Fixed Income

Back to the future of fixed income

Enough bizarre outcomes have materialized in 2020, that many people just respond, “It’s 2020!?”

September 2020

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.

Source: KaufmanHall, National Flash Report, January 2021.

"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

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

Source: Bloomberg Barclays, BMO Fixed Income.

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

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

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

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.

Disclosures

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

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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%).

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Fixed Income

4 min

September 2020