What's Ahead for Fixed Income Investors?

12.17.2019 - Jeffrey S. MacDonald, CFA


Volatility, new muni supply and a focus on credit quality

Fixed income investors can expect a fair bit of uncertainty as we head into 2020. The good news is that the issuance of municipal bonds, which are in strong demand, is expected to increase next year and corporate debt service ratios should remain healthy, aided by lower interest rates.

The ongoing trade war with China, weaker manufacturing data, slowing global GDP growth and more modest expectations for future growth have captured the attention of the Fed and central banks around the world. To confront these challenges, boost economic activity and move inflation closer to targets, global policymakers have made it clear that the possibility of easier monetary policy and lower rates is still on the table for 2020.

More easing on the horizon?

The classic response to economic slowdowns is to reduce rates and introduce other monetary stimulus measures. In fact, the Fed spent most of 2019 transitioning from a neutral monetary policy to a dovish approach in response to a weaker economic outlook, cutting rates three times in the second half of the year. That followed a period of eight rate hikes between 2016 and 2018.

However, there is a good deal of skepticism among policymakers regarding how effective monetary policy easing will be in the year ahead. One reason for this cynicism is that the outlook for growth and inflation could be dramatically changed by geopolitical developments such as the impeachment process and 2020 elections in the US, Brexit and trade war concerns.

The uncertainty surrounding these issues has encouraged investors to pile into fixed income over the past year, driving yields down and flattening yield curves. With trillions of dollars’ worth of negative-yielding debt across the globe, investors are demanding very little compensation in return for lending capital in the current environment. Investors are reaching for yield in an environment characterized by expectations for slower economic growth and mounting concerns about the resolution of geopolitical tensions. We believe this sets the stage for periodic bouts of volatility in the fixed income market as these situations play out over the course of the year.

A pickup in municipal bond supply

Demand for tax-advantaged income should continue to be strong in 2020, especially in high-tax states that have a $10,000 cap on state and local tax deductions. While the 2017 tax code did away with municipalities’ ability to “advance refund” bonds and replace them with new tax-exempt debt, lower interest rates in 2019 allowed municipalities to issue taxable bonds and reduce their interest costs compared to previously issued debt. In general, taxable bonds are more expensive for municipalities to issue versus tax-exempt debt. But taxable bonds can offer attractive advancerefunding opportunities if overall rates move low enough.

With this in mind, we believe the issuance of taxable municipal bonds should continue to rise in 2020 unless rates unexpectedly move higher. This, combined with an uptick in the issuance of traditional tax-exempt bonds, should provide a pickup in both gross and net supply for the first time in recent years— good news for investors looking to put money to work in 2020.

Because we do not foresee a US recession in the near term, which would reduce tax receipts and make it more difficult for issuers to service their debt, we prefer high-quality revenue bonds in the year ahead. While we are active investors in the general obligation (GO) sector, underfunded pension liabilities may represent challenges for some GO issuers, including the possibility of a worst-case scenario in which bondholders are not made whole in a restructuring. Therefore, we remain very selective with respect to credit quality in the GO market.

Corporate bonds: Quality matters

Corporate bonds posted very strong returns in 2019. Investment grade and high yield bonds were two of the top-performing asset classes, taking advantage of lower interest rates and tightening spreads. At the same time, corporate earnings growth slowed from the double-digit rates seen in 2018. While earnings growth appears likely to be muted throughout 2020, we believe most companies should be able to meet their payment obligations because debt service ratios remain healthy, aided by lower interest rates.

In the corporate bond market, credit quality also remains solid. But we are cautious about certain areas of the market such as investment grade bonds, as several issuers struggle with deleveraging and reorganization efforts. Within high yield, the highest-quality issuers within the lower-rated BB sector are at historically high valuations, representing an unattractive entry point. In addition, a slower-growth environment raises concerns about CCC bonds because their credit quality and default rates are highly sensitive to US GDP growth.

In summary, we recommend taking a more cautious stance against expected periods of elevated volatility in 2020. In our view, corporate bonds may offer value compared to other sectors of the fixed income market. And since we anticipate more volatility on the horizon, we prefer bonds with higher credit quality that mature in 10 years or less.

This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of December 1, 2019, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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