Fixed Income Outlook: A Rate and Reflation Balancing Act
The rise in Treasury yields that began in 2020 gathered pace in Q1 2021, with 10Y yields closing the quarter close to 120bp off the summer 2020 lows. Central bank policy easing is designed to reflate the economy, meaning large bond sell-offs often accompany quantitative easing (QE) — see our recent article, Shelter from the Storm , for further analysis.
All three of the Federal Reserve’s previous QE operations have ultimately resulted in a substantial yield correction as markets sense that stimulus measures are sufficient to reflate the economy. The latest sell-off seems to have come sooner than most market participants had anticipated, helped by the rapid progression of vaccinations in the US and a supersized fiscal stimulus package.
Figure 1: Changes in the 1M Overnight Index Swap Forwards Indicate a Fed Funds Rate Above 2%
The average correction in nominal yields in previous QE-induced sell-offs has been around 140bp, so it is perhaps premature to view the current sell-off as over. However, with terminal rate expectations for the Fed already pushing up towards 2.5%, the 2018 peak (Figure 1), there should not be much further to go in the near term.
That said, much hangs on the outlook for inflation. The current rise in yields has been driven by higher inflation expectations, with 10Y breakevens around 80bp wider than levels seen in mid-2020. Sharply rising inflation expectations are not always a feature of the broader sell-off in Treasuries. During QE3 in 2013, the rise in US yields saw breakevens actually contract. It was the sell-off in QE1 that was accompanied by a major revision of inflation expectations and that was a longer sell-off than those seen in QE2 or QE3 (Figure 2).
Figure 2: US 10Y Breakeven Changes a Key Driver of Rising Nominal Yields
So can inflation continue to outstrip expectations? The PriceStats® series highlights further upside risk to both US and global inflation. Series such as the prices paid component of the US manufacturing ISM also look extremely high, so upside price risks are real. However, food prices appear to be levelling off, oil
prices are down from recent highs and, assuming trade now gradually returns to more normal patterns, the cost of shipping should fall back to more sustainable levels. Also, the market already prices rising inflation with US 10Y breakevens having risen to 2.35%; history suggests that visits into territory above 2.5% have been short-lived.
This backdrop underlines how pivotal Q2 will be. With base effects for US CPI remaining positive into May, how the inflationary landscape appears to be panning out at the end of the quarter will be key. The Fed is likely to keep its policy loose until year-end in an ongoing effort to reflate the economy. If inflation moderates into the summer then there will be few concerns. However, if the surprises are to the upside then expect another leg higher in yields.
Theme 1: Life in US Investment Grade Credit
US investment grade credit suffered in Q1 2021 on the back of rising Treasury yields. Outright yields are now higher and spreads to government bonds a little wider, which should appeal to European investors in particular.
Yield spreads to Euro credit are at multi-year highs on a currency-hedged basis. So an allocation to US credit makes sense but, to capitalise on where the flows are going, focus on ESG funds.
Investment grade (IG) credit remains a key building block for many portfolios but we avoided it as a theme in the Q1 2021 Bond Compass given low absolute yields, tight spreads and the prospects for higher government yields.
The sell-off in the underlying government curve has indeed been sharp, with the 10Y US Treasury yield rising by over 80bp during the past quarter. With the yield to worst on the Bloomberg Barclays US Corporate Bond Index now in excess of 2.25%, its highest since June 2020, it looks considerably more interesting as a yield play than it did at the start of the year when outright yields were closer to 1.75%1. Spreads are also off their tightest levels and may re-tighten if growth continues to print strongly. The stronger economic numbers should benefit balance sheets and, indeed, the upgrades/downgrades ratio for S&P IG Corporate ratings was at its highest in Q1 2021 since the end of 2019 in both North America and Western Europe. This may give credit a greater ability to absorb higher underlying government yields if they continue to rise.
The appeal of the higher yield on offer will be especially strong for the European investor base where domestic yields are only around 35bp for an IG EUR corporate fund.2 So yield pick-up will be appealing although there would be currency risk. The weaker USD seen in 2020 acted as a drag on investment performance for non-US-based investors. The currency has defied consensus by pushing higher in Q1 2021 but is once again showing some signs of weakness.
Therefore, hedging USD-denominated positions makes sense and, because the Federal Reserve is seen keeping rates at low levels for some time to come, maintaining a fairly flat money market curve, the cost of hedging the USD is relatively low.3 The result is that the hedged yield is at its highest level since May 2017 if the blow-out in spreads seen during the COVID crisis is excluded (Figure 3). From a USD-EUR spread perspective, levels are at their widest since February 2017 (again excluding the COVID-induced spike). So a yield pick-up of over 100bp is possible for investors who overweight USD IG credit versus EUR.4
Figure 3: US IG Credit Enjoys Widest Hedged Yield Pick-Up to Euro in Over 4 years
Following the ESG Flow
The EU’s Sustainable Finance Disclosure Regulation (SFDR) came into effect on 10 March 2021. It requires disclosures on funds marketed as ESG in order to reinforce investor confidence in ESG investment vehicles. As Figure 4 illustrates, the trend towards a greener, cleaner future is already underway in Europe, with ESG flows into US IG credit dwarfing those that have found their way into more traditional funds during the past 12 months. At a more granular level, Q1 2021 actually saw outflows from traditional funds while ESG solutions continued to gather assets.
The Bloomberg SASB U.S. Corporate ESG ex Controversies Select Index is optimised so as to maximise its ESG score at the same time that the index characteristics are pushed as close as possible to its parent Bloomberg Barclays US Corporate Index. This provides a neat solution for investors seeking to switch holdings into ESG-compliant funds but at the same time remain close to the benchmark.
Figure 4: European ETF Net Flows for US IG Credit funds
The reflationary economic backdrop is expected to remain in place over the coming quarter. This should continue to support the fixed income strategies that are the most similar to equities, such as convertible bonds.
Convertibles should capture equity upside for the fixed income investor, but may also be used to limit equity exposure in mixed asset portfolios. Convertibles can also improve credit quality at a time when some government support measures may start to be removed.
The first quarter of 2021 was a tricky one for fixed income investors, with returns from most strategies ending in negative territory. This is a sharp contrast to equities, as the S&P 500 returned in excess of 6% in Q1. The moral of the quarter was to keep bond investments as equity-like as possible.
From a macro perspective we do not anticipate a big shift in the underlying drivers of market performance over the coming quarter. Economic growth is expected to remain strong, especially in the US, while inflation is seen pushing higher, with some clarity on how high emerging potentially toward the end of the quarter. In the investment universe, government bond yields remain low (despite the sell-off), forcing investors to look at higher-risk alternatives for returns.
So strategies that benefit from ongoing reflation, such as convertible bonds with their embedded equity option, are one of the more obvious ways to give fixed income portfolios equity-like characteristics.
Convertibles had a turbulent Q1, with returns for the Refinitiv Qualified Global Convertible Bond Index topping 9% by mid-February, after which we saw a reversal as the sell-off in US Treasuries intensified.5 Despite the mixed Q1 performance, investors have kept their faith in convertibles, with net inflows going into funds during the quarter.
There may be some further yield upside in Q2 but, importantly for convertibles, the intensity of the Q1 sell-off looks unlikely to be repeated unless inflation pressures gather momentum. Rising rates may not be the ideal backdrop but the reflationary environment that drives yields higher can also lift the value of the embedded equity option, which should encourage positive returns. Indeed, convertibles have proved fairly robust as a strategy; Figure 5 shows total returns against other fixed income strategies during the Federal Reserve’s QE and more recently. Returns have consistently been positive, which is not the case for many other fixed income markets.
Figure 5: Convertible Bonds — Performance During QE and Recent Yield Moves
As seen in Figure 6, the periods illustrated in Figure 5 were typically those when central bank rates remained stable but bond yields rose, steepening the curve. Over these periods, equity markets have typically done well, benefitting from central bank asset purchases pushing money out of government bonds into higher returning assets. With the delta6 on the Refinitiv Qualified Global Convertible Bond Index at around 62.5%, which is fairly high by historical standards, further equity gains should be reflected in the price of the bond. This relatively high level of sensitivity also makes convertibles interesting to those running balanced portfolios, as they provide some protection to downside equity risks.
Figure 6: Rate and Yield Changes During the Periods Illustrated in Figure 5
Finally, the credit quality of convertibles is typically higher than that of pure high yield strategies as the bond universe includes investment grade issuers. This should ease concerns over solvency issues as government support packages, which were put in place at the start of lockdowns, start to get peeled back. Convertibles also represent a quality enhancement versus equity as they tend to rank pari passu with common unsecured corporate bonds.
The challenging backdrop for fixed income means we continue to put a high value on assets that deliver yield. Those that combine yield with low duration risk are especially interesting.
High yield proved resilient in Q1 2021 and could remain a key source of returns during Q2. Short maturity hard currency emerging market debt also provides yield and has several safeguards to limit risks.
The first quarter of 2021 saw a sharp rise in US Treasury yields that left most fixed income strategies underwater. One exception has been high yield. An investment theme in the Q1 Bond Compass, the Bloomberg Barclays US High Yield 0–5 Year (Ex 144A) Index returned 1.7% and the Bloomberg Barclays Liquidity Screened Euro High Yield Bond Index returned 1.4% through the end of March.7 Targeting yield remains a key strategy for investors trying to eke out returns in such a challenging environment for fixed income. We see three important factors driving this strategy:
• Yield protects The yield to worst on the Bloomberg Barclays Liquidity Screened Euro High Yield Index is over 2.5% and for the US High Yield 0–5 Year (Ex 144A) Index over 3.6%, which will be an important source of returns if the capital values of bonds remain challenged. It also provides cover for losses. The high coupons on offer from high yield bonds mean that durations are usually shorter than for investment grade credit, in turn meaning lower price sensitivity to rising yields. The duration on the Bloomberg Barclays US High Yield 0–5 Year Index of just 1.75 years means that yields have to rise by more than 200bp before capital losses offset the yield.
• The benefits of stronger growth While the reflation trade is damaging to government bonds, stronger corporate revenues should underpin an improvement in earnings. Stronger growth expectations
have also underpinned higher oil prices, which should help energy companies, which are a meaningful portion of US high yield in particular.8 Financing conditions for high yield issuers also remain favourable, leading to an improvement in credit ratings actions: S&P upgrades outnumbered downgrades for non- investment grade bonds in both Western Europe and North America during Q1 2021.
• Spreads as a cushion for rising yields Spreads to the underlying government curve are not tight relative to five-year history, meaning a portion of any further increase in government yields could be accommodated by spread compression.
In short, high yield has the appropriate risk-reward characteristics for an environment where market participants remain concerned about duration risk.
As Figure 7 on the next page shows, the only other asset class to offer a similar risk/return ratio is emerging market debt (EMD). In contrast to high yield, EMD has not performed well year to date. After a promising start, the more difficult position that many EM countries found themselves in with COVID on the rise, currency weakness and inflation running hot caused the asset class to lose favour. However, risks can be reduced by opting for short maturity, hard currency strategies. Alongside lower duration risk9 it has been currency declines that have been a key source of underperformance10 for many EM funds. A hard currency fund would leave European investors exposed to USD risk but this can be eliminated by using a hedged share class.
Much like high yield, EM hard currency debt is viewed as a spread product to US Treasuries and those spreads were at their five-year average (as at 31 March 2021) and some 90bp off the tightest levels seen in early 2018. The ICE BofA 0–5 Year EM USD Government Bond ex-144a Index is well diversified with bonds from over 60 countries and the recovery in oil prices should help many of those issuers. The index also consists of 62% investment grade issuers, with over 97% rated B or above.
1 Source: Bloomberg Finance L.P., as of 31 March 2021.
2 For instance the yield to worst on the Bloomberg Barclays Euro-Aggregate: Corporate Index was 36bp as at 31 March 2021.
3 The cost of hedging is calculated as the 1M USD/EUR FX Forward rate on an annualised basis.
4 Based off the spread difference between the hedged Bloomberg Barclays US Corporate Bond Index and the Bloomberg Barclays Euro- Aggregate: Corporate Index as at 31 March 2021. 5 Source: Bloomberg Finance L.P., as of 31 March 2021.
6The sensitivity of the index to changes in price of the underlying equity. Source: Refinitiv, as of 31 March
7Source: Bloomberg Finance L.P. Total returns for 2021 to 31 March 2021.
8 Oil and gas accounts for 13.7% of the Bloomberg Barclays US High Yield 0–5 Year (Ex 144A) Index, as at 31 March 2021.
9The ICE BofA 0–5 Year EM USD Government Bond ex-144a Index strategy has 30% of the duration of the JP Morgan EM Global Diversified index.
10 For instance the JP Morgan EM Diversified index saw negative FX returns of 4.2% during Q1 2021 — source Bloomberg Finance.
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