Bond market outlook 2021: A winter's tale

Low interest rates are creating a cooler climate. Here’s how to prepare.

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Key takeaways

  • Low interest rates may adversely affect both bond prices and bond yields in 2021.
  • Among US investment grade, high-yield, and convertible corporate bonds, the latter may offer income-seeking investors the most opportunities in the new year.
  • If you’re looking to bonds for ballast, consider high-quality, longer duration bonds.
  • Professional investment managers may find opportunities for generating income despite pessimism about interest rates.
 

2020 was a good year for bond prices and for investors who seek bonds to preserve capital. Despite the damage done during an extraordinary week in March when COVID-19 cases spiked, many governors shut down their states, and investors sold anything they could to raise cash, the Bloomberg Barclays US Aggregate Bond index, which tracks the broad US bond market, returned 7.36% as of December 11, 2020. That’s nearly double the index’s 10-year annualized return of 3.86%. Bond prices rise when yields fall, which they’d been doing gradually since 2018, and abruptly when the Federal Reserve slashed interest rates in 2020. "Fixed income effectively pulled forward a couple years’ worth of returns last year," says Beau Coash, institutional portfolio manager in Fidelity's fixed income group.

But much as the ebullience of New Year's Eve gives way to a chilly January, the bountiful bond market of 2020—and the bull market in bonds that has run since the 1980s—may give way to tougher times for bond investors in 2021. Fidelity's Asset Allocation Research Team says returns for many categories of bonds are likely to be lower than their historical averages as the Federal Reserve's low interest rate policy starts to bite. Surveying this landscape, Institutional Portfolio Manager Michael Schmitt says, "We think this may be an alpha winter where there are no obvious high-yielding investment choices among investment-grade bonds."

How low interest rates are cooling the bond outlook

The Fed's interest rate policies are playing a key role in cooling bond markets in 2021 and beyond. The low return expectations in 2021 reflect moves the Fed made in 2020: Cutting interest rates to multi-decade lows and restarting its purchases of bonds that it began during the global financial crisis.

In March, the Fed cut the rate on 10-year Treasury bills from 2% to 0.5%. That decision to adopt ultra-low rates matters because roughly half the yield of a typical corporate bond is determined by Treasury 10-year rates. Super-low rates also matter because they limit the amount that prices can rise and deprive bonds of their ability to increase the value of an investor’s portfolio. For bond prices to rise, yields need to fall as they have been since 1981. Now, with yields approaching zero, they aren’t likely to fall much further. Central banks in Japan and Europe have lowered interest rates below zero, but the Fed’s leaders have said they don't believe negative interest rates are right for the US. Instead, they have pledged to keep rates low for the next several years, even if short term inflation increases and GDP spikes. This represents a historic change in policy because the Fed has used rate increases to keep inflation under control since the 1980s.

Coash points out that the yield on the 10-year Treasury note has historically tended to track the inflation-adjusted annual growth rate of US economic growth. He believes growth is likely to be tepid for the foreseeable future, making it hard for yields to rise back to historically average levels. "GDP growth is the sum of 2 things: growth in the labor force and growth in productivity," he explains. "The US population is aging and that reduces both, so it's hard to see how we could get growth back above 3% sustainably. After the economy reopens and COVID-impacted sectors recalibrate, we will have spikes of growth and inflation as the economy comes back, but it will be hard to see GDP much above 3% growth on a persistent basis. It's the same story in Japan, Germany, China—all the world’s big economies are getting older."

Bonds for ballast

How you should dress your portfolio while you wait for this cooler bond market to warm up depends on the role bonds play in your mix of assets. This is a good time to review your bond allocation, and to take steps to improve its ability to fulfill its intended role.

If you hold fixed income as ballast against stock-market pullbacks, consider sticking with high-quality bonds rather than chasing yield—and catching risk—in bonds with lower credit quality. Prices of lower-quality, higher-yielding bonds have historically tended to move up and down together with stock prices, making them less potent as diversifiers. On the other hand, high-quality bonds historically have had low or negative correlations to stocks and their prices have tended to rise during large stock-market declines.

However, low yields make it harder for high-quality bonds to offset big drops in stocks. “If a Treasury bond’s yield falls from 3% to 1% during a stock downturn,” says Coash, “the bond’s price would increase as a multiple of that 2-point decrease. But Treasurys with maturities less than 10 years yield less than 1%, so there’s less potential for price appreciation that could help offset losses in the stock market.”

Investors focused on diversifying stock-heavy portfolios may want to consider longer-term bonds, which offer both modestly higher yields than shorter-term securities and low correlations to stocks. Be aware, however, that longer-term bonds can be significantly more volatile than shorter-term securities and may lose value if interest rates rise.

Portfolio manager Adam Kramer says convertible bonds provide another option for those who look to bonds for capital appreciation while also managing risk. “Convertibles offer the potential for capital appreciation like stocks, but also potential downside protection in case an issuer defaults. Because convertibles are considered bonds and as such their holders are first in line to be paid if the issuer becomes insolvent. Convertible bond prices can fall if interest rates rise and stock prices decline, but they are less sensitive to such changes than both stocks and traditional corporate bonds,” he says.

Bonds for income

For those who own bonds as a source of income, super-low rates are complicating the challenge of finding that income without taking on uncomfortable levels of risk.

That need to seek return in riskier assets combined with the rising hope for a return to business-as-usual may lure some income-seeking investors toward the higher-yielding, lower-credit bonds that started to outperform late in 2020. “I think we might be at the beginning of an economic recovery, and that typically is a good time to add high-yield bonds,” says Coash. “That said, we are still in for a period of uncertainty due to the pandemic and economic recovery and valuations are reflecting a very strong economy with very few risks, so it makes sense to be judicious regarding how much risk to take.”

Coash notes that many bonds issued by energy companies and companies such as airlines and restaurants that remain challenged by COVID concerns may continue to offer sizable yield premiums. However, they also may present significant default risk. “You have to make sure the companies have enough capital to pay their debts and get to the other side of the crisis. It’s important to understand why a bond offers a high yield,” says Coash. That means analyzing company fundamentals, liquidity, the industry’s outlook, and other factors. If you are willing and able to do your own research, a wide variety of tools on Fidelity.com can help. Otherwise, consider investing with a bond manager that performs deep credit analysis in order to seek securities that can make it past the pandemic—and can help support investors’ income in the meantime.

Finding ideas

The extraordinary and mostly unexpected events of 2020 underline the riskiness of making forecasts for 2021, but also the riskiness of not being ready for whatever may come. For 2021, our bond pros are preparing for some stormy weather with a likelihood of low rates, low returns and volatility.

In this environment, maintaining a well-diversified portfolio of stocks and bonds may be as important as ever to help you reach your goals. If you’re looking to bonds for diversification, consider high-quality, longer duration bonds. But remember, diversification and asset allocation do not ensure a profit or guarantee against loss.

If you're considering individual bonds, be sure to do your research as the bond market is big and diverse, and getting the best prices can be tricky.

If you're seeking income, make sure to consider the potential risks as well as the potential rewards of high-yield bonds.

Whatever your bond investing goals, professionally managed mutual funds or separately managed accounts can help you. You can run screens using the Mutual Fund Evaluator on Fidelity.com. Below are the results of some illustrative mutual fund screens (these are not recommendations of Fidelity as of January 21, 2021).

Taxable bond funds

Fidelity funds

  • Fidelity Total Bond Fund (FTBFX)
  • Fidelity Investment Grade Bond Fund (FBNDX)

Non-Fidelity funds

  • American Funds Corporate Bond Fund (BFCFX)
  • MFS Corporate Bond Fund (MFBFX)

Investors can also gain exposure to bond opportunities through separately managed accounts (SMAs).


The Fidelity screeners are research tools provided to help self-directed investors evaluate these types of securities. The criteria and inputs entered are at the sole discretion of the user, and all screens or strategies with preselected criteria (including expert ones) are solely for the convenience of the user. Expert screeners are provided by independent companies not affiliated with Fidelity. Information supplied or obtained from these screeners is for informational purposes only and should not be considered investment advice or guidance, an offer of or a solicitation of an offer to buy or sell securities, or a recommendation or endorsement by Fidelity of any security or investment strategy. Fidelity does not endorse or adopt any particular investment strategy or approach to screening or evaluating stocks, preferred securities, exchange-traded products, or closed-end funds. Fidelity makes no guarantees that information supplied is accurate, complete, or timely, and does not provide any warranties regarding results obtained from its use. Determine which securities are right for you based on your investment objectives, risk tolerance, financial situation, and other individual factors, and reevaluate them on a periodic basis.

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