Staying fit and active are always among the most popular New Year’s Resolutions. Perhaps bond investors should resolve to do the same. 

Passively investing in funds that track the Bloomberg US Aggregate Bond Index (Agg)—the most popular benchmark for the investment-grade, US taxable bond market—may fall short in what looks to be a dynamic and tricky fixed income environment ahead. Rather, an active approach that can focus on fundamental security selection within certain credit sectors may prove to be healthier for a bond allocation. 

A Look Back

Although the economic recovery from the pandemic continued unabated during 2021, it’s not been without worries and some bouts of uncertainty and volatility, particularly later in the year. Markets were spooked by some unusually high inflation readings—certainly higher than the Federal Reserve was expecting—and, as a result, we are now bracing for what appears to be a more hawkish Fed. This likely means a more abrupt end to quantitative easing than previously thought and, possibly, faster rate hikes. That’s where we stand now, but what else did we learn from 2021?

• Credit fundamentals largely improved as companies repaired balance sheets aided by strong GDP growth.

• Lower credit quality outperformed, as municipal and corporate high yield credit spreads tightened more than the increase in Treasury yields.  Credit spreads are the additional compensation investors require to hold securities that aren’t as safe and liquid as those issued by the U.S. Treasury.  When credit spreads tighten it is potentially an indication that the market’s perception of credit risk has improved.

• The Treasury yield curve reflects the short, intermediate, and long-term rates of US Treasury securities. The Treasury yield curve is often referred to as a proxy for investor sentiment on the direction of the economy.

• Treasury securities performed poorly on higher interest rates (remember, when rates go up, yields go down)

Looking Ahead

We believe that an allocation to credit, and more specifically security selection within credit, could be a driver of incremental returns for investors. After all, the initial post-pandemic improvement in market conditions (which lifted all boats) appears to be over. This is one reason why a more active approach that can focus on security selection could prove beneficial in 2022 and beyond. Moreover, economic fundamentals should continue to support credit, as corporate earnings are strong, the domestic GDP growth forecast is robust, and the global search for yield continues. How will all this impact fixed income markets in 2022? We see: 

• High quality asset-backed securities offering value relative to high-quality corporate names.

• The opportunity cost of owning higher quality investment grade credit (i.e. more defensive bonds) is relatively low.  

• Our credit research suggests telecom, healthcare and select COVID- impacted sectors that are still recovering may offer some of the more attractive opportunities. 

• Credit quality should improve further with low default rates and credit upgrades outpacing downgrades.

On the whole, it looks like a relatively constructive environment for bonds. But investors shouldn’t sit passively and hope that all is well in their portfolios. After all, we expect volatility that can create opportunities for nimble managers. We suggest that fixed income investors consider shifting to a time-tested approach—one that:

1. Focuses on generating income as the primary driver of returns and as a cushion against rising rates.

2. Ensures duration exposure matches interest rate tolerance and be wary of strategies that actively take duration risk relative to their benchmarks. Long duration bonds (those that mature in 10 or more years) are considered riskier than shorter-term bonds because of interest rate changes that may decrease their value.

3. Does not invest based solely on macroeconomic or interest rate forecasts, since it’s virtually impossible to accurately guess future interest rate movements with any consistency.

4. Continues to use fixed income as a diversification tool for a broader investment portfolio. 

Of course, fixed income investors need to continuously monitor key risks, including the potential for lasting inflation, interest rates that rise more sharply than pundits predict, and the impact of new COVID variants on the economy. But if anything, these risks merely exemplify the benefits of an active (yet disciplined) approach to fixed income.