It’s hard not to start 2021 with a sigh of relief. COVID-19 vaccines have arrived, contentious US elections are behind us, and five years’ worth of Brexit negotiations have concluded. The worst appears to be over.
But we aren’t yet in the clear. Vaccine distribution must now outpace the spread of a significantly more contagious variant of the virus. Most countries won’t return to business as usual anytime soon. Economies will require sustained monetary and fiscal support to continue their recoveries. And concerns are mounting that the second US fiscal package—despite a nearly trillion-dollar price tag—may be not only too late but too little.
For bond investors, this means more of the same: low and negative yields, strong demand for income assets, and episodic market volatility. Here’s how we’re looking to navigate unchartered waters in the year ahead.
Navigating Low Yields
The arrival of vaccines increases the odds that global growth will pick up strongly in the second half of 2021, when the virus will likely fade as a cyclical driver. But over the near term, recovery remains fragile, and continued supportive fiscal and monetary policies remain essential.
In this environment, central banks aren’t inclined to let interest rates rise. This means yields are likely to stay very low in most parts of the world for the foreseeable future. In fact, the US Federal Reserve indicated in September that it will peg interest rates near zero through at least 2023.
At the same time, volatility remains a risk, given uncertainty around the new coronavirus strain, the speed and ease of vaccine rollouts, and the timing of reopening.
Under these conditions, a bond portfolio must limit downside risk while generating income and return despite a low-yield environment. Thankfully, the bond markets can still help investors meet both objectives.
Some market observers have suggested that low and negative yields hinder government bonds’ ability to provide a buffer against down markets because bond returns will also be low. We agree that government bond returns will be more muted than in the past because of low yield levels. Indeed, US Treasury returns have been comparatively muted for the past decade, having already reached the lower limits of a downward trend in yields that lasted 30 years.
However, we believe that the argument linking meaningful returns to risk reduction misses the mark, for two reasons.
First, a long history of extremely low yields in Japan suggests that low yields do not necessarily map to low returns. For 11 of the past 12 years, the yield on the 10-year Japanese government bond was less than 1%. In contrast, annual returns over the same period rarely matched starting yield levels. Instead, returns averaged more than twice as much as yields, thanks to a price bump as bonds rolled down the steep yield curve over time. The US Treasury yield curve is similarly steep today, with the slope between five- and 10-year Treasury yields now around the 75th percentile of their average slope since 1962.
Second, amid the dramatic sell-off in risk assets in March 2020 as the global pandemic took hold, and again in September 2020 when equity markets pulled back sharply, government bonds served as one of the few true offsets to equity market volatility.
On down days for the stock market, the daily rolling six-month correlation between US Treasuries and the S&P 500 remained below –0.4, despite a 10-year US Treasury yield well below 1%. And in Europe, where yields on 10-year German Bunds were well into negative territory when stock markets fell in March and September, correlations became more negative during sell-offs.
In other words, government bonds became more defensive when defensiveness was needed most. That argues for an allocation to government bonds as an essential buffer during periods of heightened volatility in the risk markets.
Striking the Right Balance
Meanwhile, investors’ need for income and return is as great as ever. Investors looking to make the most of their bond allocation might consider pairing exposure to government bonds with a diverse mix of higher-yielding fixed-income sectors in a single portfolio.
In contrast with a traditional, benchmark-hugging portfolio, the balanced portfolio targets the desired objectives of defense plus efficient income. This approach capitalizes on relative value opportunities while taking advantage of differing correlations among sectors.
That’s because the two groups are negatively correlated during risk-off environments, much like US Treasuries and stocks. In other words, safety-seeking assets such as government bonds tend to do well when return-seeking assets, such as high-yield corporates, have a down day.
In addition, if managed dynamically, such a portfolio can tilt toward either exposure as market conditions change. Further, an active investor can take advantage of opportunities as they arise.
For example, some risk assets have rebounded more quickly than others since the pandemic began, and active managers can rotate into lagging sectors before they recover. Spikes in volatility can create opportunities for snapping up cheaply priced bonds.
Sourcing Income and Potential Return
Today, we see opportunities—and attractive yield—in:
Emerging-market debt, particularly high-yield sovereign credits . We expect the sector to be buoyed by the weaker US dollar, fiscal stimulus, attractive valuations and strong investor demand for income in a low-yield environment.
US securitized assets such as credit risk–transfer (CRT) securities—residential mortgage-backed bonds issued by US government-sponsored enterprises—and commercial mortgage-backed securities. CRTs benefit from a still-solid US housing market, among other positive factors. Securitized assets have low correlations with other fixed-income sectors and other asset classes, and they offer a healthy yield pickup over corporate bonds.
European credit, including subordinated European bank debt. Because they’re lower in the capital structure, subordinated bonds issued by investment-grade banks offer yields comparable to speculative-grade securities. In fact, yields on European additional Tier 1 bonds, the first securities that would take a hit if the issuing bank ran into trouble, comfortably outstrip those on European and US high-yield bonds.
Global high-yield corporates. It’s true that spreads tightened significantly in 2020 following the pandemic panic. But the quality of the high-yield market has also improved , thanks to weak credits defaulting (and exiting the market) even as relatively strong fallen angels—bonds initially rated investment-grade that are downgraded below investment-grade—joined it. That improved credit quality spells room for further spread narrowing and attractive relative return potential.
US investment-grade credit. The withering pace of issuance in 2020 foreshadows much slower issuance in 2021, even as income-hungry investors drive strong demand for US corporate debt. The result? Highly supportive technical conditions. Meanwhile, dispersion of credit spreads has increased, indicating the potential for unique opportunities. It’s especially important to be selective in this kind of environment. Fundamentals matter.
Stay Active, Be Choosy
Today’s era of low yields and heightened uncertainty isn’t likely to end soon. But selective investments across regions and sectors, as well as a suitable balance of interest-rate-sensitive and credit-sensitive holdings, can help reduce volatility and increase return potential as the world economy recovers.
Investors who actively manage their bond portfolios using this dynamic approach should be well positioned to navigate rough seas.
- Scott DiMaggio
- Co-Head—Fixed Income
- Gershon Distenfeld
- Co-Head—Fixed Income & Director of Credit