As the new year kicks off, bond investors are grappling with the Fed cutting short-term rates just as long-term rates have started to rise again. The two paths are seemingly contradictory, resulting in the “steepening of the curve.” Meanwhile, credit spreads remain near multi-year tight levels.
With this context, it’s no surprise that many investors are left wondering how best to position fixed income portfolios looking out into 2025.
We thought it could be helpful to share some of the most common questions we’ve received in relation to these issues over the last couple months. Think of it as a “mailbag” of sorts. We’ve rephrased the questions and left off names, but each of the questions below is one that we’ve been asked about at least a handful of times over the past few months.
Many investors’ assumption is that low spreads must be a function of investor exuberance. And it’s hard to ignore the growing signs of animal spirits present today (as I write this, Fartcoin, a meme coin with the slogan hot air rises, is valued at $750 million). Less discussed, however, is the significant improvement in quality of the high yield index recently. For instance, over half of the ICE BofA High Yield Index (“the Index”) was rated BB as of 11/30/24 (a record high). The ~35% proportion of issuance that is secured (vs unsecured) is also a record. Distressed rates are low, and recovery trends are improving. Leverage ratios and interest coverage also appear normal relative to historical ranges. In other words, a significant portion of the spread tightening is arguably justified.
Even after adjusting for the upgrade in Index quality, however, it’s reasonable to suggest that spreads are on the tighter side. Is this justified? On a relative basis, we would argue yes. Investment grade spreads remain similarly tight, but with more duration risk. And the equity risk premium of the S&P 500 just fell to its lowest level in over 20 years. By comparison, we find the risk/reward of high yield to be just as attractive – if not more – than these other asset classes.
With a ~7.5% yield-to-worst today, the Index’s absolute level of potential return is also compelling. While past is not prologue, we would point out that a starting yield of 7-8% has led to a positive total return in the following year ~90% of the time since 2000, according to data from Barclays.
It might be!
We have conceded that we’re unable to predict the path of rates any better than the market and are only willing to extend our duration when we feel like we’re being well compensated to do so. Right now, we don’t think the additional potential return is worth the additional risk.
There are other aspects that also make us wary about adding duration. Inflation, for example, has remained stubbornly above the Fed’s 2% target while unemployment remains low – hardly an environment that screams out for more accommodative policy. President Trump’s threat of tariffs and other potential policies arguably represent another risk to inflation. Finally, while often shrugged off by investors, it’s hard for us to ignore the size of projected US Budget deficits and how the required supply of treasury issuance needed to fund them could potentially weigh on long-term rates.
We also think there are some unique aspects of short duration bonds today that make it an interesting time to be invested. For instance, the primary issuance market has picked up considerably in the last few months, and we (like many others) are expecting this to continue into 2025 as companies start to address their wall of maturities from the boom of debt issuance post-covid. Rates have risen since then, so most of these bonds trade at a discount to par. These bonds are often repaid over a year before they are due, and frequently include a call premium. This results in returns that are higher than the stated yield-to-worst, as the bonds are repaid before maturity, and sometimes at a premium to par value. We believe a portfolio that is more concentrated in shorter term bonds is better able to capture this additional return.
We would point, again, to the higher quality of the high yield index today compared to prior years. Instead, more of the lower quality borrowings have been in the levered loan market. The default rate in loans in 2024 was 3.78%—nearly triple the 1.39% level of high yield bonds[1]. Based on the credit ratings of upcoming maturities, it would not surprise us to see a similar discrepancy again in 2025.
It’s also important to note how low the current default rate is relative to history. In the last 25 years, default rates have averaged approximately 3% according to JPMorgan data. We could therefore see default rates double from current levels and still be within long-term averages.
The rapid growth in private credit could also help cushion the blow of defaults. In our observation, private credit has often acted as a “backstop” for higher risk opportunities in the high yield market. We hear chatter of private credit funds bidding for refinancing opportunities with some of the riskier businesses that we follow and have even had a portfolio holding elect to refinance its bonds through the private credit market instead of a broad syndication. As the dry powder at these private credit funds continues to swell, we believe it could result in some of the weaker credits being removed from the high yield index.
A circumspect underwriting process is critical when selecting higher yielding bonds with near-dated maturities. The last thing we want to do is pick up nickels in front of a steamroller.
As a bond approaches maturity, the company should have multiple levers to repay the principal, even in the event that the economy suddenly turns south. Usually, this means enough cash on hand to cover the bonds plus a cushion for economic uncertainty. Many companies also have significant capacity on their revolving credit facilities that can be tapped to help meet upcoming maturities. It could also involve less favorable options like selling or borrowing against unencumbered assets. Or some combination of the above.
Once bonds get closer to maturity, we demand an adequate “margin of safety” to limit the risk that the company cannot or will not repay us if conditions suddenly deteriorate. Relying on the whims of the market to refi a bond is a recipe for disaster, which is why we stress test our holdings and target businesses that we think can withstand recessionary environments and still repay their debts.
A lot of the expected move in front end rates has already happened. True, the market is pricing in another two cuts in the Fed Funds rate in 2025 (compared to four in 2024), but the impact in corporate bond yields may be less than you’d expect. Recall that the Fed Funds rate is an overnight rate. Expected changes in slightly longer duration rates are more muted. For instance, the market only expects the 3-month treasury rate to fall by 2 bps over the next year. For a 2-year treasury, the market is pricing in an increase of four basis points over the next year. Hardly enough to materially impact our views.
But the level of rate, or potential return, is just one half of the equation. The other is risk. Suppose market expectations turn out to be wildly off. Perhaps inflation re-accelerates and the Fed is forced to hike interest rates again. In that case, any pain in short duration will pale in comparison to longer dated exposure. We would argue longer duration bonds are not sufficiently compensating investors to take this marginal risk.
As always, it’s a continuous reassessment of risk vs reward. As things stand today, shorter duration exposure looks more appealing to us. But if the curve steepens further, we could find it attractive to layer in additional longer dated exposure. Stay tuned.
Disclosures & Definitions
Mutual fund investing involves risk. Principal loss is possible. Investments in debt securities typically decrease in value when interest rates rise. The risk is generally greater for longer term debt securities. Investments by the Fund in lower-rated and non-rated securities presents a greater risk of loss to principal and interest than higher rated securities. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods.
The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company. Please read it carefully before investing. A hard copy of the prospectus can be requested by calling 866-996-FUND (3863).
Intrepid Capital Management Funds are distributed by Quasar Distributors, LLC.
The fund does not directly invest in Fartcoin, Bitcoin, or other cryptocurrencies. Cryptocurrencies are a relatively new asset class and are subject to unique and substantial risks.
The ICE BofA High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have a below investment grade rating (based on an average of Moody’s, S&P and Fitch), at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of $100 million.
Bond ratings are grades given to bonds that indicate their credit quality as determined by independent nationally recognized statistics rating organizations (NSROs) such as Standard & Poor’s, Moody’s and Fitch. These firms evaluate a bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. Ratings are expressed as letters ranging from ‘AAA’, which is the highest grade, to ‘D’, which is the lowest grade.
Leverage ratio is a measurement of indebtedness calculated as a company’s interest-bearing liabilities minus cash or cash equivalents, divided by its EBITDA.
EBITDA is a measure of a company’s operating performance and refers to Earnings before Interest, Tax, Depreciation and Amortization.
Equity Risk Premium is the excess return earned by investing in the stock market compared to the risk-free rate. It is often calculated by subtracting the yield of a 10-year US Treasury note from the ratio of the earnings of the S&P 500 Index relative to the price of the S&P 500 Index.
The S&P 500 is a broad-based, unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general.
Yield-to-Worst is the lowest yield an investor can expect when investing in a callable bond.