Fixed Income Update: Fourth Quarter 2020
Support from governments globally — coupled with potential for economic growth — spurred healthy bond returns.
- Positive vaccine news, the prospect of fiscal stimulus, and continued support from global central banks buoyed financial markets, continuing their resilience in the face of rising COVID-19
- Support from global governments — coupled with potential for economic growth — spurred healthy bond returns.
- Central banks must continue to coordinate with fiscal authorities to offset the economic weakness caused by the pandemic. Global central banks will leave rates low for the foreseeable future, to spur economic growth.
- Despite massive monetary and fiscal stimulus, we still believe in our “Stuckflation” view. Inflation will face persistent headwinds due to COVID-19 related unemployment, demographics, technological efficiencies, low yields globally and a general lack of safe-haven assets available to non-central bank investors.
- The economy showed signs of improvement during the fourth quarter, but still remains on shaky ground. The unemployment rate dropped from 7.8% to 6.7% and remained flat through the final two months. The labor force participation rate also remains below pre-pandemic levels.
- Congress agreed on a $900 billion stimulus bill including $600 in direct payments to individuals, an extension of jobless benefits and additional Paycheck Protection Program funds.
- Global central banks remained accommodative, providing direct liquidity when necessary. Central banks also retracted previous restrictions on bank capital, specifically dividends and share buy backs.
- The latest economic projections from Federal Open Market Committee participants suggest the federal funds policy rate will remain between 0 and 0.25% at least until the end of 2023. Although U.S. yields are projected to remain low, they are still highest amongst major countries.
- Strong demand and little supply in the one-to-three-year space left investors competing for short-maturity bonds. Option-adjusted spreads on one-to-three- year bonds closed at a record low of 35 basis points, down 23 basis points on the quarter.
- Despite outflows from the money market fund industry, Treasury and agency yields continued to grind lower. As typical with year-end, credit spreads widened due to issuers offering higher yields to entice investors away from increasing cash positions.
- Contributors: security selection, duration
- Detractor: curve positioning
Portfolios are positioned neutral- to-long duration relative to their benchmarks.
- After breaking out of pandemic tight ranges, both 10-year and 30-year Treasurys had their largest quarterly gains this year. Vaccine distribution, government stimulus, and election results that favored Democrats boosted long end yields.
- Although a “Blue Wave” did not materialize by the end of the quarter, 10-year TIPS, a measure of expected inflation, continued to rise as the potential for more fiscal stimulus and larger deficits emerged.
- Contributors: security selection, sector allocation
- Detractors: curve positioning, duration
Portfolios are positioned neutral- to-long duration relative to their benchmarks.
- Corporate bond issuance totaled $215 billion during the quarter, mostly to retire older, more costly debt. Option-adjusted spreads tightened 36 basis points to end the year at 96 basis points, just 1 basis point wider than where it started 2020.
- Improving growth expectations — paired with continued global central bank backing — helped the asset class return 3.05% during the quarter.
- Contributors: asset allocation, security selection, curve positioning
- Detractor: duration
Portfolios are positioned neutral- to-long duration relative to their benchmarks, while maintaining a moderate overweight to corporate bonds.
- Companies took advantage of the improving economic outlook and low funding cost, issuing roughly $95.5 billion in the quarter to push high yield to a record issuance year of more than $432 billion.
- Industries most impacted by COVID-19 were the largest beneficiaries in the improved high yield market, helping bonds end the year at a record low yield- to-worst of 4.18%. Lower quality credit demonstrated another strong quarter.
- Contributors: security selection
- Detractor: sector allocation
Portfolios are positioned to manage the impact of market and sector volatility, while focusing on income generation and downside risk protection. We will continue to be positioned in the mid-range of the credit risk spectrum.
- State and local issuers continue to refinance outstanding debt and backfill deficits amid strong demand. Taxable municipal bond issuance in 2020 more than doubled from 2019.
- Tax-exempt issuance was flat year-to-date, despite strong demand from taxpaying investors.
- Positive: duration, yield curve and security selection
- Detractor: higher quality credit bias
Interest rate risk should typically be neutral-to-long to start the quarter. State and local general obligation debt and essential service revenue bonds remain our top picks.
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