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?
"I’m sure that in 1985, income is available in every corner drugstore, but in 2020, it’s a little hard to come by."
G7 average 10-year yield
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.
U.S. corporate investment grade ratio of spreads to rates
Spreads as a percentage of total yields
"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.
2020 is already a record year for issuance with more to come
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.
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.
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.
U.S. interest rates and nominal growth
This is heavy: Back to the future of income
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
Applying 1.21 gigawatts to the markets while avoiding the lightning strikes
Conclusions: Marty we have to go back! Back where? Back to the income!
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
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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.
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