Bonds awoke from their 2024 slumber in Q3 as the much anticipated first rate cut from the Federal Reserve came to fruition in mid-September with the promise of many more cuts to come now priced into fixed income markets. The 10yr US Treasury yield plummeted from 4.4% at the end of June to 3.8% to close the quarter, supporting higher bond prices. Investment Grade fixed and Municipal bonds also performed well in the quarter with the decline in rates.
At Meritage, we maintained our overweight to BBB-rated corporate bonds which served clients well in Q3, adding to the modest gains of the first half. We also pushed to extend duration in accounts in the late Spring and early Summer, however the speed of the drop in yields put us on the sideline, perhaps a little too soon given the ultimate decline. Short Duration accounts performed roughly in line with their benchmark, while Intermediate Duration accounts continue to outperform their benchmark.
As we head into the final months of the year, the bond market landscape has changed dramatically. The low-hanging fruit is not as attractive. 6%+ yields on front-end BBB corporate bonds has eroded to just 4-5%, the UST 2yr is down to 3.6%, and money market rates are heading to 4% or lower by mid-December. The positives here are, for one, high-quality bond portfolios have clawed back a substantial piece of the losses from 2022. Secondly, rate levels have come down sharply, however, relative to the last 15 years, yields remain very attractive, and we believe conservative bond portfolios can serve their traditional purpose in a client’s overall asset allocation.
From a strategy standpoint, we are positioned for and expecting a backup in long rates in the coming months. Rates in the mid-3%s in the 5-10yr sector look to us to be more risk than reward in our conservative management of bond portfolios in the face of a ballooning National debt and trillions in deficits. Generic IG Corporate bond spreads at +92bps also look rich to us, however we continue to overweight BBBs on the front-end of the credit curve where we view the risk of price depreciation as minimal, especially with the Fed cutting rates. We also continue to favor adding to USTs and Corporates over Municipal debt on a tax-adjusted basis, however for clients with a strong desire for tax-exempt income there are pockets of the Muni market that look attractive.
Although not as glaring as in Q4 of last year, we do believe the rates market is a bit ahead of itself pricing in almost 200bps of cuts by the end of 2025. Our clients have participated nicely in the bond market rebound, and should outperform if inflation should perk back up or long-end rates head higher. Two risks we believe to be currently underappreciated.
