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Q4 2020 Bond Compass
Investor Sentiment: 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% of outstanding fixed income securities globally.
Analysis
The third quarter can be best described as risk on, with economic data rebounding as lockdowns were lifted and fiscal and monetary stimulus continued to provide a tailwind. Equities completed their return from the abyss, with many major indices posting new all-time highs. All the concerns in the credit market were also apparently forgotten, with corporate new issuance shattering all records. Central banks remained a key source of market support, with the G-3 central banks growing their balance sheets by $1.1 trillion during the quarter. That said, most central bank meetings during the quarter proved to be maintenance events, as rates were slashed to the effective lower bound and volatile data made establishing a longer-term policy response near impossible. This did not stop the US Federal Reserve (Fed) from making changes to its policy objectives, moving toward average inflation targeting, while tilting its full employment mandate toward a broader-based, more inclusive segment of the populous.
While practically all risk assets rallied during the quarter — including credit, peripheral sovereigns and mortgage-backed securities (MBS) — interest rates for the largest developed markets (DM) were little changed. US Treasury yields proved to be one of the least volatile markets, although there were large movements in Treasury Inflation-Protected Securities (TIPS) and implied breakeven, hinting that investors were taking the threat of inflation seriously. Investor demand for DM sovereign bonds returned during the quarter, as the shock from the prior quarter’s rate cuts faded. US Treasury, German bund and Italian BTP 60-day flows proved to be the strongest in the sovereign space — a nod to the reach for yield, along with a continued demand for diversification and hedging optionality. The same cannot be said for emerging market activity, where the demand for local currency debt remained negative, even as the reach for yield extended into US and eurozone corporate bonds.
The end of the quarter has been dominated by positioning in anticipation of the US presidential election. The potential for a contested election, along with different fiscal outcomes based on the composition of the executive and legislative branches, has created a complicated decision tree. Volatility measures in the fixed income market are reflecting this uncertainly, and investor behavior will likely adjust from its current view of stable rates and continuing demand for inflation protection.
Protecting against inflation
The Fed formally changed its policy objectives, moving to average inflation targeting, while expanding its employment mandate to be more broad-based and inclusive. From a practical perspective, the Fed will set policy to try to generate inflation above 2% for a moderate period of time, while remaining on the sidelines even when we again approach traditional measures of full employment. Therefore, interest rates are expected to remain at the zero lower bound for the foreseeable future, with the market pricing in Fed rate inactivity for at least the next five years.
While neither inflation nor employment are anywhere near Fed targets, investors have started to buy inflation protection via the TIPS market, as real yields remain near cycle lows. Although our flow data indicates that real money investors spent most of the quarter selling TIPS, their outlook for the asset class started to change over the past two months. Our 60-day flows indicate that investors are currently buying TIPS; the flip from selling to buying occurred in mid-August, likely in anticipation of changes to the Fed mandate. However, TIPS’ yields have been moving sideways for the past few months, as the market appears to need another catalyst to drive real yields lower.
Developed still beating emerging
The reach for yield has become a consistent market theme since rate cuts earlier in the year reduced the average policy rate within the developed markets to zero. This reach for yield allowed most spread products to recapture the bulk of their March widening, while posting positive total returns year to date. While emerging market debt (EMD) fits the bill in providing incremental yield, investors have been slow to move toward this asset class. Our flow data shows that investors are still reducing their positions in local currency EMD, even though it has been slowly moving to neutral over the past few months. Regionally, our data shows that emerging Asia flows have recently turned neutral, Latin America flows are just 40%, while emerging Europe is seeing the most aggressive selling, with inflows of just 13%.
From a performance perspective, hard currency EMD has outperformed local currency bonds (which are the transactions that our data captures). Since local currency EMD is influenced by currency risk, these results are consistent with emerging market foreign currency (EMFX) results this year, which have generally lagged G-10 returns. Headwinds may well continue, as many emerging economies are still struggling to control the spread of the virus, which creates continued economic uncertainties. For the moment, demand for DM sovereign bonds remains strong despite the paltry yields offered around the world.
Brexit brings back demand for gilts
Brexit is back on the front burner — with more lines in the sand, apparently insurmountable differences, and looming deadlines. This time, mid-October has been established as the drop-dead date, but that could well slip into the end of the year, which seems to be a common occurrence in Brexit negotiations. A UK government watchdog estimates that Brexit has already cost the country 2% of GDP since 2016 and may well result in another 3% loss without a deal. The severe economic contraction from the pandemic further compounds the weak backdrop, which must now deal with a resurgence in COVID-19 cases.
Like all central banks, the Bank of England has stated its commitment to use all of its tools to normalize economic activity. To date, this has included cutting rates to zero and ramping up asset purchases. Given the weak economic backdrop, they may need to go to these wells again, and investors are increasingly pricing in the prospects of negative rates next year. Negative flows from gilts have been slowly reversing throughout the summer and turned to buying at the start of September, with positioning somewhat extended.
Footnotes
1 State Street Form 10-K, as of December 31, 2019. The fixed income flows and holdings indicators produced by State Street Global Markets — the investment, research and trading division of State Street Corporation — are based on aggregated and anonymized custody data provided to it by State Street, in its role as custodian. State Street Global Advisors does not have access to the underlying custody data used to produce the indicators
Glossary
Brexit
An abbreviation of the term “British Exit” referring to the UK referendum on June 23, 2016 that resulted in the country’s decision to withdraw from the European Union. Supporters of Brexit argued that EU membership has hurt both the competitiveness of the British economy and exposed the UK to unchecked immigration into EU countries. Under Article 50 of the EU’s Lisbon Treaty, countries that vote to exit the common market must formally trigger Article 50, after which they have 24 months to officially leave the EU.
G-10 Currencies
The G-10, or Group 10, currencies are considered to be the most liquid currencies in the world and are the most actively traded in the world. They include: 1. US Dollar (USD); 2. Canadian Dollar (CAD); 3. Japanese Yen (JPY); 4. Australian Dollar (AUD); 5. New Zealand Dollar (NZD); 6. British Pound (GBP); 7. Euro (EUR); 8. Swiss Franc (CHF); 9. Swedish Krona (SEK); 10. Norwegian Krone (NOK).
GDP or Gross Domestic Product
The monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
Fixed Income
A type of investing, usually involving bills, notes or bonds, for which real return rates or periodic income is received at regular intervals and at reasonably predictable levels. Fixed income can also refer to a budgeting style that is based on fixed pension payments.
Inflation
An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
Non-Agency Mortgage-Backed Securities, or MBS
Groups of mortgage loans that are repackaged and sold to investors who earn their collective income streams. Non-agency MBS are repackaged not by government agencies such as Fannie Mae or Freddie Mac, but by private financial institutions, such as banks.
TIPS, or Treasury Inflation-Protected Securities
Treasury Inflation-Protected Securities (TIPS) refer to Treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are backed by the US government and are thus considered an extremely low-risk investment. The par value of TIPS rises with inflation, as measured by the Consumer Price Index, while the interest rate remains fixed.
Volatility
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
Disclosures
The views expressed in this material are the views of State Street Global Advisors through the period ended September 30, 2020, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as "junk bonds," is considered speculative and involves greater risk of loss of principal and interest than investing in investment-grade fixed income securities. These lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Issuers of convertible securities may not be as financially strong as those issuing securities with higher credit ratings and may be more vulnerable to changes in the economy. Other risks associated with convertible bond investments include: Call risk, which is the risk that bond issuers may repay securities with higher coupon or interest rates before the security's maturity date; liquidity risk, which is the risk that certain types of investments may not be possible to sell the investment at any particular time or at an acceptable price; and investments in derivatives, which can be more sensitive to sudden fluctuations in interest rates or market prices, potential illiquidity of the markets, as well as potential loss of principal.
Investing involves risk, including the risk of loss of principal.