Q&A: Addressing Volatility and Uncertainty in the Fixed Income Market

Investors and advisors have likely never longed for a crystal ball more than they do today. Faced with uncertainty from the pandemic and potential for vaccines, to the shifting political landscape and record deficit spending, the question on everyone’s minds is what will the stock market make of all this?

To get a clearer picture of what may be in store for investors, financial advisors and the stock market, we spoke with Gautam Khanna, senior portfolio manager at Insight Investment. He shares his team’s thoughts on fixed income, the risks investors and advisors are ignoring, and what may be in store for the U.S. economy and stock market in 2021. Here are edited excerpts from that interview.

Are investors and financial advisors rethinking their approaches to fixed income?

The current environment features clear sources of uncertainty, particularly the ongoing pandemic and political risks. As such, investors continue to look to fixed income as a source of diversification against heightened volatility.

At the height of the pandemic in March and April, investors sold financial assets indiscriminately in favor of safe-haven money market funds, with money market fund assets increasing from $3.6 trillion pre-pandemic to a peak of $4.8 trillion.

Today, assets in money market funds have declined to about $4.3 trillion as investors have been moving from cash back into investment-grade, credit-oriented funds for yield enhancement.

Investors are focused on maximizing their investment yields and income-generation potential. Institutional investors are increasingly looking to structured and private credit investments, while retail investors maintain their focus on investment-grade, fixed income funds and have also allocated to assets, such as preferred securities.

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Will fixed income still protect a portfolio?

The lack of a “blue sweep” puts checks and balances on president-elect Joe Biden’s fiscal spending ambitions. Assuming Republicans win one of the Georgia senate races, we would expect the next fiscal stimulus to be less than $1 trillion.

Therefore, we don’t believe the upcoming stimulus will be of a “game-changing” magnitude capable of stoking substantial inflation in the near- to medium-term. As such, we do not expect the U.S. economy to reach pre-COVID levels of GDP until the end of 2021.

We don’t expect the output gap to close until early 2023 at the earliest. But considering the U.S. economy struggled to create inflation in 2019 even while operating at or above trend growth and arguably running at full employment (less than 4%), it suggests to us inflation is not a near-term risk.

Given inflation is a key determinant of the level of interest rates, and with the continuation of disinflationary headwinds in mind, we don’t expect materially higher yields to be imminent or inevitable. While the federal government is very much committed to deficit spending, we believe the Federal Reserve will continue to engage in so-called “financial repression” by purchasing government debt on its balance sheet and keeping a lid on interest rates. The Fed has purchased more than $2.4 trillion in Treasurys over just the past year.

We strongly believe that a fixed income allocation will protect a portfolio against unforeseen risk events. A spike in market volatility would, in our view, continue to be met with a “flight to quality” rally, benefiting the U.S. rates market. Although yields appear to be reaching their lower bound, the experience of Europe and Japan with negative yields demonstrates what could happen if push came to shove.

What long-term risks are investors and their advisors ignoring?

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Investors may be displaying a level of complacency regarding certain issues. For example, markets continue to have faith that the mere presence and support by the Fed will be enough to reverse any market sell-off. Thankfully, so far, they have been correct.

We believe there are also underappreciated risks to the upside. For example, the pandemic will permanently accelerate changes in how people work. On the one hand, this “new normal” may be able to usher the type of productivity growth that has mostly eluded the labor market for decades. On the other, as we move to this new normal, there will inevitably be segments of the economy that fare poorly. The ability of policymakers to manage the transition from the old regime to the new will be crucial.

What kind of sector-specific opportunities are you seeing?

The pandemic polarized sectors into clear winners and losers: The former being sectors that benefited from a stay-at-home world, such as tech, telecoms and supermarkets, the latter being those particularly exposed to the pandemic, such as restaurants, airlines and commercial real estate.

Within the winners, there are opportunities to move down the capital structure of individual issuers or into higher-yielding niche players. This is not to say that the “losing” sectors lack opportunity — only that it may be wise to stick to the largest, most competitive names in those sectors: those that have sufficient liquidity, staying power and best-in-class credentials.

The strongest plays in handicapped sectors, such as theme parks, cruise lines or energy companies, will likely benefit from reduced competition, as their weaker peers fade away. They may also be able to consolidate their market share and strengthen their position through acquisitions.

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What is your outlook for the rest of 2020 and beyond for the fixed income market?

If output remains at September 2020 levels throughout the fourth quarter, we expect GDP growth of about 3.5%. This is our baseline expectation, although we believe there are upside risks to this estimate given indicators such as unemployment, industrial production and durable goods orders.

COVID-19 remains an important source of uncertainty. Cases have accelerated across the U.S., and hospitalizations are rising to the highest level since the start of the pandemic. It is worth noting, however, that the expected increase in economic restrictions that are likely to follow over the holiday season may not be as detrimental for GDP as it may appear on the surface.

The first set of restrictions are likely to apply to restaurants — an area that has seen very little in the way of recovery since the start of the pandemic. Other areas that would carry greater weight, such as manufacturing, would likely be the last to be shut down this time around, thus muting the negative impact on GDP growth.

Looking into the New Year, economic activity will generally look strong throughout the year, given the relatively easy comparisons to depressed activity in 2020. We expect bond yields to remain range-bound, policy rates anchored, and credit spreads well-supported given reduced primary market supply and continued domestic and overseas demand for high-quality fixed income investments.

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Q&A: Addressing Volatility and Uncertainty in the Fixed Income Market originally appeared on usnews.com

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