a man on a precipice

Investors sitting on a record amount of cash would be better off investing in bonds, a report from Manulife Investment Management says, even if opportunities are scarce and the economic recovery remains uncertain.

High-yield spreads widened to more than 10% last March when the pandemic hit but have since tightened to around 4%, Manulife’s outlook report said. Spreads on investment-grade debt are also tighter than they were last February. Downgrades occurred in the spring and summer but there was no “tsunami,” and ratings didn’t change much in the second half of last year.

“After a sharp repricing of risk in March, many investors foresaw that markets would eventually return to ‘normal’—the surprise was in how quickly that return came,” the report said.

But the tightening poses a problem for fixed income investors: spreads may be at pre-pandemic levels but the economic backdrop is still much worse than a year ago. The bond market recovery has “dramatically outpaced the economic healing,” the report said.

In short, “the easy money has been made,” and risks may outweigh the low potential returns with interest rates not expected to rise.

So why use bonds at all?

The report argues that too much emphasis is often put on the income component of fixed income: “the goal isn’t typically to generate 100% of the desired cash flow through current yield; the point is to generate a total return sufficient to cover the projected outflows with minimal volatility along the way.”

Bonds provide consistency and help smooth over volatility on the equity side. U.S. households have a record amount in cash after saving last year, but it doesn’t offer a negative correlation to equities, the report said. That role is reserved for high-quality government debt.

The report also knocked short-duration strategies, which it said make little sense with interest rates unlikely to rise before 2024. “Short duration products in this sense are a relatively expensive hedge against an extremely unlikely event,” Manulife said.

Instead, the authors recommended a broad, flexible core mandate for long-term investors that’s able to access different segments of the bond market.

Manulife said there will likely be more credit upgrades than downgrades this year, as revenue growth returns to normal — barring more national lockdowns. A steeper yield curve may also support credit spreads and provide opportunities for active managers, it said. Lower debt issuance in 2021 as corporations pare down their ratios during an economic recovery could also be a positive as supply tightens.

The report pointed to opportunities in asset-backed securities — such as credit card receivables and auto loans — as delinquency rates fall and mortgages. The U.S. residential real estate market remains strong, Manulife said, and there are “pockets of opportunity” within the maligned commercial segment. Those opportunities include self-storage and cold-storage facilities, as well as commercial real estate serving the health-care sector. Office buildings and shopping malls, meanwhile, continue to lag.

“Looking out over the next year, we see an investment environment in which active managers will have a chance to earn their pay,” the report said. “None of the drivers of passive returns—clipping coupons, or tightening spreads, or falling rates—will likely be meaningful drivers of performance in 2021.”