[Part 1 of 2]
With the Covid-19 vaccination program gaining momentum in the U.S., an acceleration of growth is expected as the domestic economy eventually reopens in full. Rob Waldner, Chief Strategist and Head of Macro Research for Invesco Fixed Income, anticipates the economic recovery in the U.S. to surpass 7% growth in 2021. What he refers to as a “macro factor framework” at this point includes those strong growth expectations, plus benign inflation and easy monetary policy.
“That’s a good environment for financial markets overall in terms of liquidity and stability,” says Waldner. “It's also quite good for those things that are tied to growth, such as earnings and credit quality. In a world where treasuries have negative, real yields – we’re at about -0.6% in real yield for the 10-year Treasury in the U.S. – there are going to be some opportunities elsewhere in fixed income.”
Against that backdrop and to explore opportunities in public credit markets, II recently spoke with Waldner and Matt Brill, Head of North America Investment Grade for Invesco Fixed Income for part one of a two-part series focused on how institutional investors can make their fixed income portfolios work harder and take advantage of the current scenario.
For reasons in which institutional investors are well versed, it would be a mistake to overlook traditional fixed income just because we’re in a low-rate environment. That said, what do investors need to keep in mind as they eye their return targets?
Matt Brill: Three factors have been pushing rates lower and been deflationary for the overall market during the past two decades – aging demographics, globalization, and technological improvement. The Covid-19 pandemic hasn’t changed anything about those three things. In fact, you could argue that technological innovation has accelerated. In other words, the search for income isn’t going to end anytime soon, but rates will have some volatility and be higher over the near term – driven by enormous growth and inflation – which will give investors an opportunity they won’t want to miss out on. It’s not a time to be shy and think the trend has changed for the longer term – in our opinion, it hasn’t. Any volatility we experience now could be a buying opportunity, and while we focus on the U.S. it’s noteworthy that there’s still about $14 trillion of negative yielding debt around the globe.
What does that mean for fixed income investors in the U.S.?
Brill: The ECB [European Central Bank] and the Bank of Japan have been extremely accommodative. The rollouts are slower, particularly in Europe. Their economies are more fragile, and their aging demographics are worse than in the U.S. From that standpoint, the longer-term trend is very good. There is still dispersion of yields and the U.S. is much more attractive. Anytime you think you’re getting close to a more desirable 3% or 4% yield an investor from outside the U.S. will step in front of you and take that. Investors should continue to watch for a ceiling for how high rates can really go over the near term, even with what is expected to be heightened volatility.
There is a lot of talk about inflation, which is one topic that institutional investors are always concerned about. Should that concern be heightened at the moment?
Rob Waldner: We think the Fed is serious about letting inflation run hot for a while, and then come back down toward its target of 2% average inflation over the longer term. If inflation is above 2% for a year or two it will help the Fed achieve that target. If you look at the break-evens applied by the U.S. TIPS market, they are saying the market is expecting inflation to run above 2% for a couple of years, and then to come back down. The five-year forward [inflation expectation rate] has been quite stable. In short, there will be a lot of talk about inflations and likely a scare, we would caution investors to keep in mind that the short-term context – we’re emerging from a lockdown – differs from the longer term. You have to respect that there will be a short-term pickup in inflation, but we don’t think we’re in for a huge inflation scare or reality across the broader economy. That’s not to say we might not see increases in commodity or housing pricing, or inflation in particular areas, but we don't think longer-term inflation expectations will be broken.
Since you mentioned TIPS, Rob, where might they fit in a strategy in the inflation scenario you just described?
Waldner: If you choose to own TIPS over treasuries, you’re basically betting that the Fed will lose control of inflation and it will run hot for the longer term. If that’s your view, then you might want to own TIPS over treasuries. In the current scenario, the negative real yield of TIPS is not a tremendously compelling investment unless you need that duration for some reason. Our view is that if you think there is going to be inflation near term, perhaps you should focus more on bank loans, where you would benefit from floating rates as they go up.
There have been mixed messages about the health of companies in this economic environment, and there was a ton of issuance over the past year. What do corporate balance sheets look like now, and how can investors be positioned to capture the upside and the downside on that?
Brill: This is the year of the upgrade. One of our key themes for 2021 is that there’s going to be a lot of corporate deleveraging and a lot of opportunities in the crossover as bonds move out of high yield and into investment grade. In 2020, corporations in the U.S. investment grade market borrowed an astounding $1.8 trillion – it was all about survival. Those companies were putting that cash on the balance sheet to make sure that they could live to fight another day and then prosper once we came out on the other side. Now they see the light at the end of the tunnel and have pivoted, and they don’t need as much cash. This is not just a few companies – you’ll see a lot companies deleverage because they want to get their balance sheets in better shape in case there is a non-pandemic induced recession. We’re expecting only about $1.1 trillion of issuance this year, and it should be materially better from a technical standpoint and very good from a fundamental standpoint.
You mentioned opportunities in the crossover during expected upgrades. Where specifically do you see that occurring?
Brill: The upgrades won’t just be in investment grade. There will be crossing over from high yield to investment grade. We’re expecting about $100 billion of upgrades out of high yield and into investment grade this year. Two of the biggest areas to look for that are technology and home builders. Home builders are still generally rated high yield more than 10 years after the financial and housing market crisis, but we expect anything with a cyclical bent to be upgraded this year. There’s a significant amount of economic momentum and that’s great for high yield. We feel very positive about the ratings momentum from high yield into investment grade.
You said upgrading and re-rating represented one of your investible themes this year. What are the others?
Brill: There are two more – reopening and reflation. As far as reopening is concerned, it should be fairly obvious that some corporations in travel and leisure should do a lot better. I was recently at the airport in Phoenix, and I saw a rental car line that was probably three hours long. The reopening trade is alive and well, and we think that’s a great place for names that have potential to improve fundamentally and with contracted credit spreads.
In terms of reflation, we feel very good about the energy space and metals and mining, and not limited to traditional U.S. companies. Large emerging markets’ sovereigns that are rich in natural resources – and the corporations within them – should do well. And that’s before considering the U.S. has the potential for an infrastructure spending package later in the year. If the economy reflates as we expect near term, we think it will do well. With infrastructure spending, it could even do better.
I’ll just add to those three themes that we and everyone else are always discussing what a 10-year government bond is going to do, but we think that there is better opportunity within corporates to compensate investors for some of the interest rate risk in the underlying government bonds. Overall, the momentum is picking up for the economy and we want to be aligned with it.
There are some concerns that supply chain issues could disrupt some aspects of recovery. Do you see that happening?
Waldner: We don’t think that’s a risk for the economy overall. Certain parts of the economy are already running hot, like housing, so that’s creating supply chain issues in the housing market and driving up that cost of construction materials. The same is true with shipping. There are bottlenecks because it’s taking longer than usual to offload cargo and get it where it’s supposed to go, and freight rates are up tremendously. But mostly this is happening in parts of the economy that are already hot.
What are the tradeoffs of seeking yield and taking on more risk in the current investment environment?
Brill: We’re trying to keep core characteristics of the strategy looking and acting like a bond fund, and that generally means looking to the stability of the investment-grade space. That said, there are always ways to get more yield through credit risk, duration risk, or illiquidity risk. Right now, we’re comfortable with illiquidity risk and credit risk – and not very comfortable with duration risk in the near term. We have added more credit risk to our portfolio, with some less liquid securities on the margin making up a small portion of the portfolio. However, we don’t want to load up on a complete correlation to the equity market by adding a bunch of risk to the portfolio, so we still have some of the higher quality portions of our strategy to mitigate that risk.
Shifting gears a bit, what are investors looking for in the ESG space?
Brill: About seven years ago, one of our institutional clients told us they wanted to shift all of their funds with us into an ESG-based strategy. As a result, we feel that in sustainable investing we’re pretty far ahead of most other managers in the U.S. What we try to do is look at the fundamentals as well as the ESG factors of each individual credit. One of the things we’ve noticed is that you don’t sacrifice performance by being ESG aware – the risk adjusted performance of ESG is basically the exact same. The reason for that is ESG tends to help eliminate tail risk by ridding a portfolio of companies that have a propensity for environmental accidents, for example. Those cost money at the end of the day, and if a corporation lacks solid governance in that context it can be a huge risk to the overall credit.
Regarding the specific risk of climate change, how do you incorporate that into the portfolio?
Brill: We’re looking for positive momentum in many areas when we assess a corporation, and that includes whether it has made a conscious decision to reduce its carbon footprint. It’s easier to find companies that are doing so in Europe than in the U.S. currently, but that will improve in the U.S. in the future. Sustainability linked notes are going to become more popular. With those, a company sets a metric to meet within a certain period of time, and if it fails to achieve that goal it pays a greater coupon as a penalty. For example, the company might say it will reduce its carbon footprint by X percent in five years, and if it doesn’t it is penalized. That’s a good way to hold the entire company accountable.
That puts investors in an odd situation of getting more income if the company fails to achieve its goal.
Brill: Everyone always want more income, so it is a little weird to hope you get less income. But, again, it’s not really less – you aren’t sacrificing performance – you’re just not getting the penalty income if the company meets its goals. But by making the investment in the first place you want the company to meet its goal. The next level beyond that is to measure the overall carbon footprint of the index and create a strategy that features a smaller carbon footprint rather than just buying the market portfolio. That way we as a firm can quantify the impact we are making in your portfolio and quantify the progress an individual company is making.
This article is for US Institutional Investor Use in Canada Only. Accredited Investors as defined under National Instrument 45-106. Content was developed in March 2021. This is for informational purposes only and is not an offer to buy or sell any financial instruments. As with all investments there are associated inherent risks. This should not be considered a recommendation to purchase any investment product. Please obtain and review all financial material carefully before investing. The opinions expressed in this article are those of the authors and are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
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