It was a lackluster start to the year for high quality fixed income with the move higher in US Treasury yields largely negating the tightening in Investment Grade (IG) credit spreads. Amidst generally decent macroeconomic data and a rally in risk assets, expectations for the amount and timing of Rate cuts in 2024 have decreased substantially and been pushed out the calendar. This led to the 2yr and 10yr UST yields to rise 37bps and 32bps respectively in Q1, closing the quarter at 4.62% and 4.20%. Generic Treasury and IG bond indices were down 1% and .1% for the quarter.
At Meritage, we were skeptical at the turn of the year of the consensus view that the Fed would begin to cut Rates as early as March and over 125bps cumulatively in 2024. With the now widespread view of “higher for longer”, we maintained an underweight duration position in Intermediate portfolios. That, coupled with an overweight position in IG corporates, particularly in short-dated, BBB-rated bonds, resulted in the Meritage Taxable Fixed Income Intermediate Term strategy model outperforming its benchmark by 78bps eking out a gain of .63% in Q1. The Meritage Taxable Fixed Income Short Duration strategy model continued to take advantage of the greater than 5% returns available in 6-18-month T-bills and high yield money market funds in Q1. It again met its mandate of capital preservation and strong safety. The Meritage Tax-Exempt bond strategy model also outperformed its benchmark by 34bps largely due to its underweight duration positioning, but was essentially flat for the quarter returning -.03%. Individual client bond portfolio performance can vary for a variety of reasons including cash flows, client direction, and legacy positions.
Entering Q2, the market is implying just under 75bps of Rate cuts in 2024 beginning in June or July. We believe the Fed will begin to cut rates in 2024, as Chairman Powell has communicated, and are gradually extending duration in Intermediate portfolios as rates rise. However, we are still substantially underweight duration vs. the benchmark. The inverted yield curve and uncertainty around the speed and magnitude of a decline in inflation towards the Fed’s 2% target have us moving slowly in extending duration. As expressed in the past, but worth reiterating, we currently steer clients away from long duration fixed income portfolios given the precarious state of developed market government debt, huge US budget deficits, and rising interest expense.
On the credit front, at +93bps and +312bps respectively, Investment Grade and High Yield credit spreads are as tight as in 2021. We benefited nicely from the 14bp tightening in BBB credit spreads in Q1, mainly holding positions inside 3 years to maturity. We continue to be overweight corporates in our Short Duration and Intermediate strategies as we see absolute yields in short-dated bonds of well over 5% as attractive given that Fed Rate cuts are likely into year-end. We doubt we will see further spread tightening. We also continue to favor adding to USTs and Corporates over Municipal debt on a tax-adjusted basis.
