Rising inflation and likely interest rate hikes by the Federal Reserve this year have raised worries among investors and managers about fixed-income performance in 2022 after a year in which most segments of the bond market incurred losses.
But some bond managers said there might be some slices of the fixed-income universe where investors might get positive returns this year, including TIPS, floating rate bank loans and high-yield bonds, which were the rare success story in the fixed-income space in 2021.
Looking at fixed-income benchmark performance, the Bloomberg U.S. Corporate High Yield index gained 5.3% in 2021, the Bloomberg U.S. Aggregate Bond index dropped 1.5%, the Bloomberg Global Aggregate index returned -4.7%; and the Bloomberg U.S. Treasury index tumbled 2.3%.
At the start of 2022, inflation remains the primary worry for bond investors, exacerbated by the recent November consumer price index, which jumped an annualized 6.8%, according to a Dec. 10 Labor Department report. The increase was the fastest year-over-year pace since June 1982. In response, the Fed at its Dec. 14-15 meeting accelerated its asset repurchase program and projected three possible hikes in the short-term federal funds rate next year.
Indeed, in a speech on Dec. 17, Fed Gov. Christopher J. Waller said he expected the Fed's asset purchase program to end in March, followed by the first rate hike shortly afterwards. The rate has remained at near zero since April 2020.
Simon Lue-Fong, London-based head of fixed-income boutique at Vontobel Asset Management, said in an email the biggest risk to fixed-income markets this year would be a "fast and aggressive steepening of the yield curve" — higher interest rates and rising inflation. This, Mr. Lue-Fong noted, could lead to a "sudden and large widening of spreads across many fixed-income segments," should central banks raise rates faster than expected to keep inflation in check.
As a result, Mr. Lue-Fong said, bondholders would be "hit by a double whammy by losing money on both the duration and the spread side at the same time."
Vontobel Asset Management had about $184 billion under management as of June 30.
Since the peak of the COVID-19 crisis in 2020, the 10-year Treasury yield has risen to about 1.67% as of Jan. 4 from as low as 0.52% on Aug. 4, 2020, which has meant duration losses.
Mr. Lue-Fong further warned that most fixed-income securities are already fully valued, meaning they have little upside. "Next year's market environment is likely to place high demands on fixed-income investors," he said. "Even if spreads don't widen and rates stay where they are, many fixed-income assets do not have much room to rally, so your return will be based on the yield, and the additional return your active manager can deliver."
But Nancy Davis, founder, managing partner and chief investment officer at Greenwich, Conn.-based alternatives manager Quadratic Capital Management LLC, is not convinced the Fed will aggressively hike interest rates this year.
"I believe the Fed is likely to be more prudent and take its time to evaluate the economy before going into a fast (rate) hiking cycle with the risk of throwing the economy into recession, since the economy is still healing from the pandemic," Ms. Davis said. "The timing between the end of the tapering and the first rate hike is probably not set in stone, and the Fed will likely continue to watch closely the labor market and for signs of a naturally decelerating inflation."
Quadratic's assets under management come largely from its Quadratic Interest Rate Volatility and Inflation Hedge ETF, which had net assets of $2.4 billion as of Dec. 31.
Mark Heppenstall, CIO of Penn Mutual Asset Management, Horsham, Pa., expects theFed to begin hiking rates by midyear with an additional one to two hikes before the end of the year. Treasury yields are likely to move higher with prices for long maturity bonds suffering the most, he noted. Penn Mutual Asset had $34.6 billion in AUM as of Nov. 30.