Fixed Income Boutique
Where will bond markets go in 2021? The team heads of the Fixed Income Boutique give you their top predictions for the year.
What a year it was. In March, the onslaught of corona the faith absorber rocked and reduced investor confidence. While markets calmed and recovered throughout the remainder of the year, investors will enter 2021 with a keen awareness of how to manage risk.
I recently joined Vontobel and have had extensive discussions with our portfolio managers about how they are going to tackle 2021. In this Fixed Income Boutique 2021 outlook, the team heads reveal what they are focusing on as we begin the new year.
Of all our portfolio managers, our guardians of the global flexible universe, Hervé Hanoune and Ludovic Colin (the portfolio manager duo known as “Herdo” here at Vontobel), faced the greatest battle with the markets in 2020. Herdo came out victorious in its battle, turning the corona-induced volatility into a super-V performance shaped recovery. I’m convinced that volatility will not disappear, therefore, flexible bond strategies are well placed for this environment. In this outlook, Ludovic looks at where volatility is likely to come from in 2021 and how fixed income investors can best prepare for it.
Head of Corporate Credit Mondher Bettaieb is upbeat about 2021. According to Mondher, we’ve entered the economic recovery stage, which tends to be a sweet spot for corporate bonds. With government bonds yielding next to nothing and corporates in fine fettle, he expects spreads to tighten in 2021 as the recovery takes hold, spurred on by the corona vaccines rollouts and accommodative central bank policies.
In a yield-starved world, income is hard to come by – so the conventional thinking goes – but perhaps that’s because emerging markets are a woefully underinvested asset class. Many investors still treat emerging markets as a side dish in their portfolio, rather than a core part of their allocation. However, there is ample yield and income on offer in emerging markets. Furthermore, as an inefficient asset class, it’s a real active investor’s paradise. Active investing in emerging markets is all about digging deep and mining for bond gems. If there’s one person who knows all about that, it’s Luc D’hooge, he even has a degree in geology and mineralogy.
There’s a bullet train of legislation speeding through the financial industry and it’s all related to ESG. But it’s not just legislation that will remodel the industry, there’s also a real desire from investors and some asset managers to contribute to making the world a better place. Already, we are seeing significant flows into ESG-oriented strategies and this trend will only grow. It does raise the interesting question though: if assets start to crowd into ESG, will investors be willing to take lower returns as a trade-off for knowing that they are contributing to improving the environment and society? At the heart of ESG is the “G” – governance. Good governance turns aspirations into reality. Therefore, Head of Global & Swiss Bonds Anna Holzgang explains the importance of governance in controlling risks and improving returns in 2021.
I’m sure you’ll find the insights from my colleagues of value to you as you prepare your own portfolios for the challenges ahead. On behalf of the whole Fixed Income Boutique, I wish you good health and a prosperous 2021.
As we begin 2021, we’re in a similar situation as at the beginning of last year, with many investors feeling that asset prices look expensive – be it credit spreads, equities or currencies. The context between the beginning and end of 2020 is nevertheless different. End-of-cycle dynamics were in play in January 2020, compared to green shoots waiting for consolidation today; with a fast and furious recession in between, followed by unprecedented government and central banks support. Public debt will grow by 15% to 20% almost everywhere over the year, to “save” roughly 4% of growth.
What is supporting the current valuations? Expectations of course, they always matter in financial markets. But currently, they look particularly central. Take the US dollar, for example. Against a weighted basket of developed market currencies, it has already reached mid-2018 levels, e.g. a period of long synchronised global growth. It appears that investors assume we are already back in a reflation-without-inflation world.
We all hope and expect to get there, but the path may be more volatile than the consensus and prices reflect. Once vaccinations eradicate the virus, economies will come back to their long-term level of growth and employment. But the question is, when will that be and how long can the global economy wait? The last quarter of 2020 and the first quarter of 2021 were due to be the launchpad for an amazing 2021 recovery story. Forget it… The list of disappointments includes:
As a result, the choice is this: we either get a massive reacceleration “sugar rush” from spring, but (unfortunately) the assets prices are already nearly there… or we will have to wait longer, and assets prices might adjust lower... in a poor financial markets liquidity context.
So, what kind of assets are we comfortable with on a road that may be bumpy with volatile prices? The ones that either do not price a blue sky yet, or have nominal yield big enough to cushion any “disappointment”. Let’s remember, no yield doesn’t mean safety. It means you need to pray we don’t get a double-dip recession, or that the recovery doesn’t create too much inflation, because duration will hurt… a lot.
It is a very thin rope to walk. In the Global Flexible Investments team we’d rather embrace BIG yields, such as good quality yields in financials, in some emerging market sovereigns and corporates, and in some high yield. We also want to have a flexible and active approach to duration, so don’t be scared to be underweight duration in 2021. In addition, we will continue to use the tools available to perform when assets are volatile, even if yields rise, or spreads widen… this is our trademark.
So prepare for some bumps throughout 2021, embrace big good-quality yields, be mindful of duration, and keep cool and stay active.
With the vaccine news received during November of last year, 2021 should be defined by a return to normality with the developed world likely to immunize its vulnerable population by the spring and its entire population by early summer 2021. This should be a great victory for science and the vaccine rollouts over the next few months means that we should gradually gain back our normal course of life. This means, for instance, that:
Therefore, we continue to look through the weakness caused by Covid-19 together with the renewed cases, especially as the rebound in GDP growth in the third quarter was a record one, providing a good cushion and bridge to 2021. What is more important than GDP growth for corporates is actual profit growth as, if companies are left with little income, they start experiencing pressures to pay off debt and fund investments. This should not be the case in 2021, and in all likelihood, 2021’s growth rate for core pre-tax profit may at least be double the rate of nominal GDP growth according to Moody’s, or in the region of 10%. This is also due to great productivity gains created by the Covid-19 pandemic including working from home, which will help realize tremendous general and administrative expenses savings, amongst others. Therefore, we have faith that our swoosh-like recovery is completed with a return to pre-Covid levels by Q4 2021 at the latest. The recovery stage for 2021 is cemented in our view and should be supportive of credit spreads as communicated previously i.e. “The Sweet Spot”.
We continue to expect the world’s major central banks to maintain their very accommodative stance. Economies should still benefit from fiscal support next year too.
During the course of November last year, policy risks related to President Donald Trump dissipated, which is good news for our 2021 recovery base case. Central banks are set to add liquidity worth 0.75% of annual nominal GDP on average every month during 2021, according to Morgan Stanley. The European Central Bank has indicated it will enlarge its Asset Purchase Programme (APP) and Pandemic Emergency Purchase Programme (PEPP) with the consensus expectation calling for additional purchases in the region of 500 billion euros – with program maturity dates also to be extended. The US Federal Reserve is also anticipated to extend quantitative easing (QE) to the end of 2021, increasing the weighted average maturity of US Treasury purchases and adding the possibility of increased purchases every month.
President elect Joe Biden’s selection of Janet Yellen as Treasury Secretary now adds to the widely held assumption that he will also act decisively to revive the world’s biggest economy. Janet Yellen is equally a firm believer in fiscal support and together with Chairman Jerome Powell, who served on the Fed board as Governor when Yellen was chairwoman, they will seek to work in unity to support the fragile US economy from the pandemic. Here, connecting the dots should not be a difficult exercise given the recent Bloomberg interview given by Mrs. Yellen:
“While the pandemic is still seriously affecting the economy, we need to continue extraordinary fiscal support, but beyond what I think it will be necessary. (…) We can afford to have more debt, because interest rates will probably be low for many years to come.”
The newish Fed long-run objectives laid out at Jackson Hole targeting inflation at 2% “on average over time” will ensure that rates stay at the effective lower band or zero for quite an extended period. This framework will hence permit expansionary government spending, through greater Treasuries purchases, amongst others, ensuring recovery and supporting positive excess returns in both investment grade credit and high yield in 2021.
The hunt is on in 2021 and that hunt is for yield and income. This means bond investors’ scopes will be zooming in on emerging markets, one of the few remaining bastions of not only positive, but elevated yield and income.
It will be a jittery 2021 though. In 2020, the markets ran into sudden liquidity problems, resulting in a strong increase in sovereign defaults (e.g. Ecuador). The drawdowns and evaporation of liquidity we witnessed in March of 2020 still haunts the minds of investors, which will make them more careful and perhaps jumpier than in previous years. The drawdowns, however, offered marvelous opportunities for brave investors as we experienced a strong recovery, which is typical of emerging markets.
Now, in our opinion, solvability risk has, to a large extent, dissipated. We’ve experienced the majority of defaults in 2020 and do not expect the same level in 2021, but this improvement is already priced in as emerging market indices performed well in the second half of 2020, with spreads tightening by around 360 basis points since the March peak. Furthermore, there a positive factors that support the global economy overall, such as vaccines, the US fiscal push, huge liquidity, and China pulling the world economy along. So where to go when looking at emerging market fixed income?
One thing to look out for is local-currency debt. The US dollar strength is always a factor when investors consider local-currency bonds. Historically, local currency performs well in a benign or weak US dollar environment. Whilst we are not becoming fully-fledged dollar bears, we have observed weakening, and market expectations could lead to a continuation of this. Indeed, the global Covid reflation trade will be broad based, not just a US story. Twin deficits are growing alarmingly, whilst interest rate differentials no longer support the US dollar vs all comers. Global reflation will also positively affect the global trade momentum, which most emerging economies benefit from. For their part, emerging market currencies reflect the real demand and supply of real trade and financial flows, and they pay you a positive yield on the top of it. So, emerging market local-currency bonds are the no-nonsense option that could help you to meet your investment objectives, yet work in line with your constraints.
Then there are emerging market corporate bonds. Emerging markets are the engine driving global economic growth and corporations are the fuel that power this engine. For corporations to prosper, they require access to capital, which is why the emerging market corporate bond asset class has nearly doubled in size every five years during the past 15 years. Currently, the asset class stands at around 1.4 trillion in US dollars, even surpassing emerging market hard-currency sovereigns in assets. Despite its significant size, the emerging market corporate asset class remains inefficient, as it lacks a dedicated investor base, which results in an abundance of high return, low volatility, and decorrelated opportunities for active investors. This is why we believe that emerging market corporate bonds are an active manager’s paradise and the high level of spreads coupled with low duration render active management especially attractive.
Low-yields and the hunt for income will make hard-currency sovereign emerging market bonds attractive in 2021. Fundamentals deteriorated in 2020 as a result of the pandemic and spreads remain wide compared to the start of this year (index wise). Spreads will drive performance in 2021 and in emerging market hard currency, high-yield spreads are particularly attractive, in our opinion. This segment has lagged US high yield and all other segments of the emerging market fixed income space in 2020 (investment grade notably) and thus offers an attractive yield pick up for income hungry investors. Bond picking ability is now key in choppy markets. Opportunities will be there for those who can do thorough credit analysis and good bond picking and, as always with emerging markets, there will be plenty of event-driven opportunities. This is the right backdrop for an active approach.
If we were to put 2020 in a petri dish and examine it, it would be a test laboratory example of major economic, environmental and social changes. All of these changes involve ESG and these risks are rising.
These risks manifest themselves in accelerating trends like climate change, diminishing biodiversity and water scarcity, just to name a few. The one sure way of mitigating these developments is for companies, governments, and investors to act responsibly.
Right now, regulators are racing to implement new ESG legislation and investors are well advised to understand that this is not some passing fad, ESG is here to stay and will not only affect the way investors report their holdings, but it will also affect performance.
We consider companies, which are well prepared to master challenges stemming from ESG risks as ESG leaders, one could go even further and say they will be the survivors over the long term.
ESG leadership and governance is particularly important in areas with high exposure to ESG risks. ESG controversies – issues that could have a severe impact on the environment and society – could also lead to financially material ramifications for bond issuers. Exposure in issuers who do not handle ESG risks effectively are likely to harm portfolio performance.
Therefore, thorough and competent ESG analysis should be part of all investors risk analyses and will help them to identify companies that have consistent overall risk management and which handle controversies professionally. For example, we integrate an ESG lens into our investment process to reduce tail risks due to bad governance and large exposure to environmental and social incidents – “governance” being the critical word here. We believe those issuers that actively engage on ESG issues tend to have better risk management. Therefore, the incorporation of ESG considerations into the investment process aims at improving the long-term risk/return characteristics of our portfolios. When it comes to walking the walk, good governance becomes key. It’s through good governance that a company’s commitment and implementation of ESG factors can be tracked.
As an active manager, we consider the incorporation of ESG considerations into the investment process as a critical part of the evaluation of an investment. ESG topics can result in risks and opportunities for investors. We believe that in areas with high exposure to environmental and societal risks, a strong risk management with a proactive strategy to address those issues and strong commitment to support transition is key to achieve an improvement. In 2021, investors should strive to avoid the worst prepared issuers and aim to identify the ESG leaders sup¬porting transition to a better world.