Fixed Income Boutique

Risks are running high but there are still big yields out there in fixed income


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The year has started on a high note with investors hyped up on big expectations and valuations reaching new highs. Market participants seem to feel they have been teleported back to early 2009 heralding the onset of a massive new credit cycle that will boost every asset class for the next years. However, as things stand today, the blue-sky scenarios of a strong US recovery supported by a massive blue wave of increased fiscal expenditures, a “reflation-without-inflation” world and a return to pre-crisis corporate profit margins have been nearly fully priced in everywhere. This is why the potential for disappointment in the first part of the year is big and investors should prepare for volatility, which could arise from the following scenarios:

  • If the rollout of the COVID-19 vaccine turns out to be too slow or ineffective against some of the new variants of the virus, global immunization against the disease could be delayed. The current price action across various asset classes is driven by the assumption that we will be out of the woods by early summer. This is a scenario, which is likely, but not guaranteed.
  • A scenario that is entirely underestimated is another economic slowdown in China. The country recently sent 11 provinces and around 20 million people into new lockdowns in an attempt to stem the spread of new virus outbreaks earlier this month. Should China experience another period of economic weakness, the global economy would suffer a massive blow since the country has been the engine of growth since summer last year.
  • For now, there is no comprehensive assessment of the damage that COVID-19 has inflicted on the real economy. Even if high amounts of cash have been injected into the economy already, and more is to come, it is not clear which businesses will survive the fast-and-furious recession we have seen and who will still have a job by June this year. The current reporting season, which has kicked off with some big names in the US, is likely to provide some insights into these questions.
  • There is considerable uncertainty around the new US administration's fiscal policy. Many people think that the new 2 trillion US dollar fiscal support package is a done deal. However, they seem oblivious to the fact that the Democrats do not have a strong majority in the House and the Senate. There is a risk that some centrist Democrats will not support a massive new deal. The end game will probably be much lower than 2 trillion, and it will take time to iron out. In addition, there is a decent chance that the Republicans claim back both the House and the Senate in the mid-terms in 2022. A struggling economy would support their case, which is why they have little interest in backing any deal that the Democrats propose.
  • We are likely to see inflation of approximately 2.5% this year. This is because of the statistical effects of March and June and it will be transitory in nature. The US Federal Reserve (Fed) will need to hold its nerve. If they don’t, they could repeat the 2013 taper tantrum, which would be bad news for investment-grade and high-yield fixed income.

Should several of the above scenarios conspire to derail the current market rally, the Fed as well as other major central banks are likely to step up their quantitative easing measures again, which would send bond yields back down. Commodities, US high-yield bonds and a number of emerging market  sovereign bonds would suffer. Equities would see some stress and credit markets would be pricing in more defaults.

In contrast, if the blue skies remain cloudless, the equity rally is likely to continue while investors will make a massive shift into the real economy, which will most likely benefit retail, leisure, travel and discretionary consumer goods. As a result, sectors of the new economy might see flows drying up a bit. In fixed income, emerging-market, investment-grade corporate as well as high-yield credit spreads, especially in the energy and real economy sectors, will continue to compress.

Big high-quality yields provide a cushion for volatility

On a bumpy road with volatile prices, investors should invest in assets that either have not fully priced in the blue-sky scenarios yet or that have nominal yields big enough to protect against any disappointments. Big-yield securities are less sensitive to duration and the income they provide can cushion volatility. Examples are good-quality yields in financials, in some emerging market sovereigns and corporates, and in some high yield. In emerging markets, corporate credit currently offers big yields at increasing margins and falling debt levels, whereas EM sovereigns are getting crowded and yield potential is decreasing. European financials and insurance companies are attractive as their fundamentals are sound and the European Central Bank will make sure they continue to be properly financed. The energy sector is likely to thrive this year as long as China powers on and consumer cyclicals look attractive from a valuation standpoint. Overall, active duration management with the option to go short duration and solid portfolio construction will be key in mastering the months to come.