Coronavirus threats, surging inflation, fiscal and monetary tightening, rising rates, and flattening yield curves could make 2022 a challenging year for bond investors. But these headwinds aren’t indiscriminate. Investors must continually differentiate between regions, sectors and securities to thrive in this kind of environment. Below, we make sense of today’s complex investing landscape and provide some risk-mitigation strategies.
Flatter Yield Curves Ahead
As economies reopened in 2021, pent-up demand generated strong global growth. As a result, developed markets are now growing much faster than before the pandemic. We expect continued above-trend global growth in 2022, as momentum carries economies through the first months of the year before slowing in the second half and into 2023.
The world’s central bankers seem to have concluded that the coronavirus pandemic is more likely to drive inflation higher than to push economic growth lower. In response to stubbornly elevated inflation, central banks around the world are pivoting toward tighter policy. The pivot isn’t uniform, because policy stances and the severity of the inflation shock differ among countries. For instance, although the US Federal Reserve has accelerated its tapering of QE and is now headed toward rate hikes as soon as March, some smaller developed-market central banks have increased rates already, and many emerging-market (EM) central banks have tightened significantly. Japan is the exception to the tightening trend, thanks to its low inflation; in fact, the country recently announced significant fiscal stimulus just as other countries tap the brakes.
As the year progresses, tighter policy worldwide is likely to slow global growth. These conditions—climbing short-term rates and slowing-but-still-strong growth—are a recipe for flattening yield curves. And flatter yield curves signal caution when it comes to taking risk. Here’s how active investors can rise to the challenge.
Be Choosy—and Other Strategies for 2022
First, investors should differentiate among sectors, because today’s headwinds won’t affect all risk assets to the same degree. What’s more, some sectors tend to underperform sooner and others later in this kind of market. For example, local-currency emerging-market debt (EMD) has the poorest expected return among fixed-income sectors over the next few months, but it might be a good choice later in 2022 when the EM hiking cycle is mostly behind us. For now, hard-currency EMD—sovereign and corporate bonds alike—has more appeal.
Second, consider a wide range of higher-yielding sectors, such as US credit risk–transfer securities (CRTs), that have low correlations to government bonds and to each other. CRTs are floating-rate bonds backed by real assets—homes—that often benefit from inflation. Thanks to a robust US housing market, fundamentals look attractive for CRTs.
Third, don’t slash credit exposure. High-yield investors should actually cheer for rising rates, because the sector tends to perform well during hiking cycles. Since 1994, US high-yield posted strong returns in 13 out of 13 rising-rate cycles. And consumer and corporate balance sheets remain strong, making corporate issuers resilient. Most of the world’s companies—including US and European high-yield and investment-grade issuers, as well as many EM corporations—are in the recovery and expansion phases of the credit cycle, where the biggest event risks are mergers and acquisitions, not downgrades and defaults. In this environment, “carry”—essentially, clipping the bond’s coupon—rules the day.
Fourth, get tactical when it comes to duration, or the portfolio’s sensitivity to interest rates. This means modestly trimming sail when yields drift lower and modestly lengthening when they rise. But don’t drastically shorten your duration exposure. A cash strategy could soon have you lagging both income-generating bonds and inflation. In fact, even though rising bond yields can be painful in the short term as prices fall, rising yields are good for bond investors in the long run as coupon payments get reinvested at new and higher rates.
Finally, get ready to move. US investors especially should look outside their home market, which has performed comparatively well for several years, for diversification and opportunity. Global multisector approaches to investing are well suited to a quickly evolving landscape, as investors can closely monitor conditions and valuations and prepare to shift the portfolio mix as conditions warrant. Among the most effective active strategies are those that pair government bonds and other interest-rate-sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio.
This approach can help managers get a handle on the interplay between rate and credit risks and make better decisions about which way to lean at a given moment. The ability to rebalance negatively correlated assets helps generate income and potential return while limiting the scope of drawdowns when risk assets sell off.
Keep an Eye on Longer-Term Trends Too
While such strategies should see bond investors through near-term challenges, we believe that investors always benefit from taking the long view. To our minds, the three biggest trends to consider today are China’s role in the world; environmental, social and governance (ESG) factors; and advances in bond-investing technologies.
China’s slowing growth has worried investors who see it as a threat to global GDP. We think that’s because the government’s recent regulatory efforts have been largely misunderstood. Interventions in the education and tech areas, for example, have been perceived as negatives for credit and equity markets, and for short-term growth. But they make a lot of sense as part of a long-term strategy to promote high-quality growth by removing market distortions. And we should expect to see more of the same, as China pushes structural reforms more aggressively than it has in the past, to achieve a more sustainable and balanced growth trajectory.
Climate and other ESG risks have also emerged as a top investor concern. Investors who are eager to buy bonds that will help create a more sustainable world can start by learning about green bonds and other ESG-linked bond structures. Active investors can also play a critical role in climate action by tracking companies to make sure they’re on course to deliver on ambitious climate goals. This often entails taking a seat at the table with a company’s management team to understand the impact of ESG factors on investments, to advocate for changes in corporate behavior and practices, and to hold companies accountable as stewards of our environment. Further, we think investors should lean on issuers to explicitly tie ESG targets to their own economic outcomes—whether through step-up coupons, which rise if the issuer fails to hit a stated metric, or through lower call prices if they succeed. These kinds of bond structures have the teeth to hold issuers accountable.
But mitigating ESG risks doesn’t stop there. To fully capture and manage the risks and opportunities created by ESG, managers must thoroughly incorporate ESG factors into bond analyses and investment processes. Even investors who don’t prioritize ESG stand to benefit from the integration of ESG factors into the investment process. From catastrophic environmental events to more favorable financing terms, ESG impacts every bond issuer’s bottom line.
Lastly, manager technology isn’t top of mind among investors, but it should be. Advanced technology can help bond managers scan the entirety of the bond market in real time, suggest potential trades, build out trades in seconds and invest new portfolios more quickly, saving clients time and money. Cutting-edge tech allows traders to cut through the noise of thousands of bonds trading at any given time to find opportunities and source liquidity, even when markets become fragmented and volatile. And digital transformation paves the way to meeting evolving client needs for greater transparency and seamless portfolio customization.
In short, it puts the right info in the right hands at the right time and frees up humans to do what they do best: engage, analyze and strategize. Managers who miss this boat will find themselves at sea in the post-pandemic world.
Face 2022 with Eyes Wide Open
The coming year will bring challenges. But with some thoughtful adjustments, investors and bond managers can weather uncertainty with dispassion, prepare for inflation and flattening yield curves, and position their portfolios to prosper in the coming year.