After yesterday night’s presidential debate it’s clear that it is necessary to think strategically in order to monetize on volatility amid the US election. We have carefully analyzed three scenarios: a Trump win, a Biden win and a contested election. Within this framework, we identify threats and opportunities within the fixed income market.
Yield curve: bull flattener in the short-term; bear steepener in the long-term
In the Biden scenario, we expect a moderate flight to safety in the short-term that will push yields further down from where they are now. We believe that as the market underestimates inflation risk, there is space for interest rates to get as close to zero as the market adjusts for a democratic White House. Volatility will originate because a Biden win will be perceived as an adverse outcome for the credit market due to higher corporate taxes and more stringent regulations. Still, such a scenario will not necessarily be harmful to the corporate world as there will always be plenty of support from the Fed, stimulating the economy.
On top of that, we can expect the overall public spending to rise, implicitly benefitting the corporate world as individuals start to spend money. It is critical to understand that a bull flattener yield curve will be just a momentaneous reaction to the election. A Biden win implies that on the long term we will see higher overall interest rates. An increase in public spending means that there will be further pressure in the economy that will exacerbate inflation. Once inflation is rising, it will be unstoppable for the very reason that the political arena will be reluctant to withdraw aid from American families. Hence, in the long run, we will see the yield curve steepening sharply as inflation rises.
Credit negative - green bond focus
In the short-term, we can expect long-dated high-grade corporates to benefit from post-election volatility. We anticipate long-term maturities FAANG bonds to experience the most significant upside, especially in light of the continuous presence of COVID-19. Among various issuances, we believe that Apple with maturity August 2060 (US037833EA41) and Amazon with maturity June 2050 (US023135BT22) offering a yield of around 2.5% each, can tighten amid a Biden win. Both bonds are paying approximately 100bps over the Treasuries.
For those looking for higher returns, there are many long term-bonds in the investment-grade space that deserve attention. FedEx 2065 (US31428XBD75) offers around 4% in yield or approximately 260bps over the Treasuries. If we keep looking in the lower-rated IG space, we will find General Motors 2043 (US37045VAF76) which offers a yield close to 5%.
It is important to note that we see benefits in bonds with these characteristics only as "election trade" and the holding period should not be longer than the end of the year. Indeed, after the boost produced by a Biden victory we don't see upside holding ultra-long bonds. As a matter of facts, we expect inflation to rise and to provoke a sensible repricing in the bond market, led but longer maturities.
In the long-run, we believe that mid-term high-grade corporates will provide bondholders with safe assets and stable returns. However, inflation risk poses a severe threat to this segment, mainly because the average yield offered by these bonds is close to 1%. Hence, when looking at this space, it is vital to look for higher yields or seek protection against inflation. Among investment-grade mid-term US corporates, we have identified General Motor 2028 (US37045VAS97), Micron Technology 2029 (US595112BN22) and British American Tobacco 2027 (US05526DBB01) to provide yields well above 2%.
When looking at lower-rated investment-grade corporate bonds, it is essential to acknowledge that this segment will prove to be volatile. A lot of these companies are facing the risk of a rating downgrade as their credit outlook deteriorates following a massive debt issuance binge.
The real protagonist of a Biden win, however, will be green bonds. Green bonds are fixed-income instruments designed to finance a specific climate-related or environment project. Clean energy and environment have been areas completely neglected during Trump's presidency, but are at the core of Biden's campaign.
Green bonds will benefit significantly from a democratic White House, mainly because demand will continue to rise, but supply will remain limited. If you want to learn more about green bonds, you can find our analysis here. If you are looking for an inspirational list of green bonds, you can find it here.
Yield curve: bear steepener.
A Trump victory will be viewed as a credit positive. We can expect the republican president to continue with more of what we have seen in the past few years: tax cuts, deregulation and fiscal budget expansion. This perception will push investors towards riskier assets as they try to get some extra yield over the Treasuries. Although in the short-term, this behaviour will drive the market higher, in the long-term, we will see a rise in leverage levels that will not be sustainable. The immediate effect of a Trump victory on the US yield curve will be a slight increase in interest rates in longer maturities. Higher yields will reflect the market's risk-on appetite and increased inflation expectations. Precisely as we have seen in the Biden scenario, the short part of the yield curve will not move because of the FED controlling the yield curve.
Credit positive - energy and financials focus.
In the credit space, we will see a replay of what we have seen from 2016 until today. Hence, Companies that benefit from lower taxes and deregulation are the ones to provide the most significant upside in this scenario. Unlike the Biden scenario, we prefer the belly of the curve (maturities from five to seven years) to avoid volatility in the longer part of the yield curve. Long maturities will be volatile dictated by Trump's aggressive foreign policy and inflation expectations. Energy and financials are among our favourite sectors. In this space, it is possible to find bonds offering a considerable pick up over the Treasuries with an investment-grade rating such as BGC Partners, a US-based financial broker, with maturity 2024 (US05541TAM36) offering approximately 320 bps over treasuries for a BBB- rated bond. Also, KKR Capital, a US investment company, offers 400 bps over the treasuries (US302635AD99) for a lower investment grade rating (BBB-/Baa3).
High-yield bonds will also gain from a Trump victory. Sectors that we favour within the HY space are the ones at the core of the Trump campaign: finance, energy, construction, domestic manufacturing and defence. However, we believe it's essential to cherry-pick corporates to avoid overvalued assets and optimize risk-reward as default risk continues to rise.
In this scenario, which at the time looks to be the most probable, we will see a sudden and sustained spike in volatility. Credit spreads will widen, and safety is going to be king. The US yield curve will bull-flatten for as much as the election is going to be contested. In the worst-case scenario, we can see Treasuries diving even below zero. In the Corporate space, quality is going to be a top priority, and we will see tightening only in high-quality companies. It is important to note that once a winner will be nominated, we can expect the market to normalize and the yield curve to start steepening in order to embrace inflation.
Coronavirus, an election outsider
Bear in mind that the US election is not the only variable that will affect your portfolio. Coronavirus will continue to be a significant market driver. This is why it is important to flag that some sectors will continue to perform well because of the pandemic. Health care, online economy and digitalization are pocket of the economy that will continue to strive as COVID-19 is a recurrent topic. In this space, Netflix with maturity 2025 (US64110LAL09) offering a yield of approximately 2% looks quite interesting even though it tightened significantly since inception. Some good opportunities can also be found in the food and beverage sector, which is key for the government to run amid the pandemic. In this area, we like Kraft Heinz (US50077LAK26) with 2025 maturity offering a yield of 1.8%. Even in lockdown, people will continue to consume ketchup, right? B&G Foods with maturity 2025 (US05508RAE62) offering approximately 3% in yield and Pilgrim’s Pride 2025 (US72147KAC27) offering around 4%.
Similarly, some sectors will continue to suffer as the pandemic continues to restrict the movement of people. Avoid airline companies, retailers, leisure activities as they wrap their head around close to zero revenues.