The combination of low yields and high inflation weighed on bond investors this year. This will likely continue in 2022, but there are still reasons to hold bonds.
With a stock market nearing an all-time high, bonds can help support a portfolio if stocks fall. Experienced fund managers can mitigate the negative impact of inflation and rising interest rates by shortening the term of their holdings, selecting higher yielding bonds, or finding opportunities overseas. Barron looked for funds that returned at least 8% annualized the last time the Federal Reserve hiked rates, from 2016 to mid-2019. This has resulted in a variety of fund styles, so we spoke with the managers about how they are preparing for 2022.
While inflation has reached 6.8% in the past 12 months, the real yields of many bonds (their nominal yields minus the rate of inflation) are now in negative territory, meaning that any investment income will be. more than wiped out by the rising cost of living. Additionally, in anticipation of rate hikes next year, short-term interest rates have risen in recent months, pushing bond prices down as investors opt for new issues with higher yields. .
This dynamic will not change anytime soon. Longer-dated bonds often see their price fall further in response to rising rates, as investors in these products would be stuck with lower yields for longer periods of time. Therefore, a common way to reduce the duration risk (or price sensitivity to changes in interest rates) of a fixed income portfolio is to focus on shorter maturity debt.
The $ 1.1 billion
BrandywineGlobal High Yield
(ticker: BGHAX), for example, has an effective duration of just over three years, compared to the approximately four-year duration of its benchmark. Likewise, the $ 3.7 billion Pimco Long-Term Credit Bond (PTCIX) fund, which is only open to institutional investors, was underweight long-term bonds with a shorter six-month duration. than its benchmark, despite its mandate to generally invest in long-term bonds. – term bonds.
|Fund / Ticker||Expense ratio||AUM (bil)||Cumulative return for the year||Annualized return Last rate hike cycle *|
|BrandywineGlobal High Yield / BGHAX||0.92%||$ 1.1||5.1%||10.1%|
|Pimco / PTCIX long-term credit obligation||0.59||3.7||-1.1||9.7|
|Invesco Rochester Municipal Opportunities / ORNAX||0.95||10.1||6.7||8.7|
Data until December 28; * from 01/01/2016 to 07/01/2019
Sources: Morningstar; Bloomberg
Yet even in the face of record inflation, the Fed’s rate hikes next year are unlikely to be too aggressive, as it wants to avoid a recession, says John McClain, co-manager of the BrandywineGlobal fund. The central bank’s dot plot predicts that rates will rise to 0.9% by the end of 2022; futures markets have even lower expectations, at just 0.75%.
This means that managers must reach the scale of returns to achieve better returns. “If you are well compensated for the credit risk you bear, it can offset the negative impact of inflation and rising interest rates,” says Bill Zox, the other co-manager of the BrandywineGlobal fund. .
For the current cycle, funds need to be extremely careful when assessing credit risk because absolute returns are already low and any default can have a significant impact on total return, says Scott Cottier, who manages the Invesco fund. Rochester Municipal Opportunities of $ 10.1 billion. (ORNAX), a high-yield municipal bond fund focused on lower-rated or unrated credits from smaller and lesser-known borrowers. “You really have to choose the right borrowers who will pay you back,” he says.
Zox likes non-bank financial companies such as mortgage originators or consumer credit providers. Many of them have healthy balance sheets and a market value that is eight to ten times the total debt. But rating agencies often penalize these issuers for being smaller and newer to the debt market. These bonds can offer high yields of almost 6%, he said Barron: “We find them very attractive.”
Another area of opportunity is in industries directly affected by last year’s pandemic, such as travel, gaming and live events. Many companies in these sectors have seen their credit decline due to business closings and deteriorated balance sheets. But McClain believes they will generate strong cash flow again in 2022 as the global economy continues to reopen. More importantly, he notes, because the scars are still so fresh in the memory, these companies will likely hold onto a lot more cash in the future.
Mark Kiesel, portfolio manager of the Pimco Long-Term Credit Bond fund, is keeping a close watch on the international bond market, especially emerging markets such as Brazil, Mexico and South Africa, which have seen six to six inflation. 12 months before the United States. The central banks of these countries had already entered an aggressive cycle of rate hikes last year, which means they will likely see a colder economy and even a rate cut in 2022. “We find some of these bonds intriguing emerging markets, as rates have already fallen. a lot, ”says Kiesel.
To protect against inflation and rising rates, Kiesel also added variable rate credits, such as bank loans, and sectors with real assets, such as home builders and lumber suppliers.
Cottier of Invesco is also fond of the real estate industry, particularly municipal bonds issued to finance the development of land and infrastructure, such as sewers, streetlights and roads, before the construction of residential and commercial properties. These bonds are fairly common in states like Colorado, California and Florida, he says, and are backed by property taxes paid by prospective landowners. They can generate returns of 3% to 6%, depending on their size and other conditions.
Despite a generally tough market for bond investors, Kiesel sees positive winds in 2022: As the stock market has risen significantly, many pension funds now have a significant overweight in equities and may start looking to rebalance in bonds to maintain their balanced allocation. Kiesel expects pension funds to enter the bond market in six months after the Fed starts cutting and raising rates. If he is right, this buying force could push up bond prices despite rising rates.
Write to Evie Liu at [email protected]