The novel coronavirus brought upon us unprecedented shutdowns and economic turmoil in the first half of 2020, and there was no greater impact on righting the ship than the Federal Reserve. In the midst of our economy grinding to a halt and our GDP cratering, Federal Reserve Chairman Jerome Powell brought interest rates down to zero, and the central bank used a number of different tools in its repertoire to help the struggling economy and businesses navigate the shutdowns. These moves helped to prevent an even more dire situation, but it has left investors that rely on fixed income in a precarious position in the trade-off for receiving steady income from your money vs. the risk of capital to reach for a higher yield.
2020 returns on fixed income securities were strong due to the actions of the Fed. When interest rates drop, the price of bonds goes up, and you tend to see higher returns. It does not seem likely that the Fed will raise interest rates in 2021, and that could be as far out as 2023 if the economic impact of COVID-19 continues to dampen the U.S. economy. This portends a positive outlook in the short term for bond investors, but yields on fixed-income investments will more than likely be lower for longer due to the outlook for short-term rates. This does not mean that fixed income will not be an important part of a diversified portfolio for 2021 and beyond, however.
Money-Market and Cash Deposits
The short-term road for cash and money market investments looks bleak as the short-term rates are expected to be kept at, or near, zero moving forward. It will be difficult to earn a meaningful return on these deposits, but they will continue to be attractive for defensive investors who do not want to lose principal because of the lingering economic uncertainty due to the coronavirus, a new administration, and new Congressional economic policies.
Treasuries
With the economy continuing to recover and the COVID-19 vaccine in the process of being rolled out, we should see the yield on the 10-year treasury increase. The Federal Reserve looks to normalize this yield as the economy strengthens, seeking to control inflation. If inflation increases as it is expected to, we could see intermediate yields rise and reach a range of 0.5% to 1.6%. Short-term rates will more than likely remain at or near zero as the Fed wants to continue to prime the pump of the economy and keep money cheap.
Source: Bloomberg. 10-Year Treasury Yield and a Proprietary Multifactor Fair Value Model of the 10-Year Treasury, using JPMorgan Global PMIs, Inflation Swaps, and the Term Premium. (USGG10YR Index, MPMIGLMA Index, FWISUS55 Index, ACMTP10 Index). Using monthly data as of 10/31/2020. Past performance does not guarantee future results.
This should help businesses borrow to remain in business and even expand as the economy continues to recover. Treasuries are attractive because they are safer investments due to the fact that they are backed by the full faith and credit of the U.S. government. In the risk-reward world, this causes them to have less of a return than other fixed-income investments that require more return for the inherent risks of investing in them. Their safety and relatively modest returns should continue throughout 2021.
Treasury Inflation-Protected Securities (TIPS) can be helpful to fixed income investors in 2021 and beyond to protect against inflation risk during a rising interest rate environment and can be an important part of a fixed-income portion of a portfolio. With short-term rates having nowhere to go but up, they should be a good inflation hedge.
Corporate Bonds
2021 should create an opportunity for investment-grade corporate bond investors, but it is important to look to keep duration shorter in these investments. Duration is the time it takes for a bond to return the coupon and principal back to an investor; it can fluctuate based on interest rate changes and can be managed through diversification and bond-laddering. Credit quality is important as well because ultimately, these investments have the risk that the bond issuer could become insolvent—though at least the bondholders are ahead of the shareholders in line for payment in a bankruptcy proceeding. If you are looking for higher-yield bond returns, then you will more than likely need to invest in issuances that have more credit-quality risks. With bond yields being lower due to lower interest rates, it will be important to guard against overexposure to these investments in the search for a higher-yielding portfolio.
Global Bonds
The global bond outlook for 2021 will have a lot to do with how the valuation of the dollar moves. If the dollar weakens as it did at the end of 2020, then we should see strong overall returns in this asset class as the native currencies strengthen. As the U.S. government continues to stimulate the economy with an influx of borrowed money, and the Fed’s policies remain dovish, global bonds should become more attractive for foreign investment to fill the gap due to low yields and returns on U.S. debt. Improving global economic conditions as we come out of the coronavirus pandemic, in addition to accommodative central banks, should make this an attractive asset class in 2021. However, there is still more risk in global bonds than in U.S.-backed treasury bonds and other higher-quality issuances.
Summary
It is difficult to predict how soon the U.S. and global economies will recover from the COVID-19 pandemic. But, if there is continued economic growth, investors could find yield and returns in fixed-income. It could be a choppy year in these asset classes as central banks continue to use their tools and programs to stabilize the economy, so it will be important to monitor quality and diversify your fixed-income holdings.
2021 INVESTMENT & OUTLOOK GUIDE
This piece was part of Walkner Condon’s 2020 Review & 2021 Investment Outlook Guide, a comprehensive interactive PDF covering a wide range of subjects and trends, including the S&P 500, electric cars, and more. To read the full guide, please click the button below.
