Investor Sentiment: Fixed Income Flows and Holdings

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

Analysis

The fourth quarter brought us multiple COVID-19 vaccines, a relatively quick outcome to the US presidential election and another stimulus support program. The prospect of a return to normalcy was a welcome end to a truly unprecedented year. However, not all news was good news. The virus showed its tenacity, resurfacing in countries that had seemed to have it under control. New lockdowns and travel restrictions were enacted to slow the spread, and economic data is buckling under those strains. Even as risk increased, investors ultimately chose to look toward the light at the end of the tunnel, and the market added to record returns from the previous six months on the hopes of reflationary trends continuing into the new year.

Inflation expectations rose during the fourth quarter, especially in the US, despite rising virus cases keeping actual inflation in check. The risk-on environment pushed Treasury yields to their highest point during the pandemic, even as overall yields remained near historic lows. With the Federal Reserve (Fed) continuing to pledge its fealty to low yields for longer, most of those higher yields were at the longer end of the curve, steepening the curve to its widest point in three years. Higher yields were not universal in the developed markets, however, with a weaker growth and inflation outlook for Europe compressing most core sovereign yields. Risk-on was nonetheless beneficial for periphery rates and emerging markets (EM), which all closed with lower yields on the quarter. Corporate bonds also participated in the risk rally, with spreads compressing to their lowest levels of the year, while yields were at their lowest ever.

The prospect of higher yields has not yet deterred investors, with strong positive flows across most of the developed sovereign markets and the ancillary spread sectors. When viewed through a 20-day percentile rank lens, Treasury flows strengthened into the end of the year after moderating toward neutral in the weeks immediately following the presidential election. In contrast, flows for Treasury Inflation-Protected Securities (TIPS) experienced the exact opposite, strengthening after the election only to move toward neutral at the end of the year. These trends are worth watching as they directly speak to the outlook on growth and inflation. Credit flows ended 2020 near their strongest levels in five years, both in the US and in Europe. This apparent reach for yield did not carry over to EM bonds, however, with flows into local currency government debt the weakest of the broad fixed income asset classes we track.

Still Reaching for Treasury Yields

The combination of normalizing mobility as vaccinations reach critical mass and highly accommodative fiscal and monetary policies raises hopes for economic outperformance in 2021. This outlook has allowed inflation expectations to firm up as 10-year breakeven rates sit at 2%, the highest reading in over two years. The Fed’s commitment to keep rates low for an extended period has resulted in a steepening curve and pushed real yields into highly negative territory. Treasury yields therefore closed out 2020 near their pandemic highs, and the broad consensus is that yields — and the curve — will continue to march higher in the new year.

For the moment, our investor flows indicate continued demand for Treasuries despite an outlook for higher yields. Real money is currently showing its most aggressive buying further out the curve, with all maturities longer than three years showing positive flows above the 70th percentile. While overall Treasury yields remain near their lowest levels ever, they still produce more income than practically every other developed market sovereign bond. Additionally, while inflation-implied yields are at multi-year highs, actual inflation is nowhere near the 2% level required for the Fed to begin considering moving away from its dovish stance. This may create an environment ripe for a policy mistake, although our data indicates that is not yet a concern.  

Eurozone Periphery — Selling the Facts

The European Central Bank’s (ECB) extension of its asset purchase program in both length and size at the end of 2020 should have removed any doubts about near-term European government bonds. The central bank’s backstop has never been firmer, and progress has also been made toward a modest amount of debt mutualization. Nevertheless, long-term investor behavior toward both peripheral and Italian bonds was not as strong in Q4 2020 as one might have anticipated.

At one point in Q4, demand for the periphery, as captured by rolling 60-day average flows, hit a three-year low. Demand for Italian debt also faltered after having been close to a five-year high at the beginning of the quarter. While there is no immediate risk — ECB demand will more than capture most of the supply that is coming — the hesitation on the part of institutional investors in higher-yielding eurozone bonds is worth monitoring. The weakness of European growth dynamics and debt levels in some countries will perhaps act as a deterrent for investors, even if yields are still positive.  

Gilt Demand Beyond Brexit

Long-term investor demand for gilts has been robust for much of the last quarter. The big question now is how much of this was a hedge against a no-deal Brexit and how much reflected the underlying current weakness of the economy. While the last-minute skinny trade deal created a political platform on which to build further collaboration, it does very little for the near-term outlook other than to remove another potential short-term shock. We say “another” as the return to national lockdown for the start of 2021 seems likely to tip the economy back into a double-dip recession.

The rapid rollout of the vaccine should mean that both the lockdown and recession are relatively short-lived. Nevertheless, the interruption to the recovery increases the chance of hysteresis — that growth will simply not recover fully — as well as the possibility of negative rates. Finally, the removal of no-deal risk also negates one potential negative for gilts: an inflationary collapse in sterling.

Emerging Still Playing Catch Up

Emerging markets have the potential to be one of the bigger beneficiaries of a global reflation trade. Not only will many developing economies benefit from greater commodity consumption, but the weaker US dollar may provide an FX uplift to local currency assets. With overall yields in the developed market remaining near all-time lows, the incremental gain from EM bonds provides an attractive income alternative for bond investors. However, EM is a broad catch-all description that encompasses both regional and country-specific idiosyncrasies. Additionally, since the pandemic spared no one, many EM central banks were forced to slash their policy rates in a similar, although not as extreme, manner as developed central banks. These policy moves greatly reduced the yield advantage that many EM countries maintained over DM sovereign yields. Inflation has also bounced back stronger in many EM countries, and negative EM real yields are no longer a rarity. For the moment, real money flows in EM local currency sovereign markets remain negative, although regional nuances exist. In particular, Latin America flows have improved to neutral, while the marginal buying of Asia government bonds has recently turned to moderate selling.