Investment Strategy

Fixed income spotlight: Defensive fixed-income opportunities

• Longer-term rates have been moving higher, and our expectation is that they will continue to do so. Our year-end 2021 10-year yield target is 1.75%-2.25%. Recent market moves have changed the fixed-income environment.
• The fixed-income landscape is challenging for investors, and there are a number of sectors that investors should consider when building a more defensive bond portfolio in the current environment.

Equities: Cash on the sidelines near record highs

• Cash on the sidelines remains near an all-time high, setting the stage for greater equity market upside potential.
• We believe markets are primed for a cyclical rotation into equities, given the positive macro backdrop.

Real Assets: The “real” real assets

• Many real assets have benefited from the reflation theme, yet real estate investment trusts (REITs) have consistently underperformed.
• We say go with the flow and stick with commodities over REITs.

Alternatives: High-yield credit rating trends improving, but for how long?

• The ratio of upgrades versus downgrades has increased materially since the COVID-19 credit market dislocation, but it remains to be seen if corporate fundamentals will follow the same path.
• With recovery rates well below historical averages, high-yield credit spreads seem disconnected from the inherent risks. For this reason, we remain favorable long/short credit strategies in 2021.

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Fixed-income investors have experienced strong market returns over the last year. While all fixed-income asset classes have generally posted positive returns since equity markets bottomed on March 23, 2020, the credit-sensitive high-yield asset class is up over 30 percent, as of arch 5, 2021. Dynamics in the fixed-income market are changing. More recently, we have begun to see fixed-income performance suffer. Credit spreads are near pre-pandemic levels, limiting additional appreciation opportunities, and longer-term rates have increased. We believe selective opportunities still exist within the fixed-income asset group, but investors should take steps to position fixed-income portfolios with a more defensive posture.

Index duration lengthened

Duration is one measure of the sensitivity of a bond’s price to a change in interest rate movements. The low rate environment not only encouraged companies to issue longer-dated maturities but also naturally increased the duration of new issue securities. As a result, the duration of key bond indices have increased over the last several years. In Chart 1, you can see the duration of the Bloomberg Barclays Aggregate Bond Index. At 6.33 years, it is now at its highest level in the last 10 years. A longer duration can make your fixed-income securities more sensitive to changes in interest rates.

Chart 1. Bloomberg Barclays Aggregate duration (in years)Sources: Bloomberg, Wells Fargo Investment Institute, March 3, 2021. Past performance is no guarantee of future results.

Credit spreads tightened

Credit spreads are the excess yield an investor receives over a risk-free government security. Wider credit spreads generally increase yields and help compensate for increased risk. In the high-yield asset class, yield spreads peaked at 1100 basis point ((bps) 100 basis points equals 1%)) in March 2020, as seen in Chart 2. Today, high-yield spreads are near 320 bps, near the 10-year low of 303 bps.

Chart 2. Bloomberg Barclays High Yield option adjusted spreadSources: Bloomberg, Wells Fargo Investment Institute, March 3, 2021. Option-adjusted spread (OAS) is the spread relative to a risk-free interest rate (the comparable Treasury security).

Spread tightening has led to strong corporate and high yield performance over the last year, but we view the prospects of additional gains are limited.

The yield curve steepened

The Federal Reserve (Fed) has anchored short-term rates near zero, and we see little likelihood the Fed will change its stance over the near term. With longer-term rates moving higher the yield curve has steepened. We anticipate a positively sloped interest-rate curve can have positive fixed-income performance implications — both in terms of higher yields and positive price impact as bonds “roll down” the yield curve.¹

Defensive posture

With the potential of higher interest rates, some investors might be considering significantly reducing or eliminating their fixed-income allocations in search of better opportunities. While we see better tactical return opportunities in the equity asset group, we believe fixed income should remain a key allocation for many moderate and conservative investors. Yes, the current fixed-income landscape is challenging, as short-term securities offer little return potential, and longer-term securities can be exposed to meaningful interest rate risk. Still, we believe there are opportunities in the current environment.

Defensive fixed-income ideas

• Intermediate Bonds (neutral) – Intermediate-term bonds are rated above both short-term (most unfavorable) and long-term (unfavorable) bonds. We suggest targeting intermediate-term bonds and a neutral duration in an effort to take advantage of yield curve steepness without taking on too much interest rate risk.
• Municipal Securities (favorable) – Investors in highly effective tax brackets should consider municipal securities. In our view, better than expected municipal credit profiles, the potential of fiscal stimulus for states and the prospects of higher future tax rates make the municipal sector attractive.
• Preferred Stock (favorable) – While preferred stock often have very long or perpetual maturities, their performance tends to correlate better to the market risk appetite. Preferred stock generally tends to provide investors with higher yields than can be found in most fixed-income asset classes. Investors purchasing preferred stock should be focused on the income stream rather than the potential for price appreciation.
• Bank Loans (neutral) – Bank loans and collateralized debt obligations (CLOs) are below investment-grade (rated BB+ and lower by S&P or Fitch) securities. The duration or interest rate risk is generally quite low in these products, but we believe investors can still find a yield pickup over traditional short-term securities.
• High Yield (neutral) – High-yield bonds (rated BB+ and lower by S&P or Fitch), generally have a short or intermediate maturity date. Despite tight credit spreads we recommend a full allocation to high-yield bonds, as we do not anticipate a significant risk-off event over the near term.
• Emerging Market Debt (neutral) – We anticipate emerging markets to have an improved performance profile, given the global recovery. Higher yields are available in emerging market debt, but investors must be cognizant of the longer durations inherent in many emerging-market securities.

Dry powder, or cash on the sidelines, can be an important indicator in gauging investor sentiment. High levels of cash imply conservative investor risk appetite, while low levels can refer to a risk-on sentiment. We view the current liquidity environment as a positive catalyst for markets, with more room to run.

Money market funds (MMFs) witnessed a rise in assets under management (AUM) to an approximate $2.2 trillion following the global financial crisis (GFC) in 2009.² Within two years, capital was quickly redeployed, but it primarily poured into fixed-income assets. Equity fund flows trailed fixed-income fund flows $33 billion to $113 billion during the same period,³ while cash in MMFs declined to a low of $1.2 trillion. Following the COVID-19 sell-off, investors exhibited a similar pattern of rotating into MMFs, leading to a record level of $3.9 trillion in AUM.⁴ Despite being a year into the recovery, MMF assets have only fallen to $3.6 trillion — $830 billion above pre-pandemic levels.⁵ Those investors holding on to cash missed out on the 73.1% total return⁶ the S&P 500 Index experienced from its March lows.

Given the large quantity of cash on the sidelines, we believe markets are primed for a cyclical rotation into equities, given the current macro backdrop of historically low yields and accommodative Fed policy. Early signs of the rotation have begun to surface as equity exchange-traded-funds (ETFs) witnessed $79 billion of inflows in February.⁷ Current equity flows total $166 billion vs. fixed income’s $190 billion,⁸ outpacing the rate set during the recovery phase of the GFC.

Assets within money market funds remain near all-time highsSources: Wells Fargo Investment Institute, Bloomberg, and Morningstar Direct, monthly flow data from January 1, 2007, to January 31, 2021.

“Great minds discuss ideas; average minds discuss events; small minds discuss people.”
--Eleanor Roosevelt

The reflation theme gets a lot of play nowadays, and rightfully so. The sheer amount of liquidity sloshing around the system — monetarily and fiscally — is unprecedented. Many different assets have benefited, including and especially real assets. 2021 is littered with double-digit gains in commodities as well as in the stocks of companies that produce, process, and transport them.

If history is any guide, the move into real assets is understandable. During past reflationary periods, investors have often turned to hard assets to help preserve their purchasing power. This cycle appears to be similar, with the exception of the conspicuously poor performance of one real asset group: real estate investment trusts (REITs). REITs, the red dashed line in the chart, have consistently underperformed other real assets since last March.

REITs have struggled for a few reasons. First, large pockets of commercial real estate are tied to the consumer, whether it be retail, hotels, or even office space. Second, many areas within commercial real estate looked expensive and overbuilt prior to COVID-19. We’ve had an unfavorable rating on REITs since April 2020, and we’re inclined to keep it. REITs are no longer expensive, but they aren’t cheap either. Most importantly, the relative price action we see in the chart suggests that investors prefer commodity-related assets during this reflationary period. We say go with the flow and consider commodities over REITs.

Commodities, MLPs, and REITs versus real asset portfolioSources: Bloomberg, Wells Fargo Investment Institute. Real asset portfolio is an equal weighted index of the FTSE EPRA/NAREIT Developed Index, Alerian MLP Index, and the Bloomberg Commodity Index. Daily data: March 3, 2016 – March 3, 2021. Indexed to 100 as of start date. This chart is hypothetical and for illustrative purposes only. It is not intended to represent an actual investment. There can be no assurance any investment will increase in value. The index information is included to show general return data and is not intended to imply that an investment portfolio will be similar to the indices either in composition or element of risk. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Past performance is no guarantee of future results.

Rating agencies expressed a negative view on high-yield credit fundamentals long before the effects of COVID-19 were felt on corporate balance sheets. The chart below shows the ratio of S&P upgrades versus downgrades in high-yield U.S. corporate credit (up/down ratio). While other agencies such as Fitch and Moody’s might show slightly different ratios, the message is generally consistent: credit quality has gradually deteriorated in recent years. Despite this deterioration, high-yield spreads have largely tightened, with the exception of the fourth quarter of 2018 and, of course, the first quarter of 2020. This disconnect between spreads and fundamentals is precisely why we have been so bullish on long/short credit strategies and why we remain favorable in 2021.

As a reminder, credit spreads are a reflection of the loss if a default were to occur as well as the probability of default. While defaults have certainly moderated in recent months, recovery rates have been slower to improve. In fact, the trailing 12-month, par-weighted recovery rate for high-yield debt was only 29.8% at the end of February — well below the historical average of 44.2% that dates back to September 2005.⁹ In our view, a more active approach to high-yield corporate credit is a better way to navigate an environment in which current spreads don’t necessarily reflect the inherent risks. This could be implemented through a strategy with the ability to invest both long and short. And while rating trends have rapidly improved recently, it remains to be seen if corporate fundamentals will follow the same trajectory.

Rapid improvement in high-yield credit rating trendsSources: Bloomberg, Wells Fargo Investment Institute. Data as of March 3, 2021. The up/down ratio shows the ratio of S&P upgrades versus downgrades in high-yield U.S. corporate credit.

Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not suitable for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.

¹ “Roll down” = move one year closer to maturity.

² Morningstar Direct, Money Market-Taxable total net assets as of January 31, 2009.

³ Morningstar Direct, sum of inflows and outflows from January 2009 – December 2011.

⁴ Morningstar Direct, Money Market-Taxable total net assets as of April 30, 2020.

⁵ Morningstar Direct, Money Market-Taxable total net assets as of January 31, 2021.

⁶ March 23, 2020 – February 28, 2021.

⁷ Etf.com, data as of February 28, 2021.

⁸ Morningstar Direct, sum of inflows and outflows from March 2020 – January 2021.

⁹ BofA Global Research, HY Credit Chartbook, February 2021.

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Although Treasuries are considered free from credit risk they are subject to other types of risks. These risks include interest rate risk, which may cause the underlying value of the bond to fluctuate. Income from municipal securities is generally free from federal taxes and state taxes for residents of the issuing state. While the interest income is tax-free, capital gains, if any, will be subject to taxes. Income for some investors may be subject to the federal Alternative Minimum Tax (AMT). Preferred securities are subject to interest rate and credit risks. Preferred securities are generally subordinated to bonds or other debt instruments in an issuer's capital structure, subjecting them to a greater risk of non-payment than more senior securities. In addition, the issue may be callable which may negatively impact the return of the security. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility. Bank loans are subject to interest rate and credit risk. They are generally below investment grade and are subject to defaults and downgrades. These loans have the potential to hedge exposure to interest-rate risk but they also carry significant credit and call-risk. Call risk is the risk that the issuer will redeem the issue prior to maturity. In addition to the risks associated with investment in debt securities, CLOs are subject to other risks, including, among others, the risk that the CLOs may have a limited trading market; the possibility that distributions from collateral securities will not be adequate to make interest or other payments; the quality of the collateral may decline in value or default; and the possibility that the investments in CLOs are subordinate to other classes or tranches. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.

Exchange-traded funds are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed, or sold, may be worth more or less than their original cost. ETFs seek investment results that, before expenses, generally correspond to the price and yield of a particular index. There is no assurance that the price and yield performance of the index can be fully matched.

Investment in Master Limited Partnerships (MLPs) involves certain risks which differ from an investment in the securities of a corporation. MLPs may be sensitive to price changes in oil, natural gas, etc., regulatory risk, and rising interest rates. A change in the current tax law regarding MLPs could result in the MLP being treated as a corporation for federal income tax purposes which would reduce the amount of cash flows distributed by the MLP. Other risks include the volatility associated with the use of leverage; volatility of the commodities markets; market risks; supply and demand; natural and man-made catastrophes; competition; liquidity; market price discount from Net Asset Value and other material risks.

Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.

Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

An index is unmanaged and not available for direct investment.

Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships (MLPs) that provides investors with an unbiased, comprehensive benchmark for this emerging asset class. The index, which is calculated using a float-adjusted, capitalization-weighted methodology, is disseminated real-time on a price-return basis and on a total-return basis.

Bloomberg Barclays US Aggregate Bond Index is a broad-based measure of the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.

Bloomberg Barclays US Corporate High Yield Bond OAS Index measures the Option adjusted spreads of USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below.

FTSE EPRA/NAREIT Developed Index is designed to track the performance of listed real-estate companies and REITs in developed countries worldwide.

Bloomberg Commodity Index is comprised of 23 exchange-traded futures on physical commodities weighted to account for economic significance and market liquidity.

Moody’s uses a lettering system consisting of upper and lower case, as well as numeric modifiers. 'Aaa' and 'Aa' (high credit quality) and 'A' and 'Baa' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('Ba', 'B', 'Caa', etc.) are considered low credit quality, and are commonly referred to as "junk bonds". The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category.

Standard & Poor's (S&P) and Fitch use upper-case letters to identify a bond's credit quality rating. 'AAA' and 'AA' (high credit quality) and 'A' and 'BBB' (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations ('BB', 'B', 'CCC', etc.) are considered low credit quality, and are commonly referred to as "junk bonds". S&P ratings may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.