Three areas for fixed income investors to watch in 2021
The end of November traditionally marks ‘outlook season’ for investors, where attention turns to thoughts and predictions for the coming year. Those who wrote their pieces early this year may have missed the COVID-19 vaccine news, and the strong market rally that shapes our thinking now.
No one wants to play the Grinch at this time of year, especially following a global pandemic, but we think the recent rally may have brought forward returns. A lot of good news relating to vaccines may already be priced in.
Next year we still face a long road back to normality for sectors such as tourism or hospitality, and the long-lasting consequences of the economic shock experienced this year should not be underestimated. That caution on the economic front leads us onto our first area to watch for next year, that demand for high quality duration will remain strong.
1. Government bonds still play an important role
Downside risks from COVID-19 appear to be diminishing, but the economy is not out of the woods yet. Vaccines will take time to produce and distribute, with this only really ramping up in the first quarter of next year. While we should see restrictions loosen as the winter recedes in the northern hemisphere, it may not be until the autumn of 2021 that we see life truly returning to normal.
At the same time, the outlook in terms of fiscal support for the economy is bleaker, at least in the US. Gridlock in Washington, with the Republicans likely to retain control of the Senate, likely means that the roadmap to approving fiscal stimulus packages is more problematic, and probably not as timely too.
The implications for US Treasuries are threefold. First, we are likely to see lower issuance than we would have done in a Democratic ‘blue wave’. That will likely lead to a weaker economy in turn, improving the fundamentals for high quality duration, while also leaving the economy more reliant on monetary policy, and further entrenching policy support for the bond market.
As over the past decade, it seems that all roads still lead to fixed income support. Yields are trading in a very tight range post March 2020 (0.5-1% on the 10Y US treasury) though we do see some potential for small gains over the year by buying on dips and selling towards the lower end of that range. Within the context of a diversified portfolio, high quality government bonds also offer a natural hedge from risk-asset volatility and provide liquidity, something investors might find desirable.
2. Riskier credit tending to win out
High yield bonds share many of the same tailwinds as government bonds. Central banks will continue to support credit markets, either directly buying high yield bonds as in the US, or indirectly via other bond buying programmes, giving confidence to investors to buy higher yielding credit.
We have seen pent-up demand from prior to the US election coming to the fore with investors deploying cash that had built up on the sidelines. As we look at the market towards the end of 2020, prices do appear to have gotten ahead of themselves a little bit so we have reduced the size of our overweight, but will seek to add when we see buying opportunities.
More encouragingly, we are looking to hold a greater allocation to Asian and Chinese high yield debt given the attractive valuations, as well as broader considerations such as the more efficient pandemic responses in the region, and also the potential for a more constructive relationship with the US under a Biden presidency.
There is an interesting trade-off within investment grade – do you go for high quality investment grade which offers very little compensation for risk, or do you go down the quality ladder where you do get that compensation? The latter is a better choice in our view; we prefer BBBs and particularly like European financials in this space.
3. There is a lot of uncertainty, so we will continue to moderate our bullishness
Whatever the shape of the recovery and the success of rolling out vaccines, global growth and GDP have a long way to go to get back to pre-pandemic levels, regardless of how long the virus continues to spread and lockdowns persist.
Although central banks will remain supportive, there will no doubt be speculation about how sustainable the buying programmes and furlough schemes will be in the medium term, which could affect investor confidence about the ‘false’ market that we are witnessing at the moment, given that the underlying fundamentals of the global economy currently appear pretty challenged.
We will therefore continue to hold portfolio hedges, whether through our allocation to cash and cash-like proxies (0-5 year government bonds) or at a more complex level through our exposure to credit default swap indices. The latter works well in protecting the higher yielding part of our portfolio and was one of our best returning positions during the market volatility in March 2020.
Make use of all that fixed income offers
Ultimately, we think a barbell between high quality and lower quality could work well – looking to maintain a portfolio which has a high level of diversification to different fixed income risk factors and with the potential to generate attractive risk-adjusted returns throughout the economic cycle, whatever 2021 has in store for us.