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Diversification into low-duration credit strategies

Diversification into low-duration credit strategies

04-02-2021 | Vision
The economic fall-out from the Covid-19 pandemic and the subsequent unprecedented monetary support by global central banks have led to a dramatic compression of global bond yields. These lower bond yields are the result of lower spreads as well as historically low risk-free rates. As we approach the end of the year, and following the strong performance of risky assets, investors may be reassessing their asset allocation.
  • Victor  Verberk
    Victor
    Verberk
    CIO Fixed Income and Sustainability
  • Reinout Schapers
    Reinout
    Schapers
    Director Emerging & Global Credit
  • Fixed income investors are faced with low interest rates and therefore low bond yields
  • With the arrival of a vaccine and reopening of economies in 2021, the risk of rising interest rates will increase
  • Investors can reduce interest rate risks by diversifying into low-duration, high-quality credit strategies  
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Government and corporate bonds have delivered high single-digit or even double-digit total returns this year. Fixed income investors are now faced with lower yields on their fixed income portfolios, while the duration for government bonds and credits has increased; the latter is due to corporates and governments extending the maturity of their issues due to the historically low coupons at which they could issue. This is illustrated in Figure 1, showing that the average duration of the US credit market has increased to 8.8 years. Fixed income investors are having to consider the impact of a potential rise in bond yields on their investments.

Figure 1 | US Credit – duration vs yield

Source: Robeco, Bloomberg. Data end of October 2020.

Arrival of vaccine will shape market conditions in 2021

Vaccines in focus for each scenario

In their latest one-year outlook entitled ‘Tackling the Trilemma’, our Multi-Assets team state the view that market conditions in 2021 will be shaped by two factors: the timeliness and effectiveness of a vaccine, and how the so-called ‘New Normal’ unfolds. Vaccine effectiveness will be a function of the efficacy rate, safety profile and distribution success, as well as the willingness to be vaccinated. How this new normal looks will also influence the nature and level of economic activity, inflation and interest rates. 

In their base case scenario, their view is that disinflationary pressures will gradually disappear in the course of 2021. This is on the assumption that a Covid-19 vaccine becomes available in the first half of 2021, but that there will a slower pace in the distribution of the vaccine and a gradual return to a ‘New Normal’. 

In their bull case scenario, multiple effective vaccines will arrive early in 2021 and distribution of these vaccines is dealt with effectively, resulting in a quicker return to a ‘New Normal’. The economy will show a strong rebound and core inflation will start to improve more notably as output gaps become less negative. 

Only in a bear case scenario, where vaccine approval experiences setbacks and a vaccine only becomes broadly available at the end of 2021, could the economy take another hit. In this scenario, disinflationary pressures intensify. However as two successful vaccines have already been submitted for approval to the European Medicines Agency and the US Food and Drug Administration (‘FDA’), the probability that this scenario will unfold is decreasing.

Bond market implications vary

Government bond yields, especially in the US, will gradually increase in the base case scenario. This is in the context of the Fed aiming for an asymmetrical inflation target, leaving room to make up for below-target inflation. In a bull case scenario, reflation-like inflation expectations move substantially higher, which puts upward pressure on government bond yields.  

Credit spreads will tighten in both the case base and bull scenario. In the bull scenario, investors also face higher bond yields, which puts a cap on the performance of longer-dated credits.

In a bear scenario, investment grade spreads will widen, but the downside is capped by lower bond yields and increased bond buying by central banks. 

The latter does not apply to high yield, which does not have the support of central bank purchases. In a bear scenario, high yield credit will endure a rise in defaults and widening of credit spreads. Only in a bull case scenario with strong earnings growth will there be meaningful upside for high yield.

Diversify into lower-duration strategies

Given the above scenarios and the potential for a rise in bond yields in 2021, investors could consider diversifying into low-duration, high-quality global credit strategies to reduce the interest rate sensitivity of their portfolio, while avoiding low-quality, high-duration investments that are more sensitive to an expected rise in defaults. 

Robeco offers three low-duration global credit solutions that allow investors to reduce the interest rate sensitivity of their investments. These will also enable them to continue benefiting from the valuation opportunities in global credit markets. 

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