Q2 2021 Bond Compass

Investor Sentiment: Higher Rates Impact Fixed Income Flows and Holdings

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.

Good news was bad for bond investors in the first quarter, as improving growth prospects on the heels of accelerating vaccinations and fiscal stimulus pushed global yields higher. With administered doses nearing 700 million globally, the immunization process has been truly spectacular given we essentially started at zero just a few months ago. The rollout has been uneven, however, with the EU notably lagging the US and UK in the developed world, while the variability in emerging economies is even greater. On the stimulus front, the Biden administration quickly passed another $1.9 trillion in relief funding, providing further support to the economic recovery.

The global growth picture has improved dramatically in light of these developments, with the International Monetary Fund (IMF) upgrading its global outlook twice since the start of the year. The US is leading the charge, with the Federal Reserve (Fed) raising its 2021 gross domestic product (GDP) estimate by 230 bps since December to 6.5 percent. Inflation expectations have also risen along with the improving growth outlook, which has been a primary driver in repricing yields. The almost-40-bps increase in implied 10-year breakeven inflation accounted for half of the rise in Treasury yields in Q1, while higher rate-hike expectations accounted for the other half. As it stands now, the Fed is expected to begin raising rates by late 2022, and most of the G-10 central banks are expected to join in earnest during 2023. Central banks took disparate approaches to address rising yields, with some actively pushing back, like the European Central Bank (ECB) and Reserve Bank of Australia (RBA), while others were encouraged by the implied economic gains embedded in higher interest rates, like the Fed and Bank of Canada (BOC).

Overall, Treasuries posted their weakest quarter since the 1980s, while corporate bonds were the weakest since the Global Financial Crisis. Investor behavior reflected these concerns. Our data showed negative Treasury flows since February, with cross-border activity leading overall outflows. Eurozone sovereign flows proved more resilient, with the ECB increasing asset purchases in an attempt to contain rising yields. This has resulted in an investor preference for yield, with Italian sovereign bond (BTP) flows among the strongest during the quarter. Demand for emerging market (EM) debt was weak throughout the quarter, with an earlier preference for Asia waning, and all regions now in outflows. EM investor confidence has declined in the face of the stronger US dollar (USD) and rising inflation concerns. There was still an overall reach for yield, however, with high yield flows remaining in the top decile all quarter, while investment grade flows were closer to neutral.

Foreign Buyers Emerge for Treasuries

Treasuries were on the back foot for the better part of the first quarter as our flow data shifted from relatively strong buying to outright selling. This led to price gaps and a series of weak auctions as the marginal buyer was not yet attracted to higher yields. While our overall flows remain negative, foreign buying of Treasuries has bounced back, an indication that price concessions are at least attracting some buyer groups back into the asset class. With US government financing needs remaining high for the remainder of the year, finding a more stable clearing level for Treasuries will be important for all asset classes.

US Treasury: 20-Day Aggregate Flows vs. 20-Day Cross-Border Flows

Looking for a Safe Place to Hide

Rising yields were a global phenomenon in both developed and emerging markets during the first quarter. Even Japanese government bonds (JGBs) posted a modest rise in interest rates since the start of the year. While higher Treasury yields gained the most attention, other sovereign markets actually had similar or larger yield gains, with Canada, Australia, New Zealand, and the US all recording an 80-bps-or-more increase in 10-year yields during the quarter. Investors are nonetheless the most negative on Treasuries, with duration-weighted flows at only the 20th percentile versus overall developed market flows in the 20th percentile. Stronger flows into JGBs and the eurozone show that investors are presently favoring stability in yields over the yield advantage offered by Treasuries.

Sovereign Market 20-Day Flows vs. Holdings 

Still Reaching for High Yield

High yield was one of the few fixed income asset classes able to record a positive return in the first quarter, supported by its lower duration profile and higher-yielding average coupons. Financing conditions also remain supportive, with high yield issuance in March recording its biggest month ever at a time when upgrades are outpacing downgrades by one of their widest margins in decades. Investor flows reflect this positive bias, with 20-day high yield flows remaining in the top quartile for the past five months. In contrast, investment grade investors have been net sellers since the start of the year even as spreads remain largely unchanged on the year.

Investment-Grade vs. High Yield 20-Day Flows