COVID-19 case growth dominated news flow at the start of the year but encouragingly, rapid vaccine discovery and the start of immunizations has helped lift sentiment into year-end. Virus spread is expected to slow growth over the winter months before economic recoveries re-accelerate in the spring as mass immunizations allow the job-rich services sector to recover. Added growth supportive factors include accommodative macro policies and limited evidence of permanent economic scarring. This cyclical uplift is expected to support search-for-yield motives and risk sentiment in 2021.
As credit spreads further compress, management of credit risks and ESG factors that can present material downside risks will become increasingly essential. Investors should be mindful of lower quality and less cyclical portions of the credit market that may not benefit from growth improvements.
Approval of Pfizer and Moderna vaccines and the roll out of vaccine inoculations in late November and December buoyed the markets.
Hopes of a vaccine-driven economic rebound were dampened by concerns over a new coronavirus strain in the UK, new lockdowns, and trade talks between the UK and European Union.
The new year 2021 is starting with low policy rates, low government bond yields, and low fixed income spreads.
The markets continue strong after the finalization of the US
residential, US House and US Senate election results, and passage of the $900 billion fiscal stimulus package. All of these events are favorable for the markets in spite of last week’s dramatic events.
The Biden Administration has nominated Janet Yellen as Secretary of Treasury. If approved, coordination between the Fed and Treasury should continue to work cooperatively.
The US Congress passed a spending bill on September 30 to keep the government funded through December 11,2020.
A $900 billion coronavirus stimulus bill was signed into law, averting a government shutdown. The $2.3 trillion package included a $1.4 trillion government spending bill to fund federal agencies through September 2021.
The bill is tallied at $900 billion consisting of $325 billion in small business aid, an extension of federal unemployment benefit programs with an additional $300 per week and lastly $600 per person stimulus payments.
Congress had been in a protracted stalemate over state and local government support, corporate liability protections, enhanced unemployment benefits and infrastructure projects.
The Federal Reserve continued its quantitative easing (QE) program by purchasing $80 billion in Treasuries and $40 billion in agency MBS monthly. In 2021 the central bank efforts, QE and purchase programs focused on supporting and stabilizing credit market liquidity is expected to continue.
The Federal Reserve adopted an average inflation targeting (AIT) policy at the September 16, 2020 FOMC meeting. The Fed would seek inflation that averages 2% overtime and permit inflation to be higher than 2% until full employment is attained. The FOMC expects to keep rates low through the end of 2023.
While the FOMC upgraded its economic outlook, most participants expect a flat Federal Funds rate through 2023, reflecting the high hurdle for a rebound. The Fed did not extend the average maturity of its Treasury purchases at the central bank meeting. It provided forward guidance stating that it will continue to increase its asset holdings at the current pace until the FOMC has met its maximum employment and price stability goals.
The Fed is reluctant to raise interest rates as the US Treasury is financing the high national debt levels. Lower rates for longer will enable it to keep the interest debt payments low. The Fed is expected to keep rates low from 2020-2023. The Fed has continued to re-affirm that it would keep rates low and its willingness to let inflation increase above 2% for an unspecified period of time.
Fed Chair Powell has continued to state that negative interest rate policies (NIRP) are being considered. Experience of other central banks shows that negative interest rates have not helped stimulate growth in Europe and Japan. Negative rates create challenges for banks’ profitability, reduces lending, adversely impacts money market funds and the Fed.
Fed policy is expected to continue unchanged with the Biden Administration. Fed Chair Powell and other Fed governors have stated their intent to continue an accommodative monetary policy.
Money Market Facilities
In late November 2020 US Treasury Secretary Mnuchin announced that he would not extend the emergency liquidity facilities that were implemented in March-April 2020 beyond December 31, 2020. The Main Street Lending Program, Municipal Liquidity Facility, Primary Market Corporate Credit Facility (PMCCF), Secondary Market Corporate Credit Facility, and Term Asset-Backed Securities Loan Facility. This decision by the outgoing Treasury Secretary was met with strong objections from the Federal Reserve Chair who stated those facilities were necessary to ensure market stability and economic recovery. It is expected that the incoming Biden Administration will re-instate those facilities.
Under PMCCF, the Fed has authority to purchase investment grade corporate bonds (minimum BBB-rated) with maturities up to five years and corporate bond exchange traded funds. This provides liquidity but has kept yields low.
Labor market data reflected the impact of renewed business restrictions in response to a surge of infections, as initial jobless claims remained elevated and rose to 885,000 for the week ended December 12, 2020. The December ADP employment data showed a contraction of 123,000 jobs which represents the first sign of negative growth since April 2020. Over 20 million people continue to receive unemployment benefits. US jobless claims rose to 965,000 in the first week of January, 2021.
The airline rescue package expired September 30, 2020 and airlines started to furlough 32,000 employees in October. Other corporations announced substantial job cuts during 4Q2020. Layoffs were no longer only impacting hourly workers but also higher income employees in administrative and management positions in the private and public sector.
More layoffs are becoming permanent job losses which poses rising risk to the economy. The unemployment rate expected to range from 7%-9% may be higher if job losses continue in 1Q2021.
Recovery has slowed as only 245,000 jobs were added in November. Permanent job losses peaked in September at 3.76 million but remains high at 3.74 million.
Economic data reported in December were mixed, as rising COVID-19 cases and renewed lockdowns in some states led to weaker-than-expected retail sales.
November retail sales fell -1.1% and core retail sales fell -0.5% month-over-month which were weaker than expected.
The ISM manufacturing index rose to 60.7 in December compared to 55.4 in September. The Sentiment Index is above 50 which indicates an expansion.
New home sales and University of Michigan sentiment were favorable. The housing market has benefited from limited supply, pent-up demand and low mortgage rates that increased affordability. House appreciation is expected to continue to rise through 2021.
The Federal Reserve decided on October 4, 2020 to bar major US banks from share buy backs and cap dividends of US large banks through year-end 2020. Banks impacted are JP Morgan Chase, Citigroup, Wells Fargo and Bank of America. The intent is to ensure that banks with over $100 billion in assets and control a significant lending market share are sufficiently capitalized to handle any further economic downturn. The banking sector in the US is expected to withstand credit deterioration.
Over 30 banks will be restricted including large foreign banks operating in the US. In June, the Fed limited payouts after completing pandemic scenario stress tests on the banks. Banks cannot pay higher dividends than paid in 2Q2020. Overall, the US banking sector is expected to withstand credit deterioration.
Money Market Funds
The lack of a stimulus package combined with no corresponding increase in T-bill supply resulted in government money market yields staying low and compressed.
LIBOR an SOFR
LIBOR will be discontinued by year-end 2021 and will be replaced by SOFR. The stability and success of the Secured Overnight Financing Rate’s (SOFR) matters to the Fed. If the SOFR moves close to zero, the Fed may take action to raise that rate.
The proposed extension of the cessation date of certain USD LIBOR tenors from year-end 2021 to the end of June 2023 bodes well for legacy asset classes that lack adequate transition language
Tax rates are at an all-time low and the federal deficit is at a 10-year peak. Above average economic growth may enable the US to grow out of its high debt levels.
Treasury yields closed higher across longer-dated maturities and the curve steepened, as optimism over the start of the vaccine rollout pushed the 10-year as high as 1.54% on February 25, 2021, the highest level since March 2020. The 10-year has since eased slightly, closing at 1.45% on March 1, 2020.
Longer-dated yields rose on expectations of increased fiscal spending and higher inflation.
There was record corporate bond issuance in 2020. Favorable financing conditions and ongoing appetite for risk means that the primary issue market posted one of the best years to date for corporate bond issuance. Investment grade corporate issuers took advantage of the low yield environment in 2020, with gross new issuance volumes in the US reaching a record $1.95 trillion. New issuance is estimated to be $1.3 trillion of which $115 billion is expected in January 2021. This is expected to level off from the record high except to finance M & A transactions.
New issue volume for 2021 is expected to be lower because much of the corporate bond refinancing occurred in 2020.
Real yields (yield minus inflation rate) for US investment grade corporate credit turned negative. The US now joins the European market in having negative real yields. Inflation is expected to remain modest because of the weak economic and labor market conditions.
In 1Q2020 and 2Q2020 there were record numbers of investment grade bonds that were downgraded to below investment grade making those companies “Fallen Angels”. Approximately $151 billion in bonds across 27 issuers became “Fallen Angels” with high yield bonds. An additional $81 billion were downgraded to below investment grade in the second half of 2020.
The increase in “Fallen Angels” in the high yield market actually improved the average quality of the US High Yield market, with the share of BB-rated bonds rising from 46% of the index to 55%.
With the high demand for income generating bonds, even “junk bond” issuers or high yield-rated companies in sectors highly exposed to COVID-19 disruptions were able to issue corporate bonds at low rates. This new issuance activity provided cash for corporate balance sheets and the ability to survive the pandemic recession. Hospitality names and cruise ship companies were able to raise cash through bond offerings.
Asset Backed Securities
The ABS primary market finished with light issuance in December of only $4 billion. The ABS primary market finished 2020 with $200 billion of total issuance (down from $247 billion in 2019).
Auto ABS issuance made up more than half of all ABS issuance with $104 billion of new deals in 2020.
Credit spreads for AAA Credit Card and Auto ABS remained narrow which sustains good market values. The Fed’s Term Asset-Backed Securities Lending Facility (TALF) provided attractive financing terms for many AAA-rated ABS classes. This facility expired on 12/31/2020 but is expected to be renewed by the new Congress and Treasury Secretary in 2021.
Agency mortgage-backed securities, namely, GNMA MBS underperformed other GSE FNMA securities in 2020 which was due to reduced demand by banks for high quality liquid assets following record deposit growth.
Agency mortgage-backed securities (MBS) underperformed other securitized sectors, and lower-coupon MBS outperformed higher-coupon MBS largely due to higher demand from the Fed. The FOMC meeting minutes indicated that the Fed will continue to purchase agency MBS.
Mortgage-backed securities experienced increased prepayments from refinancing and heavy origination as mortgage rates remain low.
The Fed is continuing to purchase up to $40 billion per month of MBS. Domestic banks also drove strong demand, purchasing low coupon new issue MBS.
The Fed is reinvesting paydowns by buying additional MBS. The Fed is purchasing new origination RMBS with 2%-2.5% coupons. The 30-year mortgage rates are 2.9%-3.2%.
Commercial Mortgage-Backed Securities
Initially, the COVID-19 pandemic hit the Commercial Mortgage-Backed Securities (CMBS) market hard. Conduit CMBS are backed by a diversified pool of commercial real estate loans across an array of property types. This diversification reduces overall risk to any single sub-sector of the market.
CMBS that held higher concentrations of office buildings, shopping malls and other commercial real estate properties impacted by the COVID-19 shutdowns were under price pressure.
Senior tranches with well-collateralized securities fared well. There have been a few ratings downgrades during 2020 to some of the subordinated tranches of the CMBS sector.
The senior tranches of CMBS performed well during 4Q2020 due to limited supply factors. Only $61.6 billion CMBS were issued in 2020 which is a decline of 45% from 2019 issue levels.