Third Quarter Postmortem: The Fed Means It
The third quarter delivered a surprisingly painful head fake to fixed income investors who had already endured two quarters of steadily higher interest rates and the worst six-month returns in years. Early in the quarter, with improving inflation readings and two interest rate hikes already in the books, investors optimistically anticipated a “pivot” from the Federal Reserve’s (Fed) path of interest rate hikes in 2022 to cuts in early 2023. Corporate spreads tightened, high yield enjoyed its best single month in over a decade, and the “soft landing” narrative started to appear plausible. But at the Fed’s annual conference in Jackson Hole, Fed Chair Jerome Powell quickly snuffed out the optimism, telling the market that any talks of a pivot were premature, and adding later that the Fed’s resolve will likely result in “some pain to households and businesses.” After two more 75 basis point rate hikes and a worse-than-expected inflation print in September, investors are again feeling the pain promised by Powell. The Fed’s moves have impacted markets both domestically and abroad. Some foreign central banks have felt obligated to intervene to support their own currencies and economic interests. The result has been extreme global volatility. Treasury yields continue rising, and the 10s/2s curve inversion ended the quarter at 44 basis points, causing many economists to ramp up their calls for a recession. Corporate bonds, both investment grade and high yield, have produced large losses on the year, and even traditional safe havens such as Treasuries are deep in the red. Simultaneously, the labor market has stayed strong, giving the Fed ample justification to continue on its rate-hike path. Against this backdrop, it appears all but certain that the Bloomberg U.S. Aggregate Index (the Agg) will post its all-time worst year of returns. Although no market participant is immune in markets such as these, SBH has always favored securities that we consider high quality, which historically have provided some degree of relative protection. Read on for more details.
All the major fixed income categories posted losses in the third quarter, led lower by investment grade (IG) corporates. This marks three consecutive quarters of losses for all categories.
U.S. Treasury Market
Treasury yields continued their ascent in September and ended the quarter higher across the maturity spectrum. The jump in yield was more extreme on the short end of the curve.
The shortest T-Bills continue to benefit from higher rates; all other Treasury buckets added to their year-to-date losses.
Broad Investment Grade
The Agg was pummeled for a third consecutive quarter, with long corporates leading the march lower. Asset-backed securities and intermediate corporates outperformed similar-duration Treasuries, while all other categories posted negative excess (relative to Treasuries) returns.
Corporate spreads widened in September and finished the quarter flat in intermediates and wider in long corporates. MBS spreads widened in response to the Fed’s continuing removal of support.
All IG ratings categories were negative in the quarter, both in absolute and excess returns. BBBs were the top performer in the quarter on both measures.
Investment grade corporate spreads were U-shaped in the quarter, finishing virtually unchanged for most sectors after dropping in July and August. The sectors with the widest spreads continue to be Communications and Basic Industry.
High yield (HY) returns finished in the red for the quarter after a strong July was followed by weakness in August and September. HY outperformed Treasuries by over 200 basis points across all ratings categories.
High yield corporate spreads were mixed for the quarter; average spreads in Consumer Cyclicals and Communications widened, while every other sector moved tighter.
The high yield default rate rose in July and August before improving in September. It finished the quarter marginally higher.
Municipals & Other
Municipal returns were negative for the quarter, with longer duration munis underperforming shorter duration. Yields on all municipal ratings categories jumped significantly, most notably on the short end.
Emerging market debt outperformed Treasuries for the quarter but remains well behind YTD. Leveraged loan returns were positive for the quarter and remain one of the top performing sectors in fixed income year-to-date.
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This update provides an overview of certain broad-based Fixed Income benchmarks and does not include performance of the Segall Bryant & Hamill Fixed Income styles. Past performance cannot guarantee future results. All investments involve risk, including the possible loss of capital. All opinions expressed in this material are solely the opinions of Segall Bryant & Hamill. You should not treat any opinion expressed as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of the manager’s opinions. The opinions expressed are based upon information the manager considers reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this material does not constitute financial, legal, tax or other professional advice and is not intended as a substitute for consultation with a qualified professional. The manager’s statements and opinions are subject to change without notice, and Segall Bryant & Hamill is not under any obligation to update or correct any information provided in this material.
1 Source: Bloomberg.
2 Source: Bank of America Merrill Lynch.
3 Hypothetical yields are calculated as the AA municipal yield divided by (1-tax rate). Actual tax-adjusted yields will depend on individual tax circumstances.
4 Source: Standard & Poor’s.