Bond markets had to contend with a difficult 2021 characterized by rising inflation, a bumpier economic recovery and the start of tightening monetary policy. The threat of inflation accelerated during the year, disrupting government bond markets and peaking with the Federal Reserve’s hawkish pivot in the fourth quarter. Meanwhile, the yield trend that started in 2020 continued, as lower-grade credit rose for much of the year.
As a result, the performance of Morningstar fixed income categories was mixed, with more credit-sensitive strategies outperforming most of the pack, while interest-rate-sensitive and non-USD-denominated bond funds posted slumps. losses. Municipal high yield funds led the way, averaging 5.7%, while emerging market local currency bond funds plunged 7.3% on average. The Morningstar US Core Bond Index, a proxy for exposure to typical US bonds, fell 1.6% for the year, posting its worst return for the calendar year since the tantrum typed rocket markets. fixed income securities in 2013.
Fed tightens policy amid rising inflation
Pushed by a spike in the first quarter, interest rates rose in 2021, sometimes causing noticeable volatility as investors grappled with rising inflation, changing economic prospects and new variants of the market. coronavirus. The year began with a significant steepening of the yield curve as the market reacted to the potential for higher economic growth and inflation. The 10-year US Treasury yield climbed 81 basis points in the first quarter to end the period at 1.74%. However, as the economic recovery became more bumpy and inflation continued to rise, the yield curve partially retraced the steepening of the first quarter over the remainder of the year. Short-term yields edged up slightly, while the 10-year yield declined to 1.52% at the end of 2021.
The Fed called inflation transient for much of the year, but dropped that label in November as impressions of core price inflation continued to rise. In the most recent reading, the CPI rose 6.8% in the past 12 months through November 2021. In response to the growing threat of inflation and improving labor market, the Fed took a more hawkish stance in the fourth quarter. The Fed began cutting back on asset purchases in November, with the goal of completing the liquidation by mid-2022. However, in December, the Fed doubled the pace of the cut, speeding up the timeline to an expected end in March 2022. Fed officials also raised their expectations for a rate hike in recent meetings, latest projections now showing three rake increases in 2022..
As inflation expectations increased, inflation-protected US Treasuries outperformed nominal Treasuries; The Morningstar US TIPS Index returned 5.7% for 2021, while the Morningstar US Treasury Bond Index posted a loss of 2.3%. In the inflation-protected bond category, strategies that added credit exposure alongside TIPS led the way. One of these offerings was Lord Abbet Inflation Focused (LIFIX), which rose 10.4% to beat all but one of its peers. At the same time, short-term Treasuries outperformed longer-term issues given the steepening of the yield curve in the first quarter. Tracking one to three year issues led to a modest 0.7% decline in the Vanguard Short-Term Treasury Index (VSBSX).
Within the core and core-plus intermediate bond categories, strategies that had high allocations to securitized sectors and / or high-yield debt, both of which are less sensitive to interest rates than treasury bills and quality firms, were among the best performers, although the gains were modest. Pioneer link (PICYX) returned 0.7%, outperforming its typical core-plus counterpart by 140 basis points on its high allocations to securitized and rated undesirable credits.
Credit investors looking for yield
Along with rising inflation, credit-sensitive assets continued to outperform. Within corporate credit, low-quality rated bonds outperformed high-quality issues in 2021 as investors looked for yields, although there was a brief period of risk sentiment in the fourth quarter in 2018. due to the emergence of the omicron coronavirus variant and the more hawkish Fed. position. The Morningstar US High Yield Bond Index rose 5.2%, while the Morningstar US Corporate Bond Index (which tracks good quality issues) posted a loss of 1.1%. Energy credits received a big boost following the surge in oil prices due to robust demand. Crude Oil (WTI) started the year at just under $ 50 a barrel and ended it at $ 75, after slashing some of its substantial fourth quarter gains.
The U.S. high yield bond default rate fell below 1% in 2021, and positive credit trends helped lower-rated credits outperform. The Bloomberg index for credits rated CC to D climbed 12.5%, with the highest returns at the lower end of the credit quality spectrum. The best performers in the high yield category were generally funds that leaned toward lower quality bonds and / or had a strong allocation to equities. Fidelity Capital & Income (FAGIX) held around one-fifth of assets in equities for most of the year and took advantage of the continued rally in equities to return 11.7% for the year, outperforming almost everyone in the category.
Convertible bonds, hybrid securities combining the characteristics of debt and equities, also benefited from the continued rise in equities. MainStay MacKay Convertible (MCNVX) returned 10.1% and landed in the top decile of the convertible category over the period. Meanwhile, bank loans were back in fashion. The S & P / LSTA leveraged loan index rose 5.2% for the year, with investors eyeing the industry’s floating rate coupons, which rise as interest rates rise. Similar to the corporate bond theme, lower-rated loans outperformed. Invesco Principal Variable Rate (OOSYX) gained 9.1% and beat all of its peers in the bank lending category thanks to its significant stake in loans rated below B.
Strong dollar weighs on global yields
Alongside the Fed, central banks around the world began to tighten monetary policy in late 2021, although they did so to varying degrees. The Bank of England unexpectedly raised rates to 0.25% in December 2021, becoming the first G7 central bank to raise rates since the start of the coronavirus pandemic. The European Central Bank has taken a more gradual approach, choosing to cut back on bond purchases but continue to do so for at least the first 10 months of 2022. Meanwhile, the Bank of Japan has remained among the more accommodating central banks. by reducing certain emergency financing while committing to keep the monetary policy ultra-flexible.
The US dollar had a strong 2021, gaining 6.7% for the year against a basket of developed market currencies, driven by the relative strength of the US economy and the Fed’s tighter policy outlook. This backdrop helped the US dollar hedged version of the Morningstar Global Core Bond Index limit its decline to 1.7%, while the unhedged version fell 5.7%. Among global bond funds, those that ventured beyond sovereign debt into corporate and securitized credit performed better in 2021. AB Global Bond (ANAIX) It did exactly that, which kept its drop to 0.8% and placed it among the top performers in the global USD hedged bond category.
Emerging markets were also penalized by the strength of the US dollar as well as weaker growth prospects. Emerging market debt denominated in local currency was significantly lower than that of hard currencies, with the JP Morgan index for the former dipping 8.8%, while the latter slipping 1.8% on the year. Here too, companies have outperformed; the JP Morgan CEMBI Diversified index gained 0.5%. Avoiding local currency debt and adding a dose of corporate credit have limited Fidelity New Markets revenue (FNMIX) fall to 1.8%, while its typical counterpart in the emerging market bond category fell 2.4%.
Demand for Munis continues
Municipal debt continued to be in high demand in 2021 as further fiscal stimulus, particularly the $ 1.9 trillion US bailout of March 2021, as well as the possibility of higher income taxes have helped fuel investor appetites. Long-term munis sales topped $ 450 billion in 2021, roughly matching the record highs of 2020. This backdrop helped the Bloomberg Municipal Bond Index gain 1.5% for the year, thus exceeding US Treasuries by more than 3 percentage points.
The general theme of substandard credit fixed income securities outperforming during the year also spread to the municipal market. The Bloomberg High Yield Municipal Bond Index jumped 7.8% as the search for yield and the lower default rate of municipalities versus companies helped boost demand. BlackRock High Yield Municipal (MAYHX) was one of the best performers of the year in the high yield mun category, up 9.2% in part due to its overweight position in lower rated bonds.