While the equity markets’ selloff has garnered substantial headlines since mid-February, we thought it appropriate to provide an additional timely update on the fixed income space. Over the years, we have found that fewer investors understand the price/risk dynamics of bonds.
In our last Fixed Income update, we touched on the role that liquidity had played on recent bond pricing and how specifically non-Agency mortgage-debt was repriced in mid-March. In this piece, we want to provide a few visuals we believe will help illustrate why we believe there is substantial opportunity in other areas of fixed income right now. We will specifically look at three (3) additional areas we believe present an attractive risk/reward over the next 12-24 months.
High Yield Corporate Bonds:
As the chart below illustrates, High Yield bonds have posted equity-like gains since 1980, with more muted downturns and, in the case of 2008-09, a sharp recovery from losses. While there’s no promise that today’s market will respond like those in the past, this perspective proves valuable.
This second chart illustrates the forward return for the 44 times in history that high yield bond yields were more than 8% above the corresponding US Treasury yield. In 42 of the 44 observations, returns 12 months later were positive and were in all instances positive 24 months later. On March 19th we saw yields reach these levels for the third time since the Financial Crisis.
Raise your hand if you expect Federal tax rates to be lower in the coming years. We don’t expect it either!
Between the Federal Reserve’s recent actions and the inherent ability to levy taxes, we believe there is substantial pricing dislocation in the municipal marketplace. Coming into 2020, municipal bond analysts were writing about low supply, increasing demand, and historically low default rates compared with their taxable counterparts.
According to Lipper, year-to-date municipal bonds have seen -$21.3Billion in outflows from investors seeking to raise cash. In several instances recently, tax-exempt bonds have seen yields higher than their taxable counterparts. An S&P study covering the period of 1970-2018 showed that BBB-rated municipal bonds defaulted less often over the period than AAA-rated corporate bonds.
We are not projecting returns for municipal bonds, but believe there are many instances of mispricing to be taken advantage of by skilled and experienced managers. According to the Municipal Securities Rulemaking Board, only approximately 1% of the over 1 million securities trade on a given day. We believe forced selling, more rather than credit, is being reflected in current municipal bond prices.
Emerging Market Debt:
With the index yielding more than 5% above the like-dated US Treasury, the Emerging Market Debt space is one that we believe to be underappreciated. It is a highly fragmented market (meaning that there’s a wide spectrum of countries encompassed in the index). With that being said, we expect the recent fiscal and monetary tactics to be supportive of this asset class.
Country selection matters greatly. Commodity-dependent nations will likely face different challenges from others. Those with economic and political stability face different prospects than more volatile nations. The growth of the middle class in the next 10-15 years will come from these nations. Global growth will likely be led by many of the EM nations (consider that China and India have more than 3 times the combined population of the US and the European Union).
From 2005-2019 EM Debt was the best performing fixed-income asset, annualizing at 7.3% per annum, nearly double that of the US Treasury. For point of comparison, EM Equity returned 7.8% over the same span with nearly 3x the volatility.
Source: JP Morgan Asset Management & Brookings Institute (JPM Guide to the Markets)
As we sit today, looking out over the landscape of all available asset classes, we regularly ask the question “where are the greatest opportunities for investment returns over the next year, 3 years, and 5 years.” Three months ago, those answers mostly consisted of equities. Today, there are more appealing opportunities in fixed income than we have seen in a decade.
Through these challenging times, we greatly appreciate the words of encouragement and kindness our clients have shown. We value your business and would love for you to share this piece with your friends, colleagues, and family. There are many who will welcome our insights right now, perhaps even our phone call.
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