2020 could be the year that the almost four-decade bull market in U.S. bonds ends or at least takes a breather from this year’s mostly double-digit returns. The economy is growing, albeit moderately, and the Federal Reserve, as result, is not expected to cut interest rates, so long as there are no surprises on the downside. Most important, fears of recession have declined substantially.
If the U.S. economy grows at an annual inflation-adjusted rate just under 2% and inflation remains subdued, at or below the Federal Reserve’s 2% target — both included in the general consensus among economists — odds are Fed monetary policy will remain on hold and interest rates won’t stray far from current levels.
But if the economy gains strength and reinflates — a number of strategists continue to mention that possibility — then rates could range higher, reaching 2.25% to 2.50% by year-end, which would hurt the performance of bonds overall. Goldman Sachs strategists, who are forecasting a 2.25% yield in the 10-year Treasury for 2020, say investors should expect a “baby bear” market in bonds next year.
On Dec. 30, the 10-year treasury was yielding 1.92%, about 80 basis points below its year-ago level, and the federal funds rate was 1.50% -1.75%, down 75 basis points from a year before.
Some Common Themes
Outlooks for the bond market vary, but two recommendations stand out for their popularity among many strategists: the expected continued strength of the muni bond market and the growing risks of the leveraged loan market as well as the lower rated investment-grade bond market.
“The bright spot as almost always recently in the fixed income market is the muni market,” said Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. On a tax -equivalent basis, munis “can look particularly attractive relative to Treasuries” to high income earners, especially those living in high-tax states on the coasts who were hit by a tax increase from the 2017 tax cut legislation, said Jones. The legislation limited the federal deduction for state and local income taxes to $10,000.
Jones, like many strategists, is also wary about the leveraged loan market — a private debt market consisting of high-yield loans to high-risk corporate borrowers — because of potential increasing credit risk as the economy slows.
Elaine Stokes, portfolio manager and co-head of full discretion fixed income at Loomis Sayles, is extremely worried about the leverage loan market, which she says has “gone on too long” and is due for a correction. She’s worried about the lack of liquidity in that market when the next recession comes, and the spillover effect. Asset managers could then be forced to sell investment-grade debt to offset losses in leverage loans, which could snowball, according to Stokes.
Low credit quality characterizes not only the leveraged loan market but also the investment-grade bond market. Roughly 50% of corporate investment-grade debt is rated BBB, which is just above junk bond status, up from 35% prior to the great financial crisis, according to BofA Global Research.
“The biggest risk now is downgrades to BBB securities,” said Jones, referring to the lowest rating in investment grade bond corporate bond market. “If we hit any hiccup in the market we think spreads could widen a bit.”
Dallas Fed President Robert Kaplan is also worried about investment grade downgrades. He recently told CNBC, “If you get two or three BBB credit downgrades to BB or B that could lead to a rapid widening in credit spreads, which could then lead to a rapid tightening in financial conditions.”
The Fallout From Low Interest Rates
At the root of all these risks in the bond market are scanty interest rates, which have been trending lower for over 38 years, sending investors into lower rated and longer maturity debt in order to collect higher yields. Lower rates have also reduced the number of dealers in the corporate market, according to Dan Fuss, veteran portfolio manager of the Loomis Sayles Bond Fund.
The dwindling number of dealers has Fuss worried about liquidity in the bond market. “From what I can see, the margin of error on the credit risk side and on the liquidity side, where there is credit risk, has shrunk a lot … The structure of the market has changed.”
Although he still calls himself a “risk taker,” Fuss has been increasing the credit quality of the funds he manages and reducing their durations. The Loomis Sayles Bond Fund has its highest ever credit rating, averaging between A- and BBB+ and shortest average maturity, near five years. “It used to run around 12,” said Fuss.
According to T. Rowe Price, AAA and BBB bonds outperformed high-yield bonds during the first 10 months of this year. Total returns were close to 15% for investment-grade credits vs. 12% for single B and roughly half that for all C-rated credits. “This is the first year in history of the high-yield market that double-digit returns without CCC-rated bonds are leading the pack,” said Mark Vaselkiv, chief investment officer for fixed income at T. Rowe Price.
Longer term bonds also outperformed because they are more sensitive to a decline in interest rates, as measured by their duration.
“A lot of duration has been a tremendous tailwind for performance this year with capital appreciation,” but if rates back up just a little bit it will lead to “a fair amount of pain” for investors who favor longer term high grade bonds, said Vaselkiv.
He sees opportunities in emerging market, high-yield corporate bonds and bank loans, which he prefers over high-yield credits because of their even higher yields, if the “reflation theme” holds. He cautions investors, however, to be very selective when choosing corporate credits.
Marilyn Watson, head of BlackRock’s global fundamental bond product strategy team, also likes emerging market debt, in Brazil and Indonesia, because of their cheaper valuations relative to developed markets debt and greater likelihood that their central banks will cut interest rates compared to those in developed markets.
She recommends investors choose a high conviction, diversified risk-adjusted fixed income portfolio and focus on volatility and liquidity. “It will be very difficult to get the same kind of returns” in 2020 that were had in 2019, said Watson.
The Growing Market Risks From Climate Change
Going forward, investors also need to realize that “the environment for investing money in the bond market is changing because the environment we live in is changing and that will reshape the markets,” said Fuss, referring to the effects that climate change will wrought.
He recommends that fixed income investors take climate change and other ESG factors into consideration when investing for 2020. “ESG is an excellent credit screen right now.”
State Street Global Advisors, in its 2020 outlook, notes that “climate change is one of the greatest risks in investment portfolios today,”
Climate change and regulation “will impact business models and supply chain; carbon pricing initiatives will impact asset valuations; and increased use of renewable energy sources, due to declining prices, will create substantial risks for firms heavily dependent on fossil fuels while creating opportunities for companies that can adopt to these changes,” according to State Street. It adds that these risks may not be adequately captured in a one-year outlook.
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