Read the popular financial press and you might come away thinking fixed income is generally a terrible investment at the moment.
In recent weeks we have been told Warren Buffett thinks “fixed income investors worldwide … face a bleak future,” while Ray Dalio has declared the economics of investing in bonds has become “stupid” and shorting them is “a relatively low-risk bet.”
In my view, those with the kind of profile enjoyed by Buffett and Dalio—especially among retail investors—should be more accurate with their words. Saying “bonds” are a bad investment is a little like saying it’s going to rain tomorrow, without divulging when or where.
What I think they are specifically referring to here is lower yielding, higher-rated bond markets such as US Treasurys, and, in fairness to them, they might have a point. Ten-year US Treasury yields may have climbed some 78 basis points (bps) year-to-date to around 1.7%, but even at this level I think they offer little in the way of income, and holders remain exposed to capital losses from a likely further upward shift in yields. While I see less upward pressure on European sovereign yields, the argument for other major “risk-free” rates assets such as UK Gilts and German Bunds is hardly any stronger, in my view.
What Buffett and Dalio fail to mention is that with a global view and a multi-sector approach, it is possible to build a bond portfolio with moderate duration of three to four years targeting yields of around 4%, which, in my view, would be a reasonable return in the current climate.
Trump Rates with Credit
Active managers normally look to constantly recalibrate rates risk and credit risk in their portfolios as conditions change.
With rates risk looking poorly rewarded currently, we would expect them to look to embrace credit risk instead. Last spring, ratings agencies were forecasting some truly alarming default rates, but fast forward 12 months and we are already seeing more upgrades than downgrades across both US investment grade and high yield, and, according to those same ratings agencies, we may be heading for sub-5% high-yield defaults in the US and sub-3% in Europe by the end of 2021.
With this in mind, we anticipate managers wanting to move down the credit spectrum and add pro-cyclical risk, both to try to benefit from the anticipated contracting spreads driven by the economic recovery, and to gain some protection against rates weakness that higher yield bonds usually provide. Where for much of 2020, in our opinion, we saw the best value credit risk in bonds around the BBB rating level, we now see an increasing number of opportunities for good bottom-up investments in the BB and B brackets, and potentially lower.
A sharp economic recovery should, of course, be broadly positive for credit, but this doesn’t mean we can just buy anything; in our view, you need to target the parts of the market where you think credit risk is most likely to trump rates risk.
Let’s say an investor buys an investment grade corporate bond today at a spread of 30 bps over Treasurys. Most of the risk in that position comes from Treasurys, since if the US Treasury yield was to rise by 30 bps to 2%, then even if the company performs very well its spread is unlikely to contract by 30 bps to offset the Treasury move. With a high-yield bond at a spread of, say, 300 bps, meanwhile, there is much greater scope for the credit risk to overwhelm the rates risk.
Hang Off the Right Curve
Global bond investors must also judge where rates weakness might have the most detrimental impact if sovereign yields continue to drift higher, which means picking the right yield curve to “hang” your credit risk off.
As of April 7, the euro high-yield index had returned 1.85% year-to-date, versus 1.46% for US high yield. Given the growth momentum of the US economy, that might seem puzzling, but much of the discrepancy can be explained by US high yield being priced off the US yield curve, and thus hit harder by the particular weakness in Treasurys (plus the US index has slightly higher duration).
At the moment, we would generally prefer to have our credit risk priced off the European yield curve, which we see as more stable than its US cousin in the medium term as a result of the European Central Bank’s hefty asset purchase program and our much more serene outlook for economic growth and inflation in the eurozone.
However, that doesn’t mean we think you want to avoid US credit completely. Given the growth trajectory in the US, we would expect to see some especially positive credit stories in lower rated bonds in the next couple of years, particularly in the three- to five year part of the curve where lower duration should help protect investors from the likely corrosive impact of rising Treasury yields.
Ultimately, our outlook for fixed income in 2021 is for credit spread tightening across nearly all geographies and sectors, with credit spread compression between ratings bands.
If 2020 was all about markets rallying ahead of the fundamental recovery—which in part has provoked comments like those we’ve seen from Buffett and Dalio—we think this year will be about economies catching up, fueled by the huge market drivers of fiscal stimulus and extraordinary monetary policy. While there are certainly risks to this narrative given its reliance on the success of COVID-19 vaccine rollouts, I don’t believe this is the time to play contrarian; markets tend to do well when the direction of travel looks to be clear.
History shows bond investors can do well from embracing pro-cyclicality in trying to maximize returns as the cycle progresses. Some areas where we think managers may look to continue this approach would be by favoring financials, unsecured over secured bonds, corporate hybrids, European collateralized loan obligations (CLOs), and individual names in hard currency emerging markets.
In particular, financials have had a particularly strong 12 months and have emerged from this challenging period with more capital than when they started; they would be at the top of my credit shopping list right now. We expect subordinated bonds to bounce back quicker than seniors through the recovery, which makes Additional Tier 1 (AT1) bonds look especially attractive, in our view. At the index level, in US dollars, AT1s currently yield around 4% for an average maturity of 3.5 years, with a spread over Treasurys of 370 bps—there looks to be plenty of spread here to help defend against further rates weakness.
What we expect managers will definitely want to avoid is lower spread and longer dated products, particularly those tied to the US yield curve. In credit, we believe investors should be very wary of sectors ordinarily considered pro-cyclical which are under real structural pressures, such as automotive, travel, retail, and commercial property.
Buffett and Dalio see fixed income investors being caught uncomfortably between inflation induced capital losses and unattractively low levels of income. But viewing current fixed income markets through a multi-sector lens provides a more nuanced picture. Treating benchmark sovereign yields as wholly representative of fixed income markets, in our view, ignores compelling opportunities.
While finding income in the bond markets of 2021 is undoubtedly challenging, we think a portfolio that is able to run relatively low duration with a yield of around 4% remains achievable and would be attractive to investors.
Mark Holman is CEO and portfolio manager at TwentyFour Asset Management, a fixed income boutique of Vontobel Asset Management. He has 32 years of investment experience and has worked at Barclays Capital, Lehman Brothers, and Morgan Stanley.
This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.