By Jonathan Rocafort, CFA, Managing Director, SMA Portfolio Management; Bernie Scozzafava, CFA, Director, Quantitative Research and Portfolio Management
Vaccines and a proposed stimulus bill figure to give bonds a shot in the arm. But not all sectors will feel it the same way.
While few people are likely to look back fondly on 2020, at least bond investors had the solace of finishing out the year with solid returns. Which isn’t to say they didn’t face challenges: With 2020 volatility well above average, it was a year in which the market rewarded patience and strong stomachs.
If 2020 has taught us anything, it’s that the unanticipated can and will happen. That said, here are the themes we believe will be relevant in 2021. Our consensus is for a modestly upward bias to rates and a steepening of the yield curve. Overall we believe credit will improve, but improvements will be uneven and some issuers will struggle. A laddered portfolio supported by credit research should perform well if we’re right.
What does 2021 hold for the corporate bond market?
Investors will long remember 2020 as the year that condensed an entire credit cycle into a nine-month period. Reflecting positive investor sentiment coming into the year, the spread on the ICE BofA/Merrill Lynch 1–10 Year US Corporate Index improved slightly during January, coming within four basis points (bps) of its postcrisis low of 72 bps. However, the rapid spread of COVID-19 and a breakdown in Saudi–Russian oil negotiations created a historic economic disruption.
Credit spreads, particularly in the energy sector and others directly impacted by the economic shutdown, moved sharply wider as a result, briefly exceeding 400 bps. By the third week of March, the index’s year-to-date (YTD) return had reached -7.75%. The drawdown in the same index was a stunning -10.7% over one three-week period. Astoundingly, returns had completely reversed by the last days of 2020, ending the year just above their long-term average of 7.3%. Spreads finished the year within a few bps of where they started.
Decisive action by the Federal Reserve, coupled with substantial fiscal assistance to individuals and businesses, helped reverse both the economic and market decline. The turning point for corporate credit coincided with the announcement that the Fed would purchase investment-grade corporate bonds and some fallen angels as part of its quantitative easing program. Demand, as measured by fund flows, has been positive almost every week since then, contributing to higher bond prices.
With Treasury rates falling to record lows and spreads narrowing sharply, companies took advantage of historically low financing costs by issuing a record $1.8 trillion in new supply, almost 60% more than in the prior year. Corporations used their new-issue proceeds largely to build cash on their balance sheets, which further bolstered investor confidence. As the earnings outlook continues to improve, we expect to see more management teams focusing on improving their balance sheets by tendering for high-cost debt with this cash. Heavy 2020 issuance should materially reduce funding requirements and the new-issue calendar in 2021.
We believe the credit cycle has already successfully transitioned from distress to recovery. Business activity is clearly improving at a faster pace than expected and could gain momentum with the distribution of vaccines. The economy is better able to cope with periodic shutdowns than it was earlier in the pandemic, and the restocking of depleted inventories will further drive profitability in the coming year. However, unlike in past recoveries, the adage “a rising tide lifts all boats” is unlikely to apply: Consumer behavior will continue to evolve following the pandemic, highlighting the need for professional credit oversight, especially in the retail and leisure sectors.
We believe central banks and national governments will continue to provide a significant level of market support. The Fed has pledged to keep short-term rates low through 2023, and it continues to purchase large amounts of fixed income instruments through its quantitative easing program. These efforts should help keep intermediate Treasury rates from rising too quickly.
The Fed’s corporate bond buying program was incredibly successful at restoring investor confidence and stabilizing credit markets. Should the need arise, we expect the Fed would propose reestablishing the program known as the Secondary Market Corporate Credit Facility, especially considering the modest amount of capital it required, using just $14 billion of the $250 billion committed.
Interest rates will likely start to move higher as the recovery progresses, but we expect rates to take years to fully return to prepandemic levels. With short-term rates locked near zero, we wouldn’t be surprised to see the yield curve steepen as interest rates normalize.
In light of our constructive economic outlook, we expect BBB-rated bonds to produce attractive returns. We also see value in BB-rated bonds, which may offer more potential for spread tightening than investment-grade bonds. Demand for BB-rated bonds has been strong, especially after the Fed included fallen angels in its buying program. If the market has indeed entered an upgrade cycle, many BB-rated bonds could become rising stars, moving back into investment-grade indexes and providing another boost to returns.
What does 2021 hold for the municipal bond market?
Municipals wrapped up a historic 2020, with broad-market muni indexes up 4.25% for the year. The market has largely recovered from the pandemic-induced liquidity crisis that sent prices plummeting in the first quarter and rattled investor confidence in a portion of their portfolio commonly viewed as a safe haven. Thanks to unprecedented fiscal and monetary measures, municipals have steadily regained the support of their primary investor base: individuals in high tax brackets. Investors poured an impressive $60 billion into muni mutual funds since May, making 2020 the fourth strongest year for fund inflows on record.
Solid demand also allowed muni issuers to bring a record $495 billion of new-issue supply over the year. Demand has in fact been so strong of late that the muni market begins the year looking very similar to the start of 2020, with AAA benchmark yields back near all-time lows and muni/Treasury ratios well within overvalued territory. We anticipate an improving credit landscape combined with potential rate-driven volatility as 2021 gets underway. Municipals should remain a valuable building block of a portfolio designed to maximize after-tax income and return, but careful credit selection and positioning will remain critical.
A vaccine-led economic recovery is expected to fuel higher GDP growth in 2021. While the Fed intends to keep short-term rates near zero through 2023, and continue its monthly buying program of $120 billion in Treasuries and mortgage-backed securities, a strong economic recovery may cause Treasury rates to increase modestly above crisis levels. Continued strong fund flows and reinvestment amid light supply should support muni performance in Q1. However, with benchmark muni yields and AAA muni/Treasury ratios near all-time lows, an increase in Treasury yields may result in negative muni performance and trigger a brief outflow cycle. Given an improving credit landscape, we foresee strong performance following any rate-related sell-off.
Lawmakers ended months of negotiations with a massive year-end spending bill that included the second-biggest economic rescue package in US history. While the $900 billion package didn’t include direct aid to state and local governments, it still offered plenty of support for municipal credit—including $83 billion for education, $45 billion for transportation aid, $14 billion for mass transit, $10 billion for state highways, and $2 billion for airports.
The measure should also help avert a double-dip recession next year. This is a credit positive, with the possibility of surging COVID-19 cases and added shutdowns weighing on economic recovery in the near term. While Democrats may face challenges seeking additional assistance for state and local governments in Q1, we nonetheless expect muni credit to remain resilient, since it survived 2020 with better-than-expected revenue numbers and only a minor uptick in defaults and bankruptcies.
According to Moody’s, following a 5.5% decline in revenue in FY 2020, state revenues will decline in FY 2021 by an average of only 5%—but the median could be as low as 2%. These numbers are far better than the dire predictions made during the height of the crisis, when Moody’s projected an 18% to 23% decline through 2021. As the economy improves following widespread vaccine distribution, we expect lower-rated segments of the market (A and BBB) to outperform. We likewise expect sectors most negatively affected by COVID-19—including airports, transportation, and larger cities—to outperform in 2021.
As the legislative agenda of the new administration comes into focus, we see the potential for the passage of a bipartisan infrastructure package. According to the Volcker Alliance, state and local governments provide about 80% of US public infrastructure spending. Therefore, such policy may result in another year of record issuance and offer muni investors the ability to participate in a US infrastructure renaissance.
Along those lines, we anticipate a growing trend of ESG-minded investors increasingly looking toward their muni portfolios to make a positive environmental and social impact. While most muni issuers serve a public good, a defined ESG mandate may target exposure to issues focusing on clean water, pollution control, renewable energy, and education. An infrastructure package may also bring about a return of Build America Bonds, adding to what’s already expected to be record taxable muni issuance in 2021. This should only expand opportunities in that growing sector of the muni market.
Our recommendation is to stay invested and add on any interest-rate-related weakness. For investors with long time horizons and diversified asset allocation strategies that include munis as constant core investments, we would avoid realizing gains, paying taxes, and reinvesting at historic lows. All safe havens, including certificates of deposit and money-market funds, have become marginally less attractive and are likely to remain so. While we could see Treasury yields lift off crisis levels, surging cases and delayed vaccine distribution could keep the market in its current state for a while.
For investors subject to high federal and state tax rates, particularly following the state and local tax deduction cap, munis offer more yield compared with their taxable counterparts. As a result, they remain a valuable building block of a portfolio designed to maximize after-tax income and return. If investors are in a high tax bracket and committed to having some duration in a portfolio, munis are an attractive source. This is especially the case in lower-rated sectors of the muni market, particularly those sectors more affected by the pandemic. While we’ve witnessed spreads tighten since the March sell-off, we expect further spread compression to drive outperformance of the lower-rated tier of the muni market.
The bottom line
In 2021, as the availability of vaccines allows the economy to rebound, we expect modestly higher Treasury yields and a steeper yield curve. We believe the recovery will be good for corporate credit and that lower-rated muni issuers may outperform. However, the transformative effect of the pandemic on the economy will mean that the impact of the recovery will be uneven, which highlights the need for credit research.
We see opportunities for active managers to exploit the inefficiencies of the muni market. For both corporates and municipals, a laddered strategy should perform well in our predicted environment. It remains our fervent hope that the travails of 2020 will be left behind in 2021.
Originally published by Parametric Portfolio, 1/4/21
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