Bond investors were not spared in 2020 when the coronavirus pandemic rippled through financial markets, sending both equities and bonds plummeting in March. However central banks around the world quickly came to the rescue by cutting interest rates close to zero and unleashing massive quantitative easing.
One of the major issues for bond markets heading into this year and during the pandemic has been inflation, which has remained stubbornly low this year.
With rates already cut to extreme lows, any uptick in inflation is likely to prove challenging for bond prices.
However, one of the themes that the BlackRock Investment Institute team is expecting to take hold in the years ahead is the ‘new nominal’ and higher-than-expected inflation. Although the investment think tank said the theme is more nuanced.
“The ‘new nominal’ is not simply about our expectation for a higher inflation regime in the next five years,” the think tank noted. “It means stronger growth in the near term, and eventually higher inflation – without the typical rise in nominal bond yields.
“But even the moderately higher inflation in our base case – around 2.5-3 per cent annually – would surprise markets after a decade of undershoots.”
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Source: BlackRock Investment Institute
The think tank said the impact of the joint fiscal-monetary policy revolution and higher production costs from the expected realignment of global supply chains should spur inflation.
As such, the team said developed market government bonds will be less effective portfolio diversifiers, because central banks will limit any potential yield rises even as growth picks up.
Indeed, Sonal Desai, head of fixed income at Franklin Templeton, said investors should be wary of rising inflation next year.
“The market may also be underestimating the potential inflationary effect of the unprecedented fiscal and monetary stimulus and rescue packages,” she said, “in addition to the likelihood of increased in-sourcing and shifts in supply chains that may result from the current crisis and ongoing tensions with trading partners.
“With the economy already demonstrating a healthy capacity to rebound, and given the amount of fiscal and monetary stimulus already delivered and under consideration, an earlier-than-expected rebound in growth and price dynamics cannot be ruled out.”
Desai also highlighted the importance of being picky within the bond market.
“From the perspective of credit, bottom-up selection has never been more important,” she said. “Valuations are a concern in many sectors, as the market is not properly priced for the level of uncertainty.”
However, she hasn’t seen any obvious areas of undervaluation left in the market, and that some sectors such as commercial real estate, remain vulnerable.
Whilst some managers are worried about the return of inflation, Jupiter Asset Management’s Ariel Bezalel said there are more deflationary pressures at play.
“Rather than inflation, we think many of the developed economies will continue to face a cold world of sluggish economic growth,” said the Jupiter head of fixed income. “In recent decades the rate of economic growth has been slowing down and, worryingly, this has required ever-higher amounts of debt to deliver the necessary stimulus. Very high debt burdens hinder growth.”
He also pointed to a few other deflationary pressures: namely, globalisation, the downward pricing pressures of the internet, ageing populations, and falling fertility rates.
“Central bankers know precisely what to do about inflation, it is deflation that keeps them awake at night,” he added.
Indeed, Bezalel said that bond markets were also not expect inflation.
“When stock markets jumped for joy on promising vaccine news, bond markets barely raised an eyebrow,” he noted.
The manager said the government schemes and loans in place helping the corporate sector could be extended further, potentially postponing some insolvencies and bankruptcies.
“Although the debt burden may be worryingly high, the interest payments on that debt are comparatively low and central banks will want to keep it that way – which is why we expect them to act to keep a lid on bond yields,” he explained.
Nevertheless, with interest rates pinned to the floor in so many countries, the bond manager said it was important to be selective when buying credit and cautioned buying the entire bond market.
“Investors will need to look harder for returns,” he said. “We see select opportunities in the lower end of investment grade bonds as well as in some of the higher-yielding, higher-risk bonds issued by defensive companies.”
Asset manager Invesco was also pessimistic on US Treasuries and investment-grade bonds going into 2021. In its model asset allocation, Invesco has reduced their holdings in investment-grade corporate bonds to zero, stating that “it holds no advantage over cash”.
“US government yields have never been this low,” the investment manager noted. “Not surprisingly, future Treasury returns are correlated to yield – history suggests that with yields so low, future returns will be limited.”
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Source: Invesco
It continued: “Though we do not envisage central banks raising policy rates during 2021, we believe government yields will rise in many countries, which will further depress fixed income returns.”
However, Invesco expects credit and emerging market spreads to tighten further as the economic recovery advances, and for high yield default rates to fall to historical norms during 2021.
Therefore the asset manager expects high yield and emerging markets to offer the best fixed income returns during 2021.
On the other hand, the fund managers at Columbia Threadneedle see some opportunities in investment-grade bonds.
William Davies, Columbia Threadneedle’s chief investment officer for EMEA, said: “Investment-grade markets benefited directly from fiscal stimulus such as corporate bond-buying programmes and furlough schemes.
“We do see some downgrade risk when those props are removed, but there is a greater risk in the high yield area where investors must tread carefully due to higher financial leverage.”
Davies argued that not all of those companies are going to make it through and that, because high financial leverage is often linked to operational leverage, investors should “tread carefully”.
He said: “So while we like an element of risk within credit, we believe investment grade is ultimately a better home for it than high yield.”