"ESG bonds are likely to remain relatively well supported."
Fixed income
Anchor: fixed-income
Credit continues to shine
In 2021, core government bonds’ gains will be meager, while emerging market hard currency bonds remain appealing. In credit, investment grade offers a good risk/reward. In high yield bonds, we see select opportunities to enhance returns in the lower-rated credit segments.
With short-dated yields likely to remain anchored at low levels by central bank policy, we do not expect long-term yields to rise strongly in 2021. Nevertheless, we see a moderate steepening of government yield curves as the most likely scenario in 2021, driven by the ongoing economic recovery and central banks’ objective to raise inflation expectations.
The US Federal Reserve (Fed) made an important change to its long-term strategy in Q3 2020, introducing a policy approach of average inflation targeting in which a potential inflation overshoot would be tolerated to make up for earlier below-target inflation outcomes. The framework should allow the Fed greater flexibility in its policy choices in order to lift inflation expectations, thereby helping term premiums (the excess yield for holding long-term vs. short-term bonds) to rise from depressed levels.
Moreover, while central banks’ accommodative stance and ongoing bond purchases to support the recovery have kept fixed income volatility low in 2020, we think volatility could see some normalization in 2021 together with increased inflation tolerance by central banks, along with higher debt and fiscal deficits. With our expectation of a moderate rise in long-term yields, we believe that nominal core government bond returns should remain close to zero or negative in the next 12 months.
Inflation-linked bonds’ edge over nominal bonds
In 2020, inflation numbers fell sharply in response to the economic contraction and the drop in commodity prices. In light of the ongoing economic recovery, major economies’ inflation rates are expected to show some normalization in 2021, though likely only reaching 2.0% in the USA and 1.0% in the Eurozone, the latter being significantly below the target of the European Central Bank (ECB). However, central banks’ potential tolerance for higher inflation should help stabilize and lift long-term inflation expectations, eventually exceeding recent historical averages. Inflation-linked bonds (ILBs) – which provide compensation for rising inflation – would benefit from such a rise in inflation expectations, unlike bonds. When adjusted for duration differences, we therefore think that ILBs offer a better return prospect than respective nominal government bonds.
Look for yield in emerging market bonds
Yields of emerging market hard currency bonds (EM HC) have fallen markedly since the COVID-19 induced sell-off. Nevertheless, spreads have remained above previous lows, albeit in part due to the declining underlying US government bond yield. Record high market positioning and a narrower scope for policy support going forward is moderating the return outlook.
Notwithstanding the more stable global growth environment, many EM countries will still have to deal with the impact of the lockdowns following the initial COVID-19 shock, in particular the need to reverse some of the monetary and fiscal stimulus deployed in response to the crisis. On the other hand, the potential increase in cyclical revenues after the rebound in economic activity this year, together with some fiscal tightening and stronger external balances, would suggest a slower pace of debt supply going forward.
IG remains in demand
Most investment grade (IG) corporate bond segments delivered a positive return in 2020, supported by falling government bond yields as well as supportive monetary and fiscal policies. Nonetheless, credit spreads have widened since the beginning of the year.
Against the backdrop of a gradual recovery of the global economy, we expect central banks and governments globally to retain the very supportive monetary and fiscal policies, especially the credit facility to purchase IG corporate bonds directly, which should support further spread tightening in the new year.
As we expect long-term government bond yields to only slowly normalize, IG credit should continue to perform. With spreads for the high-grade segment having further room to tighten, we expect global IG to deliver a mid-single-digit return over the next 12 months. In our view, investors should favor good quality corporate bonds over nominal government bonds due to continued strong central bank support, not only in Europe but also in the USA. For diversification, we think that IG EM corporate bonds in USD offer an attractive yield pickup for investors looking for diversification.
We think that in the absence of additional shocks and in light of persistently low global interest rates, EM HC debt remains an important source for enhancing returns within fixed income. For the overall EM HC index that we track, we forecast a return of 4.4% by end 2021. More defensive investors might prefer to invest only in IG government bonds, even though this lowers the return outlook. After a large number of sovereign credit downgrades in 2020, we foresee a more stable environment in 2021 as we move further away from the initial COVID-19 shock and after several debt restructurings in high yield. Within major EM countries, the political agenda in 2021 is not particularly busy and may help limit specific risks. There are legislative elections scheduled in Russia and Mexico and municipal elections in South Africa.
HY spreads: Room to tighten
At the time of writing, rating agency Moody’s expects global high yield (HY) credit default rates to peak in Q1 2021. With risk sentiment improving alongside a projected economic recovery in 2021, we expect that a further moderate spread tightening in HY corporates is likely. Within HY, single-B rated bonds still offer attractive spread cushions compared to more defensive segments.
We anticipate that global HY should deliver 4.4% returns by the end of 2021. Given the prospect of a COVID-19 vaccine, consumer discretionary sectors such as airlines and gaming are likely to recover. Even though corporate leverage increased in the energy and metals sectors throughout 2020, current yields appear sufficient to compensate for default risks as we go into 2021, especially against the backdrop of ongoing central bank support.
Similarly, while European sub-financials might face higher risks in terms of rising non-performing loan provisions, the strengthened bank balance sheets and fiscal support have largely reduced European banks’ funding stress. We expect European sub-financial bonds’ performance to be in line with HY bonds in 2021.
Benefits of ESG focus
We believe investors can benefit from two aspects when it comes to environmental, social and governance (ESG) corporates in 2021. Firstly, a corporate bond portfolio that takes into account ESG criteria might be less affected by corporate defaults and credit rating downgrades over a long-term horizon. Secondly, with the benefits of ESG screening increasingly acknowledged by investors and, in turn, translated into higher ESG allocations and inflows, we expect ESG bond prices to remain relatively well supported.
