What happened with the Bond Markets in Q1 2021?

What happened with the Bond Markets in Q1 2021?


The first quarter of 2021 has been eventful with an unexpected hike of the US Treasury yields. Here, we review what happened and share our outlook on the bond market and the strategy to adopted in our portfolios.


US Market Overview

Since the breakout of covid-19, there has been a fall in the US Fed Fund rate from 1.75% to 0.25%. Followed by the fall in Fed Fund rate, the 10-year Treasury yield has reached a level below 1%. At the same time, the low Fed Fund rate has spiked up the yield of both investment grade and high yield corporate bonds.


US 10 Year Treasury Yield - Source: Bloomberg


But why the US Treasury Yields spiked that much? With the rollout of covid-19 vaccination programme, the market had gained more strength and the US Treasury yield spurred to above 1% at the beginning of 2021. The introduction of the “American Rescue Plan” that worth USD 1.9tn and other potential fiscal policies has stimulated the market further, the positive outlook to the U.S. economy induced a rapid surge in the US 10-year Treasury yield from 0.93% to a high 1.74% in 2021 Q1. Meanwhile, the Fed Fund rate remained invariant at 0.25%. The strong and fast recovery combined with a huge recovery package from the US government induced an inflation fear. In that sense, investors feared that Chairman of the Fed J. Powell might tightened financing conditions to avoid an overheating economy.

Also, the huge increase of the breakeven inflation rate in Q1 2021 translated this fear. The breakeven inflation rate rose during all Q1 2021 and is now at 2.4102% (April-28 2021) from around 2% in January 2021.


US 10 Year Breakeven Inflation Rate - Source: Bloomberg


The yields hike resulted in a massive sell-off in US Treasuries, which had a global impact on the market price of bonds. Affected by the yields hike, the corporate bonds were impacted negatively overall. The Investment Grade segment was the most severly damaged because of its longer duration and the speed of the yield hike.


Iboxx USD Liquid Investment Grade Index - Source: Bloomberg


Beyond the rise in yields it was more the speed of the rise than the rise itself that affected the market; the sell-off was brutal. New issues from the Investment Grade market (not only in the US) were not performing overall because of the brutal yield surge and the lack of adjustments in offered yield from these new issues. Investment Grade bonds have longer duration due to the low coupon rate and yields at issuance. This convexity helped them to nosedive.

The High Yield segment was also impacted but still outperformed the Investment Grade bonds in terms of returns. Major equity indexes rose to all-time-highs in Q1 2021 and continued at this pace in April. In the end of April, the S&P 500 index gained more and reached new all-time-highs sticking in the 4180-4190 area. It is known that High Yields bonds have a higher correlation to equity than other Fixed Income securities such as Investment Grade bonds. Also, High Yield bonds offer by nature higher yields than Investment Grade bonds due to their riskier profile. These two elements explain why investors were seeking to invest more into High Yield bonds than Investment Grade; investors were looking for higher returns, and shorter durations.


Iboxx USD Liquid High Yield Index - Source: Bloomberg


Nevertheless, as shown on the previous chart and mentioned earlier we can see that High Yield bonds were not spared. High Yield bonds are still bonds and remain exposed to the interest rates risk. But some new issues performed well even in the middle of these troubled times for the Bond Markets, investors had to be cautious when it came to pick securities on the primary market for their portfolios.  In the end of March, the High Yield segment started to perform well again.


Fed Fund rate Outlook

JP. Morgan mentionned that there would be a rise in Fed Fund target rate if the economy recover too quickly and inflation continues to rise. Under this situation, the demand for fixed income securities would fall, causing market yields to rise and a price drop in the existing bonds. Projections from Morgan Stanley suggested that the Fed Fund rate will rise from 0.25% in Dec 2022, to 1% in Dec 2025. But till Dec 2022, the Fed Fund rate will remain in the similar level. Meanwhile, Morgan Stanley predicted a similar result, that the Fed Fund rate will increase by 0.5% in 2024. The consensus of the projection is that, there will soon be an increase in the Fed Fund rate, however it could happen anytime from late 2022 to 2025.

The projections implied that under current circumstances, banks are expecting the global economy to recover anytime from Dec 2022 to 2025. The performance of global economy still remains gloomy.


European situation

Similarly, the European market is also gloomy. For long the European Central Bank has been using negative interest rate as one of their tools to stimulate the markets beside its Quantitative Easing program. The sudden fall in Eonia at the end of March imply that in short term, the market requires more stimulator to recover in the Covid-19 pandemic. The higher the negative interest rate, the higher the cost for banks to hold cash in hand. That would encourage banks to provide loans to the businesses, and hence, keep the money in the economy and stimulate the economic growth.


EONIA - Source : https://www.euribor-rates.eu/en/eonia


In Europe sovereign yield increased too. Nevertheless, this rise in yields was not as strong as in the US. Indeed, the inflation risk in Europe is far less concerning. The European Union has yet to unlock the full potential of the funds allocated to the EU members and the recovery appears to be slower than in the US.


10Y yield for UK, France, Germany, Italy - Source: Bloomberg


The U.K. sub-zero interest rate

The U.K. interest rate remain in sub-zero interest rate, ending at 0.1% in Q1 2021. Andrew Bailey, the governor of the Bank of England, commented on the U.K. interest rate. It is suggested that if the market does not see a sustainable 2% inflation rate, the interest rate in the U.K. would not rise. Also, if the recovery does not meet the expectation, there is a possibility to face negative interest rate as mentioned by the BoE.

However, the market no longer expects the negative interest rate in the U.K. as investors started to expect economic growth and expecting a rise in the U.K. interest rates. Bailey commented that the Bank of England has a stronger forecast comparing to the previous one.


MAC Asset Management Strategy

Our dynamic strategy and flexible management of our portfolios allow us to be more effective regarding risk management. Indeed, we are able to adapt in real time our portfolios regarding the market’s evolutions. When the interest rates rose in Q1 2021 in the US and in Europe we directly reduced our exposure through convexity adjustments. We were closely monitoring the situation and picking only newly issued bonds with huge interest from market participants and with yields high enough to reflect the new risk premium. Sometimes it was a little tricky about selecting the right bonds at the right moment. Indeed, many bonds were issued with yields not in phase with the market expectations.


Benefit from this strategy

To benefit from this strategy in your investments, you can freely subscribe to our UCITS1 Fund started on January 04, 2021 or contact us for advisory and discretionary mandates services.

A UCITS Fund like ours offers a strict regulatory framework in terms of transparency as well as protection of capital and clients. The strategy analyzes the economic environment as a whole, identifies and adjudicates market opportunities on primary and secondary market with the aim of generating absolute performance uncorrelated from the markets.

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For more information, do not hesitate to visit the dedicated page or to contact us directly.

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Image source : https://unsplash.com/photos/eBWzFKahEaU - Dmitry Demidko