Newton’s First Law
Of the many newsworthy events and policy changes over the past quarter, few, if any, have rattled the markets. Consequently, the quarter was calm and the S&P 500 Index continued to make new highs, turning in a stellar performance – up 8.12% – with very little volatility. In fact, following the Liberation Day spike, volatility measures have retreated to levels just above the post-Covid lows seen in 2023 and 2024, suggesting widespread complacency.
One possible explanation for this optimism was that investors expected the Fed to cut the fed funds rate, which would stimulate the markets and the economy. While this was certainly a factor, which we will discuss more below, we believe a bigger driver was that solid earnings growth continued in the third quarter following a robust second quarter. Moreover, the impact of tariffs (of which few were enacted in Q2) has been very modest thus far, as many companies frontloaded inventory. This allowed second quarter earnings to be much higher than the dire forecasts that were made in April. As a result, a wide swath of financial assets performed well and, as Isaac Newton posited: bodies in motion stay in motion. For now.
In fact, as you can see from the table below, most market indicators were favorable during the period, as bond yields fell (i.e., prices rose), equities rallied, spreads tightened, and volatility declined.
In high yield, the increased proportion of BB-rated bonds, now representing ~55% of the index, has helped to improve the overall credit quality of the index but has also made it more interest rate sensitive than in the past. Since the BB cohort typically carries lower spreads, more akin to the BBB bonds in the investment grade universe, comparing overall spreads today to past eras can be a bit misleading. That said, given the lower spreads in fixed income and higher equity valuations, it would not be surprising to see more muted returns from here barring further help from the Fed.
It is hard to find compelling reasons for us to justify moving away from our current defensive posture. Anecdotally, we are seeing increasing signs of froth in the markets. The investments in AI-themed names in both the venture capital world and in the public markets are but one example. The mostly paper wealth creation among those early-stage investors has been staggering, and it is fueling prodigious follow-on investment into the sector.
For fixed income investors, the AI-themed names are a cohort that exists largely outside our investment purview (although we did have one very successful investment in an AI-related convertible, which we exited at the end of 2024). Most of the AI-themed names are private, VC-owned cash burners that are not prime candidates for borrowing in the credit markets. The few that have come to market to borrow have very dubious credit profiles and have asked lenders to invest largely based on their future prospects. This is a sensible arrangement for equity holders, who receive unlimited upside in exchange for the risk they take, but for bondholders it is far less appealing, as their upside is limited to the coupon they receive while the risk is the same. We are, however, carefully monitoring this because we believe it is an apt barometer for broad investor sentiment, which is unabashedly risk-on.
The hyperscalers are budgeting hundreds of billions of dollars of CapEx to build data centers, which they hope will power a massive expansion of AI adoption in the years ahead. The numbers are astonishing, and the hype and activity around AI reminds us of the excitement around all things dot-com and dark fiber in the 1990s. The birth of the internet was a society-changing phenomenon, and AI could prove to be the same. However, it is unlikely that AI adoption will pan out exactly as planned. Given the lofty valuations ascribed to these early-stage, unproven companies, any deviation from the expected adoption rate and the ensuing revenue forecasts (many of which are still years away) could trigger at least a tremor, and possibly a much larger quake as winners and losers are parsed by the market. Stay tuned.
Another big market tailwind in the third quarter was the ever “watched pot” of Fed policy. When the Fed finally decided to cut the federal funds rate target by 25 basis points on September 18th, it was about as surprising as seeing the sun rise in the east. Traditional fixed income managers have been leaning into this cut for months, and the softening of the labor market finally gave the Fed the leeway it needed to make the move, despite data that show inflation is still exceeding the Fed’s long-held 2% target. In their dual mandate, there is no clear regulatory preference in weight given to keeping inflation in check or maintaining a stable job market, but inflation concerns over the last three years have clearly taken precedence. The recently elevated focus on the job market, potentially at the expense of inflation vigilance, could have meaningful implications regarding the shape of the yield curve going forward.
The lead up to the September meeting saw the 10-year Treasury rally nearly 35 basis points from 4.34% to 3.99%, before closing at 4.02% the day before the meeting. That enthusiasm was short lived. We have argued for the last few years that a decline in short rates does not necessarily precede a correspondent decline in longer rates. Recency bias surely plays a part in investors’ expectations about this as the period from 2008-2022 was the only extended period where the 10-year yield stayed below 4% since 1960. Otherwise, a 10-year Treasury yield above 4% puts it into what can be considered a “normal” range over the last 60+ years.
Now with a Fed focused mainly on the job market, it would seem to us the door has been left ajar for the bond vigilantes to utilize the diminished focus on inflation to take a run at the long end of the curve and drive up rates. Arguments are being posited that further cuts run the risk of overstimulating the economy and reigniting the inflationary fire that the Fed sought to quell beginning with its 2022 hiking regime. As such, we still think the 10-year Treasury will be range-bound for the foreseeable future between 4.0 – 4.5%. That makes the risk/reward tradeoff of extending duration skew negatively at current levels, particularly for higher-rated issues, which carry lower yields and are more interest sensitive.
As has often happened in the past during strong bull markets in credit, we have allowed our cash and cash-like investments to grow. New issue activity in both the investment grade and high yield bond markets has been robust, but coupons offered have been mostly unattractive at the time of issuance. Fortunately, we are still finding some opportunities in non-benchmark issues, more complex stories, or first-time issuers, where we are getting paid appropriately to extend maturities. In the meantime, we are being very careful to avoid the potholes and making sure not to stretch (accepting more credit risk) while chasing yield.
We are very patient and exercise a disciplined approach to entry points in bonds we have on our extensive watch list. Additionally, given how relatively flat the yield curve is in high yield, we are giving up very little yield today by holding short-duration assets while we wait for better entry points. Our portfolio positioning is designed to help us avoid significant drawdowns during market disruptions and should enable us to act quickly when better broad buying opportunities present themselves.
Thank you for your continued confidence in our management.
Carl Kaufman, Co-President, Co-Chief Executive Officer, Chief Investment Officer – Strategic Income & Managing Director – Fixed Income
Bradley Kane, Vice President & Portfolio Manager – Strategic Income
Craig Manchuck, Vice President & Portfolio Manager – Strategic Income
John Sheehan, CFA, Vice President & Portfolio Manager – Strategic Income
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A basis point is a unit that is equal to 1/100th of 1%.
Treasuries are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government” and thus are considered free of default risk.
Yield is the income return on an investment, such as the interest or dividends received from holding a particular security. A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.
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