The key themes driving fixed income markets have fundamentally changed since 2020. We address several updates for investors to consider throughout 2021.
Follow the Fed: The US Federal Reserve is intent on keeping interest rates low for the foreseeable future and backstopping the plumbing of the market: investment grade credit. Although the Fed has stepped away from purchasing corporates directly, we believe any economic setbacks will prompt the Fed to support investment grade credit (the lifeblood of lending for corporations) and buoy the economy.
Recovery trade: The economy is set to rebound from the COVID-19 pandemic in 2021 and may experience gross domestic product (GDP) growth of 6%, according to research from the Invesco Investment Strategy team compiled on December 31. This is positive for investment grade credit —and especially for credit that is more sensitive to economic expansion, such as consumer cyclicals. We are optimistic about subsectors, including travel and leisure, that we anticipate will benefit from an improving and open US economy. We maintain an overweight position in areas we believe will experience credit spread tightening as the economy recovers during the year.
Global negative yields: There is still roughly $17 trillion of negative-yielding debt around the globe. Consequently, foreign investors’ search for yield is leading them to the US investment grade corporate market. While the US investment grade market only makes up about 13% of the global bond market, it accounts for nearly 40% of all yield in the market.1 The size, liquidity, and higher credit ratings of the US market are attractive to foreign investors, and we believe those flows will continue. This is another reason to overweight the investment grade market.
Residential vs. commercial: We favor the residential mortgage market, including agency and non-agency mortgages, because the US housing market remains extremely strong, and most borrowers are in good financial shape. We project that the growing trend of remote working will lead to an increased demand for larger homes with outdoor space compared to smaller multifamily units. We expect that a weak supply of the former will put upward pressure on housing prices and benefit residential mortgages. While it is too early to tell how significant the remote working trend will be, struggling retail properties will not likely see a recovery in tenant demand anytime soon, and there is evidence that lack of demand is part of a longer-term structural trend.
Corporate deleveraging: After borrowing a record $1.8 trillion in 2020, US investment grade corporations no longer require excess liquidity to survive the pandemic. Companies have learned to adapt through these changing and challenging economic times, opting to begin paying down debt. This shift has already started, with record “tenders,” or corporate bond buybacks, at the end of 2020. We expect to see a sharp reduction in borrowing to $1.1 trillion in 2021. In addition, rating agencies are looking for companies to reduce leverage or be downgraded. We believe this added pressure will result in a considerable reduction in overall leverage in 2021. This will benefit credit spreads from a fundamental (lower leverage) and technical (less supply) standpoint.
Commodity rebound: Accelerating economic trends should lead to higher commodity prices. We believe there are opportunities in the metals sector, as well as in select portions of the energy market, such as pipelines, that should do well as commodity prices improve compared to the volatile and very low prices in 2020. That said, the new US administration may present some challenges to the oil and gas sectors, so security selection will be paramount.
Reflation: We expect inflation to pick up in the second quarter of 2021. While this is likely to be transitory, it could cause some concern in the Treasury market that the Fed will pull away its monetary support sooner than anticipated. While we do not expect the Fed to take this action, we do expect increased interest rate volatility. To start the year, 10-year Treasury yields have increased, recently going above 1.3%. It’s unclear how the market will react when inflation prints are actually realized in the spring and summer since high rates have already been priced in, but we do expect more rate volatility. High yield and emerging market bonds trade off dollar price and not spread, making them less sensitive to interest rate volatility. We have positioned the portfolio with greater exposure to dollar price-traded bonds, which should provide less empirical duration compared to modeled duration.
Crossovers: The year 2021 is the year of the upgrade. We believe that through select themes and security selection, we can enhance total return by buying high-yield bonds before they upgrade to investment grade. Once they upgrade, the buyer universe expands to pensions and insurers, allowing for significant price appreciation. We believe the market will see $50 billion or more in upgrades in 2021, led by technology and home builders.
We were able to generate strong returns for our clients in 2020 through active manage- ment, and now we see numerous opportunities for fixed income in 2021. We will work hard to ensure we are in a prime position to take advantage of them.
1Bank of America, Global Research, as of November 30, 2020.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions. Past performance is not indicative of future results.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Debt securities are affected by changing interest rates and changes in their effective maturities and credit quality.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The investment techniques and risk analysis used by the portfolio managers may not produce the desired results.
All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This is not to be construed as an offer to buy or sell any financial instruments and should not be relied upon as the sole factor in an investment-making decision. As with all investments, there are associated inherent risks. This should not be considered a recommendation to purchase any investment product. This does not constitute a recommendation of any investment strategy for a particular investor. Investors should consult a financial professional before making any investment decisions if they are uncertain whether an investment is suitable for them. Please obtain and review all financial material carefully before investing. The opinions expressed are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. Past performance is not indicative of future results. This portfolio is actively managed. Portfolio holdings and characteristics are subject to change.
All information is sourced from Invesco and as of 1/31/21 unless otherwise stated. Invesco Distributors, Inc. 2021
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