What’s in store for bonds in 1Q 2021 as economies reopen?
1Q 2021 bond themes and potential opportunities as economies reopen.
To cushion the economic impact of the acute respiratory pandemic, central banks have continued to expand their monetary policy toolkits, providing support to fixed income sectors outside of just core government bonds.
Central bank bond purchases1
New and revised initiatives by the US Federal Reserve (Fed) since March have extended its reach into the corporate bond market, i.e. the so-called credit assets. The Fed will purchase bonds directly from investment-grade issuers as well as bonds that are already trading in the secondary market.
The goal is to improve market liquidity and to reduce the difference in yields between government bonds and corporate bonds (known as credit spreads). Bond credit spreads act as a kind of thermometer for economic health – narrowing credit spreads tend to be a good indicator.
Which bond sectors could income seekers optimise2?
Pricing that is responsive to central bank intervention in bond markets and subdued economic activity mean that investors could focus on sectors that come under the wings of central banks, i.e. eyeing quality in fixed income markets.
Core government bonds may no longer offer up a strong level of income – or possibly none when adjusted for inflation – but their role in portfolios is still important. As market uncertainty persists, investors could continue to consider the diversification3 benefits of holding government bonds as a core diversifier3.
The higher-grade corporate bond market is where investors, based on their investment objectives and risk appetite, could find a reasonable income and the benefits of the central bank safety net.
A focus on quality and resilient business is key to picking the right bonds to invest in during a still-uncertain environment. For income seekers, this means a bottom-up approach in locating corporate bonds that are backed by companies with stronger balance sheets and the ability to operate throughout a potentially longer downturn.
Enormous monetary support may initially stave off some corporate defaults, but riskier credit securities, such as those backed by weaker businesses, will not be fundamentally strengthened in the long-term. In this regard, a shift towards quality names also applies to investing in the high yield (HY)4 bond market.
Could inflation be the silent killer?
The enemy of bond investors is inflation. This silent killer lurks in the background, slowly eroding the purchasing power of our money over time – making today’s money worth less in the future. This is why we seek to have our investments deliver returns that outperform inflation — what’s known as a ‘real’ or inflation-adjusted return.
Australian real yield6
Indeed, given low interest rates, real yields5 today on government bonds in Australia are negative when adjusted for inflation. The debate is whether the trillions of dollars of fiscal and monetary stimulus will eventually result in higher rates of inflation.
However, given that inflation did not materialise in the aftermath of the policy response to the Global Financial Crisis, it’s difficult to see the current situation being different7. There may be spikes in spending as individuals and households once again find their freedom, but spending patterns may change and savings rate increase over the long term, leading to lower rates of consumption overall, thereby keeping inflation in check.
Explore our investment solutions
To navigate market uncertainty, bond investors could focus on quality opportunities presented across all segments of the global fixed income market. This means a focus on quality when thinking about income from bonds as well as investing in bond securities that are beneficiaries of central bank purchases.