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

While we were still in a period of shock and awe during the March/April time period, the latter parts of the 2nd quarter were better described as a period of healing and adjustment. The 600 basis points (bps) in rate cuts from the developed markets’ (DMs’) central banks and 1,500 bps from the emerging markets’ (EM) central banks illustrates the global scale of the economic challenges created by COVID-19. The latest economic projections from the International Monetary Fund (IMF) forecast shrinking output from virtually every country and region. Much of this loss in growth is expected to bounce back next year, although advanced economies are expected to lag EM in their speed of recovery.

With an average policy rate in the G-10 of -20 bps, investors continue to be aggressive sellers in most DM and EM sovereign bond markets. The strongest selling occurred at the start of the quarter, which proved to be a well-timed move, as yields largely troughed when volatility was highest. Unprecedented expansion of central bank balance sheets has stabilized markets, reducing the need for portfolio hedging, and perversely lifting yields. High yields are, of course, relative -- the overall interest rate environment is near all-time low levels and policy rates are not expected to rise within the next five years in most of the largest economies.

The markets still remain very much in flux, parsing the opposing forces created by the ongoing pandemic with aggressive fiscal and monetary intervention. Flows show that most fixed income sectors saw outflows on a 60-day basis, but these should be complemented with more recent inflows given the rapidly moving nature of markets. The reach for yield is apparent in high yield credit, and investment-grade activity likely reflects the record-setting primary market corporate bond activity.

Everyone Helps in Funding the Deficit

The US fiscal response to COVID-19 has been one of the most aggressive in the country’s history and leads the overall global response from an absolute and relative standpoint. Congress has passed four separate pieces of legislation, resulting in almost $3 trillion to support individuals, corporations and state and local governments. In order to fund these programs, the US Treasury issued a record $2.7 trillion in net new debt during the 2nd quarter, bringing total outstanding debt in the US to $26.5 trillion (of which $21 trillion is owed to the public). Most of that issuance was initially focused on the short end, with T-bills making up 88% of total new issuance. More recently, the US Treasury has been attempting to lengthen the duration of its term structure, introducing a new 20-year bond, while increasing coupon issuance.

For the moment, the US government continues to borrow at all-time-low yields, as its overall interest costs continue to fall in line with lower yields, despite record outstanding debt. Our flows show that international investors remain active buyers of US Treasuries in the primary market, with 60-day flows in the 95th percentile on an unweighted basis. On a duration-weighted basis, cross-border flows are more neutral, indicating a foreign investor preference to remain in shorter-duration securities. With additional stimulus being discussed, maintaining this demand will be important if the US wants to continue to borrow at historically low yields.

The Reach for Yield Resumes

The corporate bond markets have been some of the largest beneficiaries of direct central bank support. While the European Central Bank (ECB) has been buying corporate bonds for years, the US Federal Reserve (Fed) has mostly focused on buying direct and guaranteed US government debt. Of course, this changed in March when the Fed launched two emergency programs to support the corporate market. Various revisions to these programs allowed the Fed to buy junk bonds (limited to recently fallen angels) and a basket of individual company debt. This has proven particularly important for investor confidence, as downgrades are exceeding upgrades at their greatest pace ever, while bankruptcy filings are well on their way to exceeding the 12% peak speculative default rate posted during the 2008 financial crisis.

While the debate continues whether Fed liquidity will obfuscate solvency issues, investor income needs to continue to push flows into the corporate bond markets. With $1.3 trillion in investment-grade YTD issuance, primary sales have broken all records. Since our flows capture secondary activity, IG flows had been extremely negative until recently. This has turned more neutral from a 20-day-weighted perspective, while high yield flows turned smartly positive around the time the Fed announced that it would start buying junk ETFs and fallen angels. Eurozone corporate flows have followed a similar pattern, as the ECB expanded its open-ended bond buying program, which will likely expand its corporate bond portfolio in the coming quarters.  

Indistinguishable EM

EM central banks have been equally active as their DM counterparts in addressing collapsed economic activity in the face of COVID-19. Their one advantage has been generally higher rates, which allowed them to collectively cut by 1,500 bps since March. Quantitative easing, once the domain of only DM central banks, has also been rolled out by a handful of EM banks. While all of these actions may help stabilize local markets, investors are cognizant of potential downsides, from eroding rate differentials and inflation to a potentially more challenging medical environment.

While we have seen a recovery in various risk assets over the past quarter, EM bond flows do not yet reflect the enthusiasm flowing into the developed markets. Overall flows remain squarely in the selling camp, with 60-day activity at just 10%. Looking at more recent data, 20-day flows are modestly better, although all EM regions are still in just the 20% range. Using this measurement, there is little distinction between regions, so real money does not appear ready to pick winners and losers yet, instead, simply allocating across the asset class. If the risk rally moves beyond DM, improved EM bond flows may signal broader global risk-taking.

European Questions

After something of a stuttering start, Europe’s policy response to the COVID-19 crisis appears better. Stricter lockdowns and staggered reopenings appear to have kept case numbers under control. The growth outlook is still poor, but the combined fiscal stimulus, with more to come, along with the ECB’s broad commitment to backstop all of this year’s sovereign issuance, have stabilized markets. Meanwhile, steps toward debt mutualization are moving toward addressing the Eurozone’s constant Achille’s heel.

Given this backdrop, we note that the behavior of long-term investors is surprisingly divergent. As we noted, investor behavior has been understandably volatile. One trend worth monitoring in the coming quarters is any recovery in demand for Italian debt, which is currently lagging that of overall Eurozone bonds. The vulnerability of Italy’s debt level is well known, but as with S&P’s recent decision to maintain Italy’s BBB rating, these risks are offset by the substantial policy support provided by the ECB. Nevertheless, any signs that long-term investor demand is not recovering in Italy as in other countries potentially represents a dent in rising European optimism.