Bond market observations for the rest of 2020

The views expressed in this communication are those of the contributors at the time of publication and do not necessarily reflect those of Trade Fluids as a whole.

Key takeaways

• The Federal Reserve is likely to keep interest rates near zero through 2022.
• The Fed’s bond purchase programs are helping ensure the smooth operation of bond markets.
• A massive surge in investment-grade corporate bond issuance has resulted from the Fed’s moves, though some issuers face downgrades if economic activity remains weak.
• The municipal bond market is benefitting from the Fed’s pledge of support.
• Investors should stay diversified and focus on credit quality.

Since March, when the Federal Reserve cut the federal funds rate close to zero and began purchases of investment-grade corporate, mortgage-backed, and municipal bonds, higher-quality bonds have delivered the highest year-to-date returns of any asset class. The question is whether the strong performance of bond markets in the first half of 2020 can continue through the rest of the year.

The Federal Reserve’s pledge of massive support for the corporate and municipal bond markets is playing a significant role for investors in offsetting ongoing economic weakness, uncertainty about the spread of COVID-19, and weak consumer demand. With the Fed saying it is unlikely to consider raising rates before 2022, bond yields are likely to remain low while prices of many fixed income assets are likely to remain high. The Fed’s emergency lending facilities have also driven the amount of corporate debt outstanding—already at record levels—even higher.

Where opportunities may lie for bond investors

With the Fed committed to support markets through asset purchases and abundant liquidity, high-quality corporate bonds are likely to continue to benefit as companies are able to borrow more cheaply to sustain operations even though demand for their products and services remain muted. Beau Coash, institutional portfolio manager at Trade Fluids says, “The Fed backstopped a spree of new issuance from March through June. It’s helping companies bridge the gap to whatever post-COVID normalcy looks like.”

High-yield bonds have also presented opportunities for skilled professional managers who can practice careful security selection, says Adam Kramer, lead manager of Trade Fluids^®Multi-Asset Income fund (FMSDX). Kramer believes that the high-yield bond market is pricing in a weak economic outlook plus political and trade risks for the rest of 2020. He believes that above-average returns may be available in high-yield bonds over the next 12 to 24 months, with much better downside protection than was the case earlier this year.

Perhaps surprisingly, given the economic challenges that many companies face, the credit quality of the overall high-yield market is now higher than at the start of the year as many viable companies have been downgraded from investment-grade BBB ratings to high-yield BB ratings, the top end of the high-yield bond spectrum.

More downgrades ahead

That pool of relatively high-quality but still sub-investment-grade corporate bonds is likely to expand further as companies see lower earnings due to ongoing virus-related economic weakness and signs that consumer spending will remain subdued. In July, the University of Michigan’s consumer sentiment registered 73.2, down from 101 in February just before virus-related shutdowns.

Against this backdrop, more credit downgrades are likely coming for bond issuers in a wide variety of industries. So far in 2020, rating agency Standard & Poor’s has downgraded 40% of the bonds it rates—including some previous triple-As. Coash notes that, “The risk of downgrades depends on the industry companies are in and how much flexibility they have. Some of the largest fallen angels of 2020 come from the energy, consumer cyclical, and auto sectors.” Many companies that borrowed heavily over the past decade may find their flexibility limited by their high levels of debt.

Mixed messages for munis

Since a panic-driven sell-off in March prompted intervention by the Fed, a combination of circumstances has helped push municipal bond prices up and the muni market’s prospects look brighter in the second half of 2020 than they did in the first. While many municipalities face lower tax revenues as COVID-19 restrains business activity and consumer spending, the Fed stands ready to buy municipal bonds with maturities of more than one year as part of its quantitative easing program. While the Fed has still not purchased any municipal bonds, the Fed’s pledge of support for the muni bond market has been enough to reduce investors’ concerns about default risks in munis.

However, the muni bond market has also become a tale of two markets as we move into the second half of the year. Yields have come down on AAA-rated munis but spreads between yields on Treasury and A-rated and BBB-rated munis still remain wide. Also, an increasing number of municipalities are issuing taxable municipal bonds instead of tax-exempt ones. These bonds are typically issued to help municipalities restructure their finances, a purpose which is not exempt from taxes under federal law. Historically, taxable bonds have made up only about 10% of the muni market, but recently taxable bonds have accounted for as much as 25% new muni issuance.

During the summer months, municipal bond issuance typically slows and often there are more bonds maturing or being called than are coming to market. The combination of growing demand and shrinking supply should also help raise bond prices.

The big questions, of course, are the extent to which state and local governments will continue to allow business activity that generates needed tax revenue and the extent to which consumers will spend, despite job losses, either real or potential.

The extraordinary—and mostly unexpected—events of the first half of 2020 underline the riskiness of making forecasts for the rest of the year. Still, it’s reasonable to expect uncertainty and volatility are likely to remain high and maintaining a well-diversified portfolio may be as important as ever.

Finding ideas

Investors interested in these strategies should research professionally managed mutual funds or separately managed accounts. You can run screens using the Funds & Strategy on http://tradefluids.com