As we start to decipher what 2021 entails, there are increasing variances to the dynamics experienced in 2020. The positively correlated economic recovery remains in focus as coronavirus vaccine roll outs and inoculations are set to rise throughout 2021. Vaccines accompanied with accommodative policy, increased fiscal aid, and continued quantitative easing mixes into a 2021 “thematic cocktail” that tastes like an improvement. With rapid economic and policy shifts in 2021 anticipated, below, we will discuss the bond market’s 2021 outlook.
Amid quantitative easing, the Federal Reserve (Fed) acted swiftly to combat any fundamental dislocations cratered by the coronavirus. The Fed cut interest rates (as lower financing costs encourage borrowing and investing) and engaged in bond-buying programs (MBS, investment-grade corporate bonds, etc.) to stimulate economic growth, which have both lead to strong fixed income returns in 2020. Economic recovery continues to show positive signs as:
- Corporate spreads to treasuries continue to tighten
- Unemployment rate fell to 6.3%
- Jobless claims starting to decrease
- ADP Employment Report for January increased
- ISM Services for January increased (to 58.7, showing substantial expansion)
- Mortgage applications remained little changed
- GDP normalizing annual growth rate of 4.0%
- Slight increase to nominal personal income
- The Conference Board’s Leading Economic Index remaining positive (8 consecutive months in December).
However, with economic recovery showing signs of functional improvements, the historically low 10-year Treasury yields have the potential to rise past 1%, with short-term interest rates potentially remaining near zero throughout 2021 as the Fed will likely wait to “normalize” interest rates until inflation starts to rebound back to their 2% targets. As described in “Deciphering a (COVID-19) Economic Recovery: An Equity and Fixed Income Perspective“, monetary policy dynamics may create a “bear steepening” (long-term rates rising faster than short-term rates) environment positioning short-term bonds to outperform their long-term bond counterparts. Additionally, this environment indicates the potential of increasing inflationary expectations, which remains supported by the recovery of the 10-year Breakeven Inflation Rate surpassing a pre-COVID economy:
Furthermore, short-term bonds could also exhibit favorable asymmetries if interest rates rise (a strong possibility in the near-term with interest rates at historically low levels), depressing long-term bond prices. However, inflation is likely to remain rangebound until economic recovery and growth are maintained. With the Personal Consumption Expenditure metric (Fed’s preferred inflation metric) remaining well under 2% (as it has since 2018), swift changes to Fed policy will likely be limited in the near-term. With this said, consensus estimates highlight that interest rates could remain stagnant until 2023, allowing no obstacles spurring economic growth and recovery.
For 2021 we see value in the short-term corporate bond and mortgage-backed security markets.
Short-Term Corporate Bonds
With short-term interest rates set to remain low through 2023, a low duration allocation in corporate bonds with healthy credit profiles could enable yield capture. Short-term corporate bonds remain attractive as they continue to be supported by Fed policy. The duration risk is more insulated from spikes in interest rates in a vaccine driven economic recovery. Amid corporate bond spreads to treasuries narrowing across the curve, the Fed is likely to keep short-term rates at the lower bound through at least 2023. A potential vaccine-led economic recovery may cause long-term yields to rise faster than short-term yields (“bear steepening”), suppressing bondholders’ returns at the longer end of the yield curve. During Q4, longer-term rates had already shown signs of steepening as inflation expectations increased. Eventually (likely after 2023), increased inflation may lead the Fed to raise interest rates to slow prices from rising too fast. Long-term bondholders will likely sell the unattractively yielding bonds, depressing prices and decreasing returns. Therefore, short-term bonds display a reduced exposure (vs. long-term bonds) to total return underperformance amid an expected 2021 economic recovery.
Mortgage-Backed Securities (specifically “Legacy” Non-Agency Residential Mortgage-Backed Securities)
Agency and especially non-agency residential mortgage-backed securities will likely continue their strong second half of 2020 throughout 2021. Despite affordability decreasing with home prices likely to increase, the housing market and housing credit remain healthy with demand high and supply tight amid mortgage credit availability’s potential quicker path to recovery than 2008. However, (legacy) non-agency RMBS stand out compared to their agency counterparts as most of the underlying borrower’s payments for non-agency RMBS is principal with the bonds amortizing at the top of the capital structure, removing bullet risk (amortization means that the underlying loan de-levers with the borrower’s monthly mortgage payments). Furthermore, focusing on more senior bonds remains key to non-agency’s market liquidity. Ironically, the higher percentage of senior bonds within the legacy non-agency mortgage back security universe indirectly developed from the segment’s recovery from 2008 as weaker credit and loan structured bonds from the Great Recession’s dysfunctional housing dynamics have marginally liquidated out of the MBS pools, spawning a positive opportunity bias. Therefore, non-agency RMBS remain supported by less extended corporate and sovereign balance sheets while essentially providing one of the few plays to capitalize on the economy’s household sector (COVID aside, households have been deleveraging since the Great Recession). The intuition that the longer a mortgage borrower stays in a home, the safer (as amortization structures illustrate) the underlying mortgage amid an improving macroeconomic backdrop (despite a COVID hiccup) remain supportive. Due to legacy non-agency RMBS’s uncorrelated returns to other assets and low return volatilities, as seen throughout an unpredictable 2020, the sector will likely continue to outperformance in 2021.
All in all, behavioral shifts from the pandemic and its asymmetrical correlation to economic recovery will have a compounded effect on markets, specifically in the fixed income segment. Amid a continuation of Fed’s quantitative easing, fiscal stimulus packages, and increasing vaccine inoculations throughout 2021, economic recovery and potential growth could begin a positive trajectory. With corporate spreads tightening (though short-term bonds with companies exhibiting strong fundamentals capture higher yields) and the housing market’s recovery (though Non-Agency Mortgage-Backed Securities demonstrated much less exposure), desirable opportunities reside in both segments. Short-term corporate bonds and non-agency residential mortgage-backed securities remain attractive investment opportunities capitalizing on fundamentally strong qualitative and quantitative data. Therefore, short-term corporate bonds and legacy non-agency residential mortgage-backed securities remain the top fixed-income opportunities for 2021 amid rising yields and structurally sound credit fundamentals.