Morgan Stanley
  • Investment Management
  • Feb 1, 2021

2021 Bond Market Outlook: Finding Yield in a Recovery

As global economic growth strengthens this year, bonds investors may find opportunities in high quality bonds, higher-yielding debt and assets that hedge against a declining U.S. dollar.

As fixed income investors, we expect 2021 to be a year of recovery. Many economic forecasts show U.S. GDP increasing by as much as 5%, or even 6%, and it begs the question: Won’t bond market yields rise in this environment? Rising yields of course mean falling bond prices—at least on paper for investors who own the debt. But yields will be rising for good reasons, based on economic growth and cash flow returning to markets.

Bond market movements will act as key indicators of the health of the recovery, as well as corporate performance and consumer confidence in 2021 and beyond. Compared to 2020, when global monetary and fiscal policies were focused on supporting solvency and bond investors benefitted from flocking to safe-haven assets, such as U.S. Treasuries, this year may entail a more idiosyncratic environment for credit, which will make active portfolio management paramount.

As economic growth strengthens (most likely in inverse proportion to the severity of the pandemic this year) and variation in the fixed-income market broadens, so will the opportunities for bond allocators. For investors searching for higher yields and portfolio diversification to hedge against equities and U.S. dollar weakness, we see fixed income opportunities in five key areas.

1. High Quality Fixed Income

We see value in taking a tactical barbell investing approach, which involves owning high quality and interest-rate sensitive fixed income to balance more risky credit. During the first half of 2021, investors can consider adding U.S. Treasuries and Australian and New Zealand government bonds amid an expected increase in yields. When it comes to investment grade corporate credit, we have some aversion to highly-rated bonds, including A-rated corporates with high cash balances because there’s risk that M&A activity in this cohort could weigh on valuations. We prefer a combination of triple-B corporate bonds with solid company fundamentals and U.S. Treasuries as a preferred risk allocation, as an example.

2. Lower-Quality High-Yield Bonds

As vaccinations and fiscal support help the economy restart, some industries, beaten down because of vanishing revenue streams during COVID-19, could recover quite substantially. Last year, investors in higher-quality portion of the U.S. high-yield bond market—such as double-B rated bonds—performed well, while allocators to lower-quality tranches did poorly. This outcome wasn’t surprising: Securities with stronger credit ratings tend to recover first after market dislocations. This year, in a recovery scenario, and as some investors become more comfortable taking additional risk, we could see a rotation into lower-quality single-B- and triple-C-rated bonds, which may start to outperform.

3. Securitized Assets

Bonds backed by financial assets, such as residential mortgages, credit-card loans or auto loans, may also offer attractive yields. Recovery for these types of asset-backed securities has lagged behind the broader market because of investor concerns about consumer solvency in 2020. As sentiment improves, securitized assets can offer higher yields at relatively low prices. As the economy rebounds, the personal savings rate may rise and help keep consumer credit relatively strong. Investors could even consider moving down a little in the credit quality of securitized assets, similar to a rotation into lower-rated high-yield bonds.

4. Emerging Market Debt

Economic recovery in emerging markets has lagged that of developed markets, which may make emerging-market bonds more attractive, amid expectations of a global economic rebound. As the Federal Reserve continues to purchase government securities and corporate bonds, while holding its key interest rates near zero, the value of the dollar is expected to decline against other major reserve currencies, such as the euro or yen. Indeed, late last year the International Monetary Fund estimated that the dollar may be overvalued by 15%-20%. Investors might consider increasing their weighting in emerging-market corporate debt and currencies via carry trades, i.e., borrow in a low-yielding currency and invest in higher-yielding emerging-market assets, and profit from the difference.

5. Convertible Bonds

One of the reasons we like convertible bonds, which yield interest payments and can be converted into equity shares at a predefined later date, is for their diversification, in addition to potential returns in 2021. When you invest in credit, you take on risk that the borrower may fail to repay the debt or its interest. Convertible bonds can offset some of that volatility and provide investors with more options in a fast-changing environment. The asset class proved strong in 2020 and may continue to do well this year.