Global core bonds are poised to register their worst calendar year return (-4.3%) since 2005,1 dragging down traditional 60/40 portfolios along with them. And duration risks continue to increase, with the overall duration of core bonds setting 21 new highs this year and currently sitting at the highest peak ever of 7.6.2
Given that the aggregate 10-year rate forecast for major G8 nations is a move from the current 1.12% to 1.40% in 20223 as some central banks start to tighten while others stay put, negative returns for core bonds could occur once again in 2022 from duration risks alone. But even if core bonds rebound into positive territory in 2022, as they historically have in the year following a negative return,4 returns are likely to be negative after accounting for the effects of inflation — which is forecasted to be above trend for the next two years at 3.3% and 2.8%, respectively.5
While core bonds’ returns were poor, below investment-grade credits posted gains this year (+5.06%).6 And their outlook remains sound for 2022, with default rates expected to be just 1%, down from 3.5%;7 45% earnings before interest, taxes, depreciation (EBITDA) year-over-year growth in 2021;8 the lowest gross leverage for firms since mid-20199 and roughly two upgrades for every downgrade.10 Like equities, the backdrop remains supportive for credit, even with valuations stretched as spreads are tight (306 basis points versus a 550 basis point average).11
Increasing duration, diverging central bank policies and rising inflation will present real challenges in 2022. Therefore, target real income opportunities (yields above inflation expectations) with limited rate sensitivity. Naturally, however, that may lead to higher implicit equity risk in bond portfolios at a time when bond volatility is in the 92nd percentile over the past five years.12 Therefore, seek to offset this real income credit risk with real income defensives and take on duration risk with Treasury Inflation-Protected Securities (TIPS) instead of nominals to add portfolio diversification.
Bear in Mind Central Bank Divergence
In unison, global central banks slashed rates and initiated bond purchasing programs to thwart the economic calamity of the COVID-19 pandemic. Almost two years removed, central banks around the world are beginning to take diverging paths, with some tightening measures and others maintaining crisis-level policies.
The US Federal Reserve (Fed) is starting to taper purchases slightly, while the Bank of Canada is outright cancelling their purchasing plans based on region-specific inflationary pressures.13 The European Central Bank (ECB) is looking to maintain emergency policies and keep rates low, while the Fed, the Bank of England14 and the New Zealand Central Bank15 are either already tightening or have announced tighter policy actions are coming soon.
These divergent central bank actions will not create the same tidal wave of liquidity that so fully supported risk assets throughout the early parts of the recovery. In particular, the Fed is projected to hike rates twice in 2022, based on consensus forecasts as shown in the following chart.16 But both the Bank of Japan and the ECB are not quite there yet. And the People’s Bank of China is on its own course given weakness in parts of the economy juxtaposed with elevated inflation that would make easing measures unlikely.
Markets Implied Fed Funds Rate versus Dot Plots
In the US, there will be an upward bias on rates as the Fed tries to balance inflation and growth with its policy decisions. Yet, the yield curve is likely to flatten as it has in past tightening cycles. However, the flattening may have more of a see-saw action, rising and falling at times based on the latest economic data with no consistent directional trend. And the flattening is likely to be categorized as a bear flattener, as short-term rates (pushed by the Fed) are likely to rise faster than long-term rates.
All of this will differ from what occurs in other local markets, as the peak of coordinated monetary policies is likely behind us. The movement of 2-year yields, the most sensitive government bond rate to central bank actions, among major nations offers a fair representation of this. Canadian, Australian, UK and US 2-year yields have all risen this quarter, while German, French, and Japanese bonds have fallen.17 The latter group will likely continue that trend given their central bank stances, or at least be restrained in 2022. This will limit the income potential from developed non-US bonds in 2022, a segment that still has 34% of its market value trading with a negative yield, let alone one below that of inflation.18
Meet the Real Income Challenge
The through line to all of this is that rates, even though they are set to rise in some nations, are still likely to be extremely low versus historical standards. The 45-year average yield on core bonds is 6.3%, while today the yield is 1.7%.19 However, the long-term average is not a fair comparison given the changes in the economy and crisis-era policy tools that have pushed yields structurally low since the great financial crisis. Yet, today’s yield is still well below the more recent 5- and 10-year averages (2.23% and 2.25%, respectively).20
To obtain at least the average income stream over the past decade, it would require 1.3x leverage. Even if it were attractive to use that much capital from a nominal perspective, the potential yield would still be below that of inflation expectations over the next five and 10 years. Breakeven rates are currently at 3.2% and 2.76%,21 meaning that even a levered core bond portfolio would generate negative real income. A point reinforced by the fact that currently 96% of core US bond market value has a negative real yield after considering inflation expectations for the next five years.22
Given these dynamics, investors must target credit instruments that have a yield above inflation expectations. As shown in the following chart, this doesn’t leave many options. Loans, preferreds, emerging market local debt (EMD), and US high yield are the only segments with a positive inflation-adjusted yield, as well as a positive inflation-adjusted yield per unit of duration.
For EMD this is a bit deceiving, as currency risk is a larger driver of returns and not duration. For instance, our research shows that there is an over 90% correlation of monthly returns of EMD and EM local currencies.23 And given the expectation of higher growth and rising rates in the US relative to EM broadly, currency effects could be once again a drag on EMD returns and negate the attractive yield from a total return perspective.
Preferreds, US high yield, and senior loans remain the most attractive. Preferreds have the added potential benefit of being primarily investment-grade rated,24 and fixed-rate high yield bonds have outperformed all other segments referenced in 2021,25 despite having two percentage points of return subtracted due to duration impacts.26 Yet, out of those three, while preferreds and high yield represent strong opportunities for yield in this market, loans might be the most ideal allocation right now.
Senior loans’ floating rate structure may prove to be quite valuable should rate hikes impact the short end of the curve. In addition to mitigating any potential duration-induced return headwinds, their floating rate component increases the potential yield as the securities’ underlying coupons adjust to the prevailing short-term market rate they are tied to.
Additionally, if the credit rally does stall or if macro risks pile up, loans that are more senior in their capital structure historically have witnessed lower relative levels of volatility than fixed rate high yield (4.50% vs. 6.52% ).27 The downside deviation for loans is also better than high yield (7.74% vs. 12.21%).28 Overall, loans’ potential to generate high income and the floating rate structure can possibly reduce the negative impact of higher rates, making loans an integral part of a diversified credit portfolio in this environment.
Barbell Bonds to Mitigate Risk
Barbelling credit with TIPS could add another real income stream, this time on the defensive side of a bond portfolio. Because TIPS are backed by the full faith and credit of the US government, they have low credit risk. Adding TIPS to a portfolio also could help counteract some of the equity risk introduced by overweights to credit.
Price increases are being felt across many advanced economies because of pandemic-related factors, such as supply chain disruption, consumer demand and employee shortages. As a result, so far in 2021 owning TIPS instead of nominals has been a beneficial swap, as TIPS have outperformed nominals by 8.64%.29 TIPS have also outperformed the Bloomberg US Aggregate Bond Index (Agg) by 7.70%,30 even though they have a longer duration (8.4 years versus 6.7 years).31 Given that inflationary forces (still-accommodative policies even with a taper, plus increased fiscal spending) will likely remain high, a TIPS allocation may continue to be rewarded.
Overall, as a distinct asset class from Treasuries — and not a component of the widely followed Agg — TIPS tend to behave differently from other investments that are commonly found in core bond portfolios. TIPS are not perfectly correlated to common fixed income investments and have a low correlation to both US and international, as shown in the following chart,32 making them a valuable portfolio diversifier.
Bond Sector Correlation to Equities
Therefore, including TIPS may help improve the risk/return profile of a diversified portfolio irrespective of the market’s inflation dynamics. And since TIPS ETFs pay out all earned income in the portfolio, including the inflation adjustment that is applied to the fund's underlying securities (unlike individual TIPS), a TIPS ETF may be a better source of current real income than owning TIPS outright.
Rates are likely to rise in 2022, but remain below that of inflation. This will put a strain on both positive total returns, as duration-induced price declines could wipe out any yield advantage, and real income generation. If rates were to rise by 100 basis points, 81% of core bonds’ market value would still trade below the expected rate of inflation over the next five years.33
With duration at peak levels, extending out further on the curve to obtain yield may not be optimal given the current sizeable asymmetry between yield and duration — even if the curve does flatten modestly in 2022. To focus on real income opportunities, consider:
1 Based on the returns of the Bloomberg Global Aggregate Bond Index as of November 12, 2021 per Bloomberg Finance, L.P. 2 Based on the duration of the Bloomberg Global Aggregate Bond Index as of November 12, 2021 per Bloomberg Finance, L.P. 3 Bloomberg Finance, L.P. as of November 11, 2021, based on consensus economists’ forecasts. 4 Average return was 3.18% across six observations based on the returns of the Bloomberg Global Aggregate Bond Index as of November 12, 2021 per Bloomberg Finance, L.P. and SPDR Americas Research Calculations. 5 Bloomberg Finance, L.P. as of November 11, 2021, based on consensus economists’ forecasts. 6 Based on the returns of the ICE BoFA US High Yield Index as of November 12, 2021 per Bloomberg Finance L.P. 7 Fitch now expects the high yield default rate to come in at just 1% by the end of 2022. This represents a drop from its previous forecast of a 2.5% to 3.5% default rate per Fitch, September 2021. 8 BofA High Yield Strategy, Valuations and Rel Val Going Into 2022, November 12, 2021. 9 Gross-leverage has declined from a peak of 6.2x to 4.8x now. BofA High Yield Strategy, Valuations and Rel Val Going Into 2022, November 12, 2021. 10 Bloomberg Finance, L.P. as of November 12, 2021, based on S&P ratings of US High Yield issuers. 11 Based on the option adjust spread of the ICE BoFA US High Yield Index as of November 12, 2021 per Bloomberg Finance L.P. 12 Bloomberg Finance, L.P. as of November 11, 2021, based on the ICE BofA MOVE Index. 13 “Bank of Canada ends bond buying program as economy recovers,” MarketWatch, October 27, 2021. 14 "Bank of England hints at future interest rate rise," BBC News, November 4, 2021. 15 “New Zealand raises rates for first time in seven years, more to come,” Reuters, October 5, 2021. 16 Bloomberg Finance, L.P. as of November 12, 2021. 17 Bloomberg Finance L.P., based on the US-2-year yields for the country’s sovereign bonds as of November 12, 2021. 18 Based on the holdings of the Bloomberg GLA xUSD Index per Bloomberg Finance L.P. data as of November 12, 2021. 19 Based on the yield of the Bloomberg US Aggregate Bond Index per Bloomberg Finance L.P. data as of November 12, 2021. 20 Based on the yield of the Bloomberg US Aggregate Bond Index per Bloomberg Finance L.P. data as of November 12, 2021. 21 Bloomberg Finance L.P. as of November 12, 2021. 22 Based on the holdings of the Bloomberg US Aggregate Bond Index per Bloomberg Finance L.P. data as of November 11, 2021. 23 Based on the monthly returns of the Bloomberg EM Local Currency Government Diversified Index and the return on the MSCI EM Local Currency Index, per Bloomberg Finance L.P. data from 2011 to 2021 as of October 31, 2021. 24 75% of the holdings within the ICE Exchange-Listed Fixed & Adjustable Rate Preferred Securities Index have a Bloomberg Composite Rating above investment grade. 25 As of November 12, 2021, the ICE BofA US High Yield Index had return 5.06% versus the S&P/LSTA Leverage Loan Index return of 4.92%, per Bloomberg Finance L.P. data. 26 Based on an attribution of year-to-date returns of the ICE BofA US High Yield Index as of November 12, 2021. 27 FactSet as of October 31, 2021, based on returns of the S&P/LSTA Leverage Loan Index and the ICE BofA US High Yield from October 2011 to October 2021. 28 FactSet as of October 31, 2021, based on returns of the S&P/LSTA Leverage Loan Index and the ICE BofA US High Yield from October 2018 to October 2021. 29 Bloomberg Finance, L.P. as of November 12, 2021. Based on the Bloomberg US Treasury Index and the Bloomberg US Govt Inflation-Linked All Maturities Index. 30 Bloomberg Finance, L.P. as of November 12, 2021. Based on the Bloomberg US Aggregate Bond Index and the Bloomberg US Govt Inflation-Linked All Maturities Index. 31 Bloomberg Finance, L.P. as of November 12, 2021. Based on the Bloomberg US Aggregate Bond Index and the Bloomberg US Govt Inflation-Linked All Maturities Index. 32 Bloomberg Finance, L.P. as of November 12, 2021. Based on the monthly returns of the S&P 500 Index and the Bloomberg US Govt Inflation-Linked All Maturities Index from 2011 to 2021. 33 A naïve proxy calculated by applying a parallel shift of 100 basis points to the yields of the bonds within the Bloomberg US Aggregate Bond Index as of November 12, 2021, based on Bloomberg Finance L.P. data and SPDR Americas Research calculations.
Bloomberg US Aggregate Bond Index A benchmark that provides a measure of the performance of the U.S. dollar-denominated investment-grade bond market. The “Agg” includes investment-grade government bonds, investment-grade corporate bonds, mortgage pass-through securities, commercial mortgage-backed securities and asset-backed securities that are publicly for sale in the US.
Breakeven Rates The difference in yield between inflation-protected and nominal debt of the same maturity. If the breakeven rate is negative it suggests traders are betting the economy may face deflation in the near future.
Currency Risk The possibility of losing money due to unfavorable moves in exchange rates.
Duration A commonly used measure, expressed in years, that measures the sensitivity of the price of a bond or a fixed-income portfolio to changes in interest rates or interest-rate expectations. The greater the duration, the greater the sensitivity to interest rates changes, and vice versa. Specifically, the specific duration figure indicates, on a percentage basis, by how much a portfolio of bonds will rise or fall when interest rates shift by 1 percentage point.
EBITDA Earnings before interest, taxes, depreciation, and amortization, is a measure of a company's overall financial performance and is used as an alternative to net income in some circumstances.
Emerging Market Local Debt (EMD) Bonds issued by less developed countries.
Inflation The decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
Inflation-Adjusted Return The measure of return that takes into account the time period's inflation rate. The purpose of the inflation-adjusted return metric is to reveal the return on an investment after removing the effects of inflation.
Preferred Stock Preferred stockholders have a higher claim to dividends or asset distribution than common stockholders.
Treasury Inflation-Protected Securities (TIPS) A type of Treasury security issued by the U.S. government. TIPS are indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value.
Yield The income produced by an investment, typically calculated as the interest received annually divided by the price of the investment. Yield comes from interest-bearing securities, such as bonds and dividend-paying stocks.
Yield-to-Worst The lowest potential yield that investors can expect when investing in a callable bond without the issuer defaulting.
The views expressed in this material are the views of Michael Arone, Matthew Bartolini and Anqi Dong through the period ended November 17, 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
Prior to 02/26/2021, the SPDR® Blackstone Senior Loan ETF was known as the SPDR® Blackstone / GSO Senior Loan ETF.
Prior to 05/01/2021, the SPDR ICE Preferred Securities ETF was known as the SPDR Wells Fargo Preferred Stock ETF.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
Past performance is not a reliable indicator of future performance.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Diversification does not ensure a profit or guarantee against loss.
Investing involves risk including the risk of loss of principal.
Actively managed ETFs do not seek to replicate the performance of a specified index. These investments may have difficulty in liquidating an investment position without taking a significant discount from current market value, which can be a significant problem with certain lightly traded securities. The fund is actively managed and may underperform its benchmarks. An investment in the fund is not appropriate for all investors and is not intended to be a complete investment program. Investing in the fund involves risks, including the risk that investors may receive little or no return on the investment or that investors may lose part or even all of the investment.
Investments in senior loans are subject to credit risk and general investment risk. Credit risk refers to the possibility that the borrower of a Senior Loan will be unable and/or unwilling to make timely interest payments and/or repay the principal on its obligation. Default in the payment of interest or principal on a Senior Loan will result in a reduction in the value of the Senior Loan and consequently a reduction in the value of the Portfolio’s investments and a potential decrease in the net asset value (“NAV”) of the Portfolio.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investing in high yield fixed income securities, otherwise known as “junk bonds”, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
Because of their narrow focus, financial sector funds tend to be more volatile.
Preferred securities are subordinated to bonds and other debt instruments, and will be subject to greater credit risk. The fund may contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; inflation risk; and issuer call risk. The fund may invest in US dollar-denominated securities of foreign issuers traded in the United States.
Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable
Non-diversified funds may invest in a relatively small number of issuers, a decline in the market value may affect its value more than if it invested in a larger number of issuers. While the Fund is expected to operate as a diversified fund, it may become non-diversified for periods of time solely as a result of changes in the composition of its benchmark index.
Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
SSGA Funds Management has retained Blackstone Liquid Credit Strategies LLC as the sub-advisor. State Street Global Advisors Funds Distributors, LLC is not affiliated with Blackstone Liquid Credit Strategies LLC.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value and may trade at prices above or below the ETFs net asset value. Brokerage commissions and ETF expenses will reduce returns.
Standard & Poor's®, S&P® and SPDR® are registered trademarks of Standard & Poor's Financial Services LLC (S&P); Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones); and these trademarks have been licensed for use by S&P Dow Jones Indices LLC (SPDJI) and sublicensed for certain purposes by State Street Corporation. State Street Corporation's financial products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates and third party licensors and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability in relation thereto, including for any errors, omissions, or interruptions of any index.
Distributor: State Street Global Advisors Funds Distributors, LLC, member FINRA, SIPC, an indirect wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. ALPS Distributors, Inc., member FINRA, is the distributor for DIA, MDY and SPY, all unit investment trusts. ALPS Portfolio Solutions Distributor, Inc., member FINRA, is the distributor for Select Sector SPDRs. ALPS Distributors, Inc. and ALPS Portfolio Solutions Distributor, Inc. are not affiliated with State Street Global Advisors Funds Distributors, LLC.
THIS SITE IS INTENDED FOR QUALIFIED INVESTORS ONLY.
No Offer/Local Restrictions
Nothing contained in or on the Site should be construed as a solicitation of an offer to buy or offer, or recommendation, to acquire or dispose of any security, commodity, investment or to engage in any other transaction. SSGA Intermediary Business offers a number of products and services designed specifically for various categories of investors. Not all products will be available to all investors. The information provided on the Site is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation.
All persons and entities accessing the Site do so on their own initiative and are responsible for compliance with applicable local laws and regulations. The Site is not directed to any person in any jurisdiction where the publication or availability of the Site is prohibited, by reason of that person's nationality, residence or otherwise. Persons under these restrictions must not access the Site.
Information for Non-U.S. Investors:
The products and services described on this web site are intended to be made available only to persons in the United States or as otherwise qualified and permissible under local law. The information on this web site is only for such persons. Nothing on this web site shall be considered a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction.
Before investing, consider the funds' investment objectives, risks, charges and expenses. To obtain a prospectus or summary prospectus which contains this and other information, call 1-866-787-2257, download a prospectus or summary prospectusnow, or talk to your financial advisor. Read it carefully before investing.
Not FDIC Insured * No Bank Guarantee * May Lose Value