Holding serve Holding serve http://www.federatedhermes.com/us/static/images/fhi/fed-hermes-logo-amp.png http://www.federatedhermes.com/us/daf\images\insights\article\tennis-serve-small.jpg January 19 2024 January 19 2024

Holding serve

What we got right…and wrong…in a volatile year.

Published January 19 2024
My Content
Muni ratios are rich, but demand has remained firm

Municipal market yields followed Treasury yields sharply lower in the fourth quarter, with munis outperforming on muted supply and improving investor demand. The S&P Municipal Bond Index posted a huge return of 7.18% and closed out the year posting 6.03%. We expect recent favorable investor demand should persist in 2024, particularly if recent gains in the Treasury market hold. In the short-term, net supply—issuance less calls and maturities—is forecast to switch from negative to positive in first quarter of 2024, creating potential headwind to relative value as muni ratios to AAA Treasuries ended 2023 on the rich side. Muni credit is largely strong and stable in most sectors. For instance, many state and local governments still have cash from the large Covid-era transfers and strong tax revenues accumulated during the continuing economic expansion. That said, muni credit metrics likely have peaked. Tax revenue growth is fading amid the decelerating economy, and commercial office valuations are creating downside risk for those local governments with a high tax base concentration of office property. — R.J. Gallo

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.

Tags Fixed Income . Markets/Economy . Interest Rates .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Past performance is no guarantee of future results.

Alpha: This measures a fund's risk-adjusted performance. It represents the difference between a fund's actual returns and its expected performance, given its level of risk as measured by beta (see definition of Beta). This difference is expressed as an annualized percentage.

Bond credit ratings measure the risk that a security will default. Credit ratings of A or better are considered to be high credit quality; credit ratings of BBB are good credit quality and the lowest category of investment grade; credit ratings of BB and below are lower-rated securities; and credit ratings of CCC or below have high default risk.

Effective Duration: A measure of a security’s price sensitivity to changes in interest rates. One of the methods of calculating the risk associated with interest rate changes on securities such as bonds.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Diversification does not assure a profit nor protect against loss.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited.

Bloomberg US Aggregate Bond Index: An unmanaged index composed of securities from the Bloomberg Government/Corporate Bond Index, Mortgage-Backed Securities Index and the Asset-Backed Securities Index. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indices are rebalanced monthly by market capitalization. Indexes are unmanaged and investments cannot be made in an index.

Bloomberg Municipal Bond Index: A market-value-weighted index for the long-term tax-exempt bond market. To be included in the index, bonds must have a minimum credit rating of Baa. They must have an outstanding par value of at least $7 million and be issues as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date. Indexes are unmanaged and investments cannot be made in an index.

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