Framing Fixed going into 2022
Many investors are unsure what to do with their fixed income in 2022. They are worried about the Fed raising short-term rates, long-term interest rates rising as the Fed tapers its bond purchases, and elevated inflation potentially persisting for several years. While these are all valid concerns, especially relative to savings account yields near zero and CDs earning approximately 0.6%, fixed income still warrants an allocation in investor portfolios that seek stability. Even so, a passive, plain vanilla approach will likely disappoint in 2022, and even lose money again as it did in 2021. At ACM, we believe a relatively low duration fixed portfolio that is well managed can be constructed to be rate resistant such that the portfolio’s return is not dictated solely by the magnitude of interest rate movements.
Before discussing the 2022 outlook, it is worth briefly discussing what happened in 2021. Last year, the average investment grade bond lost approximately 1%, (before any fees & expenses) as interest rates rose substantially. Notably, the 2-year, 5-year and 10-year Treasury yields rose by 0.6% to 0.9%, which presented an enormous headwind. However, the ACM Private Fixed strategy, which utilizes active management and opportunistic security selection, still delivered positive returns in a rising rate environment. 2021 fixed income returns illustrated three common fixed income misconceptions. First, while the 10-year Treasury rate is the most discussed interest rate, a low duration portfolio is more correlated with the 5-year Treasury rate. They do not necessarily move in tandem as experienced in 2021 when the 5-year Treasury rate rose 0.9% versus the 10-year Treasury which rose only 0.60%. The 0.6% rise in 10-year yields inflicted a greater loss to capital than the 0.9% rise in 5-year yields. Second, the average investment grade bond has a duration of over 8.5 years making it much more sensitive to long-term rate increases, than a moderate duration (~3.5-4.0 years) portfolio. Again, shorter maturities protect portfolio values far more effectively. Third, a rising rate environment does not mean investment grade securities must lose money over a 12-month period. For illustrative purposes, a 2% yield portfolio with a duration of 4.0 years can still generate positive returns even if interest rates increase by up to 0.50%. Even if interest rates rise more than 0.50%, security selection and active management could potentially offset some of the interest rate headwinds.
Regarding investor concerns, the Fed will very likely raise short-term interest rates multiple times in 2022 and the market is now pricing in approximately three rate increases of 0.25% each. This implies a (lower bound for the) Fed funds rate of 0.75%, which is why the 2-year Treasury is now trading at 0.73% versus only 0.12% at the end of 2020. As 2021 progressed, the market realized that the economic recovery combined with inflation pressures would lead to Fed hikes in 2022. Even so, investors need to remember that the Fed’s actions should be judged relative to expectations, not only in absolute terms. Moreover, because the Fed is tapering its purchases of government backed securities, from $120bn/month in October to likely $0 by March 2022 longer term yields may also be impacted, but this is known in the credit markets.
Regarding inflation, the Fed has acknowledged that the inflation triggered by the economic upheaval of the pandemic and the massive fiscal and monetary policy responses is not as transitory as the Fed had hoped. Demand recovered faster than policymakers’ expectations and this combined with a tight labor market to put the Fed in a tough spot. They do not want to hinder economic growth, but they also do not want to allow long-term inflation expectations to be anchored permanently well above their 2.0% target. The Fed remains optimistic that easing supply chain bottlenecks will combine with the Fed’s taper and interest rate increases to mute the long-term inflation outlook. Based on the Fed’s preferred measure, PCE, inflation is expected to decline from 5.7% in Nov. 2021 to 2-3.2% in 2022. Inflation is estimated to further decrease to 2-2.5% in 2023, closer to the long-term target of 2.0%, which we regard as somewhat optimistic. Yet the Fed would likely agree the near-term risk is to the upside.
We will be regularly monitoring the economic data and outlook to navigate this environment as carefully as possible. We believe security selection, active management, and capitalizing on select preferred opportunities provides us with the best opportunity to navigate 2022 as successfully as we did 2021. We remain focused on securities rated BBB/BBB- that we believe present the most compelling risk/reward. Many investors are so thirsty for yield or so afraid of a rising rate environment that they have become focused exclusively on high yield and/or preferred opportunities. While these may have worked well in 2021, investors should be aware that the incremental yield to own high yield instead of investment grade is near 10-year lows. Regarding preferreds, investors must realize that each issue is very different, even amongst the same issuer, and owning low coupon fixed rate preferreds is a recipe for potentially very significant losses. We remain disciplined on not chasing yield via unattractive additional credit or interest rate risk and staying ever mindful of a potentially rising rate environment.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.
