Evan Frazier, CFA, CAIA
Senior Research Analyst
The fixed income space faces several significant challenges in 2022. First, the ability of many bond strategies to generate viable income streams is limited by interest rates that remain at historic lows. Additionally, elevated levels of inflation, which may remain above the Federal Reserve’s long-term target of 2.5% throughout the year, will serve to dilute real returns. To that point, the 5-year breakeven rate, a measure of expected near-term inflation in the U.S., ended last year at 2.9% after reaching a level of 3.2% just a few weeks prior, which represents a record high for the metric since Bloomberg began tracking it in 2002. As displayed in this week’s chart, Treasuries, mortgage-backed securities, and high yield municipal bonds exhibited flat-to-negative inflation-adjusted yields at the end of 2021. Finally, many expect rates to rise this year as the Fed curtails stimulus programs and begins to implement increasingly restrictive monetary policy to combat the rise in price levels. The current landscape begs the question: What can fixed income investors do going forward?
In the coming years, traditional bond investors may need to focus on a wider variety of sectors within the asset class to attain desired yields. Specifically, preferred securities, emerging market debt (EMD), high yield bonds, and senior loans all offer yields that are in excess of the 5-year breakeven rate, even when adjusting for duration. Bank loans may be particularly attractive going forward, as these instruments typically offer floating interest rates that protect investors from increases in short-term yields. Of course, the risks of each of these spaces should be thoroughly considered before any allocation changes are implemented. The EMD space, for example, carries with it significant currency risk, while preferreds exhibit credit risk and are subordinated in the capital structure, providing investors with a lower claim on assets than more senior debt. While all of these sectors are not uncommonly featured in investment portfolios, market participants should investigate the merits and drawbacks of each before creating or modifying target allocations, with a specific focus on duration, credit spread sensitivities, and liquidity terms.
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