2022 Fixed Income Market Insights (2024)

2021 proved to be a year of transition in fixed income, starting with the early stages of an economic expansion and easy monetary policy before moving to potential accelerated tapering and the slow withdrawal of unprecedented stimulus tothe economy.

1. Expect more volatility on the short end

As the Federal Reserve adjusts to a tighter monetary policy, we expect rates on shorter maturity bonds to move higher from current levels. Both the timing and magnitude of the move may prompt increased volatility in shorter-maturing bonds relative to longer-maturing bonds. Should Federal Open Market Committee (FOMC) rate hikes happen sooner than anticipated or more aggressively than projected, the yield curve is likely to flatten as investors weigh the risks of a more proactive Fed inducing a slowdown. Moderating inflation may shrink the yield differential between longer and shorter maturities. We are decreasing allocations to short-term debt to reduce the risk that a flattening yield curve poses.

2. Corporate credit: Catch a “rising star”

We see 2022 as a year of positive ratings trajectories that will result in a higher volume of “rising stars” or companies upgraded to an investment grade rating (BBB-/Baa3 or higher). During the pandemic-induced volatility in 2020 the credit markets experienced approximately $200 billion in “fallen angels” or companies whose credit rating was reduced from investment grade to junk status (BB+/Baa1 or lower) In 2021, the downgrade trend reversed as rising stars outpaced fallen angels by2-to-1, according to data from JPMorgan. We expect this trend to continue into 2022 and beyond as more companies continue to de-lever, increase free cash flow and improve their balance sheets as the economic expansion enters its second full year.

3. Don’t count consumers out

U.S. consumers continue to be a bright spot in the economic recovery and remain poised to power future economic activity. Thanks to generous fiscal stimulus and a tight labor market, consumers are flush with savings and confidence remains high. We expect consumer spending to remain strong in these coming year. Two key metrics - the household obligation ratio and household debt to net worth - have fallen to their lowest levels in 40 years, suggesting consumers also have room to pay down debt (Figure 1). Investors in securitized credit card debt and auto loans are likely to see rapid repayments.

Figure 1: A healthy consumer sector can pay down debt

Key difference in the securitized market: Pre-global financial crisis vs. today

4.A new inflation regime

Rising wages and housing costs suggest higher inflation in the years ahead; capital spending on renewable energy and carbon-neutral initiatives will likely be inflationary longer-term. Thus, we think it is unlikely that inflation returns to pre-COVID-19 levels, despite productivity improvements gained by businesses and reductions in supplychain bottlenecks.

While the Federal Reserve has broadcast a likely shift in monetary policy, it is likely to remain highly accommodative, with real (inflation-adjusted) interest rates below zero. We don’t expect the economy to slow. Debt-financed government spending on infrastructure and social programs is also likely to support demand in an economy already well supported by previous monetary infusions and high savings rates.

5.Housing market rolls on

We expect the supply/demand imbalance in housing to support price increases in 2022. Housing prices have exceeded expectations as limited supply and competition met multi-generational demand. COVID-19 and the advent of hybrid work has meaningfully altered housing preferences.

Low inventories, particularly in the fastest growing cities, are likely to persist with little identifiable new sources coming to the market in the near term. Since the Global Financial Crisis, underwriting standards have improved as evidenced by average Fair Isaac Corporation (FICO) scores increasing and loan-to-value ratios declining.

Importantly, lenders also no longer offer affordability loans such as pay option adjustable-rate mortgages. Rising prices for underlying assets coupled with strong underwriting standards should generally support mortgage-related debt instruments.

All investments are subject to market risk, including possible loss of principal.

A credit rating is an assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. Credit rating agencies typically assign letter grades to indicate ratings. Standard & Poor’s, for instance, has a credit rating scale ranging from AAA (excellent) and AA+ to C and D. A debt instrument with a rating below BBB- is considered to be speculative or non-investment grade.

Active management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund’s portfolio. Active management strategies typically have higher fees than passive management.

A fallen angel is a bond that was once rated as investment grade but has fallen to junk-bond status because of the issuing company‘s poor credit quality.

A rising star is a bond that is rated as a junk bond but could become investment grade because of improvements in the issuing company‘s credit quality.

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