The U.S. economy has strengthened steadily in recent months, showing signs of emerging from the historic downturn caused by the pandemic. The labor market has gained back roughly half of the more than 20 million jobs lost due to the pandemic, and GDP growth looks likely to rebound in the third quarter. Mike Lillard, head of fixed income and chief investment officer for PGIM Fixed Income, says the strong U.S. economic recovery may become more moderate. “It feels more like a V-shaped recovery right now,” he says. But our expectation is that the V may turn into more of a checkmark-shaped recovery: a steep drop followed by a more drawn-out period of improvement.”
A modest-but-steady recovery is generally good news for investors. For fixed-income investors, however, that recovery is likely to be marked by continued low interest rates, which might lead many investors to look beyond the Treasury market in their search for yield, says Lillard, who adds that investors may want to consider exploring certain areas of the credit markets.
Lower For Longer
The pace of the recovery will depend on a number of factors, first of all the timing of an approved COVID-19 vaccine. Government intervention is another key variable. Both the Federal Reserve and Congress have taken effective steps to cushion the impact of the economic downturn. As of October, lawmakers were negotiating another large-scale support package for individuals and businesses. The Fed’s mid-September meeting yielded an intention to keep interest rates low for what may be several more years.
For his part, Lillard would like the Fed to message a more accommodative stance over the long term. The Fed has slashed the federal funds rate—a key short-term interest rate—to a range between 0.00% and 0.25%. But now that it has cut the federal funds rate to what it believes is the effective lower bound, the Fed may be unable to provide the accommodation needed going forward. Moreover, the Fed’s long-term forecast for the federal funds rate is 2.5%,1 clearly indicating a long-term hawkish bias to raise rates at some point in the future. Lillard believes that rate is much too high, instead pegging 1% as a more realistic target. He cites two key reasons: The labor pool is now growing much more slowly, as waves of Baby Boomers ease into retirement; and the confluence of technology and globalization is changing how companies source labor and products. “Each of these factors can lead to lower inflation and therefore lower nominal rates,” he says. In fact, even though rates are hovering near historic lows, they actually are more in line with where rates historically have been over the very long term. From the 1960s through the 1980s, rapid inflation and a fast-growing workforce were among several factors that led to a unique—and atypical—spike in interest rates.2 The high rates in that period were the anomaly, not the low rates of today. Lillard believes low rates are here to stay.
Supply And Demand
A low-rate environment poses challenges for income-oriented bond investors. Cash effectively pays zero percent, and most government-issued securities offer paltry yields. Long-term Treasurys pay only 1.40%,3 while many European government bonds carry negative yields. Lillard thinks many fixed-income investors should look instead to the credit market, where the best opportunities may be found.
Lillard expects a recovering economy and investor demand to cause the spreads between yields on corporate bonds and Treasurys to narrow. Another factor that could contribute to slimmer spreads is the likely fall of corporate bond issuance. Lillard notes that many companies issued debt to give themselves greater financial flexibility amid the uncertainty of the COVID-19 pandemic and a shaky economy. But as the economy gets back on its feet, companies may focus on stabilizing their balance sheets, leading them to issue fewer bonds. “We saw this after 2008, when companies got more conservative after the crisis and the net supply of corporate bonds declined,” he says.
In high-quality credit, Lillard favors structured products such as AAA commercial mortgage-backed securities and AAA collateralized loan obligations. He expects the relatively wide spreads of these products to come down, to potentially tighten well through pre-pandemic levels. Lillard says these securities may perform well in the run-up to the November election, because securitized assets are less vulnerable to changing corporate tax and regulatory policies.
The banking sector also appeals to Lillard. In stark contrast to the 2008 recession, leading banks have been managed more conservatively, maintaining strong balance sheets and liquidity. Their high-quality debt can earn investors a yield premium of more than 100 basis points over Treasurys with minimal risk.
In the search for investment-grade credit opportunities, Lillard and his colleagues highlight the importance of strong, bottom-up security selection. They currently are seeking out long-term, BBB-rated debt issued by companies committed to strengthening their balance sheets. “We want to find securities of issuers that are reducing leverage and improving credit quality,” he says. “Those situations offer potential for price appreciation.”
At the lower end of the credit spectrum, Lillard is cautious about bank loans, also called leveraged loans. He is constructive on emerging market debt, where he says relatively wide spreads offer value, but counsels caution due to an array of currency- and country-specific risks. U.S. high-yield bonds also offer appeal, he says, due to his expectation for declining default rates.
It used to be that retirees searching for income didn’t have to stray too far from the relative safety of the Treasury market. These days, however, Lillard notes that more creative approaches may be needed by income-oriented investors. And while the specific areas he favors may change, the sentiment remains the same: “At this point, our favorite fixed-income investments are in the credit markets.”
- “Longer Run FOMC Summary of Economic Projections for the Fed Funds Rate, Median,” Federal Reserve Bank of St. Louis, as of Sept. 24, 2020.
- “Perspectives: The Low Ranger,” Prudential Fixed Income, September 2013.
- “Daily Treasury Yield Curve Rates,” U.S. Department of the Treasury, 30-year Treasury rates as of Sept. 24, 2020.
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