The economic backdrop remains one of strong growth (4.4% in both the US and Euro area) and elevated inflation. Inflation is high and has proved durable enough to prompt many central banks to start the process of withdrawing policy stimulus. The BoE and Federal Reserve are both expected to raise rates, while the ECB should reduce the purchases of bonds. Overall this creates a difficult backdrop for fixed income. We therefore focus on strategies that should benefit from the strong economic growth momentum or that limit risks from the high inflation, policy tightening environment.
Theme 1: Sustained growth momentum: Sticking with High Yield
The solid growth backdrop and rising yield environment mean that we continue to favour high yield exposure. Its lower duration and high coupon should support returns in an otherwise bond-unfriendly backdrop.
COVID weighed on growth at the close of 2021 but expectations for 2022 remain robust, with State Street Global Advisors forecasting 4.4% for both the US and Europe.1Above-target inflation, coupled with still-strong growth, set the scene for the Federal Reserve (Fed) to start its tightening cycle and the market has now priced in more than 3 rate rises from the Fed during the course of 2022. The ECB is on a more shallow trajectory but is expected to cease bond purchases under its emergency PEPP scheme at the end of Q1 2022. There is around a 50% chance of a 25bp rate rise priced in by the end of 2022.2
COVID waves could still curtail growth, but with many G10 countries opting to vaccinate and keep their economies open, dips in growth expectations have become increasingly shallow. As a result, we continue to favour high yield exposure for a few reasons: returns from the coupon; a favourable growth backdrop and avoiding a fight with the Fed.
Much of the return comes from the coupon
In an environment where the economic backdrop is likely to push bond yields higher, the coupon will provide a key source of returns. For example, in 2021, all of the 3.33% total return from the Bloomberg Liquidity Screened Euro High Yield Index was accounted for by coupon payments. With the yield to worst on this index being just over 2.8%, this comfortably outstrips yields available on either investment grade (0.5%) or government bond strategies (0.16%).3 In the US market, the Bloomberg SASB U.S. Corporate High Yield Ex-Controversies Select Index has a yield to worst of just over 4% against 2.28% for investment grade and 1.23% for Treasuries.
In addition, high yield bonds typically have a shorter duration than investment grade funds. The Bloomberg SASB U.S. Corporate High Yield Ex-Controversies Select Index has an option-adjusted duration of 4.0 against 8.65 for its investment grade counterpart, meaning its price is half as sensitive to moves higher in yields.
Strong growth still makes for a favourable backdrop for corporates
Strong economic growth should underpin earnings and help to sustain tight credit spreads. There are several potential challenges that companies face, not least high inflation and the potential for it to push wages higher. Rising central bank interest rates may also negatively affect earnings (outside of banks) but growth is forecast to remain stronger than trend, meaning there should be scope to pass on some of the rise in costs to the end user.
Furthermore, companies entered 2022 in good financial shape. The upgrades/downgrades ratio did slip from the highs in Q4 2021 but it remains firmly in positive territory both in Europe and the US.
Figure 1: Upgrades/Downgrades ratio for Western Europe off the highs but still well above 1
Don’t Fight the Fed
Looking at the 2016 policy cycle, high yield had a shaky start but then provided solid returns for the duration of the tightening. A key reason for the negative returns into the first rate rise was that the Fed tightened policy in a weakening growth environment; the manufacturing ISM had dropped below 50 by the end of 2015. Therefore, there were real concerns that policy tightening would kill growth. This proved not to be the case and the better performance of US high yield over the remainder of the tightening cycle coincided with the recovery in the ISM.
Figure 2: High Yield returns outstripped those of Treasuries during the last Fed tightening cycle
Past performance is not an indicator of future returns. It is not possible to invest directly in an index. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.
This return profile was not reflected by Treasuries, where the lower coupon and longer duration worked against them. They initially put in a better performance around the first rate rise but then returns stagnated for much of the tightening cycle, with a meaningful upturn not arriving until the final rate rise. With the latest signals from the Fed suggesting the potential for rapid rate rises and a run-down of the balance sheet, 2022 could prove to be a similar environment.
Theme 2: Emerging Market Debt: A More Defensive Twist
The high yield on emerging market debt makes it appealing, but 2021 proved that many other factors also have to align to produce positive performance. We look to other strategies, such as Chinese bonds, to raise returns and diversify risk. An alternative is inflation-linked bonds, which can provide some protection against surging price pressures.
Emerging market (EM) debt had a tricky 2021 and failed to deliver on its potential. The combination of fears over Federal Reserve (Fed) tapering, the resilience of the USD and high domestic inflation forcing their own central banks to tighten, all resulted in weakness through both the currency and the bond price.
We still see the potential for positive returns, not least because there are yields in excess of 5% 4 on offer. But in an environment of Fed policy tightening, which pushes US Treasury yields higher and supports the USD, it is unclear what the near-term catalyst for performance will be. In addition, there are few signs that the high inflation that drove local central banks to tighten policy is easing, with the PriceStats measure of inflation still pointing to strong rises in price pressures (see the PriceStats section of the Bond Compass).
Playing a more defensive game
There are still ways that investors can access the higher yields on offer and diversification benefits of EM debt without being exposed to all of the risks. One way is through Chinese government bonds.
Yields are at the lower end of the EM spectrum but remain high relative to developed markets. The yield to worst on the Bloomberg China Treasury 100BN Index was just below 2.7% at the close of 2021 against 1.23% for the Bloomberg US Treasury Index.5 Moreover, Chinese CPI is relatively subdued at 1.5% year on year, meaning real yields are positive, unlike in most of developed markets.
In contrast to many other central banks, a slowing economy means that the PBoC is currently easing monetary policy. This should support Chinese debt even if the sell-off in US Treasuries continues and therefore provides significant diversification benefits to a fixed income portfolio.
The CNY is on a managed float and, as a result, has remained firm versus the USD. This is in contrast to other EM currencies that depreciated significantly versus the USD in 2021 due to high inflation and uncertainty over the impact of COVID.
The flow backdrop should be supportive, with Chinese government bonds being included in the FTSE World Government Bond index from October 2021. There should be regular monthly inflows from investors wanting to reflect the construction of that index. In addition, Honk Kong’s Financial Services and the Treasury Bureau announced in December that the Hong Kong Mandatory Provident Fund should be able to invest in Chinese government bonds from mid-2022.
Protection from inflation
China’s CPI has remained well contained, but it is not the case in most of the rest of the EM complex. So while yields are high in nominal terms they are often low or negative in real terms. One way of protecting against this is through an inflation-linked bond fund.
As detailed in the PriceStats section, EM inflation shows little sign of abating. This should support the coupon payments on inflation-linked bonds. As can be seen in Figure 3, the yield on the Bloomberg EM Inflation-Linked 20% Capped Index had risen to around 8% by the end of 2021, largely due to the widening of break-even spreads.6
Figure 3: Wider inflation break-even spreads have forced yields higher
Even if inflation does start to ease, the lagged nature of the coupon payments (for instance, the current coupon paid out references inflation 4 months ago for South Africa and Russia) means that coupons should remain high for the coming quarter.
Inflation-linked bonds remain subject to many of the same risks as nominal bonds. For example, the catastrophic performance of Turkish debt and the lira were a key drag on returns of the Bloomberg EM Inflation-Linked 20% Capped Index in 2021. However, the high nominal yield should act to offset bond price declines as a result of central bank tightening, while at the same time benefitting if the USD does start to soften.
Yields could continue their rise as central bank tightening moves up a gear. This should favour short-duration strategies where the short end of the curve already prices in rate rises. Investment grade exposures would be preferred given better carry than government bonds.
It has been a tricky start to 2022 for bond investors, with yields pushing higher on the back of the pivot by the Federal Reserve (Fed) toward a more aggressive policy stance. While the Fed continues to buy US Treasuries, rhetoric from the FOMC that it will accelerate policy tightening as a result of the persistently high level of inflation has seen the December 2022 Fed Funds Future move from pricing rates at 20-30bp at year-end to 95bp .7
This pricing of between 3 and 4 rate hikes is aggressive and should see the front end of the curve fairly well protected. In short, it is difficult to see the Fed delivering more than 4 hikes this year. However, that does not mean that the bond market sell-off has run its course. The market still prices a relatively low terminal rate. The 1-month USD overnight index swap rate (a proxy for the Fed Funds rate) is at just 1.75% 5 years forward. So the market is projecting a contained rate hike cycle but the peak would be low relative to the Fed’s dot plot (2.5%) and in the context of such a high inflation rate.
Many of the factors driving inflation are supply related and therefore not likely to be affected by policy rates. However, as Figure 4 illustrates, the Fed Funds rate peaks in previous cycles have at least been somewhere near to the highs in inflation, otherwise real rates remain heavily negative and are therefore insufficient to bear down on aggregate demand. While inflation is set to ease from the highs there are risks that the market starts to question the assumption of a low terminal rate and this could see yields in the belly of the curve continue to push higher.
Figure 4: The top to Fed Funds Rate has historically been above US inflation
Sticking to short-duration strategies
A focus on short-duration strategies would reduce investor sensitivity to any further upside rate risk. For instance, the Bloomberg 0-3Y EUR Corporate Index has less than 30% of the duration of the all-maturities index, meaning price losses suffered for a given rise in rates will be more than 3 times greater for holders of the all-maturities index.
We prefer investment grade (IG) credit exposures to government bonds for three reasons:
Yields are still historically low and IG exposure offers more by way of carry as spreads to government bonds have widened from their tightest levels seen over the summer.8 We see limited risk of a material spread widening given the strong underlying growth expected in 2022 – indeed, if growth materially disappoints then the Fed will most likely pause or delay the tightening cycle (see Theme 1 for a wider discussion on this).
The State Street flows tracker suggests that there has been a swing in investor preferences away from Treasuries (outside of TIPS), but flows into IG credit have picked up.
Short-end IG credit funds typically have large exposure to bank bonds – both the Europe and US Bloomberg 0-3 Year corporate bond indices have a sector allocation of more than 39% to banking bonds. Unlike regular corporates, higher yields and steeper curves typically boost banking profits and thus should not be associated with any deterioration in credit quality.
For EUR exposures there is the added backstop that the ECB continues to purchase corporate bonds. While the PEPP is scheduled to come to a close at the end of Q1 2022, purchases under the CSPP programme are likely to continue and, in 2021, these purchases averaged EUR 1.5 billion per week.
2Source: Bloomberg Finance L.P., as of 5 January 2022.
3The yield to worst levels reference the Bloomberg SASB Euro Corporate Ex-Controversies Select index and the Bloomberg Euro-Aggregate: Treasury Index for EUR and the Bloomberg SASB U.S. Corporate Ex-Controversies Select index and the Bloomberg US Treasury Index for USD. Source Bloomberg Finance L.P., as at 31 December 2021.
4The yield to worst on the Bloomberg Emerging Markets Local Currency Liquid Government Index was 5.2%. Source: Bloomberg Finance L.P., as at 31 December 2021.
5Source: Bloomberg Finance L.P., as at 31 December 2021
6The yield to worst on the Bloomberg EM Inflation-Linked 20% Capped index averaged 8.01% during the final week of 2021. Source: Bloomberg Finance L.P., as of 31 December 2021.
7Source Bloomberg Finance L.P. As of 10 January 2022
8The option-adjusted spread on the Bloomberg 0-3Y EUR Corporate Index has widened out above 56bp from tights of 48.2bp and the Bloomberg 0-3Y US Corporate Index has widened to 47bp from 34.2bp. Source Bloomberg Finance L.P., as of 10 January 2022.
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