The trajectory of bond markets will be largely dictated by the opposing forces of an effective COVID-19 vaccine deployment and potential early-year economic lockdowns, says Portfolio Manager Nick Maroutsos.
- The economy is likely nearer the end of this crisis than the beginning, which should be further aided if a large-scale vaccine campaign proves successful.
- Although interest rates may rise as the economy improves, we believe the Fed will take steps to keep a lid on Treasury yields.
- An improving economy should be favourable to corporate credits, but selectivity is likely to remain key with higher-quality, shorter-duration securities and many international names offering the most attractive risk/reward profile.
Given its arduous path due to the disruption caused by the COVID-19 pandemic, some may lose sight that fixed income markets have generated positive returns in 2020. Even with these respectable gains, we believe that bonds still have room to run. Our cautious optimism is based on our belief that we are closer to the end of this crisis than the beginning. But while encouraged that policy makers are shepherding the economy through the worst of the storm, we do not yet believe it is smooth sailing for investors.
A delicate balance
The next several weeks should prove critical as markets balance the promise of potential vaccines spurring a return to normalcy against the additional economic pain of more lockdowns.
With every day seemingly delivering progress on the vaccine front, the outlook sets up favourably for riskier assets, among them corporate credits. While the difference between the yields on corporate bonds and those on risk-free benchmarks have already narrowed considerably, we believe that an imminent exit from the pandemic along with friendly financial conditions would bode well for further narrowing of corporate spreads. And while we would not be surprised if rates on government benchmarks inched higher as the economic recovery gains traction, narrowing spreads should be more than enough to compensate for those losses.
Fed still in the game
A key ingredient of easy financial conditions is accommodative monetary policy on the part of the Federal Reserve (Fed) and other central banks. We take the Fed at its word that they have zero intention of raising policy rates over the medium term. While the central bank may allow slightly higher rates on longer maturities, we expect they would be quick to act to keep a lid on yields should the market get too aggressive in pushing rates higher. Although it may not reach the threshold of “official” yield-curve control, assertive rhetoric will likely achieve similar ends of keeping borrowing costs low.
This year’s surprisingly rapid response by the Fed is an important reason why we find ourselves enjoying buoyant bond markets and averting economic catastrophe. This is in contrast to the early days of the Global Financial Crisis when hesitation by policy makers likely made a bad situation worse. Wanting to avoid a liquidity crisis this past spring, the Fed’s first step was to backstop market functioning to ensure borrowers maintained access to credit. It worked, and as evidenced by the recovery in riskier assets, perhaps better than many could have imagined.
Avoiding the next crisis
While central banks were successful in easing market stresses, the jury is out on whether they can stave off a possible solvency crisis. The level of fiscal support extended to workers and small businesses were necessary shock absorbers during the worst of the spring lockdowns. But it has been months since the last fiscal package and the US – and much of Europe – is staring into the abyss of a second wave of COVID cases. With small business and household finances still fragile, a rise in insolvencies could lead to an even larger spike in joblessness, ultimately weighing on the recovery as the consumption growth engine is depressed. Although we expect additional fiscal stimulus, insolvency risk and its knock-on effects is worth monitoring in 2021.
A time of capital preservation
Given this near-term uncertainty, we expect bond market volatility to remain elevated. This is not a time to treat a fixed income allocation as “equities light.” The elevated volatility we expect the market to experience over the next few months will not be worth the returns in what still is a low rate environment.
A key tactic in preserving capital will be to focus in higher-quality corporate issuers. Given interest rate differentials, many of the most attractive names, in our view, exist outside of the US. Among these are Australian banks and quasi-sovereign corporates – especially in Asia ex Japan – that have implicit government backing. We believe many travel and leisure names are still best avoided, as a paradigm shift in business travel is likely to cast a long shadow over airlines and we await to see how their business models compensate for this. While the secular strength of technology is apparent, rich pricing should merit a more selective and disciplined approach.
Since our overarching outlook remains moderately positive, we believe that the risk of modestly higher yields on longer-dated Treasuries cannot be ruled out. Accordingly, we believe limiting portfolio duration – focusing on the front end of the yield curve – is a prudent tactic especially with the curve still flat by historical standards.
Credit spread is the difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
Volatility measures risk using the dispersion of returns for a given investment.