Amidst a barrage of macro headlines and new policy measures, investors wrestled with the so-called “Trump Trade” and pockets of its unwinding in Q1. Fortunately, for bond investors, high-quality fixed income had a solid quarter with the IG taxable index returning 2.4%, appropriately playing defense for diversified portfolios. Meritage’s taxable fixed income strategies finished the quarter in-line with their benchmarks returning approximately 1.5% to 2.5% with the Intermediate strategy outperforming. Tax-exempt bonds returns were less, reflecting their after-tax status.
For the first time in years, the Federal Reserve was quiet both in that there were no changes to the Federal Funds rate at 4.25%-4.50%, and in that there was very little in terms of policy headlines. To be sure, the new Trump Administration filled the void, and has offered plenty for the Rates market to digest. Although the action in bonds calmed in March, it was just 10 weeks ago when the UST 10yr yield soared to 4.80% with many calling for a move through 5% as inevitable under Trump’s policies. Instead, the 10yr has nosedived to close Q1 at 4.2%.
What changed? Well, a 10% drop in the S&P 500 and 14% move lower in the Nasdaq from record highs certainly tempered animal spirits and brought money into bond markets. Additionally, two new forces have grabbed the attention of the Treasury market. One has been the very direct speak from new Treasury Secretary Scott Bessent. Away from explicitly stating that he and Trump are focused on a lower 10yr Treasury yield, Bessent has also commented on a “detox” period being necessary for the US economy as it has become “addicted to excessive government spending”. Second, we have DOGE, the Elon Musk led department to cut Government fraud and waste. It is clear, at least in Q1, that these two new factors have put downward pressure on Treasury yields.
At Meritage, we have been largely correct in maintaining shorter durations in client bond portfolios over the past few years, choosing to enhance yield in portfolios with BBB-credit risk on the front-end. After reaching historic tights at the end of 2024, IG credit spreads have widened about 15bps with the risk-off environment. Municipal bond spreads have also begun to widen with many citing DOGE effects. While we expect spreads to widen further, we still prefer to pick-up yield in short-duration corporates, or munis, as they cheapen, rather than to extend duration by buying long Treasuries. However one feels about the new Administration, DOGE, tariffs, etc., the reality is this year’s fiscal deficit is still cruising towards $2 trillion, adding to our $37 trillion debt load.
Real progress on the deficit would be highly welcomed, but if cuts are used to simply fund new spending initiatives or lower taxes, we are not sure a 10yr at 4.2% is compelling, given the US Government’s debt backdrop. Of course, a recession, coupled with a serious drawdown in risk assets, would propel a faster pace of Fed cuts, and certainly could lead to much lower long-dated Treasury yields, but for how long? We believe the risk/reward has structurally changed in debt markets leading us to continue to favor conservative interest-rate risk positioning while adding yield through careful credit selection.
All that said, our base case for the rest of 2025 is rather benign for bond markets, and we expect solid, although unexciting, returns to continue in client portfolios. A clear weakening in the employment data, along with contained inflation readings, have the Fed biased towards cutting. Even just one or two cuts in 2025 should support high-quality front-end bond prices where we are positioned.
We believe our conservative positioning today serves client goals of capital preservation with excellent liquidity, while also providing flexibility for opportunities that will surely arise in the coming years. Thank you for your trust in the managing of your fixed income assets.
