Tracking the Bond Market, Post-Pandemic

With the potential for more volatility on the horizon, fixed income investors may want to stick closely to their strategic allocations.
 

The reopening of the global economy after a sustained lockdown from COVID-19 felt like a breath of fresh air for many investors. But for bond investors, the reopening—and the aggressive economic expansion it helped fuel—has come with plenty of questions. For starters, can the economic rebound continue once pandemic-related fiscal stimulus programs start to unwind? And amid that economic growth, will inflation continue to tick higher?

Indeed, investors are already seeing evidence of what the fixed income market may look like post-COVID-19. Central banks around the world are beginning to step back from their accommodative stances. That includes the Federal Reserve tapering its long-running bond-buying program that injected much-needed liquidity into the U.S economy. Meanwhile, central bankers in some emerging markets—and even some developed markets—are adopting hawkish approaches to interest rates to tamp down inflation. In fact, several Fed officials expect at least one rate hike in the U.S. by the end of 2022.

“Our view is that this year is going to be challenging because we’re investing through the arc of the COVID recovery,” says Robert Tipp, Chief Investment Strategist and Head of Global Bonds for PGIM Fixed Income. “But as we move forward into next year, I think the market is going to reassess and recognize that the economic recovery created an opportunity in the global bond markets and that the world we’re going into will be a lot more like the world before COVID.”

Rates remain low

Prior to the pandemic, trends such as an aging population, high debt burdens, and globalization helped keep a lid on inflation, which in turn kept interest rates low. Now, the world has continued to get older, and governments that borrowed extensively to get their economies through the COVID-19 crisis are carrying an even heavier debt load. The result for some economies may be higher taxes and lower spending, both of which can drag on economic growth.

In this environment, Tipp believes interest rates will drift back to where they were pre-pandemic in countries and regions such as Australia, Europe, and Japan. In the U.S., he expects rates to fall even lower, with yields on the 10-year Treasury staying below 2% “for the foreseeable future.”

That environment poses challenges for investors: Lower yields and tighter spreads on non-government bonds may mute the return potential of bonds. As a result, investors may be more tempted to try to time the market, whether by waiting on the sidelines for yields to rise or by selling their fixed income holdings when yields do move higher. Of course, those attempts at market timing can, in fact, be counterproductive. “I think sticking to their strategic allocations has been, and will continue to be, the single biggest challenge for investors in the years ahead.  That’s produced the best results in the bond market in the recent low-yielding years and is likely to continue to be the best approach,” Tipp says.

However, investors may also want to reconsider how best to navigate the challenges of the current market. “It’s going to pay for investors in this environment to try to structure their portfolios to be resilient to the bouts of volatility that we may have,” Tipp says. “That exercise is likely to push investors in on the yield curve in terms of their higher-risk investments and make them more selective in their sector allocations and issuer selection.”

Opportunities for investors

Amid a powerful rebound from the lows of early 2020, investors recently have been favoring equities. In fact, U.S. investors’ equity allocations are near all-time highs, while bond allocations are near record lows. Despite the challenging environment for bond investors, Tipp sees plenty of opportunities for adding value in the fixed income markets.

Tipp suggests at the higher end of the credit-risk spectrum CLOs currently offer attractive spreads relative to investment grade corporate bonds.  Other structured products opportunities exist as well in higher-quality commercial mortgage-backed securities (CMBS) backed by diversified pools of commercial real estate loans, as well as more niche opportunities in so-called SASB (single asset single borrower) structures.

While the big returns from the COVID reopening trade are behind us, corporate results remain impressive, and improving credit potential can still be seen in select issuers in both the investment grade and high yield corporate markets.  Lastly, looking outside of the U.S. may continue to pay off in the bond market where currency-hedged investments in European sovereigns and emerging market debt offer incremental yield and the ability to diversify.  “Of course, with spreads at historically narrow levels, judicious credit selection is more important than ever, both to  find undervalued issuers, but also to avoid credit blowups,” Tipp says.

In spite of a relatively unsettled environment, Tipp still expects bonds to continue to play an important role over the long term: Bonds should still outperform cash, and higher-risk bonds should continue outpacing government bonds. As a result, fixed income will continue to play a crucial role for investors, offering a middle ground between cash and equities and providing a dose of diversification against the ebb and flow of the business cycle. But investors still may need to temper their expectations. “After 40 years of declining yields and very strong returns from bonds, the current low level of yields means returns will be lower,” Tipp says. “I think it’s going to be less splashy than it’s been.”

This video is for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation in respect to any products or services. Investing involves risk, including possible loss of principal. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Past performance does not guarantee future results. Asset allocation and/or diversification do not assure a profit or protect against a loss in declining markets.

PGIM Investments and PGIM Fixed Income are affiliates.

Wall Street Journal Custom Content, Raymond James Financial, D.K. Brede Investment Management Company and Wells Fargo Advisors Financial Network are not affiliates of PGIM Investments.

PGIM Investments LLC, is an investment adviser registered with the United States Securities and Exchange Commission. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. PGIM Investments and Jennison Associates Prudential Financial, Inc. company. © 2023 Prudential Financial, Inc.

Prudential Financial, Inc. of the United States is not affiliated in any manner with Prudential plc, incorporated in the United Kingdom or with Prudential Assurance Company, a subsidiary of M&G plc, incorporated in the United Kingdom.

1054082-00001-00   Ed: 11/2021

Wall Street Journal Custom Content is a unit of The Wall Street Journal advertising department. The Wall Street Journal news organization was not involved in the creation of this content.