Yields on “risk-free” U.S. Treasuries have risen, while credit spreads have tightened to near historical levels. This is not a “normal” economic recovery.
With the first quarter of 2021 in the books, high-quality fixed income is off to one of its worst starts in recent history. The 10-year U.S. Treasury yield rose 74 basis points (bps) in three months, and well over 100 bps from its 2020 lows. Combined with historically low coupons and therefore higher duration, long-term Treasuries have handed investors losses that underline the volatility even in “risk-free” securities.
The drivers of rising rates in the U.S., and globally, have been the re-opening of the global economy as well as the unprecedented spending that governments are undertaking to support near-term growth and recovery. As a result, we’re seeing a double whammy hit safe-haven sovereign bonds: the declining attractiveness of safety, especially with real yields—taking inflation into account—that are negative. And secondly, huge amounts of new supply. Add to the mix central banks, including the U.S. Federal Reserve, that have committed to staying “on hold,” i.e., extremely accommodative, for at least a couple of years.
The 2020 recession is very different from others we have seen, including the Global Financial Crisis. Increasingly, recessions such as those in 2008 and 2001 were the product of financial market and leverage overshoots. But the pandemic-induced downturn came largely from an endogenous shock. No matter how strong the economy going into that shock, shutting down large parts of it for months was going to lead to unemployment and negative gross domestic product (GDP). As a result, we saw some of the worst reports on both measures in history.
CHART 1 | GDP AND UNEMPLOYMENT
(GDP: 30/6/00–31/12/20; UNEMPLOYMENT 30/6/00–31/3/21)
Source: Bureau of Labor Statistics, Bloomberg
On the flip side, coming out of this very unusual recession also has a very different feel. Recovery in GDP and jobs figures has been similarly unprecedented in speed. Recent U.S. unemployment data show a dramatic improvement to 6% unemployment (a figure that, when I began in finance, was broadly considered to be “full” employment) and nearly 1 million jobs created in the month of March alone. A fast recovery doesn’t mean there won’t be longer-lasting scars: even if restaurant visits recover to 90% of their prior pace, that’s still a sizeable drop from the pre-pandemic level. But the rebound will be largely fueled by a return-to-whatever-normal-looks-like versus an improvement solely in financing or credit availability. Vaccine development has been an extraordinary medical achievement, even if vaccine delivery is a less-impressive logistics case study. This is a key part of the real economy story, versus actions currently being taken by monetary and fiscal authorities.
CHART 2 | DEBT AS PERCENTAGE OF GDP
(DECEMBER 1998–DECEMBER 2020)
But those monetary and fiscal actions have had, and will continue to have, significant consequences. To put this in context, the U.S. is likely to spend something close to $4.0 trillion in about eight months to put money into the economy. This doesn’t even include a long-term infrastructure plan, which is projected to cost another $2.3 trillion. By comparison, in today’s dollars, the U.S. spent $4.1 trillion to wage World War II.1
Furthermore, by intervening directly in credit markets, central banks have had two important impacts. First, they’ve signaled that credit growth is a policy goal, and the health of those markets is paramount. Second, they have shown that lending to private sector entities is within their remit. Both outcomes have led to much looser credit conditions and historically high borrowing by companies.
One challenge for policymakers has been the significant growth in fixed income markets, partly as a result of bank regulation over the past decade, but also due to demand for income production from individuals and institutions. Though generally that has led to a large buyer base for the increasing supply of government bonds, it has also led to more and more of what used to be on bank balance sheets, marked to market quarterly if at all, being held on the balance sheets of market participants, often marked to market daily. Think back on the last 10 years since the Global Financial Crisis. We’ve had a number of “flash crash” events, including of U.S. Treasuries (UST). With more of the investor base subject to market moves but not to heavy regulation, fixed income markets are experiencing higher volatility.
“One Bad Bond Can Really Ruin Your Day”
The size of those markets has exploded. According to the Institute of International Finance, total global debt, which includes public, corporate and household debt, ballooned to $281 trillion last year, up $24 trillion, catapulting global debt-to-GDP 35 percentage points to a whopping 355%. Just in the U.S. fixed income markets, which are the world’s largest at 40%, or $46 trillion, of the $114 trillion worldwide total, corporate issuance alone jumped 50% in 2020 from the year before, while UST issuance climbed 33%, according to the Securities Industry and Financial Markets Association. But everyone is issuing more debt, and everyone is trading more of it. This represents both risk and opportunity for investors. Clearly, newly issued debt is not guaranteed to give a great ride.
While “subprime” reverberates in many memories from just over a dozen years ago, I’ve seen a number of terrible results from unbridled borrowing. Knowing the stories of municipal bond issuer MBIA 14% bonds that traded from 102 to 70 within three days of issuance, or Russia’s 2018s and 2028s sovereign issues that defaulted nearly immediately in 1998 always keeps me sensitive to the market’s at times swift and sharp shifts.
Even in “risk free” U.S. Treasuries, risk can be significant. Issued in May of last year, the UST 1.25% of 15/5/50 traded above par as recently as August, and by the end of the first quarter had stumbled down to the mid-70s, which is quite a loss. Sure, you’re guaranteed to get your 1.25% pre-tax, pre-inflation return if you bought the security at issuance and hold it to maturity, but it’s a very rough start for a long ride with a relatively paltry payoff.
At Thornburg Investment Management, we’ve long focused on the art of preserving capital in our fixed income portfolios, even within the context of strategies with more aggressive mandates. The biggest reason for that is simply the negative skew in fixed income. The best-case scenario for a bond-holder, as illustrated by the 30-year U.S. Treasury example above, is to receive the yield initially promised, barring occasional fancy footwork around selling securities for gains when available. From a credit perspective, we have found that bonds priced at par almost always return par at maturity, but because there is very little upside (in direct contrast with stocks), one bad bond can really ruin your day. Consider this simple example: a 10-bond portfolio with a yield of 2%. If one of those securities defaults with a recovery of 40%, which is nearly double the annual recovery rates of the last couple years, my return over one year will be around negative 4%. It will take me several years to earn back that loss on one security. In stocks, portfolios not only have a greater expected long-term return, the dispersion of returns is higher. It’s very possible to have one double cover a lot of bad investments. In fact, that’s pretty common.
Conversely, in fixed income, when prices are very low—think March of 2020, December of 2015, several periods in 2011/12, and much of late 2008 into 2009—the upside potential in credit is very high. That is why we try to be particularly opportunistic, and why we were able to deliver strong returns not just in the uglier part of markets last year, but on the way back up as well.
From Long Experience, Perceiving an Unsustainable State of Affairs
So where do we stand today? Yields on U.S. Treasuries are rising, and the market’s exposure to those yields is also high, with durations of many indexes increasing. Credit spreads are close to as tight as they have ever been. In a more “normal” recovery, rising Treasury yields are often offset by falling credit spreads. That was generally true for the fourth quarter of 2020, except in the very bottom of the credit spectrum (CCC corporate securities, as an example). But this time around, additional spread tightening has not offset the losses from rising Treasury yields in the first quarter of 2021.
CHART 3 | CORPORATE CREDIT SPREADS (28/9/01-8/4/21)
The Federal Reserve’s actions to support credit markets, combined with the lack of real yield in Treasuries, have pushed investors out the risk spectrum much earlier than in prior recoveries. The market has “pulled forward” returns in riskier fixed income, so it is unlikely that we will see terrific future returns even as the economy continues to find its footing.
At Thornburg, we shifted quickly to opportunistic purchases in March of last year, and then, as credit markets recovered, we have increasingly sold those positions where price returns have significantly outpaced fundamental improvement. While this could result in our underperforming if credit continues to improve, the negative skew in fixed income is always in the front of our minds. With regard to interest rate exposure, our Limited Term Income portfolio,2 the U.S. mutual fund of which will celebrate its 30th anniversary next year, has long had a short duration bias relative to many other bond portfolios.
The strategy has a three-year duration, which we have found is more suitable to a wide range of investors than portfolios that focus on much longer-term securities. We do not focus on moving our duration to generate return. Rather, we examine parts of the market where we believe our broader perspective gives us an edge. The three-year duration of the portfolio tends to be effective in providing ballast in downturns—as a high-quality fixed income portfolio is designed to do—while providing some income and lower volatility than longer-term strategies.
CHART 4 | INDEX YIELD AND DURATION (30/6/11–8/4/21)
Our Strategic Income/Multi-Sector Opportunistic portfolio,3 the U.S. mutual fund of which will celebrate its 15th anniversary next year, has long had very little correlation to interest rates, and this trend continues. The last time that rates rose notably, in 2013, there was significant interest in portfolios such as ours, and we expect a similar uptick in interest in 2021. With a look into how a portfolio performed in uglier credit conditions (say, a year ago), investors will be able to separate those portfolios that are truly adding value, given good risk-adjusted returns, versus those that simply reflexively add risk.
Right now, the market feels like we’re replaying the same day over and over again, recalling the Bill Murray movie “Groundhog Day.” Treasury yields are moving higher, credit spreads are tight, stocks are up, and the Fed is “on hold.” But from long experience we know this state of affairs is not sustainable.
At some point higher Treasury yields will cause market issues. Higher stock prices and tight credit spreads do not mean the market will crash, but rather that the market is vulnerable. We will continue to be on the lookout for value and will deploy our expertise and broad perspective to look across silos in markets as we have always done. We’re built to deliver the promise of true active management.