The combination of low yields and high inflation has taken a toll on bond investors this year. This will probably continue in 2022, but there’s still reason to own bonds.
With the stock market near a record high, bonds can help support a portfolio if stocks fall. Experienced fund managers can mitigate the negative impact of inflation and rising interest rates by shortening the durations of their holdings, selecting bonds with higher yields, or finding opportunities abroad. Barron’s looked for funds that returned at least an annualized 8% the last time the Federal Reserve raised rates, from 2016 to mid-2019. This turned up a variety of fund styles, so we spoke with managers about how they’re preparing for 2022.
As inflation reached 6.8% in the past 12 months, the real yields of many bonds—their nominal yields minus the inflation rate—are now in negative territory, meaning that any investment income will be more than wiped out by the rising cost of living. What’s more, in anticipation of rate hikes next year, short-term interest rates have been rising over the past few months, driving bond prices lower as investors opt for newer issuances with higher yields.
This dynamic won’t change soon. Bonds with longer maturities often see their price drop more in response to rising rates because investors in those products would be stuck with the lower yields for longer periods. As a result, one common way to reduce the duration risk—or price sensitivity to interest-rate changes—of a fixed-income portfolio is to tilt toward debt with shorter maturities.
The $1.1 billion Brandywine Global High Yield fund (ticker: BGHIX), for example, has an effective duration of just above three years, compared with the roughly four-year duration of its benchmark index. Similarly, the $3.7 billion Pimco Long-Term Credit Bond fund (PTCIX), which is open only for institutional investors, has been underweight long-maturity bonds with a duration half a year shorter than its benchmark, despite its mandate to generally invest in long-term bonds.
Here We Go Again
These funds performed admirably in 2016 through mid-2019, the last time the Federal Reserve was raising rates.
|Fund / Ticker||Expense Ratio||AUM (bil)||YTD Return||Annualized Return Last Rate-Hike Cycle*|
|BrandywineGlobal High Yield / BGHAX||0.92%||$1.1||5.1%||10.1%|
|Pimco Long-Term Credit Bond / PTCIX||0.59||3.7||-1.1||9.7|
|Invesco Rochester Municipal Opportunities / ORNAX||0.95||10.1||6.7||8.7|
Data through Dec. 28; *from 01/01/2016 to 07/01/2019
Sources: Morningstar; Bloomberg
Still, even in the face of record-level inflation, the Fed’s rate hikes next year probably won’t be too aggressive, since it wants to avoid a recession, says John McClain, co-manager of the Brandywine Global fund. The central bank’s own “dot plot” anticipates that rates will rise to 0.9% by the end of 2022; the futures markets have even lower expectations, at just 0.75%.
That means managers need to reach up the yield ladder for better returns. “If you are well compensated for the credit risk you are bearing, it can offset the negative impact of inflation and increased interest rates,” says Bill Zox, the other co-manager of the Brandywine Global fund.
For the current cycle, funds need to be extra prudent when evaluating credit risk, since the absolute yields are already low and any default can make a meaningful dent in the total return, says Scott Cottier, who manages the $10.1 billion Invesco Rochester Municipal Opportunities fund (ORNAX), a high-yield municipal-bond fund focused on lower-rated or nonrated credit from smaller, lesser-known borrowers. “You really need to pick the right borrowers that will pay you back,” he says.
Zox likes nonbank financial companies such as mortgage originators or consumer-finance providers. Many of them have a healthy balance sheet and a market value that’s eight to 10 times the total debt. But the credit-ratings firms often penalize these issuers for being smaller and newer to the debt market. These bonds can offer high yields of nearly 6%, he told Barron’s: “We find them very attractive.”
Another area of opportunity are sectors directly hurt by the pandemic last year, such as travel, gaming, and live events. Many firms in these industries have seen credit downgrades due to business shutdowns and worsened balance sheets. But McClain believes they’ll generate strong cash flows again in 2022 as the global economy continues to reopen. More important, he notes, because the scars are still so fresh in memory, these companies will probably preserve a lot more liquidity going forward.
Mark Kiesel, portfolio manager of the Pimco Long-Term Credit Bond fund, is closely watching the international bond market, especially emerging markets such as Brazil, Mexico, and South Africa, which experienced inflation six to 12 months before the U.S. The central banks of those countries had already entered an aggressive rate-hiking cycle this past year, and that means they’ll probably see a cooler economy and even falling rates in 2022. “We find some of these emerging markets bonds intriguing, because the rates have already gone up a lot,” says Kiesel.
To hedge against inflation and higher rates, Kiesel has also been adding floating-rate credits, such as bank loans, and sectors with real assets, such as home builders and lumber suppliers.
Invesco’s Cottier also likes the real estate sector, especially muni bonds issued to finance land and infrastructure development—such as sewers, streetlights, and roads—before any residential and commercial properties can be built. These bonds are pretty common in states like Colorado, California, and Florida, he says, and are backed by the property tax paid by the eventual landowners. They can generate yields from 3% to as much as 6%, depending on their size and other conditions.
Despite a generally challenging market for bond investors, Kiesel sees some tailwinds in 2022: Since the stock market has gone up a lot, many pension funds now have a significant overweight in equities and might start to seek rebalancing into bonds to keep their allocation balanced. Kiesel expects to see pension funds come into the bond market six months from now, after the Fed starts to taper and raise rates. If he’s right, this buying force could give bond prices a lift despite rising rates.
Write to Evie Liu at email@example.com