- 10-year Treasury yield expected to end 2022 around 2.0%-2.25%. But brace for swings between 1.25%-2.5% during the year
- Fixed income total returns will be limited, with interest payments offsetting principal loss due to a rise in interest rates
- Active management and diversifying fixed income strategies can help generate income and build a solid ballast for investment portfolios
It was not all smooth sailing for fixed income in 2021, with yields riding waves of optimism and pessimism on news of Covid, inflation, and the Federal Reserve’s reaction to both. But it will likely be remembered as an easy ride compared to 2022. The stage was set for a more volatile year in December when the Fed announced it would accelerate the winding down of its bond purchasing program, setting a path to end this March – three months earlier than planned – and signalled three rate hikes were likely this year.
Initially the markets calmly digested the Fed’s acknowledgement that inflation was no longer “transitory” and its subsequent pivot in monetary policy. But volatility hit the Treasury market during the first week of 2022, following revelations that rate lift-off could be as soon as March, and that the Fed is also contemplating ways to reduce its balance sheet. Yields moved significantly higher across the Treasury curve as a result, led by five- and 10-year maturities.
It will take considerable finesse on the part of the Fed to raise rates enough to cool inflation, without overstepping the mark and hurting economic growth. We doubt the fixed income market is in for a smooth ride in 2022.
Here’s how 2021 played out and what may be in store for fixed income in 2022:
The Fed’s Pivot
Strong economic growth and rising inflationary pressures pushed Treasury yields higher throughout 2021, but the path was far from linear.
The Fed came into 2021 believing that inflationary pressures would be transitory, as consumers burned through stimulus checks and pent-up savings arising from pandemic lockdowns in 2020. At the time, it saw little need to move away from its “zero rate” policy of keeping the benchmark federal funds rate at 0.00%-0.25%.
Strong economic growth and a dovish Fed led to a steepening of the Treasury yield curve in the first quarter of 2021, with yields rising on intermediate 10-year notes and long-term 30-year bonds, while two-year Treasury notes remained anchored.
Exhibit 1: 10-Year Treasury Yield Curve
Yet, as we predicted in our Mid-Year 2021 Fixed Income Outlook, the yield curve eventually flattened in the second half of the year, with short-term yields rising more than yields at the long end of the curve on expectations of rate hikes in 2022.
Exhibit 2: Treasury Yield Curve Flattened
After beginning the year just shy of 1%, the benchmark 10-year Treasury yield peaked at 1.74% in late March, dropped below 1.20% by late summer as the Delta variant slowed demand, and finally shot back up to around 1.50% by the end of the year. The two-year, starting 2021 below 0.25%, increased significantly by the end of the year to 0.75%, as the Fed made one of its quickest shifts in monetary policy in years.
By the fourth quarter, inflation was increasing at its fastest pace in nearly 40 years.1 The Fed admitted in November that inflation may not be as transitory as it first predicted and announced a modest $20 billion tapering of its monthly $120 billion bond purchase program. Then in December, Fed officials suddenly doubled the taper plan to $40 billion, pulling forward the program’s original end-date by almost three months to mid-March. The Fed also shared its outlook for its benchmark federal funds interest rate, which suggested as many as three hikes. Assuming a 0.25% hike each time, federal funds could end 2022 at a rate of 0.75%-1.00%.
Exhibit 3: Federal Funds Contract vs FOMC Dot Plot
Fixed income markets calmly digested news of the Fed’s pivot, as demonstrated by a flattened yield curve by the end of 2021, with short-term Treasury yields rising more than yields on long-maturities. The Fed policy shift explains why the two-year Treasury yield increased to 0.75% by the end of 2021. At the time, yields on longer-dated Treasuries didn’t rise by the same degree, however, for two reasons: Firstly, with more than $10 trillion of negative yielding sovereign debt outside of the U.S., foreign demand for Treasuries has capped how high yields can go on 10- and 30-year Treasuries. Secondly, the Fed’s shift in monetary policy raised market confidence that it would indeed be able to curb inflation and reduce inflationary expectations. This helps keep the overall level of long-term interest rates relatively low. So ironically, higher short-term interest rates reassured markets and resulted in less high intermediate and long-term yields.
Exhibit 4: Index Total Returns
But that calm was replaced with significant volatility in the first week of January, when the release of the December Fed minutes showed officials were contemplating not just a faster pace of rate hikes than many expected, but also how they could shrink the Fed’s holdings of Treasury and mortgage-backed securities. The central bank’s balance sheet has more than doubled from $4.1 trillion to over $8.7 trillion in the past two years and reducing it would draw excess cash out of the financial system. Market speculation around rate rises suddenly went from whether there would be two or three hikes this year, to whether there would be three or four.
Ideally, the Fed would like to increase the federal funds rate gradually and smoothly over the next two to three years, from 0% to 2.5%. However, we doubt all the factors needed for this will fall into place. As a result, we could see dramatic moves up and down in rates, depending on how the Fed reacts to inflation. Our range for the 10-year Treasury yield is a high of 2.5% and potentially as low as 1.25% during the year. We believe the yield will most likely end the year between 2.0% and 2.25%. Although we will likely see some periods of yield curve steepening, we expect the difference between the two-year and 10-year yields to narrow, resulting in a flatter yield curve for 2022.
Muted Outperformance of Credit
Corporate bonds delivered mixed returns in 2021, with lower quality credit generating the best performance. The combination of strong corporate earnings, low bankruptcies and defaults, and insatiable global demand for higher-yielding asset classes pushed yields lower on the weakest corporate debt. However, high quality corporate bond yields rose, given their higher correlation with Treasuries. The total return on the Bloomberg Investment Grade Corporate Index was -1.0%, versus a total return of 5.4% for the Merrill Lynch High Yield Corporate Bond Index.
Exhibit 5: Corporate High Grade vs High Yield Returns
The dispersion in returns is even more impressive considering it was a record year for high yield new issuance. High yield corporate supply came in at $505 billion, surpassing 2020’s record $440 billion, and including a record number of first-time high yield public debt issuers. The investment grade corporate bond market’s $1.5 trillion new issuance fell short of 2020’s record $1.9 trillion but ranks as the second highest on record. Clearly, corporations continued to take advantage of the low cost of capital, and this is something we also continue to encourage our wealth management clients to consider.
We anticipate corporate bond supply to decrease in 2022, mainly due to slightly higher interest rates and the fact that most companies have already taken advantage of historically low borrowing costs. We are also more upbeat for floating rate high yield to once again outperform fixed rate high yield, given the lower sensitivity of floating rate loans to an increase in the Federal funds rate.
Exhibit 6: Fixed Income Supply
Credit markets should continue to outperform Treasuries in 2022, with a strong economy and a healthy consumer base expected to fuel corporate earnings, as well as lower default and bankruptcy rates in higher quality corporates. However, outperformance versus Treasuries is likely to be more muted in 2022, given how much credit spreads have already tightened. This is especially true for high yield corporate bonds. We think 2022 will be more of a “carry” year, with total return coming more from coupons and less from price appreciation arising from a tightening of credit spreads over Treasury yields.
Cautiously Optimistic about Municipal Bonds
The municipal bond market had a comeback year in 2021 and delivered better total returns than the Treasury market. Two themes drove results: strong demand and improved credit quality. Municipal bonds attracted a record-setting $96 billion in flows into open-end municipal bond mutual funds and ETFs, surpassing the previous record of $93 billion in 2019. Flows turned positive in May of 2020 and continued throughout 2021, with demand buoyed by the potential for higher taxes as well as a vastly improved credit profile for municipalities and states.
Exhibit 7: Municipal Fund Flows
Municipal bond new issuance in 2021 was just slightly higher than the previous year at $475 billion versus $474 billion in 2020, but clearly demand outpaced supply. Tax-exempt municipal bond supply finished the year at $342 billion, slightly higher than 2020’s $328 billion. Taxable municipal bond issuance declined largely because the increase in Treasury yields pushed up the borrowing costs for taxable municipal bond issuers, making refinancing less attractive. Taxable municipal supply was only $118 billion compared to $146 billion in 2020.
Demand was particularly acute for higher yielding, lower credit quality and longer maturity municipal bonds. The total return of lower credit quality BBB-rated municipal bonds significantly outperformed the highest quality AAA-rated municipal securities, up 4.6% compared to 0.5%. Also, within the Bloomberg Municipal Bond Index, the longest maturity municipals significantly outperformed shorter maturities, with the long bond (22+ years) returning 3.2% compared to 0.4% for the 3-year maturity.
We expect municipal bonds to outperform Treasury bonds in 2022, but not to the same degree as 2021. We remain cautiously optimistic about the asset class. Improved credit fundamentals are already reflected in market trading, so we see less opportunity for credit spreads to tighten materially beyond already narrow levels. Also, the municipal yield curve has already flattened, so the likelihood of generating as strong total returns on longer-dated municipal bonds seems low. That said, demand for municipal bonds should remain robust, as the sector is still viewed as one of the last tax havens for individuals in the highest tax-bracket.
Strong economic growth and stimulus from the federal government during the pandemic has been a powerful windfall for both states and localities and has given them their strongest credit profiles in decades. The black clouds that threatened the municipal market in the spring of 2020 have completely disappeared. Annual year-over-year revenues for many general obligation issuers are up double digits. Since the beginning of the pandemic, states have received an estimated $600 billion of direct and indirect support from the federal government. Last spring, the federal government directed another $350 billion to states and municipalities when it was obvious that the fiscal condition of most issuers was no longer dire. Local general obligation issuers saw their revenues swell in 2021, as property taxes were buoyed by significantly higher property valuations and transactions.
On the revenue bond side, issuers also fared much better in 2021 than the dire predictions in the summer of 2020. A strong economy has led to a healthy bounce-back in sales tax, transportation and hotel tax revenues, and health care issuers have weathered the initial negative impact of Covid. Acknowledging the improvement, credit agencies removed most of the negative outlooks on issuers in 2021 and issued more upgrades than downgrades.
Exhibit 8: Percent of Upgrades Vs Downgrades by Year
Even the weakest high-profile issuers – such as the states of Illinois and New Jersey, the Metropolitan Transportation Authority of New York, and the Commonwealth of Puerto Rico – have seen significant fiscal improvement. These issuers will need to use this period of sound financial health to address their fiscal challenges in order to avoid budgetary stress over the next several years.
Exhibit 9: State Revenue Collections Beating Original Projections in 2021 and 2022
Correctly predicting the direction and magnitude of interest rate moves and the shape of yield curves can prove to be a humbling process at the best of times, and 2022 will be no exception. We expect more volatility within the fixed income space this year, especially compared with the relative calm in capital markets last year.
Given our outlook for muted fixed income returns in 2022, active management of intermediate maturity, high quality core fixed income portfolios will be key. Diversification of fixed income strategies to include more floating rate high yield and opportunistic funds will also help fixed income remain an important ballast in well diversified investment portfolios.