Bond Market Outlook 2021

Bond Market Review & Outlook Q2 2021

April 16, 2021
by Chris Keith, Senior Vice President, Fixed Income Manager
wdt_ID Bonds in 2021: Snapshot
1 • Interest rates tick higher in 2021 as the economy regains its footing √
2 • Inflation fears drive markets; we think they are overblown √
3 • Rising rates ding bond prices now, but are boosting yields

As stocks have soared on the prospects of a vigorous reopening of the U.S. economy, bonds have fallen precisely for the same reasons. From the low of last August, bond yields have risen and bond prices have fallen on expectations that a growing economy will require more lending and, at the same time, spark inflation. I believe more lending is a good sign in that it reflects business expansion in the face of growing demand, and that inflation fears are overstated.

After a 40-plus year bull market, the bond market’s 3.37% decline during the first quarter seemed to rattle quite a few investors. It’s not the pandemic per se that’s making investing less profitable for fixed-income investors right now. It’s growth. Many traders and investors have been worried that the stimulus measures intended to catalyze an economy laid low by the pandemic will revive inflation. But it’s not the current level of inflation that troubles market observers, rather it’s inflation expectations.

Since 1960, core inflation has averaged 3.7% per year. Today, it sits at less than half that rate, with the most recent data reflecting inflation of just 1.3%. In fact, inflation has run below its historic average for almost 30 years. An entire generation of investors and consumers have experienced nothing but lower-than-average inflation—and they’ve come to expect it. When something occurs to alter that expectation, like a series of large stimulus measures, investors become unnerved and the market is jolted by sharp dips like we saw last quarter—a tantrum without the taper.

My recommendation is to remain calm despite these market flare-ups. Annual inflation figures are calculated on a rolling 12-month basis, and over the next several months, the influence of the COVID-induced deflationary nadirs of last March, April, May and June will make the numbers look unnaturally high. Core inflation will most likely return to pre-COVID levels in the second half of 2021, after spiking over the next few months.

Market analysts seem to be coming around to my view in recent days. Inflation data released this week showed core inflation rising sharply, yet the bond market has rallied, which indicates to me that traders are less afraid of inflation than some headlines indicated. Buyers are returning to the bond market to take advantage of the highest long-term Treasury yields since January 2020. If they were truly afraid of inflation, they’d be avoiding long-duration, long-maturity bonds at all costs.

Despite the market’s dip in the first quarter, companies and governments are having no problem raising capital by selling bonds. The volume of new bonds issued has not broken the record, but it’s not far off. This is positive news for two reasons: First, access to capital is crucial for the economy. Second, it’s good for investors looking to re-balance their portfolios. Increasing yields on Treasurys and other high-quality securities mean investors can put cash to work instead of parking it on the sidelines in money markets, which are still at near-zero yields.

Keep in mind that the bond market is far from a monolith. Even when rates are marching up, not every sector follows in lockstep. Case in point: Municipal bonds (munis). In the first quarter, munis were down just 0.35% while the aggregate bond index of taxable bonds was down 3.37%. For many muni investors, no bond price is too high or yield too low as long as there’s a tax-exempt reward on the other side. With the Biden administration’s stimulus and infrastructure bills to pay for, tax rate increases are likely to come. Bad for many of us, but it makes that tax-exempt muni asset class more appealing to upper tax-bracket investors.

Looking ahead, I’m sanguine about moves that fiscal policymakers at the Federal Reserve might make. Fed Chief Jay Powell continues to assure investors that the central bank has no intention of hiking interest rates before the economy returns to full employment. (The unemployment rate is 6% today, versus 3.5% pre-pandemic.) Powell also noted that if inflation does pick up in any concerning way, he has the tools to address it.

I see plenty of upside for fixed-income investors as interest rates rise—rising yields generate more income. Whether you’re reinvesting income into more shares of a bond fund or rolling over maturing bonds into new ones, higher yields are the reward. As always, I view bonds and bond funds as a well-diversified investor’s anchor when market seas turn stormy.

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