Q3 2021 Bond Compass

Investor Sentiment: Investors Choose Safety Over Yield

State Street Global Markets builds indicators of aggregated long-term investor behavior in fixed income markets from a substantial subset of $10 trillion worth of fixed income assets under custody and administration at State Street.1

This captures behavioral trends across tens of thousands of portfolios and is estimated to capture just over 10 percent of outstanding fixed income securities globally.

The second quarter can best be described as a transitional period, as we finally got to some of the major inflection points in the reopening process. While global vaccinations were slow to start, the acceleration in administered shots in the US and UK provided optimism that herd immunity will be an obtainable goal. However, vaccine rollouts were uneven, with the eurozone and Canada quickly overcoming initial hurdles and developed Asia still lagging. Vaccine rollout in the emerging markets (EM) has proven to be an even slower process where inadequate vaccine access has increased the risk of resurgent COVID variants.

Despite these uneven reopenings, inflation readings have surged globally as reopening demand and supply chain disruptions have resulted in some of the biggest price gains seen in decades. While some of these gains can be attributed to the reversal of last year’s collapsing prices, inflation still ran hotter than expected, as reopening categories were in high demand. Most central banks still expect these price surges to be transitory, although it will now likely take longer to see whether their forecasts prove correct. Nonetheless, rising prices have started the normalization discussion for many developed markets, while a few emerging economies have already raised rates to keep prices in check.

After a fairly volatile first quarter that saw yields rise globally, the rates market was mostly rangebound for much of the quarter before rallying to lower yields near quarter end. The prospect of earlier rate hikes in the emerging markets kept investor flows relatively weak in EM sovereigns compared to the developed markets. Stronger US Treasury buying emerged near the start of the quarter, particularly from foreign buyers when yields spiked to their YTD highs. More recently, cross-border demand for Treasuries has waned, although overall demand remains marginally positive. Since the market increasingly expects the Federal Reserve (Fed) to formally begin discussing the tapering process during the third quarter, market stability would require that investors look past shrinking Fed demand as we move into 2022.

Institutional investors have nonetheless continued to reach for yield in credit during the second quarter. Flows have favored high yield, with investors looking past the prospects of policy normalization, higher inflation prints and near-record corporate issuance. More recently, flows have moderated to neutral in both the investment-grade and high yield parts of the US credit markets, while euro credit demand remains strong.

Safety over yield

In many ways, low developed market yields, expectations for a weaker USD and broad reflationary support make it a perfect environment for emerging market debt (EMD). However, this has not enticed real money investors to increase their allocations to EMD this year. As the chart indicates, investors have generally chosen safety over yield, with net buying of developed market sovereign bonds at the expense of emerging market bonds. As our PriceStats® series shows, inflation in emerging markets has far outpaced price gains in advanced economies, forcing rate hikes in several developing countries. Uneven vaccination rates also create greater risk for emerging markets, which threatens positive growth expectations.

Developed and Emerging Market 20-Day Flows

Treasuries still finding broad support

The Fed has signaled that it has started to think about the normalization process, with broad expectations that tapering of asset purchases will be announced before the end of the year. Interestingly, longer-dated Treasury yields have fallen steadily during the second quarter to levels last seen in February, while the curve has also flattened. And while expectations around the timing of the first rate hike have not changed, fewer subsequent rate hikes are now expected. Our investor flows data continue to show broad buying across most Treasury maturities, with shorter-term flows indicating accelerated buying from the intermediate into the longer end of the yield curve.

US Treasuries 5- and 20-Day Flows

Turning neutral on credit

Both US investment-grade and high yield bonds have seen their spreads tighten this year as the overall cost of corporate borrowing fell to all-time low levels. This has prompted record issuance of high yield debt, while investment-grade issuance has trailed last year’s record volumes. So far this year, investors have favored high yield issuers, with the asset class being one of the few bond categories to post a positive return, with spread tightening and coupon payments resulting in low single-digit returns. Our investor behavior reflects this preference, with positive high yield flows for most of the year and generally neutral investment-grade activity. More recently, both credit categories have gravitated toward neutral, with meaningful spread tightening unlikely from here given the overall low level of yields.

US Investment Grade and High Yield Bonds 20-Day Flows