INVESTMENT MANAGEMENT AUG 26, 2021 Bond Market Opportunities After Peak Easy Money Tweet this Share this on LinkedIn Share this on Facebook Email this Print this Select assets within the fixed income market may offer investors opportunities, amid steady economic growth, waning policy support and persistently higher inflation. Jim Caron Senior Portfolio Manager and Chief Strategist, Global Fixed Income Team, Morgan Stanley Investment Management At the start of 2021, robust support from monetary and fiscal policy buoyed asset prices across markets. Today, as the battle against coronavirus persists, even as the global economy regains strength, investors are hotly debating inflation prospects and when the Federal Reserve will raise interest rates and taper asset purchases, and how that might affect the bond market outlook—as well as stocks and alternative investments. From a fixed income perspective, we see opportunities in four key areas of the market that are less dependent on interest rates: U.S. high yield, mortgages and securitized assets, convertible bonds and emerging markets. The sudden jumpstart to economies that all but ground to a halt last year created myriad bottlenecks. Price inflation spiked in many industries and marketplaces, as pent-up business and consumer demand overwhelmed still-disrupted supply chains. While this may prove transitory, sticky higher prices could drive up wages and create other long-term inflation risks. We see opportunities in four key areas of the market that are less dependent on interest rates. Tweet this Share this on LinkedIn Share this on Facebook Email this Still, economic growth, inflation and policy support may all have already peaked in 2021. Central banks and government spending could remain supportive of markets, just less so than at the start of the year as we enter the next phase of the pandemic-driven economic cycle. The Fed, for example, probably won’t reduce its bond-buying program, known as quantitative easing, until this December or early in 2022, and we don’t expect it to start raising interest rates until mid-2023. Disparate views about inflation and the pace and path of policy tightening abound. Which means that the months ahead will likely produce higher volatility, market dislocations and buying prospects for investors aiming to manage interest-rate risk through active management for higher yields and portfolio diversification. U.S. High-Yield Bonds as the Economy Improves High-yield bonds—which have lower credit ratings than government debt or investment-grade corporate credit but offer investors higher interest income (at greater risk)—are one of the most appealing options in fixed income right now. High-yield bonds usually benefit from improving economic trends, including rising credit ratings and declining default rates. The potential for ongoing supportive monetary and fiscal policy could help boost the asset. So, too, could reflation, or the return to global growth post-pandemic. Smart reflation trades could include lower-quality high-yield bonds and debt from smaller issuers, both of which are assets that may benefit in an improving economic cycle. Related Articles WEALTH MANAGEMENT How Strong Is the U.S. Consumer? THOUGHTS ON THE MARKET PODCAST A Step Forward for Build Back Better INVESTMENT MANAGEMENT Can Sustainable Bonds Power a Greener, More Equitable Recovery? Mortgages Amid U.S. Housing Strength Turning to securitized products in our bond market outlook, U.S. residential credit may offer the best opportunity, given solid housing-market fundamentals amid strong demand. U.S. home prices on average climbed 15% in the past year. Driving the increase were low mortgage rates and housing supply combined with growing demand from Millennials coming of age and forming their own households, and evolving work-from-home dynamics, based on National Association of Realtors’ May, 2021 data. Bonds backed by assets in more pandemic-battered sectors, including those tied to aircrafts and small-business loans, may also offer attractive yields. Overall, the potential benefits of investing in the securitized market include low bond durations, higher yields and solid credit fundamentals. Convertible Bonds in an Inflationary Environment As the economy recovers, the rise in inflationary pressure could bode well for convertible bonds—corporate debt that can be converted into common stock or equity shares—compared with other fixed-income assets in our bond market outlook. Shorter durations for the asset class may help mitigate the impact of rising rates on their valuations. Despite turbulent performance in 2021, convertibles have led all fixed-income categories, with the Refinitiv Global Convertibles Focus Index up 3% year to date.1 Convertible bond issuances from companies in cyclical sectors, including materials, industrials, financials and energy, may present the best opportunities, despite a recent rebound in convertibles of certain growth companies and those that have reopened since pandemic lockdowns. Emerging-Market Assets for Higher Risk and Reward Emerging-market debt could benefit from the pickup in vaccination rates in several of these economies, especially when compared with the outlook for Treasury yields to stay near zero. High-yield emerging-market credit may be more attractive than investment-grade debt, as the former offers a bigger cushion against rising yields in the more developed world and exhibits higher volatility (thus risk, and possibly, returns) compared to global growth. There’s also opportunity in emerging-market currencies, given proactive central banks, even though the near-term risks are heightened by the dollar’s strength after the hawkish surprise at the June meeting of the Federal Open Market Committee, the policy arm of the Fed. Investors should be selective and focus on local currencies that mitigate inflationary pressures and haven’t already priced in too many rate hikes. 1 As of June 30, 2021 RISK CONSIDERATIONS Diversification neither assures a profit nor guarantees against loss in a declining market. There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and that the value of Portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. may be more sensitive to interest rate changes. Certain purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. are lower-rated securities that may have a higher degree of credit and liquidity risk. are subject to liquidity risk and the credit risks of lower-rated securities. are subject to currency, political, economic and market risks. The risks of investing in countries are greater than risks associated with investments in foreign developed countries. are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. are subject to default risk. may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. may be more difficult to sell and value than publicly traded securities (liquidity risk). In addition to the risks associated with common stocks, investments in are subject to the risks associated with fixed-income securities, namely credit, price and interest-rate risks. View disclosures Sign up to get Morgan Stanley Ideas delivered to your inbox. Email Address Email Address GO MORE STORIES ACCESS & OPPORTUNITY PODCAST THE BLACK WEALTH GAP Aug 12, 2021 Eddie Slaughter and Shelley Stewart III on the cycle of discrimination that has denied Black Americans of the opportunity to build wealth. THOUGHTS ON THE MARKET PODCAST 2022 EQUITY OUTLOOK FEEDBACK AND DEBATES Nov 22, 2021 With the release of our outlook for the coming year comes a cycle of feedback and debates from clients and investors. We look at those discussions around equity markets, valuations, and more in 2022. 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