Fixed Income Boutique

Alpha on top of market beta and spreads will drive total fixed income returns in 2022

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In 2022 the ability to generate alpha through bond selection on top of fixed income market beta and market spreads will drive total fixed income returns in an environment of above-target inflation, rising rates and increased volatility. The biggest risks to fixed income markets next year are sudden and big spread widenings, should central banks hike rates faster than expected to keep inflation in check.

Frist off let me say that there is a high chance for inflation peaking in Q1 next year and the bottlenecks on the supply side resolving, in contrast to some market participants who think the Fed is behind the curve already now. Until then, it might feel a little uncomfortable as inflation data will keep rolling in every month and the Fed will have to keep a steady hand as their credibility is at stake. However, Omicron has complicated the overall picture as another economic slowdown looms due to an increasing number of countries taking pre-cautionary measures against the spread of the variant. While new lockdowns could delay the pace of tapering, the effect on inflation is less clear as much depends on the severity of supply and demand effects.  

The Fed has given carte blanche for asset prices to soar in an effort not to choke off growth. This is important because inflation and growth are part of the solution to the debt pile governments have accumulated during the pandemic. At least this is how governments rid themselves of their debt after WW2 when debt-to-GDP ratios had increased massively. Therefore, much depends on whether growth keeps going or not. Inflation coupled with weakening growth is bad news.

The biggest risk to fixed income markets next year is a fast and aggressive steepening of the yield curve triggered by Treasury yields taking big strides which could result in a spread widening across many fixed income segments. This means that bondholders would be hit by a double whammy losing money on the duration and the spread side at the same time. Since the peak of the COVID crisis last year, rates have risen from their lows of 50 bps to 160 bps recently which has meant duration losses, until Omicron rallied rates to 150 bps in an even more recent development. Spreads in some corporate, high-yield, and emerging markets have been tightening as they normalized to pre-pandemic levels presenting investors with attractive carry offsetting losses on the duration side.

The fear is that once Treasury yields go north of 2 or 2.5% due to inflation grinding higher, spreads will have a hard time staying stable. Everything depends on the speed and quantity of the rate move of course, but there is a risk that spreads blow out as investors start unwinding positions if rates climb too fast. Such a scenario could indeed force the Fed's hand to provide accommodative measures since a lot of the liquidity they have injected into the market during the pandemic has gone into spread markets in search for yield.

In any case, next year's market environment is likely to place high demands on fixed income investors. Even if spreads don’t widen and rates stay where they are, many fixed income assets do not have much room to rally. However, some spread markets, like emerging economies, are an exception. Looking at 5-year historical averages, the current spread levels of emerging market high-yield bonds of 600 implies a potential tightening of 200 bps over the next year which could deliver sizeable returns in the lower double-digit space.

Against this background only active managers will be in the position to generate consistent alpha in addition to fixed income market beta. Since the financial crisis investors have had to complement their holdings in “risk-free” securities (govies) with ever increasing allocations to spread products to achieve their return targets. Now, as fixed income markets could be in a sticky place, investors will have to add another layer of alpha to maintain attractive returns. This layer of alpha will come from the ability to take active duration positions and skillful bond selection in segments that provide ample return opportunities arising from market inefficiencies and suboptimal investor behavior.