Recently, we had a chance to catch up with George Bory, Managing Director of Fixed Income Strategy and Product Specialists, and Nick Venditti, Senior Municipal Portfolio Manager, both from 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. The COVID-19 economy continues to recover.
The U.S. economy is in recovery mode, helped by a housing boom and resilient consumer demand. In fact, with consumers driving two-thirds of economic activity, Bory expects a pretty good holiday spending season as private payrolls and average hourly earnings continue to advance. And even though corporate spending is limping along in contrast to the stock market ripping along, it’s hard to get too bearish on the U.S. economy. At the same time, markets seem to be getting comfortable with the possibility of a “Blue Wave” outcome at next month’s election. In addition, the prospect of a large dose of fiscal spending regardless of who wins the White House is also helping sentiment and weighing on bond prices, particularly at the long end of the curve.
2. Bond yields are on the move and credit spreads are tighter.
Ten-year U.S. Treasury yields have moved modestly higher—up 13 basis points (bps; 100 bps equals 1.00%) to 0.78% since the start of October. Meanwhile the yield curve has been anchored at the front end by Federal Reserve (Fed) policy, but the longer-term part of the yield curve as measured by the difference between the 5-year and 30-year yields has steepened to 125 bps. Bory noted, “It wouldn’t be unreasonable for the longer part of the yield curve to steep another 25 bps to 150 bps over the next 6 to 12 months, especially if inflation concerns increase.” Meanwhile, credit spreads have tightened across the board as better economic growth and the prospect of fiscal support has started to flow through to credit markets. Both high yield and investment-grade credits have seen higher prices, but lower-rated credit has outperformed. High yield credit spreads are back to the tightest levels of 2020, having narrowed about 60 bps over the past three weeks. The same pattern holds for investment-grade credit spreads.
3. Municipal credit is evolving.
It was true before COVID-19 and is certainly true now. There is no substitute for fundamental, bottom-up credit research. Volatility is likely on the horizon for a number of reasons including the pandemic’s uneven effect on credits and the upcoming presidential election. Venditti explained, “That’s exciting from our perspective because volatility is synonymous with opportunity.” And he believes his portfolios are well positioned to take advantage of these opportunities that they think are coming. The credit side is more complicated. In contrast to a decade ago when 70% of the muni markets was AAA-rated, today’s mix of issuers requires robust credit research capabilities to have an in-depth understanding of an issuer’s revenue stream and how robust it is. If the market sold-off, he would be cautious about adding lower-rated credits, particularly in the high-yield muni arena, because current yields don’t offer enough protection for the downside risk, in his opinion.
4. Municipal demand remains robust.
Demand in the municipal bond market has been incredibly strong since March. Municipal bond funds have experienced net flows of $36.1 billion year to date (as of 10/9/2020) despite outflows of $21.8 billion in April. While strong demand boosted returns, it also led to homogenization (everything trades at the same level when credit spreads evaporate and yields fall towards zero). Venditti emphasized, “I’m telling you right now today that supply doesn’t matter. Demand is going to tell the tale of total returns over the next three to six months.” As Venditti went on to explain, he expects a bifurcation in the municipal bond market that produces winners and losers. When seeking winners, you need in-depth credit analysis because security selection is going to win the day on a go forward basis.
5. Current investment themes focus on yield and diversification.
Bory continues to like corporate credit for additional yield vis-à-vis Treasuries and noted that lower-rated credit has typically outperformed during an economic recovery. He also expects short duration high yield to outperform in a recovering economy with rising yields. Venditti cautioned investors to be selective in the muni market as it bifurcates between winners and losers. Bond investors should cast their net as wide as possible and look to overseas markets for diversification versus a weaker USD and incremental yield. In terms of opportunities, Bory explained, “Because we expect the dollar to weaken into next year because non-dollar currencies will strengthen as those economies do better, we are tactically adjusting allocations in core plus portfolios.”
We’ll be back with more insights from George Bory next month. In the meantime, visit wellsfargoassetmanagement.com to read more thought leadership from our entire Fixed-Income team.
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Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.
The ratings indicated are from Standard & Poor’s, Moody’s Investors Service, and/or Fitch Ratings Ltd. Credit-quality ratings: Credit-quality ratings apply to underlying holdings of the fund and not the fund itself. Standard & Poor’s rates the creditworthiness of bonds from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the rating categories. Moody’s rates the creditworthiness of bonds from Aaa (highest) to C (lowest). Ratings Aa to B may be modified by the addition of a number 1 (highest) to 3 (lowest) to show relative standing within the ratings categories. Fitch rates the creditworthiness of bonds from AAA (highest) to D (lowest).