April 2021
1st Quarter 2021 Fixed Income Review
Fixed income markets had generally negative performance in the 1st quarter of 2021 as U.S. equity markets hit all-time highs amid improving global growth and higher inflation expectations. The U.S. Aggregate Index, a proxy for the investment grade domestic bond market, suffered the largest quarterly decline in several decades. Additionally, world central banks, including the U.S. Federal Reserve, signaled continued accommodative policies.
Below are some 1st quarter Bloomberg Barclays fixed income index returns:
The 10-year U.S. Treasury (UST) Note, a bellwether yield measure used in the fixed income markets, ended Q1 2021 with a rate of 1.74%, an exceptional increase from 0.91% at the end of 2020, and the highest yield since before the pandemic began. The UST yield curve has “steepened” markedly so far this year as short-term yields have fallen a bit and longer-term yields have risen significantly. The 2-10-year UST yield spread, an often-cited measure of the slope of the Treasury yield curve, ended Q1 2021 at 158 basis points, the widest level in five years. That same yield differential has averaged around 60 basis points over the same period. Following a slow but steady economic recovery we believe the Treasury markets are also reacting negatively to a sizeable increase in Treasury issuance following trillions in emergency fiscal measures and seemingly open-ended stimulus spending out of Washington. The recent sell-off is a textbook response to the perception of a substantial increase in supply.
The chart below shows the changes in the UST yield curve from Q1 2020 (gold line) and the end of Q1 2021 (green line). The bar graph at the bottom shows the changes in yields for select maturities. Note the sizeable difference year over year.
Following their most recent meeting in March, the FOMC once again left interest rates unchanged and signaled that they would continue emergency asset purchases ($80 billion in Treasurys and $40 billion in mortgage-backed bonds per month) until the economy reaches full employment and inflation rises above 2%. In the Fed’s statement, they acknowledged that “indicators of economic and employment have turned up recently, although the sectors most adversely affected by the pandemic
remain weak.”
Additionally, the FOMC updated predictions for GDP, inflation, and unemployment. Interestingly, the Fed’s median estimate for the core Personal Consumption Expenditures (PCE) Index, the central bank’s preferred measure of inflation, is expected to be 2.2% this year – exceeding their stated goal. We have mentioned in earlier commentary the Fed has signaled it will allow inflation numbers to run well above their 2% target for a certain period of time. This is a marked change from their historic role of preemptively raising short-term rates to quell inflationary pressures in the economy.
The median estimate for GDP in 2021 rose to 6.5% from 4.2% at their December meeting. The unemployment rate is expected to be 4.5% in 2021 (from 6.2% currently).
Bond market inflation expectations for the next decade have recently increased to over 2% for the first time since 2018. With portions of the fixed income and equity markets rebounding, in some cases surpassing their pre-COVID-19 highs, it is clear the financial markets are factoring-in the effects of an extremely accommodating Fed, very substantial amounts of fiscal stimulus ongoing, and continued favorable news regarding vaccinations and the pandemic.
Similar to domestic rates, foreign sovereign bond yields generally increased in Q1 2021. Globally, negative yielding debt decreased to $13 trillion from over $18 trillion in December 2020, a material change. Although T-Bill and other money market rates are very near zero percent domestically, U.S. fixed income markets have yet to experience the negative yield phenomenon felt in Europe and Japan for several years now. Most domestic observers, including Chairman Powell of the Federal Reserve, do not expect widespread negative interest rates in the U.S. That said, slightly negative T-Bill rates, a side-effect from too little supply and other structural issues, may well be observed for short periods at some points this year according to some prognosticators. At present, the use of negative interest rates is an extraordinary monetary tool being implemented by some central banks with untested results and unknown long-term repercussions.
Below, in blue, are 10-year bond yields from several foreign countries (sorted from low to high), as of 4/1/21. Note the wide difference between the yield of the bellwether German Bund (the German ten-year note) at -0.33% compared to the U.S. ten-year note at 1.68%. This marked disparity in yields is indicative of divergent monetary policies and currency fluctuations, as well as differing economic outlooks both domestically and abroad. At present, many foreign buyers (particularly in Japan) may purchase longer dated U.S. Treasury and other fixed income securities, completely hedge their currency risk, and lock-in very favorable returns when compared to their domestic options.
Lastly, credit spreads remained relatively stable throughout the first quarter with high-yield tightening the most, by just 10 basis points, down to a 14-year low of 312 bps over Treasuries.
Even with high-yield spreads being relatively tight, they are still high relative to investment-grade spreads dating back to 2001.
Within the investment-grade sector, single A credits cheapened/underperformed relative to BBB’s and AA’s. This is likely due to the fact that single A’s tightened the most out of all the investment grade tiers for 2020.
Although the Federal Reserve has indicated it will continue with direct purchases of Treasuries and mortgage bonds in the open market in an ongoing effort to maintain artificially low interest rates, recent U.S. Treasury market observations, mentioned earlier, indicate some consternation by bond buyers to continue to accept historically low rates ongoing. In the face of heightened Treasury issuance, a change in the political winds in Washington, and the prospect of even a moderate increase in the rate of inflation, we continue to expect increases in longer term yields (yields and bond prices move in opposite directions) unless there is a material disruption in the equity markets.
As mentioned in our previous quarterly review, these are challenging times in the fixed income markets. We continue to deal with an unprecedented amount of central bank intervention with historically low (and even negative) interest rates, as well as overt political pressure for added accommodation at a time when sovereign deficits balloon to historic (some believe unsustainable) levels globally. Most fixed income sectors offer anemic cash flows, by historical perspective, and all but the most aggressive sectors of credit quality and duration offer negative “real rates” when inflation is taken into consideration.
In following, for most fixed income accounts, we currently recommend a broad diversification of strategies, both conservative and more opportunistic, as a means of preserving capital, creating cash flow, and pursuing positive risk-adjusted returns. We hope you will contact your portfolio manager, or any member of our fixed income team, to discuss our thoughts on fixed income in general, and to learn more about opportunities we believe are both appropriate and timely.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
For more information about the commentary found in this newsletter, please contact:
Sam Boldrick: sboldrick@argenttrust.com, Hutch Bryan: hbryan@argenttrust.com, or Oren Welborn: owelborn@argenttrust.com
