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Commentary by Kunal Mehta, CFA, senior investment specialist, fixed income

Fixed income monthly update – February 2021

February started in stable fashion but investors soon began to reposition their portfolios in the expectation that global economic growth would be stronger than previously anticipated. The improving sentiment was supported by better-than-expected economic data releases, continued vaccine roll-out and indications that there might be more fiscal stimulus from the US government. This gave rise to predictions that inflation could start to edge higher.

Monthly performance by market

Global government bondsCorporate bondsEmerging market bonds
 UKEuropeUSHY 
Bloomberg Barclays Global Aggregate Treasuries (USD Hedged)Bloomberg Barclays Global Aggregate GBP Corporate (USD Hedged)Bloomberg Barclays Global Aggregate EUR Corporate (USD Hedged)Bloomberg Barclays Global Aggregate USD Corporate (USD Hedged)Bloomberg Barclays Global High Yield (USD Hedged)JP Morgan Emerging Markets Bond Index EMBI Global Diversified (USD Hedged)
-1.86%-3.48%-0.71%-1.57%0.13%-2.55%

Source: Bloomberg Barclays, 29 January 2021 to 26 February 2021. Bloomberg Barclays Indices are used as proxies for each exposure.
Past performance is not a reliable indicator of future results.

Government bonds

In the government bond markets, yields rose and the yield curve steepened for US, UK and German government bonds1. In all three regions (Germany representing continental Europe), yields rose between 27 and 51 basis points for bonds in the 20- to 30-year maturity bracket.

Credit markets

In the credit markets, spreads in investment-grade corporate bonds from the US, UK and Europe tightened as a result of the stronger economic recovery expectations. In contrast, high-yield and emerging market bonds saw spreads widen.

The improved economic recovery picture was supported by earnings releases. The majority of companies had reported their fourth quarter 2020 results by the end of February and a significant number beat market expectations. This was driven in large part by stronger performance in Asia, where economic activity has moved closer to pre-pandemic levels.

Whilst many companies remained cautious in their outlooks, there were signs of greater optimism aligned to vaccine roll-out progress. Where greater detail was given, companies tended to forecast a stronger recovery taking hold in the second half of 2021, while confirming conditions remained difficult in the early months of this year as lockdowns persisted.

Credit spread levels

Credit spread levels

Source: All Bloomberg Barclays indices: Global Aggregate Credit index, Emerging Market USD Aggregate Index, USD Aggregate A and BBB Corporate Index, EUR Aggregate A and BBB rated Corporate Index, Asia Pacific Aggregate A and BBB rated corporate index, US Securitised ABS and CMBS indices and US Corporate High Yield Index. As of 26 February 2021.

With high levels of liquidity amassed by corporate bond issuers in 2020, new supply was subdued, although the capital markets remained fully open to investment-grade issuers. Ratings agency actions (including downgrades and the reassignment of credit ratings) also remained low after an eventful 2020. Where new issues did come to the market, demand was strong. This continued to be notably the case for green assets.

The European Central Bank continued with its bond purchases and the technical environment remained supportive for corporate bonds.

Emerging markets

Emerging market (EM) bonds began February on a strong note before coming under pressure from rising US Treasury yields, as investors began to appreciate the quickening pace of economies reopening and the scale of the US fiscal package’s likely impact on inflation. The move in Treasuries had a larger effect on EM investment-grade bonds due to their higher sensitivity to interest rates; here, spreads widened by more than 8 basis points while spreads for EM high yield were little changed.

Emerging market bond spreads

Emerging market bond spreads

Source: Bloomberg, JP Morgan and Vanguard. 1 February 2019 to 28 February 2021.

From a regional perspective, recent underperformance in Latin America continued. The monthly return here was -3.6%, compared with a return of around -2% for other regions1. Nevertheless, for idiosyncratic reasons, several countries bucked the trend. One of these was Costa Rica, where further progress in negotiations for assistance from the IMF provided support. Improved local market funding operations and reduced refinancing concerns were also helpful. El Salvador also outperformed on hopes that legislative elections at the end of February would produce a more unified government and pave the way for fiscal reform and an IMF programme of assistance.

Local-currency EM bonds had a challenging February as foreign exchange rates struggled in the face of rising US interest-rate expectations. Yield curves for local-currency bonds were universally steeper.

EM sovereign bonds supply slowed significantly from January, while investor flows remained robust. Net issuance totaled USD 5.3 billion. A lot of 2021’s funding needs have already been met and some issuers were reluctant to issue new debt amid the volatility in US Treasuries. For example, Peru held investor roadshows but has decided to wait before it issues new bonds.

Outlook

We are maintaining a reduced level of overall credit risk, selectively positioning across the segments of the market that should still benefit from strong investor demand and a steadily improving macroeconomic backdrop. Cyclical sectors, select Covid-19-sensitive segments and pockets of lower-quality securities offer value, but security selection and our comfort around issuer fundamentals will dictate our exposures.

While the macroeconomic outlook is relatively constructive due to vaccine roll-out, we feel much of the good news has already been priced in by the market.

In the near term, with risk sentiment strong and a continued accommodative central-bank backdrop, we believe further, modest spread tightening is possible. Within this scenario, there is also, however, a risk that markets will overshoot in their tightening, although spreads are at their most compressed level in 10 years.

We remain optimistic that EM countries should perform well in a growth rebound. The knock-on effects of a recovery in developed markets should include greater demand for commodities, an important source of earnings for many EM countries. Nevertheless, rising US interest-rate expectations could still put pressure on EM currencies in the near term.

In the nearer term, EM bonds may be challenged by the impact accelerating growth and prices could have in testing the US Federal Reserve's ability to maintain its ultra-dovish monetary policy stance. However, ultimately EM's attractive long-term return profile should continue to attract investors.

In the funds, we remain focused on relative value while remaining cautious. Any broad-based weakness will be viewed as an opportunity to add to positions.

 

1 Bloomberg as at 26 February 2021

Important risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Any projections should be regarded as hypothetical in nature and do not reflect or guarantee future results.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

Some funds invest in securities which are denominated in different currencies. Movements in currency exchange rates can affect the return of investments.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result the value of your investment may rise or fall.

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