July 20, 2020

During WWII, the U.S. government aggressively sold war bonds to individual citizens, urging them to buy bonds to help support the war, and it proved to be a very successful campaign. Today, we are fighting a different kind of “war”, but we are not exactly being enticed by the government to save and buy Treasury bonds. With interest rates at zero and $14 trillion of negative yielding bonds globally, the temptation is to do the opposite. And yet, while government bond yields have declined considerably since the Federal Reserve cut interest rates to zero, yields on non-government bonds have actually moved higher. In the current environment, with interest rates pegged at zero possibly for years to come and a more supportive Fed, certain sectors of the bond market are, in our view, poised to deliver better risk-adjusted returns going forward.

Rather than extending duration to reach for incremental yield, we see more attractive opportunities within corporate credit. While corporate credit has already recovered a lot since markets bottomed in March, continued support from the Federal Reserve and significant liquidity provide strong ongoing tailwinds. Corporate bond yields are higher today relative to where they started the year, and the newest marginal buyer of credit, the Fed, will not be going away anytime soon. In fact, the Fed has the potential to become a very large buyer of credit under new programs. The Fed currently owns just over $10.7 billion of corporate bonds and has the leeway to buy up to $750 billion worth—which represents 42% of investment-grade corporate bonds with maturities of five years or less. 

The outlook for corporate fundamentals continues to evolve. After an increase in downgrades in March and April, the pace has slowed significantly since May with only two downgrades in June. After a very strong second quarter, we believe security selection becomes more important going forward. In our view, as the economy gradually reopens, so too will the corporate bond market generally improve. 

High-yield credit is another area of the bond market that is being supported by the Fed and should continue to benefit as the economy gradually recovers. The average yield of the high-yield index is around 7.6%, a little more than 2% higher than its long-term average and almost 7% higher than what you can earn on a 10-year Treasury bond. Admittedly, investors should prepare to see more defaults this year, but that is priced into the market. The market is currently pricing in a default rate of around 10% while the actual default rate is closer to 5% at present. Fitch is forecasting a 6% default rate this year under its base-case scenario, or as high as 10% in its worst-case scenario.

For taxable investors, municipal bonds offer some of the best relative value—but this is also where much of the headline worries are these days. While all states will face economic pressure, we do not think it will result in large scale downgrades and defaults. Budget shortfalls are likely to result in austerity measures, and states have many policy levers they can pull. The Fed is buying up to $500 billion worth of municipal bonds. The CARES Act provided $150 billion to state and local governments, and more aid is expected to follow. The pandemic’s impact is also likely to be varied, with local governments that rely upon tourism and cyclical revenue streams experiencing more challenges. There is likely to be an uptick in distress across sectors such as long-term care facilities, hotels and convention centers. In contrast, we are more confident about areas of the municipal market with dedicated revenue streams such as utilities, water and sewer bonds. 

In summary, we have seen an overwhelming policy response from the Federal Reserve, which has so far mitigated some of the damage. While U.S. government bonds yields are at all-time lows, our research supports the view that investors can still find relative value by turning to other areas of the bond market. As investors everywhere must adapt to the many various challenges of today, at Sand Hill, we believe that the bond market will get by, with a little help from our friends… at the Fed.

^{Source: https://markets.jpmorgan.com/#research.rates.us}