Bond investors face a tougher environment: (expected) growth is pushing interest rates up from record lows, foreshadowing the eventual end of the ‘lower-for-longer’ era. The answer? Adopt an active approach with neither a strategic exposure to interest rate risk, nor the constraints of a benchmark.
The economic outlook for the coming year is positive, taking into account three factors:
Numerically, the increase in economic growth compared to 2020 will look even larger due to base effects. Overall, though, the picture is for a solid recovery, one that raises questions over the outlook for interest rates and by extension the bond market.
We have already seen the US bond market move in anticipation of a less accommodative US Federal Reserve (the Fed). Benchmark 10-year Treasury yields have risen from 0.9% to around 1.5% so far this year. A further rise to 1.8% over the course of 2021 is very plausible. Broadly, we would expect to see a rise in yields of this magnitude across the world.
However, investors should remember that the Fed and the European Central Bank have told us that this recovery will not be like any other. The lockdowns have hit the services sector disproportionately hard. People in many white-collar jobs have been able to work from home. For them, a resumption of normality will come much faster. For other people and those (often smaller) businesses that have been scarred the most, the recovery will take longer.
With the Fed focused on a more equitable recovery across the economy, you can expect it to take that into account when assessing the need for action. We believe this means that the Fed will move later rather than earlier on adjusting its monetary accommodation, for example, by tapering its asset purchases. For policy rates, that should mean that changes are not imminent.
Another aspect to take into consideration when thinking about the prospects for higher interest rates is the Fed’s recently introduced Average Inflation Targeting (AIT) framework. This setup means that the market can expect the US central bank to be more indulgent on inflation – now below its 2% target. We can assume the Fed will allow the economy to run hotter, and inflation to rise above its target for longer, before it would begin to tighten monetary policy.
It is far from obvious that in this recovery, we will see the usual ‘central bank tightening – yields rising’ mechanism. Instead, bond markets are already anticipating higher inflation and marking down bond prices accordingly.
We believe the Fed will be looking for clear confirmation in the data before acting. The US economy is expected to lead the way when it comes to the recovery from the COVID-induced worldwide slump, so for investors, it makes sense to use developments in the US as a guide to the outlook for bonds and interest rates in other major markets.
For bond investors, the outlook for a – slight – rise in market rates (in anticipation of the recovery) is challenging, especially since central bank policymakers are explicitly endorsing that inflation may rise above their targets. In such an environment, you would expect bonds to underperform relative to other asset classes.
With yields at extraordinarily low levels and the interest-rate sensitivity (duration) of portfolios unusually high, investors are concerned about capital losses from rising yields and from inflation eroding the value of the principal that they receive once the bond is redeemed.
There are areas of supply/demand mismatches: oil demand, for example, can be expected to pick up in a recovery as (particularly holiday) travel resumes at scale, while production is likely to be ramped up slowly, in part because increasing supply takes time and also because oil exporters are keen to see higher oil prices.
Another example is the hospitality sector: Reopening restaurants will see a release of pent-up demand, while there are likely to be limitations on the supply of tables. Such mismatches point to inflation ‘bubbling through the system’, which could harm bond returns.
Given the huge government rescue packages and the sovereign bond issuance they entail, a focus on corporate bonds could be an option, particularly as this segment typically does well in a growth environment. Indeed, this market does not look unattractive and could act as an interest-rate hedge.
However, risk premiums are already low and would appear to have limited scope to go lower, while many companies have had to borrow heavily to weather the crisis. They might well struggle to ‘grow themselves’ out of their debt loads.
Default risk might be less of an issue, but we believe zombification is. At the current low risk premiums, investors are undercompensated for the risk, we believe.
Knowing that investors typically look towards bonds as a portfolio diversifier away from equities, as a stable source of income and as a store of capital value, we believe the answer lies in an approach that is uncorrelated to the wider market and free from a benchmark that could force investors to hold assets that may not be suited to the environment.
Such an approach means using (zero-yield) cash as the basis for managing fixed income holdings rather than a market index, taking a flexible attitude towards all possible fixed income sources of returns, and – perhaps most importantly – being able to take short as well as long positions so as to actively profit in a down market.
This is what absolute return oriented fixed income investing does. It is an approach that can provide investors with the ‘diversifier-income-value’ combination that they seek from fixed income investing, and may be well suited to the potential environment outlined above.
At present, we see opportunities in commercial mortgage-backed securities, the travel & leisure sector and emerging market debt.
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