The Broad View
The COVID-19 pandemic threw the global economy into disarray in 2020, with a downturn that was far from typical. Financial markets were jolted by the consumer pullback from travel, socializing and in-person shopping, coupled with various government-mandated lockdowns designed to stymie the spread of the virus.
As it has historically, investment-grade fixed income served as a counterweight to the sharp turbulence that struck equities. In this year’s bond roundtable, Capital Group Private Client Services portfolio managers Mark Marinella and John Queen are joined by analysts Connie Lu and Andrea Montero to discuss how fixed income weathered the volatility and where markets might be headed in 2021.
Mark Marinella: It felt like we lived through an entire market cycle in seven or eight months. Early on, there was a realization that the coronavirus outbreak wasn’t happening in just one part of the world or to one economy. It was global. The markets froze, particularly the municipal bond market. Everybody was wondering where it was headed, but nobody had answers.
Connie Lu: Everything went on sale — even the highest-quality hospitals with enough cash to last for months. The pandemic has opened up a lot more opportunity for credit selection, and we’ve been able to invest in some of my favorite credits at really favorable prices for clients.
Marinella: Early enough and quickly enough, the Federal Reserve was supportive to markets. Fiscal policy was supportive, and the markets very quickly became aware that the authorities, so to speak, were going to lend support.
Marinella: Taxable bonds started rallying back rather quickly after the federal government aid package passed in March. But municipal markets lagged until the Municipal Liquidity Facility was created in April. That showed municipal bond investors that the Fed knew our market needed support as well. And municipal bonds started to rally.
Throughout the initial stage of the pandemic, there was a rolling repricing in the muni market. Investors worried that no one would get on an airplane or drive on toll roads. Prices went down, one sector at a time.
But as time passed, we saw how things were actually going. One month, a toll road’s revenue might have been down 90%, but the next month it was only down 60%, and the month after that only down 30%. Debt service reserves and things like that picked up the slack while the recovery was beginning, and those rolling repricings began to go the other way.
Marinella: I would go back earlier than that, to the start of the year, before the pandemic struck. At Capital Group, we have a very strict, fundamentals-based, bottom-up security selection and portfolio construction process. We’ve used this philosophy in the municipal bond group for more than four decades. Because of this tried-and-true approach, I reduced exposure to riskier securities in January and February.
Quite frankly, I didn’t do this because I saw a pandemic coming. I had no idea it was coming. But I took action because the value wasn’t there. It was about ensuring that we were being adequately paid for the risk we were taking. Looking back, that set us up wonderfully well to sustain ourselves during a very dramatic time.
Andrea Montero: Our fundamental research process remains intact amid such shifts, but you are forced to revise the framework for analyzing risks and opportunities. In the face of great uncertainty and mounting risks, scenario analysis plays a big role in how we think about which environment will prevail in the future and who the winners and losers will be. Finally, as credit investors, we also have to consider whether the new environment changes companies’ willingness and ability to service their debt. For the companies I follow in the oil and gas industry, I focused on what I call “survivors” — companies with strong balance sheets, ample liquidity to service their debt and the ability to withstand low oil prices. As part of my analysis, I met frequently with management teams to get a sense of what their options and priorities were and what shareholders were asking of them.
I’ll give you an example. There was a company that I had a high conviction in coming into the crisis. However, during the March period, the bonds went down in value as the markets plummeted. The key questions for me were whether this company was a survivor under the new environment and, if so, whether the value of the bonds was attractive relative to the risks. Ultimately, the answer to both questions was yes — my conviction in the company was bolstered through weekly calls I had with the CFO and the CEO. That type of communication on a weekly basis was extremely important in informing my view of the company because the environment was changing rapidly.
Marinella: I always ask analysts, “When there is an impairment on a security, is it temporary or permanent?” That difference became monumentally important in the pandemic. A permanent impairment reflects a change to the nature of a sector or industry. In a normal year, I might ask whether a bond is temporarily or permanently impaired once or twice. In 2020, I was asking that question over and over, and about whole segments. Will airports be around? Will people go to the hospital, or will they be so afraid they’ll stay home? If there is a risk of a permanent impairment, I stay away until it sorts out.
On the other hand, a temporary impairment can present an opportunity. We may be able to earn a very favorable return by taking a risk that others can’t because they don’t understand that it’s temporary. There were a number of situations throughout the year in which we were able to take advantage of temporary dislocations.
Lu: It’s never been more obvious that hospitals provide essential medical services — although the pandemic actually hasn’t helped hospitals from a bondholder perspective. My biggest concern right now is shorter-term business risk. Our national health care infrastructure isn’t designed for the high patient volumes of the COVID-19 pandemic. Hospitals have had to convert existing facilities for infectious patients, buy more protective equipment for their clinicians, build pop-up temporary facilities, hire more staff and postpone scheduled elective operations to save resources for COVID-19 patients. But those elective procedures are how hospitals make most of their money, so costs are up even as revenues have plummeted.
The problem for most hospitals that borrow via the muni market isn’t permanent impairment; the hospitals that we invest in aren’t likely to close. But the investment questions I ask myself have shifted from “What hospital has the strongest balance sheet?” to “Can this hospital absorb the COVID-19 shock without assuming a full return to pre-pandemic margins or additional government aid?”
Lu: My sister was supposed to go off to college this fall. I joke that I’m getting some of my investment conviction from how badly she wants to leave my parents’ house.
Student housing, even before the pandemic, was one of the riskier sectors in the muni market. A bond is secured by only the rental revenue from that one property. So if the building is compromised for any reason — say, it’s flooded — that affects the revenue that is guaranteeing the bonds. When schools went remote earlier this year, there obviously weren’t students to rent to.
So the sector generally is pretty challenged. I expect that to be the case until late 2021, when the 18- to 22-year-old cohort should get vaccinated. The market has recognized that, and generic sector valuations have rightfully fallen. But I think prices maybe overcorrected. Kids want to go back to campus. I think this has given us an incredible opportunity to choose credits that are well positioned to rally in a post-pandemic world.
Marinella: It’s going to be a different year. I’m expecting that the vaccines will work and will help. I think on a large-scale basis we’ll wake up in the summer saying, “Wow, this really turned things around.” I think by spring and summer — more than likely summer — there’ll be more people back to work and back at school. I anticipate that cases and mortality rates will come down. I think all those things will be better by then, which means greater economic growth.
I think we have to be careful about rates rising a little bit. Not dramatically, but my expectation is that you could see more curve in the yield curve, which graphs interest rates on shorter-term bonds against longer-term bonds. That curve usually slopes up, as longer rates are often higher than shorter rates. It does so today, but it’s flatter than it has been for years. I think there’ll be some pressure next year for that curve to steepen. That means the intermediate and the short parts of the bond market may be more appealing than the long part of the bond market.
John Queen: We haven’t gotten to the recovery yet. I think we’ve got some time in which there’ll be a balance between the pandemic, government-sponsored shutdowns, economic damage and stimulus efforts. Given what it’s said, the Fed is likely to hold its base rate lower for much longer into a recovery than we might’ve seen historically.
Queen: The answer is, it’s not a question of why fixed income now. It’s a question of why own fixed income generally. If you own fixed income to maximize your total return in yields, then you probably need to rethink the whole process. Over time, the total return from equities has exceeded that of fixed income. We own fixed income for that component of the portfolio that hedges equity volatility and seeks stability, lower volatility and preservation of capital. And it certainly provides some income.
Fixed income plays an important role. Pay attention to what that role is in your broader portfolio, and make sure that you have an appropriate allocation to it. But don’t look at it and say, “Yields are low. I shouldn’t own it,” or “Yields are low. I should reach in and take a lot more risk.” Those things are almost always in error.
Marinella: I look for the municipal bond market to be healthy in the next year. You will see support for state and local governments. I think you will see support for our market. And I think we have the opportunity to do well. This period has given us a somewhat different puzzle to solve. And when there’s a puzzle to solve, that’s when we can do our best.