Last updated: 08:34 / Tuesday, 21 September 2021
Thornburg Investment Management's vision

The Trouble with Yields

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  • At the same time, it's important to see that the role of fixed income in asset allocators' portfolios is changing. Because those real yields are so low, and yet because the opportunity in markets from a volatility perspective is rising, an investor must be significantly nimbler these days than to merely clip a coupon.
  • Consumer balance sheets, particularly in the United States, are overlooked by some. To the contrary, we believe consumer balance sheets in the United States are quite strong. The real challenges are consumer balance sheets outside the United States and the corporate and sovereign bonds that are exposed to that weakness.
  • ​​​​​​​Although the Fed is still active in markets, the economic bump in the road due to the Delta variant makes it apparent that rates cannot rise monotonically towards 2 or 3+ percent. However, as we look at the intermediate term, and we see incredible amounts of fiscal and monetary stimulus still in the system, growth should continue to be good and curves should continue to steepen. While the Fed and other central banks are anchoring rates at the front end, the long end can rise especially as that taper gets closer and closer.

As investors look across the world for opportunity and challenges within the fixed income asset class, it's important to note that real yields are at historic lows in high quality fixed income markets.

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In addition, spreads are at some of the lowest levels that we've seen in history. This is not a time to take undue risk within fixed income. At the same time, it's important to see that the role of fixed income in asset allocators' portfolios is changing. Because those real yields are so low, and yet because the opportunity in markets from a volatility perspective is rising, an investor must be significantly nimbler these days than to merely clip a coupon.

In the current market environment, we're generally positioning our fixed income portfolios to take less risk given low real yields and low spreads. There are still areas of opportunity. As is often true in investing, investors continually fight the last war. Consumer balance sheets, particularly in the United States, are overlooked by some. To the contrary, we believe consumer balance sheets in the United States are quite strong. The real challenges are consumer balance sheets outside the United States and the corporate and sovereign bonds that are exposed to that weakness.

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Outside of the U.S., we have seen an incredible penchant for spending, most notably on the sovereign front where government expenditures rose precipitously with Covid-related social spending programs. Of course, this is coming at a time when government revenues are at record lows due to lack of tax revenues with subdued economic activity. As with corporates, the recipe of a higher debt load with a lower P&L is not a comfortable dynamic, especially if prolonged.

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Investors gave governments the benefit of the doubt through 2020 with the hope that 2021 would bring some austerity. That has not been the case. We are now left with a larger public sector deficit and a higher debt load. Therefore, we are not surprised that we have seen the largest number of sovereign rating downgrades in the 21st century by nearly 200% (captured below).

 

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When Will the Fed Move?

One interesting development in markets over the course of the past quarter has been that rates have fallen, not just in the United States, but in many places across the globe. This is at odds with high inflation and high growth prints, as well as an improving labor market. A remarkable instance of the market trying to outguess the Federal Reserve.

Despite questions around the Fed’s commitment to keeping rates lower for longer, investors have seen that they have been very clear and resolute. The Fed’s plan to raise rates and taper bond purchases is on schedule for later this year.

Although the Fed is still active in markets, the economic bump in the road due to the Delta variant makes it apparent that rates cannot rise monotonically towards 2 or 3+ percent. However, as we look at the intermediate term, and we see incredible amounts of fiscal and monetary stimulus still in the system, growth should continue to be good and curves should continue to steepen. While the Fed and other central banks are anchoring rates at the front end, the long end can rise especially as that taper gets closer and closer.

No Global Lock-Step Market Movements Likely

As we look across the globe, there are a variety of different situations and potential opportunities. Emerging markets is a varied landscape: from China which has a significant virus lockdown and has seen an early cycle growth stage, earlier than other countries; to places like Brazil, where vaccination rates are much more challenging and resulting growth has been pushed into the future. At some point, we're going to see vaccines continue to take hold, and that should be a boost for growth. But is there an opportunity today before we see restored domestic demand, particularly in a healthier local consumer?

Outside the U.S., we cannot apply a blanket policy to risk. Corporate bonds offer a glimmer of hope. There are many corporates in EM who benefit from the global cycle vs domestic demand. In other words, they are exposed to the aforementioned healthy consumer/corporates we have in the United States. Because of this, we have seen leverage, interest coverage, and cashflow generation improve with global reflation.  

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The key in EM is making sure there are built-in hedges to the business (input costs, currency, interest rate) that can help weather global economic swings or offer defensive narratives. With these, we can capture EM spread levels which have lagged both U.S. and the Euro area (see below) while limiting our exposure to typical EM dynamics like cyclicality, currency depreciation and earnings volatility.

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With that in mind, we have continued to move our portfolios to a risk-off stance but with a focus on the strength of consumer and corporate balance sheets and the underwriting of fixed income in those sectors.

One last note is we need to look at the market every day, and do, because we never know what day volatility will rear its head. These are times when a nimble and wholistic approach to fixed income management really comes into its own.

 

Jason Brady, CFA, is President and CEO at Thornburg Investment Management.

Ayman Ahmed is a Senior Fixed Income Analyst at Thornburg Investment Management.

 

 

 

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About Ayman Ahmed

Ayman Ahmed is a Senior Fixed Income Analyst at Thornburg Investment Management.

 

 

 

About Jason Brady

Jason Brady, CFA, is President and CEO at Thornburg Investment Management.

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