Zero Interest Rate Policy (ZIRP) – Get Used to It

Matt Toms

Matt Toms, CFA

Chief Investment Officer, Fixed Income

There are still opportunities to prepare portfolios today for the low-yield world ahead—we see the most value in select areas of the CMBS market.

Last month, we discussed changes to the Federal Open Market Committee’s (FOMC) monetary policy framework. These changes mean accommodation likely will last longer into recovery cycles than was previously the norm. Other central banks across the globe are likely to maintain the same ultra-dovish path laid out by the FOMC in September, including the European Central Bank and Bank of Japan, whose economies also are grappling with structural deflationary headwinds. Although breakeven inflation rates have risen recently, they remain at or below pre-pandemic levels, even after some of the most aggressive government intervention in history.

What we saw throughout the last cycle is that central bank action alone may not be sufficient to pull inflation higher. As Federal Reserve Chairman Jerome Powell has repeatedly implied, fiscal stimulus is necessary to sustain the recovery and elevate inflation to the Fed’s target. Largely positive 3Q20 economic data have shown the buoying effect of initial, aggressive policy actions to counter COVID-related shutdowns; however, the fiscal medicine is wearing off and leading indicators – such as initial jobless claims, building permits and consumer sentiment – show that the recovery is starting to waver.

The scope and scale of additional fiscal stimulus is still uncertain. However, one item of the recovery has been clear from the beginning of the pandemic: The Federal Reserve will continue to do what it can to foster a vigorous revival of growth. Get used to ZIRP — it’s going to be with us for a long time.

While the fixed income markets have staged a dramatic recovery since April, there are still opportunities to prepare portfolios today for the low-yield world ahead. As we highlighted last month, we see the U.S. economy shifting into a "K-shaped" recovery. The resulting uneven pressures will create winners and losers with broad strokes across the fixed income spectrum. Longer term, in an income starved world that has experienced historic re-leveraging in corporate credit, we continue to favor securitized credit over corporate credit. Drilling into securitized credit, we are finding the most attractive long-term opportunities in the CMBS sub-sector, which has yet to see the “V” shaped recovery of other fixed income segments. Risk has clearly increased in CMBS, but 6+ months into the pandemic, fundamental impacts are much clearer while market efficiency is not—this is creating opportunities to prepare portfolios for the low-yield world ahead.

Rates, Spreads and Yields
Rates, Spreads and Yields

As of September 30, 2020. Past performance is no guarantee of future results. Source: Bloomberg, Bloomberg/Barclays, JP Morgan and Voya.

Bond Market Outlook

Global Rates: policy rates stay low, ten-year U.S. Treasury yield ranges between 0.50–1.00%

Global Currencies: U.S. dollar trends weaker against DM, EM currencies

Investment Grade: cautious on spreads in near term amid election uncertainties, look to add high quality issuers on weakness

High Yield: valuations look more attractive, especially among higher-quality spreads, and may present reasonable entry points for incremental yield

Securitized: steady Fed and bank purchases support mortgage markets as the current refinancing wave gets priced in

Emerging Markets: uneven recovery across markets leads to select opportunities, outpacing U.S. growth

Sector Outlooks

Global Rates and Currencies

Reflation optimism has suffered a temporary setback with stalled stimulus in the United States, an upward glide path for U.S. election uncertainty and another round of virus concerns in Europe. Consequently, the upward move in breakevens has stalled out. While these recent macro developments will serve as sources of near-term distraction, the outlook for the U.S. dollar and the reflation trade remain important to the bigger picture. Negative real rates still provide a constructive longer-term underpinning for risky assets, but negative real rates are not sufficient to prevent risk-off occurrences.

Monetary policy evolution took a step forward with the Federal Reserve shifting definitively towards average inflation targeting. Despite the dovish shift, the Fed and the European Central Bank left markets wanting with, at least for now, a status quo in asset purchases. Without sustained inflationary pressures, we expect the 10-year U.S. Treasury rate to remain in the 0.50–1.00% range.

The ECB is monitoring the strength of the euro given the potential threat to its inflation objective, but it did not state that it has a target level to trigger additional easing action. EU CPI data have been noisy, but we believe the noise will fade, leaving inflation still tame.

Investment Grade (IG) Corporates

IG spreads sold off in September as risk markets began to price in uncertainty around the election and the FOMC meeting disappointed some investors. Spreads widened 8 basis points (bp) in the last week of the month; heavier than expected supply added to spread widening. Fed purchases continued at a slow pace, even during the sell-off, but remain an important backstop for the IG bond market. Improvement in global macroeconomic data should be supportive of risk assets. Low interest rates pressure demand among yield-based buyers, but U.S. rates are still attractive to foreign investors. In our view, aggregate IG credit fundamentals are generally supportive of current valuations. Downgrade risk has diminished, and we may not experience the worst case fallen angel scenarios. Current spreads around 136 bp are slightly more attractive. We remain cautious to start October, but would use further widening as an opportunity to add to IG risk.

High Yield Corporates

The super-heavy new issuance calendar, combined with a few macroeconomic ripples, finally caused the HY market to blow off a little steam in September. CCC-rated bonds outperformed while BB-rated issues were the laggards, reflecting the higher-quality bias of new issuance. The November elections could cause additional turbulence, and questions loom about the trajectory of economic recovery as the coronavirus flares up around the globe; but through a longer lens, additional clarity on these uncertainties could stoke a rally from current levels. The reset triggered by the sell-off has the market looking more attractive, especially certain spreads in the higher quality space. With the Fed committed to keeping rates very low for a very long time, we think the pullback presents a reasonable entry point to pick up incremental yield.

Securitized Assets

Performance of agency residential mortgage-backed securities (RMBS) was mixed in September, starting with a lackluster tone, then bouncing back after the Fed reaffirmed its dovish stance on policy rates and asset purchase programs. We expect the prolonged low-rate environment to drive mortgage rates lower. We foresee a continuing collapse of the primary/secondary spread by as much as 25 bp, possibly extending the refinancing wave into 2021. Nonetheless, the market will be supported by a steady Fed and bank demand as the current refinancing wave gets priced into the market. Monthly carry profile should remain attractive; long-term value will surface outside Fed purchases, but that may take several months.

Non-agency RMBS performance remained positive for September with spread tightening across the legacy, credit risk transfer (CRT) and 2.0 tranches. Relative value remains and the sector should benefit with stabilized supply/demand technical factors and pricing that reflects more risk of loss than appears likely to be realized. Housing markets are firmly in expansion mode, a unique beneficiary of the pandemic. We retain our positive tactical outlook for non-agency RMBS as low rates, an expanding housing market and still attractive relative value should support the asset class.

We maintain our positive tactical outlook for commercial mortgagebacked securities (CMBS), as we expect more relative-value driven catch-up in spreads for the beleaguered sector. CMBS remain cheap on a relative and historical basis, owing to fallout from the economic shutdown, continued slowness in “contact” parts of the economy and idiosyncratic risk in commercial real estate. Longer-term CMBS performance is inextricably linked to the normalization of the retail and travel/leisure parts of the economy, but near term the sector should continue to benefit from improved sentiment, liquidity and relative value perceptions in the market.

Asset-backed securities (ABS) have led the recovery for securitized credit, with some benchmark subsectors completely retracing the sell-off while other, higher spread subsectors still have room to tighten. The key drivers (TALF, primarily) are firmly in place and have been augmented by the global economy reopening. The rally has spread, both outward in terms of sub-sectors and downward in terms of the capital structure of ABS deals. While upside may be limited for certain higher quality segments of the ABS market, we expect the sector to remain well bid overall, even into a potentially rough pre-election run-up.

Emerging Market (EM) Debt

We expect emerging-market growth to outpace U.S. growth, but recovery will be uneven across markets, leading to select opportunities. Asia is likely to lead, with China outperforming, while Latin America lags because of limited fiscal policy maneuverability. Valuations look decent, with spreads repricing as market participants await the outcome of U.S. elections. EM corporates are showing resiliency despite pressures from lingering pandemic lockdowns; potential impacts of partial lockdowns from a second COVID wave may test markets. Sustained developed market (DM) and EM quantitative easing (QE), and investors’ hunt for yield, continue to support EM credit. While EM fiscal and debt trajectories remain a concern, lower overall financing costs and quantitative easing remain supportive.

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Past performance does not guarantee future results. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions, and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.