Beyond the horizon

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October 1, 2020
Although this upcoming presidential election is filled with uncertainty, one of the best-case scenarios for bond markets, in fact all markets, will be if things remain gridlocked, according to Gautam Khanna, senior portfolio manager of the BNY Mellon Core Plus Strategy.

A gridlock occurs in US politics when no single party has full control of both the legislative and executive branches of government, making it harder to pass new laws.1 This election, it can happen if Democratic Party contender Joe Biden wins the presidency but the Republican Party maintains control of the Senate and Congress remains split. It can also happen if Republican Party incumbent Donald Trump gets reelected and Democrats maintain control of the House of Representatives but fail to take the Senate. Because split party control makes it harder for either side to propose and enact new law without being challenged, seismic shifts in policy become less likely.

“I would say markets love lack of change. The best-case outcome is void of significant changes to policy. Its’ not about Washington, it’s about the real economy,” Khanna says. “That’s probably the most plausible outcome and I believe one of those two scenarios combined would probably be 75%+ probability.”

If one party does end up with total control, Khanna says it could lead to a bumpier road for markets. For example, if Biden wins and the Democrats take control of the Senate, he would likely have an easier time implementing some of his tax proposals, including a higher corporate tax rate,2 which Khanna says would be bearish for equity markets and risk markets in general.

Regardless of the election outcome, Khanna stresses that investors should remember the purpose of fixed income. Currently, he is keeping his focus on the real economy, resilience of corporate issuers, and the prospect of recovery.

Staying the course

Amid residual volatility from Covid-19, as well as uncertainty tied to the upcoming election, Khanna says his game plan hasn’t changed all that much. It’s still about providing both income and ballast. We must not lose sight of fixed income’s intended role in portfolios, which is not about maximizing yields, he says— but instead, providing diversification and stability.

“Rates are low right now but they’re low for everyone and that impacts all asset classes. There’s no question that total return from investment portfolios are going to be lower moving forward, but do we really want to question if fixed income exposure is still necessary?” he asks. “Just on yields, we’re currently earning a little over 2% on a gross basis. That doesn’t sound like much, but relative to the Bloomberg Barclays US Aggregate Bond Index,3 or even the S&P 500,4 it’s not too bad.”

However, total return on a fixed income strategy is not solely down to upfront yield. Khanna and his team are also capturing price movements through a diversified basket of fixed income securities, which include asset-backed securities, government bonds, high yield and investment grade corporates, loans and even US$-based emerging market bonds, he says.

“One of the key things bond portfolios offer is a diversification benefit5. That’s diversification against uncertainty at a time when the path ahead is anything but certain,” he says.

Despite a cloudy forecast for post-election market conditions, Khanna says the pandemic has helped bring clarity to the health of corporate issuers and, as a result, he and his team are not unnerved by the prospect of rising default rates. Certain areas of the market had already been prone to defaulting eventually, but the pandemic has accelerated this trend, he says. For instance, some bricks-and-mortar clothing retailers were already struggling because of the shift to online shopping. But because of Covid-19 and the resulting six-foot economy, defaults, which were probably three to five years out, have been pulled forward, according to Khanna.

“It’s a structural bias to avoid issuers that would be prone to default in an environment like this,” he says. “However, there are other areas that have been downgraded because of Covid and it’s no fault of their own, but rather because of the environment.”

To Khanna’s point, not all companies currently under stress were expected to default or undergo downgrades prior to the pandemic. Some businesses that were otherwise healthy—but may have depended on ticket sales for live events, or even specialized in office wear, for instance —are now struggling due to lockdowns and shifting operational criteria. These are businesses where, prior to the pandemic, there were no secular trends brewing that could potentially knock them off kilter.

As a result, Khanna and his team take into account the reason for a particular corporation’s downgrade and differentiate whether or not the business had been undergoing secular headwinds prior to the pandemic. Taking the nuances of each situation into consideration, he believes expectations of corporate defaults may not be as bad as some project.

“We’re not too worried about the default rate spiking and I think it’s actually going to undershoot fears,” Khanna says. “This is because the market is open and the economy is bouncing back more forcefully than may have been feared at the start of this.”

“That doesn’t take away the fact that there are still winners and losers, and we are laser focused on those capital structures that we believe have durable and sustainable balance sheets where we will actually ‘realize’ the yield on offer with a high degree of confidence,” he concludes.

1 Investopedia: Gridlock. August 22, 2019.

2 Kiplinger: Election 2020: Joe Biden's Tax Plans. September 18, 2020.

3 The Bloomberg Barclays US Aggregate Index is a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the US.

4 The S&P 500 Index is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States

5 Diversification cannot assure a profit or protection against loss.



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