The year 2020 will long be remembered for the COVID-19 pandemic and its tragic human toll. And yet, it was a surprisingly strong year for the overall capital markets. Not only did almost all asset classes deliver positive total returns, but many easily surpassed their average 10-year returns. The fixed income market was no exception.
The initial shutdown of the global economy from mid-March through the end of June was the catalyst for the dramatic move lower in interest rates. Understandably, investors sought safe-haven assets such as U.S. Treasury notes and bonds and other high-quality sovereign debt, which helped push yields to historic lows.
With the Great Recession of 2008 providing policymakers with a valuable playbook, central banks around the globe acted swiftly and aggressively to lower interest rates in order to prop up the economy. The goal was to make sure there was enough liquidity in the global system to avoid a complete seizure of the financial markets.
The Federal Reserve dusted off many of the tools* used during the financial crisis and implemented many others that together kept the markets functioning. One of the first actions by the Fed was to aggressively cut short-term borrowing rates to near zero. This was quickly followed by reinstituting the quantitative easing policies. The central bank’s massive buying program not only backstopped many of the liquidity impaired markets, but also encouraged investors to take more risk than they probably would have taken in a non-COVID investment landscape.
*A listing of Fed programs and tools can be found in the appendix.
The Fed purchased over a trillion dollars of longer-dated Treasuries and mortgage backed securities. This resulted in record low Treasury interest rates during the summer of 2020, which boosted the Treasury component of the Bloomberg/Barclays Aggregate Bond Index to a total return of 8.0% for the year. The benchmark 10-Year Treasury yield fell from 1.92% at the beginning of the year to below 0.51% in August before drifting slightly higher to end the year at 0.91%.
Exhibit 1: Treasury Yields at Historic Lows
Treasury Inflation Protected Securities (TIPS) also experienced higher than normal volatility. In the spring, the implied breakeven rates plummeted, hitting a low of 0.55% as the outlook for the global economy worsened. But a better outlook for the global economy and increased expectations that fiscal stimulus would be inflationary pushed breakeven rates to above where they began the year. The total return of TIPS exceeded the return on nominal coupon Treasury securities by nearly 3%.
Exhibit 2: Oil Versus 10-Year Breakeven
The corporate bond market was another asset class that benefited from the Fed’s support. Unlike during the Great Recession of 2008, the Fed did not isolate its quantitative purchasing to just Treasuries and mortgage backed securities. In April, the Fed expanded its purchases by creating the Corporate Bond Credit Facility, which allowed the central bank to purchase corporate bonds even if a bond’s credit quality rating were to be subsequently downgraded into the junk bond territory. The Fed wanted to not only ensure that the banking system operated properly, but that corporate America had access to a low cost of capital.
Exhibit 3: Credit Spreads Tightening
The facility successfully drove the cost of borrowing for corporations lower after initially going up during the spring months. The average corporate bond yield spread began 2020 at near 1% over similar Treasury securities, which then ballooned up to about 3% over Treasury rates in the spring. However, once the Fed announced the new program, the yield spreads quickly fell and ended the year slightly tighter than where they began the year. This was quiet an impressive comeback, especially in light of the fact that corporations took advantage of the historically low rates by issuing a record amount of both investment grade and non-investment grade debt. The best performing component of the Bloomberg/Barclays Aggregate Bond Index was longer-dated, non-callable corporate bonds, which posted an impressive 13.9% annual total return.
Exhibit 4: Fixed Income Supply
High-yield bond spreads were even more volatile. They began the year at 330 basis points (bps) above Treasury rates and skyrocketed to more than 10% above Treasury rates. They too fell back to where they started the year, but settled at 360 bps above Treasury rates. Actual defaults annualized near 5%, which hampered the total returns but still allowed the Bloomberg/Barclays U.S. Corporate High Yield Index to produce returns of 7.1%.
Municipal Bond Market
The municipal bond market also experienced a significant amount of volatility in 2020. The same negative dynamics that plagued both the equity market and corporate bond market in the spring of 2020 impacted the municipal bond market as well. Fears of an economic collapse alarmed municipal bond investors, which led to massive outflows of open-end municipal bond funds. During the six-week time period of early March to mid-April, the net outflows from municipal bonds exceeded more than $44 billion. During that time period, the secondary market for municipal bonds came under extreme pressure and liquidity for even the most conservative, high quality and short maturity municipal bonds was dramatically impaired. Fortunately, the municipal bond market stabilized over the next few weeks, especially for higher credit quality issuers.
Exhibit 5: Municipal Flows Stabilize
Importantly, the Fed recognized the liquidity problem and established a new facility, Municipal Liquidity Facility, which allowed both states and large municipal localities/entities the ability to borrow directly from the Fed. In the end, very few municipal bond issuers utilized the newly created facility, but it acted as an important psychological backstop for the market. Demand quickly reversed and the municipal market rallied for much of the second half of the year, thereby recouping a significant portion of the underperformance relative to what the Treasury market experienced in the spring.
Exhibit 6: AAA Municipal Yield Curve
The improving market conditions allowed for new issue volume of municipal bonds to easily surpass last year’s tally of $426 billion with total issuance reaching $474 billion. Much like the corporate bond market, municipal bond issuers came to the marketplace to take advantage of record low interest rates. A large component of the increase in municipal bond new issue supply was not issued through the traditional tax-exempt market but came by means of the taxable bond market. Typically tax-exempt debt carries a much lower interest cost than taxable debt, but the combination of historically low Treasury rates and narrow credit spreads made issuing taxable debt very attractive. In fact, the net interest cost was so low that many municipal issuers used the taxable municipal bond market to refinance older, higher-interest cost tax-exempt debt prior to their current call date. This type of issuance is called “advanced refundings” which was disallowed in 2018 through the tax-exempt marketplace. The total amount of taxable municipal new issue volume exceeded $145 billion compared to $72 billion the previous year. This theme of growing taxable municipal debt relative to traditional tax-exempt debt has already and will continue to have a dramatic impact on the tax-exempt marketplace.
It was a somewhat disappointing year for lower-rated municipal bonds. While the COVID-19 pandemic put stress on the fiscal position of almost all municipal bond issuers, it has been even more challenging for the already weak and more leveraged localities/entities. Not surprisingly, the credit spreads of lower-rated municipal bonds widened dramatically in the spring, but recovered over the last eight months of the year. However, lingering credit concerns resulted in materially lower total return for BBB-rated municipal bonds compared to AAA-rated municipal bonds. While all credit buckets produced positive annual total returns, this was the first time in the past few years that the lowest credit quality underperformed the highest quality.
Exhibit 7: Municipal Bond Spreads
Sector return deviations were not as large as one may suspect with even healthcare and transportation revenue bonds somewhat keeping pace with the strongest performing sector – water/sewer revenue bonds. The rating agencies also did not take as much credit rating action as initially feared and actual defaults for rated municipal bonds were extremely limited. The rating agencies took a more patient approach and just put a large portion of the municipal bond universe on negative outlook. We again remind clients that the credit quality of municipal bonds is a lagging indicator and that the trough of the COVID-19 pandemic could be as far away as the summer of 2022.
Exhibit 8: Municipal Bond Credit Returns
Aid from two fiscal stimulus programs provided some of the much-needed support, but there will certainly be more challenges ahead. It will be a very difficult annual budget season this summer as issuers grapple with the fact that even with support and reserves, there will be revenue shortfalls. However, we are confident that the vast majority of states and localities will be able to use some belt tightening and deficit financing to get through this downturn without experiencing credit rating downgrades. Our view is that actual defaults will remain rare and isolated to the non-rated securities and more project-oriented revenue bond issuance such as raw land development deals and waste-to-energy deals. We are cautiously optimistic toward the outlook for revenue bonds being more dependent on user revenues such as mass transportation, convention centers, hotel tax and airport facilities. This is based on the belief that the COVID-19 pandemic will ease as the vaccines roll out across the globe in 2021.
After surprisingly strong total returns in 2020, we are looking for much more muted returns for the fixed income markets in 2021. Even though we expect growth to reach pre-crisis levels by the second half of 2021, we still believe the Fed will maintain its zero interest-rate policy. However, we anticipate yields on intermediate- and long-term Treasuries to move slightly higher in 2021. While our base case for the range of the benchmark 10-Year Treasury note is a low of 0.50% and a high of 1.75% and ending the year near 1.25%, we warn that the vast majority of economists share the same outlook. Therefore, the price gains from falling interest rates experienced in 2020 seem doubtful to repeat in 2021. However, if the economy disappoints with growth on the lower end of our forecast, we would not be surprised if yields on intermediate and long-term interest rates move slightly lower toward the historic low levels experienced this past summer. Importantly, our experience tells us that it is difficult to predict exactly where interest rates will go in any one year.
Exhibit 9: Projected Return Chart
On the credit front, we believe investors should be realistic as to how much tighter corporate bond spreads can go relative to Treasury yields. Here too, we are upbeat that the recent trend to tighter levels will persist in 2021 as the improving economic landscape propels corporate profitability, improved credit quality and less corporate bond defaults. The lower supply outlook for corporate debt issuance coupled with continued global demand for any positive yielding fixed income securities will also act as a catalyst for slightly tighter spreads. However, credit spreads are already tight and our projected additional tightening will only produce modest price gains. We believe an appropriate return expectation for the Bloomberg/Barclays Aggregate Bond Index in 2021 is positive but not above 3.0%, which is far less than the 7.5% produced in 2020.
Despite the high degree of certainty for headline-grabbing isolated credit stresses at both the state and local levels, we are upbeat about the municipal bond market in 2021. As previously mentioned, we recognize that this summer will be very challenging for some states and localities from a budgetary perspective. In many circumstances, there have been real meaningful revenue hits that have to be managed. Interestingly, we are seeing far more positive upside adjustments from the dire projections this past summer. For example, the State of California has dramatically adjusted its revenue expectations to the upside, citing improved sales tax and capital gain collections. While they will still face a deficit, it will not be nearly as deep as the $50 billion projected this past summer.
Much like 2020, we again believe that the vast majority of municipal bond issuers have the financial flexibility to tap reserves, use some deficit financing and even cut budgets to overcome the budget challenges this summer. We reiterate that actual defaults will be isolated and that downgrades will continue to be modest. Importantly, we think demand will continue to be strong. It is likely that taxes on both the federal and state level will inevitably have to go higher and many states have already or are contemplating higher taxes focused toward the highest earners.
On the supply side, the dynamic of total municipal supply increasing, but not necessarily tax-exempt municipal supply, should result in the continued imbalance the market has been experiencing over the last six months. We believe the Bloomberg/Barclays Municipal Bond Index, which underperformed the Bloomberg/Barclays Aggregate Bond Index by a wide margin in 2020, will have a relatively strong year in 2021.
We remind clients that although our total return expectations are somewhat modest relative to last year’s robust returns, it is important to maintain exposure to fixed income. In this challenging return environment, it is critical that fixed income portfolios are well-diversified, incorporating both core and satellite strategies and are actively managed in order to identify opportunities and control risk.