In 2020, coordinated central bank efforts – including quantitative easing (QE) and purchase programs aimed at supporting credit market liquidity — played a major role in stabilizing and improving the trajectory of fixed income markets. Broad core aggregate bonds returned 7.5% 1 and below-investment-grade corporate credit rallied 33% from the market’s bottom to finish up 7% on the year — pushing the coupon on high-yield bonds to an all-time low of 4.22% to end the year. 2
These unorthodox policy responses, as well as the policy statements on the outlook for interest rate adjustments from the Federal Reserve3 and other global central banks, 4 have severely distorted the fixed income markets, amplifying the decades-long trend of lower sequential returns5 to create a current income conundrum with generation-defining ramifications.
The butterfly effects of the pandemic on the fixed income market (i.e., policy regime, lower trend growth and demand for defense) have pushed the level of negative-yielding debt to over $17 trillion and sub 1%-yielding bonds to over $45 trillion (67% of the market) 6 — both all-time highs.
As a result, income-oriented investors are treading water in a sea of low rates, searching for a higher income-producing lifeboat to support portfolios with a yield close to at least 3%, essentially what Treasuries yielded as recently as 2018.7
In this environment, investors could consider mortgages to seek higher income from inside the core while balancing the reach for income outside the core with senior loans and emerging market local debt — two high-income-producing markets that have different sources of risk (credit and currency).
Theme 1: Use MBS to Increase Income in the Core but with Less Risk
Today’s vastly low and asymmetrical risk/return profile for core aggregate bonds (yield of 1.16% but duration of over six years) 8 is an issue for an exposure that often comprises a large portion of an investor’s portfolio. While we expect today’s generationally low rates to remain low for some time, the US Treasury curve is likely to steepen (long-term rates rise faster than short-term rates) over the coming months. While a higher US 10-year yield may improve income prospects, it does not overcome the asymmetrical risk/return profile of Treasuries or the Treasury-heavy Bloomberg Barclays US Aggregate Bond Index (Agg).
Investors could consider overweighting mortgage-backed securities (MBS) in the core as the sector provides higher income than Treasuries (1.24% versus 0.51%)9 while offering more balance from a risk perspective (4.7 years less in duration, and lower historical volatility of 2.40% versus 4.41%).10 Additionally, MBS have had a higher yield, lower duration, and less historical volatility (1.24%, 2.4 years, and 2.40%, respectively) 11 than the broader Agg itself (1.16%, 6.09 years, and 3.18%, respectively). And MBS’ historical negative correlation to equities (-19%)12 indicates that a potential overweight in core portfolios will not adversely impact the role bonds play in seeking to diversify risk/growth asset volatility.
All of this leads to a market segment that has a higher yield per unit of risk than Treasuries and the traditional Agg, as shown below. This structurally unique exposure may result in a higher yield in the core without adding risk (in fact, volatility is reduced), allowing income-seeking investors to take risk elsewhere.
Beyond the potential structural benefits, there are two other reasons to upweight MBS in the core. First, during the last FOMC meeting, the Fed pledged to increase its agency MBS holdings by at least $40 billion per month, 13 creating potential positive technical effects of a large buyer. Second, while some economic data has yet to rebound, the housing market is in a strong position — evidenced by the NAHB/Wells Fargo Housing Market Index being 22% higher than pre-February levels alongside both new and existing home sales also above their pre-pandemic levels14 — further stabilizing this market segment.
For mortgages, consider the SPDR® Portfolio Mortgage Backed Bond ETF [SPMB].
Theme 2: Focus on Loans for a Defensive Credit Option
Credit investors endured a rollercoaster ride in 2020 as the year saw the most issuer downgrades ever, 15 a ten-year high for defaults, 16 and actions by the Fed to ease distress that sent high-yield spreads and yields to 20-year lows of 362 basis points and 418 basis points, respectively. 17
The low-rate funding environment has sparked record issuance,18 creating a bipolar 2020 where a significant number of issuers defaulted/downgraded while other issuers rushed to raise capital. The current credit environment also presents an asymmetrical risk/return pattern, where the majority of returns are likely to come from the coupon and not from further price appreciation. There have been only a few instances in which spreads reached current levels (sub 400 basis points), and in those periods the subsequent monthly returns over the next quarter were an average 1.5%19 — indicating some mean reversion can occur at these levels. Additionally, the convexity of the high-yield market is at its second-most negatively convex level ever. 20 Lastly, when applying equity momentum techniques to the asset class, its Relative Strength Index (RSI) has been in overbought territory for seven consecutive weeks, ending 2020 above 80. 21
Despite this profile, fixed-rate high yield represents one of the few options with a yield over 4% in this yield-starved market. However, another option in the subjective credit market with a similar yield profile (4%),22 but not an asymmetrical risk/return profile, is floating-rate senior loans. As shown below, while the average price of fixed-rate high yield bonds has risen amid this rally, the average price of senior loans remains below its pre-pandemic levels and well below par — even though the market rallied 26% from its bottom in 2020. 23 With the average price below par, there is more potential for upside price appreciation than there is in high yield, in addition to the income potential of an asset carrying a yield over 4%.
Even during a hopeful recovery, idiosyncratic risks remain high in 2021, as a new administration enters the White House and an inconsistent vaccine rollout means achieving herd immunity may not occur as soon as once thought. If risks do arise and the default cycle reaccelerates as a result of stalled re-openings, loans — which are typically more senior in their capital structure and generally have higher recovery rates than high yield bonds (66% vs. 40%, respectively24) — may not be as adversely impacted.
This relative defensive aspect of loans versus high yield is evidenced by a higher yield-per-unit of average volatility than fixed-rate high-yield bonds (0.63% vs. 0.45%).25 As a result, senior loans may offer smoother income potential, and with a beta of only 0.29 to equities (versus 0.45 for high yield), 26 they may also provide elevated levels of income without adding as much implicit equity risk.
For a senior loan exposure, consider the SPDR® Blackstone/GSO Senior Loan ETF [SRLN].
Theme 3: Seek Out Currency-Driven Income Opportunities with EM Debt
Most economists are anticipating a sharp improvement in the economy in 2021. According to the recent World Bank Global Economic Prospects, global GDP growth is estimated at 4.0% in 2021. 27 That follows an expected -4.3% decline in 2020. 28 While the growth is expected to be widespread, there will be leaders. Emerging and developing economies are projected to lead global economies with an estimated growth of 5.0% of GDP in 2021, with China projected to expand 7.9%.29
The potential for more robust growth should support assets in these regions. These segments may be further aided by a Biden administration that will likely be more friendly to global trade, potentially reducing headline volatility through more predictable and less combative trade negotiations. While emerging market (EM) equities are often discussed as a likely beneficiary of these macro trends, emerging market local debt (EMD) may also stand to benefit as a result of the likely impact on currency movements, as well as the potential stabilization in geopolitical and economic foundations (i.e., lower policy risk).
Currency trends play a significant role in the risk and return of EMD, evidenced by a historical 93% correlation between EM local debt and EM local currency returns. 30 And given the US’s waning yield advantages over other currencies (90 basis point yield advantage in 2019 versus equal today) 31 and a ballooning public deficit, the US dollar (USD) may have more room to fall (down 18% since March) 32 — ushering in a secular bear market in 2021. As a result, a weakening USD may be a total-return tailwind to the asset class’ income potential. As shown below, during the last period of protracted USD weakness (2015-2018), EMD outperformed broad US core bonds by 7.79%.33
EMD, however, is not just a total return play. EMD offers a noticeable yield advantage (3.43%)34 over traditional core US Agg bonds. Yet with 85% of the issues rated above BBB, 35 EMD is still considered investment grade but with only a 26% correlation to the rate-sensitive Agg. 36 Given this balanced profile to traditional markets, and that the primary source of return deviations is from currency, EMD may be able to diversify income generation (i.e., currency-related income) within a portfolio that is taking on credit risk elsewhere to target higher levels of income.
For an emerging market local debt exposure, consider the SPDR® Bloomberg Barclays Emerging Market Local Bond ETF [EBND].
1Bloomberg Finance L.P., as of December 31, 2020, based on the return of the Bloomberg Barclays US Aggregate Bond Index.
2 Bloomberg Finance L.P., as of December 31, 2020, based on the return and yield of the Bloomberg Barclays US Corporate High Yield Index. Market bottom = March 23, 2020.
3 “The Fed has indicated in prior meetings that it expects to keep its benchmark interest rate pegged at zero at least through 2023,” Forbes, December 2020. Fed Meeting: FOMC Ends the Year with Rates Near Zero, as of December 16, 2020.
4 “Only Argentina and Nigeria are forecasted to raise rates,” Bloomberg, Ultra-Low Interest Rates Are Here to Stay: 2021 Central Bank Guide, as of January 4, 2020.
5 The Bloomberg Barclays US Corporate Bond Index returned cumulatively 242% in the 1980s, 115% in the 1990s, 76% in the 2000s, and 45% in the 2010s.
6 Bloomberg Finance L.P., as of December 31, 2020, based on the Bloomberg Barclays Global Aggregate Bond Index.
7 The US 10-Year yield was over 3% in November 2018.
8 Bloomberg Finance L.P., as of December 31, 2020, based on the Bloomberg Barclays US Aggregate Bond Index.
9 Bloomberg Finance L.P., as of December 31, 2020. Treasuries = Bloomberg Barclays US Treasury 5-7 Year Index. MBS = Bloomberg Barclays US Securitized MBS Index.
10 Bloomberg Finance L.P., as of December 31, 2020. Treasuries = Bloomberg Barclays US Treasury 5-7 Year Index. MBS = Bloomberg Barclays US Securitized MBS Index.
11 Bloomberg Finance L.P., as of December 31, 2020, based on the Bloomberg Barclays US Aggregate Bond Index.
12 FactSet, 01/31/2000-12/31/2020. Equities = S&P 500. MBS = Bloomberg Barclays US Aggregate Securitized MBS Index.
13 Financial Times, “Fed to extend debt purchases to boost flagging US economy,” as of December 16, 2020.
14 New home sales are up 17% while existing home sales are up 16%, National Assoc. of Realtors, as of December 31, 2020.
15 2,322 issuers were downgraded in high yield per Bloomberg Finance L.P., as of December 31, 2020.
16 Moody’s Investor Services, US Corporate Default Monitor, as of October 2020.
17 Based on the Bloomberg US Corporate High Yield Index, as of December 31, 2020.
18 Overall gross issuance reached $430 billion, 35% higher than the previous record in 2012.
19 Based on the Bloomberg US Corporate High Yield Index, with data from January 31, 1994 to December 31, 2020.
20 Based on the ICE BofA US High Yield Index, as of December 31, 2020.
21 Bloomberg Finance L.P., as of December 31, 2020.
22 Based on the S&P/LSTA Leveraged Loan Index, as of December 31, 2020.
23 Based on the S&P/LSTA Leveraged Loan Index, as of December 31, 2020.
24 Blackstone Credit, JP Morgan Default Monitor, November 30, 2000 to November 30, 2020.
25 FactSet, Bloomberg Finance L.P., as of December 31, 2020. Volatility is measured by standard deviation over the 36M trailing period. High Yield = Bloomberg Barclays High Yield Corporate Bond Index. Senior Loans = S&P/LSTA Leveraged Loan 100 Index. YTW is used.
26 FactSet, January 31, 2002 to December 31, 2020. Senior Loans = S&P/LSTA US Leveraged Loan 100 Index. Equities = S&P 500. HY = Bloomberg Barclays US High Yield Corporate Index.
27 World Bank, Global Economic Growth Projections, January 2021.
28 World Bank, Global Economic Growth Projections, January 2021.
29 World Bank, Global Economic Growth Projections, January 2021.
30 Bloomberg Finance L.P., as of December 31, 2020, based on the Bloomberg Barclays EM Local Currency Government Diversified Index and the MSCI EM Currency Index returns from March 31, 2009 to December 31, 2020.
31 Bloomberg Finance L.P., as of December 31, 2020, based on the yield differences for the Bloomberg Barclays US Treasury Index and the Bloomberg Barclays Global Agg Ex-US Treasuries Index.
32 Bloomberg Finance L.P., as of December 31, 2020, based on the Bloomberg Dollar Spot Index.
33 Bloomberg Finance L.P., as of December 31, 2020, based on the Bloomberg Barclays EM Local Currency Government Diversified Index and the Bloomberg Barclays US Aggregate Bond Index, from February 27, 2015 to April 30, 2018.
34 Bloomberg Finance L.P., as of December 31, 2020, based on the Bloomberg Barclays EM Local Currency Government Diversified Index.
36 Bloomberg Finance L.P., as of December 31, 2020, based on the Bloomberg Barclays EM Local Currency Government Diversified Index, the Bloomberg Barclays US Aggregate Bond Index, and the MSCI ACWI Index, based on data from December 31, 2010 to December 31, 2020, with monthly granularity.
Important Risk Discussion
The views expressed in this material are the views of Matthew Bartolini through the period ended December 31, 2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Investing involves risk, including the risk of loss of principal.
Diversification does not ensure a profit or guarantee against loss.
The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.
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The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as “junk bonds”, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Actively managed funds do not seek to replicate the performance of a specified index. An actively managed fund may underperform its benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.
Investments in Senior Loans are subject to credit risk and general investment risk. Credit risk refers to the possibility that the borrower of a Senior Loan will be unable and/or unwilling to make timely interest payments and/or repay the principal on its obligation. Default in the payment of interest or principal on a Senior Loan will result in a reduction in the value of the Senior Loan and consequently a reduction in the value of the Portfolio’s investments and a potential decrease in the net asset value (“NAV”) of the Portfolio. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. The fund is subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal.
State Street Global Advisors Funds Distributors, LLC is the distributor for some registered products on behalf of the advisor. SSGA Funds Management has retained GSO/Blackstone Debt Funds Management LLC as the sub-advisor. State Street Global Advisors Funds Distributors, LLC is not affiliated with GSO/Blackstone Debt Funds Management LLC.
Because of their narrow focus, financial sector funds tend to be more volatile. Preferred Securities are subordinated to bonds and other debt instruments, and will be subject to greater credit risk. The municipal market can be affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. The fund may contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; inflation risk; and issuer call risk. The Fund may invest in U.S. dollar-denominated securities of foreign issuers traded in the United States.
Investments in emerging or developing markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.