UE-EN Institutional

Back to the future of fixed income

From toilet paper shortages to extreme job losses and GDP figures that are literally off the charts, to oil futures trading briefly with negative dollar prices, 2020 has thwarted many embedded assumptions about the world.
September 2020

Subscribe to our insights

2020 marks the 35th anniversary of the 1985 classic Back to the Future, which embedded some delightful predictions within its time travel adventure (Cubbies win!). Predicting the future is a tough business — as this year has proven — but the movie also explores whether specific events can change the future.

The coronavirus and 2020 more broadly could be such a future-altering event. Enough bizarre outcomes have materialized in 2020, that many people just respond, “It’s 2020!?” From toilet paper shortages to extreme job losses and GDP figures that are literally off the charts, to oil futures trading briefly with negative dollar prices, 2020 has thwarted many embedded assumptions about the world.

In this context, how should investors think about income in a yield-starved world with government bond yields having set new all-time lows and unprecedented monetary policy as a lodestone sitting atop rates?

While we don’t pretend to have a sports almanac from the future or its financial market equivalent, examining the changes in policy, market data and investor demand, we explore the future of income and its importance to investors in this new landscape.

Back to the future fixed income cartoon

"I’m sure that in 1985, income is available in every corner drugstore, but in 2020, it’s a little hard to come by."

Short-term interest rates have been here before, with the Fed maintaining a zero interest rate policy (ZIRP) for nearly a decade, but 10-year Treasury yields had never fallen below 1% until 2020. There are additional challenges for income generation this time around. In the prior ZIRP period, the average 10-year government bond yield for G7 economies was over 2% compared to only 25 basis points today. Additionally, the market consistently expected interest rates to be higher in the future with short term interest rate forwards remaining well over the policy rate the entire period, while today market pricing implies policy rates will remain unchanged for at least the next three years.

G7 average 10-year yield

G7 average 10-year yield

Source: Bloomberg.

The premium to own a non-Treasury asset versus the equivalent Treasury was historically a fraction of the overall yield earned in a fixed income investment. While Treasury yields have declined nearly continuously since the early 1980s, that premium or ‘spread’ has been more consistent. As such, spread as a percentage of total yield has increased markedly to the point where what was once an incremental benefit is now the main attraction.

This paradigm shift where spreads are the bulk of income versus rates suggests a greater focus and demand for those premiums. With the need for income and greater demand for spread, the historical ranges of credit spreads may no longer hold.

U.S. corporate investment grade ratio of spreads to rates

U.S. corporate investment grade ratio of spreads to rates

Source: Bloomberg Barclays, BMO Fixed Income.

Spreads as a percentage of total yields

Spreads as a percentage of total yields

Source: Source: Bloomberg Barclays, BMO Fixed Income.

"Roads? Where we’re going, we don’t need roads."

Issuance in 2020 has been noteworthy for its breakneck pace. The record for monthly investment grade U.S. corporate issuance was set in March and set again in April. At one point, issuance was running at twice the rate of 2019 (though it has moderated) and already by August, the record for a full year’s issuance set in 2017 was broken.
At a surface level, it would be easy to observe rising issuance in the corporate bond market and conclude that corporates are over-extended in leverage. However, the nature of the recent issuance is important.

2020 is already a record year for issuance with more to come

2020 is already a record year for issuance with more to come

Source: SIFMA and BMO Fixed Income.

The current issuance is, to a large degree, defensive rather than offensive in nature. A significant amount of the issuance is either to refinance older, higher coupon bonds or to build cash reserves, rather than for expansionary purposes. While this may be less attractive from a return on equity perspective, it is fairly defensive from a lending perspective. These companies are willing to effectively pay an insurance premium to not worry about access to market in the event of a repeat of March 2020 or other volatility event. This suggests a high ability and desire to keep cash reserves to fund future payments.

At the same time, those payments from the perspective of a corporate Treasury perspective are quite affordable, i.e., the insurance premium is low. Thus, even as total debt increases, any measure of debt service is increasing at a slower pace or in some cases potentially improving as older debts are replaced with newer, cheaper ones.

An updated flux capacitor: the Fed’s shifting approach to monetary policy.

How long will low rates and affordable issuance last for corporate treasurers? Based on Fed guidance, the answer is a long time. The Federal Reserve’s updated monetary policy framework announced in August1 is a meaningful shift in policy. The decision to emphasize employment shortfalls while deemphasizing inflation overshoots reverses the approach that has guided the Fed since before Doc Brown turned a DeLorean into a time machine. With the Federal Open Market Committee (FOMC) projecting that the unemployment rate will average more than seven percent over the next several years,2 policy is likely to remain highly accommodative.

Additionally, the extraordinary policy supports from the Fed announced in the coronavirus crisis were originally pitched as mechanisms to restore market functionality amidst a period of unfathomable uncertainty and illiquidity. With market function restored, the Fed made a subtle but important shift in policy goal from market functionality to market support based on the economic outlook.3 This shift, combined with the fact that rates near the lower bound imply additional asset purchase will likely be required if the economic outlook deteriorates, suggests that extraordinary policy can continue for a prolonged period.

Is time travel possible? Don’t let the debate ruin the movie.

There is a theme among some market commentators that the Fed’s actions have overwhelmed fundamentals and distorted market outcomes. At some level this may be true, but in other ways this is entirely irrelevant. Markets have many functions, the primary purposes being to achieve financing for entities needing capital and allowing investors a source of returns. As a result, market actions signal investors’ beliefs about the economy as well as the supply and demand for capital. While the Fed may influence the signaling mechanism, the messaging emanating from the aggregation of individual buy and sell decisions, it does not fundamentally alter the need for capital and the need for investors to invest.

In this context then, we may reevaluate how to interpret signals, while still continuing to participate in financial markets. For example, for many years the outlook for long-run nominal GDP growth (real growth + inflation) was thought of as one of the best guides to the value of long-term interest rates. In recent years, as this relationship has broken down, many have pointed to the Fed and its policies as the root cause. However, this view overlooks the fact that there have been several periods in the past where interest rates have traded above or below nominal growth for extended periods. For instance, interest rates were below nominal growth levels for most of the 1960s and 1970s and above nominal growth in the 1980s and early 1990s.

U.S. interest rates and nominal growth

U.S. interest rates and nominal growth

Source: Bloomberg, BMO Fixed Income.

Additionally, this view ignores structural changes such as worsening demographics, lower potential growth rates, and the need for safe assets that all point to strong demand for U.S. Treasuries. That the signal rates send for growth is not as strong as it once was may be frustrating for those who have used markets as a tool for that purpose, but it does not obviate the need and desire for investors to generate income and invest in fixed income. It simply shifts how we interpret the results of those individual investor decisions.

This is heavy: Back to the future of income

Many observers fall into the trap of believing the overall decline in rates has driven returns across fixed income, but in reality income has been the key over any meaningful time period. In shorter periods, measuring in months, quarters or even a year, the change in yields (the combination of spreads and rates) dominates, but as those periods extend, the consistency of income versus the volatility of price changes leads to income comprising the majority of investor returns. To be sure, starting yields are lower today, but the same pattern is likely to emerge if we were to look back at today’s environment from the future.

Price moves (i.e., rate and spread changes) may dominate in a given year, but over time, income drives returns U.S. investment grade corporates

Price moves dominate in a given year, income drives returns U.S. investment grade corporates

Source: Bloomberg, BMO Fixed Income.

Applying 1.21 gigawatts to the markets while avoiding the lightning strikes

The significant level of central bank involvement has been taken by some to suggest that exposure alone to a market segment is sufficient. We believe the very opposite in fact.

We believe the component of yield from corporate spread versus Treasury yields is attractive, but this is not the same as viewing each individual bond in that context. And while the Fed is signaling support to the market, which benefits individual issuers, it is not the same as eliminating idiosyncratic risk. It is thus possible for the Fed to support the market and for a simultaneous uptick in downgrades and defaults. With the dramatic shift from the bulk of income coming from the rate component within corporates to the spread component, we believe a deep analysis of that exposure is more important than ever.

Conclusions: Marty we have to go back! Back where? Back to the income!

Fed policy supports are unprecedented and unlikely to abate any time soon. At a philosophical level, this may be seen as interfering with markets, but at a practical level it is just another consideration in a holistic view of the investment environment. This policy support just extends and amplifies what had already been a long trend toward lower treasury rates and more structural attractiveness for non-governmental fixed income, corporates in particular. This has been a long evolving trend, but one that has seen income strategies perform well, which we believe will persist.

Corporate bonds inhabit an interesting middle ground; from a corporate Treasury perspective, issuance is cheap insurance, while from an investor’s perspective, corporate debt offers a high degree of premium relative to other traditional fixed income options. In essence, corporate debt is cheap from both the borrowers’ and the lenders’ perspective.

That corporate bonds are cheap in the macro sense in this new construct is not the same as saying they are cheap in the micro sense. The parallel trends of Fed support and downgrade/default cycle illuminate the fundamental importance of deep credit research in order to best express a credit position. It is entirely possible, perhaps likely, that the corporate bond market will perform well, while implementing that exposure could perform poorly if not executed properly.

As yields have declined, corporate bonds have become more attractive, not less, as the driver of that yield decline has been from the Treasury side. As we look at a future of yields where Treasuries rates are likely to remain low thanks in part to an accommodative Fed, the income from non-governmental sectors, corporates in particular, is likely to be at a premium. Income is likely to continue driving returns over the intermediate and longer term periods and should be a key consideration in portfolios.

Subscribe to our insights


  1. The revised Statement on Longer-Run Goals and Monetary Policy Strategy is available at: https://www.federalreserve.gov/newsevents/pressreleases/monetary20200827a.htm
  2. Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents under their individual assessments of projected appropriate monetary policy, June 2020: https://www.federalreserve.gov/default.htm
  3. Federal Reserve Board announces an extension through December 31 of its lending facilities that were scheduled to expire on or around September 30: https://www.federalreserve.gov/newsevents/pressreleases/monetary20200728a.htm

All investments involve risk, including the possible loss of principal.

This report contains our opinion as of the date the report was generated. It is for general information purposes only and is not intended to predict or guarantee the future performance of any investment, investment manager, market sector, or the markets generally. We will not update this report or advise you if there is any change in this report or our opinion. The information, ratings, and opinions in this report are based on numerous sources believed to be reliable, such as investment managers, custodians, mutual fund companies, and third-party data and service providers. We do not represent or warrant that the report is accurate or complete.

Keep in mind that as interest rates rise, prices for bonds with fixed interest rates may fall. This may have an adverse effect on a portfolio.

Foreign investing involves special risks due to factors such as increased volatility, currency fluctuation and political uncertainties. High yield bond funds may have higher yields and are subject to greater credit, market and interest rate risk than higher-rated fixed-income securities.

Basis points (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%).

This presentation may contain targeted returns and forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such returns and statements, as actual returns and results could differ materially due to various risks and uncertainties. This material does not constitute investment advice. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

In the United States and Canada, BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide investment management and trust and custody services. Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations. BMO Financial Group is a service mark of Bank of Montreal (BMO).

BMO Asset Management Corp., BMO Private Bank, BMO Harris Bank N.A. and BMO Harris Financial Advisors, Inc. are affiliated companies. BMO Private Bank is a brand name used in the United States by BMO Harris Bank N.A. BMO Harris Financial Advisors, Inc. is a member FINRA/SIPC, an SEC registered investment adviser and offers advisory services and insurance products. Not all products and services are available in every state and/or location.

This financial promotion is issued for marketing and information purposes; in the United Kingdom by BMO Asset Management Limited, which is authorised and regulated by the Financial Conduct Authority; in the EU by BMO Asset Management Netherlands B.V., which is regulated by the Dutch Authority for the Financial Markets (AFM); and in Switzerland by BMO Global Asset Management (Swiss) GmbH acting as representative offices of BMO Asset Management Limited in Switzerland, which are authorised by FINMA.

Securities, investment advisory and insurance products are: NOT A DEPOSIT — NOT FDIC INSURED — NOT BANK GUARANTEED — MAY LOSE VALUE.

Related articles

Fixed Income - Credit
US Federal Reserve building
April 2021

April 2021 Fixed Income Market Update

We continue to observe demand for income-generating assets with additional relative value opportunities across the sector, quality and security levels.
Fixed Income - Credit
Gentleman riding a hoverboard in an open plaza
March 2021

Back to the future of fixed income, part 2: The search for more income

As investors rethink fixed income, understanding the state of high yield is imperative in addressing today’s income challenge and to successfully navigating the future of fixed income.
Fixed Income - Credit
Young nurse with a covid vaccine syringe
March 2021

March 2021 Fixed Income Market Update

Rates have been a notable outlier in the general market recovery since the first quarter of 2020 and some reversion is warranted.
Fixed Income - Credit
Woman wear mask
February 2021

February 2021 Fixed Income Market Update

In our view, January may prove to be a microcosm of the new year.
Fixed Income
Woman making phone call taking notes banner
December 2020

Opportunities in active fixed income

Active managers have a number of levers to pull to help outpace a passive benchmark, including sector/quality allocation, security selection and yield curve/duration management.
Fixed Income - Credit
Multiple poster with US flag
November 2020

November 2020 Fixed Income Market Update

In our view, while elections have consequences, the consequences are rarely as stark or as predictable as prognosticators suggest.