For many investors, 2023 reinforced the relative appeal of fixed income as the Fed hiked rates for a second year. It also spotlighted advancements in the asset class since rates were last this high: the digitization of trading and wider availability of data continues to boost transparency, access, and liquidity. As markets adjusted to a more normalized rate backdrop, some interesting themes emerged. The perception that loan diversification equates to risk diversification was reversed as many investors sought the comfort of knowing details around a single loan. Treasuries and municipal bonds showed unusually high correlation, suggesting potential for more porous volatility contagion. And more recently, the relationship between key volatility indicators - the stock market’s VIX, and the bond market’s ICE BofA MOVE Index has unraveled, with the VIX signaling relative calm while the MOVE is slightly higher. Here are some themes we’ll be watching in the new year.
Across developed Asian economies, bonds flourished in popularity as an asset class. This was not merely an extension of the global story where rate hikes and inflation woes boosted the relative appeal of bonds. Instead, we noted that much support came from the growth of wealth - both for the upper middle class and high net worth investors - since rates were last this high.
Continued interest in and growing knowledge of fixed income has appeared to manifest in investors’ willingness to take on more risk: this December in Taiwan, the largest fixed income ETF market in Asia, the record-breaking Capital BBB ESG Fixed Income ETF was the first ETF to be fully subscribed on day of listing, attracting about USD634 million from retail investors. This highlights a potential shift in demand from the perceived safety of Treasury ETFs earlier this year. Could high yield be next? As we noted recently, there are reasons for optimism on the outlook for that segment.
The ICE Municipal AAA yield curve showed a record and prolonged level of inversion this year, representing a rare dynamic: unlike the inverted Treasury yield curve (a common recession bellwether) the muni curve rarely inverts, even in tough economic times. This reflected a lackluster period for issuance, as higher rates saw short-term financing costs for projects jump. New muni issuance for the year-to-date is ~$350 billion and unlikely to surpass the $390.7 billion for 2022, which was ~22% below the prior year. But while supply has been tepid, demand is strong. This November’s 1.5 million trades represent a monthly record according to the Municipal Securities Rulemaking Board, which noted that demand from small investors was a major factor in the trading spike.
Another dynamic of interest: if the inverted muni curve is evidence of higher correlation between Treasuries and munis, it could spell less opportunity for relative value trades and the prospect of more porous volatility. Curve inversion has moderated since its record in mid-May and now sits around -23 basis points. The rally is in line with Treasuries and most global bond markets, on the belief the Fed may be finished raising rates.
The structural shift to hybrid work has changed investment fundamentals for commercial mortgage-backed securities - especially those backed by office properties. Exactly what this means for returns is still playing out. For now, concern swirls around looming maturities against a backdrop of high interest rates. Market participants are being far more granular in their credit analysis, with some showing a preference for single borrower/single asset CMBS where it is easier to know the details or characteristics around an asset. For the most part, investors are also assuming some probability of delay in pay-off or refinance on maturity.
While the prospect of lower interest rates next year may offer some relief, plenty of questions remain. How could new demand fundamentals change the way CMBS are issued, traded, and valued? Will this change capital allocation strategies and the way cities develop? And what does it mean for the future financing of commercial real estate?
Bond ETFs continue to exert a growing, positive influence on markets. By making fixed income accessible to a broader range of investors, they support a dynamic where more bonds are priced and traded daily - boosting liquidity. While it took nearly two decades for bond ETFs to surpass US$1 trillion in global assets, some managers predict the next stage of growth will be swifter: bond ETF assets hit US$2 trillion this year and BlackRock estimates they will triple by the end of the decade.
There’s also evidence these investment vehicles are helping price discovery. While larger bond trades tend to enjoy the highest quality execution, the need for ETFs to maintain representative baskets of holdings appears to have helped smaller odd lots find buyers - with greater liquidity for smaller trades resulting in spread compression. As electronic trading grows and data access helps price discovery, the parallel rise of bond ETFs is supporting greater sophistication across the asset class.
As key indicators of bond and stock market volatility respectively, the MOVE and VIX are watched closely by market pundits. Perhaps unsurprisingly, they tend to move in tandem: higher stock market volatility often signals economic or geopolitical concern, which can send shivers through debt markets. Both indicators showed correlation this year, but parted in early December as equities rallied on expectations that the rate-hike cycle is at its end, causing the VIX to dive. While December’s Fed meeting supported this view - with a forecast 75 basis points of rate cuts in 2024 - Europe’s central banks have warned that the inflation battle continues. Bond markets still reflect some unease over the outlook: the MOVE hit an annual high of 198.7 this March amid the regional banking crisis, and its current level of ~118 is above its five-year average of 84.8.
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