A paradigm shift
Fixed income markets are entering 2021 in uncharted territory. Unprecedented levels of manipulation by governments (fiscal stimulus) and central banks (quantitative easing) have pushed the yields on US$17 trillion worth of global government bonds negative. Real yields (i.e. nominal yields less inflation) on average global investment-grade corporate bonds are negative for the first time ever. Spreads are only in the 30th percentile, but the average yield of 4.4% on high-yield bonds is the lowest ever. The low-yield environment challenges income seekers, but the lack of volatility will impact portfolio construction for all investors. Four decades of falling interest rates saw fixed income provide investors with both real income and diversification benefits. Bonds used as effective portfolio insurance paid for themselves. Going forward, that insurance is now less effective and comes at a cost. Return and diversification expectations must be managed lower. The strength in alternative diversifiers like gold and Bitcoin, where sup ply growth is more muted and predictable than fiat currencies (government-issued currency that isn't backed by a commodity), should not be overlooked.
1 Source: Bloomberg Finance L.P., as of December 21, 2020. High yield market = ICE BofA U.S. High Yield Index.
We start 2021 with the same ‘risk-on’ positioning that worked from April 2020 onwards. Vaccine deployment gifts policymakers the leeway to bridge stimulus to economic recovery. Deficit spending would normally send government bond yields higher without aggressive, and successful, central bank intervention. Consumer confidence is on the mend, helped in part by the wealth effect. This should carry into 2021 and grow as unemployment in the service sector and small business falls. Consider the effect low interest rates have had on the housing market; prices are up $440 billion (Statistics Canada). Most investors have also done well this year even as income inequality has grown.
In government bonds we remain underweight and short duration. We recommend layering government bonds back into portfolios or to a neutral weight when or if the Government of Canada 10-year bond yields reach 0.90% or more, and the U.S. 10-year Treasury hits 1.2%. Add again if yields back up another 0.20% from those levels. While a gradual back up in rates is our base case, we believe engineered negative real rates will continue to drive higher valuations in risky assets like equities and corporate bonds. U.S. Federal Reserve (the Fed) Chair Jerome Powell at the press conference following the Fed’s December 15 meeting, demurred on any concern for the level of asset prices, suggesting they would look through any spike in inflation in 2021 due to base effect.
2 Source: Bloomberg Finance L.P., as of December 18, 2020.
In credit, we remain engaged and overweight. We have moved from being bullish on investment-grade and high-yield bonds to neutral, even as we think spreads will tighten further. Improving credit fundamentals and muted supply should be positive influences in the new year, even as corporate mergers and acquisitions increase. There may be a point in 2021 where we will be a seller into strength, taking our weights to neutral, or where we look to hedge out the interest rate risk of our investment-grade bonds, but we are not there yet. Likewise, we may hedge out volatility in our high-yield bond holdings if complacency creeps into the asset class like in early 2020. We remain bullish and overweight emerging market bonds and government credit (e.g. provincials, municipalities) as those asset classes did not keep up with the broader rally in spreads. Here, like in corporate credit, security selection and active management w ill be key. We especially like emerging market local currency bonds as broad-based U.S. dollar weakness likely persists. We anticipate needing to pay particular attention to our currency hedging levels in 2021.
There will surely be some sort of risk-off event in the new year and I can only guess it may be a taper tantrum as stimulus is removed, geopolitical saber rattling to test a new U.S. administration, a communication mishap, or broad concern of cyclical inflation pressures overcoming secular headwinds under the Fed’s new Flexible Average Inflation Targeting regime. Nonetheless, like most years it will probably be something else. Until that time when an asset allocation decision is warranted, manage expectations, stay active, stay with the positioning that worked from April onward, but be willing to reduce – not eliminate – credit as valuations tighten further and to add tactically to duration as 10-year yields rise slightly.
For a more comprehensive outlook by asset class, please check the Signature Fixed Income Q1 2021 Outlook piece to be published early in the new year.
Source: CI Global Asset Management and Bloomberg Finance L.P. as at December 23, 2020.
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Published December 30, 2020