The Beta Trade is Over: Winners and Losers Start to Emerge

Matt Toms

Matt Toms, CFA

Chief Investment Officer, Fixed Income

Fixed income markets have staged a significant recovery since April — the focus is finally starting to shift back to fundamentals.

Last month, the Federal Open Market Committee (FOMC) revised the strategic framework that governs its conduct of monetary policy, embracing significant changes. Going forward, policy will be informed by assessment of the “shortfalls of employment from its maximum level,” whereas the original document referred to “deviations from its maximum level.” The background for this change suggests that labor income distribution issues will have greater influence on FOMC policy decision-making. This could result in longer periods of accommodation than might otherwise be expected during economic recovery phases.

Complementary to this change, the FOMC has adjusted the approach to its longer-run inflation goal of 2%, now seeking to achieve inflation that averages 2% over time. After periods of persistently low inflation, the FOMC would tolerate inflation moderately above 2% “for some time,” to allow the economy to solidify a recovery. The updated strategy also acknowledges the challenges of a persistently low interest rate environment, in which policy rates alone have limited potential to benefit the economy.

This recognition helps explain why Federal Reserve officials lately have been advocating for greater fiscal policy stimulus. The last coronavirus relief provisions expired at the end of July; Congress has not yet approved a follow-up package; further relief before the November elections now may be unlikely. This is likely to hurt consumer spending overall, with worse impacts on lower-income earners.

Given the limits of monetary policy tools, the uncertainty of further fiscal policy support and the uneven fundamental outlook across corporate sectors, we see the U.S. economy shifting into a “K-shaped” recovery. The resulting uneven pressures will create winners and losers with broad strokes across the fixed income spectrum. From our view, the winners and losers in the post-COVID world fall into two camps. In the first camp are investments that are being affected by trends that were already in place and have accelerated because of the world’s response to the pandemic.

For example, among commercial mortgage-backed securities (CMBS), a potential “loser” would be brick and mortar properties anchored by lower-tiered malls. These properties already were facing significant pressure from the shift towards online retail; the response to COVID simply exacerbated their problems and accelerated the deterioration in their fundamentals. In the second camp are investments that are being affected disproportionately by the COVID response, such as select hotels and office spaces. On the positive side, online retail is one example of a segment that is gaining more market share, as are technology companies. Assessing sectors and industries through this lens of winners and losers will be critical to investment success going forward.

Rates, Spreads and Yields
Rates, Spreads and Yields

As of 8/31/2020. Past performance is no guarantee of future results. Source: Bloomberg, Bloomberg/Barclays, JP Morgan and Voya.

Bond Market Outlook

Global Rates: policy rates stay low, ten-year yields range-bound between 0.50–1.00%

Global Currencies: U.S. dollar weakens against DM, EM currencies

Investment Grade: election volatility tempers 4Q20 expectations but slowing issuance should support the market

High Yield: valuations look reasonable, though election volatility may cause some bumps

Securitized: falling mortgage rates prolong refinancing but Fed and bank purchases will remain supportive

Emerging Markets: economic growth is unlikely to return to pre-quarantine levels before 2022, but leading indicators suggest modest 3Q20 uptick

Sector Outlooks

Global Rates and Currencies

With the U.S. election season beginning to heat up, developments in fiscal policy will remain the primary focus over the short term. As the November elections approach, however, we expect attention to shift toward Biden/Harris policy proposals. The Fed reconfirmed its stance on keeping interest rates at the zero bound until possibly 2023. With the lack of sustained inflationary pressures, we see no strong catalyst for a significantly steeper yield curve and therefore expect the ten-year U.S. Treasury rate to remain in the 0.50–1.00% range. We continue to believe the Fed will not resort to negative rates given their questionable effectiveness. On the currency front, as the dollar continues to sell-off against other G10 currencies, we’re keeping a close eye on consumer spending, employment recovery and business confidence.

Investment Grade (IG) Corporates

Investment grade bonds rallied at the beginning of August, only to fully retrace mid-month under the strain of an unexpectedly large volume of new supply. By month-end, however, IGs had recouped their earlier gains. Fed purchases of IG bonds continued at a slow pace and remain an important backstop for the market. At $1.2 trillion year-to-date, new supply has already hit the expected full-year volume. We nonetheless believe a meaningful slowdown is likely through year-end, leading to a robust secondary market environment. Second quarter earnings generally surprised to the upside and most IG companies took steps to bolster liquidity and protect their balance sheets; apart from obvious virus-impacted sectors and issuers, IG fundamentals seem better than expected.

High Yield Corporates

Following July's strangely quiet market, the high volume of new debt issuance in August was met with reasonably strong demand. The visible forward calendar for new deals skews toward refinancing and higher credit ratings, thus lower coupons. Later in the year, the likelihood of persistently low rates makes us expect more refi deals. In the secondary market, BB-rated bonds offer little total return potential but are likely to offer some cushion should rates back up. Fundamentals continue to trend positively, which should support demand for risk. Valuations look reasonable for now but could change through the Fall.

Securitized Assets

Agency residential mortgage-backed securities (RMBS) outperformed their Treasury hedges on strong demand, continued Fed policy support and a “bear-steepening” Treasury curve, reflecting greater supply and the Fed’s long-term commitment to achieving 2% inflation. Elevated bank securitizations and improving seasonal housing dynamics will increase RMBS supply over the next few months. A prolonged low-rate environment will drive mortgage rates lower, potentially collapsing the primary–secondary spread as much as 50 basis points (bp) and extending the refinancing wave into 2021. Still, Fed and bank demand will support the market.

We hold to our positive tactical outlook for non-agency RMBS market as low rates, a robust housing market and still attractive relative value support the asset class, outweighing the meaningful delinquency increase from forbearance take-ups. Any correction on housing values, which now seems unlikely, will be a second- or third-order effect of the current crisis, not a challenge to the value proposition of housing.

CMBS should continue to benefit from improved risk sentiment, demand and relative value in the near term; longer-term CMBS performance is inextricably linked to the re-opening of the broader economy. Given the potential for relative-value driven bounces, the current crisis has undeniable, damaging implications for parts of the CRE universe such as student housing, hotel and retail; and potential longer-term implications for office and multifamily segments.

Asset-backed securities (ABS) have led the recovery for securitized credit, with some benchmark subsectors completely retracing the sell-off while other higher spread subsectors still have room to tighten. The key drivers (primarily TALF and fiscal stimulus) are firmly in place and close to fruition, and have been supported by the slow re-opening of the global economy. We expect the rally to spread, both outward in terms of sub-sectors and downward in terms of the capital structure of ABS deals. Consumer related sub-sectors will most directly benefit.

Emerging Market (EM) Debt

Emerging market economic growth is unlikely to return to pre-COVID levels before 2022, though leading indicators imply modest recovery in 3Q20. Inflation generally remains subdued, which should allow EM central banks to remain supportive. Certain banks are running out of space, however, and we expect to see unorthodox measures such as asset purchases. Fiscal deterioration has been common across emerging markets, as governments have had to support growth despite tumbling tax collections. We’re keeping a close eye on this deterioration, as medium-term debt trajectories could be materially impaired if it is not curbed. Accordingly, downward ratings pressure may re-appear going into 2021.

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Past performance does not guarantee future results. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions, and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.