Head of U.S. Fixed Income Greg Wilensky discusses the lessons learned in fixed income portfolios in 2020 and how they are likely to apply in the year ahead.

Key Takeaways

• Looking ahead to 2021, we think the lessons of 2020 should be kept firmly in mind: Treasuries can be useful as a hedge in times of uncertainty, core allocations to spread products like corporate bonds still make sense and active management is paramount.
• Despite low absolute yields and our belief that the risk is more skewed to higher interest rates than lower ones, we think investors may want to maintain some level of exposure to government bonds due to their potential to act as a hedge against weaker-than-expected equity and/or credit markets.
• Corporate bonds – whether investment grade or high yield – and securitized markets like mortgage- or asset-backed securities still offer an attractive yield premium over U.S. Treasury bonds, while providing some diversity from equities.

While we are happy to think 2020 will soon be in the past, in many ways the year showed us that fixed income, by and large, performed as you might expect it to in a time of crisis. The Bloomberg Barclays U.S. Aggregate Bond Index has generated a nearly 7.75% return year to date and only briefly – in mid-March – was its year-to-date return negative. U.S. Treasuries also reacted as hoped, reaching a total return just shy of 10% in the first quarter and holding those gains until the fall when longer-maturity yields started to rise. Looking ahead to 2021, we think the lessons of 2020 should be kept firmly in mind: Treasuries’ usefulness as a hedge in times of crisis were again affirmed, core allocations to spread products like corporate bonds still make sense, and active management is paramount.

Corporate bonds, whether investment grade or high yield, and securitized markets like mortgage- or asset-backed securities still offer an attractive yield premium over U.S. Treasury bonds, while providing some diversity from equities. With government bond yields near historic lows across the developed world, we expect yield – income – should remain in demand. And, in our view, the economic fundamentals supporting these spread markets should improve as the global economy recovers into and through 2021.

Indeed, certain sectors of the market, such as securities directly related to the consumer or to the U.S. housing market, may offer particularly attractive risk-adjusted returns given the relative strength in those sectors compared to previous recessions. However, given the extent of the recovery in many segments of the market since the lows of March, there may be less price appreciation potential available in 2021. This is particularly likely in the securities with higher credit ratings that, predictably, recovered first and are closer to long-term historical averages, or even lows, in their yield spread over U.S. Treasuries. As such, investors more comfortable taking additional risk may look to shift some exposure to below-investment-grade bonds in the corporate market, and lower but still investment-grade rated securitized products, such as asset-backed securities (ABS) and non-Agency mortgage-backed securities (MBS).

Investors can continue to maintain some level of exposure to government bonds, or other investments that will provide a similar sensitivity to interest rate movements, due to their potential to act as a hedge against weaker-than-expected equity and/or credit markets. But, given that we believe the risk is more skewed to higher interest rates than lower ones, and inflation expectations could follow economic growth, we believe investors should consider holding relatively less exposure to interest-rate risk then they might normally. Such a portfolio adjustment can be accomplished, among other ways, by shifting some exposure to either inflation-protected securities (whose underlying yields are less impacted by rising inflation expectations), or floating-rate securities that have even less interest-rate sensitivity.

A final lesson from 2020 was the reminder that the real threats to an investment portfolio are often the unknowns – the events or shocks that few (if anyone) were considering as they built their portfolios or advised their clients. The synchronized global impact of COVID-19 was a surprise to the market and thus a shock. Volatility surged and liquidity evaporated, with little time to prepare. While investors and asset managers today can weigh the chances of a quicker or slower economic recovery, or debate the likelihood of inflation returning, we believe investors should position their portfolios for 2021 keeping in mind that surprises happen. Absent a compelling reason, such as particularly attractive valuations, investors should look to keep their exposure diversified across their portfolio. Such a strategy not only can help smooth the volatility of the expected returns but make it easier to take advantage of opportunities as they arise, whether from shifting valuations or the inevitable surprises. As hard as it may be to imagine a more difficult or volatile year than 2020, we believe – particularly in fixed income portfolios – in the old saying, “an ounce of preparation is worth a pound of cure.”

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Returns Source: Bloomberg as of 11/13/20, BB U.S. Treasury Total Return index

Securitized credit: Refers to fixed income securities that pool financial assets together to create new securities that can be marketed and sold to investors.

Mortgage-backed security (MBS): A security which is secured (or ‘backed’) by a collection of mortgages. Investors receive periodic payments derived from the underlying mortgages, similar to coupons. Similar to an asset-backed security. MBS may be more sensitive to interest rate changes. They are subject to extension risk, where borrowers extend the duration of their mortgages as interest rates rise, and prepayment risk, where borrowers pay off their mortgages earlier as interest rates fall. These risks may reduce returns.