Recently, we had a chance to catch up with George Bory, Managing Director of Fixed Income Strategy and Product Specialists, and Janet Rilling, Senior Portfolio Manager and head of Multi-Sector Fixed Income-Plus and High Yield, both from Wells Fargo Asset Management (WFAM), 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. It’s been a big week for financial markets.

The U.S. election, several central bank meetings including the Federal Reserve (Fed), and ongoing pressure from COVID-19 are the macro matters that will matter the most going forward. The increased prospect of an orderly transfer of presidential power in the U.S., along with a politically divided U.S. Congress, ongoing central bank support, and hopes for a COVID-19 vaccine, all conspired to create a surge in risk assets and a sell-off in low-risk assets. While some investors may worry about the reemerging trends of a steeper yield curve, a weaker U.S. dollar, and tighter credits spreads, Bory reminded listeners, “It all comes down to pace (of these trends) and portfolio positioning.”

2. Preliminary election results suggest a divided U.S. government and constrained fiscal spending.

Preliminary results point to a political divide between the Democrat-controlled executive branch and House and a Republican-controlled Senate. Because a divided government suggests more gridlock in Congress, fiscal spending is likely to be more muted than it would be otherwise. Bory said, “The election took some of the negative tail risk out of the bond market, the risk of unbridled fiscal spending.” While 10-year Treasury yields may challenge the 1% level, we expect strong demand for yield would help limit the increase. Rilling said “The underlying premise is that the global search for yield will persist.”

3. The Fed stands ready and willing to do more.

The Fed is committed to a low interest rate environment for at least the next two years or more, judging by policy statements. In addition, the recent adoption of the flexible average inflation targeting has raised the bar for further tightening, reinforcing a bias toward lower rates for a longer period. In terms of bond markets, the Fed may modify (expand) its purchase program in November, which would affect longer-term Treasury bonds and corporate bonds. But in the meantime, the Fed has helped limit downside on corporate bonds, particularly because its credit facility supports investment-grade and fallen angel issuers. And given the anchoring of short-term rates by the Fed, we think 10-year Treasury yields are likely to be in a 60–80 basis point range through year-end. While 10-year Treasury yields may challenge the 1% level, we expect strong demand for yield would help limit the increase.

4. Much rests on the path ahead for COVID-19.

The number of COVID-19 cases are rising across the U.S. and another slowdown in the economy due to it remains a risk. However, the pandemic would need to get much worse to force fiscal action. And on the good news front, Pfizer announced that its COVID-19 vaccine had been more than 90% effective in trials. The pandemic is important for fundamental reasons—both in terms of economic growth and policy. Bory said the WFAM message to investors is “don’t give up on fixed income because yields are moving up slowly; instead, you need additional sources of income to offset capital losses.”

5. Corporate credit is the big winner in the current environment.

Yields are likely to stay low because of central bank support and the global search for yield. Credit spreads for many sectors have tightened significantly since their wide levels seen earlier in the year but remain wider than their longer-term averages. Rilling explained the advantages of core-plus fixed income, which is that out of benchmark sectors—corporate credit, BBB-rated debt, high yield, non-U.S., emerging markets—may add return potential and diversification. But she also said that having a material allocation to core fixed income is important because “core acts as a ballast when equity markets trade down.”

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.

Disclosure

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Basis point-(bps) 100 bps equal 1.00%.

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).

Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held by the fund. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest rate changes and their impact on the fund and its share price can be sudden and unpredictable. Loans are subject to risks similar to those associated with other below-investment-grade bond investments, such as risk of greater volatility in value, credit risk (for example, risk of issuer default), and risk that the loan may become illiquid or difficult to price. The use of derivatives may reduce returns and/or increase volatility. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to foreign investment risk, high-yield securities risk, and mortgage- and asset-backed securities risk. High-yield securities have a greater risk of default and tend to be more volatile than higher-rated debt securities. Consult the fund’s prospectus for additional information on these and other risks.

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