Day Hagan Smart Sector® Fixed Income Strategy Update March 2025
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Day Hagan Smart Sector® Fixed Income Strategy Update March 2025 (pdf)
Executive Summary
In February 2025, global fixed-income markets fared well, though they faced considerable turbulence fueled by geopolitical tensions, shifts in monetary policy, and changing investor sentiment. A key incident contributing to this uncertainty was the contentious meeting between U.S. President Donald Trump and Ukrainian President Volodymyr Zelensky on February 28. This prompted a flight to safety among investors and a subsequent decline in benchmark U.S. Treasury yields. From a performance perspective, U.S. longer-dated Treasuries and agencies outperformed in February, while short-term Treasuries, Floating Rate Notes, and international sovereign fixed-income assets underperformed (though still with positive returns).
This shift also affected European stock futures and the euro, creating a ripple effect of volatility across Wall Street, notably as President Trump announced forthcoming tariffs on imports from Mexico, Canada, and China. Investor apprehension has intensified regarding a widening inflation gap between the U.S. and the Eurozone, reaching its broadest margin since 2022. Forecasts suggest U.S. inflation could hover around 2.8% over the next two years, contrasted with just 1.9% in the eurozone.
Factors such as divergent economic growth trajectories, U.S. trade tariffs, and potential reductions in European energy costs tied to a possible resolution in Ukraine are instrumental in shaping these projections. Despite high inflation expectations, the continued decline of U.S. Treasury yields compared to European bonds reflects market expectations of impending Federal Reserve interest rate cuts, alongside heightened European defense spending impacting inflation and currency values.
The corporate bond market demonstrated significant activity, highlighted by Mars, Inc.’s plans to issue bonds valued between $25 billion and $30 billion to finance its acquisition of Kellanova, the maker of Pringles. This initiative is part of a broader $40 billion wave of acquisition financing in the bond market. Major banks, including Citigroup and JPMorgan Chase, are tasked with marketing these bonds to investors. This deal could be one of the largest investment-grade M&A financings since 2013. Additionally, software firm Synopsys aims to issue $10-15 billion in bonds to fund its $34 billion acquisition of Ansys, contributing to a projected total of around $40 billion in new investment-grade bond issuances.
The structured finance sector has seen a resurgence, evidenced by record attendance of 10,000 at the annual SFVegas conference, surpassing even major events such as the World Economic Forum. The robust appetite for structured credit, including asset-backed securities and collateralized loan obligations, contrasts starkly with the aftermath of the 2008 financial crisis, as investors increasingly seek high-yield products amid current market conditions. Nevertheless, this rapid expansion raises questions about potential market overexuberance.
Looking ahead, analysts believe that the era of low interest rates may be ending. However, they could persist at elevated levels due to structural factors such as escalating government debt, deglobalization, and enduring inflation. While temporary rate cuts may occur, central banks are likely to grapple with the challenge of preventing economic instability associated with sustained low rates, increasing borrowing costs, and influencing overall economic activity.
Deteriorating consumer sentiment in February was influenced by fears of government layoffs, rising tariffs, and persistent inflationary pressures during Trump’s second term. As a result, consumer stocks entered correction territory, escalating market uncertainty. Housing bonds are gaining favor amid these headwinds, perceived as safer amidst an economic environment increasingly characterized by rising risks and pressures on lower-income households while higher-income individuals remain less affected. Despite recession fears, credit spreads remain at multiyear lows, suggesting limited compensation for bond investors amidst declining economic sentiment. Year-to-date issuance for February totaled approximately $335 billion, reflecting a decline of $54 billion, or 14%, from the $389 billion recorded the previous year. Should economic output continue to lag behind historical trends and inflation remains subdued, central banks are likely to maintain accommodative monetary policies. Such measures aim to foster economic recovery and sustain market stability, even as challenges persist in market sentiment and global trade dynamics.
Holdings
Fixed Income Sector
US 1-3 Month T-bill
US 3-7 Year Treasury
US 10-20 Year Treasury
TIPS (short-term)
US Mortgage-Backed
US Floating Rate
US Corporate
US High Yield
International Corporate Bond
Emerging Market Bond
Outlook (relative to benchmark)
Neutral
Neutral
Overweight
Neutral
Neutral
Underweight
Neutral
Neutral
Neutral
Neutral
Position Details
U.S. Treasuries: The composite model remains neutral, though improving from early January levels. Measures of momentum, trend relative to U.S. equities, and Swap values are neutral to positive. Inflation expectations are still a headwind. On balance, we remain neutral across the curve.
Commentary: In February, the Treasury market faced significant headwinds due to rising inflation concerns and Federal Reserve statements. The January Consumer Price Index (CPI) indicated a year-over-year inflation rate of 3.2%, with core prices increasing by 0.2% month-over-month, surpassing expectations. This led to a rise in 10-year Treasury yields to 4.5%, following a mid-month auction that revealed weak demand. During his testimony, Fed Chair Jerome Powell’s hawkish commentary suggested that interest rate cuts were unlikely, given a robust labor market, which further pressured bond prices. During this period, the yield curve steepened slightly, with the 2-year note nearing 4.7% and the 30-year bond approaching 4.8%. The Bloomberg U.S. Treasury Index likely declined by 1.5–2%. A mid-February auction of 10-year Treasury bonds performed poorly, with a bid-to-cover ratio of 2.3, below the average of 2.5, as demand weakened from foreign buyers, particularly influenced by stimulus needs in China and policy uncertainties in Japan. Financial institutions reported varied performance tied to Treasury trading. JPMorgan Chase saw a 15% increase in fixed income trading revenue in Q4 2024, while Goldman Sachs reported a 20% uptick in government bond trading revenue. In contrast, rising funding costs continued to challenge banks, as highlighted by Citigroup’s 10% rise in Treasury-related trading hampered by margin compression. Amid these dynamics, the Treasury market exhibited signs of volatility influenced by both domestic and international factors.
U.S. TIPS: The TIPS composite declined with the March update. Commodity price trends are bullish, while high-yield credit spread trends and the inflation expectations and extremes indicators are neutral. Price trend indicators are unfavorable. We remain neutral.
Commentary: U.S. Treasury Inflation-Protected Securities (TIPS) experienced notable shifts driven by macroeconomic trends and sector-specific dynamics. On February 1, the 10-year breakeven rate was approximately 2.2%, rising to 2.5%-2.6% by February 27, indicating heightened expectations for inflation above 2.5% over the next decade. This anticipation, fueled by the January Consumer Price Index (CPI) report showing a year-over-year inflation rate of 3.2%, boosted the Bloomberg TIPS Index by roughly 0.5%-1% during the month, while nominal Treasuries fell by 1.5%-2%. Real yields also increased, with the 10-year TIPS yield climbing from 2.0% to 2.1%-2.2%. Demand for higher real returns from TIPS led to a defensive flow from investors amidst rising nominal yields. The Treasury’s mid-month auction for 30-year TIPS, sized at $9 billion, saw strong demand, marked by a bid-to-cover ratio of about 2.4, reflecting renewed interest from institutional investors seeking inflation hedges. Despite these positive trends, TIPS faced challenges such as duration sensitivity, which magnified price volatility and reduced secondary market liquidity, evidenced by widening bid-ask spreads. Moving forward, the Federal Reserve’s monetary policy stance and planned Treasury issuance of $815 billion in the second quarter further influenced the TIPS market.
U.S. Mortgage-Backed Securities: The MBS composite improved, reverting from oversold levels. It correlates positively with the 10-year Treasury Note’s backup in yield and option-adjusted spreads holding steady. We are increasing exposure to neutral.
Commentary: The MBS market faced significant challenges driven by persistent inflation and Federal Reserve signals. The January Consumer Price Index (CPI) report indicated a year-over-year inflation rate of 3.2%, with core prices up 0.2% month-over-month, exceeding expectations. This resulted in a rise in 10-year Treasury yields to 4.5%, following a mid-month auction that revealed weak demand, which in turn increased mortgage rates and pressured MBS prices. Fed Chair Jerome Powell’s testimony reinforced a hawkish stance, highlighting the likelihood of no immediate rate cuts due to a robust labor market. Agency MBS spreads over Treasuries saw a slight widening from 150 to about 160-170 basis points for 30-year current-coupon MBS, reflecting modest investor caution. Despite this, demand remained steady due to government-backed credit quality. Non-agency MBS, including jumbo and non-QM pools, exhibited resilience, gaining approximately 0.5-1% amid stable credit performance, though some delinquency increases were noted. Factors such as a 30-year mortgage rate increase to 7.1% and a drop in refinancing activity contributed to a stabilization of prepayment speeds. The housing market displayed mixed signals, with a reported 2% decline in existing home sales in January, while new listings increased by 8.4% in Minnesota, indicating buyer hesitance amid economic uncertainty. As of February 27, the average rate for a 30-year fixed mortgage was 6.76%.
U.S. Floating Rate Notes: The composite model deteriorated as rates declined into the end of the month. Measures of trend, momentum, option-adjusted spreads, and volatility are mostly negative. We are reducing exposure and are underweight.
Commentary: Federal Reserve Chair Jerome Powell’s testimony reaffirmed a hawkish stance, indicating no imminent rate cuts, which elevated short-term rates and significantly impacted FRNs adjusting their coupons based on the Secured Overnight Financing Rate (SOFR). During this period, the 3-month SOFR rose from 4.6% to an estimated 4.7-4.8%, enhancing the appeal of FRNs as their yields reached approximately 5.0-5.2%. A $25 billion 2-year FRN auction with a bid-to-cover ratio of 2.6 signified strong demand, particularly from institutional investors seeking floating rate exposure in light of potential rate hikes. The banking sector also contributed positively, with banks like JPMorgan Chase expanding their FRN holdings, bolstered by robust earnings in Q4 2024. However, challenges included temporary yield mismatches due to quarterly resets and reduced liquidity, evidenced by wider bid-ask spreads. Overall, the FRN market maintained resilience amid shifting economic conditions, reflecting its unique position in the fixed-income landscape.
U.S. IG Corporates: The composite model held steady in the neutral zone. Measures of implied bond volatility are moving lower, credit default swaps are still near historically low levels, and the potential for mean reversion from oversold conditions are favorable. Conversely, U.S. dollar trends and a slight widening in option-adjusted spreads (even though CDS and OAS are at low levels) remain concerns. We remain neutral.
Commentary: Early February saw robust corporate issuance, with approximately $150-175 billion in new IG bonds, driven by the financial and utilities sectors aiming to secure funding ahead of earnings reports. Financials and energy sectors outperformed, buoyed by deregulation prospects and stable oil prices, respectively. In contrast, consumer and retail sectors lagged due to tariff threats, leading to widening spreads. Overall, credit fundamentals remained stable, with ratings upgrades surpassing downgrades at a ratio of 3:1, although leverage increased slightly due to debt-funded mergers. Geopolitical tensions and refinancing risks also emerged as critical concerns. As companies reported Q4 earnings, financial firms like JPMorgan and Goldman Sachs demonstrated robust trading revenue, while others, like Dow, Inc., faced challenges from margin pressures.
U.S. High Yield: The composite model held steady with the March update. Trend, breadth, and OAS are supportive. We are somewhat concerned about the relative underperformance of small-cap stocks in February, as there is a strong correlation between HY and small-caps. Overall, we remain modestly overweight given the model’s high level.
Commentary: HY bond spreads over Treasuries tightened slightly from 350 basis points at the start of February to 330-340 basis points by the end of the month, driven by investor demand. Sectors like energy and consumer cyclicals performed well, with energy bonds benefitting from rising oil prices, while telecom bonds underperformed due to leverage concerns. Default rates remained low at 2-2.5%, supported by solid earnings from HY issuers. Despite a sell-off mid-month due to trade tariff fears, the recovery was swift. As $150-$200 billion in HY debt matures in 2025, refinancing challenges pose risks for weaker credits. Overall, the month showcased a complicated landscape where economic headwinds contrasted with resilient high-yield performance.
International IG Corporate Bonds: The composite model declined due to February’s relative underperformance relative to U.S. fixed income. International IG Corp.-related trend measures deteriorated, as expected. We are reducing exposure and are underweight.
Commentary: In Europe, anticipation of new joint EU bonds to support increased defense spending added to investor interest but is likely to create excess supply. The EU projected a need for €500 billion over the next decade, with an immediate requirement for an additional €200 billion annually. Concurrently, U.S. tariff announcements created uncertainties regarding inflation and corporate profitability. The U.S. Consumer Price Index reported a year-over-year inflation rate of 3.2%, pushing 10-year Treasury yields to 4.5%. The Federal Reserve’s hawkish stance contrasted with the European Central Bank’s potential easing. Meanwhile, European issuance surged to approximately €50-60 billion early in February, primarily driven by utility and financial sectors seeking to secure funding. Financials outperformed, with bonds from institutions like BNP Paribas tightening spreads by 5-10 basis points, supported by stable earnings and deregulation optimism. In contrast, consumer sectors faced pressure as tariffs posed risks to profit margins. Overall, credit quality remained robust, with two upgrades for every downgrade, while interest in ESG-focused bonds grew significantly, comprising 15-20% of total issuance.
Emerging Market Bonds: EM bonds did well in February but underperformed U.S. bonds. However, measures of relative currency trends, EM equity momentum, commodity market strength, and trend-related indicators are now positive. We are increasing exposure.
Commentary: Sovereign EM bonds displayed mixed results; countries like Argentina and Turkey benefited from carry trades, while investment-grade sovereigns faced relative pressure. Corporate bonds, particularly in the energy and financial sectors, fared better, with spreads tightening by 10-15 basis points driven by robust Q4 2024 earnings. Regional disparities emerged, with Latin American bonds outperforming, bolstered by stable commodity prices, while Asian bonds lagged due to trade risks. Local-currency bonds underperformed compared to dollar-denominated bonds, as a stronger dollar led to losses despite high real yields in countries like Brazil and South Africa. While default risks remained low, market liquidity challenges persisted amid uncertain economic conditions.
Catastrophic Stop Model
The Catastrophic Stop model combines time-tested, objective indicators designed to identify high-risk periods for the equity and equity-related fixed-income markets. The model (Figure 1) improved in February and entered March with a fully invested allocation recommendation. If our models shift to bearish levels (below 40% for two consecutive days), we will reduce exposure to fixed-income sectors with high correlations to equities.
Figure 1: The Catastrophic Stop Model level is 72.86%.
This strategy utilizes measures of price, valuation, economic trends, monetary liquidity, and market sentiment to make objective, unemotional, rational decisions about how much capital to place at risk and where to place that capital.
For more information, please contact us at:
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Smart Sector® Fixed Income ETF
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Disclosures
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