Elections and the Bond Market

By

Kathy Jones

Senior Vice President, Chief Fixed Income Strategist, Schwab Center for Financial Research

Kathy Jones heads up the Fixed Income and Currency strategy group at the Schwab Center for Financial Research, where she is responsible for Schwab’s point of view on the markets and investor education. Jones has covered global bond, foreign currency and commodity markets extensively throughout her career as an investment analyst and strategist, working with both institutional and retail clients.  

Kathy Jones heads up the Fixed Income and Currency strategy group at the Schwab Center for Financial Research, where she is responsible for Schwab’s point of view on the markets and investor education. Jones has covered global bond, foreign currency and commodity markets extensively throughout her career as an investment analyst and strategist, working with both institutional and retail clients.  

Prior to joining Schwab in 2011, Jones was a Fixed Income strategist at Morgan Stanley where she specialized in global-macro strategy covering domestic and international bonds and foreign exchange. She has also been a consultant in the alternative investment area and was previously Executive Vice President of the Debt Capital Markets division of Prudential Securities.

Jones received her undergraduate degree with honors in English literature from Northwestern University and her MBA in finance from Northwestern University’s Kellogg Graduate School of Management.

She makes regular broadcast appearances on CNBC, Bloomberg TV, Yahoo Finance and NPR.  She is often quoted in the financial news media including The Wall Street Journal, The New York Times, Bloomberg, Reuters and USA Today.

November 03, 2020
Bond Insights Our views on trends in the fixed income market. Information on this site is for general informational purposes only and should not be considered individualized recommendations or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market, economic and geo-political conditions. (1014-6726)Our views on trends in the fixed income market.#000000 Market Commentary Timely takes on markets and the economy. Information on this site is for general informational purposes only and should not be considered individualized recommendations or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market, economic and geo-political conditions. (1014-6726)Timely takes on markets and the economy. Election 2020 How politics and policy could affect investors Important Disclosures The policy analysis provided by the Charles Schwab & Co., Inc., does not constitute and should not be interpreted as an endorsement of any political party. Information on this site is for general informational purposes only and should not be considered individualized recommendations or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market, economic and geo-political conditions. (0920-050L) How politics and policy could affect investors ffffff0920-050L

Elections and the Bond Market

Now that Election Day is here, many investors are wondering what the outcome will mean for the bond market. There are many major policy decisions that will influence the outlook—trade, energy, taxes and budget deficits, and pandemic relief. However, it’s difficult to assess how these issues will be addressed post-election, and even more unpredictable how the market will react.

Consequently, we would avoid making any major changes to fixed income portfolios based on the elections, but we will be keeping a close eye on the fiscal stimulus talks because those have the potential to have the biggest influence on the bond market. In general, we believe it’s likely that some sort of fiscal aid package will be passed after the election, but the size, timing and specifics are up in the air. To some extent, the upward trend in long-term bond yields over the past few months and steeper yield curve suggest that the market has already begun to price in some improvement in the economy during 2021.

Treasury yields are lower, but the curve is steeper

Source: Bloomberg, data as of 10/27/2020 and 10/28/2019. Past performance is no guarantee of future results.

 

Instead of focusing too closely on the uncertainties ahead, we suggest focusing on the factors that we can assess with some certainty. Federal Reserve policy is one of those factors. The Fed has indicated very clearly that it a) will keep its policy rate near zero until inflation rises and/or the unemployment rate returns to pre-pandemic levels; b) has put in place programs and facilities to help support markets; and c) is planning to continue its bond-buying program.

With the Fed anchoring the federal funds rate near zero and expanding its balance sheet, our view is that interest rates are likely to remain lower for longer. There may be a modest rise in 10-year Treasury yields toward the 1% region on the back of a fiscal stimulus package, but it will likely be limited by ongoing low inflation and Fed policies.

Look for coupon income—cautiously

With yields near zero or negative in many markets and likely to remain that way for at least a few years, bonds with higher coupons may become more attractive. We suggest investors focus on earning current coupon income while protecting against unexpected risks, such as another downturn in the economy or inflation. Coupon payments can provide a degree of certain income, barring a default.

Highly rated investment-grade corporate and municipal bonds with lower risk of default or downgrade should fare better in an uncertain economy than riskier bonds with below-investment-grade ratings. Some exposure to high-yield corporate bonds may be appropriate for a small allocation, but we would suggest avoiding the lowest-rated bonds within the high-yield market. To date, bonds rated BB and higher have performed much better than lower-rated bonds, a trend we believe is likely to continue.

Higher-rated high-yield bonds have outperformed

Source: Bloomberg. Cumulative total returns from 12/31/2019 through 10/22/2020. Returns assume reinvestment of interest and capital gains. Indices represented are the “BB”, “B”, and “CCC” sub-indexes of the Bloomberg Barclays U.S. Corporate High-Yield Bond Index and the Bloomberg Barclays U.S. High Yield Fallen Angel 3% Capped Index. Past performance is no guarantee of future results.

 

Similarly, in the municipal bond market, we favor keeping the bulk of a portfolio in bonds rated AA or higher. The elections could result in policies that aid lower-rated bonds, but we don’t believe it’s wise to speculate on how policy may evolve for lower-rated issuers. On the surface, higher tax rates should be supportive to municipal bond prices, but tax policy proposals made on the campaign trail are often changed when the legislation is drawn. Taxable municipal bonds might also be attractive for some investors because the average credit quality tends to be higher than in the corporate bond market, while yields are similar.

For investors with a higher risk tolerance, an allocation to emerging-market bonds and preferred securities can help increase current income and potential returns. However, we would limit the amount allocated to these more aggressive asset classes to no more than 20% of an overall portfolio.

Stay adaptable

While we believe our “up in credit quality” strategy should help reduce volatility for investors, there is still potential for unexpected negative surprises. We can’t entirely eliminate risk, but we can take steps to mitigate risks ranging from the potential for a double-dip recession to surging inflation. Our view is that it makes sense to hold some Treasuries to mitigate the risk of an economic downturn or steep drop in stock prices and also some Treasury Inflation-Protected Securities (TIPS) to hedge the risk of inflation.

In sum, the elections are likely to create short-term volatility, but we suggest trying to ignore the noise. We’re staying focused on the Federal Reserve because it has such a major influence on the bond market, and looking for opportunities to generate income while mitigating risk. When times are uncertain, holding a broadly diversified portfolio can be one of the smartest strategies for investors.