In 2022 we expect the market narrative to transition to the traditional expansionary phase of the business cycle. Here’s what it means for fixed income investors.
Monetary headwinds
Throughout 2021 the invisible hand of easy global monetary
policy supported financial markets. For 2022, however, the
outlook is quite different. We have already seen central banks
pare asset purchases, and we should expect a very different
backdrop for short-term interest rates, pricing in rate hikes
for most major central banks. This waning monetary support,
coupled with expensive starting valuations, warrants a more
selective approach to fixed income in 2022.
Star potential
During recessions it is common for rating agencies to
downgrade companies whose economic fortunes begin
to dim. The volume of these “fallen angels” during the
pandemic was historic – $184 billion of corporate debt lost
its investment grade (IG) status.1 Aggressive management
of costs, capital expenditures, dividends, share buybacks
and capital structures all helped stabilise corporate cash
balances. As demand steadily returned, profit margins and
free cash flow grew rapidly allowing companies to pay down
debt and improve credit quality. We believe 2022 will be a
strong year for “rising stars” as many high yield companies
achieve IG status (Figure 1). In an environment where price appreciation appears muted, rising star candidates could represent a
rare opportunity for gains. Risk premiums between BB- and BBB-rated
bonds still offer value and prices could rise as investors anticipate higher
ratings. But it takes targeted fundamental credit research to identify these
favorable credit stories ahead of ratings agency action.
Figure 1: Rising stars: credit upgrades for high yield companies are
outpacing post-recession downgrades
Source: Bank of America/Macrobond, October 2021. High yield credit migration rates: trailing six-month net upgrades as a
percentage of market value, 1 January 2016 – 31 October 2021
Off-benchmark benefits
The Covid-induced liquidity wave pushed investors back into financial markets
globally and drove valuations to historically expensive levels across most
liquid bond markets. The notable exceptions are bonds that are less liquid,
less followed or less benchmarked. This is particularly true in structured
credit and municipal bonds. Nearly 40% of mortgage- and asset-backed
securities are not included in any benchmark, including most of the higher
yielding opportunities in that universe. The same dynamic occurs in the
municipal bond space, where a high degree of fragmentation, small issue
sizes and frequent absence of credit ratings mean that muni benchmarks
don’t include a lot of the opportunity set. In each case, a research-driven
active strategy can flesh out the risk-reward trade-off in these areas to
generate higher income and return prospects than passive alternatives.
From recovery to expansion
In 2022 we expect the market narrative to transition from the “shock
and awe” of the pandemic to the traditional expansionary phase of the
business cycle. In this stage bond investors benefit far less from owning
generic market risk as central banks move toward the exits. A much more
targeted approach, focused on improving corporate and consumer balance
sheets, should lead to better outcomes in 2022.
Macro/Government Bonds 2021-22
By Adrian Hilton, Head of Global Rates and Currency
2021 will be remembered as a year in which the word “transitory” was
used more often than normal. Specific to the market it relates to the battle
between rising inflation expectations and the idea that present outsized
levels of price rises will rebalance in the coming year, once transitory
factors such as the reopening of the economy, supply chain shortages
(both labour and capital) and surging energy increases are behind us.
It was, as a result, a hard year for core government bonds. Yields
and inflation expectations rose through much the year and returns
were negative. All the while, central bank rhetoric erred on the side of
dovishness – but frequently failed to win market confidence or support.
Our own view of lower for longer growth, inflation and bond yields was
challenged, making it a more difficult year for our funds at times.
What of the outlook? We feel this extraordinary type of inflationary
pressure is unlikely to be repeatable and will not be met with sustainable
pay rises. Thus, negative real wage growth, fiscal headwinds – particularly
in the UK – and tighter monetary policy at the margin will weigh on
economies after the strong rebound of this year.
Government bond markets should take comfort from this – and so an
outcome of better returns in 2022 than 2021 is our central forecast.
Investment Grade 2021-22
By Alasdair Ross, Head of Investment Grade Credit, EMEA
For investment grade credit markets, 2021 will be best remembered as a
year of low spread volatility – which was in stark contrast to the preceding
12 months. Global IG spreads traded in a range of around 20bps from
January 2021 to mid-November 2021, while 2020 saw a much wider range
in excess of 240bps.
This very low level of volatility and dispersion creates a more difficult
environment for active management, and while most of our funds have
outperformed this year, the extent of that outperformance is lower than
last year.
What of the outlook for the coming year? We feel fairly neutral about the
level of spreads. This reflects the balance between positive fundamentals
and expensive valuations. Specifically, while policy conditions appear to
be moving slowly in the “wrong direction”, the present low and/or negative
rates of interest and assumed future levels will continue to provide a
positive backdrop for the market.
Secondly, the global economy may be slowing a little – but for IG credit a “not
too hot, not too cold” low but positive growth environment is ideal. It creates
an atmosphere that helps rein in excessive animal spirits in the boardroom
yet doesn’t produce a risk of significant downgrades or worse. Corporate
credit quality is also heading in the right direction and we expect key metrics
to revisit where they were at the end of 2019 by the end of this year.
Lastly, we still expect to see demand for income-generating asset classes
with lower risk such as IG credit – this at a time of lower new issuance and
ongoing central bank buying in Europe.
So why are we not more bullish? The trouble is valuations or spreads.
The present level of credit spread is well through both shorter term (fiveyear)
and longer term (20-year) averages and a little over 0.5 standard
deviations expensive to the latter.
High yield 2021-22
By Roman Gaiser, Head of High Yield, EMEA
For European high yield credit markets, 2021 will be remembered as the
year of improving credit quality seen through both the return of rising stars
as well as the fall of default expectations to sub 1% levels. This was in
sharp contrast to 2020 where the market size and credit quality grew due
to the number and type of issuers who joined the EHY universe as falling
angels and default expectations almost reached double-digit levels.
EHY spreads have done a 100bps round trip in the past 12 months with
the lows reached in mid-September. Credit spreads fell back to pre-Covid
levels, helped by improving corporate fundamentals and positive credit
rating progress. This led to lower default expectations as central banks
continued to stick with lower for longer – providing good support for the
asset class.
What of the coming year? The EHY outlook continues to be supported by
a positive growth outlook and improved corporate fundamentals. Rising
numbers of Covid cases, as well as recent developments around the
Omicron variant, are a reminder of the risk. But efforts to avoid lockdowns
to support an improving economic picture remain a key aim of most
governments. Market technicals appear balanced: inflation worries linked to supply and labour shortages, as well as logistics disruptions, put
pressure on government yield curves, and central banks appear to move
away from loose monetary policy.
But appetite for income and higher yielding assets remains good and new
issuers coming to markets offer opportunities. With spreads now almost
100bps higher than the 2021 lows and back to the levels seen 12 months
ago, valuations look fair despite recent increased uncertainty. Expectations
of an ongoing post-pandemic economic recovery appear priced in, while
default concerns have fallen to historical lows. With risk premia near
historically low levels, there is some concern that compensation for
unanticipated volatility is limited. Still, with a yield pick-up and moderate
duration, the EHY market offers opportunities.
