throughout 2023 was accurate. What we got wrong on rates were in tactical moves. While we remained constructive with durations between 100% and 105%, our timing between the moves was not optimal. Ultimately, the duration pod did not add value like it had in the previous three years and five out of the last six.

In a similar fashion, our yield curve pod correctly predicted that the curve would not invert further from its extreme movements in 2022. The 2-, 3- and 5-year Treasuries declined by 5 to 15 basis points compared to the unchanged 10- and 30-year. What we got wrong is that the curve didn’t return completely to a normal shape. Our expectation is that it will in 2024.

Spread sectors Our moves in the MBS and emerging market sectors added value both strategically and tactically in 2023. We expected that the 2022 and early 2023 sell-off in MBS created historically wide spreads with unusually asymmetric convexity risks—or rather, lack of convexity risk. Similarly, our emerging markets team recognized opportunities that volatile spreads created for the sector and that a weakening dollar supported.

Overall, we were too defensive on corporate credit, both investment grade and high yield, within our multisector strategies. Despite what we saw as deteriorating fundamentals for a material segment of these universes, the technicals of low supply and reasonable demand overwhelmed. They created tighter spreads and positive excess returns for both, reflected in the performance of the individual funds we manage in those spaces.

Security selection Here, we were predominately right. This is best demonstrated with our internal core funds, which our portfolios utilize to efficiently access beta. In addition to capturing the strong market returns, or beta, in the all-important spread sectors, our core funds produced alpha by outperforming the market segment. High yield, mortgage and trade finance core were the primary drivers due to excellent security selection.

Ultimately, our benchmark-like performance in 2023 means that we held serve in our fixed-income portfolios. Our diversified investment process helped keep us in the game, and preserve—if not materially add to—recent process-driven gains. Sometimes being right means not being too wrong.

Many but not all questions were answered positively in 2023. I reported last quarter we had been persistently early with our cautious positioning in credit sectors. We begin 2024 with a similar view, driven by a range of evolving factors. To be sure, current consensus has swelled in favor of a soft landing and the “this rate cycle is different” chorus has the stage. We may indeed avert the typical tightening cycle downsides of contracting payrolls, increasing unemployment and ultimate recession—an outcome that has occurred only twice over the last 50 years. Call us cautiously pessimistic.

While the markets have decided the best-case rate cycle is the clear path, we think two other scenarios could unfold: the economy heats up quickly , with persistent inflation; or the lagged impacts of monetary policy combined with the heavy weight of interest rates are already pushing the economy into a mild recession. The latter is the more likely of the two. Long and variable lagging indicators remain in play and are flashing caution. Europe and China have weakened, and geopolitical risks have increased. We’re more neutral than this time last year, but remain cautious.

Our approach has always been to carefully weigh the downside risks that bond investors may face, rather than dismiss them. The extensive experience of our fixed-income teams helps keep our heads when we get it right and when we get it wrong.