The Global Bonds Team states that while supportive monetary policy has helped global bond markets get up off the mat, bond investors must still keep an eye on issuer fundamentals and consider employing a wider range of tools to achieve the characteristics typically associated with a fixed income allocation.
- The degree to which bond markets – including corporate credits – have rallied since their COVID-19-era low is amazing but has largely been the consequence of massive support from central banks.
- While policy support has been necessary – and welcome – investors must continue to focus on issuer and sector fundamentals, as risks to the economy remain and a potential increase in defaults is lurking.
- In order to help bond allocations deliver diversification and income, as well as lower volatility, investors will likely need to manage their interest rate and currency exposure more dynamically.
More commonly remembered for its lyrics than its title, the 1997 song “Tubthumping” by British band Chumbawamba became an international hit, ultimately topping charts globally. The group’s guitarist, Boff Whalley, purportedly said the song was inspired by “the resilience of ordinary people.”
“I get knocked down, but I get up again, you’re never gonna keep me down,” were lyrics that resonated then, and today are a fitting musical analogy that epitomizes the way countries and economies have reacted to the impact of the COVID-19 pandemic. These words’ relevance is no less fitting a description of the behavior of markets in the aftermath of the late-winter sell-off in riskier assets.
For investors, it must be said that getting back up has been relatively easy, thanks to the widespread intervention of central banks mostly adopting a “whatever it takes” attitude to support their economies and financial markets. Money has never been cheaper, with interest rates held low and likely remaining there for the foreseeable future. Notably in fixed income, repurchase programs have returned most markets to near-normal liquidity and pricing conditions.
But getting back up and staying up are not the same. The latter requires resilience, adaptability, an openness to continue to learn from the unforeseeable nature of exogenous shocks, and an understanding of what it was that laid you flat in the first place. But before we draw groans for writing yet another postmortem of the March crisis (and specifically the behavior of global fixed income markets), this piece is instead focused on the road forward, of the lessons learned and – with 20/20 hindsight – the careful evaluation of the developments that are obvious now but were perhaps less so back then.
“Technicals” Help, But Fundamentals Still Matter
At a broad level, we have said before that none of the events of the past several months have caused us to change our views about the fundamental health of a large portion of investment-grade issuers that are endowed with experienced management teams and prioritize their ability to service their debt. That is not to say that lower-rated issuers are not at risk of downgrade and default; risks in this market segment have likely increased.
The world remains in a precarious state. It is vital that investors never lose sight of fundamentals. Despite the support provided by global central banks, we consider this focus on issuer fundamentals as important as ever. Many businesses and sectors are likely to be impacted by continuing economic challenges caused by the pandemic. For example, certain real estate investment trusts (REITs) have seen their underlying assets acutely impacted by fallout from the pandemic as tenants are forced to adjust their physical footprints. Similarly, airports and other issuers directly linked to travel and tourism look to be in for a tough road.
However, “don’t fight the Fed” has been uttered many times before, and we have learned to accept the strong tailwinds provided by the widespread support of central banks. For the near-to-medium term, we believe markets are likely to continue being driven – or at least highly supported – by favorable technicals.
Expanding the Bond Playbook
While we still believe in benefits historically imbedded in investment-grade credit’s risk/reward profile – and indeed the spread over the risk-free rate for a highly rated portfolio of shorter-dated bonds is almost as attractive as it’s ever been – we also recognize the importance of casting the net as wide as possible when seeking to harvest the characteristics of income generation, diversification from equities and lowering overall portfolio volatility. We have long said that fixed income investors must now work harder to achieve these goals. The recent action of central banks and resetting of markets to lower rates makes this all the more true. Looking forward, this means prudent bond investors should increasingly consider more dynamic management of duration and currency exposure. Examples of how bond investors may need to expand their playbook to help fixed income allocations achieve their historical objectives are:
- Employing options as inexpensive hedges – given depressed levels of interest rate volatility – that may help protect the portfolio from unforeseen rate swings.
- Participating in the interest rate swap market, where the potential for income-generation on securities nearing maturity look attractive on a risk/reward basis.
- A willingness to incorporate issuers in difference currencies: With developed market central banks at or near their effective lower bounds, cross-country interest rate relative value trades provide little scope for differentiation, hence currencies have likely become an effective tool for expressing relative performance. Particularly within the context of a monetary policy framework that is firmly on hold, constructing a portfolio of uncorrelated positions stands to be a beneficial diversifier of returns through time.
Despite what Chumbawamba sang, we hopefully won’t “need a whiskey drink” or any other type of libation, nor have to sing a song to remind us of the good times or the best times. But we’ll certainly drink to the importance of perpetual learning in these unprecedented times in order to increase resilience in bond allocations.
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