- December 2020
2021 Fixed Income Outlook
Fixed income insights: Rob Burn, CFA; Campe Goodman, CFA
Views expressed are those of the authors and are subject to change. Other teams may hold different views and make different investment decisions. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.
FIXED INCOME INSIGHTS
More positives than negatives
A moderately pro-cyclical risk posture
As of this writing, broadly speaking, we somewhat favor higher-yielding fixed income sectors. We believe that over the coming year, default risk is likely to fall, potentially helping spreads to tighten in many credit sectors. Despite this generally positive outlook, we have recently suggested that clients modestly reduce credit risk and add portfolio liquidity, because some of the spread tightening we had anticipated has already occurred. We believe it prudent for investors to maintain a larger reserve of high-quality, liquid assets for the purpose of exploiting market dislocations that may occur in the months ahead.
A downside surprise with regard to a COVID-19 vaccine, a delay in additional US fiscal stimulus measures, and uncertainty around the direction of policy under a Biden administration are some catalysts for potential spikes in volatility that we will be watching closely.
Our mosaic of cycle indicators is currently sending more positive than negative signals, with extraordinary monetary and fiscal stimulus, along with reasonable asset valuations, somewhat offset by challenged economic and corporate fundamentals. As we look across the various fixed income sectors, we see a few pockets of attractive value for investors to consider.
We believe bank loans stand out
Bank loan spreads were recently in the top quintile versus their history and represent one of our highest-conviction investment ideas for multisector portfolios (Figure 1). The near-zero interest-rate environment this year has pushed down these loans’ total yield, causing them to fall out of favor with many investors. Furthermore, as default rates have increased, a handful of high-profile loans have defaulted lately, with expectations of very low recovery rates.
However, we believe these concerns are more than adequately priced into today’s attractive loan spreads. On average, loans still tend to experience higher recovery rates than comparable bonds, while also typically offering similar or better credit spreads. Despite recent retail outflows, the technical backdrop remains largely supportive, thanks to strong demand from collateralized loan obligations (CLOs) and limited new issue supply. We currently see the best opportunities in higher-quality, US-focused loan issuers in less cyclical industries.
FIGURE 1
Opportunities in EM corporate credit
We have observed a high degree of dispersion among emerging markets (EM) credits. Spreads for most higher-quality sovereign issuers appear to us to be excessively tight, as their debt trajectories look worrisome. Not only have pandemic-induced recessions led many EM countries to run large fiscal deficits in 2020, but these countries will likely need to add even more debt over the next few years.
We believe EM corporate debt issuers offer more opportunities. Company fundamentals vary by industry and are often not overly linked to the fortunes of their home countries. Our preferred credits have demonstrated resiliency in a difficult environment, with management teams that emphasized debt reduction, moderate capital expenditures, and prudent balance sheet management even prior to the crisis. As business activity and corporate earnings recover, we expect many issuers to naturally reduce leverage, which they have generally not needed to the same extent that many sovereigns have.
We also see opportunities in some high-yield EM sovereigns and, to a lesser degree, in select frontier markets. Among these riskier countries, we favor those with low repayment needs over the next few years, potentially giving them enough time to address their macro and fiscal challenges (for those that have shown a willingness to do so).
Rising corporate debt: Warning signal to markets?
Many bond-market participants have warned about the massive expansion of corporate debt that has taken place during the pandemic (Figure 2). In the past, elevated levels of debt growth predicted subpar returns for corporate credit. Historically, we have viewed rapid debt growth as driven primarily by speculative behavior on the part of corporate managements — for example, debt-financed expansions that later proved to be poor capital allocation decisions. Today’s debt growth, however, has not been fueled by mergers and acquisitions, but mainly by a judicious desire to improve liquidity in today’s highly uncertain business environment.
We therefore do not view the current increase in corporate debt in a wholly negative light, as it is indicative of precaution rather than risk-taking. Moreover, the bond-market technical backdrop looks very strong: The rising debt supply has been met by a commensurate increase in demand, as central bank bond purchases have enabled the market to absorb more corporate debt. We suggest that investors focus on those issuers best positioned to quickly deleverage their balance sheets as the global economy mends.
FIGURE 2
Fewer opportunities in structured credit
For many years, we have believed the structured credit market abounds with investable opportunities. In the post-pandemic period, however, we see fewer investment opportunities in structured finance than we once did.
Malls and other retail-exposed businesses, which were under pressure even before the onset of COVID-19, must battle stiffer headwinds than ever. Hotel and office properties may now face a difficult slog as well. In the mezzanine areas of structured credit, outcomes are likely to be quite binary, with 100% losses for certain tranches and enticing yields unlikely to be realized in many cases. We have seen a growing number of malls’ equity owners choose to stop making their loan payments and effectively “hand over the keys” to their lenders.
The brightest spots in securitized credit are primarily securities exposed to residential housing. Housing prices remain buoyant amid continued low mortgage rates, fiscal stimulus, and a favorable supply-demand dynamic that has persisted since the global financial crisis.
Stay long credit, keep some cash ready
Where fixed income meets ESG
During periods of uncertainty, companies that are able to adapt and address new challenges are more likely to emerge stronger and more sustainable. Today, as the world struggles to overcome the economic downturn caused by the COVID-19 pandemic, we look for issuers to incorporate ESG factors into their strategic planning decisions.
We believe investing to maximize risk-adjusted returns should include investing with a lens for ESG alignment. In our view, ESG issues can be meaningful drivers — or destroyers — of long-term value. Because we find that traditional investment security analysis fails to appropriately price ESG risks, we consider ESG risk premia as an integral part of our valuation framework and trading decisions.
While we see many ESG risks as tail events, they can have significant impacts on issuers. Academic research suggests that low-probability events create inefficiencies for market pricing; our research seeks to exploit the resulting dislocations. As market participants grow more aware of ESG risks, the costs of such risks should rise accordingly. As with other forms of risk, investors will demand greater compensation for holding securities with negative ESG attributes or assessments. Given the widening focus on ESG in the wake of COVID-19, the importance of these risks to security valuation is unlikely to wane over our investable time horizon. We seek to identify and quantify all underappreciated investment risks. If we feel that a security’s valuation accurately reflects associated ESG risks, we may choose to own it. If not, we may be less likely to do so.
about the authors
Rob Burn
Fixed Income Portfolio Manager, Boston
As a fixed income portfolio manager, Rob develops strategic and tactical investment strategies using both fundamental and quantitative analysis and implements those strategies in portfolios. He also focuses on portfolio construction and risk management, and is a member of the Broad Markets Team.
Campe Goodman, CFA
Fixed Income Portfolio Manager, Boston
Campe is a portfolio manager on the Broad Markets Team. His focus is sector rotation — asset allocation across the major fixed income sectors — and he leads the specialist team responsible for the development of the top-down sector rotation strategy that is utilized in many approaches.
ACTIONABLE IDEAS 2021
This is an excerpt from our 2021 Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios in the year to come.