Bond land far from homogeneous
Rising yields mean different things for different sectors of the market.
While we expect yields on the long end may well continue rising in the months ahead—never typically a good thing for bonds and for U.S. Treasuries and other government issues in particular—why they are rising is critically important. For a big part of bond land, notably corporate and emerging-market (EM) bonds, performance is driven as much if not more by economic forces as they are by rate trends. And the outlook on that front appears to be highly supportive. We are in the early stages of a recovery that this year could well see the U.S. post its strongest annual GDP growth since the early 1980s.
Even with recent increases, nominal bond yields remain extremely low on an historical basis, making for an attractive option for companies to finance expansions, capital expenditures and acquisitions that typically come during periods of economic expansion, especially during early stages of recovery. Indeed, new issuance in investment-grade and high-yield corporate bonds have been strong as companies rush to capitalize on still-low yields. And flows into the lower-quality ends of the credit market have been solid—a sign yield-seeking investors seem comfortable with the risk against the backdrop of an improving economy.
It’s true some EM countries continue to struggle with Covid, and rising U.S. yields generally lessen the attraction of EM debt. But this asset class tends to benefit whenever developing economies are growing and demand for oil, commodities and other resources rises. As global trade picks up and banks lend more, trade finance and bank loans—more specialized areas of the credit market which don’t have interest risk—typically experience solid demand, too. In sum, the backdrop for credit sectors of the bond market is more favorable than the lower-yielding government sectors, with increasing demand helping to at least partially offset the capital destruction that occurs with rising yields.
It’s not all wine and roses
To be sure, the potential exists for a “Taper tantrum 2,” in which investors decide bonds aren’t worth the risk (principal loss due to rising rates; little income; poor equity hedge, etc.). If the decade-long massive inflow into bonds begins to reverse, causing all bonds to go down in price, the least liquid credit-oriented sectors are almost certain to perform the worst if investors all decide to unload bonds at the same time. But while the short-term pain could be acute, the Fed “put” is alive and well. Should bond markets become dysfunctional and rates rise high enough to threaten the economic recovery, the Fed will step up and buy Treasuries, mortgage-backed securities, corporates, municipals, high yield and other bonds to stabilize the bond market and bring rates back down.
There have been hints of late that investors’ long-term love affair with bonds has grown stale, but it’s still early to know anything with any certainty. Despite the run-up across stocks to record highs off last March’s bear-market lows, $544 billion has flowed into bonds while $398 billion has flowed out of stocks over the past 12 months, according to Ned Davis Research—hardly a warning bell for bonds just yet.