Recapping 2020 Fixed Income Returns and 2021 Outlook

<b>Eric C. Jussaume</b><br> Senior Vice President<br>Senior Portfolio Manager<br>& Director of Fixed Income<br><br><b>Lindsey K. Donovan</b><br> Assistant Vice President, Investment Analyst & Trader

Eric C. Jussaume
Senior Vice President
Senior Portfolio Manager
& Director of Fixed Income

Lindsey K. Donovan
Assistant Vice President, Investment Analyst & Trader

January 15, 2021

Investing & Economy

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The year 2020 will be remembered not only for the pandemic and the economic hardships but also for market volatility. The Federal Reserve enacted many measures that restored normalcy and provided the necessary financial backstop for the free-flowing of capital. This financial backstop helped corporate bond performance. Credit spreads on both investment grade and high yield indexes tightened substantially and generated impressive returns since March. The Fed lowered the federal funds rate to 0% and has indicated a willingness to maintain this low rate for the foreseeable future. As a result, interest rates achieved historic lows in 2020. We provide a roundup of 2020 for the major segments of the fixed income market below.

US Treasury Bonds

Yields on US Treasuries declined in the first quarter and remained low for the rest of the year before rising in December. The 10-year US Treasury began 2020 at 1.9% and finished the year at 0.9%. Returns were dependent upon duration, and longer duration outperformed shorter maturity bonds. The 2-year US Treasury returned 3.0%, the 5-year US Treasury returned 7.3%, and the 10-year US Treasury returned 11.0%. The ICE BofA US Treasury Index, which has a duration of 7.5 years, returned 8.2%, the highest since 2011 when the index returned 9.8%.

Municipal Bonds

The municipal market generated impressive returns of 5.3%. Longer duration bonds outperformed shorter dated bonds, with the longest part of the index (22 years and longer) returning more than 6.5%.  Although many states are experiencing financial hardships in the wake of the pandemic, the new presidential administration plans to offer additional stimulus with direct aid to states to help offset the pandemic's expenses. Taxable municipal bond issuance was one of the large stories of the year, with issuance of $140 billion, double the prior year’s total of $68 billion. Our focus has been on higher quality general obligations and essential service revenue bonds.

Investment Grade Corporate Bonds

In March, the virus caused an upheaval in the corporate bond market as the spread on investment-grade corporate bonds widened close to 400 basis points above comparable Treasuries. The Federal Reserve came to the rescue with both primary and secondary market credit facilities, which helped ease fears. Since March, spreads have continued to tighten, resulting in a return of 9.8% for the ICE BofA Corporate Bond Index for the full year. Returns have been bifurcated along with credit quality and maturity. The low-rate environment has forced investors to reach for yield in longer-dated maturities and lower credit quality. We have focused our credit investments on higher quality while maintaining a defensive posture to final maturity.

Mortgage-Backed Securities (MBS)

Spreads on the Bloomberg Barclays MBS Index were flat on the year and these bonds generated a total return of 4.1%. Our exposure is predominately in 10-year and 15-year final maturity pass-through securities where the overall returns are dependent on coupon and maturity selection. We prefer to invest in these shorter maturities (verses 20-year and 30-year) securities to limit possible extension risk if interest rates rise.

Opportunistic Fixed Income

As a diversifier, we have maintained current positions in select actively managed mutual funds in high yield, bank loans, and dollar-denominated emerging market debt. All had positive total returns in the year of 9.0%, 2.4%, and 8.0%, respectively.
In the high yield index, spreads initially widened to more than 700 basis points in March before tightening back to 364 basis points by the end of the year, only 26 basis points wider than where the year began. The BB-rated segment was the strongest performing rating bucket, up 8.6% on the year, while CCC-rated was the laggard, returning 2.9%.

Floating rate loans recovered from their initial downturn in March, where the index saw dollar price levels of $76, index levels have recovered to $96 at year end. The overall size of the market stayed flat at $1.2 trillion outstanding, after 5 years of 6.5% annual issuance growth. The distress ratio of loans trading below $80 ended the year at just over 2%, after initially widening in March to more than 20%.
Emerging market (EM) credit also ended the year on a positive note after an initial sell-off in March. The US election and vaccination approvals late in the year supported a rally going into the final months of 2020. EM dollar denominated corporate bonds outperformed relative to EM dollar denominated sovereign bonds, 7.5% versus 5.7%.

Outlook for 2021

The 30-year bull market in fixed income may well continue for another year, but the returns earned in 2020 may be hard to duplicate in 2021. Interest rates remain low, and any upward movement from the low base may result in negative returns dependent upon maturity. Credit spreads have tightened since March and are currently trading below their 5-year average. Credit quality remains strong, but without further spread tightening, returns could be muted. The magnitude of an increase in rates may face headwinds. The Federal Reserve has increased its balance sheet to $7 billion in the wake of the pandemic, and any significant unwinding may damage the economy. Over $13 trillion in global securities trade at negative yields which makes US Treasuries relatively attractive. The low-interest rate environment has helped the housing market with low mortgage rates, a substantially higher move in rates will likely slow home sales.

In recent years, investors not only earned their coupon payments but have reaped the additional benefit of getting positive price return as yields fell.  This price appreciation is less likely to repeat, but the key premise for owning bonds remains in place: principal protection with dependable coupon payments. Bonds continue to warrant inclusion in portfolios. Segments of the bond market may benefit from the new presidential administration. Additional stimulus expectations might provide support to state finances, and municipal bonds may increase in demand with higher income taxes. Emerging market debt, high yield bonds, and bank loans still offer relatively attractive yields, an area that we may increase allocations. In late 2020, we reduced our overall portfolio allocation to fixed income to a modest underweight. The Cambridge Trust bond team will continue to monitor the bond market and make any necessary changes to portfolios.