The primary premise for holding bonds with credit risk is to access a reliable income stream without disruption. It is more about avoiding the losers than picking the winners. With this in mind, it stands to reason to look at any major event and determine how it could affect the flow of income (coupon payments and redemptions) and the chances of capital being forfeited.
So can we identify any fundamental changes now that Democrat Joe Biden will be the next US president, most likely with a divided Congress?
Looking beyond the election for meaningful changes
A look at the macroeconomic context tells us that the country is still very much in the throes of the COVID-19 pandemic with the caseload growing at a fast clip of more than 120,000 new infections a day, likely forcing the authorities to consider more stringent measures to contain the spread.
The outlook is for re-imposition of lockdowns in the US, if not nationally, then locally. This would weaken already slowing growth and be deflationary. The resulting stagflation would end any hopes of a V-shaped recovery from the fallout of the pandemic. Instead, the recovery graph would look like a W, with the second-quarter drop in growth marking the first leg of the wave followed by a sharp bounce higher in the third quarter.
In the current fourth quarter, a dip lower is on the cards, tracking the resurgence of the virus. The disease has been the driving force to date and will remain so in 2021, even if the incoming president succeeds in making fighting the pandemic the priority of his first months in office.
Limits to supporting growth and inflation
Biden’s ability to boost the flagging economy with another stimulus package similar in size to March’s USD 2.2 trillion could be hamstrung by a divided Congress where the Democrats look set to have a diluted majority in the House of Representatives and – at this point – at best only a chance of a slim majority in the Senate. That set-up might cause partisan gridlock to persist. That would limit support for growth and jobs, contain the upside for risk assets and severely limit any scope for reflation.
With any new stimulus from the legislative unlikely to be meaningful, it would be up to the US Federal Reserve (Fed) to come to the aid of the economy. It has signalled it is ready to do so. This could be by reducing interest rates. In addition, the Fed could expand its quantitative easing efforts, holding market interest rates and pumping cash into the economy through bond purchases, including those issued by corporates.
All the while, the economy would experience another contraction – in other words, a double dip, or the third leg down of the W – and possibly a bounce back as the virus-fighting measures take hold, by which time we could be in the second quarter of 2021. For an eventual stabilisation of the economy, the timing and production of one or more vaccines would make all the difference.
Where does this economic outlook leave bond investors?
Fixed income is a broad asset class. Some segments are closely correlated with economic and business cycles, while others are not.
To be able to deliver yield, we believe investors should generally overweight spread sectors and other higher yielding instruments relative to risk-free rate bonds or government bonds. However, since we are looking at another economic slowdown and an absence of inflationary pressures, caution is advised. We, for instance, will likely reduce our typically overweight risk position.
Support – from the administration or the Fed – should underpin investment-grade corporate bonds, even if they experience a dip as the economy deteriorates. We still expect a reasonable risk/reward from this segment.
In high-yield credit, where the risk of default is more prominent, risk premiums (‘spreads’) are now at levels that we last saw in February (see Exhibit 1), which is before the pandemic struck. At the time, the outlook was for economic growth and earnings growth and cash flows were far more positive than they are today. Default rates are now likely, in our view, to come in higher than currently priced.
We do believe opportunities may arise in the ‘third leg’, particularly in high-yield. Certain sectors are clearly at risk – travel, lodging, entertainment and energy, for example. However, sectors such as consumer staples, healthcare and gold miners, whose revenue and earnings are less sensitive to swings in the economic cycle, offer opportunities. The same holds true for investment-grade companies that have managed to weather recent dips without overly adding to their debt load.
In conclusion, it is clear to us that the US election is unlikely to change the prospect of a low-growth environment and high debt burdens. In this context, we expect fundamental analysis and security selection to be critical skills in adding financial value within fixed income.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed here do not in any way constitute investment advice.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.