Morgan Stanley
  • Investment Management
  • Aug 26, 2021

Bond Market Opportunities After Peak Easy Money

Select assets within the fixed income market may offer investors opportunities, amid steady economic growth, waning policy support and persistently higher inflation.

At the start of 2021, robust support from monetary and fiscal policy buoyed asset prices across markets. Today, as the battle against coronavirus persists, even as the global economy regains strength, investors are hotly debating inflation prospects and when the Federal Reserve will raise interest rates and taper asset purchases, and how that might affect the bond market outlook—as well as stocks and alternative investments. From a fixed income perspective, we see opportunities in four key areas of the market that are less dependent on interest rates: U.S. high yield, mortgages and securitized assets, convertible bonds and emerging markets.

The sudden jumpstart to economies that all but ground to a halt last year created myriad bottlenecks. Price inflation spiked in many industries and marketplaces, as pent-up business and consumer demand overwhelmed still-disrupted supply chains. While this may prove transitory, sticky higher prices could drive up wages and create other long-term inflation risks.

We see opportunities in four key areas of the market that are less dependent on interest rates.

Still, economic growth, inflation and policy support may all have already peaked in 2021. Central banks and government spending could remain supportive of markets, just less so than at the start of the year as we enter the next phase of the pandemic-driven economic cycle. The Fed, for example, probably won’t reduce its bond-buying program, known as quantitative easing, until this December or early in 2022, and we don’t expect it to start raising interest rates until mid-2023.

Disparate views about inflation and the pace and path of policy tightening abound. Which means that the months ahead will likely produce higher volatility, market dislocations and buying prospects for investors aiming to manage interest-rate risk through active management for higher yields and portfolio diversification.

U.S. High-Yield Bonds as the Economy Improves

High-yield bonds—which have lower credit ratings than government debt or investment-grade corporate credit but offer investors higher interest income (at greater risk)—are one of the most appealing options in fixed income right now. High-yield bonds usually benefit from improving economic trends, including rising credit ratings and declining default rates. The potential for ongoing supportive monetary and fiscal policy could help boost the asset.

So, too, could reflation, or the return to global growth post-pandemic. Smart reflation trades could include lower-quality high-yield bonds and debt from smaller issuers, both of which are assets that may benefit in an improving economic cycle.

Mortgages Amid U.S. Housing Strength

Turning to securitized products in our bond market outlook, U.S. residential credit may offer the best opportunity, given solid housing-market fundamentals amid strong demand. U.S. home prices on average climbed 15% in the past year. Driving the increase were low mortgage rates and housing supply combined with growing demand from Millennials coming of age and forming their own households, and evolving work-from-home dynamics, based on National Association of Realtors’ May, 2021 data.

Bonds backed by assets in more pandemic-battered sectors, including those tied to aircrafts and small-business loans, may also offer attractive yields. Overall, the potential benefits of investing in the securitized market include low bond durations, higher yields and solid credit fundamentals.

Convertible Bonds in an Inflationary Environment

As the economy recovers, the rise in inflationary pressure could bode well for convertible bonds—corporate debt that can be converted into common stock or equity shares—compared with other fixed-income assets in our bond market outlook. Shorter durations for the asset class may help mitigate the impact of rising rates on their valuations.

Despite turbulent performance in 2021, convertibles have led all fixed-income categories, with the Refinitiv Global Convertibles Focus Index up 3% year to date.1 Convertible bond issuances from companies in cyclical sectors, including materials, industrials, financials and energy, may present the best opportunities, despite a recent rebound in convertibles of certain growth companies and those that have reopened since pandemic lockdowns.

Emerging-Market Assets for Higher Risk and Reward

Emerging-market debt could benefit from the pickup in vaccination rates in several of these economies, especially when compared with the outlook for Treasury yields to stay near zero. High-yield emerging-market credit may be more attractive than investment-grade debt, as the former offers a bigger cushion against rising yields in the more developed world and exhibits higher volatility (thus risk, and possibly, returns) compared to global growth.

There’s also opportunity in emerging-market currencies, given proactive central banks, even though the near-term risks are heightened by the dollar’s strength after the hawkish surprise at the June meeting of the Federal Open Market Committee, the policy arm of the Fed. Investors should be selective and focus on local currencies that mitigate inflationary pressures and haven’t already priced in too many rate hikes.