Looking at their fixed-income portfolios, investors will no doubt be wondering where returns are going to come from in 2021. Bond yields are extremely low by historical standards. The yield of a diversified Canadian bond portfolio is set to finish 2020 at just 1.2%, the lowest since the bank began tracking Canadian bond yields in 1996 and over half a per cent lower than any previous year.1 In this environment, what role does fixed income play in investors’ portfolios?
Duration is not the answer
The duration of a bond portfolio describes its sensitivity to rising and falling yields. When yields fall, the value of the fixed coupon portfolio rises; its duration describes by how much. On average, bond yields have fallen every year since the late 1970s, meaning investors with long-duration portfolios have consistently enjoyed capital gains to supplement falling income expectations. We’ve heard warnings about the end of the bond bull market for much of the past 10 years, but it’s never meaningfully come to pass. Why is this time different?
First, we are in the midst of emergency measures implemented through monetary policy to combat the economic effects of the COVID-19 pandemic. Central banks have cut global rates effectively to zero and have inflated their balance sheets by buying an unprecedented amount of bonds in an effort to drive yields down even further. While central banks remain committed to these measures until economic activity recovers, they are ultimately looking for an opportunity to reduce their intervention to prepare for the next crisis, whenever it may come.
Canadian Bond Universe (CAN0 index). Source: Bank America as of November 30, 2020.
Second, governments are borrowing at an unprecedented rate to fund extraordinary fiscal stimulus programs. Deficits and debt ballooned in 2020 and are set to expand further in 2021. It will take years for governments to return to fiscal prudence, meaning government bond issuance will continue to expand.
Third, the U.S. Federal Reserve’s shift to “average inflation targeting” announced in August is now under consideration at several other G7 central banks. The premise is that central banks are prepared to let inflation rise above its target (traditionally 2%) to give economies more room for growth before tightening monetary conditions. The policy change away from a pro-active management of expected inflation has already resulted in meaningfully steeper rate curves since the summer. If economic activity and inflation continue to rebound in 2021, expect them to steepen further and long-term rates to rise.
We believe investors should consider the overall duration risk in their fixed-income portfolios. Exposure to long-term bond yields can act as insurance in a disaster scenario, but in post-disaster environments, the cost of insurance goes up. In this case, the cost comes in the form of accepting lower yields and bonds that perhaps have less room to rally if economic activity shudders to a halt again. Investors should maintain some “insurance” but consider owning less than you did 12 months ago. Our central thesis for 2021 is a year of recovery, which means risk assets rise and hedge assets (long-term government debt) fall.
Spread risk: The only game in town
The traditional formula for generating fixed income gains (falling portfolio yield offset by strong capital gains from owning duration) is unlikely to work in 2021. Although credit spreads – the difference in yield of a corporate bond and an equivalent maturity government bond – are tightening, there is still room for more, putting them in stark contrast with interest rates.
The baseline outlook amongst dealer credit research teams is for risk assets to rally and credit spreads to tighten next year. Although existing spread compression will potentially limit the degree of upside, there are reasons for investors to be optimistic.
Source: Bank of America as of November 30, 2020.
Credit spreads represent the yield premium investors demand to hold corporate debt over government debt. This can be thought of in absolute terms; “the minimum yield premium is 100 basis points,” or relative terms; “I need to earn 50% more yield.” While technical players will point to the former as rationale for why credit markets are already fully priced, we ultimately believe the latter is just as relevant. So long as the overall yield environment remains low, even as interest rates rise moderately, corporate spreads appear to have room to tighten.
Following a year where issuers flocked to raise debt to ensure sufficient liquidity in the face of a global shutdown, we expect new issue volumes to be moderate in 2021. Borrowers will still be driven to reduce the cost of debt by terming-out and calling existing high-coupon bonds, and we expect increased merger and acquisition activity, which is often debt-funded. In our view, 2021 will feel more similar to 2017-2019 and reduced supply will provide a technical tailwind for credit.
Despite the generally positive backdrop for credit spreads, there are challenges. Short-term debt yields are low, to the point where our traditional portfolio mix will struggle to generate yields in our target 3-5% range, even with leverage. We are starting the year with lower leverage and moderately extending average term, a strategy that should pay off if credit spreads rally further as anticipated, as credit curves will likely flatten with spreads on intermediate and long paper outperforming. Should spreads widen, our lower leverage profile will give us plenty of scope to take advantage by adding risk and yield to the portfolio.
An optimal environment for active management
Our goal is to add 2% plus to overall annual returns through prudent active trading, including new issue trading, range trading credit spreads and acting as a liquidity provider to the market earning bid-ask spreads in the process. Volatility remains elevated from 2019 levels and we can use this environment to our advantage. When spreads are highly stable and compressed, generating active returns becomes more difficult, just as it does when volatility is high and liquidity is scarce. We’re entering 2021 in an ideal area of “goldilocks” volatility; not too much, not too little, and we look forward to finding opportunities that are just right as the year progresses.
Source: Bloomberg Finance L.P. as at December 16, 2020.
Our overall outlook is constructive for credit markets, just as it is for most risk assets post-pandemic. It’s always worth reminding ourselves why investors allocate to fixed-income strategies in the first place. Investors want stability and income, and an asset class that will outperform in a risk-off environment. 2021 will be a year for recovery, which should mean higher prices for risk assets. In fixed income, investors will choose spread over duration. That means adding strategies around private debt, high yield and other alternative fixed-income sleeves, such as CI Lawrence Park Alternative Investment Grade Credit Fund. With safety of principal and daily liquidity, our profile is distinct from traditional corporate bond portfolios through our active management style and hedging of interest-rate duration risk. 2021 will not move in a straight line and there will inevitably be bumps in the road. A low-volatility approach and investment-grade focus might just be the optimal prescription.
1 Bank of America
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Published December 30, 2020