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Financial Industry Insights from Advisors Asset Management
On January 24, 2022
AAM Viewpoints — 2021 Fixed Income Review
2021 was a challenging year as news of fast-spreading COVID-19 variants added stress and volatility to the financial markets. Inflation spiked to 40-year highs, we witnessed numerous supply chain disruptions, and the number of open jobs reached historical highs as the quits rate also reached historic levels. Wages were up 4.8% over the prior year, but the National Federation of Independent Business reported a record 62% of respondents had few or no qualified applicants for open positions in September. Additionally, the Fed started tapering asset purchases and the expected number of rate hikes moved from one or two all the way out to three or four in 2022.
Even with the uncertainty, equity markets had another impressive year with the S&P 500 posting 70 closing highs, the most since 1995’s 77 closing highs. Meanwhile, the fixed income market faced challenges as the Bloomberg Aggregate Index posted only the fourth negative year since inception in 1976. With the move up in rates, global negative yielding debt dropped from $17.764 trillion on 12/31/20 to $11.314 trillion on 12/31/21. We expect the volatility in equity and fixed income markets to remain in 2022.
The fixed income market faced significant headwinds in the 1st quarter (Q1) of 2021 as the 10-year U.S. Treasury (UST) went from 0.91% to 1.74% and each asset class — with the exception of high yield (HY) — posted negative returns that many could not overcome by year end.
Treasuries
The 10-year Treasury started the year yielding 0.916%, which was 100bps (basis points) lower than where it started 2020. The 10-year yield closed out 2021 with a yield of 1.51%, up 60bps for the year. With a 2021 return of -2.32% we continue to believe the asset class doesn’t offer a compelling value over the long term as yields remain at historically low levels. At these levels, investors earn only 16bps of yield per unit of duration.
The Treasury market was active and the curve flattened as yields in the 2–3-year bonds were 61–71bps higher while 5-year bonds finished 90bps higher and 30-year yields rose only 26bps. Meanwhile, as shown below, the real yield on the 10-year Treasury remains negative and finished 2021 at -1.04% after a closing low of -1.19% on 8/3/21. That level was later tested on November 9.
Credit Market
Corporations have taken advantage of low rates to issue longer-dated debt which increases duration. High grade credit returns are often dominated by interest rate risk as they carry a longer average duration. BBB rated companies are often incentivized to avoid a downgrade into high yield. Heading into 2022 we favor BBB and BB corporations in financial, energy, materials and cyclical sectors.
In 2021 ICE Bank of America Merrill Lynch (BofA ML) U.S. IG (Investment Grade) Corporate Bonds had a total return of -0.95%. Maturities 1–3-year range returned -0.01% and -1.05% in the 5–7-year range. In 2021 the ICE BofA ML U.S. Corporate BBB Index returned -0.19% while A rated bonds came in at -1.77 %. The theme throughout 2021 was the lower the credit rating, the better the performance as the BofA ML HY Index posted a gain of 5.36% and CCCs returned 10.42%. As lower-rated bonds performed better last year, it was important to select appropriate credits that offer relative value to their peers rather than blindly reaching for yield.
Municipal Market
The Bloomberg Municipal Bond Index was one of the few winners last year and was up 0.72% in Q4 while posting a 1.52% gain in 2021. The 10-year Municipal-to-Treasury ratio — a popular metric to measure relative value for tax-exempt debt — finished 2021 at 68.1% which was well below the 10-year average of 97% reflecting tax-exempt municipals are expensive to Treasuries. Since the end of 2016, the 10-year AA tax-exempt yield got as rich as 65bps lower than the comparable corporate after-tax yield. The A rated municipals were 63bps lower than comparable corporates.
Past performance is not indicative of future results.
The Investment Company Institute reports Municipal funds recorded 44 consecutive weeks of inflows and added $83.6 billion in 2021. Municipal exchange-traded funds (ETFs) also have had inflows of $4.6 billion in Q4 and a record $20.9 billion this year.
Municipal bond issuance was up 4% in 2021 totaling $464 billion which eclipses the previous record of $457 billion in 2020. CreditSights is predicting $362 billion of non-taxable issuance and $118 billion in taxable issuance this year which equates to another record year. The key sector contribution includes airport bond issuance of $14 billion, up 37%, while higher education and hospital bond volume both dropped by 13% and 18% respectively.
Defaults
S&P reports we had only 72 defaults in 2021 — the lowest since 2014. That is down 70% from the previous year and even below the pre-pandemic 2019 level. Distressed exchanges accounted for 51% of the total with concentration in homebuilders and the real estate sector at 10. 2022 S&P projections for the U.S. stand at 1.8% and 1.7% in Europe.
Moody’s reports the global trailing 12-month speculative default rate closed December at 1.7% which remains near historically low levels. In the U.S., the default rate dropped to 1.2% in December after peaking at 6.8% in December 2020. Moody’s is predicting the global speculative default rate will rise to 2.4% by the end of 2022 and the U.S. rate will rise to 2.6% by year end, well below the long-term average of 4.5%.
Credit Spreads
Spreads in U.S. Investment Grade continued to tighten in 2021 as the IG index now sits near historically tight levels. IG index spreads ended at 98bps and are 5bps tighter on the year. Longer-dated bonds rallied the most last year, with 10-plus-year maturities tighter 12bps.
The ICE BofA ML U.S. Corporate BBB Option Adjusted Spread (OAS) is 121bps over Treasuries and the ICE BofA ML U.S. High Yield OAS is 310bps (see chart below). Putting this into perspective, as recently as June 2020, the spreads were 207bps and 644bps respectively during the early stages of the pandemic. BBB spreads are 9bps tighter year-to-date while HY spreads are 76bps tighter this year.
Yield Curve
The spread between the 30-year U.S. Treasury yield and the 5-year U.S. Treasury yield flattened from 128bps at the end of 2020 to 64bps on 12/31/21 but remains positively pitched. While the 30-year minus the 5-year curve is flatter by 64bps in 2021, the 10-year minus 2-year was flatter by on 2bps. The chart below shows the steepening in 30s and 5s, 10s and 2s, and 10s and 3-month Treasury bill during the pandemic and the flattening this year.
Outlook
We remain cautiously optimistic on the fixed income market in 2022 and we continue to prefer credit risk over duration risk in this environment. We also anticipate volatility will remain high in 2022 as numerous factors — not the least of which of those mentioned below — will likely have an impact on these movements.
Fed
The Federal Open Market Committee (FOMC) will continue asset purchases, though at a slowing pace, for the next few months as the Fed’s balance sheet will peak around $9 trillion. It remains unclear when the balance sheet will start to shrink and if the Fed will begin selling down the portfolio rather than letting it “runoff.” Several additional questions remain for 2022 as the probability for the first rate hike in March is near 100% and the question is no longer when will the first hike take place, but by how much. The pace of rate hikes will impact the steepness of the yield curve.
COVID-19
Blue chip reports the number of COVID-19 cases has escalated from approximately 83,000 in November to nearly 575,000 in January. Fortunately, the increase in hospitalizations is limited and the impact on individuals has been less severe. The future spread and expectation for additional variants remain a wildcard and have the potential to significantly disrupt economic growth.
Inflation
The Personal Consumption Expenditure — the measure used as a target by the Fed — has been trending up since November 2020 and reached 5.7% year over year in November 2021. We believe inflation will remain elevated in 2022 due to several sticky components such as wages and shelter, but begin declining in the second half of the year.
Supply Chain Disruptions
Last year had numerous challenges related to port congestion, the global COVID-19 impact, energy costs, chip shortages and the lack of truck drivers. We believe these challenges will continue and there is a chance they remain for the foreseeable future but should let up by late 2022.
Rising Interest Rates
The 10-year Treasury moved above 1.75% earlier this year and we believe rates will continue higher, but not at a dramatic pace. Estimates are between 1.9% and 2.13% at the end of this year — so likely minimal movement at year end; however, how we get there will probably be a bumpy ride based on the factors above.
This environment presents both opportunities and risks for fixed income investors. Low yields accompanied by high duration levels can pose a significant risk for investors. Duration management and credit selection are more important now than at any time in recent memory. This is the time to know what you own and understand where the risks lie in your fixed income portfolio. Active managers will diversify portfolios across asset classes, sectors, maturities and tactically adjust duration as needed. Our playbook is telling us to evaluate opportunities to bring in duration, beware of tight spreads, review corporate exposure and stress test portfolios. This approach allows the fixed income investors the potential to remain invested in volatile markets and provides a potential ballast to equity exposure in their portfolio.
CRN: 2022-0106-9693 R
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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