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What Bond Strategists Recommend Now: 2022 Outlook

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What You Need to Know

  • The Fed is expected to raise rates three times in 2022 and end its asset purchases in Q1.
  • The trajectory of the coronavirus pandemic and fate of President Biden's economic plan could upend those expectations.
  • Strategists recommend that investors stay in the short end of the yield curve and stick with high-quality securities.

What happens to the U.S. bond market in 2022 will depend largely on the trajectory of the coronavirus pandemic, which is raging again, and Federal Reserve policy — how fast it tapers asset purchases, how high and how quickly it raises interest rates, and whether it begins a series of quantitative tightening, retiring outstanding debt in order to reduce market liquidity.

The Federal Reserve already set the plate for the first two moves at its last policymaking meeting for the year in mid-December. The Fed said as a result of rising inflation and improvements in the labor market, it would double the pace of its tapering starting in January, reducing Treasury purchases by $20 million a month and asset-backed purchases by $10 million. The faster tapering schedule will end Fed asset purchases by mid-March, months earlier than initially expected.

All 18 Fed policymakers indicated in the so-called dot plot that the central bank would raise rates next year, including 12 who expected at least three increases. At the same time, the smaller, 11-member Federal Open Market Committee (it’s short one member) said in its meeting statement: “The path of the economy continues to depend on the course of the virus. … Risks to the economic outlook remain, including from new variants of the virus.”

If the economy continues on its firmer footing and inflation remains “well above the Fed’s 2% target,” as Fed Chairman Jerome Powell expects, then strategists anticipate the Fed will raise short-term interest rates multiple times in 2022 in 25-basis-point increments, and long-term rates will rise from around 1.5% to 2% or slightly higher by year-end.

But if the omicron variant spreads rapidly, preventing the economy from returning to full employment in 2022, and President Joe Biden’s Build Back Better Act doesn’t pass — which is likely since Sen. Joe Manchin, D-W.Va., announced he will oppose it — then the Fed may not raise rates as quickly as many expect.

“If BBB fails completely, then real GDP growth in 2022 will be reduced by 0.5%, and instead of three quarter-point increases in the funds rate in 2022, as investors currently anticipate, there will be only two rate hikes,” said Mark Zandi, chief economist at Moody’s Analytics.

Impact of Rising Rates

Still, bond yields are expected to rise in 2022, for the second year in a row, which will lower bond prices. Investors will again have to choose between collecting higher yields from riskier bonds or lower yields from safer ones.

Given the broader bond outlook, Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, favors short-duration fixed income assets such as bank loans, which have adjustable rates that will rise along with increases in short-term rates, and investment-grade corporate debt maturing in five years or less.

“Long duration is the biggest problem for investment-grade debt,”  Jones said, referring to the price sensitivity of bonds to rising rates. “The credit profile is good.”

She’s wary of high-yield debt because the yield spread to Treasurys, at around 300 basis points, is tight compared with historic averages, and high-yield debt is more vulnerable than other fixed income securities if the Fed moves more aggressively than expected in its tightening policy or if stocks fall.

David M. Lebovitz, global market strategist on the J.P. Morgan Asset Management Global Market Insights Strategy Team, in contrast, is “comfortable” with high-yield and emerging market debt so long as the bonds are not the cheapest, lowest-quality debt. He advised investors to maintain “a high quality bias” in those debt markets and also sees value in private credit and midmarket direct lending debt, which he says has a higher quality than bank loans.

Kirstie Spence, fixed income portfolio manager at Capital Group, said emerging market debt is the “the one asset class not showing its full value versus historic averages.” A weaker dollar, which some strategists are forecasting though outlooks are mixed, would also support emerging market bonds.

But despite rising expectations of rising inflation, strategists are not touting Treasury inflation-protected securities (TIPS) in 2022 because those bonds have been outperforming other U.S. bond instruments for the past two years. TIPS are up almost 5% in 2021, while the Bloomberg Barclays Aggregate Bond Index (the “Agg”) is down about 1.5%.

“If you have TIPS in [your] portfolio and continue to hold them, don’t expect good returns going forward,” Jones said.

These expectations of little or no capital appreciation and limited, though slightly higher, yields for bonds in 2022 raise the question: Should investors still allocate assets to fixed income securities? Yes, Vanguard strategists say.

Regarding a multi-asset portfolio, they write: “The negative, long-term correlation with equities— especially in times of acute market stress — still warrants bonds’ inclusion [in a multi-asset portfolio], but investors are right to worry about their impact on return. … This reinforces our view from last year’s outlook that the role of bonds is primarily as a ‘shock absorber’ in a portfolio.”


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