Bond land far from homogeneous Bond land far from homogeneous\images\insights\article\rice-field-vietnam-small.jpg March 29 2021 March 22 2021

Bond land far from homogeneous

Rising yields mean different things for different sectors of the market.

Published March 22 2021
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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.

Tags Fixed Income . Interest Rates . Active Management . Markets/Economy .

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.

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.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks and may be more volatile than investment-grade securities.

In addition to the risks generally associated with debt instruments, such as credit, market, interest rate, liquidity and derivatives risks, bank loans are also subject to the risk that the value of the collateral securing a loan may decline, be insufficient to meet the obligations of the borrower, or be difficult to liquidate.

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.

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.

Federated Investment Management Company