2021 Midyear Market Outlook

Creativity in an Era of Rising Yields

Through the first half of 2021, the correct strategy for high‑quality fixed income sectors was to keep duration1 short, Vaselkiv says. That could change in the second half, he adds, but only if demand from large institutional investors—Japanese institutions in particular—doesn’t continue to suppress U.S. Treasury yields.

In Vaselkiv’s view, yields on U.S. Treasuries and investment‑grade corporate bonds remain surprisingly low given the strength of the recovery. Average durations are still historically long (Figure 3), which doesn’t suggest a market deeply worried about interest rate risk.

Part of the explanation can be found in the negligible or negative yields offered by Japanese and German government debt, Vaselkiv says. This has fueled demand for U.S. Treasuries from income‑hungry but risk‑averse institutional investors.

Vaselkiv thinks many portfolio managers would extend duration if the 10‑year Treasury yield rose above 2.00% or 2.25%, which also would lift the income potential of mortgage‑backed securities and corporate bonds. However, such a move might attract even heavier institutional demand, pushing yields back down again. 

Interest Rate Pressures Are Building, and Some Sectors Are Potentially Exposed

(Fig. 3) Duration and yield across fixed income sectors

Duration and yield across fixed income sectors

As of May 31, 2021.

Past performance is not a reliable indicator of future performance. Yield and duration are subject to change.

Sources: Bloomberg Finance LP, J.P. Morgan Chase (see Additional Disclosures), and data analysis by T. Rowe Price.

Indexes used: U.S. Treasuries: Bloomberg Barclays U.S. Treasury Index; U.S. IG Corporates: Bloomberg Barclays U.S. Corporate Investment Grade Index; U.S. Aggregate: Bloomberg Barclays U.S. Aggregate Bond Index; U.S. High Yield: Bloomberg Barclays U.S. High Yield Index; EM Sovereign USD: J.P. Morgan EMBI Global Diversified Index; EM Sovereign Local Currency: J.P. Morgan GBI EM GD Index; EM Corporates: J.P. Morgan CEMBI Broad Diversified Index; Japan Gov’t. Bonds: Bloomberg Barclays Asian Pacific Japan Index; German Bunds: Bloomberg Barclays Global Treasury Germany Index; Global High Yield: Bloomberg Barclays Global High Yield Index; Global Aggregate USD Hedged: Bloomberg Barclays Global Aggregate Index USD Hedged; Bank Loans: J.P. Morgan Levered Loan Index; U.S. Short‑Term Gov’t./Credit: Bloomberg Barclays Short‑Term Government/Corporate Total Return Index Value Unhedged USD.

Credit Spreads Are Tight But Appear Reasonable

Fixed income investors seeking attractive opportunities in the second half may need to look to riskier credit sectors, such as U.S. and global high yield, bank loans, and EM corporate bonds, Vaselkiv says.

Corporate defaults have plummeted, and there are relatively few distressed companies left in the high yield sector...

A number of analysts, Vaselkiv notes, have argued that credit spreads—the difference between yields on bonds exposed to default risk and those on Treasuries of comparable maturity—are extremely tight by historical standards, perhaps signaling a potential bubble. But Vaselkiv takes a contrarian view, arguing that tight spreads appropriately reflect a benign credit outlook: 

  • Corporate defaults have plummeted, and there are relatively few distressed companies left in the high yield sector, even in the energy industry.
  • Companies have repaired their balance sheets, thanks to almost USD 2.8 trillion of U.S. corporate credit issuance in 2020 and another USD 1.4 trillion in the first five months of 2021.2
  • Credit upgrades rose above credit downgrades in the first half of 2021,3 and Vaselkiv says he thinks they are poised to remain higher going forward.

Floating rate bank loans, Vaselkiv adds, currently offer a particularly attractive combination of relatively high yields and very short duration (an average of 90 days). This could provide benefits all the way through the next Fed tightening cycle, he argues.

Investors may need to factor a weaker U.S. dollar into their thinking, Sharps says. Huge U.S. fiscal and trade deficits, plus continued stimulus by the Fed, create room for a gradual dollar decline, he says. This could add to inflation pressures by pushing prices of dollar‑denominated commodities higher.

But the implications are not entirely negative. Risky assets historically performed well during periods of U.S. dollar decline, Sharps says. A weaker dollar also potentially could boost returns for U.S. companies with large overseas earnings and strengthen the creditworthiness of EM firms that borrow in dollars.

Duration measures a bond’s sensitivity to changes in interest rates.

2 Includes bank loans, high yield, and investment‑grade (IG) corporate debt. Bank loan and high yield debt totals as reported by J.P. Morgan Chase’s High Yield and Leveraged Loan Market Monitor. IG corporate issuance from Bloomberg Finance L.P. (see Additional Disclosures). Data current as of May 31, 2021.

3 Data from J.P. Morgan Chase Default Monitor. Current as of May 28, 2021.

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Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets. Fixed-income securities are subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. Investments in high-yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Investments in bank loans may at times become difficult to value and highly illiquid; they are subject to credit risk such as nonpayment of principal or interest, and risks of bankruptcy and insolvency. Small-cap stocks have generally been more volatile in price than the large-cap stocks. The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. All charts and tables are shown for illustrative purposes only.

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