Financial Industry Insights from Advisors Asset Management


AAM Viewpoints – A Dive Into 2020 Fixed Income Markets & What They Tell Us For 2021

Fixed Income Market Review

The unfolding of diverse and largely unseen set of events in 2020 make it difficult to select only a few that we feel represent the tenor of the fixed income markets and the broad economy within this commentary. Clearly, the migration back into risk assets beginning in Q2 (the 2nd quarter) continued through Q4 2020 buttressed by what we think can be four primary causes:

  1. An accommodative Fed policy stance which reiterated the Federal Open Market Committee’s (FOMC) commitment to remain on the sidelines and provide liquidity support as needed
  2. Some resolution of election uncertainty surrounding Congressional and Presidential election outcomes
  3. Passage of the second COVID-19 relief bill
  4. Emergency use authorization of two COVID-19 vaccinations aimed at preventing the incidence and spread of the disease

ICE BAML 2020 Q4 & YTD Returns
Source: ICE BofAML Data Indices | Past performance is not indicative of future results.

While it is clear that some remnants of election uncertainty continued into the new year, confidence and risk appetite continued to grow throughout the final quarter of 2020. Fixed income market performance throughout the credit stack reflected the increasing appetite for risk and we feel sets the stage for continued improvement throughout 2021.

Fixed income markets discount the future and Q4 fixed income performance clearly implied that that 2021 economic activity is expected to improve. However, as we will see in the coming weeks, we believe it is likely that the U.S. economy experienced a second quarter of contraction in the final quarter of 2020 as reported new cases of COVID-19 began to escalate dramatically during the quarter. Some of the increase in reported cases is certainly due to expanded and quicker testing, but it is clearly unsettling to go from approximately 8 million reported cases on October 1 to over 16 million reported cases in early December. By December 1, the seven-day average of daily new cases had grown to over 200,000 per day from the 50,000 per day a short 60 days prior. This rampant rise in cases reported, and the accompanying increase in deaths, forced many areas of the country to limit activities and, in some cases, force local lockdowns to temper the quickening rate of spread. These lockdowns forced jobless claims to rise during the quarter and drove broad estimates of Q4 growth to -2.9%. After a whipsaw year, GDP growth estimates for the entire year will be lower than 2019 by approximately -3.7%.

broad index returns
Source: ICE BAML Data Indices | Past performance is note indicative of future results.

The broad turnaround in fixed income assets really proved to be one of the most notable stories of the year in fixed income. As the ICE BAML Composite Index above illustrates, in a year when volatility in U.S. Treasuries peaked at a level last seen just after the end of the 2007-2009 recession, each broad sector in the credit stack ended the year with positive returns. This is no small feat considering that by the end of Q1, when the broad ICE BAML Treasury Index returned +8.80%, the ICE BAML composite rated CCC Index was down -22.43% and the broad ICE BAML HY Index on the whole was down a -13.12%.

On a risk-adjusted basis, excess returns over U.S. Governments favoured Investment Grade (IG) credits and the BB-rated rung of High Yield (HY) in the stack. U.S. Treasuries finished the year within a whisker of where they finished Q1, but as the ICE BAML Composite Index benchmarks below illustrate, the recovery of risk assets did not just occur with shorter duration fixed income, but across longer duration assets as well. The combination of positive returns in the second half of the year and that these returns occurred across all duration spectrums of the stack illustrate that fixed income markets in Q4 continued to position for further economic improvement into 2021.

excess returns to governmentSource: ICE BAML Data Indices | Past performance is not indicative of future results.

Option-Adjust Spread (OAS) over an associated benchmark, usually a U.S. Treasury, is one measure of credit risk of a bond as investors are compensated through higher yields for additional credit risk. Over time, this spread to Treasury, OAS, reflects a varying level of compensation for credit risk depending largely upon the outlook for a firm and the outlook for the U.S. economy. Confidence reduces the spread and fear widens the spread on bonds.

option-adjusted spread as a percentage of YTWSource: BAML Data Indices | Past performance is note indicative of future results.

Measured as a percentage of yield, the flight from risk which occurred in Q1 2020 resulted in spread making up 75-95% of the yield on some bonds, a much higher component of yield than had been witnessed in some time. This blowout and the subsequent tightening of spreads provides additional insight into the risk appetite of the fixed income markets throughout the second half of 2020. Perhaps more importantly, this illustrates how the composition of investor’s risk appetites evolved first from finding value in composite-rated BBB credits to – as Q4 began and the election passed – searching for value in the upper rungs of HY. The expected outcome of this appetite for yield is that spreads will continue to compress over the breadth of the year and for those investors astute enough to search for relative value, this spread compression may be able to provide additional excess returns in the face of a steepening U.S. Yield Curve.

ICE BofA US High Yield Index OAS

According to the ICE BAML Composite, the robust Q4 appetite for risk drove Composite BBB spreads tighter from their peak of +171 in October to +130 by the end of the year, reducing the credit composition of yield to 63%, from a pandemic high of 86.49%. Most notable in Q4 was the rotation of investors back into the upper portions of HY as relative value in BBB’s continued to be eroded over the quarter. The ICE BAML BB Index Composite shows spreads tightening from their mid-October peak of +389 to +308 by end of the quarter as investors dipped their toes lower to find more value in a post-pandemic world. It seems unusual to say this, but the best returns for the year in the fixed income space were found at opposite ends of the ICE BAML Index credit stack: AAA and CCC or lower.

Economic Outlook, Inflation, and The FOMC

Continued FOMC statements, meeting minutes, and public discussion by FOMC officials emphasize the expectations of rates being lower for longer. While some of the fixed income markets are pricing in rate hikes as soon as late 2021, it seems that the FOMC is clearly focused on keeping the message that they will not hike rates too early this time. Perhaps most meaningful is the FOMC’s admission that the models they have been using since the 1970s may not adequately capture the disconnect between low levels of unemployment and inflation. Recall August’s Jackson Hole Virtual Conference in which Fed Chair Jerome Powell discussed specific policy changes geared to slowing the implementation of rate increases as inflation begins to rise. It is also abundantly clear that the FOMC wishes to avoid the same policy mistakes of 2018 in the future and feels that “average inflation targeting” is one of the right tools to do so.

FOMC participants assessment of appropriate monetary policySource: Federal Reserve

Clearly the fixed income markets and the FOMC can both suffer from a form of group think, but the FOMC has a history of lagging policy actions to what the fixed income markets forecast. The December 2020 dot-plot of the median Fed Funds Rate shows most participants think rates will stay lower at least through 2023. It appears that the FOMC not only believes that while growth may exceed long-run potential GDP in 2021 as a result simply of the comps, it does not feel that the corresponding increase in comparative inflation will be more than transitory. In other words, FOMC expectations are for slightly less than 2% inflation in 2021 and as the dot-plot shows above, that is not a level which appears to force the participants to considering rate increases until after 2023.

inflation zero coupon swap rates
Source: Bloomberg

Inflation has, however, been on the mind of market participants and since inflationary measures are reported on a year-over-year basis, the months of March through August will likely show inflation growing at a rate which may have normally driven the FOMC to raise rates in response. However, inflation levels for the first half of 2021 should be viewed as transitory simply because these measures are reported on year-over-year basis. As GDP fell by over 30% in Q2 the year-over-year inflation comparisons should be put into context.

It is longer-run non-transitory inflation, or more simply, inflation after the economy grows past the dip in economic activity of 2020 which is likely to move the FOMC from the sidelines. To determine what longer run inflation is expected, we can look to the U.S. Treasury yield curve constructed from the Forward Treasury Market. In general, Treasury markets discount economic expectations and inflationary expectations to determine yields adjusted according to these estimates. Some measures of expected inflation, such as the inflation swaps curve, show that pricing pressures are expected to increase and hover around the 2% level over the one- to seven-year timeframe. However, as the U.S. Forward Treasury Curve below indicates, these expected levels of inflation are not expected to propel the FOMC to raise rates much sooner than 2022 or 2023. History shows us that the U.S. Forward Treasury market is better at discounting economic activity than the FOMC. These respective outlooks are often at odds with one another and it is therefore notable that both the forward market and the FOMC outlook are consistent in their forecast of short-term rates over the next three years. In addition to the stated policy change announced in August, maybe this consistency with the forward market can provide confidence in the FOMC’s statements that they do not wish to raise rates too soon and repeat the mistakes of 2018 again.

u.s. forward treasury curvesSource: Bloomberg

The U.S. Spot Treasury Curve, above, and the earlier U.S. Forward Treasury Curve show that the curve is expected to steepen materially before the FOMC begins raising rates. With improving inflation expectations and improving prospects for growth, we continue to expect that intermediate to longer-run Treasuries will continue to discount improvement in future activity as they did in Q4. The Forward Treasury Curve illustrates that within one year we could see seven-year Treasuries above 1% while 10s rise to 1.30 and 30s to almost 2%. That steepening begins to improve three-year and five-year yields over a two- to three-year timeframe and, at this point, the FOMC may be prompted to step in and raise short-term rates as the vaccine recovery we expect to see in the first half of 2021 begins to manifest in broader economic growth beyond the shadow cast from the pandemic.

u.s. treasury yield curveSource: Federal Reserve

It is notable that one component of the recovery that all market participants are keeping an eye on is private business activity. While personal consumption consistently makes up approximately 68% of GDP and the rebound in consumption is expected to be robust and consistent with history, the long-run average contribution of private business activity to GDP is approximately 17.28%. However, as the graph above indicates, the two prior expansions witnessed business investment average 18.50%, while the most recent expansion from 2009-2020 saw business investment contribute just 16.80% of GDP. Business investment is the driver of improving productivity and while improvements in the labor market will aid in the improvement in wages, business investment provides an important foundation for improving the labor market in years to come. Given Chair Powell’s comments in the latter part of 2020 about the failure of the Main Street Lending Program, the Fed appears to have acknowledged that, as a banking regulator, they may have created a situation in which banks are reticent to lend as they do not wish to run afoul of capitalization and stress-testing requirements. To paraphrase what Chair Powell has said and draw a conclusion from the often massively confusing language, one possible solution is not to lower the Interest Paid on Excess Reserves (IOER) but perhaps improve the application of what may be overly cumbersome regulations or requirements to somehow allow banks to free up some of the capital that needs to get into the hands of small- and medium-sized businesses. We would expect the Federal Reserve to focus not only on how quickly labor market slack is removed from the economy but also how business investment recovers in the coming 18 months before moving to increase rates.

shares of GDP
 As the FOMC is clearly positioned on the sidelines for the near to intermediate term and the vaccine begins to reduce the sting of the acute pandemic-related economic crunch, the U.S. economy has the potential to continue to recover from the current recession and possibly approach an average 2.25% annual growth rate for 2021. An improving economy leads to tightening spreads and gaining careful allocation to credits or sectors which can take advantage of this cyclical tightening may allow investors to pick up performance above their benchmark. These record-low yields, however, are accompanied by record-high duration levels and the risk which duration poses for rising rates should be first and foremost in an investor’s mind. We feel that spread duration can add value, but interest rate duration should be kept well in hand. As we witnessed in Q4 2018 and in Q1 2020, when a flight to quality appears, it can violently affect non-U.S. Treasury returns. Careful credit selection and duration management may help temper the effects of these events should they, and when they, appear again.

CRN: 2020-0111-8837 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit


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