Fixed Income Outlook: A Rate and Reflation Balancing Act

Accommodative monetary policies and fiscal stimulus have fueled higher inflation expectations and have put an upward pressure on interest rates to start the year. The sell-off in US Treasuries this quarter was the worst in 40 years, with the US 10-Year Treasury yield climbing by over 80 basis points so far in 2021.


With US Treasuries posting their worst quarterly return since the 1980s, Treasury-heavy core Agg bonds had their worst quarter since 1981, falling percent over the first three months of 2021.2 Speaking to the risk-on mentality expressed in the equity markets, the only bond segments that have seen positive performance this year are credit-sensitive high yield bonds and senior loans.3

Though rates have risen recently, they do remain suppressed relative to both long-term averages (64 percent below 30-year average).The amount of global debt trading below a 1 percent yield now outpaces the entire market capitalization of the S&P 500.That’s a problem, as one of the primary functions of bonds in a portfolio is to generate income. Not to mention, the 1.6 percent yield we see today for core Agg bonds compared to five-year inflation expectations (2.60 percent) indicates the potential for a negative real return from the coupon alone.6

Looking beyond the Fed’s accommodative monetary policies and the recently passed $1.9 trillion pandemic relief stimulus bill, there are two more forces that could have an impact on the rates market as we get deeper into 2021:

  1. The recently announced $2.25 trillion infrastructure bill from the Biden administration
  2. The pent-up savings that could filter into the real economy as the recovery grows stronger

While the merits and details of the bill remain to be seen, there are identifiable savings on the sideline that are likely to have a more immediate impact. The US personal savings rate currently sits at 13.6 percent of disposable income, and there is roughly $1.2 trillion more in excess savings than pre-pandemic levels.The reopening continues to trend positively — indicating the economy could receive this cash infusion sooner rather than later — as March labor-market data showed an increase of 916,000 in US nonfarm payrolls, above the average estimate of 660,000.8 By ushering in higher growth and inflation, this could push rates even higher and have an impact throughout asset allocation models as the markets navigate this latest regime shift.

In the end, rising rates may create headwinds on a total return basis and the low starting yield presents issues from an income generation perspective in our current market — especially on an after-tax basis. To ensure portfolios remain properly diversified and meet their return objectives, investors could consider replacing traditional bonds with less rate-sensitive and more growth-sensitive bonds — both in and out of the core — using mortgage-backed securities, senior loans, and high yield municipal bonds.

Theme 1: Use MBS to Pursue Income in the Core while Tempering Interest Rate Risk

With rates well off their pandemic lows, it is fair to say rates may have bottomed out. Yet the expected returns on core aggregate bonds remain low and are likely to be below what investors have witnessed over the past decade, given there is a 95 percent correlation of the yield at time of purchase and the subsequent three-year annualized total returns.9 Current yields for the Agg sit at just 1.61 percent,10 so returns over the next three years could be around that level if the historical trend remains intact.

Mortgage-backed securities (MBS) offer a yield (1.82 percent) above that of core aggregate bonds (1.61 percent) and US Treasuries (1.00 percent) with lower volatility (2.1 percent versus 3.5 percent and 4.5 percent, respectively).11 Thanks to their lower duration and higher yield than the Agg, MBS have exhibited the highest yields per unit of volatility among all core bond segments, leading to their outperformance of 3.15 percent over the Agg so far this year.12 As yields have moved higher on the back of improving economic growth, MBS may extend their outperformance over other core bond segments. With a different rate risk profile (4.4 years duration) than other core bond sectors (6.7 years US Treasuries, 8.4 years for US investment-grade corporate bonds),13 MBS may be a valuable overweight in the core. And MBS’ historical negative correlation to equities (-20 percent)14 indicates that a potential overweight in core portfolios may not adversely impact the role bonds play in seeking to diversify growth and asset volatility.

Source: Bloomberg Finance, L.P., March 31, 2003–March 31, 2021. Treasury = Bloomberg Barclays US Treasury Index, MBS = Bloomberg Barclays US Securitized MBS Index, Agg = Bloomberg Barclays US Aggregate Bond Index. Past performance is not a guarantee of future results. It is not possible to invest directly in an index.

Favorable market trends including the strong housing market15 and the Federal Reserve continuing to purchase MBS ($40 billion a month) as part of its stimulus plan may temper extension risk fears from higher rates. The housing market is in a strong position as the average price of a single family home is at a seven-year high16 while both new and existing home sales also are above their pre-pandemic levels. Meanwhile, a tight mortgage-lending environment may reduce default risk as about 70 percent of mortgages issued in 2020 went to borrowers with credit scores of at least 760, up from 61 percent in 2019.17 Rising interest rates also indicates that prepayment risk is reduced for MBS as refinancing has fallen drastically in the last two months.18

To temper interest rate risk in a core bond portfolio while aiming to reduce extra risk, investors may consider overweighting MBS in the core through allocating to the SPDR® Portfolio Mortgage Backed Bond ETF [SPMB].

Theme 2: Focus on Loans for Defensive Yield in a Higher-Rate Environment

Like other credit exposures, loans may continue to benefit from the ongoing loose monetary and fiscal policies that have supported risk assets over the past few months. Amid the reflation rally, loans have outperformed the broader Agg in 11 months over the past year.19 Loans have also outperformed other fixed-rate securities like investment-grade corporates, Treasury bonds and even high yield in the pandemic recovery.20 Investors may want to consider loans for their credit exposure in this reflationary environment given that senior loans have a similar yield to fixed-rate high yield debt (3.74 percent vs. 4.14 percent),21 but are more senior in their capital structure and historically have witnessed lower relative levels of volatility (5.6 percent vs. 7.4 percent).22 In the event of default, loans have historically had around a 60 percent recovery rate, whereas the recovery rate for high yield has been lower (30 percent–40 percent),23 because they are unsecured.

As economic growth and inflation forecasts have climbed, senior loans may be attractive given their shorter duration and floating rate component, meaning that rising rates may not negatively impact total return as much as they could for fixed-rate high yield. The duration is usually between 30 and 90 days for senior loans, because the base rate of the floating rate component is usually one- to three-month LIBOR. Thus, if there is a concern about inflation and the potential for interest rates to increase, the loan category tends to hold its value because there is lower duration and, in fact, if short-term interest rates (LIBOR) increase then the loan coupon also increases. Curve change effects subtracted 179 basis points of return for fixed-rate high yield so far this year24 but have had a negligible impact on loans due to this floating-rate component.

The US leveraged loan market saw $337 billion of deals launched in the first three months of the year, the second-highest volume for any quarter since 2013.25 While the average price of fixed-rate high yield bonds has risen amid this rally, the average price of senior loans remains below its pre-pandemic levels and well below par26 — even though the loan market rallied 31 percent from its bottom in 2020.27 With the average price below par, there is more potential for upside price appreciation than there is in high yield.  

Senior Loans Have a Similar Yield to High Yield but with Lower Duration and Volatility

For senior loan exposure, consider the SPDR® Blackstone Senior Loan ETF [SRLN].

Theme 3: Seek Out Higher After-Tax Income with High Yield Municipal Bonds

High yield municipal bonds may be one growth-sensitive area to consider in the current environment, as this bond sector has already been less impacted by the rise in rates so far in 2021 — outperforming traditional investment grade corporates by 6.76 percent and high yield corporates by 1.54 percent.28 A government generally issues high yield bonds to pay for projects with undefined or uncertain revenue. These revenue bonds tend to offer higher yields to compensate investors for the risk and uncertainty associated with the project’s revenue stream. Because they are higher in risk, high yield municipal bonds yield more than traditional corporate high yield bonds on an after-tax basis.

Many political tailwinds have emerged in 2021 for high yield municipal bonds. A Biden administration and Democrat-controlled Congress are likely to unwind some Trump tax cuts. Anticipation of this is already creating investor demand for muni bonds for their tax-exempt qualities. The recent $300 billion dedicated to shoring up state and local balance sheets from the $1.9 trillion pandemic relief bill may alleviate any concerns of increased default risk among high yield municipal bond issuers as the bill permits governments to use federal dollars to replace revenue lost due to the pandemic. Amid the improved economic outlook, Moody’s Analytics also reduced its projected fiscal 2020 to fiscal 2022 gross shortfall for states and local governments from $450 billion to $330 billion.29

The current yield to worst on high yield municipal bonds is 3.64 percent30 while high yield corporates yield 4.18 percent pretax but just 2.63 percent post-tax.31 Income from high yield municipals is generated with lower volatility than both high yield corporates and large-cap dividend equities (8.38 percent versus 9.02 percent and 17.90 percent, respectively).32 High yield municipals are less correlated to equities than corporate investment-grade and high yield bonds are (16 percent versus 34 percent and 77 percent, respectively),33  leading to a potential source of higher income generation without additional equity risk. High yield municipals are also less correlated to traditional core Agg bonds than US IG corporates are (53 percent versus 82 percent).34 Therefore, high yield municipals’ lower volatility versus that of high yield corporates and equities suggests that this fixed-income asset class may offer investors the ideal risk-reward payoff in the current reflationary environment.

Source: Bloomberg Finance, L.P., as of March 31, 2021. US Corporate Bonds = Bloomberg Barclays Corporate Bond Index, High Yield Corporate Bonds = Bloomberg Barclays High Yield VLI, High Yield Muni Bonds = Bloomberg Barclays High Yield Municipal Bond Index. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable. After-tax yield is based on the yield to worst and applying the highest marginal federal income tax rate of 37 percent. Past performance is not a guarantee of future results. It is not possible to invest directly in an index.

For high yield municipal bond exposure, consider allocating to the SPDR® Nuveen Bloomberg Barclays High Yield Municipal Bond ETF [HYMB].

Authors

Matthew J. Bartolini, CFA
Head of SPDR Americas Research

Emily Theurer 
Assistant Vice President, SPDR Americas Research