Midyear Fixed Income Outlook: Solid but Slowing, a Favorable Environment for Fixed Income

by Jonathan Rocafort of Parametric, 6/25/24

Market expectations for Federal Reserve rate cuts in 2024 have shifted dramatically, from six cuts expected at the start of the year, to barely one or two at this writing. Here’s why we think the US economy’s resilience and the year-to-date increase in yields may prolong an attractive opportunity in fixed income.

Since the Fed last raised the federal funds target rate almost one year ago, policymakers have remained on hold—keeping the benchmark rate at a two decade high in the range of 5.25% to 5.5% for seven consecutive meetings. In our 2023 midyear outlook, we speculated this might happen. Data showing persistent inflation and a robust economy and labor market have sent yields higher: US Treasury, municipal, investment grade corporate and preferred yields are up 30 to 60 basis points (bps) year to date. Markets have adjusted to the prospect of higher for longer.

We think that’s good news for fixed income investors, extending the window to capitalize on some of the highest yields over the past decade—yields that would allow fixed income to play a larger role in diversified asset allocation.

Economic resilience and higher yields bringing fixed income solutions further into focus

Restrictive policy beginning to have an impact

The latest estimates show GDP slowed to 1.3% in Q1, down from the surprisingly strong 3.4% in Q4 and 3.1% over 2023.¹ A softer labor market, the drawdown in savings and elevated debt may be starting to weigh on consumers. Real disposable income has increased only modestly over this past year, rising at a quarter of the previous year’s pace.² We can probably attribute this to a slowing job market: The US unemployment rate ticked up to 4% in May—the highest level in two years. US job openings fell in April to the lowest level in over three years.³

Consumers may also feel the strain from less savings and more debt. According to a recent study from the San Francisco Fed, the savings rate hit a 16-month low, with households having exhausted their $2.1 trillion pandemic era savings. That was one of the primary drivers of the surprising strength we witnessed in 2023.⁴ US household debt has reached a record $17.7 trillion, and this debt comes with relatively high interest costs.⁵ Combined, these factors may lead consumers to exercise spending constraint, weakening the economy’s main growth engine.

After stronger than expected inflation readings to start the year, more recent indicators—such as May’s Core CPI print of 3.40%, the lowest since April 2021—show the disinflationary trend remains in place, though the decline is gradual.⁶

Solid but slowing growth and accommodative Fed policy favoring fixed income

Given these factors, we expect the second half of 2024 to be a favorable environment for fixed income investors. The cumulative impact of restrictive policy may continue to cool the US economy and labor market, while bringing inflation closer to target. We think that could result in the first rate cut in late 2024 or early 2025.

While income on cash sweeps, CDs and T-bills may be attractive, we see value in extending out on the curve, assuming more risk, getting some duration in a portfolio and locking in yields at or near decade highs. History suggests that stepping out of cash during Fed cutting cycles has tended to result in outperformance.

Outlook for munis, corporates and preferreds in the second half of 2024

Municipals

The muni market starts the second half with yields up 30–60 bps since January, just off year-to-date highs. Tax exempt yields in the 3% to 4% range should keep buyers engaged. For investors in higher tax brackets, this can equate to tax adjusted yields of 6% to 7%.⁷—close to equity-like return potential.
Record new issue volume in May and June has also made municipals more attractive compared to taxable alternatives. Muni to US Treasury ratios are also hovering near their year-to-date highs, suggesting the potential for outperformance ahead.
Supply/demand technical factors may support the market. Over the summer months from June to August, $120 billion of reinvestment from coupons, calls and maturities could be met with less supply—resulting in more dollars chasing fewer bonds.
In our opinion, municipal credit remains on a solid footing. Liquidity and fund balances near record levels may provide a strong cushion as the economy heads into a potential slowdown.

Corporates

Year-to-date corporate bond results showcase the benefits of a high starting yield to mitigate against rising rates. Through mid-June, the ICE BofA 1-10 Year US Corporate Index has generated a positive return despite rates increasing by 40 bps. For the year so far, corporate bond yields have been over 5.0%—a level associated with the 2008–2009 Credit Crisis, not the strong economy we now experience.
During 2024, intermediate maturity corporate bonds have outperformed similar duration US Treasury notes as credit spreads narrowed in response to strong earnings and the outlook for continued economic growth. We don’t anticipate spreads near historic lows to tighten materially in the near term. However, we believe current spreads offer good compensation given the positive trend in credit ratings, with two investment grade issuers receiving upgrades for every one being downgraded.
Healthy supply/demand technicals may continue to support the market. New issuance is expected to decline in the second half of the year. At the same time, increased coupon income reinvested in the sector would boost already strong demand.

Preferreds

Preferred securities have enjoyed some of the best returns in fixed income year to date. Despite the rise in Treasury yields, preferred spreads have tightened and still look relatively attractive to investment grade and high yield spreads. The ICE BofA Fixed Rate Securities Index is up 3.55% through May 31, and $1000 par fixed to float securities have outperformed the index.
As the market has realized that the overall banking system and the consumer are in solid shape, and regional bank issues appear to have been contained, preferred securities have shaken off some of 2023’s volatility. While commercial real estate risks persist, active management can incorporate fundamental research views that underweight financial institutions with excessive CRE exposure.
The preferred market has seen healthy fund inflows this year. New issuance has picked up significantly, yet the supply/demand technicals remain supportive as more floating rate preferreds are called than new ones are issued.
We see value in recent new issues pricing near 7%. Many of these securities offer tax advantaged qualified dividend income (QDI) for investors in taxable accounts. These yields look attractive versus similar investment grade and high yield corporate securities.
Looking forward, we believe robust fundamentals and the highest yields in 15 years are supportive of strong returns from carry, with the opportunity for total returns with lower yields and a steeper yield curve.

The bottom line

Recent metrics around growth, inflation and the labor market suggest that with the Fed’s key policy rate sitting at a two decade high, the US economy is beginning to slow. While the timing and pace of future rate cuts remain data dependent, we expect lower yields to materialize during the second half of 2024 and into 2025.

Our view is to consider stepping out of cash, assuming more risk, getting some duration in portfolios and locking in yields around decade highs. Economic resilience and the year-to-date increase in yields may simply prolong and enhance what we see as an attractive opportunity in fixed income.

¹ Bloomberg, GDP (calendar quarter over quarter) as of Q1 2024.

² Bloomberg, Bureau of Economic Analysis, change in real disposable income (year over year), April 2024

³ Bloomberg, US employment rate and JOLTS, reported June 2024.

⁴ Federal Reserve Bank of San Francisco, “Pandemic Savings Are Gone: What’s Next for U.S. Consumers?” by Hamza Abdelrahman and Luiz Edgard Oliveira, May 3, 2024.

⁵ Federal Reserve Bank of New York, Center for Microeconomic Data, Quarterly Report on Household Debt and Credit, May 2024.

⁶ Bloomberg, Personal Consumption Expenditures (calendar year over year).

⁷ Based on a 40.8% tax rate (37% Federal plus 3.8% Medicare surcharge).

Risk Considerations

Cash includes bank deposits and money market funds. Bank deposits are insured by the FDIC and offer a fixed rate of return, whereas the return and principal value of an investments fluctuates with changes in market conditions. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to such factors as interest rate sensitivity, market perception of the creditworthiness of the issuer, and general market liquidity. When interest rates rise, the value of corporate debt securities can be expected to decline. Debt securities with longer maturities tend to be more sensitive to interest rate movements than those with shorter maturities. Company defaults can impact the level of returns generated by corporate debt securities. An unexpected default can reduce income and the capital value of a corporate debt security. Furthermore, market expectations regarding economic conditions and the likely number of corporate defaults may impact the value of corporate debt securities. An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads, and a lack of price transparency in the market. There generally is limited public information about municipal issuers. As interest rates rise, the value of certain income investments is likely to decline. Longer-term bonds typically are more sensitive to interest-rate changes than shorter-term bonds. Investments in income securities may be affected by changes in the creditworthiness of the issuer and are subject to the risk of nonpayment of principal and interest. The value of income securities also may decline because of real or perceived concerns about the issuer’s ability to make principal and interest payments. Preferred securities are subject to interest rate risk and generally decreases in value if interest rates rise and increase in value if interest rates fall.

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