Boston - With Labor Day in the rearview mirror, bond market investors are confronted with stark policy contrasts coming from Washington: the relative clarity of the US Federal Reserve compared with the very murky picture posed by the congressional stalemate and the presidential election.
Here are our takeaways in the current environment:
Market volatility is likely to increase, with the path of COVID-19 infections as the overarching uncertainty factor. An example is the pace of school reopenings — the normal productive capacity (and spending habits) of parents may be significantly reduced if they have to continue as stay-at-home teachers.
Fed policy is clear: Lower short-term rates for longer (through at least 2023 based on the September policy meeting) with a bias to let inflation run above its 2% target until the unemployment rate is very low. The Fed's stance has resulted in inflation expectations creeping up from 1% last March to 1.7%, as indicated by the 10-year inflation breakeven.1
Corporate bonds have benefited greatly from Fed policy, which has included purchases of corporate investment-grade debt and high-yield ETFs. This has contributed to a general tightening of credit spreads to pre-COVID levels, with the exception of floating-rate loans.
In leveraged credit, transparency about anticipated defaults is now better, and we believe that defaults won't reach the levels we expected in March. In our view, loans have lagged other credit sectors because the floating-rate feature was viewed as a negative. But with rates at rock-bottom levels, we believe loans offer value, because we don't expect the Fed to resort to negative short-term rates.
By contrast, a cloud hangs over the municipal bond market, with no agreement in Congress over new relief for cities and states. The muni market has nevertheless rallied, driven by investor hunger for yield, leaving the high-quality sector less attractive on a risk-adjusted basis. Certain high-yield muni bonds — BBB or lower — may offer better risk-adjusted return. For example, hospitals were hard hit by COVID-19 and prices fell in March, but they have bipartisan support in Washington. A potential Democratic sweep would certainly be a significant tailwind for the municipal sector.
1 Inflation breakeven is a commonly accepted measure of the expected inflation rate, defined as the difference in yield between nominal Treasury bond rates and the real yield on Treasury Inflation Protected Securities (TIPS).