Fixed Income H2 2020: What remains of the year
Chief economist Shamik Dhar and specialists from Insight, Newton and Mellon give their take on what to possibly expect for fixed income throughout the rest of 2020.
The impact of monetary policies on fixed income
Shamik Dhar, Chief Economist at BNY Mellon Investment Management
An aggressive expansion of central banks’ balance sheets is under way in major economies, with an increase in assets on US, Japan and euro area central banks’ balance sheets already totalling ~$4.5 trillion (~5% of 2019 world GDP) year to date (as of June 10, 2020). This compares to a much smaller increase in balance sheets during the peak of the global financial crisis (GFC), when balance sheets increased $2.6 trillion in 2008–2009. So far this year, the large majority of QE purchases have targeted government bonds. In the US, out of the $2.2 trillion total assets purchased this year (as of June 10, 2020), around 70% were government bonds1.
QE impacts government bond yields (and financial markets more broadly) through a number of channels, including a liquidity channel, a monetary policy signalling, a confidence channel and a portfolio rebalancing channel. The simultaneous launch of major fiscal packages across the world will result in a huge increases in budget deficits, raising significantly the funding requirement in government bond markets.
Taking the US as an example, assuming further net issuance of around $1.8 trillion US Treasuries before the end of 2020 (based on estimates by the US Department of the Treasury and a number of assumptions) and extrapolating the most recent weekly pace ($20 billion) of US Treasuries purchases by the Fed until year end, the market may need to digest around $1.3 trillion US Treasuries overall. This amount of net issuance over a 6-month period is some of the highest in recent history, and it is taking place at significantly less attractive yield levels than in the past, which might imply some upward pressure on bond yields (mostly through the real risk premium). However, we expect that the accumulation of global savings generated whilst lockdown measures were in place will counter this and keep real equilibrium yields low regardless of issuance.
We might also observe a “cheapening” in bonds relative to swaps, particularly at longer maturities (i.e. longer term swap spreads widening). That said, if this upward pressure on bond yields were indeed to take place, we would expect it to be contained and temporary, given the presence of strong demand for higher yields from government money funds, foreign central banks, dealers and asset managers. If such demand proved to be insufficient, we would expect the Fed to expand asset purchases and limit any significant upward pressure on yields.
Investing in credit in a warlike scenario
Paul Brain, Head of Fixed Income at Newton Investment Management
• Investment grade credit has bounced and should be a stable investment for the balance of the year
• Default rates are expected at 9-10% for the US and 8-9% for Europe
• Monetary policies will ease pressure on banks
The first quarter of this year was a generally negative environment for some fixed income markets, in particular riskier assets such as high yield and EM debt. From an economic standpoint, it looks more like a wartime scenario than the Global Financial Crisis. After a difficult March, April and May saw a significant bounce back in fixed income investments – initially in the investment grade sector, which saw record amounts of new issuance – and a general easing of liquidity. The investment grade market has since stabilised, helped by the prospect of recovery and central bank market interventions. This has led to a record amount of issuance from companies looking to prop up their balance sheets. Despite the support for the authorities, there is still the chance of further economic weakness and high unemployment.
In this context we predict a default rate range of about 9-10% for the US and 8 or 9% for Europe. The high yield energy space may continue to be vulnerable to default and could also see some significant restructuring. It is becoming clear a number of companies will struggle to maintain their coupon payments as the current economic environment looks set to continue through to at least the third or fourth quarter of 2020. What is different this time is that, as the US Federal Reserve (Fed) has reiterated, companies are not to blame and it is likely continued measures will be put in place to help buy time for struggling businesses. Ultimately, however, this is more likely to have the effect of ‘flattening the curve’ – spreading any new measures out over a longer period, so that banks are not overwhelmed – rather than avoiding a very high level of defaults.
Why green bonds are not a guarantee of outperformance
Robert Sawbridge, Fund Manager of the Insight Sustainable Euro Corporate Bond Fund
• In times of dislocation, our analysis shows that it is not obvious that ‘green’ bonds outperform their ‘brown’ counterparts
• However, ESG criteria alongside an active selection approach can help to build a resilient portfolio in times of volatility
There is a perception that green bonds should outperform non-green, or ‘brown’, counterparts during periods of volatility. This is because there is a view that there are more price-insensitive buyers for green bonds, who value them as much for the impact they achieve as the spread they offer.
Some recent third-party analysis has used index performance to conclude green bonds have outperformed in the Covid related market turmoil but analysing in this way does not consider the quality or sector differences which exist between such indices.
When we looked at the relationships during the period of heightened volatility from 1 March 2020 to 30 April 2020, we focused on maturity-matched pairs of bonds issued by the same company – one green, one brown – to determine if there was any difference in their performance.
This gives a cleaner form of analysis and isolates the ‘green’ component we were seeking to understand. Although data was limited, we found little evidence that green bonds systematically outperformed brown equivalents over the period in question.
At the same time, looking at ESG profiles more broadly, our analysis indicates that spreads generally widened more for issuers with worse ESG ratings on our proprietary scale.
We believe sustainability-focused portfolio tilts and allocations benefited portfolio performance over this period and this support our long-held view that a focus on ESG factors should be accretive to performance and not detrimental. Combined with robust active management capabilities, there is the potential for such strategies to deliver meaningful alpha over the longer term.
Emerging markets: Phase 2
Colm McDonagh, Head of Emerging Market Fixed Income at Insight Investment
• Active selection is key to capture the attractive yield offered by emerging markets debt in normal times, especially now post COVID and
• Parts of EM high yield (sovereign and corporate) offer attractive returns for the underlying risks, especially as global interest rates remain low
• Differences in how successfully governments have dealt with the public health shock will be reflected more widely in asset prices in the coming months
Emerging markets are not a homogeneous block. Different regions present such a varying degree of size and complexity that, for EM debt investors, it is crucial to adopt an active selection approach at the country and security level. This is true also for the recent Covid-19 pandemic. The path of infection, the political response and even the healthcare capabilities have been quite varied. Some EM countries have adopted extraordinary policies, sometimes in the form of QE, but not everyone could do that. China, for example, has been pretty proactive, while in Latin American countries such as Brazil and Mexico the pandemic has been exacerbated by arguably less effective political action.
For the second half of 2020, and for 2021, the question for EM debt investors is: what will happen after the initial shock and after the phase of fiscal and monetary response? There is currently little certainty about the nature of economic growth we will return to, and there is danger in trying to make a forecast. Much will depend on the extent of the lockdown, and on the permanent damage to certain industries. Things that were taken for granted, such as supply lines and tourism (which are very important parts of some EM economies), will be different and the global economy will need some time to adjust. We will monitor each country and how they manage the next phase, what structures they will put in place after the fiscal and monetary phase. Structural reforms will be needed to ensure that the growth rate in EM countries will be sufficient to manage the higher debt burden.
We have split emerging markets in four clusters, ranging from those with sound balance sheets and that we believe will recover relatively well, such as Colombia, Panama, Chile, Qatar, Abu Dhabi, Uruguay, to those who present a much higher credit risk, already reflected in debt reprofiling in places such as Argentina, Ecuador, Lebanon, Venezuela and Zambia.
In March, EM asset prices were cheap, in some cases cheaper than they were during the global financial crisis. Now there has been a decent recovery and some of the extra premium has been reabsorbed. Nonetheless, the income in EM high yield is still very attractive. Sovereign valuations are still cheap, but with good reason, as they are at the weaker end of the spectrum in the asset class. Looking at corporate, the underlying fundamentals are a lot better than what is implied by valuations and the default rates are not as high. There is value to be found in EM debt over the coming months, but security selection must be at the forefront of any investment approach. The US elections and the full effect of the Covid-19 may generate some noise and additional risks in the second half of 2020, so a cautious approach is warranted and investors will need to be very selective when searching for yield in EM debt.
Fallen angels let fixed income returns fly
Paul Benson, Head of Fixed Income Efficient Beta at Mellon
• Today’s economic environment has prompted credit rating agencies to downgrade a substantial amount of debt from companies.
• Three reasons support investing in fallen angels right now: the increase in downgrades, the attractive spreads and the Fed buying high yield bonds.
As a company’s financial performance deteriorates, whether it’s due to a black swan event or a gradual weakening of their balance sheet, rating agencies will downgrade its bonds. This can create a forced-selling scenario among investors who can no longer continue to hold these bonds.
The U.S. investment grade bond market is roughly US$6 trillion in size and nearly five times the size of the high-yield market. Forced selling can send ripples of disruption through the high yield market, creating a supply-demand imbalance.
This ‘technical indigestion’ typically results in about 150 basis points (bps) of discount relative to where fair value should be for these bonds. The key is to invest broadly, in a highly diversified manner, to exploit this unique structural alpha opportunity while minimizing idiosyncratic risk.
There are three reasons why the time could be right to invest in fallen angels.
- With ongoing uncertainty about the economic recovery during this COVID-19 pandemic, companies are issuing bonds at a record pace in order to build a cash buffer to weather the storm. Lower top-line growth for the foreseeable future combined with weaker balance sheets will likely result in a continuation of the elevated pace of downgrades.
- While Fallen Angel OAS spreads have retraced from the triple-digit highs seen in March, current levels are still wide relative to history and offer an attractive entry point for investors.
The Federal Reserve continues to show support for US credit, including Fallen Angel bonds, as they evolve their purchase program. This has helped to mitigate downside risk, which should allow technically oversold Fallen Angel bonds a faster path to mean reversion.