markets & economy  |  january 21, 2021

Creativity in a Low-Yield Era

Bond investors could face more challenging markets in 2021.

 

Key Insights

  • Fixed income investors will need to be creative in 2021, as low yields and tighter credit spreads could make attractive returns harder to find.

  • A strengthening economic recovery in 2021 could favor fixed income sectors that potentially can do well in a rising interest rate environment.

  • Yields in the credit sectors still appear relatively attractive. However, ample financing could allow weak firms to survive, lowering credit quality.

Mark Vaselkiv

Chief Investment Officer, Fixed Income

David Giroux

Chief Investment Officer, Equity and Multi-Asset

Strengthening economic recovery in 2021 would carry risks for bond investors, warns Mark Vaselkiv, chief investment officer, Fixed Income. He says investors will need to be creative in seeking out fixed income sectors—such as floating rate bank loans and emerging market corporates—that potentially can do well in a rising interest rate environment.

Massive infusions of central bank liquidity successfully stabilized global credit markets in 2020, even as a pandemic-driven flight to quality pushed already-low sovereign yields even lower. These dual trends produced strongly positive returns across most fixed income sectors.

Moving into 2021, however, investors face a more challenging environment, Vaselkiv says. With short-term yields at ultralow or negative levels and the U.S. yield curve steepening as economic growth and inflation expectations revive (Figure 1), interest rate risk could become a critical issue, he cautions.

Credit markets also no longer appear as attractive as they did after central banks launched their rescue operations in 2020, Vaselkiv says. With investment-grade (IG) and high yield credit spreads1 back closer to their historical norms—despite the lingering effects of the pandemic—active sector and security selection are likely to play more critical roles in seeking yield and managing risk in 2021.

“We think it will take significant creativity to find attractive opportunities in such a low interest rate environment,” Vaselkiv says.

Creativity, Vaselkiv notes, could mean moving further out the credit risk spectrum, potentially increasing allocations to floating rate loans and other low-duration assets, and seeking opportunities in ex-U.S. debt markets. Skilled credit analysis could be crucial to success.

Yield Curves Are Lower but Steeper Than at the Beginning of 2020

(Fig. 1) Sovereign yield curves (left) and yield curve slopes (right)

This shows two line charts. The one on left displays the yield (percent) at the 3 month, 2 year, 5 year, 10 year, 20 year, and 30 year time periods for U.S., Germany, and Japan. At 3 months, U.S. was just above 0.0%, Germany was around -0.3%, and Japan was just under 0.0%. At 30 years, U.S. was a little over 1.5%, Germany was just under 0.0%, and Japan was just over 0.5%. The one on the right displays the spread of 2-year government yield to 10-year government yield (percentage points) from November 2010 to November 2020 for U.S., Germany, and Japan. In November 2010, the U.S. was just above 2%, Germany was just under 2%, and Japan at 1% and in November 2020 the U.S. was just under 1% and Germany and Japan were both just above 0%.

As of November 30, 2020.
Past performance is not a reliable indicator of future performance.
Source: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved.

An Expanded Credit Universe

For credit investors, the flood of new U.S. dollar-denominated corporate issuance seen in 2020—an estimated USD 2 trillion in investment-grade debt and more than USD 500 billion in high yield debt—offers both potential opportunities and additional risks, Vaselkiv says.2

On one hand, yields in the credit universe still appear attractive on a relative basis, in Vaselkiv’s view. While many companies have increased their debt loads, he says, in many cases liquidity ratios actually have improved. This should help businesses in cyclical sectors such as energy, airlines, and lodging fend off insolvency until economic conditions normalize.

However, ample financing also could allow structurally weak firms to survive even though their longer-term prospects for profitability appear dim. “We may end up with a universe of companies that limp along for the next five to seven years just because the credit markets keep them afloat,” Vaselkiv says.

In an environment where short-term rates are at or close to zero, but prospects for a post-pandemic recovery appear to be brightening, duration—a key measure of interest rate risk—could become a top issue for many fixed income investors in 2021, Vaselkiv says.

Extended durations for high-quality sovereigns and investment‑grade corporates (Figure 2) mean that even modest upticks in interest rates and inflation could produce significant capital losses on those assets, he warns.

Interest Rate Risk Potentially Makes Shorter-Duration Assets More Attractive

(Fig. 2) Yield versus interest rate risk (duration)

This chart shows the yield (by percent) vs interest rate risk or duration (in years) for various pinpoints. Floating Rate Bank Loans are at 6% at a few months; Global High Yield Bonds just under 6% at 4 years; Emerging Market Bonds (local currency) just above 4% at almost 6 years; Global Ex-U.S. IG Corporate Bonds just under 2% at almost 8 years; Global Aggregate Bonds just over 1.5% at a little over 7 years; Emerging Market Bonds (USD) just over 4% at a little over 8 years; U.S. IG Corporate Bonds about 2% at almost 9 years; 10-year U.S. Treasury just below 2% at almost 10 years; 10-year Japanese Government Bond just under 1% at almost 10 years; and 10-year German Bund just under 0% at almost 10 years.

As of November 30, 2020.
Yields and duration are subject to change.
Sources: T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved; J.P. Morgan Chase & Co.; and Bloomberg Barclays (see Additional Disclosures). Index performance is for illustrative purposes only and is not indicative of any specific investment. Investors cannot invest directly in an index. Floating Rate Bank Loans = J.P. Morgan Leveraged Loan Index; Global High Yield Bonds = Bloomberg Barclays Global High Yield Index; Emerging Market Bonds (Local Currency) = J.P. Morgan GBI-EM Global Diversified Composite Index; Emerging Market Bonds (USD) = J.P. Morgan EMBI Global Index; Global Ex-U.S. IG Corporate Bonds = Bloomberg Barclays Global Corporate IG Index; U.S. IG Corporate Bonds = Bloomberg Barclays U.S. Investment Grade Corporate (300MM) Index; Global Aggregate Bonds = Bloomberg Barclays Global Aggregate Index; 10-Year U.S. Treasury = U.S. Benchmark Bond–10 Yr; 10-Year German Bund = Germany Benchmark Bond–10 Yr; 10‑Year Japanese Gov’t. Bond = Japan Benchmark Bond–10 Yr.

Potential Opportunities in Floating Rate and Emerging Market Debt

Floating rate bank loans—syndicated loans to companies that are then sold to mutual funds and other institutional investors—offer potentially attractive advantages in this environment, according to David Giroux, CIO, Equity and Multi-Asset. Bank loans sit higher in the borrower’s capital structure than high yield bonds, he notes.

Historically, he says, this has resulted in higher recoveries in default situations.

The floating rate feature of bank loans also gives them an extremely low duration profile—comparable to U.S. Treasury bills and other short-term instruments—but with substantially higher yields, Giroux says. “Historically, floating rate loans have been the one fixed income sector that has tended to appreciate when interest rates are rising,” he argues.

Fixed income assets outside the U.S.—especially emerging markets corporate debt denominated in local currencies—also could hold opportunities for global bond investors in 2021, Vaselkiv says. A weaker U.S. dollar, he adds, could enhance that appeal by potentially boosting returns on nondollar assets for dollar-based investors and potentially improving the creditworthiness of U.S. dollar bond issuers.

Key factors such as relative interest rates, relative growth rates, and relative monetary liquidity suggest that the trend toward U.S. dollar depreciation could continue in 2021, Vaselkiv argues. “Historically, U.S. dollar currency cycles have tended to last for significant amounts of time,” he says. “This potentially bodes well for international allocations—not just in fixed income, but also for equity names that generate a large portion of their earnings outside the U.S.”

Conclusions

For fixed income investors, 2021 could be challenging, as the falling yields and tightening credit spreads that boosted broad market returns in 2020 aren’t likely to play that role again. Rather, extended durations and the potential for a modest revival in inflation could make managing interest rate risk a portfolio priority, boosting the appeal of floating rate assets.

1Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar-maturity, high-quality government security.
2See: John Lonski, “Record-High Bond Issuance Aids Nascent Upturn,” Weekly Market Outlook, Moody’s Analytics, October 1, 2020.  

Additional Disclosures

Information has been obtained from sources believed to be reliable but J.P. Morgan does not warrant its completeness or accuracy. The index is used with permission. The Index may not be copied, used, or distributed without J.P. Morgan’s prior written approval. Copyright © 2021, J.P. Morgan Chase & Co. All rights reserved.

Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of January 2021 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

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 (floating rate 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. All charts and tables are shown for illustrative purposes only.

202101-1473870

 

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