2021 has been a difficult year for bond investors, with inflation eclipsing bond markets throughout the year. Will investors see any improvements this year? Money Marketing asked four bond experts to share their outlook for 2022.
Kipp Cummins, Head of EMEA Bonds and Vice President of Dimensional Fund Advisors
The first quarter of 2021 was difficult for bond investors. Talks about tapering and expectations of rising inflation have pushed yields higher and prices lower. For long-term bond investors, this meant negative returns at the start of the year. In some bond markets, this was the worst quarter in decades.
Few bond investors experience a rout, but this volatility creates opportunities that we can systematically exploit. The level of return is only part of the fixed income story, and a flexible approach to term, credit and country exposure can increase your expected return.
For example, the yield curve for the US Treasury steepened in 2021, which means that US medium and long-term bonds are now paying comparatively more than in 2020; more than their shorter-term counterparts; and more than other equivalent markets (including UK). The same goes for curves in Australia, New Zealand and Canada.
The flexibility to allocate to other countries (while hedging exposure to foreign currencies) and the dynamic adjustment of forward exposure, presented opportunities to increase the expected returns of bond portfolios in 2021.
This flexibility is also useful in the credit markets. When credit spreads widen, your expected return should increase. This has made corporate credit markets relatively less attractive than their higher-quality government counterparts recently, as the difference in yield between higher-rated and lower-rated bonds (the spread) has been narrow. We will be watching this closely next year and if markets start to reassess credit risk and spreads widen, we will look to take on more credit risk by buying lower rated bonds in search of higher premiums. high.
An important consideration in 2022 will be understanding how asset prices are set. Information (even information speculation) is quickly processed and incorporated into prices. This means that today’s prices already reflect everyone’s expectations for this year’s themes such as cut, central bank rate, inflation, credit risk and anything that affects value. current future cash flow. Adopting a strategy that accepts this point and can aim for a return above the market without relying on the predictions of these variables may make sense.
Peter Doherty, Head of Fixed Income at Sanlam
As an investor with over 30 years of experience in the financial markets, I have developed a healthy skepticism about the usefulness of macro forecasting. Not only is macro forecasting virtually impossible, but taking advantage of a good market response to a given macro environment is the second part of the challenge.
Indeed, consumer and commodity price inflation in 2021 provided the perfect example of values that no one had expected (3% pa to 8% pa) combined with a bond market reaction that no one had expected. could not have expected. given these inflation rates (US, UK and European 10-year yields) which end the year well below 2%.
Two drivers of significantly negative real rates on government bonds and part of the credit markets can be seen as “tactical” and “structural”.
Tactically, investors have kept government bonds with the idea that inflation is transitory (transitory having taken over from “unprecedented” as the term most used). Structurally, and I think much more importantly, the regulatory framework of banks, insurance companies and pension funds results in massive uneconomic demand for government bonds which are therefore by definition artificially expensive.
So a starting point for navigating fixed income securities in 2022 is to minimize government bond holdings in favor of cash. There is an argument for staying invested in the asset class because if this demand is permanent, there will always be support for the market. But, given the very low real yields and very flat yield curves (meaning that the yields don’t increase much with maturity), cash is arguably safer because it has no nominal value risk, only a “real value” risk.
Second, in 2018-2021, many companies took advantage of low multi-generational interest rates to issue bonds. While corporate balance sheets are generally strong right now, in the event of an economic downturn or prolonged economic downturn related to Covid-19, credit may become less readily available and credit spreads may increase.
If we look at the global credit markets, there are many Single A and BBB bonds with a yield of less than 3% and where the duration and credit risk are built in. The risk here is less about the permanent loss of default capital and more about the market risk and mark-to-market losses, which can take a long time to recover from the current low return. The SLXX LN ETF is a perfect example: it has a negative return worse than – 4% in 2021 or greater than “- 8% actual”.
There is virtually no risk of default in the portfolio’s credit securities, but the combination of low yields, credit market risk and long duration is toxic. The 2021 market decline in this ETF will take more than 2 years to recover at current yields on a nominal basis only and rather 4 years on an actual basis. If yields continue to rise, this time around, sustaining capital value in real terms could easily extend over 6 to 8 years. It is a risk with no return.
So what to do? Today’s environment lends itself beautifully to detailed research, bottom-up investing, and “brick-by-brick” portfolio construction. Every £ of allocated capital must be useful! This means recovering idiosyncratic premiums, liquidity and complexity from individual titles where there is clearly identified differentiation and added value characteristics.
Ironically, the flip side of QE and central bank lavishness is that there is no more free money to invest on credit – certainly not after inflation. The generic long index only and fixed income ETF products offer the average return of the asset class and I can say without ambiguity that in 2022 this average return of an average generic fixed income portfolio will not be attractive. Be active, focus, and leave the unattractive generic market middle on its own until it redefines pricing to deliver an investment return.
Jim Leaviss, Director of Investments, Public Fixed Income
If you had asked me a few years ago where the yield on 30-year bonds would be if inflation in the United States was above 6%, I certainly would not have answered below 2%.
The Federal Reserve seems more concerned with the unemployment rate than inflation – despite the market talking about two Fed rate hikes in 2022 – and yet the unemployment rate is falling every month.
When I think about the type of fixed income assets that might perform well in this kind of environment, I like inflation-linked bonds and inflation-protected treasury securities because they will protect you in a to some extent when inflation rises.
The other thing that works well for me in this kind of environment is emerging market bonds. As always, there is going to be a lot of risk and volatility when investing in emerging market debt, but this probably seems like the best place for fixed income value to be right now.
We’re going to see a lot more green bonds and sustainable linked bonds over the course of 2022 and this will be a great opportunity for our funds to start buying some of these assets.
Noelle Cazalis, manager of the Rathbone High Quality Bond Fund
Inflationary pressures continue to worry the markets. Price pressures are mounting in most major economies, and we expect inflation next year to remain high, forcing central banks to keep promises to raise rates to contain inflation.
Concerns about the ability of inflation to undermine the rebound in post-pandemic growth are also growing, especially as some European countries embark on new waves of restrictions due to a surge in Covid cases .
As a result, we expect rate volatility to continue. Changes in interest rate expectations led to a sharp revaluation of the short end of the gilt curve in September – these moves provide us with opportunities to secure a higher yield.
Overall, we consider the risk associated with rate market returns to be on the upside, particularly on the long end of the curve. To help protect against these, we recently sold our longer term loan and reduced our term.
On the credit side, a moderate rise in rates should be manageable for spreads. The outlook for default is benign and collection rates have improved this year. We expect this to continue into the next year as the policy, on the whole, remains accommodative.
However, as valuations are somewhat tight, the scope for reducing spreads is limited compared to last year. Stock selection remains the key.
We continue to favor bonds issued by well-capitalized financials and which should benefit from a steeper yield curve.