Recently, we had a chance to catch up with George Bory, Managing Director of Fixed Income Strategy and Product Specialists at Wells Fargo Asset Management on what’s driving the fixed-income markets and how investors can respond to a highly volatile environment for bonds. Here were the top 5 takeaways.
1. Expect low rates for a very long time.
Over the past month, the Federal Reserve (Fed) has indicated they will focus on average-levels of inflation over a period of time rather than focus on a point-in-time estimate. The Fed has signaled this as a change in strategy, but Bory believes the Fed is only codifying a continuation of the policy that has been in place over the past decade. The latest core consumer price index (CPI) print was 1.6%, up from July’s reading, and markets will be closely watching the next release on Friday, September 11, for confirmation of movement toward higher inflation. Looking into next week, markets will be parsing Fed Chairman Powell’s comments for policy clarifications. Bory concluded, “Our base case is that you are likely going to have a very accommodative Fed for a very long time.”
2. Fixed income markets are establishing new trading ranges.
There have been some shifts over the past summer in expected trading ranges that we watch, and they are likely indicative of where rates will go and also where spread product* may go. The 10 year Treasury has moved up about 15 basis points (1 basis point is equal to 0.01%) over the summer. A more important change has been in the steepening of the yield curve. Bory thinks the long end of the curve is important to watch with likely fiscal stimulus coming down the pike and the need to finance it. The dollar may also be coming off its recent oversold status and establishing a slightly higher trading range. Bory expects that the “bear steepener” interest rate environment (where long term rates rise faster than shorter term rates) is setting up well for credit spreads, and that spread products* can be a good way for investors to access positive real yields.
3. Municipal bond markets are offering selective opportunities going forward.
Bory believes the municipal bond market is looking more attractive from both a spread and a total return perspective following a rough second quarter for the asset class. The broad muni market is up about 3.3% year-to-date (as of 09/08/2020), and the taxable market has been a standout, up about 8.5% over the same period. Bory suggests emphasizing higher quality issues, but if investors want to dip into lower quality they should consider focusing on local general obligation bonds (GOs) or revenue bonds that historically have had stable revenue sources, such as, water and sewer bonds, for example. In contrast, those sectors that are more exposed to shifts in consumer behaviors, like senior housing, privatized student housing, transports, or hospitals, are areas to exercise more caution. Issuance across the board is up 41% year-over-year and up about 270% in the taxable space, ultimately reacting to strong demand and inflows to the asset class over the past few months.
4. Corporate bonds are seeing slowing in default rates and ratings migration.
Investors will continue to look for yield in corporate bond markets and Bory believes that fundamentals may improve going forward. Default rates appear to have peaked from about 6.7% in July down to 6.4% in August, and are expected to continue to slow going into next year, particularly with the aid of stimulus and improved economic growth. Moreover, credit migration from investment grade to the high yield space, which has paced about $215 billion year-to-date (as of 09/08/2020), has also slowed. It is important to point out that much of dollar value of these downgrades was concentrated in relatively few issuers. There are still downgrades on the horizon, but, as Bory notes, “some of the best opportunities in the world of corporate bonds have been in investing in companies after they’ve been downgraded,” and these can present attractive opportunities where fundamentals are still intact.
5. The upcoming elections should cause some excitement in bond markets.
It’s very difficult to predict election outcomes. Since World War II, the incumbent president has won re-election 70% of the time, yet where we stand with COVID later this year will likely play a significant part in this election’s outcome. Currently, Predictit.org show that candidate Biden has a 58% of winning and a 56% chance that the Senate is taken over by the Democrats. There are three outcomes that investors can consider: divided government, a blue wave (where Democrats take control of the Senate and the Presidency), and a red wave (where Republicans make major gains in the House). Divided government may be the best for fixed income markets due to the likelihood of forced compromise over spending priorities. In a blue wave scenario, Bory sees a relatively anchored short end of the market likely with longer rates coming down, widening spreads, and stronger dollar. Bory sees a red wave producing a mirror outcome of long rates rising faster than the short end of the curve, tightening spreads, and a weaker dollar.
We’ll be back with more insights from George Bory next month. In the meantime, visit wfam.com to read more thought leadership from our entire Fixed-Income team.
* Spread product: Bonds that typically trade based on the difference between their yield and the yield of a comparable risk free security, ie. US Treasury. Examples include corporate bonds, high-yield bonds and mortgaged-backed securities.