In the fourth quarter of 2023, the Bloomberg US Corporate High Yield Index (“Index”) return was 7.16% bringing the year to date (“YTD”) return to 13.44%. The S&P 500 index return was 11.68% (including dividends reinvested) bringing the YTD return to 26.26%. Over the period, while the 10 year Treasury yield decreased 69 basis points, the Index option adjusted spread (“OAS”) tightened 71 basis points moving from 394 basis points to 323 basis points.
All ratings segments of the High Yield Market participated in the spread tightening as BB rated securities tightened 63 basis points, B rated securities tightened 89 basis points, and CCC rated securities tightened 72 basis points. The chart below from Bloomberg displays the spread moves in the Index over the past five years. For reference, the average level over that time period was 413 basis points.
The sector and industry returns in this paragraph are all Index return numbers. The Index is mapped in a manner where the “sector” is broader with the more specific “industry” beneath it. For example, Energy is a “sector” and the “industries” within the Energy sector include independent energy, integrated energy, midstream, oil field services, and refining. The Brokerage, Banking, and Finance sectors were the best performers during the quarter, posting returns of 11.80%, 9.37%, and 8.40%, respectively. On the other hand, Transportation, Energy, and Other Industrial were the worst performing sectors, posting returns of 4.25%, 5.24%, and 6.53%, respectively. At the industry level, retailers, media, and building materials all posted the best returns. The retailers industry posted the highest return of 10.03%. The lowest performing industries during the quarter were oil field services, airlines, and independent energy. The oil field services industry posted the lowest return of 3.10%.
While there was a dearth of issuance during 2022 as interest rates rapidly increased and capital structures were previously refinanced, the primary market perked up a bit during each quarter this year. Issuance has remained low by historical standards as so much was pushed out by the large issuance during 2020 and 2021. For 2024, strategists are looking for issuance in the range of $200-$230 billion. Of the issuance that did take place during Q4, Finance took 29% of the market share followed by Energy at 28% share and Industrials at 13% share.
The Federal Reserve did hold the Target Rate steady at the November and December meetings. There was no meeting held in October. This made three consecutive meetings without a hike. The last hike was back in July. For the first time since March of 2021, the Fed is not projecting additional hikes. In fact, the Fed dot plot shows that Fed officials are forecasting 75 basis points in cuts during 2024. It sure seems like the worm has finally turned and the market is responding positively. During the December post meeting press conference, Chair Powell did pay lip service to the ability to hike again if needed, but the focus moved to rate cuts. With regard to when it will become appropriate to cut rates, Powell said “That begins to come into view and is clearly a topic of discussion out in the world and also a discussion for us at our meeting today.”i The Fed’s main objective has been lowering inflation and it continues to trend in the desired direction. The most recent report for Core CPI showed a year over year growth rate of 4.0% down from a peak of 6.6% over one year ago. Further, the most recent Core PCE growth rate measured 3.2% off the peak of 5.6% from February of 2022.
Intermediate Treasuries decreased 69 basis points over the quarter, as the 10-year Treasury yield was at 4.57% on September 30th, and 3.88% at the end of the fourth quarter. The 5-year Treasury decreased 76 basis points over the quarter, moving from 4.61% on September 30th, to 3.85% at the end of the fourth quarter. Intermediate term yields more often reflect GDP and expectations for future economic growth and inflation rather than actions taken by the FOMC to adjust the target rate. The revised third quarter GDP print was 4.9% (quarter over quarter annualized rate). Looking forward, the current consensus view of economists suggests a GDP for 2024 around 1.3% with inflation expectations around 2.6%.ii
Being a more conservative asset manager, Cincinnati Asset Management does not buy CCC and lower rated securities. Additionally, our interest rate agnostic philosophy keeps us generally positioned in the five to ten year maturity timeframe. During Q4, Index performance was very strong leading to our cash position being a drag on performance. Additional performance drag was due to our credit selections within banking and brokerage as we positioned in high quality credits in those sectors. Benefiting our performance this quarter were our credit selections in capital goods, technology, and electric utilities.
The Bloomberg US Corporate High Yield Index ended the fourth quarter with a yield of 7.59%. Treasury volatility, as measured by the Merrill Lynch Option Volatility Estimate (“MOVE” Index), has picked up quite a bit the past couple of years. The MOVE averaged 121 during 2023 relative to a 62 average over 2021. However, the current rate of 114 is well below the spike near 200 back in March during the banking scare. Data available through November shows 39 defaults during 2023 which is up from 16 defaults during all of 2022. The trailing twelve month dollar-weighted default rate is 2.46%.iii The current default rate is relative to the 1.14%, 1.30%, 1.74%, 1.93% default rates from the previous four quarter end data points listed oldest to most recent. While defaults are ticking up, the fundamentals of high yield companies still look good. From a technical view, fund flows were positive in the quarter at $6.7 billion and total -$22.6 billion YTD.iv No doubt there are risks, but we are of the belief that for clients that have an investment horizon over a complete market cycle, high yield deserves to be considered as part of the portfolio allocation.
What a difference several months can make. Not too long ago 10 year rates were at 15 year highs topping out close to 5%. Today the 10 year rate is just under 4%. Crude oil was over $90 per barrel and now it is a touch over $70 per barrel. As we move forward in 2024, the labor market is holding up but cooling as job seekers are beginning to struggle to find work. Consumer delinquencies have been ticking up across most loan categories while savings have dwindled and the savings rate remains below average.v No doubt that this softness is being taken into account by market participants. That is the reason for the lower GDP projections and the Fed talking potential cuts at this point in time. Our exercise of discipline and credit selectivity is important as we continue to evaluate that the given compensation for the perceived level of risk remains appropriate. As always, we will continue our search for value and adjust positions as we uncover compelling situations. Finally, we are very grateful for the trust placed in our team to manage your capital.
This information is intended solely to report on investment strategies identified by Cincinnati Asset Management. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. Fixed income securities may be sensitive to prevailing interest rates. When rates rise the value generally declines. Past performance is not a guarantee of future results. Gross of advisory fee performance does not reflect the deduction of investment advisory fees. Our advisory fees are disclosed in Form ADV Part 2A. Accounts managed through brokerage firm programs usually will include additional fees. Returns are calculated monthly in U.S. dollars and include reinvestment of dividends and interest. The index is unmanaged and does not take into account fees, expenses, and transaction costs. It is shown for comparative purposes and is based on information generally available to the public from sources believed to be reliable. No representation is made to its accuracy or completeness. Additional disclosures on the material risks and potential benefits of investing in corporate bonds are available on our website: https://www.cambonds.com/disclosure-statements/.
i Bloomberg December 13, 2023: Fed Pivots to Rate Cuts
ii Bloomberg January 2, 2024: Economic Forecasts (ECFC)
iii Moody’s December 14, 2023: November 2023 Default Report and data file
iv CreditSights December 21, 2023: “Credit Flows”
v Moody’s December 2023: State of the US Consumer