2022 Market Outlook

Target Real Income Opportunities

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.

Inflation-Adjusted Yields

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.

Implementation Ideas

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:

Senior Loans

High Yield