Be ready for anything Be ready for anything\images\insights\article\trees-birch-autumn-small.jpg November 4 2020 October 8 2020

Be ready for anything

A disputed election headlines potential risks heading into year-end.

Published October 8 2020
My Content

Munis in a holding pattern

As is the case with other fixed-income credit markets, there’s not a lot of conviction in the municipal bond market as it enters the fourth quarter. On the one hand, the economy continues to improve, particularly housing, manufacturing and services. On the other hand, nonfarm job growth has moderated considerably after a late-spring/early-summer surge, recovering roughly half of the jobs lost from pandemic-driven shutdowns and social distancing. This could be a drag on consumer spending and overall recovery as we close out the year, particularly if more relief isn’t forthcoming for households and state & local governments. After four months of debate and discussion, President Trump this week appeared to put the kibosh on further comprehensive fiscal stimulus until after the election. Many large states and local governments face wide deficits due to sharply lower income and sales taxes because of the Covid recession. Several revenue bonds sectors—including Airports, Hospitals and Higher Education—are being particularly squeezed by cost challenges. This isn’t to suggest we are negative on all muni bonds. Valuations relative to Treasuries look attractive among both high-grade tax-exempt and high-yield muni bonds. But the opportunities likely will remain selective until there is a firmer grasp on the outcome of the election, the path of the ongoing pandemic and the health of the economy going into 2021. – R.J. Gallo

To say it’s been an interesting year is an understatement—and we still have almost three months to go! Consensus appears to be a contested election, with the current tilt toward a Biden victory with control of the Senate less certain. It helps that the base case has been a disputed election, with the new dynamics of mail-in balloting fairly well understood. This would suggest less tail risk since it’s arguably priced in the market. But if there’s anything we learned this year, and really the last four years, it’s that caution on consensus is merited. Thus we enter this final stretch of 2020 roughly neutral on both credit and rates positioning because, quite simply, we want to be ready for anything.

To review how we got here, we entered 2020 in a somewhat defensive position with regard to credit, not because we foresaw the Covid-19 crisis but because we had such a strong run in 2019 that we felt it was time to take some bets off the table. Thus our shift to underweights on investment-grade and high yield for the first time in a decade proved beneficial in the first quarter when the virus’s arrival sparked a dramatic risk-off trade. Then as the second quarter got underway—and really, just before the first quarter was ending—we added exposure in much of the credit space and profited from the subsequent dramatic risk-on trade when unprecedented Fed and fiscal stimulus flooded the markets.

The third quarter vacillated between the two extremes. July saw somewhat of a renewed risk-off trade as a second wave of Covid cases raised concerns a budding recovery may stall.  This resulted in a bullish flattener as long rates fell faster than short rates (already anchored at historic lows by the Fed). August got a reversal—a bearish steepener with long rates rising on a consistent stream of positive economic surprises, particularly in housing and manufacturing, amid signs Covid cases were stabilizing/declining. September bounced between risk-on and risk-off, weighing the Fed’s pledge to keep benchmark rates near zero-bound for three years or until inflation hits and holds at 2% against election uncertainties and slowing labor-market improvement. In the end, the quarter ended roughly where it began, with the 2-year Treasury yield down 2 basis points and the 10-year Treasury yield up 2 points.

A neutral stance allows for flexibility

So where does that leave us as the fourth quarter gets underway? Neutral on most of our credit sectors, with a slight overweight on investment-grade corporate bonds offset by a slight underweight to high-yield corporates and commercial mortgage-backed securities, where social distancing and work-from-home orders tossed a monkey wrench into normal commercial real estate operations. A case can be made that, whoever wins the election, a relief risk rally may ensue because markets are going to get stimulus either way—fiscal if it’s Biden/Democrats, or tax cuts if it’s Trump/Republicans.

More than anything, once it’s all over, the markets will get some certainty against a backdrop of an improving economy still in the early stages of recovery. (This past week’s risk-on rally during widening election polling supports this view.) That favors equities over fixed income, and I wouldn’t be surprised if we start seeing that dynamic start to play out in fund flows, which in the second and third quarters were very strong for bonds. But because rates are at such low levels, duration of the benchmarks has been pushed out, heightening the potential of a sell-off on the longer-end of the curve in higher-quality credit assets, where spreads have narrowed back to normal levels.

Adding value in this ultra-dovish world is a challenge; we expect some opportunities will come on the rate front through tactical moves in duration and along the yield curve. For instance, we just shifted to a short position on duration on evidence longer rates seem to have made a technical breakout from range-bound summer levels. That said, we would envision taking off that short if the 10-year starts to near 1.00%. Think about that—100 basis points. This shows you just how little we are playing for and reminds us to scale these decisions with risk and return both firmly in mind. For similar reasons, we could make a tactical shift from neutral to a bearish steepener on the yield curve, with an eye toward picking up a little alpha. Finally, we will be looking at credit spreads and currency pairs carefully, again with the objective of adding small diversified sources of alpha. These days, we try to get it wherever we can.

Tags Fixed Income . Politics . Markets/Economy . Interest Rates .

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Alpha: This measures a fund's risk-adjusted performance. It represents the difference between a fund's actual returns and its expected performance, given its level of risk as measured by beta (see definition of Beta). This difference is expressed as an annualized percentage.

Bond credit ratings measure the risk that a security will default. Credit ratings of A or better are considered to be high credit quality; credit ratings of BBB are good credit quality and the lowest category of investment grade; credit ratings of BB and below are lower-rated securities; and credit ratings of CCC or below have high default risk.

Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices.

Diversification and asset allocation do not assure a profit nor protect against loss.

Duration is a measure of a security's price sensitivity to changes in interest rates. Securities with longer durations are more sensitive to changes in interest rates than securities of shorter durations.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risk and may be more volatile than investment-grade securities. For example, their prices are more volatile, economic downturns and financial setbacks may affect their prices more negatively, and their trading market may be more limited.

International investing involves special risks including currency risk, increased volatility, political risks, and differences in auditing and other financial standards. Prices of emerging-market and frontier-market securities can be significantly more volatile than the prices of securities in developed countries, and currency risk and political risks are accentuated in emerging markets.

Municipal bond income may be subject to the federal alternative minimum tax (AMT) and state and local taxes.

The value of some mortgage-backed securities may be particularly sensitive to changes in prevailing interest rates, and although the securities are generally supported by some form of government or private insurance, there is no assurance that private guarantors or insurers will meet their obligations.

Yield Curve: Graph showing the comparative yields of securities in a particular class according to maturity. Securities on the long end of the yield curve have longer maturities.

Federated Investment Management Company