Franklin Templeton Fixed Income

Portfolio Construction Sector Views

Our fundamental research allows us to dive deep into sectors and provide a uniquely comprehensive outlook for the quarter.

As of March 31, 2021

Overall Risk Outlook—Neutral Reason for Optimism

Risk sentiment improved in dramatic fashion during the first quarter of 2021 as focus quickly shifted from concerns about the COVID-19 pandemic after a winter resurgence to the potential for a broad global economic recovery fueled by accelerating vaccine campaigns and staggering amounts of additional fiscal stimulus. In the United States, the rapid decline in coronavirus infections and the rapid pace of vaccinations has allowed a number of states to begin considering reopening their economies. Other countries around the world have also made important inroads against the virus, contributing to confidence that a global recovery will gradually take hold. Though progress is still uneven. Europe in particular still lags behind in its vaccination efforts, and several major EU countries have launched a new round of lockdowns (e.g., France, Germany, Italy) that will delay the recovery. The United Kingdom has moved fast on vaccinations but has nonetheless decided to maintain tight restrictions until the summer. Even in these cases, however, the expectation is that both infection rates and business activity will improve considerably in the second half of the year.

Multiple

Arrows represent any change since the last quarter-end.
The sector settings reflect our six-to-twelve month outlook on each asset class.

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US Treasuries

Moderately Bearish

US Treasuries

At the end of last year, 10-year US Treasury (UST) yields stood at 0.91% and the expectation implied by market pricing was for yields to reach a mere 1.12% by year-end 2021. As expectations rose for the passage of a third unprecedented stimulus package and vaccination campaigns accelerated and paved the way for a broad reopening of the economy, growth estimates were revised up sharply and strengthening reflation expectations led to a material repricing of yields. The 10-year UST note yield rose quickly and breached 1.75% by mid-March, the highest level since January 2020, before the full impact of the coronavirus pandemic on the global economy was realized. Despite increasing concerns regarding financial stability and a sharp rise in inflation expectations, a very accommodative US Federal Reserve (Fed) continues to signal that it will keep policy rates anchored at the effective lower bound and maintain its policy of extraordinary monetary support until the economy has fully recovered, jobs and wage gains have extended to disadvantaged categories, and inflation has been running in a sustained way above its 2% target. With the Fed allowing the economy to run hot to compensate for past periods of muted inflation, markets have been forced to revise their pricing for year-end and now expect 10-year yields to rise above 1.80%. We believe investors should be prepared to see year-end rates exceed even these revised projections, and despite the recent rise in long-term yields and the subsequent bear steepening of the yield curve, we remain cautious on the duration outlook and have downgraded our view on Treasuries to moderately bearish.

US Treasury Inflation-Protected Securities (TIPS)

Neutral Reason for Optimism

US Treasury Inflation-Protected Securities (TIPS)

Since the beginning of the year, we have seen break-even (BE) inflation rates increase rapidly in the US Treasury Inflation-Protected Securities (TIPS) market, especially those in the intermediate portion of the yield curve, taking five-year BE rates to the highest level since 2008. It is our belief that the combination of unprecedented fiscal stimulus, a very accommodative Fed, and an economy poised to rebound as vaccination campaigns pave the way for reopening businesses may have a more sustained impact on inflation dynamics. Supply-side disruptions and the global recovery have already pushed up commodity prices, from oil to copper to steel, as well as a variety of other input prices, from semiconductors and electronic components to corrugated boxes. The Fed has repeatedly stated it will maintain the current course of very accommodative monetary policy until it determines that the economy has moved back to full employment and that inflation has settled above their 2% inflation target in a durable manner. Although we still see substantial slack in the labor market, the unemployment rate has already dropped quite quickly, and job openings remain high (at around 2017–2018 levels). We have already seen consumers’ estimates of future inflation rise substantially, partly due to higher gasoline prices and grocery costs. In our view, central bankers might be underestimating how difficult it will be to deal with increased levels of inflation, especially if inflation expectations become unmoored, and we therefore maintain a modestly positive view of the asset class. Despite the significant increase in inflation expectations and BE rates, BE rates may continue to rise over the next year, and we remain neutral with reasons for optimism on the sector. We continue to pay close attention to duration exposure, as TIPS have the dual consideration of BE rates and duration changes which may affect performance.

Eurozone Government Bonds

Neutral Reason for Optimism

Eurozone Government Bonds

European bond markets fell sharply to start 2021 as investors became more concerned about the potentially inflationary effects of a strong worldwide economic recovery and renewed interest in the reflation trade led to yields and real interest rates rising across the region. Against this backdrop, benchmark 10-year German Bund and French OAT yields rose considerably to levels not seen since last June. With the notable rise in long-term yields threatening to thwart any recovery from the region’s double-dip recession, the European Central Bank (ECB) indicated concerns about the risk of tighter financing conditions and ramped up its emergency bond purchases. In this type of environment, we believe the ECB will remain highly accommodative and will continue its asset purchasing programme, which has flooded the market with liquidity. Nonetheless, we believe it will be some time before Europe returns to pre-pandemic levels of economic activity and, as a result, do not forecast interest rates rising in the eurozone for at least five years. For comparison purposes, Europe took over a decade to revert to pre-crisis output levels after the global financial crisis (GFC). Renewed restrictions in much of the euro area following a spike in new COVID-19 cases, which are likely to be extended into the summer, and a problematic rollout of vaccine campaigns are further delaying an economic rebound. Fiscal policy in the region is likely to provide sustained support to economic growth and allow countries to maintain more expansionary policy measures. Political developments also bode well for stability in the euro area, in particular the formation of a new government in Italy under former ECB Chair Mario Draghi that is pushing for reforms at both the European and Italian levels. We believe there will be more centralization of control, which will help Europe become much more investible for the global audience and allow for additional large EU issuance of pan-European debt. In addition, we believe the chances of durable inflation in the eurozone remains very low. Overall, we are constructive on European bond markets and continue to favor a longer duration profile and see new potential opportunities within the market based on mispricing of rate-hike expectations. While benchmark European government bonds will likely offer limited return potential, we continue to believe there are other pockets of opportunity in the periphery which should continue to be well-supported.

Japanese Government Bonds

Neutral

Japanese Government Bonds

Growth in Japan is projected to contract in the first quarter of 2021, after rebounding strongly during the second half of 2020, due to January’s state of emergency declaration which depressed economic activity and consumer spending. Despite the slowdown, the 10-year Japanese government bond (JGB) yield rose to 0.16% in February, the highest level since October 2018, in alignment with sovereign bond yields worldwide on expectations of a broad global economic recovery. The Bank of Japan (BoJ) left interest rates unchanged during its March meeting and maintained the target for the 10-year JGB at around 0%, as widely expected, but introduced yield-curve control flexibility by widening the tolerable band for fluctuations in 10-year JGB yields to around ± 25 basis points (bps) from the target level (from ± 20 bps since July 2018 and ± 10 bps when first introduced in September 2016). The central bank also introduced “fixed-rate purchase operations for consecutive days” which will allow it to purchase unlimited amounts of JGBs to cap increases in yields and noted no intention to seek to steepen the yield curve. The BoJ also reemphasized its commitment to support the economy with additional stimulus if needed by introducing a new “Interest Scheme to Promote Lending,” which would offer lending incentives that would increase if policy rates were cut, signaling to the market that it would ease monetary policy if required despite already being deep in negative territory. As inflation has remained negative in recent months despite significant and sustained fiscal and monetary stimulus since last April, we do not expect interest rate hikes for the next several years. Given this backdrop and the upward pressure on yields in other government bond markets, JGBs have become relatively more attractive as the BoJ continues to anchor long-term yields close to its target and we maintain a neutral view.

Agency MortgageBacked Securities (MBS)

Neutral Reason for Concern

Agency Mortgage-Backed Securities (MBS)

The relatively low level of yields at the start of the year left approximately 80% of the mortgage universe 50 bps “in-the- money” to refinance their mortgage loans. After the selloff in rates, the percentage of borrowers with an incentive to refinance has declined substantially, to approximately 60% of the agency MBS universe, which is supportive of the sector.20 However, despite mortgage rates reverting to their nine-month highs, refinance applications have remained stubbornly high, and we believe prepayments should remain elevated over the next three to six months. The Fed continues to purchase US$40 billion/month of agency MBS, now owning approximately 30% of the overall agency market, which we expect to continue through the rest of the year at a reduced pace as prepayments decrease. As prepayments begin to slow down in the medium term, we expect the runoff from the Federal Reserve’s portfolio to reduce, which could lead to widening of spreads from their current tight levels. Also, as the economy normalizes, talk related to tapering of quantitative easing purchases could lead to further widening of spreads. The involvement of the Fed in the market should keep spreads somewhat range-bound, though, as well as benefit the lower coupons and their associated mortgage dollar rolls with positive carry. Given the prepayment risks in the near term, combined with spreads tighter than their 10-year averages, we believe that spreads need to be wider than their current levels to compensate for the risks in the asset class. We continue to prefer 30-year securities over 15-year securities, generally favor conventional 30-year and conventional 15-year securities prepayment characteristics over Ginnie Mae (GNMA) 30-year securities and are biased slightly up in coupon with an overweight in the 2.5% and 4.5% coupons given the recent selloff in rates.

Non-Agency Residential Mortgage-Backed Securities (RMBS)

Neutral Reason for Optimism

Non-Agency Residential Mortgage-Backed Securities (RMBS)

Fundamentally, housing remains strong and housing activity firm. In February, on a year-over-year (Y/Y) basis, existing home sales decreased 6.6%, new home sales increased 8.2% Y/Y and mortgage applications increased 9.8%. The Federal Housing Finance Agency (FHFA) Purchase-Only and S&P CoreLogic Case-Shiller Home Price national indices (both seasonally adjusted) gained 11.4% and 10.4% for the calendar year 2020.21 Based on our home price appreciation (HPA) model, we now forecast HPA of 4.3% through December 2021. In comparison to the GFC, even if the 2.7 million properties that are currently under forbearance were to enter the inventory of existing homes as foreclosed properties, the net supply would be about half of what was experienced at peak supply during 2007–2008, when home prices depreciated by 30%. The significant move in rates may eventually impact housing affordability and could negatively impact HPA, as well as translate into slower prepayment speeds which can slow structure deleveraging. Both factors are modestly credit negative. Overall spreads in various RMBS sectors have largely recovered from their March 2020 wides, but early fixed severity deals which do not contain natural disaster language have continued to lag. We favor RMBS holdings with significant locked-in home equity, where slower prepays due to lock out and higher rates should allay negative convexity concerns and boost returns for premium priced securities. Despite headwinds in the market, we still expect select non-agency RMBS to provide consistent risk-adjusted returns and are neutral on the sector.

Commercial Mortgage-Backed Securities (CMBS)

Bearish

Commercial Mortgage-Backed Securities (CMBS)

Fundamentals in the commercial real estate (CRE) sector continue to be challenged. Net operating income (NOI) growth turned negative in the fourth quarter (4Q) 2020, the first time 4Q NOI growth has been negative since 2010.22 Vacancies were also elevated in the hotel, retail and office sectors, and demand remains tepid. Stricter implementation of lockdowns from potential virus variants, a lack of direct support to CRE sponsors and a decline in non-discretionary spending may continue to impact certain property types, such as retail and hotels. Approximately $2.3 trillion of CRE mortgage loans will mature over the next five years and any dislocation in valuations or worsening fundamentals could result in higher delinquencies. CMBS conduit delinquencies (30+ days), at 7%, already are reaching elevated levels. However, appraisal-based property prices have increased in 2020 due to low transaction volume, with stronger performing sectors like industrial and multifamily rebounding close to pre-crisis levels.23 A record amount of investors targeting attractive CRE investment may also potentially act as a backstop for valuations. Looking forward, we believe certain geographies which are characterized by lower taxes, enjoy higher than average population growth and are attractive destinations for tech companies will see higher growth in commercial property prices. From a sectoral standpoint, industrial, multifamily and Class A office are likely to outperform other property types. Valuations in the CMBS market have moved in a direction largely looking through any of the current and future issues ailing the sector, with AAA last cashflow (LCF) spreads over swaps reaching their post-GFC tights. Given current valuations, we do not favor below-AAA exposure, and in AAA LCFs we prefer deals with lower exposure to hotel and retail sectors. Overall, we continue to believe downside risks outweigh upside potential at these levels and maintain a bearish outlook on CMBS.

Asset-Backed Securities (ABS)

Neutral

Asset-Backed Securities (ABS)

The ABS market remains relatively insulated from rate moves as the bulk of ABS paper is concentrated in the very short end of the yield curve and spreads remain at recent record tight levels, consistent with broader credit markets. Total household debt increased by US$206 billion (up 1.4% quarter over quarter (Q/Q) and up 4.4% year over (Y/Y) in the fourth quarter, driven by growth in mortgage debt. On a Y/Y basis, non-housing balances were down 0.7%, driven by an 11.7% decline in credit card debt, partly offset by increases in auto and student loan balances (up 3.2% and 3.1%, respectively).24 Additional stimulus will be a definitive positive for consumer performance for 2021. While secondary spreads for a variety of ABS sectors are trading near or at multi-year tight levels, we expect these sectors to have relatively stable spreads and continue to believe sectors trading wider than pre-crisis levels could experience spread tightening as the economy rebounds. Although likely with additional volatility, travel-related sectors such as aircraft and containers stand to be the main beneficiaries. With the credit curve relatively flat we continue to prefer up in the capital structure and avoidance of floating rate deals without clear LIBOR fallback language. While fundamentals have shown signs of deterioration in below-prime borrowers, this has yet to have a material impact on bond cash flows, and ABS continues to offer incremental yield pickup over Treasuries. We remain neutral on consumer ABS overall and favor three-year and in AAA fixed rate benchmark issuers.

US Investment-Grade Corporates

Neutral

US Investment-Grade Corporates

US IG corporate bonds continue to benefit from strong demand as investors look to the asset class as a relatively safe source of yield. Corporate fundamentals have broadly stabilized or improved since the depths of the COVID-19 downturn, although recovery in some sectors remains slow. Corporate leverage remains at elevated levels, but earnings growth should enable a rebound in credit metrics across most of the IG credit universe over the coming quarters. However, we are closely monitoring how issuers choose to deploy excess liquidity and whether they utilize free cash flow to repair their balance sheets. Credit spreads have rallied significantly and are at or below their pre-crisis levels, and are approaching the lowest levels since the 2008–2009 global financial crisis, reflecting a very supportive economic and risk outlook for the remainder of 2021. We expect demand to remain generally strong, with yield-oriented investors increasing allocations as yields rise and foreign investment to continue given the prevalence of low or negative yields in many regions. However, we would expect some caution due to possible further total return losses stemming from rising longer-term UST rates. We believe that the medium-term risk environment remains generally positive, helped by strong growth prospects, supportive fiscal and monetary policy, and a visible path toward containment of COVID-19 cases as we go through 2021. There remains some uncertainty about the US political climate and potential US regulatory and tax policy changes that may impact corporate borrowers. While we have a constructive medium-term view, we believe the market has embraced a best-case recovery scenario; spreads have already discounted most positive economic developments and are now fairly valued at best. Our base case calls for flattish spreads over the remainder of the coming year, with arguably more downside than upside risk, especially in the case of a disorderly move higher in rates or a faster than anticipated tapering of Fed policy. We are neutral on the sector given tighter valuations, but remain generally comfortable with fundamentals and market technicals. We favor select intermediate bonds, including BBB rated issuers, while taking advantage of new issues or any market dislocations to add exposure.

European Investment-Grade Corporates

Neutral Reason for Optimism

European Investment-Grade Corporates

European IG corporate fundamentals should improve after deteriorating since the last quarter of 2020 due to renewed lockdowns in European countries, as sales and earnings bounce back. While the outlook from management teams has been rather encouraging, they remain cautious for the time being. It will take time to see the positive impact of the vaccine rollout on the economic recovery, and we expect companies will remain conservative in keeping excess cash available on the balance sheet and focusing on deleveraging by further cutting costs to protect margins and/or selling assets. Merger & acquisition activity and shareholder distributions could increase, though, jeopardizing credit metrics. European fiscal authorities have extended their supportive measures, such as furlough schemes and state guarantees, until the end of the third quarter and the ECB’s Pandemic Emergency Purchase Programme (PEPP) remains in place until March 2022. The ECB’s sponsorship was strong in 2020, purchasing large amounts of Euro IG corporate bonds through the PEPP and the Corporate Sector Purchase Programme (CSPP), which supported spreads. However, recent ECB purchases have declined, implying a lack of interest for the euro IG market. The most significant threat to spreads would be a taper or a halt of the ECB’s corporate bond purchases, but we feel this is unlikely in the foreseeable future. If spreads were to widen abruptly, we expect the ECB to support the market by increasing its purchases. Low yields have been an issue for the euro IG asset class, mostly due to a large part of the market trading at negative yields. We view higher rates as healthy, making euro IG more attractive, in particular short and intermediate maturities. However, if rates volatility rises, spreads will widen, which should represent a buying opportunity for investors looking for quality yield when rates stabilize. We remain neutral on the sector with reasons for optimism, based on improving fundamentals and still supportive technicals. We continue to favor non-financials over financials, due to improving fundamentals and large cash positions on the balance sheet. In our view, ECB eligible credits will supply some risk-off protection, as these securities should outperform in volatile market conditions.

US High-Yield Corporates

Moderately Bullish

US High-Yield Corporates

Given an improving macroeconomic outlook from accelerating vaccine distribution and the passage of an additional large-scale fiscal stimulus package, we believe US HY corporate bonds stand to benefit and remain constructive on the asset class. Credit fundamentals should start improving meaningfully by the second quarter of 2021 as the precipitous lockdown-related drops of the corresponding year-ago quarter are cycled and fiscal stimulus kicks in while life starts to normalize as vaccination rates climb substantially. Default rates should continue to fall from an October peak in excess of 6% toward 2% during the second half of 2021, where they are likely to stay through at least 2022 as wide-open capital markets have allowed many troubled issuers to build up liquidity buffers and push out maturities. While increases in US Treasury (UST) yields could lead to bouts of volatility, we believe there is room for further spread compression to absorb a relatively orderly rise in rates given that spreads remain materially wide of historical and post-GFC tights across ratings tiers. History has shown that spreads can remain at lows for extended periods of time, and we believe current conditions are conducive to such an outcome. Having said that, we believe credit selection will be more important than ever in 2021 given that the flood of money into the asset class over the past year has led to some mispricing of risk at the issuer level.

Euro High-Yield Corporates

Neutral

Euro High-Yield Corporates

Despite negative developments regarding the COVID-19 pandemic and increasing concerns about rising global interest rates, EHY corporate spreads have continued to tighten in the first quarter of 2021. Although a quick rise in the long-term interest rates may cause some sector reallocation, we ultimately believe such volatility could be beneficial for dedicated EHY investors as the more speculative buyers exit the market and we would therefore use volatility as a buying opportunity to increase exposure. While the vaccine campaign has helped keep market volatility somewhat muted, EHY spreads continue to benefit from an everlasting technical bid for euro-denominated higher-yielding assets. Although not as high as forecasted in April/May of last year (>8% default expectations), EHY default rates have increased to a 10-year high at year-end 2020.25 Going forward, we expect the number of defaults to decline during the next 12 months but, equally, we expect recoveries to come down due to a lower level of support from shareholders, banks and governments. In the context of historically low spreads and yields, we believe a cautious stance is due and retain our neutral recommendation on the sector. From a tail-risk standpoint, we believe the major risk will continue to be the containment of COVID-19 rather than increasing global bond yields. While companies and consumers have learnt how to deal with current mobility restrictions, high leverage multiples, increasing operating expenses and lower government and shareholder support will test the capital structure of the weakest issuers if growth comes below expectations. We remain cautious with regard to directly exposed COVID-19 sectors, as Europe continues to lag in its vaccination rollout, and we believe current credit spreads discount a rather optimistic scenario with regard to the recovery. In our view, the manufacturing sector that, for large part, has thrived during the pandemic may experience challenges, including margin pressure, over the next year caused by increasing supply chain disruptions, lack of shipping space to Asia, and higher commodity prices. We favor callable bonds offering a positive yield, select BB exposure to longer duration bonds following recent underperformance, and remain neutral on GBP-denominated high yield securities.

Floating Rate Loans

Moderately Bullish

Floating Rate Loans

Since the beginning of 2021, floating-rate bank loans have continued to build on the positive momentum they saw toward the end of last year. Spreads have been tightening and we believe the asset class is in the early stages of a rates-driven technical recovery and share fundamental tailwinds with other credit sectors. After suffering from heavy outflows in 2020, investor interest in the sector has rapidly improved starting in December in response to rising US Treasury (UST) yields and increasing concerns regarding the potential for inflation. We expect robust inflows into the loan market as capital activity has historically been strongly correlated with upward moves in 10-year UST yields. Demand from collateralized loan obligations (CLOs) has also bolstered support for loan prices, as new CLO volume has exceeded the pace from last year. Fundamentals have been slowly but steadily recovering from the unprecedented declines in revenue and cash flow that followed the Q2 2020 shutdowns, albeit still not to pre-COVID-19 levels in most cases. We expect these improving trends to continue through the remainder of 2021. Despite sequential improvement in EBITDA, leverage has continued to increase in many sub-sectors, but going forward we expect an inflection in leverage starting in first quarter 2021 as companies face easier year-prior comparables. The floating-rate bank loan market showed more resiliency than many expected, with defaults peaking at 4.5% by par amount in November despite the global economic shutdown before ending January 2021 at 4.1%, providing increased comfort to investors in the asset class.26 We expect defaults to continue to decline on improving fundamentals and technicals, and gradual improvement in corporate fundamentals will allow issuers to service debt and maintain adequate liquidity as well as help issuers to extend maturities and/or raise incremental capital to extend liquidity runways. With this favorable technical and fundamental backdrop, we expect continued spread tightening and are finding opportunities to add exposure to attractive credits and industries that are better positioned to benefit from the broader economic recovery. We have upgraded our outlook to moderately bullish but stress that current market conditions in no way suggest an indiscriminate buying of the broader loan index; security selection remains of paramount importance with a focus on capital structures, liquidity profiles, upcoming maturities and the sustainability of business models in a post-COVID-19 world. We favor B-rated loans and selectively adding exposure to COVID-19-impacted sectors that have lagged the broader recovery but are expected to accelerate as the economic rebound progresses.

Collateralized Loan Obligations (CLOs)

Neutral Reason for Optimism

Collateralized Loan Obligations (CLOs)

Collateralized loan obligations (CLOs) lagged the initial recovery in other credit sectors post-crisis but have had strong performance through the end of last year and into 2021. Primary market activity has been robust in both the US and Europe with structures having reverted to the longer reinvestment periods typical pre-crisis and new issue spreads nearing all-time tights in both markets. Secondary spreads for all investment-grade tranches have also fully recovered to their pre-crisis levels as well, although they remain above the all-time tights reached in first quarter of 2018. With the significant improvement in market sentiment, CLO assets continue to trade up along with the broader move in the loan market and the amount of distressed and lower priced loans is now lower than it was pre-crisis. With upgrades exceeding downgrades, we anticipate this improvement will continue to flow through to ratings-driven metrics, which have been somewhat slower to improve and tend to lag in an improving economy. This strong performance has brought a level of comfort back to AAA investors, and demand has been strong, outstripping supply, pushing new issue AAA spreads tighter. We remain constructive on the CLO sector and favor those at the top of the ratings stack (AAA/AA/A/BBB), which remain attractive given the expected increase in rates and its relative value versus other high-quality alternatives. However, with spreads not far off their all-time tights, the likelihood for further spread compression is diminished, particularly in the United States. In the new issue market, we favor CLOs with longer non-call periods, which have more potential to trade above par as spreads tighten. In the secondary market, while difficult to source, we have a preference for CLOs trading at a discount and would look to add on weakness in the market.

Emerging Market Debt

Moderately Bullish

Emerging Market Debt

After EM debt posted one of the strongest quarters in recent times in the fourth quarter of 2020 on the back of positive vaccine news and a decisive US presidential election, in the first two months of 2021, hard-currency EM debt has recorded its worst start to the year in over twenty years on a total return basis. Local-currency EM debt performed similarly but has experienced far worse starts in the past. This weakness is, however, almost entirely due to the significant upward move in USTs since the beginning of the year and the asset class’s high sensitivity to core rates. EM debt has seen only modest spread widening accompanying the rise in benchmark rates, but the latter has raised concerns of a possible repeat of the 2013 “Taper Tantrum.” But, in contrast to 2013, the largest issuers’ external positions now are healthier and the pandemic has, in many cases, led to stronger current account balances. Government finances have mostly weakened, but the largest increases in government debt have occurred in countries that can rely on their local markets for funding, such as Brazil and South Africa. Countries with the most concerning government debt statistics tend to be small, and risk for further contagion is therefore limited. Throughout 2020, EM debt fundamentals weakened as a consequence of the COVID-19 crisis. However, given the stronger economic outlook for the global economy and the reflationary benefits this will bring in terms of balance sheet repair for most EM countries, we retain our positive outlook for the asset class and are moderately bullish. For those countries that are unable to adjust quickly enough to the changing landscape, we continue to expect strong multilateral support but are wary of the potential for programs such as the G20 Common Framework to create frictions for bondholders. We continue to believe that borrowing across EM sovereigns will be orderly and self-regulating, having passed the 2020 stress test in funding. Strong technical conditions for the asset class in 2020 came from the inflow of funds from investors seeking to enhance yields versus low or negative home market interest rates. As developed market government yields rise, perhaps the greatest risk to the EM sector is that the marginal investor will no longer need to utilize EM debt to meet yield requirements and will therefore divert funds from the sector. For now, we are still comfortable that developed market interest rates will remain at levels where EM assets continue to be relatively more attractive.

Emerging Market Corporates

Moderately Bullish

Emerging Market Corporates

The COVID-19 crisis has once again demonstrated the relative resilience of EM corporate debt. Last year, the EM corporate high-yield default rate peaked well below the US default rate, and recoveries were substantially higher. We believe that this is best explained by a combination of EM corporate sector mix, sovereign support and a healthier starting point in terms of credit fundamentals. Having deteriorated in the first half of 2020, EM corporate credit fundamentals rebounded in the second half of the year, reflecting stronger EBITDA and cash generation against a backdrop of appreciating commodity prices and improving global aggregate demand. Net leverage ticked up over the year but remains manageable at around 2.0×, and well below the United States on a rating-adjusted basis. This trend of improving fundamentals gives us confidence that the EM corporate high yield default rate will moderate from the year-end 2020 level of 5.0% toward 3.0%.27 The primary market was busy for the majority of last year—in contrast to the EM sovereign world—and we expect this to remain the case in 2021 as corporates look to refinance existing debt and term out their maturity profiles. The demand for new issuance in external markets has been insatiable, with issuers able to attract large order books for bonds that price on the cusp of fair value. The key risks that we see for EM corporate bonds going forward are situated at the macro and geopolitical level. Capital outflows similar to the “Taper Tantrum” of 2013 pose a risk, but with short-end rates anchored, ample liquidity assured and EM current account balances in surplus, we do not expect material outflows from the asset class. Indeed, global liquidity conditions continue to encourage a hunt for yield that will benefit those fixed income assets that offer an attractive spread pick up for their risk. While the sharp steepening of the UST yield curve has been a drag on performance in 2021, this has been largely offset by a further tightening of spreads which has left the yield to worst of the index only modestly above its five-year low. However, EM corporates continue to look appealing from a relative value basis as the spread pick up over US corporates is visible in each ratings bucket, and in the higher quality end of the spectrum this spread pick up comes with a substantially lower duration, which helps to reduce volatility. We retain a positive view on EM corporates as an asset class whose short duration and spread cushion makes it well-placed to absorb the current bout of UST volatility and ultimately post a positive return over the next 12 months, and we remain moderately bullish.

Municipal Bonds

Neutral Reason for Optimism

Municipal Bonds

The municipal (muni) bond market kicked off 2021 with a very similar tone to 2020. Feverish technical conditions pushed investment-grade (IG) yields to their generational lows and inflows in the first quarter of 2021 were four times higher than historical norms. Ratios of muni bond versus UST yields set record lows with the 10-year AAA ratio reaching 54% and the 30-year AAA ratio hitting 68% during February 2021 after averaging 97% and 105%, respectively, over the past 10 years. However, as UST yields moved higher funds flows turned negative, putting some selling pressure on the market and leading to modestly higher ratios. Despite the recent correction of the muni market, we believe the supply/ demand technical support for the market, with limited supply of tax-exempt bonds, will be the primary directional force in the municipal market and will support valuations for the foreseeable future. Increasing household wealth, strong credit quality, state and federal tax advantages and lower historical volatility will continue to attract investors and keep demand elevated. Fundamentals have also improved during 2021. Projected deficits for many muni issuers have been lower than initially projected as strong consumer spending improved tax receipts. Additionally, the American Rescue Plan passed in March contained US$350 billion to support state and local governments. However, for the first time in six years municipal bond rating downgrades exceeded upgrades with five times the dollar amount downgraded vs. upgraded. While it is reasonable to expect the downgrade/upgrade balance to remain biased toward the downside, we do not expect any meaningful changes to bankruptcies in 2021 given the pre-crisis strength of most issuers, the speed of budget recovery in 2020 and favorable federal policies. We remain neutral with optimism for the tax-exempt market and believe it still has value for investors that can take advantage of the tax-exemption. The taxable muni bond sector has followed a somewhat similar path with strong demand and low supply, but unlike tax-exempt muni bonds, have much higher sensitivity to interest rate movements and have seen a contraction of taxable muni spreads with the recent rise in UST yields. We continue to believe taxable muni bonds offer value to investors seeking high income and a strong credit profile while simultaneously participating in mild spread tightening. Our approach to muni-bond credit remains cautious and we are biased toward the upper end of the high-grade municipal bond universe but see selective spread opportunities in the lower high-grade market.