It’s an overused term, but this has truly been a Goldilocks economic environment for fixed-income markets over the past decade. The U.S. economy has been neither too hot nor too cold, allowing the Federal Reserve to maintain a set of highly accommodative monetary policies. As we look ahead to 2022, a different backdrop is likely to emerge: an economic environment both too hot and too cold.

On the bright side, the post-pandemic reopening has been generating robust gross domestic product growth as goods producers rebuild depleted inventories and consumers spend the billions they saved during the extended economic lockdown. As a result, the U.S. economy may expand roughly 6% this year.

Then again, many speed bumps have risen: parts shortages, supply-chain woes and hard-to-fill jobs requiring higher wages. All these factors are pushing inflation gauges to levels not seen in many years.

It’s not only inflation that’s of concern. These challenges are already having a clear impact on the economy. For example, IHS Markit says the auto industry could have sold five million more vehicles this year were it not for a shortage of semiconductors.

Fed Chairman Jerome Powell and his colleagues contend that the headwinds buffeting the U.S. economy stem from short-term “transitory” factors. If they’re right, a series of monetary policy changes planned for the next 12 to 18 months will be smoothly digested by fixed-income markets. If not, the shift away from monetary stimulus could prove more disruptive than the markets currently anticipate.

The new backdrop portends a possible shift from what we’ve seen since the Great Recession. Since that era, the personal consumption expenditures price index (PCE), the Fed’s preferred inflation gauge, has largely remained below the Fed’s target goal of 2%. As a result, “we’ve seen a long period of extremely accommodative global central bank policies,” says Fran Rodilosso, the head of fixed-income ETF portfolio management at VanEck. “The Fed and other central banks have tried to stimulate inflation but have failed and have kept upping the ante in ways never before seen as a series of drastic measures proved insufficient to meet their targets.”

These days, signs of inflation are everywhere you look. Prices for durable goods, commodities and groceries are all on the rise. According to J.D. Power, the average new vehicle cost 19% more in September than it did a year earlier, largely because automakers are focusing their production efforts on the highest-margin vehicles.

In fact, the PCE index has been above 4% in recent months, levels not seen in 30 years, leading to questions about the Fed’s go-slow approach toward a more neutral monetary backdrop. The shift away from quantitative easing means a reduction in bond buying in the coming months, and QE will reach its outright end in the middle of 2022, at which point the Fed’s set of benchmark short-term interest rates are expected to start moving higher.

Kelly Ye, director of research at IndexIQ, says “the Fed’s tone has evolved. Their main themes had been aimed at price stability and maximizing employment. … Now, they remain more squarely focused on maximizing employment.”

Still, she shares Fed chairman Powell’s view that “transitory inflation trends will steadily taper,” she says, noting that “implied forward [interest] rates remain quite stable.”

Rodilosso thinks bond investors have built great faith in the Fed, given longer-term interest rates (such as the yield on 10-year Treasurys), which are only slightly above all-time lows. “The Fed has managed to exert control over the entire yield curve until now [through accommodative policies], but it’s fair to wonder if they can as easily manage the other side of the easing process,” he says.

Shifting from accommodative to neutral monetary policy (and perhaps eventually an even tighter policy) may prove a Herculean challenge. “After all, the Fed’s balance sheet sits north of $7 trillion,” noted Greg Bassuk, the chief executive officer of AXS Investments, in a recent blog post titled “How Federal Reserve Tapering Can Impact Portfolio Decisions.”

Based on the CME Group’s FedWatch tool, markets give it a two-thirds chance that the Fed’s interbank lending rate range will either remain at the current 0% to 0.25% or move up by a quarter point by the end of 2022. That gauge also projects a roughly one-third chance of the fed funds rate moving up to 0.75% to 1.25%.

Karen Schenone, head of fixed-income strategy at iShares, believes that “much of price inflation in areas such as energy, cars and trucks, grocery prices and other items is the result of the post-pandemic economic reopening.” She predicts “we’ll see higher inflation through the end of this year,” and more benign inflation readings in 2022.

Yet some strategists are on guard that inflation could still disrupt fixed-income (and by extension, equity) markets. Harley Bassman, a managing partner at Simplify Asset Management, says that beyond the near-term pressures on prices, there are demographic changes in the population that could also fuel inflation. “If you look out over the past 70 years, the only period of high inflation was when baby boomers entered the workforce and formed new households in large numbers,” he says. Millennials, he adds, are an equally significant demographic force, and their increased spending on houses and other items will pressure prices higher in the same way.

Housing is just one area where a demographic bulge will push up prices. Home prices are now roughly 20% above their levels a year ago, according to the S&P CoreLogic Case-Shiller Home Price Index, as demand clearly outstrips supply. Realtor.com notes that there were roughly 1.4 million homes for sale in the country in 2018. That figure has since fallen by more than half.

But this demographic influence on prices may not necessarily be a bad thing. “The Fed wants a steeper yield curve,” says Bassman, noting that higher long-term interest rates would “support our levered financial system,” as banking and insurance industry profit margins expand. (Net interest margins in the financial services sector expand and contract in tandem with the yield curve.)

Simplify offers a range of ETFs aimed at sideswiping the impact of rising long-term rates. One of these funds is the Simplify Interest Rate Hedge ETF (PFIX), which uses interest rate options to provide “convex exposure to large upward moves in interest rates and interest rate volatility.”

Bassman sees a “strong chance of significantly higher rates” in coming years, resulting from both an uptick in core inflation and a shift away from negative real interest rates toward neutral real rates. Over much of the past century, real rates, or the difference between nominal interest rates and the rate of inflation, had been modestly positive, but they have been mostly negative for much of the past decade.

“The Fed wants that to get back to a 2.0% real rate range,” says iShares’ Schenone, though she adds that it may take a few years for that shift to play out. If she’s right in her expectation that core inflation will move up to 2.5%, then the Fed may eventually hike rates to around 4.5%.

Lisa Hornby, head of U.S. multisector fixed income at Schroders, noted that the Fed used to adhere to the “Taylor rule,” which suggests that in a period of rising inflation, the real interest rate should also rise (acting, in effect, as a multiplier). While the Fed may not push real rates into positive territory anytime soon, Hornby, who spoke in late September, still sees a coming uptick in rates. “We are focused on short-duration bonds. The market has yet to reprice long-term interest rates,” she says.

In Search Of Yields
If and when the yield curve steepens, advisors will once again be offering clients an array of fixed-income ideas with more robust payouts. Until then, it has been a challenge to find decent yields without assuming a lot of risk.

Junk bonds are one area where the risk doesn’t seem to match up with the reward. In early 2019, the effective yield of the ICE BofA U.S. High Yield Index stood at 8%. These days, the yields are at only half that level.

The recent strengthening of the U.S. economy, however, suggests that junk bonds face less default risk. Indeed, Fitch Ratings noted in August that high-yield defaults are on pace to be at their lowest level since 2007 and “could finish below 1% by year’s end.” VanEck’s Rodilosso says “high-yield bonds sport yields that are historically tight [in terms of the spread compared to blue-chip bonds] but many high-yield issuers are on very solid financial footing these days.”

Anders Persson, chief investment officer of global fixed income at Nuveen, says leveraged loans and preferred stocks will also continue to see improvement. “Corporate balance sheets are growing healthier, and ratings agencies are upgrading bond issues, not downgrading them,” he says. Persson thinks this is a good time to shoulder credit risk, favoring “lower quality over higher quality.” He suggests that the Nuveen Preferred Securities and Income Fund (NPSRX), which has more than 80% of its assets invested in the banking and insurance sectors, is ideally positioned to benefit from a firming economy and low bond default rates.

While investment strategists such as Persson suggest positioning fixed-income portfolios for a firming economy, high-yield bonds might move out of favor if signs emerge that the current expansion is starting to wane. Even if the underlying finances of high-yield issuers themselves remain strong, the mere perception that defaults could increase might push high-yield bond prices well lower.

Still, the current junk bond yield at around 4% seems tempting when blue-chip corporate bonds are yielding less than 2.5%. Bassuk at AXS thinks that looking at sub-investment-grade bonds within an environmental, social and governance framework can solve the risks associated with them.

“ESG ratings help identify bond issuers that adhere to good governance practices,” he says, adding that “well-run firms that make smart capital allocation decisions tamp down the risks associated with high yields.” His firm’s AXS Sustainable Income Fund (AXSKX) owns bonds issued by firms that grade well in the context of decarbonization, social responsibility, diversity and inclusion, and transparency and disclosure. The fund currently yields around 4.4%.

“Fallen angels” offer another way of tapping the impressive payouts of high-yield bonds. These bonds were once investment grade, but they were downgraded to junk status by the rating agencies for a variety of problems that might be temporary—perhaps because of a sizable acquisition that put the acquirer’s bonds under review. When that happens, funds that owned the bonds as investment-grade securities must sell the holdings, pushing the bonds down in price. Fallen angel funds benefit by buying these securities when they’re out of favor and unload them once the investment-grade ratings have been restored.

The VanEck Fallen Angel High Yield Bond ETF (ANGL) is the largest in this category, with $5 billion in assets and a 0.35% expense ratio. Morningstar says the five-star rated fund has led its average peer by an annualized 3.6 percentage points over the past nine years.

Kelly Ye at IndexIQ isn’t a big fan of high-yield bonds these days, however, noting that “investors are being forced to take on undue risk” for what are historically low spreads. She adds that investors are likely to continue to shun long-term bonds ahead of a possible rise in interest rates. In the current environment, she focuses more on senior loan funds, which offer decent yields without taking on excess duration risk. Senior loans typically offer higher yields than blue-chip bonds but lower yields than junk bonds, since bank loans are more senior in the capital stack and ranked above all unsecured loans that a firm carries on its books. The SPDR Blackstone Senior Loan ETF (SRLN) is the largest in the category and has a 30-day SEC yield just below 4%, and the average maturity of its bonds is 5.1 years.

Schenone says a rising rate environment can still be beneficial for equities. She also noted in a September blog post that convertible bonds offer some of the upside offered by equity markets and the downside protection of fixed income. The iShares Convertible Bond ETF (ICVT), with $1.7 billion in assets, “is generally less influenced by changes in interest rates than other fixed-income securities,” she says.

Municipal bonds also offer a stop on the carousel of fresh fixed-income ideas. Hornby notes that a potential hike in tax rates in coming months may push more investors toward these bonds—especially since finances at the state and local level are now far stronger than they have been in recent memory, thanks to federal stimulus efforts in 2020 and 2021.

Scratch beneath the surface and you’ll find a variety of fixed-income opportunities still available. While credit risk is not a current concern for many strategists, duration risk surely is, pushing long-term bond funds out of favor.

Yet an uncertain inflation and interest rate backdrop could eventually lead to more respectable payouts among long-term fixed issues. That’s why the playbook is bound to evolve as we head into 2022.