Bond Compass

Fixed Income Outlook: Preparing for Normalization


Q1 2022

Head of SPDR Americas Research

From a cultural and societal perspective, normalcy is unlikely to be restored to pre-pandemic levels in 2022 — if ever. However, recent comments and actions from global central banks make policy normalization more likely. Yet, with the central banks in Japan, Europe and China still anchored in crisis-related policies, it will not be a coordinated approach.

A diverging path to normalization will likely foster heightened rate volatility. And while rates will likely rise, they will remain low relative to historical levels as well as to expected inflation. This means investors will have to navigate this normalization path alongside a still stubbornly substandard income environment.

These low levels of income generation were met by negative total returns in 2021. That said, bonds have not had back-to-back calendar year losses since 1973.1 When positioning for the new year, sector selection may support bond portfolios on this path to normalization.

Diverging paths for normalization

The US Federal Reserve (Fed) has accelerated its taper and is forecast to be done by March, while the Bank of Canada has canceled its purchasing plans. The European Central Bank is looking to maintain emergency policies and keep rates low. Yet the Fed, the Bank of England and the New Zealand Central Bank have already either begun tightening or announced that tighter policy actions are coming soon.

More specifically, the Fed is planning to hike rates three times this year, with the first action most likely coming in May (99% probability based on implied market pricing). There is a 66% chance, however, that the Fed hikes in March.2 Therefore, higher rates could be on the horizon as early as Q1 — a possibility underscored by the statement in December’s meeting minutes that “participants generally noted that, given their individual outlooks for the economy, the labor market and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”3

Beyond this divergence among large developed central banks, there is an even greater divide between developed market (DM) and emerging market (EM) central banks. Given the more significant upward inflation pressure in their regions, 35% of central banks in EM nations have raised rates in the past three months versus just 16% in DM nations.4 Finally, there is also divergence within EM, as China, seeking to quell a housing crisis and a slowing economy, has already cut rates and is expected to continue to do so in 2022.

High volatility and higher, but still low, rates

These divergent central bank actions will likely stoke rate volatility, a possibility highlighted by the CBOE MOVE Index, a measure of implied rate volatility, in the 91st percentile over the past three years.5

The 30-day realized volatility for US Treasury bonds also sits in the 91st percentile based on a three-year lookback and is in the 97th percentile over the past decade.6 Credit volatility, however, is in just the 57th percentile for both periods,7 as credit markets continue to exude:

  • Strong fundamentals: High yield earnings have fully recovered from COVID-19 back to 2019 levels8
  • Supportive sentiment: There are currently 1.5 upgrades to every downgrade in high yield9

Combined with a default cycle that is expected to remain below historical averages,10 strong fundamentals and supportive sentiment have served as backstops to increased risk.

Amid the likely uptick in rate volatility, however, there will be an upward bias for US rates as the economy continues to slowly recover and the Fed implements its forecast policy decisions. Yet the yield curve is likely to flatten, as it has in past tightening cycles. This flattening is likely to be categorized as a bear flattener, as short-term rates (pushed by the Fed) will likely rise faster than long-term rates.

This is a trend we have witnessed over the past three months (39 basis points of flattening),11 as the Fed has telegraphed its plans (impacting the two-year yield) and the long end remains somewhat constrained given the lingering virus concerns.

While the curve is likely to flatten, the movements most likely will have more of a seesaw action, rising and falling based on the latest economic data with no consistent directional trend.

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. Today’s yield on core aggregate bonds (1.9%) is below five- and 10-year averages (2.23% and 2.33%, respectively).12 To obtain at least the average income stream over the past decade would require 1.2x 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, at 2.83% and 2.50%, respectively.13 In fact, roughly 90% of core US bond market value has a negative real yield after considering inflation expectations for the next five years. And while inflation may have peaked in 2021, it is forecast to be above trend globally for the next two years at 3.9% and 2.9%, respectively,14 and that will impact portfolios.

To prepare for normalization, investors may want to consider these three tactics for the next quarter:

1. Focus on ultra-short duration to move with the Fed

As revealed in the December meeting minutes, the Fed is taking a more hawkish stance than previously thought. Its comments, as well as forecast actions (potentially three rate hikes this year), are likely to push the short end of the curve, the segment most sensitive to policy actions.

However, duration is extended on traditional core bond exposures, both short and intermediate. The Bloomberg US Government/Credit 1-5 Year Index averaged a duration of 2.81 years in 2021 — its highest annual figure ever.15 As we enter 2022, its duration currently sits at 2.8. For the broader Bloomberg US Aggregate Bond Index, the same trend holds; the current duration level is 6.75 years versus an average of 5.7 over the past decade.16

With rate risk elevated, focusing on mitigating the impacts of rising rates may serve investors well from a total return perspective. As a result, ultra-short duration credit-related strategies that have variable and floating yields may be one solution.

For example, the Bloomberg Capital US Floating Rate Note < 5 Years Index contains debt instruments that pay a variable (i.e., floating) coupon rate, based on prevailing short-term market rates plus a fixed spread. As a result of the quarterly coupon resets, the duration profile is historically and structurally low (0.07 years currently),17 a stark difference compared to the same maturity band of fixed-rate debt mentioned above.

While floating-rate debt yields may be low right now, the income potential of a floating rate exposure will increase as rates rise. For instance, as shown below, from 2015 to 2018, when the Fed raised rates from 25 to 250 basis points, the yield on the index increased alongside it, rising from 91 to 361 basis points. Throughout this period, duration-induced price declines were negligible given the low duration, leading to 50 basis points of outperformance versus the Bloomberg US Government/Credit 1-5 Year Index.18

Source: Bloomberg Finance L.P. as of January 6, 2022. Past performance is not a reliable indicator of future performance.

Even though the Fed has yet to act, the yield on a floating-rate note exposure already increased from 30 to 45 basis points during Q4 2021,19 as policy sentiment turned hawkish. And this floating-rate profile leads to a significantly more attractive yield-per-unit-of-duration profile (6.4) versus other short-term exposures that could be considered to trim duration (e.g., 1-3 year Treasuries, 0.38).20

For further yield enhancement and depth of sector coverage in the ultra-short market, an actively managed strategy that, in addition to investment-grade debt, also allocates to high yield corporates as well as securitized credits (ABS, MBS, CMBS) could be useful. Beyond the expanded sector reach, the credit selection and risk management process could be additive from a total return perspective.

For ultra-short duration strategies, consider the SPDR® Bloomberg Investment Grade Floating Rate ETF [FLRN] and the actively managed SPDR® SSGA Ultra-Short Term Bond ETF [ULST].

2. Target higher (real) yields

The outlook for below-investment-grade credit remains sound for 2022 with expected default rates of just 1%, down from 3.5%;21 45% earnings before interest, taxes and depreciation (EBITDA) year-over-year growth in 2021;22 the lowest gross leverage for firms since mid-201923 and roughly two upgrades for every downgrade.24 Like equities, the backdrop remains supportive, even with valuations stretched as spreads are tight (283 basis points versus a 523-basis-point average).25

Given these dynamics, investors must target credit instruments that have a yield above inflation expectations if they are seeking higher income and total returns, after the effects of inflation, than those of core US Agg bonds. As shown in the following chart, this doesn’t leave many options. The inflation-adjusted yield uses the current nominal yield and subtracts the expected inflation rate over the next five years, as a proxy for the impacts of our current inflationary regime.

Inflation Adjusted Yield

Based on the above, 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 (which measures a breakeven rate of return versus rate risk).

For EMD, the inflation-adjusted yield per unit of duration is a bit deceiving, as currency risk is a larger driver of returns than duration. In fact, our research shows that there is an over 90% correlation of monthly returns of EMD and EM local currencies.26 And while the yield advantage of EM local debt is near its five-year high versus core US Agg bonds27 as EM central banks have begun to rachet up rate hikes, signaling a value-oriented yield pay for EM debt, our currency team feels the near-term backdrop for the US remains strong over the next few months. If so, that could continue to pressure the currency-sensitive EM local debt market from a total return perspective.

Given this data, high yield and senior loans are stronger options. And senior loans’ floating rate structure may prove to be even more 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 stalls or if macro risks pile up, loans are more senior in their capital structure and historically have witnessed lower relative levels of volatility than fixed-rate high yield (4.50% vs. 6.52% ).28 The downside deviation for loans is also better than high yield (7.74% vs. 12.21%).29

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 today’s environment.

For high income strategies that may offer a yield above inflation expectations, consider the actively managed SPDR® Blackstone Senior Loan ETF [SRLN].

3. Mitigate inflation’s impact by adding inflation-protected bonds

Supply chain issues that plagued topline Q3 economic growth may have masked certain inflationary pressures building beneath the surface.

First, the strong gain in services spending may hint at greater momentum for inflation-adjusted services in 2022, causing this measure, which is still below pandemic levels, to catch up to the growth already witnessed within goods. Second, a still healthy savings rate and continued momentum in the labor markets should further support stronger spending. Credit card trends, with delinquencies at all-time lows, also reinforce healthy consumer behavior.

Simply put, strong demand should support prices. Even if supply constraints start to ease, wage increases and rent trends may keep inflation elevated in 2022. And with record-high job openings and quit rates, more wage inflation is likely in 2022 as employers seek to hire enough workers to meet stronger consumer demand. Additionally, if President Joe Biden’s Build Back Better bill is approved, the roughly $2 trillion in new spending has the potential to boost prices in the short term, even if it’s just from a signaling effect, as tax increases to finance this effort will be spread over many years.

Beyond consumer demand and any potential legislation, inflation rates of rent and owners’ equivalent rent (OER), which account for 30% of headline CPI and 40% of Core CPI, are still below their pre-pandemic levels.30 Yet, research by the Federal Reserve Bank of Dallas shows that strong housing price growth historically has preceded rent and OER inflation by roughly 18 months.31 Given that prices in the housing market have risen by 25% above pre-pandemic levels,32 the research projects rent and OER inflation to accelerate above historical averages in 2022 and 2023, which could drive overall inflation higher.

Owning Treasury Inflation-Protected Securities (TIPS) instead of nominals was a beneficial swap in 2021, as TIPS outperformed nominals by 8.3%.33 TIPS also outperformed the Bloomberg US Aggregate Bond Index (Agg) by 7.5%,34 even though they have a longer duration (8.4 years versus 6.7 years).35 Given that the inflationary forces discussed above will most likely remain high, a TIPS allocation may continue to be rewarded.

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, making them a valuable portfolio diversifier to some of the credit/equity-sensitive solutions discussed in previous sections.

Bond Sector Correlations to Equities

Overall, including TIPS may help improve the risk/return profile of a diversified portfolio irrespective of the market’s inflation dynamics. And because 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 such as the SPDR® Portfolio TIPS ETF (SPIP) may be a better source of current real income than owning TIPS outright.


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