As the US presidential election result is only a few weeks away, I thought it might be good to think about the implications of the election result for Fixed Income / Bond investors.
Democrats v Republicans
Here is a scorecard comparing the key differences in policies between the two parties and how they may impact the fixed income / bond market. This summary is sourced from Lord Abbett.
Credit Spreads
Credit Spread is the difference between the Government and Corporate borrowing rates. For Example, if the 10-year US Treasury Bond is trading at a yield of 6% and a 10-year Corporate Bond is trading at a yield of 8%, the Corporate Bond offers 200 bps or 2% spread over the Treasury Bond. The credit spread indicates the risk premium of the Corporate Bond over the Treasury Bote. Credit Spreads tend to widen i.e. risk premiums increase when Corporate Bonds are considered to be a lot riskier compared to the Treasury Botes issued by the US Treasury and backed by the US Government. Under macroeconomic stress environments / shock, credit spreads tend to widen very aggressively and investors flock to buy more Treasury Bonds as it is believed that a bond backed by the US Government is as close to being risk-free. Treasury Bonds also have an active secondary market, making these instruments highly liquid i.e. easy/quick to convert to cash if/when required.
In general, corporate credit spreads are a better signal of recessions than stock prices. We will discuss in a separate post about why stock markets are not neccessarily a good reflection of the actual state of an economy. In March 2020, when the Covid-19 crisis resulted in lockdown measures across the different parts of the world, the corporate credit spreads widened aggressively. See chart below for the investment grade corporate credit spread, which reached 3.5% in March 2020. Global High Yield / Sub Investment Grade credit spreads reached 1,000 bps (10%) at the same time. This was not as high as the credit spreads widening seen during the global financial crisis in 2009, but it was very much headed in that direction. In the last week of March 2020, the fed intervention brought some stability to the markets and credit spreads started to tighten again. By October 2020, when I am writing this post, the spreads are nearly 4/5th the way back to pre-Mar-2020 levels. However, given the uncertainty around the US Presidential Elections, the credit spreads may widen again around Nov 3 2020 and we should expect some volatility in the bond markets.
The important thing here is that when Credit Spreads widen, risk premiums increase, return expectations increase due to higher risk, yield expectations increase and eventually applying a downard pressure on the bond prices.
Fixed Income Market
There are broadly four segments within the Fixed Income market:
Leveraged Credit
Investment Grade
Liquid and Securitized Products
Municipal Bonds
Leveraged Credit is provided to companies with risky credit profiles, i.e. lower credit ratings that fall in the speculative grade bucket. They are also referred to as High Yield issuers. Companies that fall in this bucket tend to have high financial leverage i.e. they will have more tranches of debt relative to the EBITDA (cash) they generate. Higher financial leverage implies higher risk and higher risk of default / bankruptcy due to being unable to meet mandatory interest payments on debt as and when they fall due. Higher risk means higher return expectations by the investors and therefore, higher interest rates and more stringent measures to protect the more senior tranches of debt within the overall capital structure. The COVID-19 macroeconomic stress has already had a large impact on the leveraged credit market and I think this effect will far outweigh any impact from the upcoming presidential election. There may be some increased volatility leading up to the election, but I expect the credit spreads in the sub investment grade to fall back to at least the current levels soon after the elections irrespective of a Democrat or Republican victory. There is likely to be a higher impact on credit spreads from potential COVID-19 resurgence and the associated prolonged lockdown measures than the US presidential elections.
Investment Grade market contains companies / issuers with a good credit rating. Again, the impact of the elections will be less of a factor in the long run. The 2016 US election was a good example. After the Republican / Trump victory in 2016, we saw significant volatility in the Treasury Bonds market where the trading volume of Treasury Bonds nearly doubled, with the bulk of the volume centralized in the 1.5 to 10 year maturity range. Asset Managers, Hedge Funds, Pension Funds, Endowment Funds, Central Banks across the world - all flocked to buy the US Treasury Bonds. Leading up to the election date in 2016, buyers outpaced the sellers but the pace of buying slowed down as the results of the 2016 election became cleaerer. I'd expect a similar trend this time around irrespective of a democrat or republican victory - we should see significant volaitlity in yields, widening credit spreads but short-lived before yields and spreads normalize to pre-election levels. Fun Fact - US Presidential Elections are held every 4 years on the first Tuesday of November. In 2020, the elections fall on Nov 3 2020.
Liquid and Secuiritized products are basically asset-backed secuirities (ABS). I'd expect less to no impact on this market. I think the tax policies will get more scrutiny than the financial regulation of these products, which means even a Biden / Democrat administration will have a lower impact on consumer finance sector through financial regulations compared to the previous Obama / Democrat administration in the 2008/09 financial crisis.
Municipal Bonds are debt securities issued by the state and local governments. Munis are often placed in the market as loans for investors to make directly to local governments and are used to fund public works such as infrastructure, healthcare etc. In my opinion, market for Municipal Bonds will be the most impacted by the US Presidential Elections as it touches on three key policy areas of conflict between the Democrats and the Republicans - (i) Tax, (ii) Healthcare and (iii) Infrastructure. So, lets look at these three important areas:
Tax: If Republicans win, the tax rates would stay at or closer to current levels. If the Democrats win, the tax rates are expected to go up, which can increase demand for Tax-Free bonds issued by the states. In either case, the US deficit is expected to grow as the governments (including the US) have to spend to get the economy back on track after the Covid-19 set back. Funding the deficit with prevailing tax rates may be difficult even for a Republican administration. So, there is a high chance that tax rates will go up under either administration.
Healthcare: Republican plans are less clear. If Democrats win, the Affordable Care Act brought into effect by the Obama Administration is likely to broaden in its scope. This is generally a good / supportive thing for the municipal bond issuers as more insured individuals would be able to pay their bills using the government assisntance. So, hospitals and health systems are less likely to have a cash inflow issue and unpaid bills.
Infrastructure: Biden is currently running on a 'Build Back Better' plan which seeks to create much needed jobs to build a modern, sustainable infrastructure and facilitate the adoption of green clean energy. If Democrats win the elections and the Senate to control the government, there is a high possibility of the market being flooded with new municipal bonds to boost infrastructure spending. This is generally a good thing for the Municipal Bond market and any upward pressure on yields initially will be absorbed by the market in the long run. Under the Obama Adminstration, we saw the 'Build America Bonds' - which were municipal bonds that featured tax credits or subsidies for bondholders. We may see something similar if Biden / Democrats are to win the election.
So, overall - I expect increased volatility leading up to the presidential elections but yields/spreads will rebound to pre-election levels in the short term. I expect the most material impact to be on the municpal bond market as the key issues of tax, healthcare and infrastructure can all have a profound impact on the level of issuance, pricing and yields/interest rates in the municpal bonds market.
In either case of Democrat or Republican victory, given the macroeconomic stress scenario the global economy is currently experiencing due to Covid-19 impacts, the long term interest rates will price in the requirement for greater funding needs as the governments (including the US) across the world are going to be spending a lot of money to fix their respective economies.
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