Another Challenging Year Ahead
January 2022
While 2021 was a profitable year for investors in equities, it proved to be a difficult one for fixed income investors. The Bloomberg U.S. Aggregate Index (Agg), a proxy for diversified core investment-grade fixed income exposure, ended the year lower by 1.5%, the index’s first negative return year since 2013. Investment-grade (IG) corporate bonds didn’t fare much better as the Bloomberg Corporate index fell 1% as the longer duration nature of these bonds made the index more negatively impacted by rising interest rates in the belly (5 to 10-year area) of the yield curve throughout the balance of ’21. We expect the longer duration profile of the IG corporate bond index to act as a headwind in 2022 as Treasury yields across the curve move higher amid FOMC policy normalization and moderating, albeit above-trend U.S. economic growth. This backdrop leads us to favor short duration IG corporate bonds relative to short-term U.S. Treasuries as investors can clip a modestly higher coupon with minimal price risk.
Lower quality, higher yielding bonds performed well last year, evidenced by the 5.3% total return generated by the Bloomberg U.S. High Yield index. The High Yield index has a duration of just 3.8 years versus 6.8 years for the Agg and 8.6 years for the Corporate index, thus an allocation to high yield bonds is one avenue for investors to clip a higher coupon while lowering interest rate sensitivity within their portfolio in the process. However, while the 4.6% yield-to-worst (YTW) on the High Yield index holds appeal relative to the Agg’s sub-2% yield and the IG corporate index yield of 2.5%, yields on riskier corporate bonds remain paltry relative to historical levels and as the FOMC takes steps to normalize monetary policy, volatility in interest rates and wider credit spreads will likely follow. We expect true price discovery to return to the corporate bond market as the FOMC steps away from pandemic-era support, and credit risk could quickly become more appropriately priced via higher yields on corporate bonds, which would present asset allocators and active managers with a more appealing opportunity set as defaults should remain near rock-bottom levels throughout the balance of ’22.
While early in the new year, 2022 has brought with it sharply higher yields on U.S. Treasuries and European sovereign bonds. The yield on the 10-year U.S. Treasury ended the first week of the new year higher by 21 basis points, while the 10-year German bund yield closed the week 25 basis points above its December 15 close. The pace of the year-to-date move higher in global sovereign bond yields has been unsettling for fixed income investors and has contributed to losses for fixed income indices early in the new year, a hole that will be difficult to dig out of as we expect rates to continue to rise, albeit at a more gradual pace, over the balance of 2022.
While it may feel like the time to make sweeping changes to fixed income portfolios, three simple concepts – diversification is key, know what you own, and boring is often best - that served us relatively well in 2021 remain top of mind for us, and we expect few near-term shifts to our preferred positioning. Specifically, we maintain a portfolio duration below that of our benchmark to limit interest rate sensitivity as we expect U.S. Treasury yields to rise in ’22. We prefer short duration investment-grade corporate bonds relative to short-term Treasuries, maintain an allocation to lower quality high yield corporates in-line with our strategic target, and continue to bolt-on exposure to emerging market debt as a diversification tool. Stay patient and diversified as we expect more appealing relative value opportunities to be presented over coming quarters.
Source: Bloomberg, Factset
