As investors entered into 2021 with an optimistic outlook, you could have been forgiven for thinking that volatility would be 2020’s business. Telegraphed reopenings by governments facilitated by highly effective vaccines following a year of incredibly supportive fiscal and monetary policy resulted in a well-formed consensus amongst investors and economists alike for strong nominal growth. The first five months of 2021 revealed that while the sharp rebound in growth has occurred in earnest as forecasted, a smooth trajectory for bond market returns in the first half of the year did not.
In this blog, we look at the performance of the global fixed income universe year to date and the sectors that are at the top of the leader board as we head into second half of the year. We discuss which sectors may be more resilient in the face of continued inflationary pressures and an expected reduction in monetary policy accommodation.
Upside inflation surprises and rising government bond yields are generally bad news for bond investors, however, there are areas of opportunity within the fixed income universe that can outperform and even in some cases generate positive total return. This is evidenced in the table above displaying the first five months of performance across bond sectors. U.S. Loans have returned close to 3% so far this year as investors have positioned for higher yields by allocating to floating rate products as illustrated by a pick-up in flows into bank loan funds. With loans currently trading with average discount margin of ~400bps, their valuation advantage versus other credit sectors, like U.S. HY and EUR HY which are both trading with spreads in mid-to-low 300bps range, is clear. Given the continued search for yield, we expect demand to remain robust. We have observed similar interest for short-duration securitized credit, such as: asset-backed securities (ABS) with collateral pools of consumer or auto loans.
High Yield corporates (HY) and Contingent Convertibles (CoCos) have also absorbed rising yields in stride this year. With the abundance of yield hungry investors crossing into the sub-investment grade space, we have seen spreads compress 52bps in HY and 57bps in CoCos so far this year. Fundamentals have provided an additional tailwind for HY as default rates have fallen. Given the robust growth backdrop and remaining tailwind from generous fiscal support, we can expect fundamentals and technicals to remain supportive for these sectors despite spreads already at the lower end of the historical ranges.
The biggest losses came from developed market government debt whose poor returns year to date are in sharp contrast to the top performers. The J.P. Morgan GBI Global Government Bond Index had a negative total returns of -3.01% year to date as of May 28, 2021. Global government bonds faced headwinds as yields rose sharply in the first quarter on the back of another wave of fiscal spending on both sides of the Atlantic. At the same time, markets pulled forward expectations for the first rate hike in the U.S. to early 2023 and also have started to price in rate hikes in Europe. Nevertheless even in government bonds, there were still some opportunities to earn positive returns: China is a great example. The relatively new entrant into global indices carries a significant yield advantage over and above the U.S., UK, Australia and Germany (Figure 1). Year to date, Chinese government bonds have returned 2.35% in local terms (1.16%, USD hedged).
As developed market central banks look to reduce quantitative easing (QE) and while this should put upward pressure on sovereign yields, at some point the value proposition for bonds vs. equities could shift more favourably back towards fixed income. Absent runaway inflation, this relative value relationship should serve as guardrails for how much core bond yields can rise. This is particularly true as neutral monetary policy rates across developed economies have fallen over the past decades driven by global factors like an excess of savings relative to investment as well as aging populations. Structural differences in the U.S. inflation process versus other developed markets like Europe and Japan where low inflation remains more entrenched could also provide additional relative value opportunities.
In the near term, as inflation narratives continue to control the airwaves along with taper talk and the continued reopening of economies, core yields may have room to move higher yet again later this year. The silver lining for government bonds would be after a period of pain from rising rates, the emergence of higher yields (Figure 2) may once again offer more useful diversification and hedging benefits for investors. In addition to higher rates, steeper developed market yield curves also mean that longer-maturity bonds can once again serve as a more traditional ballast to portfolios and provide more adequate risk-off protection. Take for example, both 30yr U.S. and Germany yields are back at the levels they traded prior to the COVID crisis.
Ultimately in this environment, a flexible approach to investing in fixed income should be utilised. As the story so far this year shows, there were corners of the fixed income market that provided helpful diversification even when there was an expectation that positive economic data and less accommodative monetary policy that could challenge fixed income investments. As such, the onus will be on investors to operate dynamically to capture positive returns in the pockets of the market best placed for rising rates.
 According to our quantitative research team’s mutual fund and ETF tracker, there have been 26.6bln into bank loan funds through the end of May 2021 compared to 22bln of outflows in 2020 over the same period last year.