Market participants and strategists say investors should expect a challenging yield environment this year as the Federal Reserve is expected to keep rates at historically low levels — likely keeping a lid on the yields of the safest fixed-income investment, U.S. Treasurys.
It’s possible that income-seeking investors may need to accept a little more risk if they want more yield. That means considering dividend-paying stocks or going outside the U.S. to tap into the global bond market, which includes emerging markets.
Bryce Doty, senior portfolio manager at Sit Investment Associates, says news related to the pandemic will dominate investor sentiment and projections for economic growth in the first part of 2021. As society moves to a post-pandemic world, the outlook for bonds will evolve, market watchers say, with hopes that economies will improve as vaccines are distributed. An improving economy could lift bond yields, but it may also spur inflation — something else for investors to watch.
Here’s a look at the bond market outlook for 2021:
— Fed likely to stand pat.
— Credit outlook remains positive.
— Consider some foreign debt for yield.
Fed Likely to Stand Pat
The Fed is likely to keep the federal funds rate at historically low levels this year and maybe into 2022 as the central bank seeks to reinvigorate the economy. Short-term interest rates, those with a maturity of less than three years, are highly correlated and sensitive to Fed actions, says Jeff MacDonald, head of fixed-income strategies at Fiduciary Trust.
“We don’t expect a whole lot of movement in that part of the yield curve,” he says.
Longer-term rates, anything with five years or more until maturity, will likely be influenced by growth and inflation expectations, MacDonald adds. In the beginning of the year, those rates should be stable, but as 2021 moves into the second half of the year, those longer-dated rates may rise as vaccine distribution improves, allowing the economy to reopen and gross domestic product growth to accelerate.
Combined with monetary and fiscal stimulus, inflation expectations may increase, causing the yield curve to slope up as rates for longer-dated maturities rise.
“A positively sloped yield curve generally suggests that the market believes that GDP growth is ahead,” he says. “It’s a good indication for future growth and inflation.”
[SEE: 7 Best ESG Funds to Buy.]
Jeffrey Buchbinder, equity strategist for LPL Financial, says bond investors need to have patience and brace for lower returns. The current yield for the 10-year U.S. Treasury note is around 1.15%, and the firm is targeting a 10-year Treasury range of 1.25% to 1.75% for year-end 2021 on the idea that the economy rebounds and inflation normalizes.
“However, we have a bias toward the lower end of this target as accommodative Federal Reserve policy and foreign buyers drawn to the relatively higher U.S. rates may keep a limit on potential yield increases,” he says.
Buchbinder also forecasts modest returns for bonds. Last year, the benchmark Bloomberg Barclays US Aggregate Bond Index had a total return of 6.87%, but for 2021, he expects flat to low-single-digit returns for the index.
With a small uptick in rates expected if the economy improves, Buchbinder says investors could consider adding mortgage-backed securities and investment-grade corporate bonds. “MBS may not offer the upside potential of corporate bonds, but they can be more resilient when rates rise,” he says.
John Loffredo and Robert DiMella, co-heads of MacKay Municipal Managers, say the municipal bond market may benefit under President-elect Joe Biden’s administration as new policies could result in greater infrastructure spending. With Biden’s focus on addressing climate change, too, there could be a greater volume of infrastructure-related muni bond issuance of interest to impact-oriented investors for its environmental, social and corporate governance impact.
Credit Outlook Remains Positive
2020’s pandemic lockdowns shook credit markets. Since then, those markets have recovered — and for 2021, the outlook for credit “is still constructive,” MacDonald says.
During 2020, investment-grade corporations issued a record amount of debt as they sought to raise cash during the pandemic, and now these companies have “a war chest of liquidity.” Valuations are high, and he doesn’t expect spreads between the different types of investment-grade credits to narrow much.
High-yield credit, also known as junk bonds, could see some gains. Junk bonds were routed in early 2020, and like investment-grade credit, they rebounded. Because of the demand for yield, investors could return to this market, MacDonald says, and he is keeping an eye on the possibility of spreads tightening versus other fixed-income classes.
Doty says he’s looking to take advantage of any bond market dislocations spurred by pandemic news. Specifically, he’s looking at cyclical sectors such as energy and leisure, which were hit hard last year.
“We are expecting vaccine news as a steady wind at our back that will eventually lead to a tremendous rebound in economic activity in 2021, and you don’t want to be on the wrong side of that trade,” Doty says.
Consider Some Foreign Debt for Yield
Mark Haefele, chief investment officer, global wealth management, at UBS, says investors may want to look outside the U.S. bond market for higher income. He says UBS particularly likes emerging-market, U.S. dollar-denominated sovereign bonds, which have shown yields of 4.7%, while some Asian high-yield bonds have a 7.2% yield.
Additionally, dividend-paying stocks “can potentially offer an attractive source of income,” he says.
Buchbinder agrees that credit-sensitive sectors such as high-yield bonds and emerging-market debt may help compensate income-hungry investors in a low interest rate environment, but he says to be careful with these vehicles.
“We would still prefer high-quality bonds to make up the bulk of any bond portfolio,” he says. “Should any material risks to the economic recovery present themselves, these credit-sensitive sectors would be more vulnerable.”
More from U.S. News
Bond Market Outlook: Yields Likely to Stay Low in 2021 originally appeared on usnews.com